Chapter 03 Audit Planning, Types of Audit Tests, and Materiality Answer Key

Multiple Choice Questions

14. Hawkins requested permission to communicate with the predecessor auditor and review certain portions of
the predecessor auditor's working papers. The prospective client's refusal to permit this will bear directly on
Hawkins' decision concerning the
A. Adequacy of the preplanned audit program.
B. Ability to establish consistency in application of accounting principles between years.
C. Apparent scope limitation.
D. Integrity of management.

15. In assessing whether to accept a client for an audit engagement, a CPA should consider
A. The current financial health of the prospective client.
B. The integrity of management.
C. The CPA's overall engagement risk.
D. All of the above should be considered.

16. Evaluating a prospective client requires the following step(s):

A. Communicate with the predecessor auditor.
B. Preplan the audit.
C. Establish the terms of the engagement.
D. None of the above.

17. An auditor has withdrawn from an audit engagement of a publicly held company after finding fraud that
may materially affect the financial statements. The auditor should set forth the reasons and findings in
correspondence with the
A. Securities and Exchange Commission.
B. Client's legal counsel.
C. Stock exchanges where the company's stock is traded.
D. Audit committee of the board of directors.

18. When a CPA is approached to perform an audit for the first time, the CPA should make inquiries of the
predecessor auditor. This is a necessary procedure because the predecessor may be able to provide the successor
with information that will assist the successor in determining
A. Whether the predecessor's work should be utilized.
B. Whether, in the predecessor's opinion, the financial statements are materially correct.
C. Whether, in the predecessor's opinion, the company's internal controls have been satisfactory.
D. Whether the engagement should be accepted.

19. Which of the following should an auditor obtain from the predecessor auditor prior to accepting an audit
engagement?
A. Analysis of balance sheet accounts.
B. Analysis of income statement accounts.
C. All matters of continuing accounting significance.
D. Facts that might bear on management integrity.

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20. Which of the following factors most likely would cause a CPA not to accept a new audit engagement?
A. The prospective client's unwillingness to permit inquiry of its legal counsel.
B. The inability to review the predecessor auditor's documentation.
C. The CPA's lack of understanding of the prospective client's operations and industry.
D. Indications that management has not investigated employees in key positions before hiring them.

21. An auditor who discovers that a client's employees paid small bribes to municipal officials most likely
would withdraw from the engagement if
A. The payments violated the client's policies regarding the prevention of illegal acts.
B. The client receives financial assistance from a federal government agency.
C. Documentation that is necessary to prove that the bribes were paid does not exist.
D. Management fails to take the appropriate remedial action.

22. A successor auditor should request the new client to authorize the predecessor auditor to allow a review of
the predecessor's
A. Engagement letter.
B. Audit working papers.
C. Engagement letter and audit working papers.
D. It would not be typical to allow a review of either the engagement letter or the audit working papers.

23. Evaluating a prospective client requires the following step(s):

A. Communicate with the SEC.
B. Preplan the audit.
C. Determine if the firm is independent of the client.
D. Communicate with the AICPA.

24. Which of the following factors most likely would lead a CPA to conclude that a potential audit engagement
should be rejected?
A. The details of most recorded transactions are not available after a specified period of time.
B. Internal control activities requiring segregation of duties are subject to management override.
C. It is unlikely that sufficient appropriate evidence is available to support an opinion on the financial
statements.
D. Management has a reputation for consulting with several accounting firms about significant accounting
issues.

25. Which of the following factors most likely would cause a CPA to decide not to accept a new audit
engagement?
A. The CPA's lack of understanding of the prospective client's internal auditor's computer-assisted audit
techniques.
B. Management's disregard of its responsibility to maintain an adequate control environment.
C. The CPA's inability to determine whether related party transactions were consummated on terms equivalent
to arm's-length transactions.
D. Management's refusal to permit the CPA to perform substantive procedures before the year-end.

26. Before accepting an engagement to audit a new client, a CPA is required to obtain
A. An understanding of the prospective client's industry and business.
B. The prospective client's signature on the engagement letter.
C. A preliminary understanding of the prospective client's control environment.
D. The prospective client's consent to make inquiries of the predecessor auditor, if any.

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27. Which of the following situations would most likely require special audit planning?
A. Some items of factory and office equipment do not bear identification numbers.
B. Depreciation methods used on the client's tax return differ from those used on the books.
C. Assets costing less than $500 are expensed even though the expected life exceeds one year.
D. Inventory is comprised of precious stones.28. During the initial planning phase of an audit, a CPA most
likely would
A. Identify specific internal control activities that are likely to prevent fraud.
B. Evaluate the reasonableness of the client's accounting estimates.
C. Discuss the timing of the audit procedures with the client's management.
D. Inquire of the client's attorney as to any unrecorded claims.

29. An auditor is required to establish an understanding with a client regarding the responsibilities for each
engagement. This understanding generally includes
A. Management's responsibility to guarantee that there are no material misstatements due to fraud.
B. The auditor's responsibility to plan and perform the audit to provide reasonable, but not absolute, assurance
of detecting material errors or fraud.
C. Management's responsibility for providing the auditor with an assessment of the risk of material
misstatement due to fraud.
D. The auditor's responsibility for the fairness of the financial statements.

30. A written understanding between the auditor and the client concerning the auditor's responsibility for the
discovery of illegal acts is usually set forth in a(n)
A. Client representation letter.
B. Letter of audit inquiry.
C. Management letter.
D. Engagement letter.

31. Engagement letters include all of the following except:

A. A list of additional services that will be provided.
B. A list of adjusting journal entries.
C. Information about the audit fee.
D. Arrangements involving the use of specialists.

32. Which of the following matters generally is included in an auditor's engagement letter?
A. Management's responsibility for the entity's compliance with laws and regulations.
B. The factors to be considered in setting preliminary judgments about materiality.
C. Management's liability for illegal acts committed by its employees.
D. The auditor's responsibility to guarantee accuracy of the financial statements.

33. To provide for the greatest degree of independence in performing internal audit functions, an internal auditor
most likely should report to the
A. Vice-President - Finance
B. Corporate controller.
C. Audit committee of the board of directors.
D. Corporate stockholders.

34. All of the following refer to an internal auditor's competence except:

A. The party in the entity to which the internal auditor reports.
B. The quality of internal audit documents and reports.
C. Professional certification.
D. Supervision and review of internal audit activities.
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35. An independent auditor might consider the procedures performed by the internal auditors because
A. They are employees whose work must be reviewed during substantive testing.
B. They are employees whose work might be relied upon.
C. Their work impacts the cost/benefit tradeoff in evaluating inherent limitations.
D. Their degree of independence may be inferred by the nature of their work.

36. As generally conceived, the audit committee of a publicly held company should be made up of
A. Representatives of the major equity interests (preferred stock, common stock).
B. The audit partner, the chief financial officer, the legal counsel, and at least one outsider.
C. Representatives from the client's management, investors, suppliers, and customers.
D. Members of the board of directors who are not officers or employees.

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37. To emphasize auditor independence from management, publicly traded corporations are required to
A. Appoint a partner of the CPA firm conducting the examination to the corporation's audit committee.
B. Establish a policy of discouraging social contact between employees of the corporation and the independent
auditors.
C. Request that a representative of the independent auditor be on hand at the annual stockholders' meeting.
D. Have the independent auditor report to an audit committee of independent members of the board of directors.

38. An auditor obtains knowledge about a new client's business and its industry in order to
A. Make constructive suggestions concerning improvements to the client's internal control.
B. Develop an attitude of professional skepticism concerning management's financial statement assertions.
C. Evaluate whether the aggregation of known misstatements causes the financial statements taken as a whole
to be materially misstated.
D. Understand the events and transactions that may have an effect on the client's financial statements.

39. Which of the following is an example of a related party transaction?

A. An action is taken by the directors of Company A to provide additional compensation for vice presidents in
charge of the principal business functions of Company A.
B. A long-term agreement is made by Company A to provide merchandise or services to Company B, a long-
time, friendly competitor.
C. A short-term loan is granted to Company A by a bank that has a depositor who is a member of the board of
directors of Company A.
D. A nonmonetary exchange occurs whereby Company A exchanges property for similar property owned by
Company B, an unconsolidated subsidiary of Company A.

40. An independent auditor finds that Holdaway Corporation occupies office space, at no charge, in an office
building owned by a shareholder. This finding likely indicates the existence of
A. Management fraud.
B. Related party transactions.
C. Window dressing.
D. Weak internal control.

41. Which of the following would not necessarily be a related party transaction?
A. Sales to another corporation with a similar name.
B. Purchases from another corporation that is controlled by the corporation's chief stockholder.
C. Loan from the corporation to a major stockholder.
D. Sale of land to the corporation by the spouse of a director.

42. The existence of a related party transaction may be indicated when another entity
A. Sells real estate to the corporation at a price that is comparable to its appraised value.
B. Absorbs expenses of the corporation under audit.
C. Borrows from the corporation at a rate of interest which equals the current market rate.
D. Lends to the corporation at a rate of interest which equals the current market rate.

43. In the context of an audit of financial statements, substantive procedures are audit procedures that
A. May be eliminated under certain conditions.
B. Are primarily designed to discover significant subsequent events.
C. May be either tests of details of transactions, tests of details of account balances, or analytical procedures.
D. Will increase proportionately with an increase in the auditor's reliance on internal control.

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44. Which of the following is not an audit procedure that is commonly used in performing tests of controls?
A. Inquiring.
B. Observing.
C. Confirming.
D. Inspecting.

45. Tolerable misstatement is

A. Materiality allocated to an assertion.
B. Materiality for the balance sheet as a whole.
C. Materiality for the income statement as a whole.
D. Materiality allocated to a specific account.

46. Which of the following would an auditor most likely use in determining the auditor's planning materiality?
A. The anticipated sample size for planned substantive procedures.
B. The entity's annualized interim (i.e. quarterly) financial statements.
C. The results of the internal control questionnaire.
D. The contents of the management representation letter.

47. Which of the following is not a qualitative factor that may affect an auditor's establishment of materiality?
A. Potential for fraud.
B. The company is close to violating loan covenants.
C. Firm policy sets materiality at 4% of pretax income.
D. A small misstatement would interrupt an earnings trend.

48. Which of the following is not a concern as to whether a misstatement is qualitatively material?
A. The misstatement hides a failure to meet analysts' expectations.
B. The misstatement is less than 5% of pretax income.
C. The misstatement increases management's compensation.
D. The misstatement changes a small amount of profit to a small reported loss.

49. In assessing the competence of an internal auditor, an independent CPA most likely would obtain
information about the
A. Quality of the internal auditor's work.
B. Organization's commitment to integrity and ethical values.
C. Influence of management on the scope of the internal auditor's duties.
D. Organizational levels to which the internal auditor reports.

50. Which of the following procedures would an auditor most likely include in the initial planning of a financial
statement audit?
A. Perform detailed testing of the individual balance sheet accounts.
B. Examining documents to detect illegal acts having a material effect on the financial statements.
C. Considering whether the client's accounting estimates are reasonable in the circumstances.
D. Determining the extent of involvement of the client's internal auditors.

51. The in-charge auditor most likely would have a supervisory responsibility to explain to the staff assistants
A. That immaterial fraud is not to be reported to the client's audit committee.
B. How the results of various auditing procedures performed by the assistants should be evaluated.
C. How the overall audit strategy will allow the firm to reach a sufficiently low level of audit risk.
D. How overall materiality was selected.

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52. Which of the following audit procedures would be least likely to disclose the existence of related party
transactions of a client during the period under audit?
A. Reading "conflict-of-interest" statements obtained by the client from its management.
B. Scanning accounting records for large transactions at or just prior to the end of the period under audit.
C. Reading minutes of the Board of Directors meetings for authorization or discussion of material transactions.
D. Confirming purchases and sales transactions with the vendors and/or customers involved.

53. A dual-purpose test

A. Simultaneously tests debits and credits.
B. Is a procedure completed by both the internal and external auditors.
C. Is useful to both the entity and the auditor.
D. Is both a substantive test of transactions and a test of controls.

54. The element of the audit planning process most likely to be agreed upon with the client before
implementation of the audit strategy is the determination of the
A. Methods of statistical sampling to be used in confirming accounts receivable.
B. Pending legal matters to be included in the inquiry of the client's attorney.
C. Evidence to be gathered to provide a sufficient basis for the auditor's opinion.
D. Timing of the audit.

55. The audit client's board of directors and audit committee refused to take any action with respect to an
immaterial illegal act which was brought to their attention by the auditor. Because of their failure to act, the
auditor withdrew from the engagement. The auditor's decision to withdraw was primarily due to doubts
concerning
A. Adequate financial statement disclosures.
B. Compliance with the statutory laws and regulations.
C. Scope limitations resulting from their inaction.
D. The integrity of management.

56. Which of the following procedures would an auditor most likely include in the initial planning of an
examination of financial statements?
A. Assess the need for the use of specialists in the audit.
B. Inquiring of the client's attorney as to any claims that are likely to be asserted.
C. Perform detailed testing of the individual financial statement accounts.
D. Determining whether necessary internal controls procedures are being applied as prescribed.

57. An entity's financial statements were misstated over a period of years due to large amounts of revenue being
recorded in journal entries that involved debits and credits to an illogical combination of accounts. The auditor
could most likely have been alerted to this fraud by
A. Scanning the general journal for unusual entries.
B. Performing a revenue cutoff test at year-end.
C. Tracing a sample of journal entries to the general ledger.
D. Examining documentary evidence of sales returns and allowances recorded after year-end.

58. Under the Sarbanes-Oxley Act, the audit committee of a public company has the following requirement(s):
A. Each member of the committee must be a board member and shall be independent.
B. The audit committee must preapprove all audit and nonaudit services.
C. The audit committee must establish and maintain procedures to handle all issues that relate to accounting,
internal control, and auditing.
D. All of the above.
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59. Which of the following is a general audit test?
A. Fee assessment procedures.
B. Tests of controls.
C. Preparation of corporate tax returns.
D. Active testing procedures.

60. Which of the following arranges the general types of audit tests in the order they are normally performed in
an audit?
A. Substantive procedures, tests of controls, and risk assessment procedures.
B. Substantive procedures, risk assessment procedures, and tests of controls.
C. Risk assessment procedures, tests of controls, and substantive procedures.
D. Risk assessment procedures, substantive procedures, and tests of controls.

61. Which of the following relatively small misstatements most likely would have a material effect on an
entity's financial statements?
A. An illegal payment to a foreign official that was not recorded.
B. A piece of obsolete office equipment that was not retired.
C. A petty cash fund disbursement that was not properly authorized.
D. An uncollectible account receivable that was not written-off.

62. Which of the following is the most important qualitative factor that auditors should consider when making
materiality judgments?
A. A misstatement exceeded five percent of net income.
B. The auditor also provides consulting services to the audit client.
C. The misstatement will cause the client to fail to meet an earnings forecast.
D. The audit committee is not well-educated about the accounting principle in question.

63. Which element(s) is/are pervasive to the application of generally accepted auditing standards, particularly
the standards of fieldwork and reporting?
A. The elements of materiality and audit risk.
B. The element of internal control.
C. The element of corroborating evidence.
D. The element of reasonable assurance.

64. Which of the following statements is not correct about materiality?

A. The concept of materiality recognizes that some matters are important for fair presentation of financial
statements in conformity with GAAP, while other matters are not important.
B. An auditor considers materiality for the aggregate level of misstatements that could be material to any one of
the financial statements individually.
C. Materiality judgments are made in light of surrounding circumstances and necessarily involve both
quantitative and qualitative judgments.
D. An auditor's consideration of materiality is influenced by the auditor's perception of the needs of a
reasonable person who will rely on the financial statements.

Short Answer Questions

65. Cart and Blanche, a regional accounting firm is determining whether it wants to accept a new client,
Ivy Photos. Ivy Photos is currently a privately held photography studio operating 24 studios in several
states, but the company's management is planning an Initial Public Offering in the near future. This is
the company's first audit. What steps should Cart and Blanche take in evaluating this new client?

To evaluate the client, the auditors should obtain and review available financial information and should inquire
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of third parties about any information concerning the integrity of the prospective client and its management.
These inquiries should be directed to the prospective client's bankers and attorneys, credit agencies, and other
members of the business community who may have such knowledge. The auditor should also consider whether
the prospective client has any circumstances that will require special attention or that may represent unusual
business or audit risks, such as litigation or going concern problems. The auditor should also determine if Cart
and Blanche is independent of Ivy Photos and has the necessary technical skills and knowledge of the industry
to complete the engagement. Finally, Cart and Blanche needs to determine if acceptance of the client would
violate any applicable regulatory agency requirements or the Code of Professional Conduct.

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66. Define the engagement letter and discuss its importance.

An engagement letter formalizes the arrangement reached between the auditor and the client. This letter serves
as a contract, outlining the responsibilities of both parties and preventing misunderstandings between the two
parties.

67. BDK Accounting is auditing a new client, A La Carte Catering. BDK could save audit time by using
work from A La Carte's internal audit staff. The staff consists of three accountants with public
accounting experience and certification. A La Carte requires every member of its accounting department
to spend two out of every five years on the internal audit staff. Then, the employee is rotated back into
the accounting department for a couple of years. What factors should BDK consider when determining
whether or not it can use work of the internal audit staff? In this case, what should BDK decide?

The major issue for BDK is the competence and objectivity of the internal auditors and the effect of their work
on the audit. A La Carte's internal audit staff seems competent, as all of its auditors are certified. However, BDK
should seriously question how objective the audit staff is. All of the internal auditors are also associated with
other positions within the company. Further, all of the auditors are from the accounting department, so none of
them could objectively audit the accounting area they worked in. To maintain independence, BDK would not be
able to use the work of the internal audit staff in place of BDK's work.

68. Name three Sarbanes-Oxley Act requirements of the members and duties of the audit committee of a
public company.

Students must provide three of the following:

1. Each member of the audit committee must be a member of the board of directors and must be independent.
2. The audit committee is directly responsible for the appointment, compensation, and oversight of the work of
any registered public accounting firm employed by the company.
3. The audit committee must preapprove all audit and nonaudit services provided by its auditor.
4. The audit committee must establish procedures for the receipt, retention, and treatment of complaints
received by the company regarding accounting, internal control, and auditing.
5. Each audit committee member must have the authority to engage independent counsel or other advisors as he
or she deems necessary to carry out his or her duties.

69. How would an auditor identify related parties and what is the importance of doing so?

Transactions between an entity and any related parties may not be made at "arms length." Accordingly, the
auditor must scrutinize such transactions and ensure proper disclosures regarding related parties are made in
accordance with GAAP. The auditor can identify related parties by evaluating the client's procedures for
identifying related parties, requesting a list of related parties from management and for publicly traded clients,
reviewing filings with the Securities and Exchange Commission and other regulatory agencies. It is important
that the auditor attempts to identify all related parties during the planning phase of the audit so that the auditor
can properly plan for evaluating transactions that may have occurred between the entity and any related parties.

70. In the planning stages of an audit, what information does an auditor gain through analytical
procedures?
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An auditor is required to apply analytical procedures at the planning phase for all audits. In the planning phase,
analytical procedures help the auditor to understand the client's business and transactions. Analytical procedures
also guide the auditor towards financial statement accounts that are likely to contain errors. With this
information, the auditor is able to plan the nature, timing, and extent of audit procedures.

71. Discuss the purposes for planning the audit and identify the steps that are performed during this
phase of the engagement.

Engagement planning involves all the issues the auditor should consider in developing an overall strategy for
conducting the audit. The objective of the audit plan is to conduct an effective and efficient audit. This means
that the audit is to be conducted in accordance with auditing standards and that the risk of material
misstatements is reduced to an acceptably low level. The audit plan should also consider how to conduct the
engagement in a cost-effective manner. When preparing the audit plan, the auditor should be guided by the
results of the risk assessment and procedures performed to gain and support the understanding of the entity.
Additional steps that should be performed include:

1. Assess a preliminary level for control risk by account and assertion.

2. Assess the possibility of illegal acts.
3. Identify related parties.
4. Conduct preliminary analytical procedures.
5. Develop an overall audit strategy and prepare audit programs.
6. Consider additional value-added services.

72. Name and describe three supervisory activities that should be performed by the engagement partner
and other engagement team members performing supervisory activities.

Student's examples may vary:

Inform engagement team members of their responsibilities including 1) the objectives of the planned
procedures, 2) the nature, timing, and extent of planned procedures, and 3) matters that could affect the
procedures to be performed or the evaluation of the results of procedures.
Direct engagement team members to bring significant accounting and auditing issues they identify to the
attention of supervisory engagement team members.
Review the work of engagement team members to evaluate 1) the work performed and documented, 2) the
objectives of the procedures were achieved, and 3) the results of the work support the conclusions reached.

73. Name the three types of analytical procedures and provide a definition and example for each.

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The three types of analytical procedures are trend analysis, ratio analysis, and reasonableness analysis.

Student's examples may vary:

Trend analysis involves the examination of changes in an account over time. For instance, an auditor might
examine the client's revenue over a period of ten years to see if the trend is consistent with the auditor's
expectation.
Ratio analysis is the comparison, across time or to a benchmark, of relationships between financial statement
accounts or between an account and nonfinancial data. As an example, an auditor could compare the client's
inventory turnover for the current and prior year to industry results to test for obsolescence.
Reasonableness analysis is the development of a model to form an expectation using financial data, nonfinancial
data, or both, to test account balances or changes in account balances between accounting periods. For example,
an auditor might test revenue against an expectation formed using standard prices and the number of recorded
sales.

74. Often in an audit, total combined tolerable misstatement is greater than overall materiality. Why is
this the case?

Answers may vary, but could include:

1. Not all accounts will be misstated by the full amount of their tolerable misstatement allocation.
2. Audits of the individual accounts are conducted simultaneously. If accounts were audited sequentially,
unadjusted misstatements observed during testing would count against materiality and, theoretically, the auditor
could carry the unused portion of materiality to the next account, and so forth.
3. When control weaknesses or misstatements are identified in an account, the auditors typically perform
additional procedures in that and related accounts. Thus, the actual testing will often achieve a much smaller
margin for misstatement than planned tolerable misstatement.
4. Overall financial statement materiality serves as a "safety net." If individual misstatements in accounts are
below their tolerable misstatement, but the aggregate of the misstatements is greater than materiality, an
adjustment will need to be made.

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