Auditing A Business Risk Approach with Cases 8th Edition By Rittenberg – Test Bank

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Auditing A Business Risk Approach with Cases 8th Edition By Rittenberg – Test Bank

Chapter 5: Internal Control over Financial Reporting

Student: ___________________________________________________________________________

  1. Internal control is a process designed to guarantee the achievement of the objectives of reliable financial reporting, compliance with laws and regulations and ineffective and inefficient operations.
    True    False

 

  1. Auditing standards require that the auditor exercise professional judgment and maintain professional skepticism throughout the planning and performance of the audit.
    True    False

 

  1. If internal controls are not enforced they are useless and can lead to waste and fraud.
    True    False

 

  1. If an organization is too lenient in its treatment of employees who committed fraud, the control environment will be seen as stronger than if the treatment were harsher.
    True    False

 

  1. Weakness in the tone at the top have been associated with most financial frauds during the past decade.
    True    False

 

  1. Virtually all major financial frauds from the past decade were associated with organizations that had weaknesses in the control environment
    True    False

 

  1. Internal control is a process designed to provide reasonable assurance regarding the achievement of the objectives of reliable financial reporting, compliance with laws and regulations and effective and efficient operations, and safeguarding of the assets.
    True    False

 

  1. The quality of an organization’s internal control will affect both the audit approach and the amount of testing needed for an engagement.
    True    False

 

  1. Control activities are the policies and procedures that are established to assist in accomplishing objectives and to mitigate risks.
    True    False

 

  1. Computer controls that are pervasive and affect every computerized system are referred as application controls.
    True    False

 

  1. Control is considered to be part of corporate governance.
    True    False

 

  1. Good control means that risks are identified and dealt with effectively.
    True    False

 

  1. Investors do not place much value on the internal control of the companies in which they invest.
    True    False

 

  1. The PCAOB, in Auditing Standard No. 5, indicates that auditors should use a “bottom-up approach” that begins at the financial statement level.
    True    False

 

  1. Internal control is applied across all activities of the organization.
    True    False

 

  1. The more effective the quality of internal control, the lower the control risk.
    True    False

 

  1. The five major components of an organization’s internal control are: the control environment, risk assessment, control activities, information and communication, and materiality.
    True    False

 

  1. A company’s internal auditing practices should not be considered when assessing control risk.
    True    False

 

  1. An organization’s control environment is established and maintained by the internal auditing department.
    True    False

 

  1. Authorization Procedures include that all senior members of the accounting department have the authority to record any transaction.
    True    False

 

  1. Physical controls are necessary to protect and safeguard assets from accidental or intentional destruction and theft.
    True    False

 

  1. Monitoring of the internal controls involves assessment by appropriate personnel of the design and operation of controls on a timely basis and taking necessary actions.
    True    False

 

  1. An auditor is not required to obtain evidence about the design and operation of the internal controls to reduce the assessment of control risk below maximum.
    True    False

 

  1. Segregation of duties refers to the duties of authorizing a transaction, recording the transaction, and taking physical custody of assets related to the transaction.
    True    False

 

  1. In addition to controls being specific, they may be broad, such as policies regarding a code of ethics.
    True    False

 

  1. Physical controls to safeguard assets are not intended to include simple controls such as fences and locks.
    True    False

 

  1. Self-checking digit algorithms have been developed to test for transposition errors associated with identification numbers.
    True    False

 

  1. When control risk is assessed at a maximum level, the auditor assumes that the internal controls are reliable in preventing or detecting material misstatements.
    True    False

 

  1. When control risk is assessed at a minimum level, the auditor assumes that the internal controls are reliable in preventing or detecting material misstatements.
    True    False

 

  1. Performing a walk-through provides an auditor an understanding of the nature of processing in important accounting applications.
    True    False

 

  1. The payroll department should be responsible for signing payroll checks.
    True    False

 

  1. A strong control environment can reduce all the financial reporting risks to zero.
    True    False

 

  1. The auditor’s preliminary assessment of control risk is based on an understanding of the control system as it has operated in the past and is designed to operate.
    True    False

 

  1. When control risk is assessed at less than maximum, the auditor must gain assurance that the control procedures are effective.
    True    False

 

  1. The auditor is obligated to report significant deficiencies in the control structure discovered during an audit to the audit committee or its equivalent.
    True    False

 

  1. One of the advantages of a computerized accounting system is that the computerized system eliminates the need for internal controls.
    True    False

 

  1. Transaction-oriented controls should be tested using the guidelines developed for attribute testing utilizing statistical sampling techniques.
    True    False

 

  1. Control risk can be evaluated on a scale from high to low.
    True    False

 

  1. Testing internal control for effectiveness is done in every audit.
    True    False

 

  1. Walkthroughs and inquiries are often used to obtain an understanding of internal controls.
    True    False

 

  1. The auditor should obtain an understanding of whether the client’s controls sufficiently address the risk of material misstatement due to fraud.
    True    False

 

  1. The PCAOB’s requirement is that documentation must be able to be interpreted by an auditor not connected to the engagement.
    True    False

 

  1. When the auditor believes the design of controls of a non-public company is effective but does not test the controls, the auditor can assess control risk as moderate in some circumstances but otherwise it should be assessed as high.
    True    False

 

  1. Transaction oriented controls are designed to operate on every transaction throughout the year.
    True    False

 

  1. An external auditor provides a separate opinion on the effectiveness of internal control for large publicly traded companies.
    True    False

 

  1. One of the components of internal control, monitoring, refers to the process of identifying, capturing, and exchanging information in a timely fashion to enable accomplishment of the organization’s objectives.
    True    False

 

  1. One of the components of internal control, the control environment, is considered pervasive and the auditor should start the evaluation of controls at this level.
    True    False

 

  1. Control activities may be implemented at the organizational level and at the transactional level.
    True    False

 

  1. Internal control objectives are designed to assist the organization in assuring which of the following:
    A. the organization has  effective and efficient operations related to its overall strategy
    B. the activities of the organization are in compliance with applicable laws and regulations
    C. the assets of the organization are safeguarded from theft and fraud
    D. all of the above.

 

  1. There is a high risk, as well as a history, that fraud is instituted through which of the following:
    A. adjusting entries.
    B. closing entries.
    C. unusual journal entries.
    D. all of the above.

 

  1. The quality of an organization’s internal controls affects
    A. the reliability of financial data.
    B. the ability of management to make good decisions.
    C. the ability to sustain an effective business.
    D. all of the above.

 

  1. Internal control is a process designed to achieve objectives in which one of the following categories?
    A. reliability of financial reporting
    B. compliance with applicable laws
    C. ineffectiveness of operations
    D. both A and B

 

  1. Which of the following is not a reason that the auditor must gain an understanding of the client’s internal control system?
    A. to better understand the client, its risks, and how it manages those risks.
    B. to assess control risk and identify the types of financial statement misstatements that are most likely to occur.
    C. to plan direct tests of account balances to determine if misstatements have occurred.
    D. all are reasons why auditors must gain an understanding of the client’s internal control system.

 

  1. Which one of the following groups is interested in an organization’s control structure?
    A. board members
    B. lenders
    C. auditors
    D. all of the above

 

  1. The tone of internal control typically originates internally with:
    A. auditors.
    B. employees.
    C. management.
    D. stockholders.

 

  1. The major components of an organization’s internal control structure consist of all of the following except
    A. control risk.
    B. the control environment.
    C. risk assessment.
    D. control activities.

 

  1. What is management’s primary purpose of effective internal control in an organization?
    A. Obtaining high-quality data for making good business decisions.
    B. Completion of a successful audit for the entity.
    C. Shareholder involvement in the company’s success.
    D. Obtaining profitability and financial strength.

 

  1. Which one of the following components of the system of internal controls sets the tone for the organization?
    A. control risk assessment
    B. control environment
    C. information and communication
    D. monitoring

 

  1. The control environment includes all of the following except
    A. management philosophy and operating style.
    B. methods of assigning authority and responsibility.
    C. personnel policies and practices.
    D. control activities.

 

  1. Which of the following is not one of the seven underlying principles of an effective control environment as developed by COSO?
    A. integrity and ethical values.
    B. management’s philosophy and operating style.
    C. authority and responsibility.
    D. information and communication.

 

  1. One of the major components of an organization’s internal control structure includes:
    A. major new financing.
    B. the financial environment.
    C. risk assessment.
    D. telecommunication equipment.

 

  1. A component of COSO’s internal control system concerns the process of identifying, capturing, and exchanging information in a timely fashion to enable accomplishment of the organization’s objective. This component is called
    A. control activities.
    B. information and communication.
    C. monitoring.
    D. control environment.

 

  1. The PCAOB requires auditors of public companies to perform
    A. a financial statement audit and an attest audit.
    B. a financial statement audit and an assurance audit.
    C. a financial statement audit and agreed upon procedures.
    D. a financial statement audit and an audit of internal control.

 

  1. The control environment includes which of the following?
    A. Control activities.
    B. Management philosophy and operating style.
    C. Assessing activity level risks.
    D. Application level controls.

 

  1. Personnel policies and procedures are designed to ensure that the organization
    A. hires the right people.
    B. complies with federal and state laws in its hiring and retention decisions.
    C. has employees that are properly trained and supervised.
    D. performs all of the above.

 

  1. Management of large public companies is required to report on its internal controls with its financial statements. This report is required to include all of the following except:
    A. its responsibility for control of financial reporting.
    B. the framework used for internal control.
    C. an assessment of the effectiveness of the company’s internal control
    D. the statement that the company is not required to have an audit on internal control.

 

  1. Which one of the following represents a classification of control deficiency by the PCAOB?
    A. A missing control that is required for achievement of objectives.
    B. A control that operates as designed.
    C. A control that ensures the reliability of financial reporting.
    D. An immaterial individual misstatement in internal control.

 

  1. Which one of the following will an audit of a company’s internal control include?
    A. Reliance on client’s internal controls testing.
    B. Sampling of key controls and related testing.
    C. Concluding on the accuracy of income statement balances.
    D. Design of the internal control system by the auditor.

 

  1. All of the following are pervasive computer controls except:
    A. Planning and controlling the data processing function.
    B. Controlling access to equipment, data, and programs.
    C. Ensuring data is accessible to management on a timely basis.
    D. Controlling applications development and changes to programs.

 

  1. The personnel department should be responsible for:
    A. authorization of new employees.
    B. generation of payroll checks.
    C. timekeeping.
    D. all of the above.

 

  1. If the auditor of financial statements understands internal control and assesses control risk as low, it is assumed that internal control:
    A. will be tested to support the assessment.
    B. is not required to be tested as it is considered strong.
    C. is considered relatively weak and will not be tested.
    D. has been assessed erroneously by the auditor.

 

  1. To support an assessment that control risk is low, the auditor of financial statements must:
    A. achieve the same conclusion after appropriately testing internal control.
    B. achieve the same conclusion after appropriately performing substantive procedures.
    C. perform increased substantive procedures in order to compensate for the lower rating.
    D. perform limited substantive procedures as the assessment is justified.

 

  1. Which of the following is an example of a type of control that may be tested?
    A. Interest accrued on notes payable.
    B. Cash surrender value of life insurance classified as long-term asset.
    C. A spreadsheet used to create a pivot table for the summarization of accounts receivable.
    D. Reconciliations performed monthly on accounts.

 

  1. A graphic representation of an accounting application that normally identifies key controls that are effective in achieving specific control policies and procedures is:
    A. an internal control questionnaire.
    B. a flowchart.
    C. an internal control narrative.
    D. a walk-through.

 

  1. Which of the following best represents a walk-through?
    A. The controller reviews the bank reconciliation prepared by the accountant and its resulting journal entries.
    B. The auditor walks the production line to find inefficiencies in the inventory process and reports them to management.
    C. The controller takes a sample of write-offs to ensure they have been adequately documented and recorded.
    D. The auditor traces three purchasing transactions from the purchase order to the financial statement for observation and understanding.

 

  1. The auditor uses a variety of procedures to test whether controls effectively. These procedures may all of the following except:
    A. Take a sample of purchase orders and trace them through the system to determine whether (a) there was proper review of credit, and (b) credit authorization or denial was proper.
    B. Take a sample of recorded items (accounts payable) and send a positive confirmation to the related vendors to determine whether the balance is properly stated.
    C. Take a sample of recorded items (accounts receivable) and trace back to the credit approval process to determine that it was performed appropriately.
    D. Use a computer audit program to read all accounts receivable and develop a print-
    out of all account balances that exceed their credit authorization.

 

  1. Which of the following would result in an adverse report issued by an auditor on an audit of internal control?
    A. The control risk is assessed at a lower level.
    B. The tests of controls support the documented understanding of controls.
    C. There is a material weakness in the design or operation of controls.
    D. A confirmation is not returned by a customer in a timely manner.

 

  1. Physical controls to safeguard assets would include:
    A. hiring only trustworthy cashiers
    B. segregation of duties
    C. locks on the warehouse doors
    D. safety audits on the production-line

 

  1. A financial statement auditor concludes that internal controls over cash are not functioning as designed. She believes that material misstatements to the cash accounts are possible because of the deficiencies. What is the course of action that the auditor will most likely take?
    A. Report the audit to the regulatory agencies of the IRS and SEC.
    B. Develop specific tests for cash balances to determine the extent of misstatement.
    C. Explain to the client that the audit firm will not be able to complete the audit.
    D. Test the internal control over cash.

 

  1. Which one of the following is not a control activity implemented in most accounting systems?
    A. segregation of duties
    B. competent, trustworthy employees
    C. authorization procedures
    D. all of these activities are normally implemented.

 

  1. A material weakness in the design of the operation of controls discovered in an audit of internal controls results in:
    A. A qualified management letter.
    B. An adverse report on internal controls.
    C. The firing of the auditors.
    D. Adjusting audit journal entries.

 

  1. An auditor obtains evidence of the internal control over the accounting system by all of the following except:
    A. performing walkthroughs of the accounting system.
    B. making inquiries of banks and attorneys.
    C. reviewing system flowcharts.
    D. taking plant and operational tours.

 

  1. Which of the following will an auditor perform to better understand a client’s internal control over accounting systems?
    A. An auditor will re-test subsequent year working papers.
    B. An auditor will review previous year working papers.
    C. An auditor will copy previous year working papers.
    D. An auditor will re-draft subsequent year working papers.

 

  1. Internal control is a process affected by the organization’s board of directors, management, and other personnel to provide reasonable assurance of achieving certain objectives. Which of the following does not fit into one of these categories of objectives?
    A. reliability of financial reporting.
    B. compliance with laws and regulations.
    C. continuing existence.
    D. effectiveness and efficiency of operations.

 

  1. Which of the following will an auditor use to document an understanding of internal control?
    A. Checklists, disclosures and procedures.
    B. The audit report, internal control opinions and confirmations.
    C. Workpapers, engagement letters and management representation letters.
    D. Questionnaires, narratives and flowcharts.

 

  1. Which is clearly a test of control?
    A. Confirmation to a customer of an accounts receivable balance.
    B. Examination of a sample of purchase order records for electronic, authenticated, authorization.
    C. Observing the controller’s use of company owned equipment.
    D. Sending a letter to the client’s attorney to determine litigation that is pending between plaintiff and the defendant.

 

  1. An auditor’s test of transaction processing whereby the auditor is evaluating both the operation and effectiveness of controls and the correctness and completeness of processing and posting to an account balance is:
    A. a test of controls.
    B. a substantive test.
    C. a dual-purpose test.
    D. an analytical review procedure.

 

  1. An auditor of a client company that has multiple locations must:
    A. increase control risk to moderate or high.
    B. conclude that independent business units of the consolidation are immaterial.
    C. issue multiple audit reports for each segment of the company.
    D. determine the universal application of controls across the company.

 

  1. In order to further understand internal control, an auditor may use inquiry methods by:
    A. interviewing key employees to gain further insight into the internal control environment.
    B. observing the safeguarding of assets by checking locked doors and safes.
    C. tracing a transaction from the boundary of the organization through to the final reporting.
    D. documenting thoroughly the internal control through the use of narratives.

 

  1. In a large company, who usually actively performs the monitoring of internal control?
    A. Internal auditors
    B. PCAOB
    C. CFO
    D. External auditors

 

  1. Which of the following is not true of internal control as defined by COSO?
    A. it is narrower than internal control over financial reporting.
    B. it is a process that includes all elements of internal control working together.
    C. it includes all the people in the organization.
    D. it starts at the top of the organization in setting a tone.

 

  1. Which of the following is not true of the concepts that are embodied in the COSO framework of internal control?
    A. Internal control relates to the organization’s objectives.
    B. The six components of internal control are logically and operationally intertwined.
    C. Internal control applies across all activities of the organization.
    D. All of the above are important concepts

 

  1. The major components of an organization’s internal controls consists of all of the following except
    A. risk assessment.
    B. control environment.
    C. control activities.
    D. control risk

 

  1. Which of the following is part of the control environment of an organization?
    A. management’s philosophy and operating style.
    B. organizational structure.
    C. human resources.
    D. all of the above

 

  1. When control risk is assessed as high the auditor needs to:
    A. perform more tests of controls.
    B. perform more direct testing of account balances.
    C. perform significantly fewer tests of controls.
    D. perform significantly less testing of account balances.

 

  1. Which of the following is a detective control designed to detect the occurrence of a misstatement?
    A. access controls.
    B. edit controls.
    C. reconciliations.
    D. all of the above are detective controls.

 

  1. A component of COSO’s internal control system concerns the process that provides feedback on the effectiveness of the other components of internal control. This component is called:
    A. information and communication.
    B. monitoring.
    C. control activities.
    D. risk assessment.

 

  1. Internal control

    Define the term “internal control” and identify the major components of an internal control system.

 

 

 

 

 

  1. Control environment

    One of the elements of an organization’s control system is the “control environment.” Identify at least four factors that the auditor should consider when reviewing the control environment and discuss how the auditor would relate this review to the assessment of control risk.

 

 

 

 

 

  1. Understanding internal control

    The auditor identifies four phases or steps in the control risk assessment procedure. Phase I involves obtaining an understanding of the internal control structure. Identify at least four methods the auditor might use in gathering the information and briefly describe each one.

 

 

 

 

 

  1. Documenting internal control understanding

    Auditors must document their understanding and evaluation of the internal control system. Identify and briefly describe the three most commonly used methods for such documentation.

 

 

 

 

 

  1. Integrated audit

    Explain the application of an integrated audit as it relates to regulation. Discuss the reasons that this integrated approach may occur.

 

 

 

 

 

  1. Assessing control risk

    Discuss the impact of control risk assessment on an audit of the financial statements.

 

 

 

 

 

  1. Documenting internal control

    Discuss how an auditor would utilize a client’s flowchart documentation in the audit of financial statements.

 

 

 

 

 

  1. COSO: A Framework for Internal Control

    What is internal control as defined by COSO? Also explain, the other elements of the definition that are important to internal control

 

 

 

 

 

  1. Pervasive control activities

    Discuss what pervasive control activities are and provide an example of at least three.

 

 

 

 

 

  1. Auditor Evaluation of Internal Controls

    What are the steps in integrated audit process?

 

 

 

 

 

  1. IT Controls Integrated into Internal Control Evaluations

    Explain Input Controls

 

 

 

 

 

  1. Relationship of the five internal control components

    The five components of the COSO internal control system are conceptually and logically integrated. List the five components of the model and describe how they are integrated with each other in the internal control process.

    Use the following format:

Components Description
   
   
   
   
   
   
   
   

 

 

 

 

 

 

 

 

Chapter 5: Internal Control over Financial Reporting Key

  1. Internal control is a process designed to guarantee the achievement of the objectives of reliable financial reporting, compliance with laws and regulations and ineffective and inefficient operations.
    FALSE

 

  1. Auditing standards require that the auditor exercise professional judgment and maintain professional skepticism throughout the planning and performance of the audit.
    TRUE

 

  1. If internal controls are not enforced they are useless and can lead to waste and fraud.
    TRUE

 

  1. If an organization is too lenient in its treatment of employees who committed fraud, the control environment will be seen as stronger than if the treatment were harsher.
    FALSE

 

  1. Weakness in the tone at the top have been associated with most financial frauds during the past decade.
    TRUE

 

  1. Virtually all major financial frauds from the past decade were associated with organizations that had weaknesses in the control environment
    TRUE

 

  1. Internal control is a process designed to provide reasonable assurance regarding the achievement of the objectives of reliable financial reporting, compliance with laws and regulations and effective and efficient operations, and safeguarding of the assets.
    TRUE

 

  1. The quality of an organization’s internal control will affect both the audit approach and the amount of testing needed for an engagement.
    TRUE

 

  1. Control activities are the policies and procedures that are established to assist in accomplishing objectives and to mitigate risks.
    TRUE

 

  1. Computer controls that are pervasive and affect every computerized system are referred as application controls.
    FALSE

 

  1. Control is considered to be part of corporate governance.
    TRUE

 

  1. Good control means that risks are identified and dealt with effectively.
    TRUE

 

  1. Investors do not place much value on the internal control of the companies in which they invest.
    FALSE

 

  1. The PCAOB, in Auditing Standard No. 5, indicates that auditors should use a “bottom-up approach” that begins at the financial statement level.
    FALSE

 

  1. Internal control is applied across all activities of the organization.
    TRUE

 

  1. The more effective the quality of internal control, the lower the control risk.
    TRUE

 

  1. The five major components of an organization’s internal control are: the control environment, risk assessment, control activities, information and communication, and materiality.
    FALSE

 

  1. A company’s internal auditing practices should not be considered when assessing control risk.
    FALSE

 

  1. An organization’s control environment is established and maintained by the internal auditing department.
    FALSE

 

  1. Authorization Procedures include that all senior members of the accounting department have the authority to record any transaction.
    FALSE

 

  1. Physical controls are necessary to protect and safeguard assets from accidental or intentional destruction and theft.
    TRUE

 

  1. Monitoring of the internal controls involves assessment by appropriate personnel of the design and operation of controls on a timely basis and taking necessary actions.
    TRUE

 

  1. An auditor is not required to obtain evidence about the design and operation of the internal controls to reduce the assessment of control risk below maximum.
    FALSE

 

  1. Segregation of duties refers to the duties of authorizing a transaction, recording the transaction, and taking physical custody of assets related to the transaction.
    TRUE

 

  1. In addition to controls being specific, they may be broad, such as policies regarding a code of ethics.
    TRUE

 

  1. Physical controls to safeguard assets are not intended to include simple controls such as fences and locks.
    FALSE

 

  1. Self-checking digit algorithms have been developed to test for transposition errors associated with identification numbers.
    TRUE

 

  1. When control risk is assessed at a maximum level, the auditor assumes that the internal controls are reliable in preventing or detecting material misstatements.
    FALSE

 

  1. When control risk is assessed at a minimum level, the auditor assumes that the internal controls are reliable in preventing or detecting material misstatements.
    TRUE

 

  1. Performing a walk-through provides an auditor an understanding of the nature of processing in important accounting applications.
    TRUE

 

  1. The payroll department should be responsible for signing payroll checks.
    FALSE

 

  1. A strong control environment can reduce all the financial reporting risks to zero.
    FALSE

 

  1. The auditor’s preliminary assessment of control risk is based on an understanding of the control system as it has operated in the past and is designed to operate.
    TRUE

 

  1. When control risk is assessed at less than maximum, the auditor must gain assurance that the control procedures are effective.
    TRUE

 

  1. The auditor is obligated to report significant deficiencies in the control structure discovered during an audit to the audit committee or its equivalent.
    TRUE

 

  1. One of the advantages of a computerized accounting system is that the computerized system eliminates the need for internal controls.
    FALSE

 

  1. Transaction-oriented controls should be tested using the guidelines developed for attribute testing utilizing statistical sampling techniques.
    TRUE

 

  1. Control risk can be evaluated on a scale from high to low.
    TRUE

 

  1. Testing internal control for effectiveness is done in every audit.
    FALSE

 

  1. Walkthroughs and inquiries are often used to obtain an understanding of internal controls.
    TRUE

 

  1. The auditor should obtain an understanding of whether the client’s controls sufficiently address the risk of material misstatement due to fraud.
    TRUE

 

  1. The PCAOB’s requirement is that documentation must be able to be interpreted by an auditor not connected to the engagement.
    TRUE

 

  1. When the auditor believes the design of controls of a non-public company is effective but does not test the controls, the auditor can assess control risk as moderate in some circumstances but otherwise it should be assessed as high.
    TRUE

 

  1. Transaction oriented controls are designed to operate on every transaction throughout the year.
    TRUE

 

  1. An external auditor provides a separate opinion on the effectiveness of internal control for large publicly traded companies.
    TRUE

 

  1. One of the components of internal control, monitoring, refers to the process of identifying, capturing, and exchanging information in a timely fashion to enable accomplishment of the organization’s objectives.
    FALSE

 

  1. One of the components of internal control, the control environment, is considered pervasive and the auditor should start the evaluation of controls at this level.
    TRUE

 

  1. Control activities may be implemented at the organizational level and at the transactional level.
    TRUE

 

  1. Internal control objectives are designed to assist the organization in assuring which of the following:
    A.the organization has  effective and efficient operations related to its overall strategy
    B. the activities of the organization are in compliance with applicable laws and regulations
    C. the assets of the organization are safeguarded from theft and fraud
    D. all of the above.

 

  1. There is a high risk, as well as a history, that fraud is instituted through which of the following:
    A.adjusting entries.
    B. closing entries.
    C. unusual journal entries.
    D. all of the above.

 

  1. The quality of an organization’s internal controls affects
    A.the reliability of financial data.
    B. the ability of management to make good decisions.
    C. the ability to sustain an effective business.
    D. all of the above.

 

  1. Internal control is a process designed to achieve objectives in which one of the following categories?
    A.reliability of financial reporting
    B. compliance with applicable laws
    C. ineffectiveness of operations
    D. both A and B

 

  1. Which of the following is not a reason that the auditor must gain an understanding of the client’s internal control system?
    A.to better understand the client, its risks, and how it manages those risks.
    B. to assess control risk and identify the types of financial statement misstatements that are most likely to occur.
    C. to plan direct tests of account balances to determine if misstatements have occurred.
    D. all are reasons why auditors must gain an understanding of the client’s internal control system.

 

  1. Which one of the following groups is interested in an organization’s control structure?
    A.board members
    B. lenders
    C. auditors
    D. all of the above

 

  1. The tone of internal control typically originates internally with:
    A.auditors.
    B. employees.
    C. management.
    D. stockholders.

 

  1. The major components of an organization’s internal control structure consist of all of the following except
    A. control risk.
    B. the control environment.
    C. risk assessment.
    D. control activities.

 

  1. What is management’s primary purpose of effective internal control in an organization?
    A.Obtaining high-quality data for making good business decisions.
    B. Completion of a successful audit for the entity.
    C. Shareholder involvement in the company’s success.
    D. Obtaining profitability and financial strength.

 

  1. Which one of the following components of the system of internal controls sets the tone for the organization?
    A.control risk assessment
    B. control environment
    C. information and communication
    D. monitoring

 

  1. The control environment includes all of the following except
    A. management philosophy and operating style.
    B. methods of assigning authority and responsibility.
    C. personnel policies and practices.
    D. control activities.

 

  1. Which of the following is not one of the seven underlying principles of an effective control environment as developed by COSO?
    A.integrity and ethical values.
    B. management’s philosophy and operating style.
    C. authority and responsibility.
    D. information and communication.

 

  1. One of the major components of an organization’s internal control structure includes:
    A.major new financing.
    B. the financial environment.
    C. risk assessment.
    D. telecommunication equipment.

 

  1. A component of COSO’s internal control system concerns the process of identifying, capturing, and exchanging information in a timely fashion to enable accomplishment of the organization’s objective. This component is called
    A.control activities.
    B. information and communication.
    C. monitoring.
    D. control environment.

 

  1. The PCAOB requires auditors of public companies to perform
    A.a financial statement audit and an attest audit.
    B. a financial statement audit and an assurance audit.
    C. a financial statement audit and agreed upon procedures.
    D. a financial statement audit and an audit of internal control.

 

  1. The control environment includes which of the following?
    A.Control activities.
    B. Management philosophy and operating style.
    C. Assessing activity level risks.
    D. Application level controls.

 

  1. Personnel policies and procedures are designed to ensure that the organization
    A.hires the right people.
    B. complies with federal and state laws in its hiring and retention decisions.
    C. has employees that are properly trained and supervised.
    D. performs all of the above.

 

  1. Management of large public companies is required to report on its internal controls with its financial statements. This report is required to include all of the following except:
    A.its responsibility for control of financial reporting.
    B. the framework used for internal control.
    C. an assessment of the effectiveness of the company’s internal control
    D. the statement that the company is not required to have an audit on internal control.

 

  1. Which one of the following represents a classification of control deficiency by the PCAOB?
    A.A missing control that is required for achievement of objectives.
    B. A control that operates as designed.
    C. A control that ensures the reliability of financial reporting.
    D. An immaterial individual misstatement in internal control.

 

  1. Which one of the following will an audit of a company’s internal control include?
    A.Reliance on client’s internal controls testing.
    B. Sampling of key controls and related testing.
    C. Concluding on the accuracy of income statement balances.
    D. Design of the internal control system by the auditor.

 

  1. All of the following are pervasive computer controls except:
    A. Planning and controlling the data processing function.
    B. Controlling access to equipment, data, and programs.
    C. Ensuring data is accessible to management on a timely basis.
    D. Controlling applications development and changes to programs.

 

  1. The personnel department should be responsible for:
    A.authorization of new employees.
    B. generation of payroll checks.
    C. timekeeping.
    D. all of the above.

 

  1. If the auditor of financial statements understands internal control and assesses control risk as low, it is assumed that internal control:
    A.will be tested to support the assessment.
    B. is not required to be tested as it is considered strong.
    C. is considered relatively weak and will not be tested.
    D. has been assessed erroneously by the auditor.

 

  1. To support an assessment that control risk is low, the auditor of financial statements must:
    A.achieve the same conclusion after appropriately testing internal control.
    B. achieve the same conclusion after appropriately performing substantive procedures.
    C. perform increased substantive procedures in order to compensate for the lower rating.
    D. perform limited substantive procedures as the assessment is justified.

 

  1. Which of the following is an example of a type of control that may be tested?
    A.Interest accrued on notes payable.
    B. Cash surrender value of life insurance classified as long-term asset.
    C. A spreadsheet used to create a pivot table for the summarization of accounts receivable.
    D. Reconciliations performed monthly on accounts.

 

  1. A graphic representation of an accounting application that normally identifies key controls that are effective in achieving specific control policies and procedures is:
    A.an internal control questionnaire.
    B. a flowchart.
    C. an internal control narrative.
    D. a walk-through.

 

  1. Which of the following best represents a walk-through?
    A.The controller reviews the bank reconciliation prepared by the accountant and its resulting journal entries.
    B. The auditor walks the production line to find inefficiencies in the inventory process and reports them to management.
    C. The controller takes a sample of write-offs to ensure they have been adequately documented and recorded.
    D. The auditor traces three purchasing transactions from the purchase order to the financial statement for observation and understanding.

 

  1. The auditor uses a variety of procedures to test whether controls effectively. These procedures may all of the following except:
    A. Take a sample of purchase orders and trace them through the system to determine whether (a) there was proper review of credit, and (b) credit authorization or denial was proper.
    B. Take a sample of recorded items (accounts payable) and send a positive confirmation to the related vendors to determine whether the balance is properly stated.
    C. Take a sample of recorded items (accounts receivable) and trace back to the credit approval process to determine that it was performed appropriately.
    D. Use a computer audit program to read all accounts receivable and develop a print-
    out of all account balances that exceed their credit authorization.

 

  1. Which of the following would result in an adverse report issued by an auditor on an audit of internal control?
    A.The control risk is assessed at a lower level.
    B. The tests of controls support the documented understanding of controls.
    C. There is a material weakness in the design or operation of controls.
    D. A confirmation is not returned by a customer in a timely manner.

 

  1. Physical controls to safeguard assets would include:
    A.hiring only trustworthy cashiers
    B. segregation of duties
    C. locks on the warehouse doors
    D. safety audits on the production-line

 

  1. A financial statement auditor concludes that internal controls over cash are not functioning as designed. She believes that material misstatements to the cash accounts are possible because of the deficiencies. What is the course of action that the auditor will most likely take?
    A.Report the audit to the regulatory agencies of the IRS and SEC.
    B. Develop specific tests for cash balances to determine the extent of misstatement.
    C. Explain to the client that the audit firm will not be able to complete the audit.
    D. Test the internal control over cash.

 

  1. Which one of the following is not a control activity implemented in most accounting systems?
    A.segregation of duties
    B. competent, trustworthy employees
    C. authorization procedures
    D. all of these activities are normally implemented.

 

  1. A material weakness in the design of the operation of controls discovered in an audit of internal controls results in:
    A.A qualified management letter.
    B. An adverse report on internal controls.
    C. The firing of the auditors.
    D. Adjusting audit journal entries.

 

  1. An auditor obtains evidence of the internal control over the accounting system by all of the following except:
    A. performing walkthroughs of the accounting system.
    B. making inquiries of banks and attorneys.
    C. reviewing system flowcharts.
    D. taking plant and operational tours.

 

  1. Which of the following will an auditor perform to better understand a client’s internal control over accounting systems?
    A.An auditor will re-test subsequent year working papers.
    B. An auditor will review previous year working papers.
    C. An auditor will copy previous year working papers.
    D. An auditor will re-draft subsequent year working papers.

 

  1. Internal control is a process affected by the organization’s board of directors, management, and other personnel to provide reasonable assurance of achieving certain objectives. Which of the following does not fit into one of these categories of objectives?
    A.reliability of financial reporting.
    B. compliance with laws and regulations.
    C. continuing existence.
    D. effectiveness and efficiency of operations.

 

  1. Which of the following will an auditor use to document an understanding of internal control?
    A.Checklists, disclosures and procedures.
    B. The audit report, internal control opinions and confirmations.
    C. Workpapers, engagement letters and management representation letters.
    D. Questionnaires, narratives and flowcharts.

 

  1. Which is clearly a test of control?
    A.Confirmation to a customer of an accounts receivable balance.
    B. Examination of a sample of purchase order records for electronic, authenticated, authorization.
    C. Observing the controller’s use of company owned equipment.
    D. Sending a letter to the client’s attorney to determine litigation that is pending between plaintiff and the defendant.

 

  1. An auditor’s test of transaction processing whereby the auditor is evaluating both the operation and effectiveness of controls and the correctness and completeness of processing and posting to an account balance is:
    A.a test of controls.
    B. a substantive test.
    C. a dual-purpose test.
    D. an analytical review procedure.

 

  1. An auditor of a client company that has multiple locations must:
    A.increase control risk to moderate or high.
    B. conclude that independent business units of the consolidation are immaterial.
    C. issue multiple audit reports for each segment of the company.
    D. determine the universal application of controls across the company.

 

  1. In order to further understand internal control, an auditor may use inquiry methods by:
    A.interviewing key employees to gain further insight into the internal control environment.
    B. observing the safeguarding of assets by checking locked doors and safes.
    C. tracing a transaction from the boundary of the organization through to the final reporting.
    D. documenting thoroughly the internal control through the use of narratives.

 

  1. In a large company, who usually actively performs the monitoring of internal control?
    A.Internal auditors
    B. PCAOB
    C. CFO
    D. External auditors

 

  1. Which of the following is not true of internal control as defined by COSO?
    A.it is narrower than internal control over financial reporting.
    B. it is a process that includes all elements of internal control working together.
    C. it includes all the people in the organization.
    D. it starts at the top of the organization in setting a tone.

 

  1. Which of the following is not true of the concepts that are embodied in the COSO framework of internal control?
    A.Internal control relates to the organization’s objectives.
    B. The six components of internal control are logically and operationally intertwined.
    C. Internal control applies across all activities of the organization.
    D. All of the above are important concepts

 

  1. The major components of an organization’s internal controls consists of all of the following except
    A. risk assessment.
    B. control environment.
    C. control activities.
    D. control risk

 

  1. Which of the following is part of the control environment of an organization?
    A.management’s philosophy and operating style.
    B. organizational structure.
    C. human resources.
    D. all of the above

 

  1. When control risk is assessed as high the auditor needs to:
    A.perform more tests of controls.
    B. perform more direct testing of account balances.
    C. perform significantly fewer tests of controls.
    D. perform significantly less testing of account balances.

 

  1. Which of the following is a detective control designed to detect the occurrence of a misstatement?
    A.access controls.
    B. edit controls.
    C. reconciliations.
    D. all of the above are detective controls.

 

  1. A component of COSO’s internal control system concerns the process that provides feedback on the effectiveness of the other components of internal control. This component is called:
    A.information and communication.
    B. monitoring.
    C. control activities.
    D. risk assessment.

 

  1. Internal control

    Define the term “internal control” and identify the major components of an internal control system.

Internal control is defined as a process effected by management to provide reasonable assurance that the following objectives are met:

1. the reliability of financial reporting;
2. compliance with applicable laws and regulations;
3. effectiveness and efficiency of operations; and
4. the safeguarding of assets.
   

The major components of internal control are:

1. control environment;
2. risk assessment;
3. control activities;
4. information and communication; and
5. monitoring.
   

 

  1. Control environment

    One of the elements of an organization’s control system is the “control environment.” Identify at least four factors that the auditor should consider when reviewing the control environment and discuss how the auditor would relate this review to the assessment of control risk.

The factors that an auditor should consider when reviewing the control environment would include:

· management’s philosophy and operating style.
· the entity’s organization structure.
· the functioning of the board of directors and its committees.
· methods of assigning authority and responsibility.
· management’s control methods for monitoring and following up on performance, including internal auditing.
· personnel policies and practices.
· external influences such as bank regulatory agencies.
   

The auditor would examine his or her findings relating to each of the listed factors in determining whether control risk was high, medium or low. For example, if the philosophy of management placed little priority on internal controls the auditor would be concerned about control risk.

 

  1. Understanding internal control

    The auditor identifies four phases or steps in the control risk assessment procedure. Phase I involves obtaining an understanding of the internal control structure. Identify at least four methods the auditor might use in gathering the information and briefly describe each one.

Methods for obtaining an understanding of the internal control structure might include:

· Walkthroughs – Walkthroughs provide an understanding of the nature of processing in important accounting applications. The auditor actually walks a document through the system to determine how the system actually works.
· Inquiries – An auditor interviews key employees to learn about segregation of duties, extent of computer usage, the documents the application generates, and the overall nature of transaction processing.
· Review of accounting manuals and job descriptions – These manuals may contain a description of the accounting policies, a detailed chart of accounts and an outline for processing accounting transactions.
· Plant and operational tours – Tours give an auditor a chance to determine conscientiousness of operational employees. (Such as, are receiving reports filled out as goods are received?)
· Prior year working papers – The evaluation of internal controls is an ongoing process. The auditor may use previous work as a basis for review and update.
   

 

  1. Documenting internal control understanding

    Auditors must document their understanding and evaluation of the internal control system. Identify and briefly describe the three most commonly used methods for such documentation.

The three most commonly used methods for documenting the auditor’s understanding of internal control are:

· Flowcharts – Flowcharts provide a graphic description of an application or a process. Flowcharts can be very detailed or depict a broad overview of an application.
· Questionnaires – Questionnaires present an efficient alternative, or complementary approach, to document the structure. They are designed to gather information by functional area. Questionnaires have the advantage of being fairly simple to use, but yet are comprehensive.
· Narratives – Narratives are usually used as supplements to flowcharts and questionnaires. They may be used to document relatively simple applications or for small-business applications.
   

 

  1. Integrated audit

    Explain the application of an integrated audit as it relates to regulation. Discuss the reasons that this integrated approach may occur.

The Sarbanes-Oxley Act of 2002 requires reporting by management of publicly-held companies on the effectiveness of internal control over financial reporting. The Public Company Accounting Oversight Board (PCAOB) requires the external auditor to perform an integrated audit of the effectiveness of internal controls and financial reporting. In other words, the same auditor must attest to both the financial statements and management’s assertions regarding the effectiveness of internal controls over financial reporting.

Because of the above mentioned regulatory requirements, auditors will perform an audit on both financial statements and internal controls for all public clients.

 

  1. Assessing control risk

    Discuss the impact of control risk assessment on an audit of the financial statements.

An auditor assesses control risk preliminarily by understanding and documenting controls. This includes a walk-through of a sample of key transactions. This understanding aids the auditor in determining the types of misstatements that may be apparent in certain areas of the financial statements. The assessment of control risk is critical in determining the nature, timing and extent of substantive audit procedures to be applied.

Auditors of public companies must report on management’s assertion regarding the effectiveness of internal control.

Auditors of non-public companies must report to management and the board the existence of significant deficiencies in the design or operation of internal controls that are identified in the normal course of the audit. The preliminary assessment of control risk must be supported by tests of controls if assessed below the maximum. When the auditor has decided to establish control risk at the maximum level the auditor is not required to perform tests of controls to document the assessment. The auditor must take care to perform the substantive tests at the maximum levels and to document the findings in the audit documentation.

 

  1. Documenting internal control

    Discuss how an auditor would utilize a client’s flowchart documentation in the audit of financial statements.

A flowchart is a graphic representation of an accounting application or process. The auditor can use the client’s flowcharts to obtain an understanding of the overall accounting system, the various accounting cycles and accounting applications. The flowcharts provide an overview of how documents flow into and out of a computerized application or manual process. An auditor can use client’s flowcharts to identify key controls that are effective in achieving specific control objectives as part of the auditor’s preliminary assessment of control risk.

 

  1. COSO: A Framework for Internal Control

    What is internal control as defined by COSO? Also explain, the other elements of the definition that are important to internal control

COSO defines internal control as a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
(1) reliability of financial reporting,
(2) compliance with applicable laws and regulations, and
(3) effectiveness and efficiency of operations.

The other elements of the definition that are important. They state that internal control:
* Is a process designed to accomplish the organization’s objectives.
* Starts at the top of the organization with the board of directors and management creating and reinforcing a structure and a tone for controls in the organization.
* Directly or indirectly includes all people in the organization, ranging from the shipping clerk to the internal auditor to the chief financial officer.
* Is broader than internal control over financial reporting.

 

  1. Pervasive control activities

    Discuss what pervasive control activities are and provide an example of at least three.

Pervasive control activities are those controls activities whose implementation affects almost all accounting systems.

Some examples of pervasive control activities include:

  *segregation of duties
  *authorization procedures
  *documented transaction trail
  *physical controls to safeguard assets
  *reconciliation of control accounts with subsidiary ledgers, of transactions recorded
   with transactions submitted for processing, and of physical counts of assets with
   recorded assets
  *competent, trustworthy employees
   

 

  1. Auditor Evaluation of Internal Controls

    What are the steps in integrated audit process?

Integrated audit process includes the following steps:

1. Update information about various risks.
2. Consider the possibility of account misstatements.
3. Complete preliminary analytical procedures.
4. Understand the client’s internal controls.
5. Identify controls to test.
6. Make a plan to test the controls and execute that plan.
7. Consider the results of control testing.
8. Conduct substantive audit tests.

 

  1. IT Controls Integrated into Internal Control Evaluations

    Explain Input Controls

The control procedures designed to assure that the organization fully captures all the transactions between itself and another entity, and to properly record those transactions, are referred to as input controls.
Input controls are designed to ensure that authorized transactions are correct, complete, and recorded in a timely fashion and that only authorized transactions exist. They include:
* Computerized input validation tests
* Self-checking digits
* Use of stored data reference items to eliminate input of frequently required data
* On-screen input verification techniques

 

  1. Relationship of the five internal control components

    The five components of the COSO internal control system are conceptually and logically integrated. List the five components of the model and describe how they are integrated with each other in the internal control process.

    Use the following format:

Components Description
   
   
   
   
   
   
   
   

 

 

Components Description
Control environment The control environment establishes management’s commitment to good governance, risk analysis, and control. It sets the tone for the organization’s implementation of effective internal control.
   
Risk assessment Management establishes a risk management policy and process to identify risks that affect the organization, including analysis of risks associated with financial reporting.
   
Control activities Management and employees develop and implement controls that reduce the risks to an acceptable level. Accounting controls are designed into accounting information systems and are tested to determine that they are working effectively.
   
Information and communication An effective information and communication system is developed and implemented to process transactions and to develop reports that enable all levels of management to make reliable decisions and to recognize improper processing. Further, information is communicated both up and down in the organization to facilitate effective operation of controls.
   
Monitoring Management monitors the effectiveness of its internal controls by designing on-going monitoring activities. Management also monitors the effectiveness of internal controls by engaging an effective internal audit department to perform separate evaluations of internal control.
   

Chapter 7: A Framework for Audit Evidence

Student: ___________________________________________________________________________

  1. Audit evidence is also referred to as an audit opinion.
    True    False

 

  1. The amount of evidence gathered is not important to an auditor since the quality of the evidence is of primary importance.
    True    False

 

  1. Based upon the risk of misstatement, the auditor uses judgment to determine which balances and transactions should be tested in the financial statements.
    True    False

 

  1. Assertions are relevant to the audit process because they are the representations of management embodied in the financial statements.
    True    False

 

  1. Assertions are not relevant to an audit because they relate to the auditor and financial statements are management’s responsibility instead of the auditor’s.
    True    False

 

  1. Presentation and disclosure assertions state that all transactions and balances are properly presented, and the company has disclosed every financial transaction and arrangement it entered into during the year in the footnotes.
    True    False

 

  1. Evidence is generally of higher quality if it involves a member of the audit team actually going out to physically observe it than if it was obtained from another source.
    True    False

 

  1. A client’s original signed purchase order is higher quality evidence than a confirmation returned from the client’s bank.
    True    False

 

  1. An auditor may test an account balance by testing the transactions that comprise the balance, by directly testing the final account balance, or a combination of both.
    True    False

 

  1. Internal documentation is more reliable to the auditor if the internal control surrounding the documentation is considered strong than if it is considered weak.
    True    False

 

  1. Documentation that is produced electronically by the client’s internal systems is not considered appropriate to the audit process.
    True    False

 

  1. Emails and faxes are documents that represent important evidence to the auditor, however, they are sometimes difficult to substantiate as authentic.
    True    False

 

  1. Test of transactions, directional testing and substantive analytical procedures are used to provide evidence about management’s assertions embedded in the financial statements.
    True    False

 

  1. Vouching recorded transactions involves taking a sample from the journal and tracing the items back to the source documents to ensure the transactions occurred.
    True    False

 

  1. Vouching is a process that helps establish that recorded transactions are valid.
    True    False

 

  1. One strategy used by auditors in testing assertions is to perform directional testing to find overstatements or understatements.
    True    False

 

  1. The direction of testing from recorded amounts toward supporting documentation provides evidence as to existence of assets and revenues.
    True    False

 

  1. The direction of testing from the source documents to recorded amounts provides evidence regarding the completeness of liabilities and expenses.
    True    False

 

  1. For an auditor to test the existence assertion of assets, testing will be performed beginning with the recorded asset and ending with the source documents.
    True    False

 

  1. Ulanda and Mudana, CPAs are performing an audit on McArnee, Inc. Ulanda selects a sample from certain source documents and traces them forward to the accounts payable ledger. The purpose of this test is to determine the possibility of understated liabilities.
    True    False

 

  1. The auditor’s concern for potential fraud in the financial statements will most likely result in increased testing for the overstatement of revenues.
    True    False

 

  1. The extent of evidence gathered during an audit is affected by the auditor’s assessment of detection risk.
    True    False

 

  1. Auditors should mail third party confirmations through the client’s mailroom.
    True    False

 

  1. The primary evidence in support of an auditor’s conclusions is the auditor’s documentation.
    True    False

 

  1. Audit documentation serves as support for the financial statements.
    True    False

 

  1. The auditor’s opinion on the financial statements taken as a whole is the single most important piece of information documenting the financial statements.
    True    False

 

  1. The primary importance of the audit program is its guidance of the overall conduct of the audit.
    True    False

 

  1. Inquiries of client personnel are not an effective means of evidence gathering by an auditor.
    True    False

 

  1. The performance of analytical procedures is often used by an auditor as a procedure to gather certain types of audit evidence.
    True    False

 

  1. An example of physical examination is the auditor’s testing of inventory by counting it to substantiate the existence assertion.
    True    False

 

  1. The auditor multiplies the quantity of inventory on the inventory ledger by the cost of the inventory to arrive at total inventory balance per product number. This is an example of recomputation by footing.
    True    False

 

  1. Some audit procedures may be performed prior to the close of the year under audit.
    True    False

 

  1. The audit program specifies what the client must do to perform the audit in accordance with generally accepted accounting procedures.
    True    False

 

  1. The auditor utilizes the same audit program and the same procedures each year for a client in order to ensure that nothing is missed in the current year audit.
    True    False

 

  1. Lead schedules are often created by auditors to combine similar accounts, such as all inventory accounts for further testing and documentation.
    True    False

 

  1. Audit planning workpapers are prepared to support the foundation of the audit and are prepared for the client to assist in their understanding of the specific audit procedures that will be performed.
    True    False

 

  1. The quality of electronic evidence depends on the controls built into the information system.
    True    False

 

  1. Recent regulation requires that audit documentation be retained for at least seven years.
    True    False

 

  1. Audit documentation should include either manual or electronic initials in order to identify the audit personnel responsible for the work and the managers and partners reviewing the work.
    True    False

 

  1. The reliability of audit evidence is a measure of the quality of the underlying evidence and is influenced by risk, potential management bias associated with the evidence, and the quality of the internal control system underlying the preparation of the evidence.
    True    False

 

  1. The client’s original signed purchase orders and invoices are a more persuasive type of evidence than evidence directly observed by the auditor.
    True    False

 

  1. Underlying accounting records consists of evidence of controls as well as supporting records such as checks, invoices, the general and subsidiary ledger and journal entries.
    True    False

 

  1. Reliable evidence usually exists more for transactions than for items making up an ending balance.
    True    False

 

  1. Analytical procedures are a type of substantive evidence.
    True    False

 

  1. Direct tests of account balances and of transactions are dual purpose tests.
    True    False

 

  1. Dual purpose tests examine both controls and the reasonableness of dollar amounts. A good example is testing a sample of purchase transactions that occurred throughout the year.
    True    False

 

  1. Testimonial evidence concerns review of publicly available information about the client.
    True    False

 

  1. In the performance of audit procedures there is a preference by auditors to focus on changes in account balances during the year if the opening balances were audited the previous year.
    True    False

 

  1. An advantage of directional testing is that it is more efficient by providing evidence on complementary sets of accounts.
    True    False

 

  1. Which one of the following statements is false?
    A. Auditing includes the process of gathering evidence to test assertions.
    B. No general audit program suits the needs for all situations.
    C. Even though all audits are different, they can all be approached in the same manner.
    D. All audits involve testing management’s assertions contained in written communications to another party and independently gathering evidence to test the relevant assertions.

 

  1. Which one of the following assertions regarding an inventory of ski equipment for Matterhorn, Inc. would be considered an incorrect statement?
    A. The inventory exists at the balance sheet date.
    B. The inventory is owned by Matterhorn.
    C. Footnote disclosures concerning inventory are not required given the objective nature of this account.
    D. The inventories are properly valued.

 

  1. Taft company only holds cash in the local currency of the country in which it operates. Which one of the following management assertions would require the least amount of audit procedures for the cash account of Taft?
    A. existence
    B. valuation
    C. completeness
    D. presentation

 

  1. Directional testing involves testing transactions or balances primarily for which type of error?
    A. overstatement
    B. understatement
    C. either overstatement or understatement
    D. neither overstatement nor understatement

 

  1. Which one of the following would be considered the most persuasive type of audit evidence?
    A. purchase orders from vendors
    B. customer accounts receivable files
    C. computerized general ledger
    D. confirmations from banks

 

  1. Which one of the following would be the most persuasive type of evidence?
    A. check register
    B. bank statement
    C. observation of assets
    D. inquiry with the in-house attorney

 

  1. Which one of the following would be the least persuasive type of evidence?
    A. Confirmations returned by bank directly to the auditor.
    B. Letters of communication from the Securities Exchange Commission.
    C. Physical examination of perpetual inventory.
    D. General ledger information.

 

  1. Management’s assertions in the financial statements are of relevance to the audit process because:
    A. they are the procedures that will be performed by the audit team.
    B. they are utilized by auditors in developing proper tests and procedures.
    C. they are direct evidence that management has prepared financial statements in accordance with generally accepted audit standards.
    D. they relate more to the audit while the financial statements belong to the auditor.

 

  1. For the financial statements to be presented in accordance with generally accepted accounting principles, the information included must:
    A. embody the appropriate assertions of management.
    B. be consistent, comparable and fully accurate.
    C. have full and adequate disclosure of all transactions.
    D. be prepared by an independent auditor.

 

  1. The process of vouching helps establish that all recorded transactions
    A. have been recorded.
    B. are complete.
    C. are valid.
    D. are presented properly.

 

  1. Footing, cross-footing, and tests of extensions are examples of which approach to gathering evidence?
    A. reprocessing
    B. recalculation
    C. vouching
    D. examination of documentation

 

  1. Reprocessing of transactions helps establish that all valid items have been recorded. Reprocessing tests which of the following assertions?
    A. occurrence.
    B. rights.
    C. existence.
    D. completeness.

 

  1. Sufficient evidence gathered by the auditor involves which of the following?
    A. The amount of evidence to be obtained.
    B. The type of evidence to be obtained.
    C. Obtaining limited evidence to achieve efficiency.
    D. The use of an audit program to obtain evidence.

 

  1. Which of the following provides the primary support of an audit?
    A. the financial statements.
    B. the audit working papers.
    C. the audit report.
    D. the confirmation documentation.

 

  1. The reliability of a client’s internal documentation is most affected by which of the following?
    A. the auditor’s independence.
    B. management’s motivation to misstate accounts.
    C. the type of audit report that will be issued.
    D. management’s ability to understand generally accepted audit standards.

 

  1. External documentation may lack reliability. Which of the following is the most probable reason for that?
    A. the external party may be competent in performing duties.
    B. the documentation may be properly understood by the client in the response.
    C. the auditor may decide not to use the documentation and replace it with other documents.
    D. the documentation may have been altered if the process is not controlled from inception.

 

  1. When may audit procedures be performed?
    I – on the balance sheet date.
    II – prior to the balance sheet date.
    III – subsequent to the balance sheet date.
    A. I only.
    B. I and III only.
    C. II only.
    D. I, II, and III.

 

  1. An auditor selects a sample of items recorded and traces them back to the supporting documentation. This is an example of which of the following?
    A. directional testing for existence.
    B. directional testing for completeness.
    C. direct testing for valuation.
    D. direct testing for rights.

 

  1. Directional testing is important to an auditor because of which of the following factors?
    A. Certain accounts are more prone to be misstated by overstatement than others.
    B. The auditor must remain organized when conducting an audit.
    C. The primary concern of the auditor is the understatement of asset and revenue accounts.
    D. It tests for existence and completeness simultaneously.

 

  1. Which of the following assertions is the primary assertion that is satisfied by physically observing the client’s count of inventory?
    A. rights.
    B. valuation.
    C. completeness.
    D. existence.

 

  1. How would an auditor most likely test the mechanical accuracy of a 6,000 page inventory report?
    A. Examine a random sample of inventory documents.
    B. Use generalized audit software to foot and recalculate.
    C. Send confirmations to vendors.
    D. Inquire of the inventory manager as to the accuracy.

 

  1. The audit team asks the client to pull a sample of vendor files and examines the invoices supporting the purchases of inventory items during the year. What is the most probable reason for the use of this evidence?
    A. Confirmation of vendors supplying inventory for existence.
    B. Analytical procedures to determine completeness of inventory.
    C. Testing for the valuation of inventory using the FIFO cost flow assumption.
    D. Reading the terms of the arrangements with vendors for disclosure.

 

  1. The extent of procedures is affected mostly by which of the following factors?
    A. the sheer volume of procedures to be applied by the auditor.
    B. the time of year in which the client takes a physical inventory in the warehouse.
    C. the auditor’s judgment that misstatements are probable in certain balances.
    D. the availability of the client’s staff at or near the balance sheet date.

 

  1. An audit program is created to specify which of the following?
    A. the type of audit opinion to be rendered based upon procedures performed.
    B. the audit procedures that will be performed every year for the client.
    C. how an auditor should think while performing audit procedures.
    D. audit objectives and procedures to be followed during the audit process.

 

  1. Which one of the following is the primary reason for documenting audit work?
    A. to prevent litigation by other parties that question the audit performance.
    B. to provide a stand-alone medium that gives audit conclusions and supports the opinion.
    C. to give the client a full reporting of all work performed on their behalf.
    D. to supply a point of reference for all auditors performing the work subsequently.

 

  1. Which one of the following original documents would most likely be found in the audit working papers?
    A. Vendor invoices
    B. Check registers
    C. Returned confirmation requests
    D. Payroll time cards

 

  1. Conclusions are typically documented by auditors in which type of work paper?
    A. audit planning memo
    B. audit program
    C. audit memoranda
    D. representation letter

 

  1. Which of the following is an example of poorly-developed audit documentation?
    A. clear communication as to how testing was performed, the results and conclusions.
    B. organization and assembly of documentation in an orderly fashion.
    C. headings that include the name and signature of the client representative that the auditor interacted with while performing testing.
    D. authenticated identification of the person responsible for completing the procedure and conclusions.

 

  1. The audit firm of Lake and South, LLP is wrapping up its audit of Brycestone, Inc. The evidence has been relatively easy to obtain except in one case. Which of the following would represent a balance or transaction that would be most difficult for Lake and South to obtain evidence?
    A. prepaid expenses
    B. cash
    C. accrued wages and salaries
    D. accrued warranties

 

  1. Which of the following is the primary source for evidence to corroborate the existence of pending litigation?
    A. vendor confirmations
    B. disclosures in financial statements
    C. management representation letters
    D. attorney confirmations

 

  1. Performance of audit procedures at an interim date causes the risk of material misstatement occurring between the interim date and the end of the year to
    A. decrease.
    B. increase.
    C. remain the same.
    D. become more difficult to ascertain.

 

  1. Shelfco, Inc. has an inventory report that is approximately 4,000 pages. The audit program requires James Morris, the staff auditor, to test the report for accuracy. What is the most efficient and effective means for James to perform the procedure?
    A. Ask the client to foot and extend the report and return the results of the test to the auditor for concluding.
    B. Foot and extend every 100th page and extrapolate the results of footing to the total of the report.
    C. Obtain an electronic copy of the file and use generalized audit software in footing and extending.
    D. Skip the procedure as the cost of footing and extending exceeds the benefit derived from the audit test.

 

  1. What is the role of a concurring partner in an audit engagement?
    A. to provide a “fresh”, quality review of the audit documentation and conclusions and its relationship to the opinion.
    B. to go back over the staff, senior and manager work and redo the more difficult areas of the audit.
    C. to work as a liaison between the audit committee and the audit team should there be disagreements.
    D. to act as an advocate of the client in order to ensure quality customer service has been given.

 

  1. Which of the following is not an estimate that requires significant auditor judgment and skepticism?
    A. Obligations for pension plans.
    B. Valuation of goodwill.
    C. Allowance for bad debt.
    D. Common stock and related additional paid-in capital.

 

  1. Empire Business Machines, Inc. (EBM) is audited by Flintstone and Sigmond Co. Empire utilizes periodic inventory and has ten locations throughout Wyoming, Utah and Idaho. The audit program of Flintstone and Sigmond requires that the following procedure be performed by the senior auditor, manager and four other auditors:
A. Haphazardly select six of the EBM locations, (two of which that were not selected in the previous audit) to be visited at 5:30 a.m. on January 1, 20XX. Do not inform EBM of the locations, but make the client aware that we could visit any one of the ten locations at 5:30 a.m. that morning.  
  1. Observe and count 45 product types at each location. Recount any differences with client records and statistically analyze remaining differences for possible misstatement to inventory accounts. Keep an inventory tag range/sequence control list and document the tag numbers present in the warehouse and those utilized in your count.
     

Procedure A-1 of Flintstone and Sigmond primarily relates to which management’s assertion?
A. existence
B. valuation
C. observation
D. rights

 

  1. Empire Business Machines, Inc. (EBM) is audited by Flintstone and Sigmond Co. Empire utilizes the FIFO cost flow assumption at the lower of cost or market for its inventory and has ten locations throughout Wyoming, Utah and Idaho. The audit program of Flintstone and Sigmond requires that the following procedures be performed by the senior auditor:
B. Using the computerized audit software supplied by Flintstone and Sigmond:  
  1. Statistically select a sample of inventory units and perform price tests to the FIFO cost flow assumption.
  2. Perform lower of cost or market tests on the inventory sample selected above.
     

Procedure B-1 and B-2 of Flintstone and Sigmond primarily relates to which management’s assertion?
A. existence
B. valuation
C. rights and obligations
D. presentation and disclosure

 

  1. Directional testing creates audit efficiency by taking advantage of the double-entry bookkeeping system. Which of the following is not a primary reason for this effect?
    A. misstatement of some accounts are more likely to occur in one direction than the other.
    B. increase the persuasiveness of the evidence.
    C. provides evidence on a complementary set of accounts.
    D. some assertions are directional by nature.

 

  1. Which of the following type(s) of evidence is considered substantive evidence?
    A. tests of controls.
    B. analytical procedures.
    C. direct tests of account balances and transactions.
    D. Both B and C.

 

  1. Which of the following types of audit evidence is the most reliable?
    A. evidence from the client’s organization.
    B. evidence from a poorly controlled system.
    C. directly observable evidence.
    D. facsimiles of documents.

 

  1. Which of the following types of audit evidence is the least reliable?
    A. evidence from the client’s organization.
    B. evidence derived from a well-controlled system.
    C. evidence from independent outside sources.
    D. original documents.

 

  1. In evaluating cost of evidence, which of the following phases of the audit usually has the lowest cost?
    A. test transactions and account balances.
    B. understand client and industry.
    C. assess risk of material misstatement.
    D. Both A and B.

 

  1. Recalculations of the client’s computations would not include which of the following types of evidence?
    A. cutoff.
    B. footing.
    C. extension.
    D. cross-footing.

 

  1. Vouching of transactions deals with which of the following?
    A. testing forward.
    B. testing backward.
    C. testing at a point in time.
    D. directional testing either forward or backward.

 

  1. Reprocessing of transactions involves which of the following?
    A. testing forward.
    B. testing backward.
    C. test at a point in time.
    D. directional testing either forward or backward.

 

  1. Which of the following characteristics are not normally included in good audit documentation?
    A. initials of the person preparing and reviewing the document.
    B. an index.
    C. a cross-reference.
    D. all are included in good audit documentation.

 

  1. Dual purpose audit tests are useful as which of the following types of tests?
    A. tests of controls
    B. tests of account balances.
    C. tests of controls or tests of account balances
    D. tests of controls and tests of account balances.

 

  1. The auditor normally considers both underlying accounting data and corroborating information in the audit process. Underlying accounting data does not include which of the following items?
    A. evidence of controls.
    B. minutes of meetings.
    C. checks, invoices, and contracts.
    D. general and subsidiary ledger.

 

  1. Auditors have traditionally focused most audit procedures on the direct tests of assets and liability account balances, as opposed to examining transactions during the year, because
    A. there are usually fewer items in ending balances.
    B. more reliable evidence usually exists for ending balances.
    C. there is a preference to focus on change in account balances.
    D. both A and B.
    E. all of the above.

 

  1. Audit assertions and objectives – accounts receivable

    Based on management assertions implicit in the accounts receivable account, explain the audit objectives for the accounts receivable and related balances.

 

 

 

 

 

  1. Directional testing

    Explain the meaning of “directional testing” and identify the reasons why directional testing leads to audit efficiency. Give examples of directional testing for the existence and completeness assertions.

 

 

 

 

 

  1. Proper audit documentation

    Audit documentation serves as the primary support of an audit. Give at least six examples of the components of proper working paper documentation.

 

 

 

 

 

  1. Reliability of audit evidence

    The Auditing Standards Board established guidelines to assist auditors in evaluating the reliability of audit evidence. Discuss the criteria for the more reliable types of evidence and include an example for each.

 

 

 

 

 

  1. Sufficient appropriate evidential matter

    Discuss the source of the phrase “sufficient appropriate evidential matter is to be obtained…”
    What is the importance of obtaining sufficient appropriate evidential matter? Contrast sufficiency to competency as it relates to such audit evidence.

 

 

 

 

 

  1. Audit assertions and procedures on Cash balances

    Identify and demonstrate the audit assertions and different approaches to the obtaining audit evidence for an audit of cash balances in a financial statement audit.

 

 

 

 

 

  1. Audit procedures for accounts receivable

    In the process of gathering and evaluating evidence, documentation is derived in various forms. Rank the following types of evidence in the audit of Accounts Receivable from most persuasive to least persuasive and provide explanations for your decision.
· oral statements from management that the accounts receivable are fairly presented
· confirmations received from customers
· deposit slips subsequent to year end showing deposits by customer name
· copies of sales invoices
   

 

 

 

 

 

 

  1. Audit program

    Discuss the purpose of the audit program and its importance to the auditor.

 

 

 

 

 

  1. Audit standards of proper documentation

    Discuss the audit standards that must be applied to the auditor’s documentation. Give five examples the types of documentation will be found in the audit work papers.

 

 

 

 

 

  1. Audit procedures

    Discuss how each of the following procedures could be used in the audit of fixed assets, e.g., various types of equipment used in the business.
Procedure How used Assertion(s) tested
Observation    
Physical examination    
Inquiry    
Confirmation    
Examination of documents    
Recomputation    
Reprocessing    
Vouching    
Analytical    
Procedures    
     

 

 

 

 

 

 

  1. Audit procedures

    Businesses often have litigation against them that the auditor has to identify and adequately disclose. List the financial assertions that apply to Contingencies. For each assertion indicate two or three audit procedures that would address that assertion.

    Organize you answer as follows:

Financial statement assertion Audit procedure(s)  
     
     
     
     
     
     
     
     
     
     
     
     
     
     

 

 

 

 

 

 

 

 

Chapter 7: A Framework for Audit Evidence Key

  1. Audit evidence is also referred to as an audit opinion.
    FALSE

 

  1. The amount of evidence gathered is not important to an auditor since the quality of the evidence is of primary importance.
    FALSE

 

  1. Based upon the risk of misstatement, the auditor uses judgment to determine which balances and transactions should be tested in the financial statements.
    TRUE

 

  1. Assertions are relevant to the audit process because they are the representations of management embodied in the financial statements.
    TRUE

 

  1. Assertions are not relevant to an audit because they relate to the auditor and financial statements are management’s responsibility instead of the auditor’s.
    FALSE

 

  1. Presentation and disclosure assertions state that all transactions and balances are properly presented, and the company has disclosed every financial transaction and arrangement it entered into during the year in the footnotes.
    FALSE

 

  1. Evidence is generally of higher quality if it involves a member of the audit team actually going out to physically observe it than if it was obtained from another source.
    TRUE

 

  1. A client’s original signed purchase order is higher quality evidence than a confirmation returned from the client’s bank.
    FALSE

 

  1. An auditor may test an account balance by testing the transactions that comprise the balance, by directly testing the final account balance, or a combination of both.
    TRUE

 

  1. Internal documentation is more reliable to the auditor if the internal control surrounding the documentation is considered strong than if it is considered weak.
    TRUE

 

  1. Documentation that is produced electronically by the client’s internal systems is not considered appropriate to the audit process.
    FALSE

 

  1. Emails and faxes are documents that represent important evidence to the auditor, however, they are sometimes difficult to substantiate as authentic.
    TRUE

 

  1. Test of transactions, directional testing and substantive analytical procedures are used to provide evidence about management’s assertions embedded in the financial statements.
    TRUE

 

  1. Vouching recorded transactions involves taking a sample from the journal and tracing the items back to the source documents to ensure the transactions occurred.
    TRUE

 

  1. Vouching is a process that helps establish that recorded transactions are valid.
    TRUE

 

  1. One strategy used by auditors in testing assertions is to perform directional testing to find overstatements or understatements.
    TRUE

 

  1. The direction of testing from recorded amounts toward supporting documentation provides evidence as to existence of assets and revenues.
    TRUE

 

  1. The direction of testing from the source documents to recorded amounts provides evidence regarding the completeness of liabilities and expenses.
    TRUE

 

  1. For an auditor to test the existence assertion of assets, testing will be performed beginning with the recorded asset and ending with the source documents.
    TRUE

 

  1. Ulanda and Mudana, CPAs are performing an audit on McArnee, Inc. Ulanda selects a sample from certain source documents and traces them forward to the accounts payable ledger. The purpose of this test is to determine the possibility of understated liabilities.
    TRUE

 

  1. The auditor’s concern for potential fraud in the financial statements will most likely result in increased testing for the overstatement of revenues.
    TRUE

 

  1. The extent of evidence gathered during an audit is affected by the auditor’s assessment of detection risk.
    TRUE

 

  1. Auditors should mail third party confirmations through the client’s mailroom.
    FALSE

 

  1. The primary evidence in support of an auditor’s conclusions is the auditor’s documentation.
    TRUE

 

  1. Audit documentation serves as support for the financial statements.
    FALSE

 

  1. The auditor’s opinion on the financial statements taken as a whole is the single most important piece of information documenting the financial statements.
    FALSE

 

  1. The primary importance of the audit program is its guidance of the overall conduct of the audit.
    TRUE

 

  1. Inquiries of client personnel are not an effective means of evidence gathering by an auditor.
    FALSE

 

  1. The performance of analytical procedures is often used by an auditor as a procedure to gather certain types of audit evidence.
    TRUE

 

  1. An example of physical examination is the auditor’s testing of inventory by counting it to substantiate the existence assertion.
    TRUE

 

  1. The auditor multiplies the quantity of inventory on the inventory ledger by the cost of the inventory to arrive at total inventory balance per product number. This is an example of recomputation by footing.
    FALSE

 

  1. Some audit procedures may be performed prior to the close of the year under audit.
    TRUE

 

  1. The audit program specifies what the client must do to perform the audit in accordance with generally accepted accounting procedures.
    FALSE

 

  1. The auditor utilizes the same audit program and the same procedures each year for a client in order to ensure that nothing is missed in the current year audit.
    FALSE

 

  1. Lead schedules are often created by auditors to combine similar accounts, such as all inventory accounts for further testing and documentation.
    TRUE

 

  1. Audit planning workpapers are prepared to support the foundation of the audit and are prepared for the client to assist in their understanding of the specific audit procedures that will be performed.
    FALSE

 

  1. The quality of electronic evidence depends on the controls built into the information system.
    TRUE

 

  1. Recent regulation requires that audit documentation be retained for at least seven years.
    TRUE

 

  1. Audit documentation should include either manual or electronic initials in order to identify the audit personnel responsible for the work and the managers and partners reviewing the work.
    TRUE

 

  1. The reliability of audit evidence is a measure of the quality of the underlying evidence and is influenced by risk, potential management bias associated with the evidence, and the quality of the internal control system underlying the preparation of the evidence.
    TRUE

 

  1. The client’s original signed purchase orders and invoices are a more persuasive type of evidence than evidence directly observed by the auditor.
    FALSE

 

  1. Underlying accounting records consists of evidence of controls as well as supporting records such as checks, invoices, the general and subsidiary ledger and journal entries.
    TRUE

 

  1. Reliable evidence usually exists more for transactions than for items making up an ending balance.
    FALSE

 

  1. Analytical procedures are a type of substantive evidence.
    TRUE

 

  1. Direct tests of account balances and of transactions are dual purpose tests.
    FALSE

 

  1. Dual purpose tests examine both controls and the reasonableness of dollar amounts. A good example is testing a sample of purchase transactions that occurred throughout the year.
    TRUE

 

  1. Testimonial evidence concerns review of publicly available information about the client.
    FALSE

 

  1. In the performance of audit procedures there is a preference by auditors to focus on changes in account balances during the year if the opening balances were audited the previous year.
    TRUE

 

  1. An advantage of directional testing is that it is more efficient by providing evidence on complementary sets of accounts.
    TRUE

 

  1. Which one of the following statements is false?
    A.Auditing includes the process of gathering evidence to test assertions.
    B. No general audit program suits the needs for all situations.
    C. Even though all audits are different, they can all be approached in the same manner.
    D. All audits involve testing management’s assertions contained in written communications to another party and independently gathering evidence to test the relevant assertions.

 

  1. Which one of the following assertions regarding an inventory of ski equipment for Matterhorn, Inc. would be considered an incorrect statement?
    A.The inventory exists at the balance sheet date.
    B. The inventory is owned by Matterhorn.
    C. Footnote disclosures concerning inventory are not required given the objective nature of this account.
    D. The inventories are properly valued.

 

  1. Taft company only holds cash in the local currency of the country in which it operates. Which one of the following management assertions would require the least amount of audit procedures for the cash account of Taft?
    A.existence
    B. valuation
    C. completeness
    D. presentation

 

  1. Directional testing involves testing transactions or balances primarily for which type of error?
    A.overstatement
    B. understatement
    C. either overstatement or understatement
    D. neither overstatement nor understatement

 

  1. Which one of the following would be considered the most persuasive type of audit evidence?
    A.purchase orders from vendors
    B. customer accounts receivable files
    C. computerized general ledger
    D. confirmations from banks

 

  1. Which one of the following would be the most persuasive type of evidence?
    A.check register
    B. bank statement
    C. observation of assets
    D. inquiry with the in-house attorney

 

  1. Which one of the following would be the least persuasive type of evidence?
    A.Confirmations returned by bank directly to the auditor.
    B. Letters of communication from the Securities Exchange Commission.
    C. Physical examination of perpetual inventory.
    D. General ledger information.

 

  1. Management’s assertions in the financial statements are of relevance to the audit process because:
    A.they are the procedures that will be performed by the audit team.
    B. they are utilized by auditors in developing proper tests and procedures.
    C. they are direct evidence that management has prepared financial statements in accordance with generally accepted audit standards.
    D. they relate more to the audit while the financial statements belong to the auditor.

 

  1. For the financial statements to be presented in accordance with generally accepted accounting principles, the information included must:
    A.embody the appropriate assertions of management.
    B. be consistent, comparable and fully accurate.
    C. have full and adequate disclosure of all transactions.
    D. be prepared by an independent auditor.

 

  1. The process of vouching helps establish that all recorded transactions
    A.have been recorded.
    B. are complete.
    C. are valid.
    D. are presented properly.

 

  1. Footing, cross-footing, and tests of extensions are examples of which approach to gathering evidence?
    A.reprocessing
    B. recalculation
    C. vouching
    D. examination of documentation

 

  1. Reprocessing of transactions helps establish that all valid items have been recorded. Reprocessing tests which of the following assertions?
    A.occurrence.
    B. rights.
    C. existence.
    D. completeness.

 

  1. Sufficient evidence gathered by the auditor involves which of the following?
    A.The amount of evidence to be obtained.
    B. The type of evidence to be obtained.
    C. Obtaining limited evidence to achieve efficiency.
    D. The use of an audit program to obtain evidence.

 

  1. Which of the following provides the primary support of an audit?
    A.the financial statements.
    B. the audit working papers.
    C. the audit report.
    D. the confirmation documentation.

 

  1. The reliability of a client’s internal documentation is most affected by which of the following?
    A.the auditor’s independence.
    B. management’s motivation to misstate accounts.
    C. the type of audit report that will be issued.
    D. management’s ability to understand generally accepted audit standards.

 

  1. External documentation may lack reliability. Which of the following is the most probable reason for that?
    A.the external party may be competent in performing duties.
    B. the documentation may be properly understood by the client in the response.
    C. the auditor may decide not to use the documentation and replace it with other documents.
    D. the documentation may have been altered if the process is not controlled from inception.

 

  1. When may audit procedures be performed?
    I – on the balance sheet date.
    II – prior to the balance sheet date.
    III – subsequent to the balance sheet date.
    A.I only.
    B. I and III only.
    C. II only.
    D. I, II, and III.

 

  1. An auditor selects a sample of items recorded and traces them back to the supporting documentation. This is an example of which of the following?
    A.directional testing for existence.
    B. directional testing for completeness.
    C. direct testing for valuation.
    D. direct testing for rights.

 

  1. Directional testing is important to an auditor because of which of the following factors?
    A.Certain accounts are more prone to be misstated by overstatement than others.
    B. The auditor must remain organized when conducting an audit.
    C. The primary concern of the auditor is the understatement of asset and revenue accounts.
    D. It tests for existence and completeness simultaneously.

 

  1. Which of the following assertions is the primary assertion that is satisfied by physically observing the client’s count of inventory?
    A.rights.
    B. valuation.
    C. completeness.
    D. existence.

 

  1. How would an auditor most likely test the mechanical accuracy of a 6,000 page inventory report?
    A.Examine a random sample of inventory documents.
    B. Use generalized audit software to foot and recalculate.
    C. Send confirmations to vendors.
    D. Inquire of the inventory manager as to the accuracy.

 

  1. The audit team asks the client to pull a sample of vendor files and examines the invoices supporting the purchases of inventory items during the year. What is the most probable reason for the use of this evidence?
    A.Confirmation of vendors supplying inventory for existence.
    B. Analytical procedures to determine completeness of inventory.
    C. Testing for the valuation of inventory using the FIFO cost flow assumption.
    D. Reading the terms of the arrangements with vendors for disclosure.

 

  1. The extent of procedures is affected mostly by which of the following factors?
    A.the sheer volume of procedures to be applied by the auditor.
    B. the time of year in which the client takes a physical inventory in the warehouse.
    C. the auditor’s judgment that misstatements are probable in certain balances.
    D. the availability of the client’s staff at or near the balance sheet date.

 

  1. An audit program is created to specify which of the following?
    A.the type of audit opinion to be rendered based upon procedures performed.
    B. the audit procedures that will be performed every year for the client.
    C. how an auditor should think while performing audit procedures.
    D. audit objectives and procedures to be followed during the audit process.

 

  1. Which one of the following is the primary reason for documenting audit work?
    A.to prevent litigation by other parties that question the audit performance.
    B. to provide a stand-alone medium that gives audit conclusions and supports the opinion.
    C. to give the client a full reporting of all work performed on their behalf.
    D. to supply a point of reference for all auditors performing the work subsequently.

 

  1. Which one of the following original documents would most likely be found in the audit working papers?
    A.Vendor invoices
    B. Check registers
    C. Returned confirmation requests
    D. Payroll time cards

 

  1. Conclusions are typically documented by auditors in which type of work paper?
    A.audit planning memo
    B. audit program
    C. audit memoranda
    D. representation letter

 

  1. Which of the following is an example of poorly-developed audit documentation?
    A.clear communication as to how testing was performed, the results and conclusions.
    B. organization and assembly of documentation in an orderly fashion.
    C. headings that include the name and signature of the client representative that the auditor interacted with while performing testing.
    D. authenticated identification of the person responsible for completing the procedure and conclusions.

 

  1. The audit firm of Lake and South, LLP is wrapping up its audit of Brycestone, Inc. The evidence has been relatively easy to obtain except in one case. Which of the following would represent a balance or transaction that would be most difficult for Lake and South to obtain evidence?
    A.prepaid expenses
    B. cash
    C. accrued wages and salaries
    D. accrued warranties

 

  1. Which of the following is the primary source for evidence to corroborate the existence of pending litigation?
    A.vendor confirmations
    B. disclosures in financial statements
    C. management representation letters
    D. attorney confirmations

 

  1. Performance of audit procedures at an interim date causes the risk of material misstatement occurring between the interim date and the end of the year to
    A.decrease.
    B. increase.
    C. remain the same.
    D. become more difficult to ascertain.

 

  1. Shelfco, Inc. has an inventory report that is approximately 4,000 pages. The audit program requires James Morris, the staff auditor, to test the report for accuracy. What is the most efficient and effective means for James to perform the procedure?
    A.Ask the client to foot and extend the report and return the results of the test to the auditor for concluding.
    B. Foot and extend every 100th page and extrapolate the results of footing to the total of the report.
    C. Obtain an electronic copy of the file and use generalized audit software in footing and extending.
    D. Skip the procedure as the cost of footing and extending exceeds the benefit derived from the audit test.

 

  1. What is the role of a concurring partner in an audit engagement?
    A.to provide a “fresh”, quality review of the audit documentation and conclusions and its relationship to the opinion.
    B. to go back over the staff, senior and manager work and redo the more difficult areas of the audit.
    C. to work as a liaison between the audit committee and the audit team should there be disagreements.
    D. to act as an advocate of the client in order to ensure quality customer service has been given.

 

  1. Which of the following is not an estimate that requires significant auditor judgment and skepticism?
    A.Obligations for pension plans.
    B. Valuation of goodwill.
    C. Allowance for bad debt.
    D. Common stock and related additional paid-in capital.

 

  1. Empire Business Machines, Inc. (EBM) is audited by Flintstone and Sigmond Co. Empire utilizes periodic inventory and has ten locations throughout Wyoming, Utah and Idaho. The audit program of Flintstone and Sigmond requires that the following procedure be performed by the senior auditor, manager and four other auditors:
A. Haphazardly select six of the EBM locations, (two of which that were not selected in the previous audit) to be visited at 5:30 a.m. on January 1, 20XX. Do not inform EBM of the locations, but make the client aware that we could visit any one of the ten locations at 5:30 a.m. that morning.  
  1. Observe and count 45 product types at each location. Recount any differences with client records and statistically analyze remaining differences for possible misstatement to inventory accounts. Keep an inventory tag range/sequence control list and document the tag numbers present in the warehouse and those utilized in your count.
     

Procedure A-1 of Flintstone and Sigmond primarily relates to which management’s assertion?
A. existence
B. valuation
C. observation
D. rights

 

  1. Empire Business Machines, Inc. (EBM) is audited by Flintstone and Sigmond Co. Empire utilizes the FIFO cost flow assumption at the lower of cost or market for its inventory and has ten locations throughout Wyoming, Utah and Idaho. The audit program of Flintstone and Sigmond requires that the following procedures be performed by the senior auditor:
B. Using the computerized audit software supplied by Flintstone and Sigmond:  
  1. Statistically select a sample of inventory units and perform price tests to the FIFO cost flow assumption.
  2. Perform lower of cost or market tests on the inventory sample selected above.
     

Procedure B-1 and B-2 of Flintstone and Sigmond primarily relates to which management’s assertion?
A. existence
B. valuation
C. rights and obligations
D. presentation and disclosure

 

  1. Directional testing creates audit efficiency by taking advantage of the double-entry bookkeeping system. Which of the following is not a primary reason for this effect?
    A.misstatement of some accounts are more likely to occur in one direction than the other.
    B. increase the persuasiveness of the evidence.
    C. provides evidence on a complementary set of accounts.
    D. some assertions are directional by nature.

 

  1. Which of the following type(s) of evidence is considered substantive evidence?
    A.tests of controls.
    B. analytical procedures.
    C. direct tests of account balances and transactions.
    D. Both B and C.

 

  1. Which of the following types of audit evidence is the most reliable?
    A.evidence from the client’s organization.
    B. evidence from a poorly controlled system.
    C. directly observable evidence.
    D. facsimiles of documents.

 

  1. Which of the following types of audit evidence is the least reliable?
    A.evidence from the client’s organization.
    B. evidence derived from a well-controlled system.
    C. evidence from independent outside sources.
    D. original documents.

 

  1. In evaluating cost of evidence, which of the following phases of the audit usually has the lowest cost?
    A.test transactions and account balances.
    B. understand client and industry.
    C. assess risk of material misstatement.
    D. Both A and B.

 

  1. Recalculations of the client’s computations would not include which of the following types of evidence?
    A.cutoff.
    B. footing.
    C. extension.
    D. cross-footing.

 

  1. Vouching of transactions deals with which of the following?
    A.testing forward.
    B. testing backward.
    C. testing at a point in time.
    D. directional testing either forward or backward.

 

  1. Reprocessing of transactions involves which of the following?
    A.testing forward.
    B. testing backward.
    C. test at a point in time.
    D. directional testing either forward or backward.

 

  1. Which of the following characteristics are not normally included in good audit documentation?
    A.initials of the person preparing and reviewing the document.
    B. an index.
    C. a cross-reference.
    D. all are included in good audit documentation.

 

  1. Dual purpose audit tests are useful as which of the following types of tests?
    A.tests of controls
    B. tests of account balances.
    C. tests of controls or tests of account balances
    D. tests of controls and tests of account balances.

 

  1. The auditor normally considers both underlying accounting data and corroborating information in the audit process. Underlying accounting data does not include which of the following items?
    A.evidence of controls.
    B. minutes of meetings.
    C. checks, invoices, and contracts.
    D. general and subsidiary ledger.

 

  1. Auditors have traditionally focused most audit procedures on the direct tests of assets and liability account balances, as opposed to examining transactions during the year, because
    A.there are usually fewer items in ending balances.
    B. more reliable evidence usually exists for ending balances.
    C. there is a preference to focus on change in account balances.
    D. both A and B.
    E. all of the above.

 

  1. Audit assertions and objectives – accounts receivable

    Based on management assertions implicit in the accounts receivable account, explain the audit objectives for the accounts receivable and related balances.

The audit objectives for the audit of accounts receivable would determine that:

· Accounts receivable actually exist with valid customers. (Existence)
· The client has the right to or controls the receivables and has not pledged or factored them. (Rights)
· Accounts receivable are recorded at historical cost or invoice price. (Valuation gross)
· Accounts receivable are recorded net of any applicable sales discounts, returns or allowances. (Valuation gross)
· An allowance for doubtful accounts has been established for an estimate of dollars that will not be received on account. (Valuation net)
· All accounts receivable are recorded for the period and are not understated. (Completeness)
· Footnote disclosures discuss the collectibility of accounts receivable, pledging and factoring and any concentration of credit risk. A reconciliation of the allowance for doubtful accounts has been presented in the footnotes. (Presentation and disclosure)
   

 

  1. Directional testing

    Explain the meaning of “directional testing” and identify the reasons why directional testing leads to audit efficiency. Give examples of directional testing for the existence and completeness assertions.

Directional testing involves testing transactions or balances primarily for one type of error, either overstatement or understatement, but not for both at the same time. For example, an audit test for an understatement of Accounts Payable also tests for an understatement of Purchases. Directional testing also leads to audit efficiency for the following reasons:

· Misstatements of some accounts are more likely to occur in one direction than the other.
· Directional testing of an account balance provides evidence on a complementary set of accounts.
· Specific assertions are normally tested directionally. An example is the testing of the existence assertion for overstatements or the completeness assertions for understatements.
   

An example of directional testing for existence includes the sampling of assets recorded on the balance sheet, such as fixed assets and tracing those items back through the system to original source documents such as vendor invoices. This procedure tests for the possible overstatement of the fixed assets. Item(s) selected from the general ledger that are found to lack adequate supporting vendor invoices to substantiate existence are evidence of the overstatement of assets.

Testing directionally for completeness, on the other hand is just the opposite. Source documents are sampled and traced forward through the journals, ledgers and to the general ledger. An example may be vendor invoices for expenses. Invoices that are not found in the general ledger balance prove that the system is incomplete. In the example of an expense, net income would be overstated and liabilities may be understated.

 

  1. Proper audit documentation

    Audit documentation serves as the primary support of an audit. Give at least six examples of the components of proper working paper documentation.

Audit documentation serves as the primary evidence in support of the auditor’s opinion. Well prepared documentation should include:

· a heading that includes the name of the audit client, an explanatory title, and the balance sheet date.
· the initials or electronic signature of the auditor performing the audit test and the date the test was completed.
· the initials or electronic signature of the senior, manager, or partner who reviewed the working papers and the date the review was completed.
· a description of the nature of the test performed and the findings.
· an assessment of whether the test indicates the possibility of material misstatement in the account.
· manual or electronic tick marks and a legend indicating the nature of the work performed by the auditor.
· an indexing or electronic sequencing routine to identify the location and organization of working papers.
· a cross reference or electronic link to related working papers.
   

Many of these components are electronic in nature and are resident in a paperless audit software and storage combination. Nonetheless, such components remain vital in proper documentation of audit testing and conclusions.

 

  1. Reliability of audit evidence

    The Auditing Standards Board established guidelines to assist auditors in evaluating the reliability of audit evidence. Discuss the criteria for the more reliable types of evidence and include an example for each.

Evidence that is considered to be more reliable includes:

· Directly observable evidence such as counting inventory or observing fixed assets.
· Evidence derived from a client’s strong internal control structure such as reconciliations or the information system itself.
· Evidence from independent external sources such as confirmations from banks, customers and attorneys.
   

Examples provided by the students may vary and the instructor must use his or her judgment.

 

  1. Sufficient appropriate evidential matter

    Discuss the source of the phrase “sufficient appropriate evidential matter is to be obtained…”
    What is the importance of obtaining sufficient appropriate evidential matter? Contrast sufficiency to competency as it relates to such audit evidence.

The third standard of field work of the generally accepted audit standards states that “sufficient appropriate evidential matter is to be obtained” by performing various audit procedures in order to support the audit opinion regarding the financial statements under audit.

The sufficiency and competency of evidence is of critical importance to the audit as it affects the nature, timing and extent of audit testing to be performed by the audit team.

Competency of evidence includes the quality or reliability of the evidence obtained. It must be valid and relevant to management’s assertions or it is not a proper form of evidence. Typically, the competency of audit evidence can be judged by an auditor based upon the underlying internal control, the independence of outside sources and the auditor’s own knowledge of the evidence. Sufficiency deals with the amount or nature of the evidence that will be obtained such as the accounting data itself and the corroborating data.

These concepts also bear functional relationships to audit risk assessment. For instance, the less competent the evidence is, the more sufficient the evidence that must be obtained. In other words, as in the audit risk model, the higher the risk of poor internal control over evidence, the more audit work that must be performed to mitigate detection risk. This is how the risk of material misstatements existing in the financial statements and not being discovered by the auditor is reduced.

 

  1. Audit assertions and procedures on Cash balances

    Identify and demonstrate the audit assertions and different approaches to the obtaining audit evidence for an audit of cash balances in a financial statement audit.

In the performance of the audit of cash the auditor is most concerned the existence, valuation, and rights assertions. The audit of cash may use the following approaches:

· Observe the client’s handling of the petty cash fund and the control over incoming cash and cash storage. Observe the process of cash received in the mailroom, deposits to the bank and reconciliation by a separate individual.
· Physically count the petty cash, cash in drawers and cash in safes.
· Examine documents such as the bank statement.
· Make inquiries of personnel concerning the handling of daily deposits or the mail receipts.
· Confirm the bank balance with financial institutions using proper confirmation procedures.
· Recalculate the bank reconciliation computation trace the book balance to the general ledger.
· Inquire of materially aged outstanding checks and deposits in transit.
· Trace outstanding checks and deposits in transit clearing subsequent bank statements from a qualified source.
· Vouch material and unusual entries in the cash account.
· Perform an analysis of bank transfers at or near cutoff.
· Use analytical procedures to determine the reasonableness of the reported cash balance.
   

This response is only intended to be a sample. The instructor must evaluate the quality of the student responses.

 

  1. Audit procedures for accounts receivable

    In the process of gathering and evaluating evidence, documentation is derived in various forms. Rank the following types of evidence in the audit of Accounts Receivable from most persuasive to least persuasive and provide explanations for your decision.
· oral statements from management that the accounts receivable are fairly presented
· confirmations received from customers
· deposit slips subsequent to year end showing deposits by customer name
· copies of sales invoices
   

 

The ranking of these pieces of evidence on accounts receivable and the reasons for the rankings are as follows:

· Accounts receivable confirmations would be most persuasive as these forms of evidence are obtained from independent parties and sent directly to the auditor.
· Deposits subsequent to year end showing customer names would be next in line. The reason is that even though the deposit slips are generated and held internally they have had outside intervention in the hands of the banks.
· Sales invoices would rank next as they are also prepared inside the client’s office and held by the client but they have no outside intervention.
· Oral statements by management concerning the fairness of the financial statements would be least persuasive as they have no validity until we can prove their statements to be true by other means.
   

 

  1. Audit program

    Discuss the purpose of the audit program and its importance to the auditor.

An audit program specifies the actual procedures to be performed in gathering the required audit evidence about the assertions embodied in the client’s financial statements. Because the audit program guides the overall conduct of the audit it is the single most important piece of documentation in an audit engagement. The program is an effective means for:

· organizing and distributing audit work.
· monitoring the audit process and progress.
· reviewing for possible omission of material areas from the audit.
· recording the audit work performed.
· reviewing the completeness and persuasiveness of procedures performed.
   

 

  1. Audit standards of proper documentation

    Discuss the audit standards that must be applied to the auditor’s documentation. Give five examples the types of documentation will be found in the audit work papers.

Auditing standards require adequate documentation in the general standards under both planning and supervision and gaining an understanding of internal control.

The third standard of field work states that “sufficient appropriate evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.”

Pursuant to all of these requirements, audit work papers will include such items as:

1. Evidence of planning such as the planning memo, risk assessments and the audit program.
2. Evidence of the auditor’s understanding and assessment of internal control over the client organization.
3. The client’s trial balance and proposed audit adjustments.
4. Copies of certain internal and external documents such as letters of communication with the client and returned confirmations.
5. Audit memoranda documenting the testing process, auditor reasoning and conclusions.
6. Results of analytical procedures and audit testing.
7. Auditor generated analysis of account balances such as the allowance for doubtful accounts.
   

 

  1. Audit procedures

    Discuss how each of the following procedures could be used in the audit of fixed assets, e.g., various types of equipment used in the business.
Procedure How used Assertion(s) tested
Observation    
Physical examination    
Inquiry    
Confirmation    
Examination of documents    
Recomputation    
Reprocessing    
Vouching    
Analytical    
Procedures    
     

 

 

Procedure How used Assertion(s) tested
Observation Observe taking of inventory of assets Existence
Physical examination Inspect existence and condition of assets. Existence, Valuation
Inquiry Inquire of management of assets not recorded or that have been sold or discarded. Existence, Completeness
Confirmation Confirm details of purchase with seller of asset. Existence, Valuation, Presentation and Disclosure, Rights
Examination of documents Examine supporting documentation. Existence, Valuation, Rights
Recomputation Recompute depreciation Valuation
Reprocessing Reprocess a sample of purchase transactions Existence
Vouching Vouching a sample of recorded assets Existence, Valuation, Rights
Analytical Analysis depreciation Valuation, Completeness
Procedures expense  
     

 

  1. Audit procedures

    Businesses often have litigation against them that the auditor has to identify and adequately disclose. List the financial assertions that apply to Contingencies. For each assertion indicate two or three audit procedures that would address that assertion.

    Organize you answer as follows:

Financial statement assertion Audit procedure(s)  
     
     
     
     
     
     
     
     
     
     
     
     
     
     

 

 

Financial statement assertion Audit procedure(s)  
Existence Inquiry of management  
  Send confirmation request to legal counsel  
Completeness Inquiry of management  
  Vouch legal expenses  
  Review nature of legal services to determine if a liability might exist  
Rights and Obligations Inquiry of management  
  Confirmation from legal counsel  
  Examine payments related to in-progress litigation  
Valuation and Allocation Inquiry of management  
  Confirmation of legal counsel  
  Review court rulings  
Presentation and Disclosure Inquiry of management  
  Confirmation of legal counsel  
     

Chapter 17: Professional Liability

Student: ___________________________________________________________________________

  1. The contract law concept of liability is based on breach of contract.
    True    False

 

  1. The concept of auditor’s liability is based entirely on common law.
    True    False

 

  1. The common law concept of liability is based on negligence and fraud.
    True    False

 

  1. Common law is written law established by each state subject to specific federal guidelines .
    True    False

 

  1. The statutory law concept of liability is based on state and federal securities laws.
    True    False

 

  1. The statutory law concept of liability is primarily based on state securities laws, or “blue sky”.
    True    False

 

  1. The “deep pocket theory” is based on joint and several liability and, as a result, auditors are often responsible for the full amount of losses to plaintiffs.
    True    False

 

  1. Joint and several liability requires that damages should be paid by each guilty party, only to the extent each party is responsible.
    True    False

 

  1. Contingent-fee compensation for lawyers protects the privileged and discourages lawsuits.
    True    False

 

  1. Audit reports accompanying a financial statement serve as a guarantee that an investment in the audited company is free of risk.
    True    False

 

  1. Class-action suits are designed to give plaintiffs with small losses the ability to join together to afford the costs of litigation.
    True    False

 

  1. Plaintiffs who sue auditors almost always allege that the auditors committed fraud.
    True    False

 

  1. Breach of contract occurs when a person fails to perform a contractual duty that has not been excused.
    True    False

 

  1. Gross negligence is often referred to as constructive fraud.
    True    False

 

  1. An auditor can be construed to act negligently if he or she fails to follow GAAS requirements and the actions result in harm to others or their property.
    True    False

 

  1. Ordinary negligence is often referred to as constructive fraud.
    True    False

 

  1. Gross negligence is the failure to exercise minimal care without evidence of intent to cause damage to others or deceive others.
    True    False

 

  1. A breach of contract suit brought by a client may result in compensatory damages if specific performance is not appropriate.
    True    False

 

  1. An identified user of a financial statement is one known to the auditor to be a user of the financial statement.
    True    False

 

  1. In common law litigation against auditors, third parties must prove that they relied on financial statements.
    True    False

 

  1. A foreseeable user of a financial statement is unknown to the auditor, but the auditor can reasonably expect this type of person to use the financial statement.
    True    False

 

  1. Auditors have similar responsibilities to identified, foreseen and foreseeable users of financial statements.
    True    False

 

  1. In a common law case against auditors, third parties must prove that the auditors knew or should have known the financial statements were misleading.
    True    False

 

  1. Privity is a concept defining the unwritten relationship between the auditor and third-party beneficiaries
    True    False

 

  1. The Wisconsin Supreme Court extended auditor liability to foreseeable users in the case of Citizens State Bank v. Timms Schmidt & Co.
    True    False

 

  1. The Ultramares case established the initial precedent that auditors’ liability for ordinary negligence is limited to those who are in privity of contract.
    True    False

 

  1. The Securities Act of 1934 regulates the issuance of securities in the primary market.
    True    False

 

  1. The Restatement of Torts approach further supports the Ultramares conclusion that only clients may sue auditors for breach of contract.
    True    False

 

  1. The Continental Vending case represented the first criminal action against auditors who were found guilty of a conspiracy, even though they did not personally gain from it.
    True    False

 

  1. The cornerstone of any defensive practice program is professional liability insurance.
    True    False

 

  1. The AICPA requires its members in public practice to complete 120 hours of continuing education each year to retain membership.
    True    False

 

  1. Engagement letters are the cornerstone of a defensive practice program by CPAs.
    True    False

 

  1. If public accounting firms practice defensive auditing, there is no need for professional liability insurance.
    True    False

 

  1. The Private Securities Litigation Reform Act of 1995 intends to curb frivolous class action lawsuits brought under federal securities laws.
    True    False

 

  1. Increased auditor liability has resulted from class action lawsuits and the complexity of accounting principles.
    True    False

 

  1. Contingent-fee based cases are alleviating the intensity and volume of lawsuits against auditors.
    True    False

 

  1. Breach of contract involves a tort on the part of the auditor.
    True    False

 

  1. The doctrine of due care means that auditors are expected to be infallible.
    True    False

 

  1. Failure to perform a contractual duty that has not been excused is considered malpractice.
    True    False

 

  1. Fraud is an intentional concealment or misrepresentation of a material fact that causes damage to those deceived.
    True    False

 

  1. Defensive auditing means taking special actions to avoid lawsuits.
    True    False

 

  1. The Securities Act of 1933 deals with the initial registration of the issuance of new securities with the SEC and it requires plaintiffs to prove fraud or gross negligence.
    True    False

 

  1. The Securities Act of 1934 regulates the trading of securities after their initial issuance and it requires plaintiffs to prove fraud or gross negligence.
    True    False

 

  1. Under common law in states using the Ultramares rule, third-party users must prove gross negligence or fraud unless they are able to get themselves classified as third-party beneficiaries of the financial statements.
    True    False

 

  1. Under common law in states using the Restatement of Torts rule, third-party users must prove gross negligence or fraud unless they classify themselves as third-party beneficiaries of the financial statements.
    True    False

 

  1. Generally the courts have held auditors liable to third-party users when the auditor has been found guilty of fraud or gross negligence.
    True    False

 

  1. A tort is a wrongful action against someone that results in harm to them.
    True    False

 

  1. Third-party users of audited financial statements generally must prove that they suffered a loss, reliance on the financial statements, and that the auditors knew or should have known that the financial statements were misstated.
    True    False

 

  1. The duty of care that third-party users of audited financial statements generally must prove differs between the various states based upon court cases. The foreseeable rule is the one most extensively utilized among the states.
    True    False

 

  1. Most large U.S. CPA firms are affiliates of international organizations. Such organizational structures have important implications for legal liability, although the legal liability outcomes are not always predictable.
    True    False

 

  1. An unsettled issue of liability for CPA firms concerns audited financial information disseminated on the Internet.
    True    False

 

  1. In 2009, the SEC issued rules requiring companies to provide financial information in a form that can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist in automating regulatory filings.
    True    False

 

  1. All of the following factors have led to increased litigation against the auditor except
    A. class-action suits.
    B. increased complexity of accounting standards.
    C. less demanding auditing standards for detection of errors and regularities.
    D. joint and several liability statutes.

 

  1. Which of the following terms refers to an intentional concealment or misrepresentation of a material fact that causes damage to those deceived?
    A. gross negligence.
    B. fraud.
    C. ordinary negligence.
    D. breach of contract.

 

  1. Which of the following is known as the failure to exercise reasonable care, thereby causing harm to another or to property?
    A. ordinary negligence.
    B. gross negligence.
    C. fraud.
    D. scienter.

 

  1. Jack Box, CPA, misinterpreted the results of several accounts receivable confirmations in the audit of Jones Company. Box would be guilty of which of the following?
    A. fraud.
    B. scienter.
    C. ordinary negligence.
    D. gross negligence.

 

  1. Sally Schultz, CPA, neglected to observe the taking of physical inventory when she audited Gordy Company. Inventory is material to the balance sheet. Schultz is most likely guilty of which of the following?
    A. fraud.
    B. scienter.
    C. ordinary negligence.
    D. gross negligence.

 

  1. Thomas Leegins, CPA, purposely omitted the confirmation of accounts receivable because of his knowledge that management had grossly overstated this account. Accounts receivable are material to the balance sheet. Leegins is most likely guilty of which of the following?
    A. fraud.
    B. a civil tort.
    C. ordinary negligence.
    D. gross negligence.

 

  1. The shareholders of a bank sue Joe Bush, CPA, for malpractice due to an audit failure that preceded the insolvency of the bank. The jury determines that Bush is 20 percent at fault and the bank management is 80 percent at fault. Bush is fully insured. Under joint and several liability, Bush will pay which of the following?
    A. between 20 percent and 100 percent of the damages.
    B. 100 percent of the damages.
    C. 50 percent of the damages.
    D. 80 percent of the damages.

 

  1. A reasonable cause for action against the auditor for breach of contract may include all of the following except which of the following?
    A. violating client confidentiality.
    B. withdrawing from an audit engagement without justification.
    C. failure to provide the audit report on time.
    D. failure to discover an immaterial error.

 

  1. Which of the following is considered a failure to perform a contractual duty that has not been excused?
    A. breach of contract.
    B. malpractice.
    C. fraud.
    D. third-party defense.

 

  1. Which aspect of statutory law places the burden of proof onto the auditor?
    A. Scienter.
    B. Securities Act of 1933.
    C. Joint and Several Liability.
    D. Ultramares.

 

  1. Which of the following is an example of Joint and Several Liability?
    A. Chirs Schrewers, CPA will not be liable because of due diligence.
    B. David, CPA will be required to pay 100%, even though he is only 40% responsible.
    C. Kate Brownman, CPA does not have privity of contract with the client’s bank.
    D. Meadow Elkins states that the client contributed to the loss of the users.

 

  1. Who may sue an auditor under common law for a tort?
    A. clients
    B. foreseeable parties
    C. foreseen parties
    D. anyone with grounds

 

  1. The law that requires companies to file registration statements with the SEC before they may issue new securities to the public is known as the
    A. RICO law.
    B. Securities Exchange Act of 1934.
    C. Securities Act of 1933.
    D. Securities Act of 1934.

 

  1. If an auditor does not complete an audit according to the terms of the engagement letter, there is a risk that the auditor will be sued for
    A. the Restatement approach.
    B. breach of contract.
    C. joint and several liability.
    D. privity of contract.

 

  1. Which of the following most likely constitutes breach of contract of the auditor with a client?
    A. Withholding client information from interested external parties.
    B. Withdrawing from the engagement due to accepting a new client.
    C. Failing to discover immaterial fraud in the client’s payroll department.
    D. Providing the audit opinion to the client prior to the due date.

 

  1. The Securities Act of 1933 regulates which of the following?
    A. The initial registration of all corporations with the federal government.
    B. The initial registration of all corporations with state governments.
    C. Corporations to file registration statements when reselling prior issues to the public.
    D. Corporations to file registration statements when issuing new securities to the public.

 

  1. The Securities Exchange Act of 1934 places the burden of proof on which of the following parties?
    A. third-party plaintiff.
    B. attorney defendant.
    C. auditor defendant.
    D. client plaintiff.

 

  1. An example of a case that subjected an auditor to criminal charges is
    A. the McKesson & Robbins case.
    B. the Citizens Timm case.
    C. the Bily v. Arthur Young & Co. case.
    D. the Equity Funding case.

 

  1. The Jaillet v. Cashman gives indication to which of the following?
    A. Mass dissemination of erroneous financial information may give way to corporate lawsuits.
    B. Scienter leads to fraudulent reporting by the auditors in a Securities Act of 1934 filing.
    C. Rule 11 of the Securities Exchange Act of 1934 gives the plaintiff the right to sue underwriters.
    D. Criminal actions of auditors will be measured by RICO standards.

 

  1. The Securities Act of 1934 has the primary objective of regulating which of the following?
    A. Trading of securities after their initial issuance.
    B. Initial issuances of securities.
    C. Adherence to the Sarbanes-Oxley Act of 2002.
    D. The registration of audit firms with the PCAOB.

 

  1. The primary objective of the Securities Act of 1933 is the regulation of which of the following?
    A. Trading of securities after their initial issuance.
    B. Initial issuances of securities.
    C. Adherence to the Sarbanes-Oxley Act of 2002.
    D. The registration of audit firms with the PCAOB.

 

  1. Defensive auditing includes all of the following except
    A. clarifying the nature of the arrangement through the use of a written engagement letter.
    B. knowing when your client is about to fire your firm before hand.
    C. carefully selecting which clients to accept and retain.
    D. evaluation of a firm’s capacity to adequately perform services for a specific client.

 

  1. An intent to deceive is best known in the regulatory arena as which of the following?
    A. contributory negligence.
    B. ordinary negligence.
    C. gross negligence.
    D. scienter.

 

  1. The audit firm must prepare to minimize exposure against litigation and regulatory investigation. Which of the following represents the best method of performing this task?
    A. Engaging competent and trustworthy criminal defense attorneys.
    B. Lobbying the SEC to become allies with CPAs and related constituents.
    C. Instituting a sound system of quality control within the firm.
    D. Restructuring to a traditional partnership to share the risk with other professionals.

 

  1. Which of the following is one method utilized by the auditing profession to assist in maintaining independence?
    A. quality continuing education in relevant areas.
    B. screening of auditors by the Federal Trade Commission.
    C. partner rotation on public engagements every five years.
    D. prohibition of audit services on any public client.

 

  1. When the client and the auditor are both sued and judgment is rendered against both, the auditor will be required to settle the entire judgment if the client is bankrupt. Which of the following is a representation of the above?
    A. Private Litigation Reform.
    B. Joint and several liability statutes.
    C. Comparative fraud.
    D. The Securities Acts.

 

  1. The court case that established the precedent that an auditor can be held liable to third parties for fraud and gross negligence, but limited auditor liability for ordinary negligence to those who are in privity of contract, is the
    A. McKesson and Robbins case.
    B. 1136 Tenants Corporation case.
    C. CIT Financial Corporation case.
    D. Ultramares Corporation case.

 

  1. The auditor of Moab Ridge, Inc. and subsidiaries, a public company, performs a valuation analysis for the purpose of testing the goodwill for impairment. Moab Ridge did not have a valuation analysis performed previously and will use the auditors’ valuation for internal purposes as well. The above situation best represents which of the following?
    A. A violation of common law.
    B. A prohibited service.
    C. Scienter on behalf of the auditor.
    D. Value added auditing for client retention.

 

  1. Proving that reasonable procedures were used, that there was reason to believe that the financial statements were presented fairly, and that the auditor planned and conducted the audit in accordance with GAAS provides the auditor with which defense?
    A. Contributory negligence.
    B. Due diligence.
    C. Justifiable privity.
    D. Joint and several liability.

 

  1. In order to reduce the auditor’s liability exposure, engagement letters should include which of the following?
    A. a clearly stated scope of the work to be done.
    B. a statement that a trial by jury is acceptable.
    C. the guaranteed fee structure for the engagement.
    D. a statement that the auditor is not liable to the SEC.

 

  1. Which of the following best assists auditors in protecting personal assets against damages from lawsuits?
    A. Restructuring to limited liability partnerships.
    B. Shredding documents prior to an investigation.
    C. Engaging in torts at the federal and state levels.
    D. The Securities Act of 1933.

 

  1. In a lawsuit brought under the Securities Act of 1933, which of the following must the plaintiff show?
    A. Reliance on financial statements.
    B. Auditors guilt.
    C. Due diligence.
    D. That a loss was sustained.

 

  1. The federal securities laws, e.g., the Securities Act of 1933 and the Securities Exchange Act of 1934 are a form of which type of law?
    A. statutory law.
    B. common law.
    C. contract law.
    D. civil law.

 

  1. In this type of internal peer review program, a partner not otherwise involved in the audit performs a review near the end of each audit to make sure that documented evidence supports the audit opinion.
    A. Benchmark audit.
    B. Engagement quality review
    C. Interoffice review
    D. Supplementary review

 

  1. Auditor defenses for suits brought under the Securities Act of 1933 include which of the following?
    A. the auditor is an expert in financial accounting.
    B. the auditor followed the required level professional performance on the engagement.
    C. the financial statements were materially misstated, and the auditor was aware of that fact.
    D. the contract is between the auditor and the shareholders.

 

  1. Which of the following Acts have been passed by the U.S. Congress to curb frivolous securities class lawsuits and discontinue joint and several treatment?
    A. Private Securities Litigation Reform Act of 1995.
    B. Sarbanes-Oxley Act of 2002.
    C. Securities Act of 1933.
    D. Public Companies Litigation Reduction Act of 1998.

 

  1. A legal concept that is not significant to the doctrine of privity is that of
    A. negligence.
    B. ultramares.
    C. scienter.
    D. engagement letters.

 

  1. The primary factor that delineates statutory law, as they relate to audits, is that of liability founded on which of the following?
    A. circuit court decisions.
    B. federal securities laws.
    C. arbitration by private parties.
    D. breach of contract.

 

  1. Who may sue an auditor under common law for breach of contract?
    A. clients
    B. foreseeable parties
    C. foreseen parties
    D. anyone with grounds

 

  1. The Securities Exchange Act of 1933 places the burden of proof on which of the following?
    A. third-party plaintiff.
    B. attorney defendant.
    C. auditor defendant.
    D. client plaintiff.

 

  1. The court case that established the precedent that an auditor can only be held liable to plaintiffs for fraud and gross negligence under the 1934 Act is
    A. McKesson and Robbins case.
    B. 1136 Tenants Corporation case.
    C. Ernst & Ernst v. Hochfelder.
    D. Ultramares Corporation case.

 

  1. Which of the following factors do not have to be proved by a client under common law?
    A. breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. The failure to use even minimal care in the conduct of the audit is called
    A. negligence.
    B. constructive negligence.
    C. fraud.
    D. scienter.

 

  1. Which of the following factors do not have to be proved by a third party beneficiary in an Ultramares state under common law?
    A. breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors do not have to be proved by a foreseen user in a Rusch Factors state under common law?
    A. breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors have to be proved by a plaintiff against an auditor under 1933 Securities Act?
    A. breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors do not have to be proved by a plaintiff against an auditor under 1934 Securities Exchange Act?
    A. breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Common law is based upon which of the following?
    A. state statues.
    B. federal statutes.
    C. court decisions.
    D. contracts.

 

  1. The auditor is responsible for ordinary negligence in most states to which of the following parties?
    A. clients.
    B. third-party users.
    C. third-party beneficiaries.
    D. both A and C.

 

  1. When is the auditor required to prove due diligence?
    A. 1933 Securities Act.
    B. 1934 Securities Exchange Act.
    C. Common law.
    D. Torts.

 

  1. There are various professional requirements for CPA firms to help assure audit quality. These requirements potentially minimize the exposure of public accounting firms and partners to lawsuits. These requirements include
    A. auditor independence requirements.
    B. quality-control programs.
    C. review programs.
    D. all of the above.

 

  1. Emerging and unsettled liability issues that CPA firms face include which of the following?
    A. the legal considerations for CPA firms that operate as international organizations.
    B. the role of CPA firms for identifying fraud.
    C. the dissemination of audited financial information over the internet.
    D. all of the above.

 

  1. Litigation against auditors

    Identify five factors affecting the extent of litigation against auditors.

 

 

 

 

 

  1. Joint and several liability

    Why has the statute concerning joint and several liability been so devastating to the auditing profession? What changes in tort law help to mitigate the effects of such liability?

 

 

 

 

 

  1. Auditor breach of contract

    Discuss the causes for action against the auditor for breach of contract and the defenses the auditor may use.

 

 

 

 

 

  1. Liability of auditors to others

    Provide a audit liability scenario that includes the following parties:
A. a party with whom privity exists
B. third-party beneficiary
C. foreseen party
D. foreseeable party
   

Be sure to identify each type of party.

 

 

 

 

 

  1. Defensive auditing

    A. What is meant by the term “defensive auditing”?
    B. Present examples of defensive auditing practices.

 

 

 

 

 

  1. Minimizing Liability Exposure

    State the approaches that help mitigate the exposure of public accounting firms and partners to lawsuits.

 

 

 

 

 

  1. Auditor liabilities in the public arena

    Contrast the auditor’s liability under the Securities Act of 1933 and the Securities Exchange Act of 1934.

 

 

 

 

 

  1. Auditor common law liabilities

    Contrast the auditor’s liability to a client with their responsibility to third-party users of the financial statements.

 

 

 

 

 

 

 

Chapter 17: Professional Liability Key

  1. The contract law concept of liability is based on breach of contract.
    TRUE

 

  1. The concept of auditor’s liability is based entirely on common law.
    FALSE

 

  1. The common law concept of liability is based on negligence and fraud.
    TRUE

 

  1. Common law is written law established by each state subject to specific federal guidelines .
    FALSE

 

  1. The statutory law concept of liability is based on state and federal securities laws.
    TRUE

 

  1. The statutory law concept of liability is primarily based on state securities laws, or “blue sky”.
    FALSE

 

  1. The “deep pocket theory” is based on joint and several liability and, as a result, auditors are often responsible for the full amount of losses to plaintiffs.
    TRUE

 

  1. Joint and several liability requires that damages should be paid by each guilty party, only to the extent each party is responsible.
    FALSE

 

  1. Contingent-fee compensation for lawyers protects the privileged and discourages lawsuits.
    FALSE

 

  1. Audit reports accompanying a financial statement serve as a guarantee that an investment in the audited company is free of risk.
    FALSE

 

  1. Class-action suits are designed to give plaintiffs with small losses the ability to join together to afford the costs of litigation.
    TRUE

 

  1. Plaintiffs who sue auditors almost always allege that the auditors committed fraud.
    FALSE

 

  1. Breach of contract occurs when a person fails to perform a contractual duty that has not been excused.
    TRUE

 

  1. Gross negligence is often referred to as constructive fraud.
    TRUE

 

  1. An auditor can be construed to act negligently if he or she fails to follow GAAS requirements and the actions result in harm to others or their property.
    TRUE

 

  1. Ordinary negligence is often referred to as constructive fraud.
    FALSE

 

  1. Gross negligence is the failure to exercise minimal care without evidence of intent to cause damage to others or deceive others.
    TRUE

 

  1. A breach of contract suit brought by a client may result in compensatory damages if specific performance is not appropriate.
    TRUE

 

  1. An identified user of a financial statement is one known to the auditor to be a user of the financial statement.
    TRUE

 

  1. In common law litigation against auditors, third parties must prove that they relied on financial statements.
    TRUE

 

  1. A foreseeable user of a financial statement is unknown to the auditor, but the auditor can reasonably expect this type of person to use the financial statement.
    TRUE

 

  1. Auditors have similar responsibilities to identified, foreseen and foreseeable users of financial statements.
    FALSE

 

  1. In a common law case against auditors, third parties must prove that the auditors knew or should have known the financial statements were misleading.
    TRUE

 

  1. Privity is a concept defining the unwritten relationship between the auditor and third-party beneficiaries
    FALSE

 

  1. The Wisconsin Supreme Court extended auditor liability to foreseeable users in the case of Citizens State Bank v. Timms Schmidt & Co.
    TRUE

 

  1. The Ultramares case established the initial precedent that auditors’ liability for ordinary negligence is limited to those who are in privity of contract.
    TRUE

 

  1. The Securities Act of 1934 regulates the issuance of securities in the primary market.
    FALSE

 

  1. The Restatement of Torts approach further supports the Ultramares conclusion that only clients may sue auditors for breach of contract.
    FALSE

 

  1. The Continental Vending case represented the first criminal action against auditors who were found guilty of a conspiracy, even though they did not personally gain from it.
    TRUE

 

  1. The cornerstone of any defensive practice program is professional liability insurance.
    FALSE

 

  1. The AICPA requires its members in public practice to complete 120 hours of continuing education each year to retain membership.
    FALSE

 

  1. Engagement letters are the cornerstone of a defensive practice program by CPAs.
    TRUE

 

  1. If public accounting firms practice defensive auditing, there is no need for professional liability insurance.
    FALSE

 

  1. The Private Securities Litigation Reform Act of 1995 intends to curb frivolous class action lawsuits brought under federal securities laws.
    TRUE

 

  1. Increased auditor liability has resulted from class action lawsuits and the complexity of accounting principles.
    TRUE

 

  1. Contingent-fee based cases are alleviating the intensity and volume of lawsuits against auditors.
    FALSE

 

  1. Breach of contract involves a tort on the part of the auditor.
    FALSE

 

  1. The doctrine of due care means that auditors are expected to be infallible.
    FALSE

 

  1. Failure to perform a contractual duty that has not been excused is considered malpractice.
    FALSE

 

  1. Fraud is an intentional concealment or misrepresentation of a material fact that causes damage to those deceived.
    TRUE

 

  1. Defensive auditing means taking special actions to avoid lawsuits.
    TRUE

 

  1. The Securities Act of 1933 deals with the initial registration of the issuance of new securities with the SEC and it requires plaintiffs to prove fraud or gross negligence.
    FALSE

 

  1. The Securities Act of 1934 regulates the trading of securities after their initial issuance and it requires plaintiffs to prove fraud or gross negligence.
    TRUE

 

  1. Under common law in states using the Ultramares rule, third-party users must prove gross negligence or fraud unless they are able to get themselves classified as third-party beneficiaries of the financial statements.
    TRUE

 

  1. Under common law in states using the Restatement of Torts rule, third-party users must prove gross negligence or fraud unless they classify themselves as third-party beneficiaries of the financial statements.
    FALSE

 

  1. Generally the courts have held auditors liable to third-party users when the auditor has been found guilty of fraud or gross negligence.
    TRUE

 

  1. A tort is a wrongful action against someone that results in harm to them.
    TRUE

 

  1. Third-party users of audited financial statements generally must prove that they suffered a loss, reliance on the financial statements, and that the auditors knew or should have known that the financial statements were misstated.
    TRUE

 

  1. The duty of care that third-party users of audited financial statements generally must prove differs between the various states based upon court cases. The foreseeable rule is the one most extensively utilized among the states.
    FALSE

 

  1. Most large U.S. CPA firms are affiliates of international organizations. Such organizational structures have important implications for legal liability, although the legal liability outcomes are not always predictable.
    TRUE

 

  1. An unsettled issue of liability for CPA firms concerns audited financial information disseminated on the Internet.
    TRUE

 

  1. In 2009, the SEC issued rules requiring companies to provide financial information in a form that can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist in automating regulatory filings.
    TRUE

 

  1. All of the following factors have led to increased litigation against the auditor except
    A. class-action suits.
    B. increased complexity of accounting standards.
    C. less demanding auditing standards for detection of errors and regularities.
    D. joint and several liability statutes.

 

  1. Which of the following terms refers to an intentional concealment or misrepresentation of a material fact that causes damage to those deceived?
    A.gross negligence.
    B. fraud.
    C. ordinary negligence.
    D. breach of contract.

 

  1. Which of the following is known as the failure to exercise reasonable care, thereby causing harm to another or to property?
    A.ordinary negligence.
    B. gross negligence.
    C. fraud.
    D. scienter.

 

  1. Jack Box, CPA, misinterpreted the results of several accounts receivable confirmations in the audit of Jones Company. Box would be guilty of which of the following?
    A.fraud.
    B. scienter.
    C. ordinary negligence.
    D. gross negligence.

 

  1. Sally Schultz, CPA, neglected to observe the taking of physical inventory when she audited Gordy Company. Inventory is material to the balance sheet. Schultz is most likely guilty of which of the following?
    A.fraud.
    B. scienter.
    C. ordinary negligence.
    D. gross negligence.

 

  1. Thomas Leegins, CPA, purposely omitted the confirmation of accounts receivable because of his knowledge that management had grossly overstated this account. Accounts receivable are material to the balance sheet. Leegins is most likely guilty of which of the following?
    A.fraud.
    B. a civil tort.
    C. ordinary negligence.
    D. gross negligence.

 

  1. The shareholders of a bank sue Joe Bush, CPA, for malpractice due to an audit failure that preceded the insolvency of the bank. The jury determines that Bush is 20 percent at fault and the bank management is 80 percent at fault. Bush is fully insured. Under joint and several liability, Bush will pay which of the following?
    A.between 20 percent and 100 percent of the damages.
    B. 100 percent of the damages.
    C. 50 percent of the damages.
    D. 80 percent of the damages.

 

  1. A reasonable cause for action against the auditor for breach of contract may include all of the following except which of the following?
    A.violating client confidentiality.
    B. withdrawing from an audit engagement without justification.
    C. failure to provide the audit report on time.
    D. failure to discover an immaterial error.

 

  1. Which of the following is considered a failure to perform a contractual duty that has not been excused?
    A.breach of contract.
    B. malpractice.
    C. fraud.
    D. third-party defense.

 

  1. Which aspect of statutory law places the burden of proof onto the auditor?
    A.Scienter.
    B. Securities Act of 1933.
    C. Joint and Several Liability.
    D. Ultramares.

 

  1. Which of the following is an example of Joint and Several Liability?
    A.Chirs Schrewers, CPA will not be liable because of due diligence.
    B. David, CPA will be required to pay 100%, even though he is only 40% responsible.
    C. Kate Brownman, CPA does not have privity of contract with the client’s bank.
    D. Meadow Elkins states that the client contributed to the loss of the users.

 

  1. Who may sue an auditor under common law for a tort?
    A.clients
    B. foreseeable parties
    C. foreseen parties
    D. anyone with grounds

 

  1. The law that requires companies to file registration statements with the SEC before they may issue new securities to the public is known as the
    A.RICO law.
    B. Securities Exchange Act of 1934.
    C. Securities Act of 1933.
    D. Securities Act of 1934.

 

  1. If an auditor does not complete an audit according to the terms of the engagement letter, there is a risk that the auditor will be sued for
    A.the Restatement approach.
    B. breach of contract.
    C. joint and several liability.
    D. privity of contract.

 

  1. Which of the following most likely constitutes breach of contract of the auditor with a client?
    A.Withholding client information from interested external parties.
    B. Withdrawing from the engagement due to accepting a new client.
    C. Failing to discover immaterial fraud in the client’s payroll department.
    D. Providing the audit opinion to the client prior to the due date.

 

  1. The Securities Act of 1933 regulates which of the following?
    A.The initial registration of all corporations with the federal government.
    B. The initial registration of all corporations with state governments.
    C. Corporations to file registration statements when reselling prior issues to the public.
    D. Corporations to file registration statements when issuing new securities to the public.

 

  1. The Securities Exchange Act of 1934 places the burden of proof on which of the following parties?
    A.third-party plaintiff.
    B. attorney defendant.
    C. auditor defendant.
    D. client plaintiff.

 

  1. An example of a case that subjected an auditor to criminal charges is
    A.the McKesson & Robbins case.
    B. the Citizens Timm case.
    C. the Bily v. Arthur Young & Co. case.
    D. the Equity Funding case.

 

  1. The Jaillet v. Cashman gives indication to which of the following?
    A.Mass dissemination of erroneous financial information may give way to corporate lawsuits.
    B. Scienter leads to fraudulent reporting by the auditors in a Securities Act of 1934 filing.
    C. Rule 11 of the Securities Exchange Act of 1934 gives the plaintiff the right to sue underwriters.
    D. Criminal actions of auditors will be measured by RICO standards.

 

  1. The Securities Act of 1934 has the primary objective of regulating which of the following?
    A.Trading of securities after their initial issuance.
    B. Initial issuances of securities.
    C. Adherence to the Sarbanes-Oxley Act of 2002.
    D. The registration of audit firms with the PCAOB.

 

  1. The primary objective of the Securities Act of 1933 is the regulation of which of the following?
    A.Trading of securities after their initial issuance.
    B. Initial issuances of securities.
    C. Adherence to the Sarbanes-Oxley Act of 2002.
    D. The registration of audit firms with the PCAOB.

 

  1. Defensive auditing includes all of the following except
    A. clarifying the nature of the arrangement through the use of a written engagement letter.
    B. knowing when your client is about to fire your firm before hand.
    C. carefully selecting which clients to accept and retain.
    D. evaluation of a firm’s capacity to adequately perform services for a specific client.

 

  1. An intent to deceive is best known in the regulatory arena as which of the following?
    A.contributory negligence.
    B. ordinary negligence.
    C. gross negligence.
    D. scienter.

 

  1. The audit firm must prepare to minimize exposure against litigation and regulatory investigation. Which of the following represents the best method of performing this task?
    A.Engaging competent and trustworthy criminal defense attorneys.
    B. Lobbying the SEC to become allies with CPAs and related constituents.
    C. Instituting a sound system of quality control within the firm.
    D. Restructuring to a traditional partnership to share the risk with other professionals.

 

  1. Which of the following is one method utilized by the auditing profession to assist in maintaining independence?
    A.quality continuing education in relevant areas.
    B. screening of auditors by the Federal Trade Commission.
    C. partner rotation on public engagements every five years.
    D. prohibition of audit services on any public client.

 

  1. When the client and the auditor are both sued and judgment is rendered against both, the auditor will be required to settle the entire judgment if the client is bankrupt. Which of the following is a representation of the above?
    A.Private Litigation Reform.
    B. Joint and several liability statutes.
    C. Comparative fraud.
    D. The Securities Acts.

 

  1. The court case that established the precedent that an auditor can be held liable to third parties for fraud and gross negligence, but limited auditor liability for ordinary negligence to those who are in privity of contract, is the
    A.McKesson and Robbins case.
    B. 1136 Tenants Corporation case.
    C. CIT Financial Corporation case.
    D. Ultramares Corporation case.

 

  1. The auditor of Moab Ridge, Inc. and subsidiaries, a public company, performs a valuation analysis for the purpose of testing the goodwill for impairment. Moab Ridge did not have a valuation analysis performed previously and will use the auditors’ valuation for internal purposes as well. The above situation best represents which of the following?
    A.A violation of common law.
    B. A prohibited service.
    C. Scienter on behalf of the auditor.
    D. Value added auditing for client retention.

 

  1. Proving that reasonable procedures were used, that there was reason to believe that the financial statements were presented fairly, and that the auditor planned and conducted the audit in accordance with GAAS provides the auditor with which defense?
    A.Contributory negligence.
    B. Due diligence.
    C. Justifiable privity.
    D. Joint and several liability.

 

  1. In order to reduce the auditor’s liability exposure, engagement letters should include which of the following?
    A.a clearly stated scope of the work to be done.
    B. a statement that a trial by jury is acceptable.
    C. the guaranteed fee structure for the engagement.
    D. a statement that the auditor is not liable to the SEC.

 

  1. Which of the following best assists auditors in protecting personal assets against damages from lawsuits?
    A.Restructuring to limited liability partnerships.
    B. Shredding documents prior to an investigation.
    C. Engaging in torts at the federal and state levels.
    D. The Securities Act of 1933.

 

  1. In a lawsuit brought under the Securities Act of 1933, which of the following must the plaintiff show?
    A.Reliance on financial statements.
    B. Auditors guilt.
    C. Due diligence.
    D. That a loss was sustained.

 

  1. The federal securities laws, e.g., the Securities Act of 1933 and the Securities Exchange Act of 1934 are a form of which type of law?
    A.statutory law.
    B. common law.
    C. contract law.
    D. civil law.

 

  1. In this type of internal peer review program, a partner not otherwise involved in the audit performs a review near the end of each audit to make sure that documented evidence supports the audit opinion.
    A.Benchmark audit.
    B. Engagement quality review
    C. Interoffice review
    D. Supplementary review

 

  1. Auditor defenses for suits brought under the Securities Act of 1933 include which of the following?
    A.the auditor is an expert in financial accounting.
    B. the auditor followed the required level professional performance on the engagement.
    C. the financial statements were materially misstated, and the auditor was aware of that fact.
    D. the contract is between the auditor and the shareholders.

 

  1. Which of the following Acts have been passed by the U.S. Congress to curb frivolous securities class lawsuits and discontinue joint and several treatment?
    A.Private Securities Litigation Reform Act of 1995.
    B. Sarbanes-Oxley Act of 2002.
    C. Securities Act of 1933.
    D. Public Companies Litigation Reduction Act of 1998.

 

  1. A legal concept that is not significant to the doctrine of privity is that of
    A.negligence.
    B. ultramares.
    C. scienter.
    D. engagement letters.

 

  1. The primary factor that delineates statutory law, as they relate to audits, is that of liability founded on which of the following?
    A.circuit court decisions.
    B. federal securities laws.
    C. arbitration by private parties.
    D. breach of contract.

 

  1. Who may sue an auditor under common law for breach of contract?
    A.clients
    B. foreseeable parties
    C. foreseen parties
    D. anyone with grounds

 

  1. The Securities Exchange Act of 1933 places the burden of proof on which of the following?
    A.third-party plaintiff.
    B. attorney defendant.
    C. auditor defendant.
    D. client plaintiff.

 

  1. The court case that established the precedent that an auditor can only be held liable to plaintiffs for fraud and gross negligence under the 1934 Act is
    A.McKesson and Robbins case.
    B. 1136 Tenants Corporation case.
    C. Ernst & Ernst v. Hochfelder.
    D. Ultramares Corporation case.

 

  1. Which of the following factors do not have to be proved by a client under common law?
    A.breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. The failure to use even minimal care in the conduct of the audit is called
    A.negligence.
    B. constructive negligence.
    C. fraud.
    D. scienter.

 

  1. Which of the following factors do not have to be proved by a third party beneficiary in an Ultramares state under common law?
    A.breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors do not have to be proved by a foreseen user in a Rusch Factors state under common law?
    A.breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors have to be proved by a plaintiff against an auditor under 1933 Securities Act?
    A.breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Which of the following factors do not have to be proved by a plaintiff against an auditor under 1934 Securities Exchange Act?
    A.breach of duty.
    B. loss.
    C. gross negligence.
    D. causal relationship between loss and breach of duty.
    E. all have to be proved.

 

  1. Common law is based upon which of the following?
    A.state statues.
    B. federal statutes.
    C. court decisions.
    D. contracts.

 

  1. The auditor is responsible for ordinary negligence in most states to which of the following parties?
    A.clients.
    B. third-party users.
    C. third-party beneficiaries.
    D. both A and C.

 

  1. When is the auditor required to prove due diligence?
    A.1933 Securities Act.
    B. 1934 Securities Exchange Act.
    C. Common law.
    D. Torts.

 

  1. There are various professional requirements for CPA firms to help assure audit quality. These requirements potentially minimize the exposure of public accounting firms and partners to lawsuits. These requirements include
    A.auditor independence requirements.
    B. quality-control programs.
    C. review programs.
    D. all of the above.

 

  1. Emerging and unsettled liability issues that CPA firms face include which of the following?
    A.the legal considerations for CPA firms that operate as international organizations.
    B. the role of CPA firms for identifying fraud.
    C. the dissemination of audited financial information over the internet.
    D. all of the above.

 

  1. Litigation against auditors

    Identify five factors affecting the extent of litigation against auditors.

Factors leading to increased litigation against accountants include the following:

· A liability environment that includes joint and several liability statutes permitting a plaintiff to recover the full amount of a settlement from a public accounting firm, even though that firm is found to be only partially responsible for the loss
· Pressures to reduce audit time and improve audit efficiency in the face of increased competition among public accounting firms
· A misunderstanding by some users that an unqualified audit opinion represents an insurance policy against investment losses
· Contingent-fee-based compensation for law firms, especially in class action suits
· Increased complexity of audits caused by integrated electronic commerce, new types of business transactions and operations, increased international business, and more complicated accounting standards
· Class action suits and associated user awareness of the possibilities and rewards of litigation
   

 

  1. Joint and several liability

    Why has the statute concerning joint and several liability been so devastating to the auditing profession? What changes in tort law help to mitigate the effects of such liability?

Joint and several liability statutes have been devastating to the auditing profession because these statutes permit a plaintiff to recover the full amount of settlement from a public accounting firm even though the firm is found only partially responsible for the loss. This concept has become known as the deep pocket theory which means to sue those who have the ability to pay.

Proportionate liability limits the damages to those originally determined by the courts. Such a concept varies by state.

The U.S. Congress passed the Private Securities Litigation Reform Act of 1995, which is designed to curb frivolous securities class action lawsuits brought under Federal securities laws against companies whose stock performs below expectations. Under this act, liability is proportional rather than joint and several, unless the violation is willful; that is, the auditor knowingly participated in a fraud. In some situations, a defendant may have to cover some of the obligation of another defendant who is unable to pay their share.

 

  1. Auditor breach of contract

    Discuss the causes for action against the auditor for breach of contract and the defenses the auditor may use.

Causes for action against the auditor for breach of contract include:

· violation of client confidentiality
· failure to provide the audit report on time
· failure to discover a material error or employee irregularity
· withdrawal from an engagement without justification
   

Defenses that may be used by the auditor against a charge of breach of contract would include the following:

· auditor’s claim that due professional care in accordance with the contract were exercised
· contributory negligence on the part of the client
· client losses were not caused by the breach of contract
   

 

  1. Liability of auditors to others

    Provide a audit liability scenario that includes the following parties:
A. a party with whom privity exists
B. third-party beneficiary
C. foreseen party
D. foreseeable party
   

Be sure to identify each type of party.

The students have a great variety of choice in developing the response to this question. It is important that they identify the key concepts surrounding the terms they are asked to illustrate. For example, privity relationship would involve a contractual relationship between the auditor and the client. Primary beneficiary relationship would be one where the user of the report is specifically known to the auditor and the purpose for which the report was to be used is specifically known to the auditor. The foreseen party would be one that, while not individually known to the auditor, is a member of a known or intended class of third-party users that, through knowledge gained from client, the auditor could foresee may use the statements. The foreseeable party would be one that the auditor would recognize as a potential user of the report.

 

  1. Defensive auditing

    A. What is meant by the term “defensive auditing”?
    B. Present examples of defensive auditing practices.

Defensive auditing means taking special actions to avoid lawsuits. Defensive auditing include:

· maintaining good quality controls
· submitting the firm to quality/peer reviews
· issuing engagement letters
· screening clients
· evaluating the audit firm’s limitations
· maintaining high-quality audit documentation
   

 

  1. Minimizing Liability Exposure

    State the approaches that help mitigate the exposure of public accounting firms and partners to lawsuits.

Approaches that help mitigate the exposure of public accounting firms and partners to lawsuits include:
1. policies to help assure auditor independence
2. quality-control programs
3. review programs
4. continuing education requirements for individual auditors
5. defensive auditing

 

  1. Auditor liabilities in the public arena

    Contrast the auditor’s liability under the Securities Act of 1933 and the Securities Exchange Act of 1934.

Under the Securities Act of 1933, which regulates new issuances of stock, an auditor may be held liable to purchasers of securities for negligence, as well as fraud and gross negligence. Purchasers need to prove only that they incurred a loss and that the financial statements were materially misleading or not fairly stated. They do not need to prove reliance on the financial statements, that such statements had been read or even seen, or that the auditors were grossly negligent. The auditor must prove that the audit was not negligent or fraudulent, that the statements were not materially misstated, or the purchaser did not incur a loss caused by the misleading financial statements.

Under the Securities Exchange Act of 1934, which regulates the trading of securities after their initial issuance, an auditor may be held liable for fraud in the purchase or sale of any security. The act specifically makes it unlawful to make any untrue statement of a material fact or to omit to state a material fact that is necessary for understanding the financial statements. This act returns the burden of proof to the plaintiff. The plaintiff must show scienter on the part of the auditor, as well as that they suffered a loss and causation, i.e., that the damage was due to the misleading financial statements. Defenses of the auditor might be that they followed lack of scienter, lack of misstatement of the financial, and/or that the financial statements were not the cause of the loss.

 

  1. Auditor common law liabilities

    Contrast the auditor’s liability to a client with their responsibility to third-party users of the financial statements.

The auditor has greater responsibilities to their clients than to third-party users of the audited financial statements. Clients can sue under contract law and have a privity relationship so they have a lower bar to jump over. Clients must prove that the auditor accepted a duty of care, they breached that duty, that the client suffered a loss, and that the loss was caused by the auditor’s breach of their duty. Since clients have a privity relationship, they only have to prove a lack of ordinary negligence on the part of the auditor to win their cases. Third-party users lack a relationship with the auditor so can’t sue under contract law but must sue under tort law, i.e., that they were harmed by the actions of the auditor. As a result they still have to show breach, loss, and causation, but third-party users must be able to show gross negligence or fraud on the part of the auditor in order to win their cases.

Privity of relationship with the auditor has been extended by the state courts to various third-party users. Most states have adopted the Ultramares rule and specifically identified third-party beneficiaries for whose benefit the financial statements were prepared also only have to show ordinary negligence in order to win their cases. Some states have extended that to foreseen users, who are third parties that are members of a known or intended class for whose benefit the financial statements were prepared. A few states have extended that to foreseeable third-party users, where foreseeable is defined by the state.

 

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