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ISBN: 9780470923849 (Volume 2 paperback); 9781118107140 (ebk); 9781118107157 (ebk);
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10 9 8 7 6 5 4 3 2 1
PREFACE
Passing the CPA exam upon your first attempt is possible! TheWiley CPA Examination Reviewpreparation ma
terials provide you with the necessary materials (visit our Web site at www.wiley.com/cpa for more information). It’s up
to you to add the hard work and commitment. Together we can beat the firsttime pass rate of less than 50%. All Wiley
CPA products are continuously updated to provide you with the most comprehensive and complete knowledge base.
Choose your products from the Wiley preparation materials and you can proceed confidently. You can select support
materials that are exambased and userfriendly. You can select products that will help you pass!
The first purpose of Volume 2 is to provide CPA candidates with sample examination problems/questions organized
by topic (e.g., internal control, consolidations, etc.). This text includes over 2,600 multiplechoice questions. These
questions provide an effective means of studying the material tested on past exams; however, it is also necessary to work
with taskbased simulations to develop the solutions approach (the ability to solve CPA questions and problems
efficiently).
The second objective of this volume is to explain the AICPA unofficial answers and author question answers to the
examination problems/questions included in this text. The AICPA published all CPA examinations and unofficial an
swers through the November 1995 exam and selected questions and answers since then. No explanation is made, how
ever, of the procedures that should have been applied to the examination problem to obtain the unofficial answers. Relat
edly, the unofficial answers to multiplechoice questions provide no justification and/or explanation. This text provides
explanations of both how to work problems and the unofficial answers to multiplechoice questions.
This text is designed to be used in conjunction with Volume 1, Outlines and Study Guides, but may be used with or
without any other study source. Both volumes are organized into 47 manageable study units (modules) to assist candi
dates in organizing their study programs. The multiplechoice questions in this volume are grouped into topical catego
ries (submodules) that correspond to the sequencing of material as it appears in Volume 1.
New authorconstructed questions have been added to this ThirtyEighth Edition. As new questions and problems
are added, older ones are deleted. New problems have been added to address the new content of the exam that was
adopted January 1, 2011.
A Sample Examination for each of the four parts of the exam is included in the Appendix at the end of this volume.
The CPA exam is one of the toughest exams you will ever take. It will not be easy. But if you follow our guidelines
and focus on your goal, you will be thrilled with what you can accomplish.
Ray Whittington
April 2011
Don’t forget to visit our Web site at www.wiley.com/cpa
for supplements and updates.
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CONTENTS
1 HOW TO USE THIS BOOK 1
2 AUDITING AND ATTESTATION 7
*
Module
Abbreviations Numbers
Professional Responsibilities RESP 1 8
Engagement Planning, Obtaining an Understanding
of the Client and Assessing Risks ENPL 2 24
Understanding Internal Control and Assessing
Control Risk IC 3 67
Responding to Risk Assessment: Evidence
Accumulation and Evaluation EVID 4 113
Reporting REPT 5 163
Accounting and Review Services AARS 6 202
Audit Sampling AUDS 7 214
Auditing with Technology ATEC 8 230
3 FINANCIAL ACCOUNTING AND REPORTING 239
Basic Theory and Financial Reporting TREP 9 241

A. Basic Concepts 241
B. Error Correction 268
C. Accounting Changes 280
D. Financial Statements 295
Inventory INVY 10 333
Fixed Assets FA 11 361
Monetary Current Assets and Current Liabilities CACL 12 392
Present Value PV 13 426
A. Fundamentals 426
B. Bonds 437
C. Debt Restructure 456
D. Pensions 460
E. Leases 473
Deferred Taxes DETX 14 494
Stockholders’ Equity STK 15 513
Investments IVES 16 546
Statement of Cash Flows SCF 17 573
Business Combinations and Consolidations BCC 18 592
Derivative Instruments and Hedging Activities DIHA 19 617
Miscellaneous MISC 20 634
A. Personal Financial Statements 634
B. Interim Reporting 638
C. Segment Reporting 642
D. Partnership Accounting 649
E. Foreign Currency Translation 661
Governmental (State and Local) Accounting GOV 21 670
NotforProfit Accounting NFP 22 695
4 REGULATION 711
*
As explained in Chapter 1, this volume is organized into 47 modules (manageable study units). Volume 1 is organized in a parallel
fashion.
5 PROFESSIONAL RESPONSIBILITIES AND BUSINESS LAW 713
Module
Abbreviations Numbers
Professional and Legal Responsibilities PLR 23 714
Federal Securities Acts FEDE 24 730
Business Structure BSTR 25 742
Contracts CONT 26 761
Sales SALE 27 778
Commercial Paper CPAP 28 793
Secured Transactions SECU 29 810
Bankruptcy BANK 30 818
DebtorCreditor Relationships DBCR 31 829
Agency AGEN 32 837
Regulation of Employment and Environment EMEN 33 845
Property PROP 34 856
6 FEDERAL TAXATION 861
Individual Taxation ITAX 35 862

Transactions in Property TPRO 36 931
Partnerships Taxation PTAX 37 948
Corporate Taxation CTAX 38 974
Gift and Estate Taxation GETX 39 1031
7 BUSINESS ENVIRONMENT AND CONCEPTS 1055
Corporate Governance, Internal Control, and
Enterprise Risk Management CGIC 40 1056
Information Technology IFTC 41 1066
Economics, Strategy, and Globalization ECON 42 1093
Financial Risk Management and Capital Budgeting RMCB 43 1114
Financial Management FINM 44 1132
Performance Measures PERM 45 1158
Cost Measurement COST 46 1171
Planning, Control, and Analysis PLAN 47 1186
APPENDIX A: SAMPLE EXAMINATIONS 1207
APPENDIX B: SAMPLE TESTLETS RELEASED FROM THE AICPA 1299
APPENDIX C: 2011 RELEASED AICPA QUESTIONS 1323
ABOUT THE AUTHORS
Ray Whittington, PhD, CPA, CMA, CIA, is the dean of the College of Commerce at DePaul University. Prior
tojoining the faculty at DePaul, Professor Whittington was the Director of Accountancy at San Diego State University.
From 1989 through 1991, he was the Director of Auditing Research for the American Institute of Certified Public Ac
countants (AICPA), and he previously was on the audit staff of KPMG. He previously served as a member of the Audit
ing Standards Board of the AICPA and as a member of the Accounting and Review Services Committee and the Board of
Regents of the Institute of Internal Auditors. Professor Whittington has published numerous textbooks, articles, mono
graphs, and continuing education courses.
Patrick R. Delaney, deceased, was the dedicated author and editor of theWiley CPA Exam Reviewbooks for
twentyyears. He was the Arthur Andersen LLP Alumni Professor of Accountancy and Department Chair at Northern
Illinois University. He received his PhD in Accountancy from the University of Illinois. He had public accounting
experience with Arthur Andersen LLP and was coauthor of GAAP: Interpretation and Application, also published by
John Wiley & Sons, Inc. He served as Vice President and a member of the Illinois CPA Society’s Board of Directors, and
was Chairman of its Accounting Principles Committee; was a past president of the Rockford Chapter, Institute of
Management Accountants; and had served on numerous other professional committees. He was a member of the
American Accounting Association, American Institute of Certified Public Accountants, and Institute of Management
Accountants. Professor Delaney was published in The Accounting Review and was a recipient of the Illinois CPA
Society’s Outstanding Educator Award, NIU’s Excellence in Teaching Award, and Lewis University’s Distinguished
Alumnus Award. He was involved in NIU’s CPA Review Course as director and instructor.
ABOUT THE CONTRIBUTORS
Anita L. Feller, PhD, CPA, is a Lecturer in Accountancy at the University of Illinois at UrbanaChampaign. She
isthe recipient of the Commerce Council Excellence in Teaching Award. Formerly a staff accountant in the tax
department at KPMG Peat Marwick, she teaches courses in financial accounting and applied professional research.
Professor Feller also teaches financial and managerial topics in the University of Illinois CPA Review Course. She is
also the author of
Mastering Accounting Research for the CPA Exam and Wiley CPA Exam Review Impact Audios (both published
byWiley).
Edward C. Foth, PhD, CPA, is the Administrator of the Master of Science in Taxation Program at DePaul Univer
sity. He is a member of the American Accounting Association, the American Institute of Certified Public Accountants,
the Illinois CPA Society, and the American Taxation Association. He has been a recipient of the Ledger & Quill Faculty
Excellence Award, and is the author of CCH Incorporated’s Federal Tax Study Manual, Federal Taxation
RefresherCourse, and is coauthor of their S Corporations Guide. He prepared Chapter 6.
Mark L. Frigo, PhD, CPA, CMA, is Director of The Center for Strategy, Execution and Valuation in
KellstadtGraduate School of Business and Eichenbaum Foundation Distinguished Professor of Strategy and
Leadership in the School of Accountancy at DePaul University. Professor Frigo authored the Performance Measures
module for the Business Environment and Concepts section of this manual.
Kurt Pany, PhD, CPA, is a Professor of Accounting at Arizona State University. Prior to entering academe,
heworked as a staff auditor for Deloitte and Touche LLP. He is a former member of the AICPA’s Auditing
Standards Board and has taught in the Arizona State University CPA Review Course.
Patricia L. Smith, MBA, CPA, is an instructor in the School of Accountancy at DePaul University. She has
abackground in auditing and financial accounting. She has audit experience with KPMG. She contributed to the auditing
modules.
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HOW TO USE THIS BOOK
This volume is a collection of CPA questions, taskbased simulations and solutions. The text is designed
and organized to be used in conjunction with Volume 1, CPA Examination Review: Outlines and StudyGuides,
but may be used with or without any other study source. Each module in this volume corresponds to amodule
in Volume 1. In this volume, a module consists of
1. Multiplechoice questions
2. Taskbased simulations
3. Written communication tasks
4. Unofficial answers for the multiplechoice questions with the author’s explanations
5. Answers for taskbased simulations
The sources of the questions and taskbased simulations material in each module are, of course, the four
sections of the CPA Exam. The modules are grouped together into chapters, which correspond with the four
sections of the exam. The following table shows how the modules are organized in Volume 2.
This manual has been updated for the major changes that occurred in the CPA exam effective January 1,
2011.
CPA EXAM SECTION AND CORRESPONDING MODULES
Auditing and Attestation CH 2 Modules 16
Financial Accounting and Reporting CH 3 Modules 720
Regulation CH 5 & 6 Modules 2137
Business Environment and Concepts CH 7 Modules 3845
The material in Volume 2 allows candidates to work CPA exam questions, some of which have appeared on
previous examinations. This provides candidates with an effective method of studying the material tested on the
exam. However, candidates should also realize that the CPA has new material. Therefore, candidates should use
the study guides and outlines included in Volume 1 as a means of bridging this gap.
Also included at the end of this volume are sample exams for all four sections. They are included to en
able candidates to gain experience in taking a “realistic” exam. While working through the modules, the can
didate can become accustomed to concentrating on a fairly narrow range of topics. By taking the sample ex
aminations near the end of their study program, candidates will be better prepared for taking the actual
examination.
Before you begin working the CPA questions in this volume, peruse the table of contents and scan through
the book, noting the manner in which the chapters and modules are organized. The schedule at the beginning
of each chapter provides an index to the questions appearing in each module. Some questions have been
modified to reflect recent changes in law or practice. For a complete analysis of recent examinations and the
AICPA Uniform CPA Examination Content Specification Outlines of future examinations, see the beginning
of each chapter starting with Chapter 5 in Volume 1, Outlines and Study Guides.
MultipleChoice Questions
The multiplechoice questions and answer explanations can be used in many ways. First, they may be
used as a diagnostic evaluation of your knowledge. For example, before beginning to review audit sampling
you may wish to answer every fourth multiplechoice question to determine your ability to answer CPA ex
amination questions on audit sampling. The apparent difficulty of the questions and the correctness of your
answers will allow you to determine the necessary breadth and depth of your review. Additionally, exposure
to examination questions prior to review and study of the material should provide motivation. You will de
velop a feel for your level of proficiency and an understanding of the scope and difficulty of past examination
questions.
Second, the multiplechoice questions can be used as a poststudy or postreview evaluation. You should
attempt to understand all concepts mentioned (even in incorrect answers) as you answer the questions. Refer
to the explanation of the answer for discussion of the alternatives even though you selected the correct re
2 CH 1 HOW TO USE THIS BOOK
sponse. Thus, you should read the explanation of the unofficial answer unless you completely understand the
question and all of the alternative answers.
Third, you may wish to use the multiplechoice questions as a primary study vehicle. This is probably the
quickest, but least thorough, approach. Make a sincere effort to understand the question and to select the cor
rect reply before referring to the answer and explanation. In many cases the explanations will appear inade
quate because of your unfamiliarity with the topic.
The multiplechoice questions in Volume 2 are grouped into study sets. The study sets include a smaller
amount of related material than the study modules, which provides greater flexibility in the individual candi
date’s study strategy. The answer explanations for the multiplechoice questions in Volume 2 also include
headings which provide crossreferences to the text material in Volume 1. For example, in Module 11, Fixed
Assets, the heading “F. Depreciation” appears above the answers to those questions dealing with depreciation.
The topical coverage of depreciation in Volume 1 can then be found by referring to the corresponding
heading within Module 11.
One of the benefits of working through multiplechoice questions is that it helps you to identify your
weak areas. Once you have graded your answers, your strong areas and weak areas should be clearly evident.
Yet, the important point here is that you should not stop at a simple percentage evaluation. The percentage
only provides general feedback about your knowledge of the material contained within that particular module.
The percentage does not give you any specific feedback regarding the concepts which were tested. In order to
get this feedback, you should look at the questions missed on an individual basis because this will help you
gain a better understanding of why you missed the question. This feedback process has been facilitated by the
fact that within each module where the multiplechoice answer key appears, two blank lines have been
inserted next to the multiplechoice answers. As you grade the multiplechoice questions, mark those
questions which you have missed. However, instead of just marking the questions right and wrong, you
should now focus on marking the questions in a manner which identifies why you missed the question. As an
example, a candidate could mark the questions in the following manner: for math mistakes, x for conceptual
mistakes, and ? for areas which the candidate was unfamiliar with. The candidate should then correct these
mistakes by reworking through the marked questions. The objective of this marking technique is to help you
identify your weak areas and thus, the concepts which you should be focusing on. While it is still important
for you to get between 75% and 80% correct when working multiplechoice questions, it is more important
for you to understand the concepts. This understanding applies to both the questions answered correctly and
those answered incorrectly. Remember, most of the questions on the CPA exam will be different from the
questions in the book; however, the concepts will be the same. Therefore, your preparation should focus on
understanding concepts, not just getting the correct answer.
The multiplechoice questions substantially outnumber the taskbased simulations in this book. This is
similar to what can be expected on the CPA exam. The multiplechoice questions make up about between
60% and 85% (depending on the section) of the total examination.
One difficulty with so many multiplechoice questions is that you may overemphasize them. Candidates
generally prefer to work multiplechoice questions because they are shorter and less time consuming and
solvable with less effort.
Another difficulty with the large number of multiplechoice questions is that you may tend to become
overly familiar with the questions. The result may be that you may begin reading the facts and assumptions of
previously studied questions into the questions on your examination. Guard against this potential problem by
reading each multiplechoice question with extra care.
Although not as critical as for taskbased simulations, the solutions approach (a systematic problem
solving methodology) is relevant to multiplechoice questions.
MultipleChoice Screen Layout
The following is a computer screenshot that illustrates the manner in which multiplechoice questions will
be presented:
CH 1 HOW TO USE THIS BOOK 3
As indicated previously, multiplechoice questions will be presented in three individual testlets of 24 to
30 questions each. Characteristics of the computerized testlets of multiplechoice questions include the
following:
1. You may move freely within a particular testlet from one question to the next or back to previous
questions until you click the “Exit” button. Once you have indicated that you have finished the
testlet by clicking on the “Exit” button and reconfirmed, you can never return to that set of
questions.
2. A button on the screen will allow you to “flag” a question for review if you wish to come back to
it later.
3. A fourfunction computer calculator with an electronic tape is available as a tool.
4. The time remaining for the entire exam section is shown on the screen.
5. The questions will be shown at the bottom of the screen. You may navigate between questions
by simply clicking on the question number.
6. The “Help” button will provide you with help in navigating and completing the testlet.
The screenshot above was obtained from the AICPA’s sample exam at www.cpaexam.org. Candidates
are urged to complete the tutorial and other example questions on the AICPA’s Web site to obtain
additional experience with the computerbased testing.
MultipleChoice Questions Solutions Approach
1. Work individual questions in order.
a. If a question appears lengthy or difficult, skip it until you can determine that extra time is
available. Mark it for review to remind you to return to it later.
2. Read the stem of the question without looking at the answers.
a. The answers are sometimes misleading and may cause you to misread or misinterpret the
question.
3. Read each question carefully to determine the topical area.
a. Study the requirements first so you know which data are important
b. Note keywords and important data
c. Identify pertinent information
d. Be especially careful to note when the requirement is an exception (e.g., “Which of the
following is not an effective disclaimer of the implied warranty of merchantability?”).
e. If a set of data is the basis for two or more questions, read the requirements of each of the
questions before beginning to work the first question (sometimes it is more efficient to
work the questions out of order)
f. Be alert to read questions as they are, not as you would like them to be. You may encounter a
familiar looking item; don’t jump to the conclusion that you know what the answer is
without reading the question completely.
4. Anticipate the answer before looking at the alternative answers.
a. Recall the applicable principle (e.g., offer and acceptance, requisites of negotiability, etc.)
and the respective applications thereof.
b. If a question deals with a complex area, it may be very useful to set up a timeline or diagram
using abbreviations.
5. Read the answers and select the best alternative.
6. Click on the correct answer (or your educated guess).
7. After completing all of the questions including the ones marked for review click on the “Done”
button to close out the testlet. Remember once you have closed out the testlet you can never re
turn to it.
Currently, all multiplechoice questions are scored based on the number correct, weighted by a difficulty
rating (i.e., there is no penalty for guessing). The rationale is that a “good guess” indicates knowledge. Thus,
you should answer all multiplechoice questions.
TaskBased Simulations
Simulations are casebased problems designed to
• Test integrated knowledge
• More closely replicate realworld problems
• Assess research and other skills
Any of the following types of responses might be required on taskbased simulations:
• Dropdown selection
• Numeric and monetary inputs
• Formula answers
• Check box response
• Enter spreadsheet formulas
• Research results
To complete the simulations, candidates are provided with a number of tools, including
• A fourfunction computer calculator with an electronic tape
• Scratch spreadsheet
• The ability to split windows horizontally or vertically to show two tabs on the screen (e.g., you can
examine the situation tab in one window and a requirement tab in a second window)
• Access to professional literature databases to answer research requirements
• Copy and paste functions
In addition, the resource tab provides other resources that may be needed to complete the simulation. For
example, a resource tab might contain a present value table for use in answering a lease problem. A window
on the screen shows the time remaining for the entire exam, and the “Help” button provides instructions for
navigating the simulation and completing the requirements.
TaskBased Simulations Solutions Approach
The following solutions approach is suggested for answering simulations:
1. Review the entire background and problem. Get a feel for the topical area and related concepts
thatare being tested. Even though the format of the question may vary, the exam continues to test your
understanding of applicable principles or concepts. Relax, take a deep breath, and determine your strategy for
conquering the simulation.
2. Identify the requirements of the simulation. This step will help you focus in more quickly on
thesolution(s) without wasting time reading irrelevant material.
3. Study the items to be answered. As you do this and become familiar with the topical area
beingtested, you should review the concepts of that area. This will help you organize your thoughts
so that you can relate logically the requirements of the simulation with the applicable concepts.
CH 1 HOW TO USE THIS BOOK 5
4. Use the scratch paper (which will be provided) and the spreadsheet and calculator tools to
assist you in answering the simulation.
You are urged to complete the tutorial and other sample tests that are on the AICPA’s Web site
(www.cpaexam.org) to obtain additional experience with the interface and computerbased testing.
TaskBased Research Simulations
One research simulation will be included on the Auditing and Attestation, Financial Accounting and
Reporting, and Regulation sections of the exam. Research simulations require candidates to search the
professional literature and income tax code in electronic format and interpret the results. The table below
describes the research material that will be available for each section of the exam that includes research
simulations.
Section Potential research resources
Auditing and Attestation • AICPA Statements on Auditing Standards and
Interpretations (AU)
• PCAOB Auditing Standards and Interpretations
(PCAOB)
• AICPA Statements on Attestation Standards and
Interpretations (AT)
• AICPA Statements on Standards for Accounting and
Review Services and Interpretations (AR)
• AICPA Code of Professional Conduct (ET)
• AICPA Bylaws (BL)
• AICPA Statements on Standards for Valuation Services
(VS)
• AICPA Statement on Standards for Consulting Services
(CS)
• AICPA Statements on Standards for Quality Control
(QC)
• AICPA Peer Review Standards (PR)
• AICPA Statement on Standards for Tax Services (TS)
• AICPA Statement on Responsibilities in Personal
Financial Planning Practice (PFP)
• AICPA Statement on Standards for Continuing
Professional Education Programs (CPE)
Financial Accounting and Reporting • FASB Accounting Standards Codification
Regulation • Internal Revenue Code
The research material may be searched using the table of contents or a keyword search. Therefore,
knowing important code sections, FASB codification sections, auditing standards section numbers, etc.
may speed up your search.
If possible, it is important to get experience using an electronic version of the research databases to
sharpen your skills. If that is not available, you should use the printed copy of the professional standards and
the IRS code and regulations to answer the simulations in the manual. Remember, the AICPA offers an
electronic version of professional standards to registered candidates. Refer to the AICPA Web site at
www.cpaexam.org.
Written Communication Tasks
The Business Environment and Concepts section of the exam will require the completion of three
written communication questions. Communication questions will involve some realworld writing
assignment that a CPA might have to perform, such as a memorandum to a client explaining a management
technique. The subject of the communication will be a Business Environment and Concepts topic.
It is essential for the communication to be in your own words. In addition, the communication will not be
graded for technical accuracy. If it is on point, it will only be graded for usefulness to the intended user and
writing skills. The following screenshot illustrates a task requiring the composition of a memorandum to a
company president.
Diagnose Your Weaknesses prior to the Exam
This volume of questions, taskbased simulations and solutions provides you with an opportunity to
diagnose and correct any examtaking weaknesses prior to your taking the examination. Continuously analyze
the contributing factors to incomplete or incorrect solutions to CPA questions prepared during your study
program. General categories of candidates’ weaknesses include
1. Failure to understand the exam question requirements
2. Misunderstanding the supporting text of the question
3. Lack of knowledge of material tested, especially recently issued pronouncements
4. Failure to develop proficiency with practice tools such as electronic research databases and spread
sheets
5. Inability to apply the solutions approach
6. Lack of an exam strategy (e.g., allocation of time)
7. Sloppiness and computational errors
8. Failure to proofread and edit
Time Management
Each section of the CPA exam will contain a number of multiplechoice testlets, and all of the sections ex
cept Business Environment and Concepts will contain two simulations. As you complete each testlet keep
track of how you performed in relation to the AICPA suggested times. After you finish the multiplechoice
testlets, budget your time for the simulations based on your remaining time and the AICPA suggested times.
For example, if you have two hours remaining to complete two simulations that each have the same AICPA
suggested time, budget one hour for each simulation. Remember that you alone control watching your prog
ress towards successfully completing this exam.
Additional Study Aids
A more complete discussion of the solutions approach, including illustrations thereof, appears in Chapter 3
of Volume 1, Outlines and Study Guides. Additionally, use of “note cards” as an integral part of your study
program is discussed and illustrated in Chapter 1 of Volume 1. Chapter 4 of Volume 1 includes a detailed
checklist to assist candidates with their lastminute preparation and to provide guidance concerning the actual
taking of the exam.
NOW IS THE TIME
TO MAKE A COMMITMENT
AUDITING AND ATTESTATION
The Auditing and Attestation Exam is scheduled for four and onehalf hours. Based on information released by the
AICPA, candidates should expect three multiplechoice testlets of approximately thirty questions each, and two
simulations.The Uniform CPA Examination Content Specifications appear in Volume 1, Outlines and Study
Guides.
Module 1/Professional Responsibilities (RESP)
39 MultipleChoice 8 17
7 TaskBased Simulations 12 21
Module 2/Engagement Planning, Obtaining an Understanding of the Client and
Assessing Risks (ENPL)
Module 3/Understanding Internal Control and Assessing Control Risk (IC)
Module 4/Responding to Risk Assessment: Evidence Accumulation and Evaluation
(EVID)
Module 5/Reporting (REPT)
Module 6/Accounting and Review Services (AARS)
Module 7/Audit Sampling (AUDS)
Module 8/Auditing with Technology (ATEC)
1 TaskBased Simulation 233 238
Auditing and Attestation Sample Examination 1207
Auditing and Attestation Regulation AICPA Sample Testlets 1299
Auditing and Attestation 2011 Released AICPA Questions 1323
7
8 MODULE 1 PROFESSIONAL RESPONSIBILITIES
PROFESSIONAL RESPONSIBILITIES
MULTIPLECHOICE QUESTIONS (139)
attest
engage
1. Which of the following best ment.
describes what is meant by the d. Management selection of the CPA
term generally accepted auditing firm.
standards?
a. Rules acknowledged 4. Which of the following is a
by the accounting “self review” threat to
profession because of member independence?
their universal a. An
application. engagemen
b. Pronouncements issued t team
by the Auditing member
Standards Board. has a
c. Measures of the spouse that
quality of the serves as
auditor’s perfor CFO of the
mance. attest
client.
d. Procedures to be used to gather
b. A second
evidence to support financial
partner
statements.
review is
2. For which of the following can a required on
member of the AICPA receive an all attest
automatic expulsion from the engagemen
AICPA? ts.
c. An
I. Member is convicted of a felony.
engagement
II. Member files his own fraudulent tax
team
return.
member
BI. Member files
fraudulent tax return
prepares
for a client knowing invoices for
that it is fraudulent. the attest
client.
a. I only. d. An
b. I and II only. engagement
c. I and III only. team member
d. I, II, and III. has a direct
financial
3. Which of the following is an
interest in the
example of a safeguard attest client.
implemented by the client that
might mitigate a threat to 5. According to the standards of the
independence? profession, which of the
a. Requir following circumstances will
ed prevent a CPA performing audit
contin engagements from being
uing independent?
educati a. Obtaining a
on for collateralized
all automobile
attest loan from a
engage financial
ment institution
team client.
membe b. Litigation
rs. with a client
b. An effective corporate relating to
governance structure. billing for
c. Requir consulting
ed services for
second which the
partner amount is
review immaterial.
of an c. Employment
of the CPA’s b. Actual fee would be
spouse as a substantially lower
client’s di than the fees charged
rector of by other CPAs for
internal comparable services.
audit. c. CPA would not be independent.
d. Acting as an d. Fee was a competitive bid.
honorary
trustee for a 7. According to the ethical
notfor standards of the profession,
profit which of the following acts is
organization generally prohibited?
client. a. Issuing a modified
report explaining a
6. The profession’s ethical
failure to follow a
standards most likely would be
governmental
considered to have been violated
regulatory agency’s
when a CPA represents that
standards when
specific consulting services will
conducting an attest
be performed for a stated fee and
service for a client.
it is apparent at the time of the
representation that the b. Revealing confidential
client information
a. Actual fee would be substantially
during a quality review
higher.
of a professional
practice by a team from
the state CPA society.
c. Accepting a contingent
fee for representing a
client in an examination
of the client’s federal
tax return by an IRS
agent.
d. Retaining client records
after an engagement is
terminated prior to
completion and the
client has demanded
their return.
8. According to the profession’s
ethical standards, which of the
following events may justify a
departure from a Statement of
the Governmental Accounting
Standards Board?
New Evolution of a new form
legislation of business transaction
a. No Yes
b. Yes No
c. Yes Yes
d. No No
9. May a CPA hire for the CPA’s
public accounting firm a non
CPA systems analyst who
specializes in developing
computer systems?
a. Yes, provided the CPA is
qualified to perform each of the
specialist’s tasks.
b. Yes, provided the CPA is able to
supervise the specialist and
evaluate the specialist’s end
product.
c. No, because nonCPA
professionals are not
permitted to be
associated with CPA
firms in public
practice.
d. No, because
developing computer
systems is not
recognized as a
service performed by
public accountants.
10. Stephanie Seals is a CPA who is working
as a controller for Brentwood Corporation.
She is not in public practice. Which
statement is true?
a. She may use the CPA
designation on her
business cards if she
also puts her
employment title on
them.
b. She may use the CPA
designation on her
business cards as long
as she does not
mention Brentwood
Corporation or her title
as controller.
c. She may use the
CPA designation on
company transmittals
but not on her
business cards.
d. She may not use the
CPA designation
because she is not in
public practice.
11. According to the standards of
the profession, which of the
following activities would most
likely not impair a CPA’s
independence?
a. Providing advisory services for a
client.
MODULE 1 PROFESSIONAL RESPONSIBILITIES 9
a publishing
company.
b. Contracting with a c. Accepting
client to supervise the a
client’s office commissi
personnel. on for
c. Signing a client’s checks in recommen
emergency situations. ding a
d. Accepting a luxurious gift from a product to
client. an audit
client.
12. Which of the following reports d. Accepting
may be issued only by an engagements
accountant who is independent obtained
of a client? through the
a. Standard report on an efforts of
examination of a third parties.
financial forecast.
b. Report on consulting services. 16. To exercise due professional care an
c. Compilation report auditor should
on historical a. Critically
financial state review the
ments. judgment
d. Compilation report on a financial exercised by
projection. those assisting
in the audit.
13. According to the standards of b. Examine all
the profession, which of the available
following activities may be corroborating
required in exercising due care? evidence sup
Consulting Obtaining porting
with experts specialty accreditation managements
a. Yes Yes assertions.
b. Yes No c. Design the
c. No Yes audit to
d. No No detect all
instances of
14. Larry Sampson is a CPA and is illegal acts.
serving as an expertwitness in a trial d. Attain the
concerning a corporation’s financial state proper
ments. Which of the following is(are) balance of
true? professional
I. Sampson’s status as an expert witness experience
is based upon his specialized and formal
knowledge, experience, and training. education.
AI. Sampson is required by
AICPA ruling to present his 17. Kar, CPA, is a staff auditor
position objectively. participating in the audit
BI. Sampson may regard himself as acting engagement of Fort, Inc. Which
as an advocate. of the following circumstances
impairs Kar’s independence?
a. I only.
a. During the
b. I and II only.
period of the
c. I and III only.
professional
d. III only. engagement,
15. According to the ethical Fort gives Kar
standards of the profession, tickets to a
which of the following acts is football game
worth $75.
generally prohibited?
b. Kar owns
a. Purchasing a product from a
stock in a
third party and reselling it to a
corporation
client. that Fort’s
b. Writing a 401(k) plan
financial also invests in.
managemen
t newsletter
promoted
and sold by
19. Which of the following
c. Kar’s statements is(are) correct re
friend, garding a CPA employee of a
an CPA firm taking copies of
employe information contained in client
e of files when the CPA leaves the
another firm?
local ac I. A CPA leaving a firm
counting may take copies of
firm, information contained
prepares in client files to assist
Fort’s another firm in serving
tax that client.
returns. AI. A CPA leaving a firm
d. Kar’s sibling is director of may take copies of
internal audit at Fort. information contained
in client files as a
18. On June 1, 2008, a CPA
method of gaining
obtained a $100,000 personal technical expertise.
loan from a financial institution
client for whom the CPA a. I only.
provided compilation services. b. II only.
The loan was fully secured and c. Both I and II.
considered material to the d. Neither I nor II.
CPA’s net worth. The CPA paid
the loan in full on December 31, 20. Which of the following
2009. On April 3, 2009, the statements is correct regarding
client asked the CPA to audit an accountant’s working
the client’s financial statements papers?
for the year ended December 31, a. The accountant
2009. Is the CPA considered owns the
independent with respect to the working papers
audit of the client’s December and generally
31, 2009 financial statements? may disclose
a. Yes, because the loan was fully them as the
secured. accountant sees
b. Yes, because fit.
the CPA was b. The client owns the working
not required papers but the accountant has
to be inde custody of them until the
pendent at the accountant’s bill is paid in full.
time the loan c. The
was granted. accountant
c. No, owns the
because the working
CPA had a papers but
loan with generally
the client may not
during the disclose them
period of a without the
professiona client’s
l consent or a
engagemen
court order.
t. d. The client
owns the
d. No,
working
because
the CPA papers but, in
had a loan the absence
with the of the
client accountant’s
during the consent, may
period not disclose
covered by them without
the a court order.
financial
21. Which of the following is
state
an authoritative body
ments.
designated to promulgate
attestation standards?
a. Auditing Standards Board.
b. Governmental Accounting
Standards Board.
c. Financial Accounting Standards
Board.
d. General Accounting Office.
22. According to the profession’s
standards, which of the
following would be considered
consulting services?
Advisory Implementation Product
services services services
a. Yes Yes Yes
b. Yes Yes No
c. Yes No Yes
d. No Yes Yes
e
cli
23. According to the standards of the en
profession, which ofthe following events t.
would require a CPA performing a b. Not perform any attest services for
consulting services engagement for a the client.
nonaudit client to withdraw from the c. I
engagement? n
f
I. The CPA has a conflict of
o
interest that is disclosed to the
r
client and the client consents to
the CPA continuing the m
engagement. t
AI. The CPA fails to obtain h
a written understanding e
from the client cl
concerning the scope of ie
the engagement. n
t
a. I only.
o
b. II only. f
c. Both I and II. si
d. Neither I nor II. g
24. Which of the following services n
may a CPA perform in carrying if
out a consulting service for a ic
client? a
n
I. Analysis of the client’s accounting t
system. r
AI. Review of the client’s prepared business e
plan. s
III. Preparation of information for obtaining e
financing. r
a. I and II only. v
b. I and III only. at
c. II and III only. i
d. I, II, and III. o
n
25. Under the Statements on Standards for s
Consulting Services, which of the c
following statements best reflects a CPA’s o
responsibility when undertaking a n
consulting services engagement? The CPA
must c
a. N e
ot r
se n
ek i
to n
m g
od t
if h
y e
an b
y e
ag n
re e
e fi
m ts
en o
t f
m t
ad h
e e
wi e
th n
th g
a plann
g ing
e deci
m sions.
e c. Monitoring progress in achieving
nt goals.
. d. Upd
d. Obta atin
in a g
writt reco
en mm
unde end
rstan atio
ding ns
with and
the revi
sing
clien
plan
t
ning
con deci
cerni sion
ng s.
the
time 27. In relation to the AICPA Code of
for Professional Conduct, the IFAC
com Code of Ethics for Professional
pleti Accountants
on a. Has more outright prohibitions.
of b. Has fewer outright prohibitions.
the c. Has no outright prohibitions.
enga d.
gem Applies
ent. onl
y
26. Which of the following to
services is a CPA generally pro
required to perform when fes
conducting a personal sio
financial planning nal
engagement? acc
a. Assi ou
sting nta
the nts
clien in
t to bus
ident ine
ify ss.
tasks 28. Based on the IFAC Code of
that
Ethics for
are
esse ProfessionalAccountants,
ntial threats to independence arise
in from all of thefollowing
order except:
to a. Self interest.
act b. Advocacy.
on c. The audit relationship.
plan d. Intimidation.
ning
decis 29. If an audit firm discovers threats
ions. to independence with respect to
b. Assis an audit engagement, the IFAC
ting Code of Ethics forProfessional
the Accountants indicates that the
client firm should
to
take
actio
n on
a. International auditing
a. Immediately resign from the standards do not
engagement. require an audit of
b. Notify the appropriate regulatory internal control.
body. b. International auditing
c. Document the issue. standards do not allow
d. Evaluate the reference to division of
significance of the responsibilities in the
threats and apply audit report.
appropriate safeguards c. International auditing
to reduce them to an standards require
acceptable level. obtaining an
attorney’s letter.
30. With respect to the acceptance of d. International auditing
contingent fees for professional standards are based on a
services, the IFAC Code of Ethics risk assessment
forProfessional Accountants approach.
indicates that the accounting firm
a. Should not accept contingent fees. 34. Which of the following is not
b. Should establish true about international
appropriate safeguards auditing standards?
around acceptance of a a. Audit report modification for
contingent fee. consistency in the application of
c. Should accept accounting principles is required.
contingent fees only for b. Confirmation of
assurance services accounts
receivable is not
other than audits of
required.
financial statements.
c. The location in which
d. Should accept the auditor practices
contingent fees if it is must be disclosed in the
customary in the audit report.
country. d. International auditing
31. With regard to marketing standards do not
professional services, the IFAC require an audit of
Code of Ethics for Professional internal control.
Accountants indicates that
35. Independence standards of the
a. Direct marketing is prohibited.
GAO for audits in accordance
b. Marketing is allowed if lawful. with generally accepted
c. Marketing should be honest and government auditing standards
truthful. describe three types of
d. Marketing of audit services is impairments of independence.
prohibited. Which of the following is not
32. What body establishes international one of these types of
impairments?
auditing standards?
a. Personal.
a. The Public Company Accounting
b. Organizational.
Oversight Board.
c. External.
b. The International Federation of
d. Unusual.
Accountants.
c. The World Bank. 36. In accordance with the
d. The International Assurance independence standards of the
Body. GAO for performing audits in
accordance with generally
33. Which of the following is not
accepted government auditing
true about international
standards, which of the fol
auditing standards?
lowing is not an
example of an
external impairment
of independence?
a. Redu
cing
the
exten
t of
audit
work
due
to
press
ure
from
mana
geme
nt to
reduc
e
audit
fees.
b. Sel
ecti
ng
aud
it
ite
ms
bas
ed
on
the
wis
hes
of
an
em
plo
yee
of
the
org
ani
zati
on
bei
ng
aud
ite
d.
c. Bias
in
the
item
s the
audit
ors
deci
de to
selec
t for
testi
ng.
d.
Influenc
e
by
ma
nag
eme
nt
on
the
pers
onn
el
assi
gne
d to
the
aud
it.
37. Under the
independence
standards of the
GAO for per
forming audits
in accordance
with generally
accepted gov
ernment
auditing
standards,
which of the
following are
overreaching
principles for
determining
whether a
nonaudit
service impairs
independence?
I.
Audi
t
o
r
s

m
u
s
t

n
o
t

p
e
r
f
o
r
m

n
o
n
a
u
d
i
t

s
e
r
v
i
c
e
s

t
h
a
t

i
n

v
o
l
v
e

p
e
r
f
o
r
m
i
n
g

m
a
n
a
g
e
m
e
n
t

f
u
n
c
t
i
o
n
s

o
r

m
a
k
i
n
g

m
a
n
a
g
e
m
e
n
t

d
e
c
i
s
i
o
n
s
.

AI.
Audit
o
r
s
m
u
s
t
n
o
t
a
u
d
it
t
h
e
i
r
o
w
n
w
o
r
k
o
r
p
r
o
v
i
d
e
n
o
n
a
u
d
it
s
e
r
v
i
c
e
s
i
n
s
it
u
a
ti
o
n
s
i
n
w
h
i
c
h
t
h
e
n
o
n
a
u
d
it
s
e
r
v
i
c
e
s
a
r
e
s
i
g
n
i
f
i
c
a
n
t
o
r
m
a
t
e
r
i
a
l
t
o
t
h
e
s
u
b
j
e
c
t
matter of the audit.
BI.
Audi
t
o
r
s

m
u
s
t

n
o
t

p
e
r
f
o
r
m

n
o
n
a
u
d
i
t

s
e
r
v
i
c
e
s

w
h
i
c
h

r
e
q
u
i
r
e

i
n
d
e
p
e
n
d
e
n
c
e
.

a. I only.
b. I and II only.
c. I, II and III.
d. II and III only.
38. Which of the
following
bodies
enforce the
audit re
quirements
of the
Employee
Retirement
Security Act
of 1974
(ERISA)
with respect
to employee
benefit
plans?
a. The Department of Labor.
b. The Department of Pension Management.
c. The Securities and Exchange Commission.
d. The Public Company Accounting Oversight Board.
39. The requirement
for
independence by
the auditor re
garding audits of
employee
benefit plans
apply to the plan
as well as
a. In
ve
st
m
en
t
co
m
pa
ni
es
do
in
g
bu
si
ne
ss
wi
th
th
e
pl
an
.
b. Members of the plan.
c. The plan sponsor.
d. The actuary firm doing services for the plan.
SIMULATIONS
TaskBased Simulation 1
Independence
Issues
Authoritative
Literature Help
Assume that you are analyzing relationships for your firm to identify situations in which an auditor’s independence may
be impaired. For each of the following numbered situations, determine whether the auditor (a covered member in the situation)
is considered to be independent. If the auditor’s independence would not be impaired select No. If the auditor’s independence
would be impaired select Yes.
1. T
2. T
3. T
4. T
h
5. T
6. T
7. T
8. T
I
n
V
a
L
i
The director of the audit committee of Hanmei Corp., a nonissuer (nonpublic) company, has indicated that the company
may be interested in engaging your firm to perform various professional services. Consider each of the following potential
services by itself, and determine whether a CPA firm may provide such a service. If a CPA firm may provide the service, fill in
the circle under the first or second column of replies based upon whether independence is required. If the service may not be
provided, fill in the circle under “May Not Provide.” For each service you should have only one reply.
Service
1. Provide an opinion on whether financial statements are
prepared following the cash basis of accounting.
2. Compile a forecast for the coming year.
3. Compile the financial statements for the past year and
issue a publicly available report.
4. Apply certain agreedupon procedures to accounts receivable
for purposes of obtaining a loan, and express a summary of
findings relating to those procedures.
5. Review quarterly information and issue a report that includes
limited assurance.
6. Perform an audit of the financial statements on whether
they are prepared following generally accepted
accounting principles.
7. Perform a review of a forecast the company has prepared
for the coming year.
May provide, May provide,
independence independence is May
is required not required not provide
Service
8. Compile the financial statements for the past year, but not issue
a report since the financial statements are only for the
company’s use.
9. Calculate the client’s taxes and fill out the appropriate tax
forms.
10. Design a new payroll system for Hanmei and base billings on
Hanmei’s actual savings for the next three years.
Research
Authoritative
Literature Help
3. Regardless of what you find, he would like you to determine whether a covered member
may have such an immaterial financial investment in an audit client. What title,
section, and paragraph addresses this issue?
Providing Various
Services
Authoritative
Literature Help
The firm of Willingham and Whiting, CPAs, has had requests from a number of clients and prospective clients as to
providing various types of services. Please reply as to whether the appropriate independence rules (AICPA and/or PCAOB)
allow the following engagements with
A—Allowable, given these facts. N
—Not allowable, given these facts.
(If both AICPA and PCAOB rules apply and one of them does not allow the services answer N.)
Allowable (A)
Public or or not
nonpublic allowable
Case Request client (NA)?
1. Provide internal audit outsourcing as well as perform the audit. Public
2. Prepare the corporate tax return as well as perform the audit. Public
3. Prepare the corporate tax return as well as perform the audit. Nonpublic
4. Provide bookkeeping services as well as perform the audit; WW will not Nonpublic
determine journal entries, authorize transactions, prepare or modify source
documents.
5. Provide financial information systems design and implementation assistance; Public
WW provides no attest services for that company.
6. Serve on the board of directors of the company; WW provides no attest Public
services for that company.
7. Implement an offtheshelf accounting package as well as perform the audit. Nonpublic
8. Provide actuarial services related to certain liabilities as well as perform the Nonpublic
audit; the subjectively determined liabilities relate to a material portion of the
9. Provide actuarial services related to certain liabilities as well as perform the Public
audit; the subjectively determined liabilities relate to material portion of the
10. Corporate executives of an audit client want to have WW provide tax planning Public
for themselves (not the company).
Research
Authoritative
Literature Help
Payroll System Engagement
Michael Edlinger is president of Edlinger Corporation, a nonpublic manufacturer of kitchen cabinets. He has been
approached by Marla Wong, a partner with Wong and Co., CPAs, who suggests that her firm can design a payroll system for
Edlinger that will either save his corporation money or be free. More specifically, Ms. Wong proposes to design a payroll
system for Edlinger on a contingent fee basis. She suggests that her firm’s fee will be 25 % of the savings in payroll for each
of the next four years. After four years Edlinger will be able to keep all future savings. Edlinger Corporation’s payroll system
costs currently are approximately $200,000 annually, and the corporation has not previously been a client of Wong. Edlinger
Corporation is audited by another CPA firm and Wong & Co. provides no other services to Edlinger Corporation. Select one
of the following topics to answer question 1.
D.
Selections
A. AU
B. PCAOB AR
C. AT E.
ET
F. BL
G. CS
H. QC
1. Which topic of the Professional Standards addresses this issue and will be helpful
in determining whether Wong & Co. may perform this engagement under these
terms without violating professional requirements?
(A) (B) (C) (D) (E) (F) (G) (H)
2. Provide the appropriate paragraph citation that addresses this issue.
3. Interpret your findings in parts 1. and 2. and conclude on whether Wong & Co. may perform this service without
violating professional standards.
___Yes, this service may be performed without violating professional standards.
___No, this service may not be performed without violating professional standards.
Research
Authoritative
Literature Help
Professional Standards
You have worked with James & Co. CPAs for approximately 4 months. Jen Jefferson, who has just started with James
& Co., has asked you to explain the nature of various professional standards to her. More specifically, she would like to
have a better understanding of which standards to address, in which circumstances.
Select the appropriate title of standards for 1. through 10. below. Standards may be selected once, more than once, or not
at
all.
Title of Standards
A. AICPA Bylaws (BL)
B. Code of Professional Conduct (ET)
C. PCAOB Auditing Standards
D. Standards for Performing and Reporting on Peer Reviews (PR)
E. Statements on Auditing Standards (AU)
F. Statements on Quality Control Standards (SQCS)
G. Statements on Standards for Accounting and Review Services (SSARS)
H. Statements on Standards for Attestation Engagements (SSAE)
I. Statements on Standards for Consulting Services (CS)
J. Statements on Standards for Tax Services (TS)
8. For reporting on client pro forma
Standards that provide guidance financial information.
1. For performance of a review of a 9. On whether an investment of a CPA
nonpublic company’s annual financial impairs her independence with respect
statements. to a client.
2. On whether a contingent fee may be billed to a client. 10. On performing a compilation of a
3. Related to firm requirements of CPA firms nonpublic company’s quarterly
that are enrolled in an AICPAapproved statements.
practicemonitoring system.
4. For an examination of a client’s financial forecast.
5. Relating to overall requirements when
providing services for an advisory
services engagement.
6. For the audit of a public company.
7. For the performance of an interim review of
the quarterly financial statements of a
nonpublic audit client.
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J)
Research
Authoritative
Literature Help
Code of Professional Conduct
Assume that you are employed by DFW, CPAs. One of the partners has asked you to research the professional standards
for the section that identifies the requirements regarding the acceptance of contingent fees for engagements.
Title choices
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
1. Which title of the Professional Standards addresses this issue and will be
helpful in responding to the partner?
2. Enter the exact section and paragraphs with helpful information.
*
MULTIPLECHOICE ANSWERS
1. C __ __ 10. a __ __ 19. d __ __ 28. c __ __ 37. b __ __
2. D __ __ 11. a __ __ 20. c __ __ 29. d __ __ 38. a __ __
3. B __ __ 12. a __ __ 21. a __ __ 30. b __ __ 39. c __ __
4. C __ __ 13. b __ __ 22. a __ __ 31. c __ __
5. C __ __ 14. b __ __ 23. d __ __ 32. b __ __
6. A __ __ 15. c __ __ 24. d __ __ 33. c __ __
7. D __ __ 16. a __ __ 25. c __ __ 34. a __ __
8. C __ __ 17. d __ __ 26. a __ __ 35. d __ __ 1st: __/39 = __%
9. B __ __ 18. b __ __ 27. b __ __ 36. c __ __ 2nd: __/39 = __%
MULTIPLECHOICE ANSWER EXPLANATIONS
because although the conviction of a felony can result in
A.1.–3. Code of Professional Conduct automatic expulsion, likewise can the other two. An
1. (c) The requirement is to identify the statement thatbest swers (b) and (c) are incorrect because all three can result
describes the meaning of generally accepted auditing in automatic expulsion from the AICPA.
standards. Answer (c) is correct because generally 3. (b) Answer (b) is correct because an effective
accepted auditing standards deal with measures of the corporate governance structure is a control that
quality of the performance of audit procedures (AU 150). can be implemented by a client that increases
Answer (d) is incorrect because procedures relate to acts to independence of the attest team. Answer (a) is
be performed, not directly to the standards. Answer (b) is incorrect because it is a safeguard that is
incorrect because generally accepted auditing standards implemented by regulation or the CPA firm.
have been issued by predecessor groups, as well as by the Answer
Auditing Standards Board. Answer (a) is incorrect because (c) is incorrect because it is a safeguard that is required by
there may or may not be universal compliance with the regulation or the CPA firm. Answer (d) is incorrect
standards. because it represents a threat rather than a safeguard.
2. (d) All of these can result in the automatic expulsion of 4. (c) Answer (c) is correct because the team
the member from the AICPA. Answer (a) is incorrect member would be reviewing his or her own
work. Answer (a) is incorrect because this is an are not intentional misstatements. Answer (c) is incorrect
example of a familiarity threat. Answer (b) is because while one must remain objective while
incorrect because this is an example of a performing consulting services, independence is not
safeguard to threats to independence. Answer required unless the CPA also performs attest services for
(d) is incorrect because this represents a that client.
financial selfinterest threat to independence.
7. (d) The requirement is to determine which act is generally
5. (c) According to the Code of Professional prohibited. Answer (d) is correct because “If an
Conduct, Rule 101 regarding independence, a engagement is terminated prior to completion, the member
spouse may be employed by a client if s/he does is required to return only client records” (ET 501). Answer
not exert significant influence over the contents (a) is incorrect because issuing a modified report
of the client’s financial statements. This is a key explaining a failure to follow a governmental regulatory
position as defined by the Interpretation of Rule agency’s standards when conducting an attest service is
101. not prohibited. Answer (c) is incorrect because accepting a
contingent fee is allowable when representing a client in
6. (a) According to Rule 102 of the Code of Profes an examination by a revenue agent of the client’s federal
sional Conduct, in performing any professional or state income tax return (ET 302). Answer (b) is
service, a member shall maintain objectivity and incorrect because revealing confidential client information
integrity, avoid conflicts of interest, and not during a quality review of a professional practice by a
knowingly misrepresent facts. Answer (a) is team from the state CPA society is not prohibited (ET
correct as this would be knowingly misrepre 301).
senting the facts. Answers (b) and (d) are
incorrect as these 8. (c) According to Rule 203 of the Code of
Professional Conduct, CPAs are allowed to
depart from a GASB Statement only when
results of the Standard would be misleading.
Examples of possible circumstances justifying
departure are new legislation and a new form of
business transaction.
9. (b) The requirement is to determine whether a
CPA may hire a nonCPA systems analyst and,
if so, under what conditions. Answer (b) is
correct because ET 291 allows such a situation
when the CPA is qualified to supervise and
evaluate the work of the specialist. Answer (a) is
incorrect because the CPA need not be qualified
to perform the specialist’s tasks. Answer (c) is
incorrect because nonCPA professionals are
permitted to be associated with CPA firms in
public practice. Answer (d) is incorrect because
nonprofessionals may be hired, and because
developing computer systems is recognized as a
service performed by public accountants.
10. (a) She may use the CPA designation on her
business cards when she does not imply
independence but shows her title and her
employer. Therefore, answer (b) is incorrect.
Answer (c) is incorrect because she may use the
CPA designation on her business cards or
company transmittals if she does not imply
independence. Answer (d) is incorrect because
under the above situations, she can use the CPA
designation.
11. (a) The requirement is to determine the activity
that would most likely not impair a CPA’s
independence. Ac
*
Explanation of how to use this performance record appears on page 2.
specialized knowledge,
training, and experience.
counting and consulting services do not
normally impair independence because 15. (c) The requirement is to determine which
the member’s role is advisory in nature act is generally prohibited. Answer (c) is
(ET 191). Answers (b) and (c) are correct because “a member in public
incorrect because management functions practice shall not for a commission rec
are being performed (ET 191). Answer ommend or refer to a client any product or
(d) is incorrect because accepting a service, or for a commission recommend or
luxurious gift impairs a CPA’s refer any product or service to be supplied
independence (ET 191). by a client, or receive a commission when
the member or the member’s firm perform
12. (a) The requirement is to identify the type for that client: (1) an audit of a financial
of report that may be issued only by an statement; or (2) a compilation of a fi
independent accountant. Answer (a) is nancial statement when the member
correct because AT 101 requires an expects that a third party will use the
accountant be independent for all financial statement and the member’s
attestation engagements. An attestation compilation report does not disclose a lack
engagement is one in which the accountant of independence; or (3) an examination of
expresses a conclusion about the reliability prospective financial information.” Answer
of assertions which are the responsibility of (a) is incorrect because a member may
another party. A standard report on an purchase a product and resell it to a client.
examination of a financial forecast requires Any profit on sale would not constitute a
the auditor to express an opinion, which commission (ET 591).
requires an accountant to be independent.
Answer (b) is incorrect because CS 100 16. (a) The principle of due care requires the
indicates that consulting services are member to observe the profession’s
fundamentally different from the attestation technical and ethical standards, strive
function, and therefore do not require continually to improve competence and the
independence of the accountant. Answers quality of services, and discharge
(c) and (d) are incorrect because AR 100 responsibility to the best of the member’s
indicates that an accountant who is not ability. Answer (b) is incorrect as the
independent is not precluded from issuing a auditor is not required to examine all
report on a compilation of financial corroborating evidence supporting
statements. management’s assertions, but rather to
examine evidence
13. (b) Per ET 56, due care requires
a member to discharge
professional responsibilities with
competence and diligence.
Competence represents the
attainment and maintenance of a
level of understanding and
knowledge that enables a
member to render services with
facility and acumen. It also
establishes the limitations of a
member’s capabilities by
dictating that consultation or
referral may be required when a
professional engagement exceeds
the personal competence of a
member or a member’s firm.
Accordingly, answer (b) is
correct as it may be required to
consult with experts in
exercising due care. Due care
does not require obtaining
specialty accreditation.
14. (b) Under ruling 101 under Rule
of Conduct 102, when a CPA is
acting as an expert witness, s/he
should not act as an advocate
but should give his/her position
based on objectivity. The expert
witness does this based on
incorrect because statement II
on a scope basis based on his/her also is incorrect. Answer (c) is
consideration of materiality and level of incorrect because statements I
risk assessed. Answer (c) is incorrect as the and II are both incorrect.
auditor should be aware of the possibility
20. (c) Information in the CPA’s
of illegal acts, but an audit provides no
assurance that all or any illegal acts will be working papers is confidential
detected. Answer (d) is not the best answer and may not be disclosed except
because competence is derived from both with the client’s consent or by
education and experience. The principle of court order. Answer (a) is
due care requires the member to strive to incorrect because disclosure of
improve competence, however, attaining the information would generally
the proper balance of professional violate Rule 301 on confidential
experience and formal education is not a client information. Answers (b)
criterion for exercising due care. and (d) are incorrect because the
CPA owns the working papers.
17. (d) The fact that a close relative
of Kar works for Fort impairs 21. (a) The requirement is to identify
Kar’s independence. Answer (a) the listed authoritative body
is incorrect because the gift is of a designated to promulgate
token amount which does not attestation standards. Answer (a)
impair Kar’s independence. is correct because only the
Answer (b) is incorrect because a Auditing standards Board, the
joint financial investment must be Accounting and Review Services
material to impair independence, Committee, and the Management
and this would generally not Advisory Services Executive
occur with respect to a retirement Committee have been authorized
plan. Answer (c) is incorrect to promulgate attestation
because preparation of the client’s standards.
tax return is not a service that A.4. Responsibilities in Consulting
impairs independence.
Services
18. (b) Independence was not required at the
time the loan was obtained, and because it 22. (a) Types of consulting
is fully secured it is grandfathered by 101 services include consultations,
5. Answer (a) is incorrect because if the advisory services,
CPA is required to be independent, a implementation services,
mortgage loan would not be permitted even transaction services, staff and
if it was fully secured. Answer (c) is other support services, and
incorrect because the CPA was not required product services.
to be independent of the client. Answer (d) 23. (d) According to the Statements on Standards
is incorrect because the CPA was not for Consulting Services, independence is not
required to be independent of the client. required for performance of consulting
19. (d) Both of the statements are services unless the CPA also performs attest
incorrect; either would violate services for that client. However, the CPA
Rule 301 on confidential client must remain objective in performing the
information. Answer (a) is consulting services. Furthermore, the
incorrect because statement I also understanding with the client for performing
is incorrect. Answer (b) is the services can be established either in
writing or orally.
identify the characteristicthat
differs between the two sets of
24. (d) CS 100 indicates that the ethical standards. Answer (b)
nature and scope of consulting is correct because the IFAC
services is determined solely by Code has fewer outright
the practitioner and the client, prohibitions than the AICPA
typically in which the Code. Answers (a) and (c) are
practitioner develops findings, incorrect because the IFAC
conclusions, and Code has fewer outright
recommendations for the client. prohibitions. Answer (d) is
All three services listed would incorrect because the IFAC
fall under the definition of Code applies to all professional
consulting services. accountants.
25. (c) The AICPA Statement on 28. (c) The requirement is to
Standards for Consulting identify the item that is nota
Services, Section 100, describes threat to independence. Answer
general standards for all (c) is correct because the audit
consulting services, in addition to relationship, in itself, is not a
those established under the threat to independence.
AICPA Code of Professional Answers (a), (b), and (d) are
Conduct. Section 100 addresses incorrect because they all represent
the areas of client interest, types of threats to independence.
understanding with the client, and
communication with the client. 29. (d) The requirement is to identify the
Specifically, this section states appropriatecourse of action when threats to
that the accountant should inform independence are discovered. Answer (d)
the client of significant is correct because the firm should evaluate
reservations concerning the scope the significance of the threats and apply
or benefits of the engagement. safeguards, if necessary, to reduce them to
an acceptable level. Answer (a) is incorrect
A.5. Responsibilities in Personal because the firm would only resign if
Financial Planning appropriate safeguards could not reduce the
threats to an acceptable level, or it is
26. (a) Personal financial planning required based on a prohibition. Answer (b)
engagements are onlythose that involve is incorrect because the firm would not
developing strategies and making notify a regulatory body at this point.
recommendations to assist a client in Answer (c) is incorrect because the firm
defining and achieving personal financial would document the issue, but only after it
goals. Personal financial engagements is resolved.
involve all of the following:
20. Defining engagement objectives
21. Planning specific procedures
appropriate to engagement
22. Developing basis for
recommendations
23. Communicating recommendations
to client
24. Identifying tasks for taking
action on planning decisions.
Other engagements may also include, but
generally are not required to perform,
the following:
1. Assisting client to
take action on
planning decisions
2. Monitoring client’s progress in
achieving goals
3. Updating
recommendations and
helping client revise
planning decisions.
D. International Standards—Ethical
27. (b) The requirement is to
risk of material misstatement.
54. (b) The requirement is to identify Answers (a), (b) and (d) are
what the IFAC incorrect because they are all
Code of Ethics for Professional true about international auditing
Accountants provides withrespect to standards.
contingent fees. Answer (b) is correct
34. (a) The requirement is to identify
because the IFAC Code indicates that if the
contingent fee presents a threat to apply the item that is nottrue about
fundamental principles, the firm should international auditing standards.
establish appropriate safeguards. Answer Answer (a) is correct because
(a) is incorrect because a contingent fee international auditing standards
may be accepted if threats can be reduced do not require a modification of
to an acceptable level. Answers (c) and (d) the audit report for consistency
are incorrect because the IFAC Code does in the application of accounting
not contain these provisions. principles. Answers (b), (c), and
(d) are incorrect because they are
55. (c) The requirement is to true about international auditing
identify the IFAC standards.
Codeprovision regarding
marketing. Answer (c) is F.2. Government Accountability Office
correct because the IFAC Code (GAO)
indicates the marketing must
35. (d) The requirement is to identify
be honest and truthful.
Answers (a) and (d) are the impairment thatis not one of
incorrect because no particular the three types of impairments
form of marketing is described in the GAO standards.
prohibited. Answer (b) is Answer (d) is correct because an
incorrect because marketing unusual impairment is not one of
must be honest and truthful as the types of impairments
well as legal. described in the GAO standards.
Answers (a), (b) and (c) are
E. International Standards incorrect because they are the
Auditing/Assurance three types of impairments
described in the GAO standards.
32. (b) The requirement is to identify the body
that establishes international auditing 36. (c) The requirement is to identify
standards. Answer (b) is correct because the example thatdoes not
the International Auditing and Assurance represent an external impairment
Standards Board of the International of independence. Answer (c) is
Federation of Accountants establishes correct because this item is an
international auditing standards. Answer example of a personal
(a) is incorrect because the Public impairment of independence.
Company Accounting Oversight Board Answers (a), (b) and
establishes standards for the audit of public (d) are incorrect because they are all
companies in the US. Answers (c) and (d) examples of external impairments of
are incorrect because these bodies do not independence.
establish auditing standards. 37. (b) The requirement is to identify
33. (c) The requirement is to identify the overreachingprinciples for
the item that is nottrue about identifying whether nonaudit
international auditing standards. services impair independence.
Answer (c) is correct because Answer (b) is correct because I
international auditing standards and II are the two principles.
require obtaining an attorney’s Answer (a) is incorrect because II
letter only if the auditors assess a is also an
overreaching principle. Answer (c) is incorrect because III is not an overreaching principle.
Answer (d) is incorrect because I is an overreaching principle and III is not.
F.3. Department of Labor (DOL)
38. (a) The requirement is to identify the body that enforces the audit requirements of ERISA.
Answer (a) is correct because the Department of Labor is responsible for enforcing the audit
requirements. Answer (b) is incorrect because the Department of Pension Management does
not exist. Answers (c) and (d) are incorrect because the SEC and the PCAOB deal with
auditing requirements for entities with publicly traded securities (issuers).
39. (c) The requirement is to identify the party that independence standards also apply
to when performing an audit of an employee benefit plan. Answer (c) is correct
because the Department of Labor rules also apply to independence from the plan and
the plan sponsor. Answers (a), (b) and (d) are incorrect because the independence
standards do not apply to these parties.
SOLUTIONS TO SIMULATIONS
Independence
Issues Authoritative
Literature Help
Yes No
1. The auditor is a cosigner of a client’s checks.
2. The auditor is a member of a country club which is a client.
3. The auditor owns a large block of stock in a client but has placed it in a blind trust.
4. The auditor placed her checking account in a bank which is her client. The account is fully
insured by a federal agency.
5. The client has not paid the auditor for services for the past two years.
6. The auditor is leasing part of his building to a client.
7. The auditor joins, as an ordinary member, a trade association which is also a client.
8. The auditor has an immaterial, indirect financial interest in the client.
Explanation of solutions
1. (Y) Since the auditor is a cosigner on a client’s check, the auditor could become
liable if the client defaults. This relationship impairs the auditor’s
independence.
2. (N) Independence is not impaired because membership in the country club is essentially
a social matter.
3. (Y) An auditor may not hold a direct financial interest in a client. Putting it in a
blind trust does not solve the impairment of independence.
4. (N) If the auditor places his/her account in a client bank, this does not impair
independence if the accounts are state or federally insured. If the accounts are
not insured, independence is not impaired if the amounts are immaterial.
5. (Y) The auditor’s independence is impaired when prior years’ fees for professional
services remain unpaid for more than one year.
6. (Y) The auditor’s independence is impaired when s/he leases space out of a building
s/he owns to a client.
7. (N) When the auditor does not serve in management, s/he may join a trade association
who is a client.
8. (N) Independence is impaired for direct financial interests and material, indirect
financial interests but not for immaterial, indirect financial interests.
Independence and
Various Services Authoritative
Literature
Help
Service
1. Provide an opinion on whether
financial statements are prepared
following the cash basis of accounting
2. Compile a forecast for the coming year.
3. Compile the financial statements for the
past year and issue a publicly available
report.
4. Apply certain agreedupon procedures to
accounts receivable for purposes of
obtaining a loan, and express a summary of
findings relating to those procedures.
5. Review quarterly information and issue a
report that includes limited assurance.
Service
6. Perform an audit of the financial
statements on whether they are
prepared following generally accepted
7. Perform a review of a forecast the
company has prepared for the coming
year.
8. Compile the financial statements for the past
year, but not issue a report since the
financial statements are only for the
company’s use.
9. Calculate the client’s taxes and fill out the appropriate tax
forms.
10. Design a new payroll system for Hanmei and base billings on
Hanmei’s actual savings for the next three years.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
1. He thinks that he recalls the issue relates to whether you are or are not a
“covered member.” He would like you to find the definition of a covered
member in the professional standards. Which title of the Professional Stan
dards addresses this issue and will be helpful in responding to the senior?
2. Enter the exact section and paragraphs with helpful information. 92 06
3. Regardless of what you find, he would like you to determine whether a covered member
may have such an immaterial financial investment in an audit client. What title, section, ET 101 02
and paragraph addresses this issue?
Providing Various
Services
Authoritative
Literature Help
1. Not allowable (PCAOB requirements prohibit)
2. Allowable
3. Allowable
4. Allowable
5. Allowable (Because no attest services are provided, the PCAOP allows this)
6. Not allowable
7. Allowable
8. Not allowable (AICPA rules prohibit this when amounts are subjectively determined
and material)
9. Not allowable (Both AICPA nor PCAOB rules prohibit this when amounts are
subjectively determined and material)
10. Not allowable
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)

1. Which topic of the Professional Standards addresses this issue and will be
helpful in determining whether Wong & Co. may perform this engagement
under these terms without violating professional requirements?
2. Provide the appropriate paragraph citation that addresses this issue. 302 01
3. Interpret your findings in parts 1 and 2 and conclude on whether Wong & Co.
may perform this service without violating professional standards.
_x_ Yes, this service may be performed without violating professional standards.
___ No, this service may not be performed without violating professional
standards.
Research
Authoritative
Literature Help
Standards that provide guidance (A) (B) (C) (D) (E) (F) (G) (H) (I) (J)
1. For performance of a review of a nonpublic company’s annual financial
statements.
2. On whether a contingent fee may be billed to a client.
3. Related to firm requirements of CPA firms that are enrolled in an
AICPAapproved practicemonitoring system.
4. For an examination of a client’s financial forecast.
5. Relating to overall requirements when providing services for an
advisory services engagement.
6. For the audit of a public company.
7. For the performance of an interim review of the quarterly financial
statements of a nonpublic audit client.
8. For reporting on client pro forma financial information.
9. On whether an investment of a CPA impairs her independence with
respect to a client.
10. On performing a compilation of a nonpublic company’s quarterly
statements.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
24 MODULE 2 ENGAGEMENT PLANNING AND ASSESSING RISKS
ENGAGEMENT PLANNING, OBTAINING AN UNDERSTANDING
OF THE CLIENT AND ASSESSING RISKS
6. Financial statement assertions are
established foraccount balances,
1. Which of the following is a conceptual Classes of transactions Disclosures
difference between the attestation standards a. Yes Yes
and generally accepted auditing standards? b. Yes No
a. The attestation standards do not apply c. No Yes
to audits of historical financial d. No No
statements, while the generally
accepted auditing standards do. 7. Which of the following is not a financial
b. The requirement that the practitioner statement assertion relating to account
be independent in mental attitude is balances?
omitted from the attestation a. Completeness.
standards. b. Existence.
c. The attestation standards do not c. Rights and obligations.
permit an attest engagement to be d. Valuation and competence.
part of a business acquisition study
or a feasibility study. 8. As the acceptable level of detection
d. None of the standards of fieldwork in risk decreases, an auditor may
generally accepted auditing standards are
included in the attestation standards.
2. Which of the following is not an indications of employee
attestation standard? fraud and illegal acts.
a. Sufficient evidence shall be c. Objective review of the
obtained to provide a adequacy of the technical
reasonable basis for the training and proficiency of
conclusion that is ex firm personnel.
pressed in the report. d. Critical review of the
b. The report shall identify the judgment exercised at
subject matter on the every level of supervision.
assertion being reported on
5. After fieldwork audit procedures are
and state the character of
completed, a partner of the CPA
the engagement.
firm who has not been involved in
c. The work shall be the audit performs a second or wrap
adequately planned and up working paper review. This
assistants, if any, shall be second review usually focuses on
properly supervised.
a. The fair presentation of the
d. A sufficient understanding
financial statements in
of internal control shall be
conformity with GAAP.
obtained to plan the
b. Fraud involving the
engagement.
client’s management and
3. Which of the following is most likely its employees.
to be unique to the audit work of c. The materiality of the
CPAs as compared to work adjusting entries proposed
performed by practitioners of other by the audit staff.
professions? d. The communication of internal
a. Due professional care. control weaknesses to the client’s
b. Competence. audit committee.
c. Independence.
d. Complex body of knowledge.
4. The third general standard states
that due care is to be exercised in
the performance of an audit. This
standard is ordinarily interpreted to
require
a. Thorough review of the
existing safeguards over
access to assets and
records.
b. Limited review of the
a. Reduce substantive testing by
relying on the assessments of
inherent risk and control risk.
b. Postpone the planned
timing of substantive tests
from interim dates to the
yearend.
c. Eliminate the assessed level
of inherent risk from
consideration as a planning
factor.
d. Lower the assessed level of
control risk from the
maximum level to below
the maximum.
9. The risk that an auditor will conclude,
based on substantive tests, that a
material misstatement does not exist
in an account balance when, in fact,
such misstatement does exist is
referred to as
a. Sampling risk.
b. Detection risk.
c. Nonsampling risk.
d. Inherent risk.
10. As the acceptable level of detection
risk decreases, the assurance directly
provided from
a. Substantive tests should increase.
b. Substantive tests should decrease.
c. Tests of controls should increase.
d. Tests of controls should decrease.
11. Which of the following audit risk
components may be assessed in
nonquantitative terms?
Control risk Detection risk Inherent risk
a. Yes Yes No
b. Yes No Yes
c. Yes Yes Yes
d. No Yes Yes
12. Inherent risk and control risk differ
from detection risk in that they
a. Arise from the
misapplication of auditing
procedures.
b. May be assessed in
either quantitative or
nonquantitative terms.
c. Exist independently of the
financial statement audit.
d. Can be changed at the auditor’s
discretion.
13. On the basis of the audit evidence
gathered and evaluated, an auditor
decides to increase the assessed level of
control risk from that originally
planned. To achieve an
MODULE 2 ENGAGEMENT PLANNING AND ASSESSING RISKS 25
b. Corroborating evidence.
c. Quality control.
overall audit risk level that is substantially d. Materiality and relative risk.
the same as the planned audit risk level, the
auditor would 18. In considering materiality for
a. Decrease substantive testing. planning purposes, an auditor
b. Decrease detection risk. believes that misstatements
c. Increase inherent risk. aggregating $10,000 would have a
d. Increase materiality levels. material effect on an entity’s income
statement, but that misstatements
14. Relationship between control risk would have to aggregate $20,000 to
and detection risk is ordinarily materially affect the balance sheet.
a. Parallel. Ordinarily, it would be appropriate to
b. Inverse. design auditing procedures that
c. Direct. would be expected to detect
d. Equal. misstatements that aggregate
a. $10,000
15. Which of the following would an b. $15,000
auditor most likely use in determining c. $20,000
the auditor’s preliminary judgment d. $30,000
about materiality?
a. The anticipated sample size of the 19. Which of the following would an
planned substantive tests. auditor most likely use in
b. The entity’s annualized determining the auditor’s preliminary
interim financial state judgment about materiality?
ments. a. The results of the initial assessment of
c. The results of the internal control control risk.
questionnaire.
d. The contents of the
management representation
letter.
16. Which of the following statements is
not correct about materiality?
a. The concept of materiality
recognizes that some matters
are important for fair
presentation of financial
statements in conformity
with GAAP, while other
matters are not important.
b. An auditor considers
materiality for planning
purposes in terms of the
largest aggregate level of
misstatements that could be
material to any one of the
c. Materiality judgments are
made in light of sur
rounding circumstances
and necessarily involve
both quantitative and
qualitative judgments.
d. An auditor’s consideration
of materiality is influenced
by the auditor’s perception
of the needs of a reasonable
person who will rely on the
17. Which of the following elements
underlies the application of
generally accepted auditing
standards, particularly the standards
of fieldwork and reporting?
a. Internal control.
c. Reasonable assurance.
b. The anticipated sample d. Supervision.
size for planned substan
tive tests. 23. Professional skepticism requires that
c. The entity’s financial statements of an auditor assume that management is
the prior year. a. Honest, in the absence of fraud risk
d. The assertions that are factors.
embodied in the financial b. Dishonest until completion of audit
statements. tests.
c. Neither honest nor dishonest.
20. Holding other planning considerations equal, a d. Offering reasonable assurance of
decrease in the amount of misstatement in a honesty.
class of transactions that an auditor could
tolerate most likely would cause the auditor to 24. Which of the following is an
a. Apply the planned example of fraudulent financial
substantive tests prior to reporting?
the balance sheet date. a. Company management
b. Perform the planned changes inventory count
auditing procedures closer tags and overstates ending
to the balance sheet date. inventory, while un
c. Increase the assessed level derstating cost of goods
of control risk for relevant sold.
financial statement b. The treasurer diverts
assertions. customer payments to his
d. Decrease the extent of personal due, concealing his
auditing procedures to be actions by debiting an
applied to the class of expense account, thus
transactions. overstating expenses.
c. An employee steals
21. When issuing an unqualified opinion, inventory and the
the auditor who evaluates the audit “shrinkage” is recorded in
findings should be satisfied that the cost of goods sold.
a. Amount of known d. An employee steals small
misstatement is tools from the company and
documented in the neglects to return them; the
management representation cost is reported as a
letter. miscellaneous operating
b. Estimate of the total expense.
likely misstatement is
less than a material 25. Which of the following best describes
amount. what is meant by the term “fraud risk
c. Amount of known factor?”
misstatement is a. Factors whose presence
acknowledged and indicates that the risk of
recorded by the client. fraud is high.
d. Estimate of the total likely misstatement b. Factors whose presence
includes the adjusting entries already often have been observed in
recorded by the client. circumstances where frauds
have occurred.
22. An attitude that includes a c. Factors whose presence
questioning mind and a critical requires modification of
assessment of audit evidence is planned audit procedures.
referred to as d. Material weaknesses identified during
a. Due professional care. an audit.
b. Professional skepticism.
tofraud?
a. Failure to correct known reportable
26. Which of the following is correct conditions on a timely basis.
concerning requirements about b. Nonfinancial
auditor communications about management’s
fraud? preoccupation with the
a. Fraud that involves senior selection of accounting
management should be reported principles.
directly to the audit committee c. Significant portion of management’s
regardless of the amount involved. compensation represented by bonuses
b. Fraud with a material effect based upon achieving unduly
on the financial statements aggressive operating results.
should be reported directly d. Use of unusually
by the auditor to the conservative accounting
Securities and Exchange practices.
Commission.
32. Which of the following conditions
c. Fraud with a material effect on the
identified during fieldwork of an
financial statements should ordinarily
audit is most likely to affect the
be disclosed by the auditor through
use of an “emphasis of a matter” auditor’s assessment of the risk of
paragraph added to the audit report. misstatement due to fraud?
d. The auditor has no a. Checks for significant
responsibility to disclose amounts outstanding at
fraud outside the entity yearend.
under any circumstances.
27. When performing a financial
statement audit, auditors are
required to explicitly assess the risk
of material misstatement due to
a. Errors.
b. Fraud.
c. Illegal acts.
d. Business risk.
28. Audits of financial statements are
designed to obtain assurance of
detecting misstatement due to
Fraudulent Misappropriation
Errors financial reporting of assets
a. Yes Yes Yes
b. Yes Yes No
c. Yes No Yes
d. No Yes No
29. An auditor is unable to obtain absolute
assurance thatmisstatements due to fraud will
be detected for all of the following except
a. Employee collusion.
b. Falsified documentation.
c. Need to apply professional
judgment in evaluating
fraud risk factors.
d. Professional skepticism.
30. The most difficult type of
misstatement to detect is fraud
based on
a. The overrecording of transactions.
b. The nonrecording of transactions.
c. Recorded transactions in subsidiaries.
d. Relatedparty receivables.
31. When considering fraud risk
factors relating to management’s
characteristics, which of the
following is leastlikely to indicate
a risk of possible misstatement due
personnel is low.
b. Computer generated documents. b. Insiders recently purchased
c. Missing documents. additional shares of the
d. Yearend adjusting journal entries. entity’s stock.
c. Management places
33. Which of the following is most substantial emphasis
likely to be a response to the on meeting earnings
auditor’s assessment that the risk of projections.
material misstatement due to fraud d. The rate of change in the entity’s
for the existence of inventory is industry is slow.
high?
a. Observe test counts of 36. Which of the following statements
inventory at certain loca reflects an auditor’s responsibility for
tions on an unannounced detecting misstatements due to errors
basis. and fraud?
b. Perform analytical a. An auditor is responsible
procedures rather than for detecting employee
taking test counts. errors and simple fraud,
c. Request that inventories be but not for discovering
counted prior to yearend. fraud involving employee
d. Request that inventory collusion or management
counts at the various loca override.
tions be counted on different b. An auditor should plan the
dates so as to allow the same audit to detect mis
auditor to be present at statements due to errors
every count. and fraud that are caused
by departures from GAAP.
34. Which of the following is most likely c. An auditor is not responsible
to be an example of fraud? for detecting misstatements
a. Defalcations occurring due to errors and fraud
due to invalid electronic unless the application of
approvals.
GAAS would result in such
b. Mistakes in the
detection.
application of accounting
principles. d. An auditor should design
c. Mistakes in processing data. the audit to provide rea
sonable assurance of
d. Unreasonable accounting
detecting misstatements due
estimates arising from
to errors and fraud that are
oversight.
material to the financial
35. Which of the following statements.
characteristics most likely would
37. Disclosure of fraud to parties other than a
heighten an auditor’s concern
client’s senior management and its audit
about the risk of intentional
committee or board of directors ordinarily is
manipulation of financial
not part of an auditor’s responsibility.
statements?
However, to which of the following outside
a. Turnover of senior accounting
parties may a duty to disclose fraud exist?
conditions relating to financial stress of
employees or adverse relationships between a
To a governmentcompany and its employees?
To the SEC To a successor funding agency a. The auditor is required to
when the auditor when the from which the plan the audit to detect
client reports successor makes client receives these conditions on all
an auditor appropriate financial audits.
change inquiries assistance b. These conditions relate to
a. Yes Yes No fraudulent financial re
b. Yes No Yes porting, and an auditor is
c. No Yes Yes required to plan the audit to
d. Yes Yes Yes detect these conditions
38. Under Statements on Auditing when the client is exposed
Standards, which of the following to a risk of misappropriation
would be classified as an error? of assets.
a. Misappropriation of assets c. The auditor is required to
for the benefit of man plan the audit to detect
agement. these conditions whenever
b. Misinterpretation by they may result in mis
management of facts that statements.
existed when the financial d. The auditor is not required
statements were prepared. to plan the audit to discover
c. Preparation of records these conditions, but should
by employees to cover a consider them if he or she
fraudulent scheme. becomes aware of them
d. Intentional omission of the during the audit.
recording of a transaction
to benefit a third party.
39. What assurance does the auditor
provide that misstatements due to
errors, fraud, and direct effect illegal
acts that are material to the financial
statements will be detected?
Direct effect
Errors Fraud illegal acts
a. Limited Negative Limited
b. Limited Limited Reasonable
c. Reasonable Limited Limited
d. Reasonable Reasonable Reasonable
40. Because of the risk of material
misstatement, an audit of financial
statements in accordance with
standards should be planned and
performed with an attitude of
a. Objective judgment.
b. Independent integrity.
c. Professional skepticism.
d. Impartial conservatism.
41. Which of the following most
accurately summarizes what is
meant by the term “material
misstatement?”
a. Fraud and directeffect illegal acts.
b. Fraud involving senior
management and material
fraud.
c. Material error, material
fraud, and certain illegal
acts.
d. Material error and material illegal
acts.
42. Which of the following statements best
describes the auditor’s responsibility to detect
46. At which stage(s) of the audit may
43. When the auditor believes a
fraud risk factors be identified?
misstatement is or may be the result
of fraud but that the effect of the Obtaining Conducting
misstatement is not material to the Planning Understanding fieldwork
financial statements, which of the a. Yes Yes Yes
following steps is required? b. Yes Yes No
a. Consider the implications c. Yes No No
for other aspects of the d. No Yes Yes
audit. 47. Management’s attitude toward
b. Resign from the audit. aggressive financial reporting and its
c. Commence a fraud examination. emphasis on meeting projected profit
d. Contact regulatory authorities. goals most likely would significantly
influence an entity’s control
environment when
correct relating to the auditor’s
a. External policies established
consideration of fraud?
by parties outside the entity
a. The auditor’s interest in fraud
affect its accounting
consideration relates to fraudulent acts
practices.
that cause a material misstatement of
b. Management is dominated
by one individual who is
b. A primary factor that
also a shareholder.
distinguishes fraud from er
c. Internal auditors have direct
ror is that fraud is always
access to the board of
intentional, while errors are
directors and the entity’s
generally, but not always,
management.
intentional.
c. Fraud always involves a
d. The audit committee is active in
overseeing the entity’s financial
pressure or incentive to
reporting policies.
commit fraud, and a
misappropriation of assets. 48. Which of the following is least likely
d. While an auditor should be aware of to be required on an audit?
the possibility of fraud, management, a. Test appropriateness of
and not the auditor, is responsible for journal entries and adjust
detecting fraud. ment.
b. Review accounting estimates for
45. Which of the following factors
biases.
or conditions is an auditor least
c. Evaluate the business
likely to plan an audit to
rationale for significant un
discover?
usual transactions.
a. Financial pressures affecting
d. Make a legal
employees.
determination of whether
b. High turnover of senior management. fraud has occurred.
c. Inadequate monitoring of significant
controls. 49. Which of the following is most
d. Inability to generate likely to be an overall response to
positive cash flows from fraud risks identified in an audit?
operations.
d. Small highdollar inventory items.
a. Supervise members of the 54. Which of the following is most likely

audit team less closely and to be presumed to represent fraud risk
rely more upon judgment. on an audit?
b. Use less predictable audit procedures. a. Capitalization of repairs
c. Only use certified public and maintenance into the
accountants on the en property, plant, and
gagement. equipment asset account.
d. Place increased emphasis on b. Improper revenue recognition.
the audit of objective c. Improper interest expense accrual.
transactions rather than d. Introduction of significant new
subjective transactions. products.
50. Which of the following is least 55. An auditor who discovers that a

likely to be included in an auditor’s client’s employees paid small
inquiry of management while bribes to municipal officials most
obtaining information to identify the likely would withdraw from the
risks of material misstatement due to engagement if
fraud? a. The payments violated the
a. Are financial reporting client’s policies regarding
operations controlled by the prevention of illegal
and limited to one acts.
location? b. The client receives financial
b. Does it have knowledge of fraud or assistance from a federal
suspect fraud? government agency.
c. Does it have programs to mitigate c. Documentation that is
fraud risks? necessary to prove that the
d. Has it reported to the audit bribes were paid does not
committee the nature of the exist.
company’s internal control? d. Management fails to take
the appropriate remedial
51. Individuals who commit fraud are action.
ordinarily able to rationalize the
act and also have an 56. Which of the following factors most
Incentive Opportunity likely would cause a CPA to not
a. Yes Yes accept a new audit engagement?
b. Yes No
c. No Yes
d. No No
52. What is an auditor’s responsibility
who discovers management
involved in what is financially
immaterial fraud?
a. Report the fraud to the audit
committee.
b. Report the fraud to the
Public Company Oversight
Board.
c. Report the fraud to a level
of management at least one
below those involved in the
fraud.
d. Determine that the
amounts involved are
immaterial, and if so,
there is no reporting
responsibility.
53. Which of the following is most likely to be
considered a risk factor relating to fraudulent
financial reporting?
a. Domination of management by top
executives.
b. Large amounts of cash processed.
c. Negative cash flows from operations.
c. Violations of antitrust laws.
a. The prospective client d. Price fixing.
has already completed its
physical inventory count. 60. Which of the following relatively
b. The CPA lacks an small misstatements most likely could
understanding of the have a material effect on an entity’s
prospective client’s financial statements?
operation and industry. a. An illegal payment to a
c. The CPA is unable to foreign official that was
review the predecessor not recorded.
auditor’s working papers. b. A piece of obsolete office
d. The prospective client is equipment that was not
unwilling to make all fi retired.
nancial records available c. A petty cash fund
to the CPA. disbursement that was not
57. Which of the following factors properly authorized.
would most likely heighten an d. An uncollectible account
auditor’s concern about the risk of receivable that was not
fraudulent financial reporting? written off.
a. Large amounts of liquid
61. During the annual audit of Ajax Corp., a
assets that are easily con
vertible into cash. publicly held company, Jones, CPA, a
b. Low growth and continuing auditor, determined that illegal
profitability as compared to political contributions had been made during
other entities in the same each of the past seven years, including the year
industry. under audit. Jones notified the board of
directors about the illegal contributions, but
c. Financial management’s
they refused to take any action because the
participation in the initial
amounts involved were immaterial to the
selection of accounting
financial statements. Jones should reconsider
principles.
the intended degree of reliance to be placed on
d. An overly complex the
organizational structure
a. Letter of audit inquiry to the client’s
involving unusual lines of
authority. attorney.
b. Prior years’ audit programs.
58. An auditor who discovers that a
client’s employees have paid small
bribes to public officials most likely
would withdraw from the
engagement if the
a. Client receives financial
assistance from a federal
government agency.
b. Evidence that is necessary
to prove that the illegal acts
were committed does not
exist.
c. Employees’ actions affect
the auditor’s ability to
rely on management’s
representations.
d. Notes to the financial
statements fail to disclose
the employees’ actions.
59. Which of the following illegal acts
should an audit be designed to
obtain reasonable assurance of
detecting?
a. Securities purchased by
relatives of management
based on knowledge of
inside information.
b. Accrual and billing of an
improper amount of reve
nue under government
contracts.
necessary.
c. The illegal act was
c. Management representation letter. committed during a prior
d. Preliminary judgment about year that was not audited.
materiality levels. d. The auditor has already
assessed control risk at the
62. The most likely explanation why the maximum level.
auditor’s examination cannot
reasonably be expected to bring all 65. Under the Private Securities
illegal acts by the client to the Litigation Reform Act of 1995,
auditor’s attention is that Baker, CPA, reported certain
a. Illegal acts are perpetrated uncorrected illegal acts to
by management override Supermart’s board of directors. Baker
of internal control. believed that failure to take remedial
b. Illegal acts by clients often action would warrant a qualified
relate to operating aspects audit opinion because the illegal acts
rather than accounting had a material effect on Supermart’s
aspects. financial statements. Supermart failed
c. The client’s internal control to take appropriate remedial action
may be so strong that the and the board of directors refused to
auditor performs only inform the SEC that it had received
minimal substantive such notification from Baker. Under
testing. these circumstances, Baker is re
d. Illegal acts may be quired to
perpetrated by the only a. Resign from the audit
person in the client’s engagement within ten busi
organization with access to ness days.
both assets and the b. Deliver a report
accounting records. concerning the illegal acts
to the SEC within one
63. If specific information comes to an business day.
auditor’s attention that implies the c. Notify the stockholders
existence of possible illegal acts that that the financial state
could have a material, but indirect ments are materially
effect on the financial statements, misstated.
the auditor should next d. Withhold an audit opinion
a. Apply audit procedures until Supermart takes
specifically directed to as appropriate remedial
certaining whether an action.
illegal act has occurred.
66. Which of the following would be least likely to
b. Seek the advice of an
informed expert qualified to be considered an audit planning procedure?
practice law as to possible
contingent liabilities.
c. Report the matter to an
appropriate level of man
agement at least one level
above those involved.
d. Discuss the evidence with
the client’s audit com
mittee, or others with
equivalent authority and
responsibility.
64. An auditor who discovers that
client employees have committed
an illegal act that has a material
effect on the client’s financial
statements most likely would
withdraw from the engagement if
a. The illegal act is a
violation of generally
accepted accounting
principles.
b. The client does not take
the remedial action that
the auditor considers
predecessor had with the
a. Use an engagement letter. client concerning auditing
b. Develop the overall audit strategy. procedures and accounting
c. Perform risk assessment. principles.
d. Develop the audit plan. b. The predecessor’s evaluation of
matters of continuing accounting
67. Which of the following factors would significance.
most likely cause a CPA to decide not c. The degree of cooperation the
to accept a new audit engagement? predecessor received concerning the
a. The CPA’s lack of inquiry of the client’s lawyer.
understanding of the d. The predecessor’s
prospective client’s assessments of inherent risk
internal auditor’s and judgments about
computerassisted audit materiality.
techniques.
b. Management’s disregard of 70. Before accepting an audit
its responsibility to maintain engagement, a successor auditor
an adequate internal control should make specific inquiries of
environment. the predecessor auditor regarding
the predecessor’s
c. The CPA’s inability to
determine whether related a. Opinion of any subsequent
party transactions were events occurring since the
consummated on terms predecessor’s audit report
equivalent to arm’slength was issued.
transactions. b. Understanding as to the
d. Management’s refusal to reasons for the change of
permit the CPA to per auditors.
form substantive tests c. Awareness of the
before the yearend. consistency in the
application of GAAP
68. Before accepting an engagement to between periods.
audit a new client, a CPA is required d. Evaluation of all matters of
to obtain continuing accounting
a. An understanding of the significance.
prospective client’s indus
try and business. 71. An auditor is required to establish an
b. The prospective client’s understanding with a client regarding
signature to the engage the services to be performed for each
ment letter. engagement. This understanding
generally includes
c. A preliminary understanding of the
prospective client’s control a. Management’s
environment. responsibility for errors and
the illegal activities of
d. The prospective client’s
employees that may cause
consent to make inquiries
material misstatement.
of the predecessor auditor,
if any. b. The auditor’s
responsibility for ensuring
69. Before accepting an audit that the audit committee is
engagement, a successor auditor aware of any significant
should make specific inquiries of deficiencies in internal
the predecessor auditor regarding control that come to the
a. Disagreements the auditor’s attention.
they exist, will not be
detected.
c. Management’s d. After performing our
responsibility for preliminary analytical
providing the auditor with procedures we will discuss
an assessment of the risk with you the other proce
of material misstatement dures we consider necessary
due to fraud. to complete the en
d. The auditor’s responsibility for gagement.
determining preliminary judgments
about materiality and audit risk 75. Which of the following
factors. documentation is not required for an
audit in accordance with generally
72. Which of the following matters is accepted auditing standards?
generally included in an auditor’s a. A written audit plan
engagement letter? setting forth the
a. Management’s procedures necessary to
responsibility for the accomplish the audit’s
entity’s compliance with objectives.
laws and regulations. b. An indication that the
b. The factors to be considered accounting records agree or
in setting preliminary reconcile with the financial
judgments about statements.
materiality. c. A client engagement
c. Management’s vicarious letter that summarizes the
liability for illegal acts timing and details of the
committed by its auditor’s planned field
employees. work.
d. The auditor’s d. The assessment of the
responsibility to search for risks of material misstate
significant internal ment.
control deficiencies.
76. An engagement letter should
73. During the initial planning phase ordinarily include information on
of an audit, a CPA most likely the objectives of the engagement
would and
a. Identify specific internal
CPA Client Limitation of
control activities that are responsibilities responsibilities engagement
likely to prevent fraud. a. Yes Yes Yes
b. Evaluate the b. Yes No Yes
reasonableness of the c. Yes No No
client’s accounting d. No No No
estimates.
c. Discuss the timing of the
audit procedures with the
client’s management.
d. Inquire of the client’s
attorney as to whether any
unrecorded claims are
probable of assertion.
74. Which of the following statements
would least likely appear in an
auditor’s engagement letter?
a. Fees for our services are
based on our regular per
diem rates, plus travel and
other outofpocket ex
penses.
b. During the course of our
audit we may observe op
portunities for economy in,
or improved controls over,
your operations.
c. Our engagement is subject
to the risk that material
misstatements or fraud, if
factory equipment.
77. Arrangements concerning which of
81. A CPA wishes to determine how various
the following are least likely to be
publicly held companies have complied with
included in engagement letter? the disclosure requirements of a new financial
a. A predecessor auditor. accounting standard. Which of the following
b. Fees and billing. information sources would the CPA most likely
c. CPA investment in client securities. consult for information?
d. Other services to be provided in a. AICPA Codification of
addition to the audit. Statements on Auditing
Standards.
78. The auditor should document the
b. AICPA Accounting Trends and
understanding established with a
Techniques.
client through a(n)
a. Oral communication with the client. c. SEC Quality Control Review.
b. Written communication with the d. SEC Statement 10K Guide.
client. 82. An auditor should design the written audit
c. Written or oral communication with program so
the client. that
d. Completely detailed audit plan.
a. All material transactions
79. Which of the following factors most will be selected for sub
likely would influence an auditor’s stantive testing.
determination of the auditability of b. Substantive tests prior to
an entity’s financial statements? the balance sheet date
a. The complexity of the accounting will be minimized.
system. c. The audit procedures selected will
b. The existence of relatedparty achieve specific audit objectives.
transactions. d. Each account balance will
c. The adequacy of the accounting be tested under either
records. tests of controls or tests of
transactions.
d. The operating effectiveness of control
procedures. 83. The audit program usually cannot be
finalized until the
80. Which of the following is most likely
a. Consideration of the
to require special planning
entity’s internal control
considerations related to asset
has been completed.
valuation?
b. Engagement letter has
a. Inventory is comprised of diamond
been signed by the auditor
rings.
and the client.
b. The client has recently
c. Reportable conditions have
purchased an expensive
been communicated to the
copy machine.
audit committee of the
c. Assets costing less than board of directors.
$250 are expensed even
d. Search for unrecorded
when the expected life
liabilities has been per
exceeds one year.
formed and
d. Accelerated depreciation methods are documented.
used for amortizing the costs of
c. Read current issues
of specialized
84. Audit programs should be designed so that industry journals.
a. Most of the required d. Reevaluate the client’s
procedures can be internal control environ
performed as interim work. ment.
b. Inherent risk is assessed at a
89. On an audit engagement performed
sufficiently low level.
by a CPA firm with one office, at the
c. The auditor can make minimum, knowledge of the relevant
constructive suggestions to professional accounting and auditing
management.
standards should be held by
d. The audit evidence gathered
a. The auditor with final responsibility
supports the auditor’s
for the audit.
conclusions.
b. All professionals working upon the
85. In designing written audit programs, audit.
an auditor should establish specific c. All professionals working
audit objectives that relate primarily upon the audit and the
to the partner in charge of the
a. Timing of audit procedures. CPA firm.
b. Costbenefit of gathering evidence. d. All professionals working in the
c. Selected audit techniques. office.
d. Financial statement assertions. 90. An auditor obtains knowledge
86. With respect to planning an audit, about a new client’s business and
which of the following statements is its industry to
always true? a. Make constructive
a. It is acceptable to perform a suggestions concerning
portion of the audit of a improvements to the
continuing audit client at client’s internal control.
interim dates.
b. An engagement should
not be accepted after the
client’s yearend.
c. An inventory count must be observed
at yearend.
d. Final staffing decisions
must be made prior to
completion of the
planning stage.
87. The element of the audit planning process most
likely to be agreed upon with the client before
implementation of the audit strategy is the
determination of the
a. Evidence to be gathered to
provide a sufficient basis
for the auditor’s opinion.
b. Procedures to be
undertaken to discover
litigation, claims, and
assessments.
c. Pending legal matters to be
included in the inquiry of
the client’s attorney.
d. Timing of inventory
observation procedures to
be performed.
88. To obtain an understanding of a
continuing client’s business, an
auditor most likely would
a. Perform tests of details
of transactions and bal
ances.
b. Review prior year working
papers and the permanent
file for the client.
that Star’s prior year’s financial
c. Evaluate whether the statements, which were audited by
aggregation of known mis Tell, require substantial revisions.
statements causes the Under these circumstances, Land
financial statements taken as should
a whole to be materially a. Notify Star’s audit
misstated. committee and stockholders
d. Understand the events and that the prior year’s
transactions that may have an financial statements cannot
effect on the client’s be relied on.
financial statements. b. Request Star to reissue the
prior year’s financial
91. Which of the following procedures
statements with the
would an auditor least likely appropriate revisions.
perform while obtaining an c. Notify Tell about the information and
understanding of aclient in a
make inquiries about the integrity of
financial statement audit?
Star’s management.
a. Coordinating the assistance
d. Request Star to arrange a
of entity personnel in data
meeting among the three
preparation.
parties to resolve the matter.
b. Discussing matters that may
affect the audit with firm 94. A successor auditor should request
personnel responsible for the new client to authorize the
nonaudit services to the predecessor auditor to allow a
entity. review of the predecessor’s
c. Selecting a sample of Engagement letter Working papers
vendors’ invoices for com a. Yes Yes
parison to receiving b. Yes No
reports. c. No Yes
d. Reading the current year’s d. No No
interim financial state
ments. 95. Which of the following procedures would an
auditormost likely perform in planning a
92. Ordinarily, the predecessor auditor permits the financial statement audit?
successor auditor to review the predecessor’s
a. Inquiring of the client’s legal
working paper analyses relating to
counsel concerning pending
Contingencies Balance sheet accounts litigation.
a. Yes Yes b. Comparing the financial statements
b. Yes No to anticipated results.
c. No Yes c. Examining computer generated
d. No No exception reports to verify the
93. In auditing the financial statements of effectiveness of internal control.
Star Corp., Land discovered d. Searching for unauthorized
information leading Land to believe transactions that may aid in
detecting unrecorded liabilities.
b. Develop an attitude of professional skepticism con 96. Analytical procedures used in planning an
audit should
cerning management’s financial statement focus on
assertions. a. Reducing the scope of tests of controls
and substantive tests.
with the conclusions to be
presented in the auditor’s
b. Providing assurance that report.
potential material mis c. Audit procedures
statements will be performed are approved
identified. in the professional
c. Enhancing the auditor’s standards.
understanding of the cli d. Audit has been performed
ent’s business. by persons having ade
d. Assessing the adequacy of the quate technical training
available evidence. and proficiency as audi
tors.
46. The objective of performing
analytical procedures in planning 50. While assessing the risks of
an audit is to identify the existence material misstatement auditors
of identify risks, relate risk to what
a. Unusual transactions and events. could go wrong, consider the
b. Illegal acts that went magnitude of risks and
undetected because of a. Assess the risk of misstatements due
internal control to illegal acts.
weaknesses. b. Consider the complexity
c. Relatedparty transactions. of the transactions in
d. Recorded transactions that volved.
were not properly au c. Consider the likelihood
thorized. that the risks could result
in material misstatements.
47. Which of the following nonfinancial d. Determine materiality levels.
information would an auditor most
likely consider in performing 51. Which of the following are
analytical procedures during the considered further audit procedures
planning phase of an audit? that may be designed after assessing
a. Turnover of personnel in the risks of material misstatement?
the accounting depart Substantive Risk assessment
ment. tests of details procedures
b. Objectivity of audit committee a. Yes Yes
members. b. Yes No
c. Square footage of selling space. c. No Yes
d. Management’s plans to repurchase d. No No
stock.
48. The incharge auditor most likely
would have a supervisory
responsibility to explain to the staff
assistants
a. That immaterial fraud is
not to be reported to the
client’s audit committee.
b. How the results of various auditing
procedures performed by the
assistants should be evaluated.
c. What benefits may be
attained by the assistants’
adherence to established
time budgets.
d. Why certain documents are
being transferred from the
current file to the
permanent file.
49. The audit work performed by each
assistant should be reviewed to
determine whether it was adequately
performed and to evaluate whether
the
a. Auditor’s system of quality
control has been main
tained at a high level.
b. Results are consistent
The nature
103. Which of the following is least likely The CPA of the CPA Costbenefit
to be considered a risk assessment firm’s size firm’s practice considerations
procedure? a. Yes Yes Yes
b. Yes Yes No
a. Analytical procedures. c. Yes No Yes
b. Confirmation of ending accounts d. No Yes Yes
receivable.
c. Inspection of documents. 108. A CPA firm may communicate its quality
d. Observation of the controlpolicies and procedures to its personnel in
performance of certain which manner(s):
accounting procedures. Orally Written
104. In an audit of a nonissuer a. No No
(nonpublic) company, the auditors b. No Yes
identify significant risks. These c. Yes No
d. Yes Yes
risks often
a. Involve routine, highvolume 109. Which of the following is not an
transactions. element of qualitycontrol?
b. Do not require special audit attention. a. Acceptance and continuance of client
c. Involve items with lower levels of relationships and specific
inherent risk. engagements.
d. Involve judgmental matters. b. Human resources.
105. The auditor with final responsibility c. Internal control.
for an engagement and one of the d. Monitoring.
assistants have a difference of
opinion about the results of an
auditing procedure. If the assistant
believes it is necessary to be
disassociated from the matter’s
resolution, the CPA firm’s
procedures should enable the
assistant to
a. Refer the disagreement
to the AICPA’s Quality
Review Committee.
b. Document the details of the
disagreement with the
conclusion reached.
c. Discuss the disagreement with the
entity’s management or its audit
committee.
d. Report the disagreement
to an impartial peer re
view monitoring team.
106. An examination of a financial
forecast is a professional service
that involves
a. Compiling or assembling a financial
forecast that is based on
management’s assumptions.
b. Limiting the distribution of
the accountant’s report to
management and the board
of directors.
c. Assuming responsibility to
update management on key
events for one year after the
report’s date.
d. Evaluating the preparation
of a financial forecast and
the support underlying
management’s assump
tions.
107. The nature and extent of a CPA
firm’s quality control policies and
procedures depend on
110. Quality control for a

CPA firm, as referred to
in Statements on
Quality Control
Standards, applies to
a. Auditing services only.
b. Auditing and management advisory services.
c. Auditing and tax services.
d. Auditing and accounting and review services.
111. One of a CPA firm’s
basic objectives is to
provide professional
services that conform
with professional stan
dards. Reasonable
assurance of achieving
this basic objective is
provided through
a. A system of quality control.
b. A system of peer review.
c. Continuing professional education.
d. Complianc
e with
generally
accepted
reporting
standards.
is correct concerning
PCAOB guidance that
uses the term “should”?
a. The auditor must fulfill the responsibilities.
b. The auditor
must comply
with
requirements
unless s/he
demonstrates
that alternative
actions were
sufficient to
achieve the
objectives of
the standard.
c. The auditor
should
consider
performing
the
procedure;
whether the
auditor
performs
depends on
the exercise
of
professional
judgment in
the
circumstance
s.
d. The auditor
has complete
discretion as
to whether to
perform the
procedure.
sets of standards does the
Public Company
Accounting Oversight
Board not have the au
thority to establish for
audits of public
companies?
a. Auditing standards.
b. Quality control standards.
c. Accounting standards.
d. Independence standards.
SIMULATIONS
Audit Risk
Application
Authoritative
Literature Help
Green, CPA, is considering audit risk, including fraud risk, at the financial statement level in planning the audit of National
Federal Bank (NFB) Company’s financial statements for the year ended December 31, 2005. Audit risk at the financial state
ment level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to
management, the industry, and the entity. In assessing such factors Green has gathered the following information concerning
NFB’s environment.
Company profile
NFB is a federally insured bank that has been consistently more profitable than the industry average by marketing mort
gages on properties in a prosperous rural area, which has experienced considerable growth in recent years. NFB packages its
mortgages and sells them to large mortgage investment trusts. Despite recent volatility of interest rates, NFB has been able to
continue selling its mortgages as a source of new lendable funds.
NFB’s board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer.
Management at the bank’s branch offices has authority for directing and controlling NFB’s operations and is compensated based
on branch profitability. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the
board’s audit committee.
The accounting department has experienced little turnover in personnel during the five years Green has audited NFB.
NFB’s formula consistently underestimates the allowance for loan losses, but its controller has always been receptive to
Green’s suggestions to increase the allowance during each engagement.
Recent developments
During 2005, NFB opened a branch office in a suburban town thirty miles from its principal place of business. Although
this branch is not yet profitable due to competition from several wellestablished regional banks, management believes that the
branch will be profitable by 2007. Also, during 2005, NFB increased the efficiency of its accounting operations by installing a
new, sophisticated computer system.
Based only on the information above, indicate by marking the appropriate button whether the following factors indicate an
increased or decreased audit risk. Also, indicate whether the factor is a fraud risk factor.
Factor Increased audit risk Decreased audit risk Fraud risk factor
1. Branch management authority
2. Government regulation
3. Company profitability
4. Demand for product
5. Interest rates
6. Availability of mortgage funds
7. Involvement of principal shareholder in
Management
8. Branch manager compensation
9. Internal audit reporting relationship
10. Accounting department turnover
11. Continuing audit relationship
12. Internal controls over accounting estimates
13. Response to proposed accounting
Adjustments
14. New unprofitable branch
15. New computer system
Risk of Material Authoritative
Misstatement Literature Help
Green, CPA, is considering audit risk, including fraud risk, at the financial statement level in planning the audit of National
Federal Bank (NFB) Company’s financial statements for the year ended December 31, 2005. Audit risk at the financial state
ment level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related to
management, the industry, and the entity. In assessing such factors Green has gathered the following information concerning
NFB’s environment.
Company profile
NFB is a federally insured bank that has been consistently more profitable than the industry average by marketing mort
gages on properties in a prosperous rural area, which has experienced considerable growth in recent years. NFB packages its
mortgages and sells them to large mortgage investment trusts. Despite recent volatility of interest rates, NFB has been able to
continue selling its mortgages as a source of new lendable funds.
NFB’s board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer.
Management at the bank’s branch offices has authority for directing and controlling NFB’s operations and is compensated based
on branch profitability. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the
board’s audit committee.
The accounting department has experienced little turnover in personnel during the five years Green has audited NFB.
NFB’s formula consistently underestimates the allowance for loan losses, but its controller has always been receptive to
Green’s suggestions to increase the allowance during each engagement.
Recent developments
During 2005, NFB opened a branch office in a suburban town thirty miles from its principal place of business. Although
this branch is not yet profitable due to competition from several wellestablished regional banks, management believes that the
branch will be profitable by 2007. Also, during 2005, NFB increased the efficiency of its accounting operations by installing a
new, sophisticated computer system.
Assume you are preparing for the audit personnel discussion of potential risks of material misstatement due to fraud for
the NFB audit. While any matters below might be discussed, indicate by marking the appropriate four highest risks based on
the information contained in the simulation description and requirements of professional standards.
Risk Highrisk item
1. Computer fraud risk
2. Risk related to management override of internal control
3. Fraud by branch management
4. Fraud by accounting personnel
5. Misstatement of accounting estimates
6. Fraud by loan processing clerks
7. Fraud by internal auditors
8. The risk of fraudulent misstatement of revenues
Research
Topics
Authoritative
Literature Help
Assume that you have been hired to perform the audit of Hanmei’s financial statements. When planning such an audit, you
often may need to refer to various of the profession’s auditing standards. For each of the following circumstances in Column A,
select the topic from the Professional Standards that is likely to provide the most guidance in the planning of the audit. A topic
may be selected once, more than once, or not at all.
Topic
A. Analytical Procedures F. Illegal Acts by Clients
B. Audit Risk and Materiality G. Management Representations
C. Communications between Predecessor and Successor H. Part of the Audit Performed by Other Independent
Auditors Auditors
D. Consideration of Fraud in a Financial Statement Audit I. Related Parties
E. Understanding the Entity and Its Environment and
Assessing the Risks of Material Misstatement
T
r
1. P
2. T
h
3. H
4. C
o
5. A
u
6. R
e
7. A
u
8. T
h
9. D
10. T
h
Risk Authoritative
Analysis Literature Help
DietWeb Inc. (hereafter DietWeb) was incorporated and began business in March of 20X1,
seven years ago. You are working on the 20X8 audit—your CPA firm’s fifth audit of DietWeb.
The company’s mission is to provide solutions that help individuals to realize their full potential
through better eating habits and lifestyles. Much of 20X1 and 20X2 was spent in developing a unique
software platform that facilitates the production of individualized meal plans and shopping lists using
a specific mathematical algorithm, which considers the user’s physical condition, proclivity to
exercise, food preferences, cooking preferences, desire to use prepackaged meals or dine out, among
others. DietWeb sold its first online diet program in 20X2 and has continued to market memberships
through increasing online advertising arrangements through the years. The company has continued to
develop this program throughout the years and finally became profitable in 20X6.
DietWeb is executing a strategy to be a leading online provider of services, information and
products related to nutrition, fitness and motivation. In 20X8, the company derived approximately 86%
of its total revenues from the sale of approximately 203,000 personalized subscriptionbased online
nutrition plans related to weight management, to dietary regimens such as vegetarianism and to
specific medical conditions such as Type 2 diabetes. Given the personal nature of dieting, DietWeb
assures customers of complete privacy of the information they provide. To this point DietWeb’s
management is proud of its success in assuring the privacy of information supplied by its customers—
this is a constant battle given the variety of intrusion attempts by various Internet hackers.
DietWeb nutrition plans are paid in advance by customers and offered in increments of thirteen
weeks with the customers having the ability to cancel and receive a refund of the unused portion of the
subscription—this results in a significant level of “deferred revenue” each period. Although some
DietWeb members are billed through use of the postal system, most DietWeb members currently purchase
programs and products using credit cards, with renewals billed automatically, until cancellation.
One week of a basic DietWeb membership costs less than onehalf the cost of a weekly visit to the
leading classroombased diet program. The president, Mr. William Readings, suggests that in addition
to its superior costeffectiveness, the DietWeb online diet program is successful relative to classroom
based programs due to its customization, ease of use, expert support, privacy, constant availability, and
breadth of choice. The basic DietWeb membership includes
• Customized meal plans and workout schedules and related tools such as shopping lists,
journals, and weight and exercise tracking.
• Interactive online support and education including approximately 100 message boards on
various topics of interest to members and a library of dozens of multimedia educational
segments presented by experts including psychologists, mental health counselors,
dietitians, fitness trainers, a spiritual advisor and a physician.
• 24/7/365 telephone support from a staff of approximately 30 customer service
representatives, nutritionists and fitness personnel.
Throughout its nineyear history, Mr. William Readings has served as chief executive officer. The
other three founders of the company are also officers. A fifth individual, Willingsley Williamson, also
a founder, served as Chief Financial Officer until mid20X8 when he left the company due to a
difference of opinion with Mr. Readings. The four founders purchased Mr.
Williamson’s stock and invested an additional approximately $1.2 million in common stock during
20X8 so as to limit the use of longterm debt.
The company’s board of directors is currently composed of the four individuals who remain
active in the company; these four individuals also serve as the company’s audit committee; Mr.
Readings chairs both the board and the audit committee. Previously, Mr. Readings had also served
on the board and the audit committee. With Mr. Williamson’s departure, Ms. Jane Jennings,
another of the founders, became the company’s CFO.
The nutrition and diet industry in many ways thrives because individuals are becoming more
aware of the negative health and financial consequences of being overweight, and consider important
both weight loss and healthy weight maintenance. A study by two respected researchers concluded
that obesity was linked to higher rates of chronic illness than living in poverty, than smoking, or than
drinking. In addition, the American Cancer Society reported that as many as 14% of cancer deaths in
men and 20% of cancer deaths in women could be related to being overweight.
The financial costs of excess weight are also high. A 20X8 study based on data from a major
automobile manufacturer’s healthcare plan showed that an overweight adult has annual healthcare
costs that are 7.3% higher than a person in a healthy weight range, while obese individuals have
annual healthcare costs that are 69% higher than a person of a healthy weight. With healthcare cost
inflation running in the double digits in the United States since 20X4, supporters of the industry
believe that the implementation of effective weight management tools will attract more attention from
insurers, employers, consumers, and the government. As of January 20X9 five nutrition or fitness
related bills were being considered in Congress, and several states had enacted or were considering
enacting legislation relating to the sale of “junk” food in public schools. In addition, the US Food and
Drug Administration, Department of Health and Human Services, and Federal Trade Commission are
contemplating new labeling requirements for packaged food and restaurant food, new educational and
motivational programs related to healthy eating and exercise, and increased regulation of advertising
claims for food.
In response to consumers’ growing demand for more healthful eating options, quickservice
and fullservice restaurants have introduced new offerings including salads, sandwiches, burgers,
and other food items designed for the weightconscious person. At the retail level, sales of natural
and organic foods have been growing more rapidly than the overall food and overthecounter drug
market for the last several years. Nutritional supplement sales in the US, for instance, are estimated
to have grown 34% between 20X4 and 20X8, while natural and organic foods are estimated to be
growing at a rate of approximately 15% annually. Also, the industry has a tendency to change
quickly as “dieting fads” regularly are introduced; some remain popular for years, some for only
months.
Approximately 60% of the US adult population, or 120 million adults, are overweight and, of
those, the Calorie Control Council estimates only about 50 million are dieting in a given year.
About 15% of these dieters are using a commercial weight loss center, generating revenues of
approximately $1.5 billion annually. DietWeb targets dieters who are online, which represents
about twothirds of the total universe at current Internet penetration rates, or 34 million adults, about
5 million of whom are spending approximately $1 billion at weight loss centers.
At the same time, the online dieting segment of the market is growing rapidly. The online diet
industry in the US generated in excess of $100 million in 20X8, compared to revenues of
approximately $75 million in 20X2. The industry includes other online nutrition and dietoriented
Web sites.
Another group of competitors to DietWeb are commercial weight loss centers, an industry that
has shown marked decline in the last decade. According to Market Analysis Enterprises, the number
of commercial weight loss centers in the US declined approximately 50% between 20X2 and 20X8,
from over 8,600 to approximately 4,400. DietWeb competes against this segment on the basis of
lower price, superior value, convenience, availability, the ability to personalize a meal plan on an
ongoing basis, its extensive support capabilities, and the breadth of its meal plan options.
1. O
f
A. M
B. a
M
C. Ia
D. In
n
2. W
A. I
B. In
C. n
E
D. nM
i
(A) (B) (C)
(D)
3. Which of the following is most accurate concerning DietWeb’s
audit committee?
A. It should be considered very independent in that the company’s founders serve on it.
B. Mr. Readings’ chairmanship of the audit committee creates a situation in which the audit
committee serves a strong independent role due to his closeness to company operations.
C. Because all committee members are members of management, the audit committee lacks
independence.
D. The audit committee does not have enough members in that the size of the board of directors
should be less than that of the audit committee.
(A) (
B
)
(
C
)
(
D
)
4. Which of the following indicates an increased risk of
misstatement due to fraud?
A. Resignation of Mr. Williamson.
B. Domination of management by company founders.
C. Issuance of debt during 20X8.
D. Competition with nonInternet weight loss organizations.
(A) (B) (C)
(D)
5. Which of the following is the most significant risk facing DietWeb that might cause it to not be
able to continue increasing sales?
A. A decreasing market in the United States for dietary products.
B. DietWeb must respond to “dieting fads” on a timely basis.
C. The constantly decreasing number of individuals in the United States.
D. Obsolescence of the Internet.
Financial Statement
Analysis
Authoritative
Literature Help
DietWeb Inc. (hereafter DietWeb) was incorporated and began business in March of 20X1, seven
years ago. You are working on the 20X8 audit—your CPA firm’s fifth audit of DietWeb. Analyze the
following financial statements and reply to each of the questions that follow.
DietWeb, Inc.
BALANCE SHEET
December 31, 20X8 and 20X7
(in thousands)
20X8 20X7
Assets
Current assets
Cash and cash equivalents $3,032 $1,072
Trade receivables 485 450
Prepaid advertising expenses 59 609
Prepaid expenses and other current assets 175 230
Total current assets 3,751 2,361
Fixed assets, net 3,321 3,926
Total assets $7,072 $6,287
Liabilities and shareholders’ equity
Current liabilities
Accounts payable $1,070 $ 909
Current maturities of notes payable 42 316
Deferred revenue 1,973 1,396
Other current liabilities 171 12
Total current liabilities 3,256 2,633
Longterm debt, less current maturity 34 176
Accrued liabilities 792 690
Deferred tax liability 15 145
Total liabilities 4,097 3,644
Shareholders’ equity
Common stock 6,040 4,854
Retained earnings (3,065) (2,211)
Total shareholders’ equity 2,975 2,643
Total liabilities plus shareholders’ equity $7,072 $6,287
DietWeb, Inc.
INCOME STATEMENT
Two Years Ended December 31, 20X8 and 20X7
(in thousands)
20X8 20X7
Revenue $19,166 $14,814
Costs and expenses
Cost of revenue 2,326 1,528
Product development 725 653
Sales and marketing 13,903 8,710
General and administrative 2,531 2,575
Depreciation and amortization 629 661
Impairment of intangible assets 35
Total costs and expenses 20,149 14,127
Net income before taxes (983) 687
Income tax benefit 129 125
Net income (loss) $(854) $812
DietWeb, Inc.
STATEMENT OF CASH FLOWS
Year Ended December 31, 20X8
20X8 20X7
Cash flows from operations
Net income (loss) $(854) 812
Adjustments to net income
Depreciation 629 660
Increase in receivables (35) (47)
Decrease (Increase) in prepaid advertising 550 (650)
Decrease in other current assets 55 74
Increase (Decrease) in accounts payable 161 (540)
Increase in accrued liabilities 102 43
Increase (Decrease) in deferred revenue 432 (665)
Increase in common stock issued 1,186
Increase in other current liabilities 159 43
Net cash provided (used) by operations 2,385 (270)
Cash flows from investing activities
Purchase of property and equipment (320) 2,016
Cash flows from financing activities
New debt 613 40
Debt payments (718) (918)
Net cash provided (used) by financing activities (105) (878)
Net increase in cash and cash equivalents $1,960 868
Cash and equivalents at beginning of year $1,072 204
Cash and equivalents at end of year $3,032 1,072
Required
(A) (B) (C) (D)
1. The most likely misstatement in the financial statements is
A. The increase in cash in 20X8.
B. Treatment of impaired intangible assets as an expense in 20X8.
C. Treatment of common stock issued as an adjustment to net income (loss) under cash flow
from operations.
D. An income tax benefit on the income statement as contrasted to income tax expense.
(A) (B
)
(C
)
(D
)
2. Which of the following is the most unexpected change on the balance sheet, if one assumes the
revenue increase in 20X8 is correct?
A. Decrease in prepaid advertising expenses.
B. Increase in accounts payable.
C. Decrease in deferred revenues.
D. Increase in common stock.
4
0
C. I
D. nM
r
4. W
A. C
B. l
C
C. lA
D. R

e
5. W
A. T
B. h
T
C. hA
D. n
A
n
(
Risk of Material
Misstatement Analysis Authoritative
Literature Help
You are working with William Bond, CPA, and you are considering the risk of material
misstatement in planning the audit of Toxic Waste Disposal (TWD) Company’s financial statements
for the year ended December 31, 20X0. TWD is a privately owned entity that contracts with municipal
governments to remove environmental waste. Based only on the information below, indicate whether
each of the following factors would most likely increase (I), decrease (D), or have no effect on the risk
of material misstatement (N).
3. The
internal
1. Because municipalities have received increased federal and state funding auditor
for environmental purposes, TWD returned to profitability for the first reports
year following three years with losses. to the
2. TWD’s Board of Directors is controlled by Mead, the majority stockholder, controll
who also acts as the chief executive officer. er and
the
controller reports to Mead.
4. The accounting department has experienced a high rate of turnover of key
personnel.
5. TWD’s bank has a loan officer who meets regularly with TWD’s CEO and
controller to monitor TWD’s financial performance.
6. TWD’s employees are paid biweekly.
7. TWD has such a strong financial presence in its history so as to allow
it often to dictate the terms or conditions of transactions with its
suppliers.
8. During 20X1, TWD changed its method of preparing its financial statements
from the cash basis to generally accepted accounting principles.
9. During 20X1, TWD sold onehalf of its controlling interest in United
Equipment Leasing (UEL) Co. TWD retained significant influence over UEL.
10. During 20X1, litigation filed against TWD from an action ten years ago that
alleged that TWD discharged pollutants into state waterways was dropped by
the state. Loss contingency disclo
sures that TWD included in prior years’ financial statements are being
removed from the 20X1 financial statements.
11. During December 20X1, TWD signed a contract to lease disposal
equipment from an entity owned by Mead’s parents. This relatedparty
transaction is not disclosed in TWD’s notes to the 20X1 financial
statements.
(I) (D) (N)
(I) (D) (N)

12. During December 20X1, TWD completed a barter transaction with a
municipality. TWD removed waste from the municipally owned site
and acquired title to another contaminated site at below market price.
TWD intends to service this new site in 20X2.
13. During December 20X1, TWD increased its casualty insurance coverage on several pieces of
sophisticated machinery from historical cost to replacement cost.
14. Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 20X1
disclosed a new policy. TWD guaranteed to several municipalities that it would refund the
federal and state funding paid to TWD if any municipality fails a federal or state site cleanup
inspection in 20X2.
15. An initial public offering of TWD’s stock is planned for late 20X2.
Identifying
Risks
Authoritative
Literature Help
Planning
You are beginning the 20X8 audit of Toastco, a nonpublic company that manufactures various
kitchen products. This is your firm’s sixth annual audit of Toastco.
Toastco’s most profitable product is a deluxe toaster that is designed for those who want “a truly
outstanding toaster.” The toaster was first marketed through Sky Mall Magazine, which offers
specialtytype products to airplane passengers. Demand has grown so that at this point the company
advertises the product much more broadly through a variety of media. Sales have been outstanding
from the start and continue to increase. The recorded level of sales for 20X8 indicates that the
company now controls approximately 5% of the toaster market, which represents 55% of company
sales. In addition to the toaster, the company manufactures other products, including toaster ovens,
coffee makers, food blenders, and electric can openers. Most of the manufacturing process is
performed in several plants in Asia.
The highly successful toaster is the product of Bill Williams, who became Toastco’s chief
executive officer in 20X3. Bill and several other officers invested heavily in the company at that time
with the intent of ultimately selling common stock to the public. His and those individuals’ lives are
centered about the firm and making it a success. Consistently, Toastco is of critical importance to
each of these individuals financially.
Recently you discussed the coming audit with Bill. You quickly found that he was elated that the
company had earned $1.21 per share, one cent more than he had assured the bank that had provided
Toastco with extensive financing during 20X8. He suggested that some had feared that Toastco
wouldn’t make it after somewhat weak second and third quarters, but that he knew all along that a
strong fourth quarter was ahead and that it would “bring us through.” He also pointed out that sales are
up about 38% compared to the previous year and income by 54%. Furthermore, he indicated that an
initial public offering of securities was planned for approximately eighteen months from now.
Toastco’s outstanding performance for the past several years is in large part due to the highly
profitable toaster, with other products gaining sales at approximately the industry’s growth rate. In
fact, Bill indicated that the toaster has become even more profitable this year due to reengineering of
its production process and components, which brought costs of production down and decreased sales
returns and allowances.
Bill also suggested to you that the $42,216,000 bank loan received during the year has been
primarily used to increase inventories and fixed assets to support the rapidly rising demand for the
toaster, as well as Toastco’s other products. He pointed out that the company could never have
achieved its projected earnings per share goal without the bank’s support. This bank support has also
allowed Toastco to work on developing what Bill refers to as “our next super product… an
improved can opener that works well with all sizes of cans and doesn’t leave a mess.”
Finally, Bill said that there was some sad news. The Chairman of the Board of Directors, John
Whing, an independent director, had been forced to step down for health reasons. Bill had replaced
Mr. Whing as Chairman of the Board, and Toastco Vice President Sam Adamson filled the empty seat
on the board of directors. The sevenmember board is now composed of Bill (who will begin serving
as Chairman), Sam Adamson, two others from management, and the three independent directors. The
audit committee has not been affected by the change, as the three independent directors continue to
serve in that role.
Industry Information
In the portions of the kitchen product industry in which Toastco operates, demand is influenced
by economic trends such as increases or decreases in consumer disposable income, availability of
credit, and housing construction. Competition is very active in all products and comes from a number
of principal manufacturers and suppliers. An important factor is the degree of product differentiation
achieved through innovation and new product features. Other significant factors include product
quality and cost, brand recognition, customer responsiveness, and appliance service capability.
Overall, for the industry, sales have been and are expected to remain relatively stable with a slight
increase—increases have approximated 3% industrywide per year during the past five years, and are
expected to continue at that rate of increase for the
next five years. Much of the manufacturing of these products takes place in Asia, and to a lesser extent in South America. In
creasingly, Asian companies are becoming directly involved in marketing their own household products.
Required
(A) (B) (C) (D)
1. Which of the following identifies an aspect of the company’s business model, strategies, and/or
business environment that is most likely to increase Toastco’s inherent risk?
A. Manufacturing in Asia.
B. An expected industry growth rate in sales of approximately 3%.
C. Product obsolescence or loss of product differentiation advantages.
D. Overstated accounts receivable due to internal control deficiencies.
(A) (B) (C) (D)
2. Which of the following identifies a situation most likely to increase the risk of misstatement arising
from fraudulent financial reporting?
A. The household products industry seems stable, and is not rapidly growing.
B. Toastco reported a strong fourth quarter that brought it up to expectations for earnings per share.
C. Toastco controls approximately 5% of the market for toasters.
D. Toastco has one relatively profitable product, and a number of products that are not as profitable.
(A) (B) (C) (D)
3. Which of the following identifies an aspect of the company’s business model, strategies, and/or
business environment that is most likely to increase the risk of misstatement arising from fraudulent
financial reporting?
A. Toastco sells more than one type of product.
B. The president’s wealth is based on the success of Toastco.
C. The audit committee is composed entirely of independent directors.
D. Toastco continues to hire your firm for its fifth year.
Ratio Analysis
Below are two sets of ratios that were identified as significant in the current and prior years’ audits of Toastco. For each
pair, compare the values of each ratio. Then select an audit finding that is consistent with these metrics. Each of the audit
findings may be used once, more than once, or not at all. Ratios using balance sheet numbers are based on end of year
balances.
Ratio 20X8 20X7
Gross margin percentage 0.154 0.166
Current ratio 2.619 3.688
Substantive procedure
A. Increases in costs of purchases were not completely passed on to customers through higher selling prices.
B. Increases in trade receivables.
C. Owners’ equity increased due to retention of profits.
D. A larger percentage of sales occurred during the last month of 20X8, as compared to 20X7.
E. Interest expense decreased during 20X8.
F. The percentage tax included in the provision for income taxes for 20X8 was less than the percentage in 20X7.
G. A significant amount of longterm debt became current.
(A) (B) (C) (D) (E) (F) (G)
1. An audit finding most consistent with the change in the gross margin percentage
2. An audit finding most consistent with the change in the current ratio
Ratio 20X8 20X7

Inventory turnover 10.52 7.95
Return on equity 0.40 0.67
Audit findings
H. Increases in costs of purchases were not completely passed on to customers through higher selling prices.
I. Increases in trade receivables.
J. Owners’ equity increased due to retention of profits.
K. A larger percentage of sales occurred during the last month of 20X8, as compared to 20X7.
L. Interest expense decreased during 20X8.
M. The percentage tax included in the provision for income taxes for 20X8 was less than the percentage in 20X7.
(H) (I) (J) (K) (L) (M)

3. An audit finding consistent with the change in inventory turnover for Toastco
4. An audit finding consistent with the change in the return on equity
Observed Ratio
Changes Authoritative
Literature Help
Items 1 through 6 represent an auditor’s observed changes in certain financial statement ratios or amounts from the
prioryear’s ratios or amounts. For each observed change, select the most likely explanation or explanations from List B.
Select only the number of explanations as indicated. Answers on the list may be selected once, more than once, or not at all.
List B
A. Items shipped on consignment during the last month of the year were recorded as sales.
B. A significant number of credit memos for returned merchandise that were issued during the last month of the year
were not recorded.
C. Yearend purchases of inventory were overstated by incorrectly including items received in the first month of
the subsequent year.
D. Yearend purchases of inventory were understated by incorrectly excluding items received before the yearend.
E. A larger percentage of sales occurred during the last month of the year, as compared to the prior year.
F. A smaller percentage of sales occurred during the last month of the year, as compared to the prior year.
G. The same percentage of sales occurred during the last month of the year, as compared to the prior year.
H. Sales increased at the same percentage as cost of goods sold, as compared to the prior year.
I. Sales increased at a greater percentage than cost of goods sold increased, as compared to the prior year.
J. Sales increased at a lower percentage than cost of goods sold increased, as compared to the prior year.
K. Interest expense decreased, as compared to the prior year.
L. The effective income tax rate increased, as compared to the prior year.
M. The effective income tax rate decreased, as compared to the prior year.
N. Shortterm borrowing was refinanced on a longterm basis at the same interest rate.
O. Shortterm borrowing was refinanced on a longterm basis at lower interest rates.
P. Shortterm borrowing was refinanced on a longterm basis at higher interest rates.
Auditor’s observed changes (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) (O) (P)
1. Inventory turnover increased substantially from
the prior year. (Select 3 explanations)
2. Accounts receivable turnover decreased substan
tially from the prior year. (Select 3 explanations)
3. Allowance for doubtful accounts increased from
the prior year, but allowance for doubtful accounts
as a percentage of accounts receivable decreased
from the prior year. (Select 3 explanations)
4. Longterm debt increased from the prior year, but
interest expense increased a largerthan
proportionate amount than longterm debt. (Select
one explanation)
5. Operating income increased from the prior year
although the entity was less profitable than in the
prior year. (Select two explanations)
6. Gross margin percentage was unchanged from the
prior year although gross margin increased from
the prior year. (Select one explanation)
Assertions and Authoritative
Audit Procedures Literature Help
You are a staff auditor with Williams and Co. CPAs. Bill Jones, a new hire, has come to you with
questions concerning “assertions” and “audit procedures.” For 1. through 6. match each assertion with
the statement that most closely approximates its meaning. Each statement may be used only once.
Statement
A. There is such an asset
B. The company legally owns the assets
C. All assets have been recorded
D. Transactions are recorded in the correct accounting period
E. Assets are recorded at proper amounts
F. Assets are properly classified
Assertion (A) (B) (C) (D) (E) (F)
1. Completeness
2. Cutoff
3. Existence and occurrence
4. Presentation and disclosure
5. Rights and obligations
6. Valuation
Auditors perform audit procedures to obtain audit evidence that will allow them to draw
reasonable conclusions as to whether the client’s financial statements follow generally accepted
accounting principles. Match each audit procedure with its type. Each type of audit procedure is used,
one of them twice.
Type of audit procedure
A. Analytical procedures
B. Tests of controls
C. Risk assessment procedures (other than analytical procedures)
D. Test of details of account balances, transactions, or disclosures
Audit procedures (A) (B) (C) (D)
1. Prepare a flowchart of internal control over sales.
2. Calculate the ratio of bad debt expense to credit sales.
3. Determine whether disbursements are properly approved.
4. Confirm accounts receivable.
5. Compare current financial information with comparable prior periods.
Audit Risk and
Its Components Authoritative
Literature Help
You recently graduated from college and joined a CPA firm as a junior assistant. You have been
assigned to audit Wiglo, Inc. At lunch one of Wiglo’s accountants said to you that he is having some
trouble with basic audit concepts, and this bothers him since he thinks he may want to take the CPA
exam at some point in the future. He has the following questions for you to which you should reply
with a “yes” if it is correct, and a “no” if it is incorrect.
Yes
No
1. Am I right that the risk of material misstatement is composed of the three components of
audit risk?
2. Is inherent risk the possibility of material misstatement before considering the client’s
internal control?
3. In our company I think our control risk is lower this year than it was last year; does that mean that
there is an increase in the risk of material misstatement?
M
4. I
5. A
6. A
m
7. D
o
8. D
T
Research:
Supervision
Authoritative
Literature Help
You graduated from college recently and joined a CPA firm as an assistant. You have been
assigned to the audit of PJ Wholesale, Inc. The CEO of the nonpublic company cannot understand why
a supervisor from your firm needs to review your audit work, given that you have a formal accounting
education and took auditing courses in college.
Title choices
A. AU
B.
PCAOB
C. AT
D. AR
E. ET
F. BL (A) (B) (C) (D) (E) (F) (G)
G. CS (H)
H. QC
1. Which title of the Professional Standards addresses this issue and
will be helpful in responding to the CEO?
2. Enter the exact section and paragraph with helpful information.
Research: Tone
at the Top
Authoritative
Literature Help
Bill Jensen, CPA, has just become partner of Wigg & Co. CPAs. He is concerned that the “tone at
the top” of the firm could use some improvement in the messages it sends to employees concerning the
firm’s culture. He has asked you to find any professional standards that address the need for a CPA
firm to have a proper tone at the top.
Title choices
A. AU
B.
PCAOB
C. AT
D. AR
E. ET
F. BL (A) (B) (C) (D) (E) (F) (G)
G. CS (H)
H. QC
will be helpful in responding to the partner?
Effects on Audit Risk Components Authoritative
Literature Help
Bestwood Furniture, Inc., a private company that produces wood furniture, is undergoing a year 2
audit. The situations in the table below describe changes Bestwood made during year 2 that may or
may not contribute to audit risk. For each situation, select from the list provided the impact, if any, that
the situation has on a specific component of audit risk for the year 2 audit. A selection may be used
once, more than once, or not at all.
I
m
A
.B
.C
.D
.E
.F
.G
.
S
i
1. D
u
2. I
n
3. E
a
Research
Authoritative
Literature Help
Quality Control Standards
Assume that you are employed by Wilson & Wilson CPAs. One of the partners has asked you to
research the professional standards for the reference that identifies the requirements for documentation
of a firm’s quality control policies and procedures.
Title choices
A. AU
B.
PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS (A) (B) (C) (D) (E) (F) (G)
H. QC (H)
will be helpful in responding to the partner?
1. a __ __ 21. b __ __ 41. c __ __ 61. c __ __ 81. b __ __ 101. c __ __

2. d __ __ 22. b __ __ 42. d __ __ 62. b __ __ 82. c __ __ 102. b __ __
3. c __ __ 23. c __ __ 43. a __ __ 63. a __ __ 83. a __ __ 103. b __ __
4. d __ __ 24. a __ __ 44. a __ __ 64. b __ __ 84. d __ __ 104. d __ __
5. a __ __ 25. b __ __ 45. a __ __ 65. b __ __ 85. d __ __ 105. b __ __
6. a __ __ 26. a __ __ 46. a __ __ 66. c __ __ 86. a __ __ 106. d __ __
7. d __ __ 27. b __ __ 47. b __ __ 67. b __ __ 87. d __ __ 107. a __ __
8. b __ __ 28. a __ __ 48. d __ __ 68. d __ __ 88. b __ __ 108. d __ __
9. b __ __ 29. d __ __ 49. b __ __ 69. a __ __ 89. a __ __ 109. c __ __
10. a __ __ 30. b __ __ 50. a __ __ 70. b __ __ 90. d __ __ 110. d __ __
11. c __ __ 31. d __ __ 51. a __ __ 71. b __ __ 91. c __ __ 111. a __ __
12. c __ __ 32. c __ __ 52. a __ __ 72. a __ __ 92. a __ __ 112. b __ __
13. b __ __ 33. a __ __ 53. c __ __ 73. c __ __ 93. d __ __ 113. c __ __
14. b __ __ 34. a __ __ 54. b __ __ 74. d __ __ 94. c __ __
15. b __ __ 35. c __ __ 55. d __ __ 75. c __ __ 95. b __ __
16. b __ __ 36. d __ __ 56. d __ __ 76. a __ __ 96. c __ __
17. d __ __ 37. d __ __ 57. d __ __ 77. c __ __ 97. a __ __
18. a __ __ 38. b __ __ 58. c __ __ 78. b __ __ 98. c __ __
19. c __ __ 39. d __ __ 59. b __ __ 79. c __ __ 99. b __ __ 1st: __/113 = __%
20. b __ __ 40. c __ __ 60. a __ __ 80. a __ __ 100. b __ __ 2nd: __/113 = __%
compared to work performed by
A. Overview practitioners of other professions.
1. (a) The requirement is to identify a Answer (c) is correct because
conceptual difference between the independence is absolutely required
attestation standards and generally for the performance of audits; other
accepted auditing standards. Answer professions do not in general require
(a) is correct because AT 101 states such independence. Answers (a), (b),
that the attestation standards do not and (d) are incorrect because the
apply to audits of historical financial various professions require due
statements. Answer (b) is incorrect professional care and competence
because an independent mental and have a complex body of
attitude is required for attestation knowledge.
engagements. Answer (c) is incorrect 4. (d) The requirement is to determine what is
because an attest engagement may be meant by the third general standard’s
related to a business acquisition requirement of due care in the performance of
study or a feasibility study. Answer an audit. Answer (d) is correct because due care
(d) is incorrect because while there is requires critical review at every level of
no internal control fieldwork standard supervision of the work done and the judgment
under the attestation standards, both a exercised by those assisting
planning and an evidence standard of
fieldwork are included.
2. (d) The requirement is to identify the
reply which is not an attestation
standard. Answer (d) is correct
becausethe attestation standards do
not include a requirement that a
sufficient understanding of internal
control be obtained to plan the
engagement. There is no internal
control standard because the concept
of internal control may not be
relevant to certain assertions on
which a CPA may be engaged to
report (e.g., aspects of information
about computer software). Answers
(a), (b), and (c) are all incorrect
because standards exist for evidence,
reporting on the assertion or subject
matter, and proper planning.
3. (c) The requirement is to identify the
characteristic that is most likely to be
unique to the audit work of CPAs as
in the audit. Answer (a) is incorrect because the many matters the review may address in an
due care standard does not directly address effort to address fairness of presentation of the
safeguards over access to assets and records. financial statements.
Answer (b) is incorrect because due care does
not relate to a limited review of employee fraud A.1. Financial Statement Assertions
and illegal acts. Answer (c) is incorrect because
6. (a) The requirement is to identify the categories
the first general standard addresses technical
training and proficiency as an auditor. of financial statement assertions. Answer (a) is
correct because the professional standards
5. (a) The requirement is to identify the focus establish financial statement assertions for
of afinal wrapup review performed by a second account balances, classes of transactions and
partner who has not been involved in the audit. disclosures. Answer (b) is incorrect because
Answer (a) is correct because this second or financial statement assertions are established
“cold” review aims at determining whether the for disclosures. Answer (c) is incorrect
financial statements result in fair presentation in because financial statement assertions are
conformity with GAAP and with whether established for classes of transactions. Answer
sufficient appropriate evidence has been (d) is incorrect because financial statement
obtained. Answer (b) is incorrect because most assertions are established for both classes of
frequently fraud involving the client’s man transactions and disclosures.
agement and its employees have not been
discovered and, even if they have been, the
focus of the review is still on the fairness of item that is not a financial statement
presentation of the financial statements. An assertion relating to account balances.
swers (c) and (d) are incorrect because Answer (d) is correct because
decisions on materiality and communications valuation and allocation is an account
with the audit committee are only two of the balance assertion, not valuation and
com
misstatement, assuming that there are no
related controls.
petence. Answer (a) is incorrect because
completeness is anassertion relating to account 10. (a) The requirement is to identify an effect
balances. Answer (b) is incorrect because of a decrease in the acceptable level of
existence is an assertion relating to account detection risk. Answer (a) is correct because as
balances. Answer (c) is incorrect because rights the acceptable level of detection risk decreases,
and obligations is an assertion relating to the assurance provided from substantive tests
account balances. should increase. To gain this increased
assurance the auditors may (1) change the
A.2. Audit Risk nature of substantive tests to more effective
procedures (e.g., use independent parties
8. (b) The requirement is to determine a
outside the entity rather than those within the
likely auditor reaction to a decreased
entity), (2) change the timing of substantive
acceptable level of detection risk.
Answer (b) is correct because tests (e.g., perform them at yearendrather than
postponement of interim substantive at an interim date), and (3) change the extent of
tests to yearend decreases detection substantive tests (e.g., take a larger sample).
risk by reducing the risk for the Answer (b) is incorrect because the assurance
period subsequent to the provided from substantive tests increases, it
performance of those tests; other does not decrease. Answers (c) and (d) are
approaches to decreasing detection incorrect because the acceptable level of
risk include changing to more detection risk is based largely on the assessed
effective substantive tests and levels of control risk and inherent risk.
increasing their extent. Answer (a) is Accordingly, any tests of controls will already
incorrect because increased, not have been performed.
reduced, substantive testing is
required. Answer (c) is incorrect
because inherent risk must be
considered in planning, either by
itself or in combination with control
risk. Answer (d) is incorrect because
tests of controls must be performed
to reduce the assessed level of con
trol risk.
9. (b) The requirement is to identify the
risk that an auditor will conclude,
based on substantive tests, that a ma
terial error does not exist in an account balance
when, in fact, such error does exist. Answer (b)
is correct because detection risk is the risk that
the auditor will not detect a material
misstatement that exists in an assertion.
Detection risk may be viewed in terms of two
components (1) the risk that analytical
procedures and other relevant substantive tests
would fail to detect misstatements equal to
tolerable misstatement, and (2) the allowable
risk of incorrect acceptance for the substantive
tests of details. Answer (a) is incorrect
because sampling risk arises from the
possibility that, when a test of controls or a
substantive test is restricted to a sample, the
auditor’s conclusions may be different from the
conclusions he or she would reach if the tests
were applied in the same way to all items in
the account balance or class of transactions.
When related to substantive tests sampling
risk is only a part of the risk that the auditor’s
substantive tests will not detect a material
misstatement. An
swer (c) is incorrect because nonsampling risk
includes only those aspects of audit risk that
are not due to sampling. Answer (d) is
incorrect because inherent risk is the
susceptibility of an assertion to a material
14. (b) The requirement is to determine
11. (c) The requirement is to determine
the relationship between control risk
whether inherent risk, control risk,
and detection risk. Inverse is correct
and detection risk may be assessed
because as control risk increases
in nonquantitative terms. Answer (c)
(decreases) detection risk must
is correct because all of these risks
decrease (increase).
may be assessed in either
quantitative terms such as A.3. Materiality
percentages, or nonquantitative
terms such as a range from a 15. (b) The requirement is to identify the
minimum to a maximum. information that an auditor would
most likely use in determining a pre
12. (c) The requirement is to determine a manner liminary judgment about materiality.
in which inherent risk and control risk differ Answer (b) is correct because many
from detection risk. Answer (c) is correct materiality measures relate to an
because inherent risk and control risk exist annual figure (e.g., net income, sales).
independently of the audit of the financial Answer (a) is incorrect because the
statements as functions of the client and its preliminary judgment about
environment, whereas detection risk relates to materiality is a factor used in
the auditor’s procedures and can be changed at determining the anticipated sample
his or her discretion. Answer (a) is incorrect size, not the reverse as suggested by
because inherent risk and control risk are the reply. Answers (c) and (d) are
functions of the client and its environment and incorrect because materiality will not
do not arise from misapplication of auditing normally be affected by the results of
procedures. Answer (b) is incorrect because the internal control questionnaire or
inherent risk, control risk and detection risk the contents of the management
may each be assessed in either quantitative or representation letters.
nonquantitative terms. Answer (d) is incorrect
because inherent risk and control risk are 16. (b) The requirement is to identify the
functions of the client and its environment, statement that is not correct
they cannot be changed at the auditor’s concerning materiality. Answer (b) is
discretion. However, the assessed levels of the proper reply because the auditor
inherent and control risk (not addressed in this considers materiality for planning
question) may be affected by auditor decisions purposes in terms of the smallest, not
relating to the cost of gathering evidence to the largest, aggregate amount of
substantiate assessed levels below the misstatement that could be material
maximum. to any one of the financial
13. (b) The requirement is to determine statements. Answers (a), (c),
the best way for an auditor to achieve and (d) all represent correct statements about
an overall audit risk level when the materiality.
audit evidence relating to control risk
indicates the need to increase its
assessed level. Answer (b) is correct
because a decrease in detection risk
will allow the auditor achieve an
overall audit risk level substantially
the same as planned. Answer (a) is
incorrect because a decrease in
substantive testing will increase, not
decrease, detection risk and thereby
increase audit risk. Answer (c) is
incorrect because an increase in
inherent risk will also increase audit
risk. Answer (d) is incorrect because
there appears to be no justification
for increasing materiality levels
beyond those used in planning the
audit.
judgment will affect the anticipated sample size
for planned substantive tests, sample size does
17. (d) The requirement is to identify the not affect the materiality judgment. Answer (d)
elements which underlie the is incorrect because the assertions embodied in
application of generally accepted the financial statements remain the same from
auditing standards, particularly the one audit to another.
standards of fieldwork and reporting.
Answer (d) is correct because AU 20. (b) The requirement is to identify the
150 states that materiality and most likely effect of a decrease in the
relative risk underlie the application tolerable amount of misstatement
of all the standards. Answer (a) is (tolerable misstatement) in a class of
incorrect because a consideration of transactions. Answer (b) is correct
internal control is one of the field because auditing standards state that
standards, not an element underlying decreasing the tolerable amount of
the standards. Answer (b) is incorrect misstatement will require the auditor
because the second fieldwork to do one or more of the following:
standard, on evidence, relates most (1) perform auditing procedures
directly to corroborating evidence. closer to the balance sheet date
Answer (c) is incorrect because (answer [b]); (2) select a more
while it is accurate that quality effective auditing procedure; or (3)
control standards encompass the increase the extent of a particular
firm’s policies and procedures to pro auditing procedure. Answer (a) is
vide reasonable assurance of incorrect because in such a
conforming with professional circumstance substantive tests are
standards, the standards are not more likely to be performed at or
related more directly to the fieldwork after the balance sheet date than prior
and reporting standards than to the to the balance sheet date. Answer (c)
general group of generally accepted is incorrect because decreasing the
auditing standards. tolerable amount of misstatement will
not necessarily lead to an increase in
18. (a) The requirement is to determine the assessed level of control risk.
the appropriate level of materiality for Answer (d) is incorrect because the
planning purposes when $10,000 extent of auditing procedures will be
would have a material effect on an increased, not decreased.
entity’s income statement, but
$20,000 would materially affect the
balance sheet. AU 312 states that the
audit should be designed to obtain
reasonable assurance about whether
the financial statements are free of
material misstatement. Because it will
ordinarily be difficult to anticipate
during the planning stage of an audit
whether all misstatements will affect
only one financial statement, the
auditor is generally required to use
the lower financial statement figure
for most portions of planning.
Therefore, answer (a), $10,000, is
correct. Answers (b), (c), and (d) are
all incorrect because they are dollar
amounts which exceed the lowest
level of materiality.
information that an auditor would be most
likely to use in making a preliminary judgment
about materiality. Answer (c) is correct because
auditors often choose to use a measure relating
to the prior year’s financial statements (e.g., a
percentage of total assets, net income, or
revenue) to arrive at a preliminary judgment
about materiality. Answer (a) is incorrect
because materiality is based on the magnitude
of an omission or misstatement and not on the
initial assessment of control risk. Answer (b) is
incorrect because while an auditor’s materiality
what presumption concerning
21. (b) The requirement is to identify the management’s honesty that
necessary condition for an auditor to professional skepticism requires.
be able to issue an unqualified opin Answer (c) is correct because profes
ion. Answer (b) is correct because if sional skepticism requires that an
the estimate of likely misstatement is auditor neither assume dishonesty nor
equal to or greater than a material unquestioned honesty. Answers (a)
amount a material departure from and (b) are incorrect because neither
generally accepted accounting prin honesty in the absence of fraud risk
ciples exists and thus AU 508 requires factor nor dishonesty are assumed.
either a qualified or adverse opinion Answer (d) is incorrect because the
in such circumstances. Answer (a) is concept of reasonable assurance is not
incorrect because the amount of directed towards management’s
known misstatement (if any) need not honesty.
be documented in the management
representation letter. Answer (c) is A.4. Errors and Fraud
incorrect because it ordinarily is not 24. (a) The requirement is to identify the example
necessary for the client to of fraudulent financial reporting. Answer (a) is
acknowledge and record immaterial correct because fraudulent financial reporting
known misstatements. Answer (d) is involves intentional misstatements or
incorrect because the total likely omissions of amounts or disclosures in financial
misstatement need not include the statements to deceive financial statement users
adjusting entries already recorded by and changing the inventory count tags results in
the client. such a misstatement. Answers (b), (c), and (d)
22. (b) The requirement is to determine are all incorrect because they represent the
which concept requires an attitude misappropriation of assets. See AU 316 which
that includes a questioning mind and a divides fraudulent activities into misstatement
critical assessment of audit evidence. arising from fraudulent financial reporting and
Answer (b) is correct because AU 230 misstatements arising from misappropriation of
states that professional skepticism assets (sometimes referred to as defalcation).
includes these qualities. Answer (a) is 25. (b) The requirement is to identify the
incorrect because due professional best description of what is meant by
care is a broader concept that a “fraud risk factor.” Answer (b) is
concerns what the independent correct because AU 316 suggests that
auditor does and how well he or she while fraud risk factors do not
does it. Answer (c) is incorrect necessarily indicate the existence of
because reasonable assurance is based fraud, they often have been observed
on the concept that an auditor is not in circumstances where frauds have
an insurer and his or her report does occurred. Answer (a) is incorrect
not provide absolute assurance. because the risk of fraud may or may
Answer (d) is incorrect because not be high when a risk factor is
supervision involves the directing of present. Answer (c) is incorrect
the efforts of assistants who are because the current audit program
involved in accomplishing the may in many circumstances
objectives of the audit and appropriately address a fraud risk
determining whether those objectives factor. Answer (d) is incorrect
were accomplished. because a fraud risk factor may or
23. (c) The requirement is to determine may not represent a material
weakness.
incorrect because they represent factors
considered in the professional literature for
26. (a) The requirement is to identify the providing reasonable, and not absolute assur
reply which represents an auditor ance.
communication responsibility relating
to fraud. Answer (a) is correct 30. (b) The requirement is to identify the type of
because all fraud involving senior fraudulent misstatement that is most difficult to
management should be reported detect. Answer (b) is correct because
directly to the audit committee. transactions that have not been recorded are
Answer (b) is incorrect because generally considered most difficult because
auditors are only required to report there is no general starting point for the auditor
fraud to the Securities and Exchange in the consideration of the transaction. Answers
Commission under particular (a), (c), and (d) all represent recorded
circumstances. Answer (c) is incorrect transactions which, when audited, are in general
because auditors do not ordinarily easier to detect.
disclose fraud through use of an 31. (d) The requirement is to identify the least
“emphasis of a matter” paragraph likely indicator of a risk of possible
added to their report. Answer (d) is misstatement due to fraud. Answer (d) is correct
incorrect because under certain because one would expect unusually aggressive,
circumstances auditors must disclose rather than unusually conservative accounting
fraud outside the entity. practices to indicate a risk of misstatement due
27. (b) The requirement is to identify the risk to fraud. Answers (a), (b), and (c) are all
relating to material misstatement that auditors incorrect because they represent risk factors
are required to assess. Answer (b) is correct explicitly included in AU 316, which provides
because SAS 109 and AU 316 require auditors guidance on fraud.
to specifically assess the risk of material
misstatements due to fraud and consider that
assessment in designing the audit procedures to
be performed. Answer (a) is incorrect because
while SAS 109 also requires an assessment of
the overall risk of material misstatement
(whether caused by error or fraud) there is no
requirement to explicitly assess the risk of
material misstatement due to errors. Answer (c)
is incorrect because the auditor need not
explicitly assess the risk of misstatement due to
illegal acts (see AU 317 for information on
illegal acts). Answer (d) is incorrect because no
assessment of business risk is required.
28. (a) The requirement is to determine
whether audits are designed to
provide reasonable assurance of
detecting misstatements due to
errors, fraudulent financial
reporting, and/or misappropriation
of assets. Answer (a) is correct
because AU 110 and AU 316
require that an audit obtain
reasonable assurance that material
misstatements, whether caused by
error or fraud, be detected.
Fraudulent financial reporting and
the misappropriation of assets are
the two major types of fraud with
which an audit is relevant.
29. (d) The requirement is to identify the reply
which is not a reason why auditors are unable to
obtain absolute assurance that misstatements
due to fraud will be detected. Answer (d) is
correct because while an auditor must exercise
professional skepticism when performing an
audit it does not represent a limitation that
makes is impossible to obtain absolute
assurance. Answers (a), (b), and (c) are all
(d) are all incorrect because mistakes
32. (c) The requirement is to determine in the application of accounting
the reply which represents principles or in processing data, and
information most likely to affect the unreasonable accounting estimates
auditor’s assessment of the risk of arising from oversight are examples
misstatement due to fraud. Answer of misstatements rather than fraud.
(c) is correct because AU 316 states
that missing documents may be
indicative of fraud. Answer (a) is characteristic most likely to heighten an
incorrect because checks for auditor’s concern about the risk of intentional
significant amounts are normally manipulation of financial statements. Answer
expected to be outstanding at year (c) is correct because the placement of
end. Answer (b) is incorrect because substantial emphasis on meeting earnings
almost all audits involve computer projections is considered a risk factor. Answer
generated documents and their (a) is incorrect because high turnover, not low
existence is not considered a turnover, is considered a risk factor. Answer
condition indicating possible fraud. (b) is incorrect because insider purchases of
Answer (d) is incorrect because while additional shares of stock are less likely to be
lastminute adjustments that indicative of intentional manipulation of the
significantly affect financial results financial statements than is undue emphasis on
may be considered indicative of meeting earnings projections. Answer (d) is
possible fraud, yearend adjusting incorrect because a rapid rate of change in an
journal entries alone are to be industry, not a slow rate, is considered a risk
expected. factor.
33. (a) The requirement is to identify the 36. (d) The requirement is to identify an

most likely response to the auditor’s auditor’s responsibility for detecting
assessment that the risk of material errors and fraud. Answer (d) is
misstatement due to fraud for the correct because AU 110 requires that
existence of inventory is high. an auditor design the audit to provide
Answer (a) is correct because reasonable assurance of detecting
observing test counts of inventory on misstatements due to errors and
an unannounced basis will provide fraud that are material to the finan
evidence as to whether record cial statements. Answer (a) is
inventory exists. Answer (b) is incorrect because audits provide
incorrect because replacing test reasonable assurance of detecting
counts with analytical procedures is material errors and fraud. Answer (b)
not likely to be particularly effective. is incorrect because it doesn’t restrict
Answers (c) and (d) are incorrect the responsibility to material errors
because the inventories might well be and fraud. Answer (c) is incorrect
counted at yearend, all on the same because it is less precise than answer
date, rather than prior to yearend and (d), which includes the AU 110
at differing dates. responsibility on errors and fraud.
34. (a) The requirement is to identify the 37. (d) The requirement is to identify the

reply that is most likely to be an circumstances in which an auditor
example of fraud. Answer (a) is most may have a responsibility to disclose
likely, since “defalcation” is another fraud to parties other than a client’s
term for misstatements arising from senior management and its audit
misappropriation of assets, a major committee or board of directors.
type of fraud. Answers (b), (c), and Answer (d) is cor
adverse relationships between a
company and its employees. Answer
rect because AU 316 states that such a (d) is correct because AU 316 states
responsibility may exist to the SEC when there that, while the auditor is not required
has been an auditor change to a successor to plan the audit to discover informa
auditor or to comply with SEC 1995 Private tion that is indicative of financial
Securities Reform Act communication stress of employees or adverse
requirement, when the successor auditor makes relationships between the company
inquiries, and to a government agency from and its employees, such conditions
which the client receives financial assistance. must be considered when an auditor
In addition, that section states that an auditor becomes aware of them. Answers (a),
may have such a disclosure responsibility in (b), and (c) are all incorrect because
response to a subpoena, a circumstance not the auditor does not plan the audit to
considered in this question. detect these conditions.
38. (b) Errors refer to unintentional 43. (a) The requirement is to identify an
mistakes in financial statements auditor’s responsibility when he or
such as misinterpretation of facts. she believes that a misstatement is or
Answers (a), (c), and (d) all may be the result of fraud, but that
represent fraud which are defined as the effect of the misstatements is
intentional distortions of financial immaterial to the financial
statements. statements. Answer (a) is correct
39. (d) The requirement is to identify the because AU 316 states that in such
level of assurance an auditor circumstances the auditor should
provides with respect to detection of evaluate the implications of the fraud,
material errors, fraud, and direct especially those dealing with the
effect illegal acts. Answer (d) is organizational position of the
correct because AU 110 requires the person(s) involved.
auditor to design the audit to provide
reasonable assurance of detecting
material errors, fraud and direct effect
illegal acts. (A “direct effect” illegal
act is one that would have an effect
on the determination of financial
statement amounts.)
40. (c) The requirement is to identify the proper
attitude of an auditor who is performing an
audit in accordance with generally accepted
auditing standards. Answer (c) is correct
because the auditor should plan and perform the
audit with an attitude of professional
skepticism, recognizing that the application of
the auditing procedures may produce evidence
indicating the possibility of misstatements due
to errors or fraud. Answer (a) is incorrect
because while the CPA must exhibit objective
judgment, “professional skepticism” more
accurately summarizes the proper attitude
during an audit. Answer (b) is incorrect because
while a CPA must be independent and have
integrity, this is not the “attitude” used to plan
and perform the audit. Answer (d) is incorrect
because the audit is not planned and performed
with impartial conservatism.
41. (c) The requirement is to identify the meaning
of the term “material misstatement” when used
in the professional standards. Answer (c) is
correct because SAS 107 and
AU 316 state that a material misstatement may
occur due to errors, fraud, and illegal acts with
a direct effect on financial statement amounts.
42. (d) The requirement is to identify an
auditor’s responsibility for detecting
financial stress of employees or
likely that management’s attitude
44. (a) The requirement is to identify the toward aggressive financial reporting
correct statements relating to the and toward meeting projected profit
auditor’s consideration of fraud. An goals would most likely significantly
swer (a) is correct because AU 316 influence an entity’s control
states that the auditor’s interest environment. Answer (b) is correct
relates to fraudulent acts that cause a because when management is
material misstatement of financial dominated by one individual, that in
statements. Answer (b) is incorrect dividual may be able to follow overly
because errors are unintentional. aggressive accounting principles.
Answer (c) is incorrect because
fraud does not necessarily involve
procedure least likely to be required
the misappropriation of assets (it
may involve fraudulent financial re on an audit. Answer (d) is
porting). Answer (d) is incorrect correctbecause fraud is a broad legal
because an auditor must design an concept and auditors do not make
audit to obtain reasonable assurance legal determinations of whether fraud
of detecting misstatements, has occurred. Answers (a), (b), and
regardless of whether they are (c) are incorrect because considering
caused by errors or fraud. journal entries, estimates, and unusual
transactions are ordinarily required
45. (a) The requirement is to identify the factor or audit procedures to address the risk of
condition that an audit is least likely to be management override of controls.
planned to discover. Answer (a) is correct See AU 316 for information on the
because it represents a financial stress, and auditor’s responsibility for the
auditors are not required to plan audits to dis consideration of fraud in a financial
cover information that is indicative of financial statement audit.
stress of employees or adverse relationships 49. (b) The requirement is to identify the most
between the entity and its employees. Answers
likely response when a risk of fraud has been
(b), (c), and (d) are all incorrect because they
identified on an audit. Answer (b) is correct
represent examples of risk factors that should
because AU 316 indicates that overall
be considered in an audit and are included in
responses to the risk of material misstatements
AU 316.
due to fraud include (1) assigning personnel
46. (a) The requirement is to determine with particular skills relating to the area and
when audit risk factors may be considering the necessary extent of supervision
identified. Answer (a) is correct to the audit, (2) increasing the consideration of
because AU 316 states that fraud risk management’s selection and application of
factors may be identified during accounting principles, and (3) making audit
planning, obtaining an understanding, procedures less predictable. Answer (a) is
or while conducting fieldwork; in incorrect because closer supervision, not less
addition, they may be identified while close supervision, is more likely to be
considering acceptance or appropriate. Answer (c) is incorrect because
continuance of clients and individuals with specialized skills may be
engagements. needed who are not CPAs. Answer (d) is
incorrect because subjective transactions (e.g.,
47. (b) The requirement is to identify the accounting estimates) often provide more risk
circumstance in which it is most than objective transactions.
fraudulent financial reporting.
50. (a) The requirement is to identify 54. (b) The requirement is to identify the

the least likely inquiry of most likely fraud risk factor on an
management relating to identifying audit. Answer (b) is correct because
the risk of material misstatement the possibility of improper revenue
due to fraud. Answer (a) is correct recognition is ordinarily presumed on
because financial operations of audits. Answers (a), (c), and (d) all
many companies are not ordinarily represent potential risks, but risks
controlled by and limited to one that are not ordinarily presumed on
location. Answers (b), (c), and (d) an audit. See AU 316 for information
are all incorrect because they are in on the auditor’s responsibility for
cluded in AU 316 as inquiries that the consideration of fraud in a
should be made of management. financial statement audit.
51. (a) The requirement is to identify the 55. (d) The requirement is to identify the

attributes ordinarily present when circumstances relating to the discovery of the
individuals commit fraud. Answer (a) payment of small bribes to municipal officials
is correct because AU 316 suggests that is most likely to cause an auditor to
that the three conditions generally withdraw from an engagement. Answer (d) is
present when fraud occurs are that correct because AU 317 states that
individuals have an (1) incentive or management failure to take the appropriate
pressure, (2) opportunity, and (3) remedial action is particularly problematical
ability to rationalize. Answers (b), (c), since it may affect the auditor’s ability to rely
and (d) are all incorrect because they on management representation and may
suggest that one of the three elements therefore lead to withdrawal. Answers (a), (b),
is not ordinarily present. and (c) all represent circumstances which the
auditor will consider, but are not ordinarily
52. (a) The requirement is to determine considered as serious as failure to take the
an auditor’s reporting responsibility appropriate remedial action.
when he or she has discovered that
management is involved in a
financially immaterial fraud. Answer
(a) is correct because AU 316
requires that all management fraud,
regardless of materiality, be reported
to the audit committee. Answer (b) is
incorrect because fraud is not directly
reported to the Public Company
Accounting Oversight Board. Answer
(c) is incorrect because if anything, in
addition to the audit committee, the
fraud is reported to a level of
management at least one level above
those involved in a fraud. Answer (d)
is incorrect because there is a
reporting responsibility for
financially immaterial management
fraud.
most likely risk factor relating to
fraudulent financial reporting. An
swer (c) is correct because negative
cash flows from operations may
result in pressure upon management
to overstate the results of operations.
Answer (a) is incorrect because one
would expect a company’s top
executives to dominate management
—domination by one or a few might
be considered a risk factor. Answers
(b) and (d) are incorrect because large
amounts of cash being processed and
small highdollar inventory items are
more directly related to the misappro
priation of assets than they are to
discovered that a client’s employees
56. (d) The requirement is to identify the factor most have paid small bribes to public
likely to cause a CPA not to accept a new audit officials. Answer (c) is correct
engagement. Answer (d) is correct because a part because AU 317 states that
of the understanding an auditor must obtain with a resignation should be considered
client is that management is responsible for when an illegal act does not receive
making all financial records and related infor proper remedial action, because such
mation available (see SAS 108). Accordingly, if inaction may affect the auditor’s
the client refuses to make such information ability to rely on management
representations and the effects of
available the auditor is unlikely to accept the audit
continued association with the client.
client. Answer (a) is incorrect because a
Answer (a) is incorrect because the
circumstanceimposed scope limitations such as
receipt of federal funds in such a
completion of the physical inventory count results
situation is not as likely to result in
in a situation in which the auditor may consider auditor withdrawal as is answer (c).
using alternative procedures (including making Answer (b) is incorrect because it
some test counts) to determine whether inventory seems inconsistent with the premise
counts are proper. Answer (b) is incorrect because of the question in that, if no evidence
an auditor may obtain an understanding of the exists, the auditor is unlikely to know
client’s operations and industry while performing that bribes have been paid. Answer
the audit. Answer (c) is incorrect because while a (d) is incorrect because such small
review of the predecessor auditor’s working bribes will not ordinarily need to be
papers is ordinarily desirable, it is not required. disclosed. Alternatively, if the auditor
believes that there is such a need, the
lack of such disclosure represents a
57. (d) The requirement is to identify the factor
departure from generally accepted
most likely to heighten an auditor’s concern accounting principles and either a
about the risk of fraudulent financial reporting. qualified or adverse opinion is
Answer (d) is correct because AU 316, which appropriate.
presents a variety of risk factors, suggests that
an overly complex organizational structure is 59. (b) The requirement is to identify the
such a risk factor. Answer (a) is incorrect illegal act that an audit should be
because large amounts of liquid assets that are designed to obtain reasonable assurance
easily convertible into cash represent more of a of detecting. Answer (b) is correct
risk relating to misappropriation of assets rather because the accrual and billing of an
than to fraudulent financial reporting. Answer improper amount of revenue under
(b) is incorrect because high growth, rather government contracts is an illegal act
than low growth, is considered a risk factor. with a direct effect on the determi
Answer (c) is incorrect because one would nation of financial statement amounts,
expect financial management’s participation in and audits are designed to detect such
the initial selection of accounting principles. illegal acts. Answers (a), (c), and (d)
A.5. Illegal Acts are all incorrect because they represent
illegal acts with an indirect financial
58. (c) The requirement is to identify the statement effect and an audit provides
situation in which an auditor would be no assurance that such acts will be
most likely to withdraw from an detected or that any contin
engagement when he or she has
terial, but indirect effect on the
financial statements. Answer (a) is
gent liabilities that may result will be disclosed. correct because AU 317 requires the
See auditor to apply audit procedures
AU 317 for detailed guidance on auditor specifically designed to determine
responsibility with respect to direct and whether an illegal act has occurred
indirect illegal acts. when such information comes to
his/her attention. Answers (b), (c),
60. (a) The requirement is to identify the and (d) are all incorrect because they
small misstatement that is most likely represent procedures the auditor
to have a material effect on an would perform after initial
entity’s financial statements. Answer procedures had confirmed the
(a) is correct because an illegal existence of the possible illegal
payment of an otherwise immaterial act(s).
amount may be material if there is a
reasonable possibility that it may lead 64. (b) The requirement is to determine
to a material contingent liability or a the circumstance in which it is most
material loss of revenue. likely that a CPA would withdraw
from an audit engagement after
61. (c) The requirement is to determine what an having discovered that client
auditor might reconsider when a client’s board employees have committed an illegal
of directors has refused to take any action act. Answer (b) is correct because the
relating to an auditor’s disclosure that the auditor may conclude that withdrawal
company has made immaterial illegal is necessary when the client does not
contributions. Answer (c) is correct because in take the remedial action, even when
such a circumstance the failure to take remedial the illegal act is not material to the
action may cause an auditor to decrease financial statements. Answers (a) and
reliance on management representations. (c) are incorrect because whether
Answer (a) is incorrect because the reply by the generally accepted accounting
attorney is likely to disclose any claims, principles have been violated and
litigation or assessments that the client has whether the illegal act occurred
improperly omitted from the letter of audit during a prior year that was not
inquiry. Answer (b) is incorrect because the audited may or may not have an effect
prior years’ audit programs are not being relied on
upon for this year’s audit. Answer (d) is
incorrect because the preliminary judgment
about materiality levels would not be expected
to change.
62. (b) The requirement is to identify a
reason why audits cannot reasonably
be expected to bring all illegal acts to
the auditor’s attention. Answer (b) is
correct because illegal acts relating to
the operating aspects of an entity are
often highly specialized and complex
and often are far removed from the
events and transactions reflected in
partially correct since management
override represents a limitation of the
effectiveness of internal control. Yet,
auditors are more likely to identify
such transactions because they relate
to events and transactions reflected in
the financial statements. Answer (c)
is incorrect because many illegal acts
are not subject to the client’s internal
control. Answer (d) is incorrect
because illegal acts may be
perpetrated without access to both
assets and accounting records.
an auditor’s responsibility when
information comes to his/her
attention that implies the existence
of possible illegal acts with a ma
reporting, and management’s disregard in this
the decision to withdraw from the engagement. area may lead the CPA to reject the
Answer (d) is incorrect because the assessed engagement. Answer (a) is incorrect both be
level of control risk will not have a direct cause a CPA may not need an understanding of
relationship on the decision to withdraw from the prospective client’s internal auditor’s
the engagement. computerassisted audit technique to form an
opinion on the financial statements, and
65. (b) The requirement is to identify a CPA’s because if such understanding is necessary, it
responsibility under the Securities Litigation can be obtained subsequent to engagement
Reform Act of 1995 for uncorrected illegal acts acceptance. Answer (c) is incorrect because AU
which have been communicated to the board of 334 indicates that a CPA often will be unable to
directors which refuses to inform the SEC of determine whether relatedparty transactions
their existence. Answer (b) is correct because were consummated on terms equivalent to
CPAs are required under the law to deliver a arm’slength transactions. Answer (d) is
report on those illegal acts to the SEC within incorrect because while management’s refusal
one business day in such circumstances. to permit the performance of substantive tests
Answer (a) in incorrect because there is no re before the yearend may present a problem, the
quirement to resign, although the auditor may auditor may be able to effectively perform such
decide to do so. Answer (c) is incorrect because tests after yearend.
the Act sets up reporting to the SEC, not to the
stockholders. Answer (d) is incorrect because B.1. Communicate with Predecessor
withholding of the audit opinion is not Auditors (Prior to Engagement
suggested in the Act. Acceptance)
B. Audit Planning 68. (d) The requirement is to identify a
66. (c) The requirement is to identify the procedure requirement prior to accepting an
least likely to be considered an audit planning engagement to audit a new client.
procedure.Answer (c) is correct because Answer (d) is correct because AU
performing the risk assessment occurs 315 requires that an auditor attempt
subsequent to audit planning. Answer (a) is to obtain client permission to contact
incorrect because an engagement letter is used the predecessor prior to accepting a
to establish an understanding with the client, new engagement. Answers (a), (b),
and this is a planning procedure. Answer (b) is and (c) are incorrect because they
incorrect because auditors develop the overall may all be obtained subsequent to
audit strategy during audit planning. Answer (d) accepting an engagement.
is incorrect because the audit plan is developed 69. (a) The requirement is to determine the nature
during planning. of the inquiries that a successor auditor should
67. (b) The requirement is to identify the factor make of the predecessor auditor prior to
accepting an audit engagement. Answer (a) is
most likely to cause a CPA to decide not to
correct because the inquiries should include
accept a new audit engagement. Answer (b) is
specific questions to management on (1)
correct because a certain level of internal
disagreements with
control is essential for financial statement
incorrect because management
liability (if any) for illegal acts
management as to auditing procedures and committed by employees is not gener
accounting principles (reply [a]), (2) facts that ally included in an engagement letter.
might bear on the integrity of management and Answer (d) is incorrect because
(3) the predecessor’s understanding as to the while an auditor is required to obtain
reasons for the change of auditors. Answers an understanding of internal control,
(b), (c), and (d) are incorrect because, if made he or she is not required to search for
at all, they will be after the engagement has significant internal control
been accepted. deficiencies.
70. (b) The requirement is to identify the 73. (c) The requirement is to identify the
correct statement regarding a successor most likely procedure during the
auditor’s inquiries of the predecessor auditor. initial planning phase of an audit. An
Answer (b) is correct because the successor swer (c) is correct because during
should request information such as (1) facts initial planning the timing of
that might bear on the integrity of procedures will be discussed due to
management, (2) disagreements with the need for client assistance with
management as to accounting principles, many of these procedures. Answer
auditing procedures, or other significant (a) is incorrect because the timing of
matters, and (3) the predecessor’s audit procedures will occur
understanding of the reasons for the change of subsequent to the initial planning
auditors. Answers (a), (c), and (d) all relate to stage of an audit. Answer (b) is
matters not required to be discussed prior to incorrect because the evaluation of
accepting an audit engagement. reasonableness of the client’s
accounting estimates will occur after
B.2. Establishing an Understanding with
planning (see AU 342). Answer (d) is
the Client (Engagement Letters) incorrect because the inquiry of a
71. (b) The requirement is to identify the item client’s attorney will occur
ordinarily included when an auditor establishes
an understanding with a client regarding the
services to be performed. Answer (b) is correct
because auditing standards require that an
auditor ensure that the audit committee is aware
of any significant deficiencies which come to
the CPA’s attention. Answer (a) is incorrect
because while an understanding will include a
statement that management is responsible for
the entity’s financial statements, an explicit
statement about errors and illegal activities of
employees is not ordinarily included. Answer
(c) in incorrect because management does not
provide the auditor with an assessment of the
risk of material misstatement due to fraud.
Answer (d) is incorrect because no such
statement about an auditor’s responsibility for
determining preliminary judgments about
materiality and audit risk factors is ordinarily
included in establishing an understanding. See
SAS 108 for information on establishing an
understanding with a client.
72. (a) The requirement is to identify the
matter generally included in an
auditor’s engagement letter. Answer
(a) is correct because AU 310, which
outlines requirements for engagement
letters, indicates that an engagement
letter should include an indication that
management is responsible for
identifying and ensuring that the
company complies with the laws and
regulations applicable to its activities.
Answer (b) is incorrect because such
detailed information on materiality is
not generally included in an
engagement letter. Answer (c) is
swer (c) is correct because AU 311,
subsequently to initial planning (see AU 337). which provides information on
See SAS 108 for information on planning. obtaining an understanding with the
client, does not suggest any
arrangement concerning CPA
statement thatis least likely to appear in an investment in client securities; indeed
auditor’s engagement letter. Answer (d) is such investments are prohibited by
correct because auditors ordinarily will not the Code of Professional Conduct.
discuss with management the details of Answers (a), (b), and (d) all represent
procedures that are necessary to perform the arrangements which AU 311 suggests
audit. Answers (a), (b), and (c) are incorrect may be included in an engagement
because engagement letters will include a state letter (or other form of understanding
ment on the risk of not detecting material with a client).
errors and fraud, and may include information
on fees and observed opportunities for B.3. Preliminary Engagement Activities
economy. 78. (b) The requirement is to identify form(s) of
75. (c) The requirement is to identify the item for documentation of the understanding obtained
which the generally accepted auditing standards with a client. Answer (b) is correct because the
do not require documentation. Answer (c) is professional standards require that an auditor
correct because while a CPA firm will include document the understanding through a written
an engagement letter in the working papers, it communication with the client. Answer (a) is
will not detail the auditor’s planned fieldwork. incorrect because an oral communication is not
Answer (a) is incorrect because SAS 108 sufficient. Answer (c) is incorrect because the
requires a written audit plan. Answer (b) is communication should be in writing. Answer
incorrect because SAS 103 requires that the (d) is incorrect because the understanding is not
working papers document the agreement or documented in a completely detailed audit plan
reconciliation of the accounting records with —a term of questionable meaning.
the financial statements. Answer (d) is incorrect 79. (c) The requirement is to identify the
because SAS 109 requires the auditor to factor that most likely would
document the assessment of the risks of influence an auditor’s determination
material misstatement. of the auditability of an entity’s
76. (a) The requirement is to determine financial statements. Answer (c) is
what types of items are ordinarily correct because inadequate
included in an engagement letter in accounting records may cause an
addition to the objectives of the auditor to conclude that it is unlikely
engagement. Answer (a) is correct that sufficient appropriate evidence
because SAS 108 also requires will be available to support an
inclusion of information on CPA opinion on the financial statements;
responsibilities, client accordingly, an auditor may
responsibilities, and limitations of the determine that the financial
engagement. statements are not auditable. Answer
(a) is incorrect because an auditor
77. (c) The requirement is to determine should be able to obtain the
the reply which is least likely to be knowledge necessary to audit a
included in an engagement letter. An complex
B.5. The Audit Plan
accounting system. Answer (b) is incorrect 82. (c) The requirement is to determine why an

because while relatedparty transactions may auditor should design a written audit program.
raise transaction valuation issues due to the Answer (c) is correct because an audit program
lack of an “arm’slength transaction,” the sets forth in detail the audit procedures that are
problem is normally not so severe as to make necessary to accomplish the objectives of the
the entity not auditable. Answer (d) is audit. Answer (a) is incorrect because audit
incorrect because a lack of operating programs address topics beyond selecting
effectiveness of controls may often be material transactions and this is not their primary
overcome through an increase in the scope of focus. Answer (b) is incorrect because a program
substantive tests. may include numerous substantive tests to be per
B.4. Developing an Overall Strategy formed prior to the balance sheet date. Answer (d)
is incorrect because immaterial accounts often are
80. (a) The requirement is to identify the not tested and because tests of transactions, tests
area that is most likely to require of balances, and analytical procedures are used to
special audit planning considerations. test account balances; account balances are not
Answer (a) is correct because an directly tested through tests of controls.
inventory comprised of diamond
rings is likely to require that the 83. (a) The requirement is to determine a
auditor plan ahead to involve a point at which an audit program may
specialist to assist in valuation issues. be finalized. Answer (a) is correct
Answer (b) is incorrect because because the consideration of internal
valuation of an asset such as a new control helps the auditor to assess
copy machine is not ordinarily control risk and to plan the audit:
expected to provide valuation accordingly, the audit program is not
difficulties. Answer (c) is incorrect generally finalized prior to the con
because the expensing purchases of sideration of internal control. Answer
such small assets is ordinarily ac (b) is incorrect because, while
ceptable due to the immateriality of generally desirable, engagement
the transactions. Answer (d) is letters are not required on audits.
incorrect because accelerated Answer (c) is incorrect because
depreciation methods are ordinarily report
acceptable.
information source that a CPA would
most likely consult for information on
how various publicly held companies
have complied with the disclosure
requirements of a new financial
accounting standard. Answer (b) is
correct because AICPA
AccountingTrends and Techniques,
which is issued annually, summarizes
such disclosures of 600 industrial and
merchandising corporations. Answer (a)
is incorrect because the AICPA
Codification of Statements on Auditing
Standards codifies the various
Statements on Auditing Standards and
does not include information on
individual company compliance with
disclosure requirements. Answer (c) is
incorrect because Quality Control
Review standards are established by the
AICPA and because they do not include
information on individual company
compliance with disclosure
requirements. Answer (d) is incorrect
because Form 10K itself provides
information on preparing Form10K and
this form does not include information
on individual company compliance with
disclosure requirements.
acceptable for a continuing client.
able conditions may be communicated at various Also, when a new client has engaged
times subsequent to finalization of the audit an auditor prior to yearend, a portion
program. Answer (d) is incorrect because audit of the audit may be conducted prior to
programs are often finalized prior to the yearend. Answer (b) is incorrect
performance of the search for unrecorded because an engagement may be
liabilities. accepted after the client’s yearend.
84. (d) The requirement is to determine the manner alternative procedures may be
in which audit programs should be designed. possible when an inventory count was
Answer (d) is correct because an audit program not observed at yearend. Answer (d)
should be designed so that the audit evidence is incorrect because final staffing
gathered is sufficient to support the auditor’s decisions need not be made prior to
conclusions. Answer (a) is incorrect because, completion of the planning stage of
often, most audit procedures will not be audits.
performed as interim work. Answer (b) is
incorrect because inherent risk need not be 87. (d) The requirement is to identify the element
assessed at a low level. Answer (c) is incorrect of the audit planning process most likely to be
because while providing constructive agreed upon with the client before
suggestions to management is desirable, the implementation of the audit strategy. Answer
audit program is not based on developing con (d) is correct because the auditor will ordinarily
structive suggestions. observe the counting of inventory and this will
require a degree of coordination between the
85. (d) The requirement is to determine performance of audit procedures and client
what specific audit objectives are count procedures. Answer (a) is incorrect
addressed when designing an audit because the client will not determine the
program. Answer (d) is correct evidence to be gathered to provide a sufficient
because in obtaining evidence in basis for the auditor’s opinion. Answers (b)
support of financial statement and (c) are incorrect because these procedures
assertions, the auditor develops will be determined subsequent to
specific audit objectives in the light of implementation of the audit strategy.
those assertions. Answers (a), (b),
and (c) are all incorrect because these C. Obtain an Understanding of
replies do not relate specifically to the the Entity and Its
audit objectives as do the financial Environment
statement assertions.
88. (b) The requirement is to determine the
B.7. Timing of Audit Procedures manner inwhich an auditor plans an audit of a
continuing client. Answer (b) is correct
86. (a) The requirement is to identify the because a review of prior year working papers
statement that is always true with and the permanent file may provide useful
respect to planning an audit. Answer information about the nature of the business,
(a) is correct because it is acceptable organizational structure, operating
for an auditor to perform a certain characteristics, and transactions that may
portion of the audit at an interim date; require special attention. Answer (a) is
for example, performing a portion of incorrect because tests of details of transactions
planning prior to yearend is always and balances occur subsequent
because while planning the audit,
CPAs may discuss matters that affect
to planning. Answer (c) is incorrect because the audit with firm personnel
while reading specialized industry journals will responsible for providing nonaudit
help the auditor to obtain a better services to the entity. Answer (d) is
understanding of the client’s industry, it is incorrect because any available
likely to be less helpful than reviewing the current year interim financial
working papers. Answer (d) is incorrect statements will be read during the
because a reevaluation of the client’s internal planning stage.
control environment occurs subsequent to the
ordinal planning of the audit. C.1. Communicate with Predecessor
Auditors (Subsequent to
89. (a) The requirement is to determine who, at a
Engagement Acceptance)
minimum, must have knowledge of the
relevant professional accounting and auditing 92. (a) The requirement is to identify
standards when an audit is being performed. whether a predecessor auditor should
Answer (a) is correct because AU 230 requires permit a successor auditor to review
that, at a minimum, the auditor with final working paper analyses relating to
responsibility have such knowledge. Answers contingencies, balance sheet
(b), (c), and (d) are all incorrect because they accounts, or both. Answer (a) is
suggest a higher minimum requirement. correct because AU 315 states that a
predecessor auditor should ordi
90. (d) The requirement is to determine
narily permit the successor to review
why an auditor obtains knowledge
working papers, including
about a new client’s business and its
documentation of planning, internal
industry. Answer (d) is correct
control, audit results, and other
because obtaining a level of
matters of continuing accounting and
knowledge of the client’s business
auditing significance, such as the
and industry enables the CPA to
working paper analysis of balance
obtain an understanding of the events,
sheet accounts and those relating to
transactions, and practices that, in the
contingencies.
CPA’s judgment, may have a sig
nificant effect on the financial 93. (d) The requirement is to determine a successor
statements. Answer (a) is incorrect auditor’s responsibility when financial statements
because providing constructive audited by a predecessor auditor are found to
suggestions is a secondary, and not require substantial revi
the primary, reason for obtaining
knowledge about a client’s business
and industry. Answer (b) is incorrect
because while a CPA must develop
an attitude of professional skepticism
concerning a client, this attitude is not
obtained by obtaining knowledge
about the client’s business and
industry. Answer (c) is incorrect
because information on the business
and industry of a client will provide
only limited information in
determining whether financial
statements are materially misstated,
and numerous other factors are
considered in evaluating audit
findings.
least likely procedure to be
performed in planning a financial
statement audit. Answer (c) is correct
because selecting a sample of
vendors’ invoices for comparison to
receiving reports will occur normally
as a part of the evidence
accumulation process, not as a part
of the planning of an audit. Answer
(a) is incorrect because coordination
of the assistance of entity personnel
in data preparation occurs during
planning. Answer (b) is incorrect
96. (c) The requirement is to determine the proper
sions. Answer (d) is correct because when a
successor auditor becomes aware of focus of analytical procedures used in planning an
information that indicates that financial audit. Answer (c) is correct because analytical
statements reported on by the predecessor may procedures used in planning should focus on (1)
require revision, the successor should request enhancing the auditor’s understanding of the
that the client arrange a meeting among the client’s business and the transactions and events
three parties to discuss and attempt to resolve that have occurred since the last audit date, and (2)
the matter. Answer (a) is incorrect because the identifying areas that may represent specific risks
successor is not required to notify the audit relevant to the audit. Answer (a) is incorrect
committee and stockholders. Answer (b) is because while analytical procedures performed as
incorrect because the client should first substantive tests may affect the scope of other
communicate with the predecessor before substantive tests and of tests of controls, analytical
revising the financial statements. Answer (c) is procedures used in planning generally do not.
incorrect because a meeting of the three parties Answer (b) is incorrect because the general nature
is arranged by the client and because the of analytical procedures used in planning provide
situation may or may not have anything to do only very limited assurance that potential
with the integrity of management. misstatements will be identified; analytical
94. (c) The requirement is to determine procedures used as substantive tests provide a
whether asuccessor auditor should request a level of assurance that potential misstatements
new client to authorize the predecessor auditor will be identified. Answer (d) is incorrect because
to allow a review of the predecessor’s analytical procedures performed at the review
engagement letter, working papers, or both. stage of audits more directly relate to assessing the
An adequacy of the available evidence.
swer (c) is correct because AU 315 states that 97. (a) The requirement is to identify the
it is advisable that a successor auditor request
objective of performing analytical
to be allowed to review the predecessor’s
procedures in planning an audit. An
working papers.
swer (a) is correct because AU 329
C.2. Perform Analytical Procedures states that the objective of such
procedures during planning is to identify
95. (b) The requirement is to identify such things as the existence of unusual
the audit procedure that an auditor transactions and events, amounts, ratios
will most likely perform in and trends that might indicate matters
planning a financial statement that have financial statement and audit
audit. Answer (b) is correct
planning ramifications. An
because AU 329 requires that an
swers (b), (c), and (d) are all incorrect
auditor perform analytical proce
because while analytical procedures may
dures such as comparing the
lead to the discovery of illegal acts, related
financial statements to anticipated
party transactions, and unauthorized
results during the planning stage of
transactions, this is not the primary objective.
an audit. Answers (a), (c), and (d)
are all incorrect because these 98. (c) The requirement is to identify the
procedures will all occur type of nonfinancial information an
subsequent to planning. auditor would most likely consider in
101. (c) The requirement is to identify the next step
in assessing the risks of material misstatement
performing analytical procedures during the after auditors identify risks, relate risks to what
planning phase of an audit. Answer (c) is could go wrong, and consider the magnitude of
correct because the square footage of selling risks. Answer (c) is correct because the
space may be used in considering the overall professional standards suggest that auditors
reasonableness of sales. Answer (a) is incorrect should then consider the likelihood that risks
because while the turnover of personnel in the involved could result in material misstatements.
accounting department may provide a measure Answer (a) is incorrect because the assessment
of risk relating to the accounting function, it is is not limited to illegal acts. Answer (b) is
not ordinarily used in performing analytical incorrect because the complexity of
procedures. Similarly, answer (b) is incorrect transactions is not next to be considered.
because while the objectivity of audit Answer (d) is incorrect because determining
committee members is an important consid materiality levels occurs prior to this stage of
eration, it is not ordinarily used in performing the audit.
analytical procedures. Answer (d) is also
incorrect because management’s plans to 102. (b) The requirement is to identify
repurchase stock is not directly related to whether substantive tests of details
analytical procedures. See AU 329 for and/or risk assessment procedures
information on analytical procedures. are considered further audit
procedures that may be designed
C.4. Supervision Requirements
after assessing the risks of material
99. (b) The requirement is to identify the misstatement. Further audit
information that is most likely to be procedures are composed of
communicated by a supervisor to staff substantive procedures
assistants. Answer (b) is correct
because staff assistants must be
aware of how their procedures should
be evaluated in order to perform these
procedures effectively. Answer (a) is
incorrect because some immaterial
fraud may be reported to the client’s
audit committee. Answer (c) is
incorrect because the emphasis in an
audit must be on performing the
audit effectively and not merely on
adhering to time budgets. Answer (d)
is incorrect because decisions
regarding transferring documents
from the current file to the permanent
file are generally of less importance
than the procedure suggested by
answer (b).
100. (b) The requirement is to determine why the
work of each assistant should be reviewed.
Answer (b) is correct because AU 311 suggests
that the work performed by each assistant
should be reviewed to determine whether it was
adequately performed and to evaluate whether
the results are consistent with the conclusions to
be presented in the auditor’s report. Answer (a)
is incorrect because CPA firms, not individual
auditors within the firms, have systems of
quality control. Answer (c) is incorrect because
the professional standards do not in general
approve specific audit procedures. Answer (d)
is incorrect because while determining that the
audit has been performed by persons having
adequate technical training and proficiency as
auditors is important, it should be addressed
prior to the commencement of fieldwork.
D. Assess the Risks of Material
Misstatement and Design
Further Audit Procedures
quality control standards require
(tests of details and analytical procedures) and documentation of the considerations involved
tests of controls. Answer (b) is correct in the resolution of differences of opinion. An
because while substantive tests of details are swer (a) is incorrect because the AICPA does
further audit procedures, risk assessment pro not, in general, rule on disagreements of this
cedures are not. Answer (a) is incorrect nature. Answer (c) is incorrect because the
because risk assessment procedures are not disagreement relates to an auditing procedure
further audit procedures. Answer (c) is and therefore in most such circumstances the
incorrect because substantive tests of details entity’s management or its audit committee
are further audit procedures and because risk will have no particular expertise. Answer (d) is
assessment procedures are not. Answer (d) is incorrect because the disagreement need not
incorrect because substantive tests of details necessarily be reported to a peer review
are further audit procedures. “monitoring” team.
103. (b) The requirement is to identify the E.4. Prospective Financial Statements
procedure that is least likely to be
considered a risk assessment 106. (d) The requirement is to identify what is
procedure. Answer (b) is correct includedin the examination of a financial
because confirmation is a substantive forecast. Answer (d) is correct because an
test, rather than a risk assessment examination of a forecast includes an
procedure. Answers (a), (b), and (c) evaluation of its preparation and the support
are all risk assessment procedures, as underlying management’s assumptions. As
are certain inquiries of others outside discussed in AT 301, an examination also
the entity. includes evaluating the representation of the
prospective financial statements for conformity
104. (d) Answer (d) is correct because with AICPA presentation guidelines and the
significant risks often involve issuance of an examination report. Answer (a)
accounting estimates or complex is incorrect because the service need not
accounting that involves significant include the compiling or assembling of the
judgments. Answer (a) is incorrect financial forecast. Answer (b) is incorrect
because routine, highvolume because distribution of financial forecasts
transactions typically have lower need not be limited. Answer (c) is incorrect
risk. Answer (b) is incorrect because because the CPA assumes no responsibility to
significant risks do require special update management on key events. See AT
audit attention. Answer (c) is 301 for information on prospective financial
incorrect because significant risks information.
involve items with high levels of
E.5. Quality Control
inherent risk.
107. (a) The requirement is to determine the
E. Quality Control
factors thataffect the nature and extent of a CPA
105. (b) The requirement is to determine the firm’s quality control policies and procedures.
propermethod for handling a difference of Answer (a) is correct because the nature and
opinion between auditors concerning extent of a firm’s quality control policies and
interpretation of the results of an auditing procedures depend on a number of factors,
procedure. Answer (b) is correct because the including its size,
professional standards.
the degree of operating autonomy allowed to E.6. Public Company Accounting
its personnel and practice offices, the nature Oversight Board
of its practice, its organization, and Requirements
appropriate costbenefit considerations.
108. (d) The requirement is to identify the correct statement concerning PCAOB
manners in which a CPA firm may guidance that uses the term “should.” Answer
communicate its quality control (a) is correct because the term “should” means
policies and procedures to its that the auditor must comply with the
personnel. Answer (d) is correct requirements unless he or she can demonstrate
because the requirements relating to that alternative actions were sufficient to
quality control standard achieve the objectives of the standards.
documentation state that either orally Answer (a) is incorrect because terms such as
or written are acceptable. Answers “must,” “shall,” and “is required to” are used
(a), (b) and (c) all include one or to indicate that the auditor must fulfill the
more inappropriate “no” replies. responsibilities. Answer (c) is incorrect
109. (c) The requirement is to identify the because terms such as “may,” “might,” and
“could” are used when the auditor should
reply that is not one of the elements
consider performing the audit procedure.
of quality control. Answer (c)
Answer (d) is incorrect because no particular
iscorrect because there is no quality
terms are used for the situation in which the
control element on internal control.
auditor has complete discretion whether to
Acceptance of client relationships
perform the procedure.
and specific engagements (a), human
resources (b), and monitoring (d) are
all elements of quality control. In
addition, the following also are
elements of quality control:
leadership responsibilities for
engagement performance, quality
within the firm, and relevant ethical
requirements.
110. (d) The requirement is to determine the types of
services to which Statements on Quality
Control Standards apply. Answer (d) is correct
because the standards explicitly limit
application to auditing and accounting and
review services. Although the quality control
standards may be applied to other segments of a
firm’s practice (e.g., management advisory
services and tax), the standards do not require
it.
111. (a) The requirement is to determine how a CPA
firm obtains reasonable assurance of providing
professional services that conform with
professional standards. Answer (a) is correct
because a system of quality control is designed
to provide a CPA firm with reasonable
assurance of meeting its responsibility to
provide professional services that conform with
professional standards. Answer (b) is incorrect
because a peer review provides information on
whether a CPA firm is following an appropriate
system of quality control. Answer (c) is
incorrect because it is less complete than an
swer (a) since continuing professional
education helps achieve the specific quality
control element of professional development.
Answer (d) is incorrect because complying with
generally accepted reporting standards is only
one part of the basic objective of providing
professional services that conform with
companies. Answer (a) is incorrect because the
113. (c) The requirement is to determine the set PCAOB has authority to issue auditing
of standards that the PCAOB does not have standards. Answer (b) is incorrect because the
authority to establish. Answer (c) is correct PCAOB has the authority to issue quality
because the FASB establishes accounting control standards. Answer (d) is incorrect
standards for both public and nonpublic because the PCAOB has the authority to issue
independence standards.
SOLUTION TO SIMULATIONS
Audit Risk
Application Authoritative
Literature Help
Factor Increased audit riskDecreased audit risk Fraud risk factor

1. Branch management authority
2. Government regulation
3. Company profitability
4. Demand for product
5. Interest rates
6. Availability of mortgage funds
7. Involvement of principal shareholder in
management
8. Branch manager compensation
9. Internal audit reporting relationship
10. Accounting department turnover
11. Continuing audit relationship
12. Internal controls over accounting estimates
13. Response to proposed accounting adjustments
14. New unprofitable branch
15. New computer system
Risk of Material
Misstatement Authoritative
Literature Help
Risk High risk item
1. Computer fraud risk
2. Risk related to management override of internal control
3. Fraud by branch management
4. Fraud by accounting personnel
5. Misstatement of accounting estimates
6. Fraud by loan processing clerks
7. Fraud by internal auditors
8. The risk of fraudulent misstatement of revenues
Research
Topics Authoritative
Literature Help
T
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1. P
2. T
h
(
Transactions (A) (B) (C) (D) (E) (F) (G) (H) (I)
4. Comparing a client’s unaudited results for the year with last year’s audited results.
5. Auditing and reporting guidance on the possible need to reaudit previous year
results due to the disbanding of the firm that performed last year’s audit.
6. Requirements relating to identifying violations of occupational safety and health
regulations.
7. Audit report considerations when audit of a subsidiary of the client will be
performed by Williams & Co., CPAs.
8. The need to “brainstorm” among audit team members about how accounts could
be intentionally misstated.
9. Details on considering design effectiveness of controls.
10. The importance of considering the possibility of overstated revenues (for example,
through premature revenue recognition).
Risk Analysis
Authoritative
Literature Help
(A
)
(B
)
(C
)
(D
)
1. Of the following, which is likely to be one of DietWeb’s major risks of doing business on
the Internet in the future?
2. Which of the following is likely to be the most significant business risk for DietWeb?
3. Which of the following is most accurate concerning DietWeb’s audit committee?
4. Which of the following indicates an increased risk of misstatement due to fraud?
5. Which of the following is the most significant risk facing DietWeb that might cause it to not be
able to continue increasing sales?
1. (A) The requirement is to identify DietWeb’s major listed risk of doing business on the
Internet. Answer (A) is correct because DietWeb must carefully maintain the privacy of
their customers’ information—both due to law and due to DietWeb’s assurance provided to
its customers. Answer (B) is incorrect because there are no major Federal Communications
Commission Internet use fees. Answer (C) is incorrect because the case indicates no
particular problem in providing 24/7/365 support. Answer (D) is incorrect because the
Internet is able to reach customers beyond the United States.
2. (C) The requirement is to identify the most significant business risk listed for DietWeb.
Answer (C) is correct because barriers to entrance on the Internet are ordinarily not high.
Another organization might develop similar (or more accepted) software, and/or charge
lower prices than those charged by DietWeb. Answer (A) is incorrect because internal
control limitations need not necessarily be a major problem, and because internal control
relates to control risk more directly than to the company’s business risk. Answer (B) is
incorrect because while Internet instability may cause difficulties, few would consider it as
significant a problem as new competitors. Answer (D) is incorrect because determining
appropriate yearend cutoffs is not likely to create major difficulties.
3. (C) The requirement is to identify the most accurate statement concerning DietWeb’s audit
committee. Answer (C) is correct because the audit committee has no members who are
independent of management. Answer (A) is incorrect because the audit committee has no
members who are independent of management. Answer (A) is incorrect because the
company founders are not independent. Answer (B) is incorrect because Mr. Readings’
chairmanship of the audit committee is likely to result in a weak, not a strong audit
committee. Answer (D) is incorrect because the size of the board of directors virtually
always exceeds that of the audit committee—is not equal to or less than in size.
4. (A) The requirement is to identify a factor that indicates an increased risk of misstatement due to fraud.
Answer (A) is correct because the simulation provides no explanation of the nature of the disagreement
that led to Mr. Williamson’s resignation from an apparently very desirable job. Answer (B) is incorrect
because many small companies are dominated by company founders and those companies do not
generally misstate earnings due to fraud. Answer (C) is incorrect because the issuance of debt need not
indicate fraud. Answer (D) is incorrect because competition itself need not lead to an increased risk of
misstatement due to fraud.
5. (B) The requirement is to identify the most significant risk facing DietWeb that might
cause it not to be able to continue increasing sales. Answer (B) is correct because the
industry information makes clear that the market changes rapidly—only
companies that can respond in a timely basis are likely to be able to maintain and improve sales.
Answers (A) and (C) are incorrect because there is no indication that the United States will face a
decreasing market for dietary products or that the population is decreasing. Answer (D) is
incorrect because at this point there is no indication of obsolescence of the Internet.
F
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5. W
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1. (C) The requirement is to identify a likely misstatement in the financial statements. Answer
(C) is correct because common stock issued should be treated under financing rather than
operations. Answer (A) is incorrect because an increase in cash may well occur—even
during a year in which the company encounters a loss. Answer (B) is incorrect because there
is no indication that the impairment expense is inappropriate. Answer (D) is incorrect
because previous years’ pattern of income and losses may create a situation in which a net
income tax benefit occurs.
2. (A) The requirement is to identify, of the balance sheet changes listed, the most unexpected
one. Answer (A) is unexpected in that prepaid advertising expenses decreased by more than
ninety percent—at a time when the company increased its sales and marketing expenses so
significantly. Answer (B) is incorrect because the relatively small increase in accounts
payable may be expected given the increase in revenues. Answer (C) is incorrect because one
would expect such an increase in deferred revenues as revenues increase. Answer (D) is
incorrect since the company simply issued more stock—as indicated in the company profile.
3. (A) The requirement is to identify the factor that might lead the auditors to question
whether DietWeb has the ability to continue as a going concern. Answer (A) is correct
because the current net loss may raise a question as to future profitability. Answer (B) is
incorrect because there was an increase in cash, not a decrease. Answer (C) is incorrect
because fixed assets decreased rather than increased during 20X8. Answer (D) is incorrect
because Mr. Reading’s serving as CEO indicates no particular problem.
4. (B) The requirement is to identify an incorrect classification in the financial statements.
Answer (B) is correct because accrued liabilities are in general current, not noncurrent,
liabilities. Answer (A) is incorrect because prepaid expenses are ordinarily assets. Answer
(C) is incorrect because one would expect the deferred tax liability to have a positive
balance. Answer D is incorrect because the retained earnings negative balance may be
explained by early year losses.
5. (A) The requirement is to identify the most unexpected change. Answer (A) is most unexpected because
the expanded scale of operations would lead one to expect an increase in fixed assets, not a decrease.
Answer (B) is incorrect because small changes in prepaid expense and other current assets are expected.
Answer (C) is incorrect because it is not surprising that cash may increase when there is a net loss—
particularly in a year when common stock has been issued. Answer (C) is incorrect because an increase
in accrued liabilities is consistent with an increase in the scale of operations as indicated by a large
increase in sales.
Risk of Material Authoritative
Misstatement Analysis Literature Help
AU 110, 312, and 316 all require that auditors consider factors influencing the risk of material
misstatement and that the risk of material misstatement be considered during the planning phase of
an audit engagement.
1. (D) Since TWD returned to profitable operation, its healthier financial condition leads to a decrease in
the risk of material misstatement.
2. (I) The risk of material misstatement increases when management is dominated by a single
person. Since Mead controls the Board of Directors, is a majority stockholder, and is the
CEO, it would appear that Mead dominates management.
3. (I) The risk of material misstatement increases when the internal auditor reports to top management rather than to the
audit committee because it is less likely that the internal auditor will be able to objectively perform the function.
4. (I) The risk of material misstatement increases when the key management positions (particularly senior accounting
personnel) encounter turnover.
5. (D) The loan officer’s continual monitoring of TWD decreases the risk of material misstatement.
6. (N) Timing of payroll cycles would normally have no impact on the risk of material misstatement.
7. (I) A strong financial presence or ability to dominate a certain industry sector that allows a company to dictate
terms or conditions to suppliers or customers may result in inappropriate or nonarm’slength transactions.
8. (I) A change to generally accepted accounting principles will increase the risk of material misstatement because the change in
basis requires management to prepare a number of entries that have not been made in the past; these entries may be made
improperly. Also, difficulties in determining beginning accrual basis balances increases the risk of misstatement.
9. (I) The sale of onehalf of the company’s controlling interest in United Equipment Leasing is an entry that is out
of the ordinary course of business, and accordingly, increases the risk of material misstatement.
10. (D) Litigation results in contentious and difficult accounting valuation issues because an accountant must attempt
to determine the likelihood of loss and the amount.
11. (I) The risk of material misstatement increases when significant relatedparty transactions occur and management
has an aggressive attitude towards reporting of the transactions.
12. (I) The risk of material misstatement increases in situations where there are unusual and difficult accounting issues present. It
would appear that the barter transaction with a belowmarket purchase would be considered an unusual transaction.
13. (N) The amount of insurance coverage would have little impact on the risk of material misstatement.
14. (I) The risk of material misstatement increases as it appears that management has taken an aggressive attitude
toward reporting this transaction. In addition, this appears to be an unusual and difficult accounting issue involving
revenue recognition.
15. (I) Experience has shown that a number of entities have intentionally misstated reported financial condition and
operating results in situations in which a public (or private) placement of securities is planned. Accordingly, an initial
public offering of stock increases the risk of material misstatement.
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1. (C) The requirement is to identify the factor that is most likely to increase Toastco’s inherent risk. Answer (C) is correct because
Toastco relies significantly upon the toaster, and since obsolescence of that product could cause very major difficulties for the
company. Answer (A) is incorrect because the manufacturing continues to be in Asia and there is no indication of a related
problem. Answer (B) is incorrect because the growth of 3%, while high, does not increase inherent risk. Answer (D) is incorrect
because overstated accounts receivable due to internal control deficiencies relates to control risk, not inherent risk.
2. (B) The requirement is to determine the aspect of Toastco that is most likely to increase the risk of misstatement
arising from fraudulent financial reporting. Answer (B) is correct because the president, Bill Williams, felt pressure to
meet the earnings per share number he had promised the bank due to weak second and third quarters. Therefore the
high earnings in the fourth quarter represent a risk. Answer (A) is incorrect because the stability of the industry
presents no particular risk. Answer (C) is incorrect because Toastco’s market share by itself does not seem to pose a
risk of misstatement. Answer (D) is incorrect because while Toastco would certainly be in a safer position with more
profitable products, this is not as significant a fraud risk as is the pressure to achieve the earnings per share target.
3. (B) The requirement is to determine an aspect of a company that is most likely to increase the risk of misstatement
arising from fraudulent financial reporting. Answer (B) is correct because the president’s investment in Toastco
creates a situation in
which losses in value of the company will profoundly affect him—particularly given his desire to take the company public.
Answer (A) is incorrect because selling more than one type of product may or may not affect the risk of misstatement. An
swer (C) is incorrect because it is desirable to have the audit committee composed entirely of independent directors. Answer
(D) is incorrect because the fact that this is a continuing engagement has no direct tie to the risk of misstatement.
Ratio Analysis
(A) (B) (C) (D) (E) (F) (G)
1. An audit finding most consistent with the change in the gross margin percentage
2. An audit finding most consistent with the change in the current ratio
1. (A) The requirement is to identify an audit finding most consistent with a decrease in the gross margin percentage—
gross margin/sales. Answer (A) is correct because the inability to pass on increases in costs will decrease the gross
margin because cost of goods sold as a percentage of sales will increase.
2. (G) The requirement is to identify an audit finding that is consistent with a decrease in the current ratio—current
assets/current liabilities. Answer (G) is correct because the longterm debt becoming current increases the
denominator of the current ratio, which decreases the ratio.
(H) (I) (J) (K) (L) (M)
3. An audit finding consistent with the change in inventory turnover for Toastco
4. An audit finding consistent with the change in the return on equity
3. (K) The requirement is to identify the finding that is consistent with an increase in the inventory turnover ratio—
cost of goods sold/inventory. Answer (D) is correct because a larger percentage of sales in the last month is likely to
result in a lower ending inventory, thus increasing the inventory turnover ratio since the denominator of the fraction
becomes smaller.
4. (J) The requirement is to identify the reply that is consistent with a decrease in the return on equity ratio—net
income/ shareholders’ equity. Answer (C) is correct because retention of profits increases the shareholders’ equity,
thereby decreasing the ratio.
Observed Ratio Authoritative
Changes Literature Help
A
u
1. I
n
2. A
c
3. A
l
4. L
o
(
6. Gross margin percentage was unchanged from the
prior year although gross margin increased from
the prior year. (Select one explanation)
1. (A, B, D) The requirement is to identify three explanations for an increase in the inventory turnover when compared to
theprior year. The inventory turnover is calculated by dividing the cost of goods sold by the inventory. An increase may occur
either through (1) an overstatement of the cost of goods sold (the numerator), (2) an understatement of inventory (the denomi
nator), or (3) a combination of changes. Answer (A) is correct because the recording of the consignment shipment as a sale will
overstate cost of goods sold and understate the ending inventory. Answer (B) is correct because not recording the credit memos
will result in understatement of inventory. Answer (D) is correct because the understatement of purchases of inventory will
understate the ending inventory.
Answer (C) is incorrect because overstating the yearend purchases will result in overstatement of inventory, and thereby
decrease the inventory turnover. Answers (E) through (J) are all incorrect because such changes in sales will not affect the in
ventory turnover ratio. Answers (K) through (P) are all incorrect because the interest expense, income tax rate, and the short
term borrowing do not affect the inventory turnover. Note that this question relies upon an unstated assumption that the year
end inventory is not adjusted to a yearend physical count.
2. (A, B, E) The requirement is to identify three explanations for a decrease in the accounts receivable turnover when com
pared to the prior year. The accounts receivable turnover is calculated by dividing sales by accounts receivable. A decrease
may occur through (1) an understatement of sales (the numerator), (2) an overstatement of accounts receivable (the
denominator), or (3) a combination of misstatements of sales and accounts receivable that decrease the ratio. Answer (A)
is correct because recording the consignment as sales overstates both sales and accounts receivable by an identical amount,
thus decreasing the ratio; the decrease is due to the entry debiting accounts receivable and crediting sales for the same
amount. Answer (B) is correct because not recording the credit memo overstates both sales and accounts receivable by an
identical amount, thus decreasing the ratio; this identical amount of decrease is due to the lack of a debit to sales returns
and allowances and a credit to accounts receivable. Note that answers (A) and (B) are correct in any situation in which the
ratio is greater than 1.0; when the ratio is less than 1.0 they result in an increase in the ratio. Answer (E) is correct because
while the sales for the year remain at the expected level, accounts receivable at yearend will be at a higher than average
level due to the yearend sales.
Answers (C) and (D) are incorrect because the level of inventory does not affect the ratio. Answers (F) and (G) are incor
rect because a larger, not a smaller or the same, percentage of sales near yearend decreases the ratio. Answers (H), (I) and (J)
are incorrect because one would expect accounts receivable to increase at the same rate as the increase in sales. Answers (K)
through (P) are all incorrect because interest expense, income tax rate, and the shortterm borrowing do not affect the accounts
receivable turnover.
3. (A, B, E) The requirement is to identify three explanations for an increase in the allowance for doubtful accounts, but
a decrease in the allowance for doubtful accounts as a percentage of accounts receivable. The allowance for doubtful
accounts as a percentage of accounts receivable is calculated by dividing the allowance for doubtful accounts by
accounts receivable. The percentage may decrease due to (1) a decrease in the allowance for doubtful accounts, (2) an
increase in the accounts receivable, or (3) a combination of misstatements that decrease the ratio; here, however, we
are told that reason (1), a decrease in the allowance, has not occurred. Answer (A) is correct because recording the
consignment as a sale results in an increase in accounts receivable which decreases the ratio. Answer (B) is correct
because not recording the credit memos overstates accounts receivable, thereby decreasing the ratio. Answer (E) is
correct because the larger percentage of sales occurring during the last month of the year results in accounts receivable
at yearend that will be at a higher than average level due to the yearend sales.
Answers (C) and (D) are incorrect because the level of inventory does not affect the ratio. Answers (F) and (G) are incor
rect because a larger, not a smaller or the same, percentage of sales near yearend decreases the ratio. Answers (H), (I), and (J)
are incorrect because one would expect accounts receivable and the allowance for doubtful accounts to increase at approxi
mately the same rate as the increase in sales. Answers (K) through (P) are all incorrect because interest expense, income tax
rate, and the shortterm borrowing do not affect the accounts receivable turnover.
4. (P) The requirement is to identify a reason why longterm debt increased, but interest expense increased a larger
thanproportionate amount than longterm debt. Answer (P) is correct because the higher interest rates on longterm
debt will result in higher interest expense. Answers (A) through (M) are all incorrect because they relate neither to
longterm debt nor interest expense. Answers (N) and (O) are incorrect because refinancing at the same or a lower
interest rate will result in smallerthanproportionate amounts of interest expense.
5. (L, P) The requirement is to identify two reasons why operating income might increase, yet the company would be
less profitable. Since operating income increased and net income decreased, the explanation must be items that are
listed on the income statement between operating income and net income—interest expense and federal income taxes.
The net of these two expenses must have increased to result in a situation in which the entity was less profitable.
Answer (L) is correct because an increase in the effective income tax rate could decrease the profit when compared to
the prior year. Answer (P) is correct because higher interest rates decrease profits. Answers (A) through (J) are all
incorrect because they pertain to details of operating income. Answers (K) and (M) are incorrect because a decrease
in interest expense or the income tax rate would increase net income. Answer (N) is incorrect because refinancing at
the same rate will not affect net income. Answer (O) is incorrect because refinancing at a lower interest rate will
increase profits.
6. (H) The requirement is to identify one reason why the gross margin percentage may remain unchanged, despite an
increase in gross margin from the prior year. Answer (H) is correct because when sales increase at the same
percentage as cost of goods sold, the gross margin percentage remains unchanged, and yet the increased sales will
result in an increase in the gross margin.
Answers (A) through (D) are all incorrect because they will result in a change in the gross margin percentage. Answers (E), (F),
and (G) are all incorrect because no increase in sales is indicated and no information on the gross margin is provided. Answers
(I) and (J) are incorrect because they suggest a decrease and an increase in the gross margin, respectively. Answers (K) through
(P) are all incorrect because interest expense, income tax rate, and debt do not affect gross margin.
Assertions and
Audit Procedures Authoritative
Literature Help
Assertion (A) (B) (C) (D) (E) (F)
1. Completeness
2. Cutoff
3. Existence and occurrence
4. Presentation and disclosure
5. Rights and obligations
6. Valuation
Audit procedures (A) (B) (C) (D)

1. Prepare a flowchart of internal control over sales
2. Calculate the ratio of bad debt expense to credit sales.
3. Determine whether disbursements are properly approved.
4. Confirm accounts receivable.
5. Compare current financial information with comparable prior periods.
Audit Risk and
Its Components Authoritative
Literature Help
1. (No) The risk of material misstatement is composed of inherent risk and detection risk.
2. (Yes)
3. (No) A decrease in control risk, absent other changes, results in a decrease in the risk of material misstatement.
4. (Yes) Detection risk is a function of the audit and its procedures. If there is no audit there is no measure of detection risk.
5. (No) This is backwards. Auditors restrict detection risk through the performance of more substantive procedures.
Auditors assess inherent risk and control risk.
6. (Yes)
7. (No) The error is the “or immaterially.” Audit risk deals with material misstatements.
8. (Yes)
2. Enter the exact section and
TaskBased Simulation 11 paragraph with helpful
information
Research:
Supervision
Authoritative
Literature Help
1. Which title of the Professional Standards addresses this issue and will be helpful in
responding to the CEO?
(A) (B) (C) (D) (E) (F) (G) (H)
210 03
Research: Tone
at the Top Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
1. Which title of the Professional Standards addresses this issue and will be helpful
in responding to the partner?
Effects on Audit
Risk Components Authoritative
Literature Help
S
i
1. D
u
2. I
n
3. E
a
TaskBased Simulation 14 (A) (B) (C) (D) (E) (F) (G) (H)
Research
Authoritative
10 12
Literature Help
1. Which title of the Professional Standards addresses this issue and will be helpful in
responding to the partner?
MODULE 3 UNDERSTANDING INTERNAL CONTROL AND ASSESSING CONTROL RISK 67
UNDERSTANDING INTERNAL CONTROL
AND ASSESSING CONTROL RISK
Audit Integrity and
committee ethical values Organizational
1. Which of the following most likely would not be a. Yes Yes No
considered an inherent limitation of the b. Yes No Yes
potential effectiveness of an entity’s internal c. No Yes Yes
control? d. Yes Yes Yes
a. Incompatible duties.
b. Management override.
c. Mistakes in judgment.
d. Collusion among employees.
2. When considering internal control, an auditor
should be aware of the concept of reasonable
assurance, which recognizes that
a. Internal control may be ineffective due
to mistakes in judgment and personal
carelessness.
b. Adequate safeguards over access to
assets and records should permit an
entity to maintain proper accountability.
c. Establishing and maintaining internal
control is an important responsibility of
management.
d. The cost of an entity’s internal control
should not exceed the benefits expected
to be derived.
3. Proper segregation of functional responsibilities
calls for separation of the functions of
a. Authorization, execution, and payment.
b. Authorization, recording, and custody.
c. Custody, execution, and reporting.
d. Authorization, payment, and recording.
4. An entity’s ongoing monitoring activities often include
a. Periodic audits by the audit committee.
b. Reviewing the purchasing function.
c. The audit of the annual financial statements.
d. Control risk assessment in conjunction
with quarterly reviews.
5. The overall attitude and awareness of an entity’s
board of directors concerning the importance of
internal control usually is reflected in its
a. Computerbased controls.
b. System of segregation of duties.
c. Control environment.
d. Safeguards over access to assets.
6. Management philosophy and operating style most likely
would have a significant influence on an entity’s control
environment when
a. The internal auditor reports directly
to management.
b. Management is dominated by one individual.
c. Accurate management job descriptions
delineate specific duties.
d. The audit committee actively oversees the financial
reporting process.
7. Which of the following factors are included in
an entity’s control environment?
8. Which of the following is not a component of out recording the purchase or receipt of the merchandise.
an entity’s internal control? When vendors’ invoices arrive, one of the employees ap
a. Control risk. proves the invoices for payment. After the invoices are paid,
b. Control activities. the employee destroys the invoices and the related vouchers.
c. Monitoring. In gathering evidence regarding the fraud, the auditor most
d. Control environment. likely would select items for testing from the file of all
a. Cash disbursements.
9. Which of the following is a provision of the b. Approved vouchers.
Foreign Corrupt Practices Act? c. Receiving reports.
a. It is a criminal offense for an auditor to d. Vendors’ invoices.
fail to detect and report a bribe paid by
an American business entity to a 11. Which of the following procedures most likely
foreign official for the purpose of would provide an auditor with evidence about
obtaining business. whether an entity’s internal control activities are
b. The auditor’s detection of illegal acts suitably designed to prevent or detect material
committed by officials of the auditor’s misstatements?
publicly held client in conjunction with a. Reperforming the activities for a sample of
foreign officials should be reported to transactions.
the Enforcement Division of the Securi b. Performing analytical procedures using
ties and Exchange Commission. data aggregated at a high level.
c. If the auditor of a publicly held c. Vouching a sample of transactions
company concludes that the effects on directly related to the activities.
the financial statements of a bribe given d. Observing the entity’s personnel
to a foreign official are not susceptible applying the activities.
of reasonable estimation, the auditor’s 12. Which statement is correct concerning the
report should be modified.
relevance of various types of controls to a
d. Every publicly held company must financial audit?
devise, document, and maintain internal a. An auditor may ordinarily ignore a
control sufficient to provide reasonable consideration of controls when a
assurances that internal control substantive audit approach is taken.
objectives are met.
b. Controls over the reliability of financial reporting
10. An auditor suspects that certain client employees are are ordinarily most directly relevant to an audit,
ordering merchandise for themselves over the Internet with but other controls may also be relevant.
68 MODULE 3 UNDERSTANDING INTERNAL CONTROL AND ASSESSING CONTROL RISK
17. Decision tables differ from program
c. Controls over safeguarding of flowcharts in that decision tables
assets and liabilities are of primary emphasize
importance, while controls over a. Ease of manageability for complex programs.
the reliability of financial reporting b. Logical relationships among
may also be relevant. conditions and actions.
d. All controls are ordinarily relevant to an c. Cost benefit factors justifying the program.
audit. d. The sequence in which operations are
performed.
13. In an audit of financial statements in
accordance with generally accepted auditing 18. During the consideration of internal control
standards, an auditor is required to in a financial statement audit, an auditor is
a. Document the auditor’s not obligated to
understanding of the entity’s a. Search for significant deficiencies
internal control. in the operation of the internal
b. Search for significant deficiencies control.
in the operation of internal control. b. Understand the internal control and the
c. Perform tests of controls to information system.
evaluate the effectiveness of the
entity’s internal control.
d. Determine whether controls are
suitably designed to prevent or
detect material misstatements.
14. In obtaining an understanding of an
entity’s internal control relevant to audit
planning, an auditor is required to obtain
knowledge about the
a. Design of the controls pertaining to internal
control components.
b. Effectiveness of controls that
have been implemented.
c. Consistency with which controls
are currently being applied.
d. Controls related to each principal
transaction class and account
balance.
15. An auditor should obtain sufficient
knowledge of an entity’s information
system to understand the
a. Safeguards used to limit access to
computer facilities.
b. Process used to prepare significant
accounting estimates.
c. Controls used to assure proper
authorization of transactions.
d. Controls used to detect the concealment of
fraud.
16. When obtaining an understanding of an
entity’s internal control, an auditor should
concentrate on the substance of controls
rather than their form because
a. The controls may be operating
effectively but may not be
documented.
b. Management may establish
appropriate controls but not
enforce compliance with them.
c. The controls may be so
inappropriate that no reliance is
contemplated by the auditor.
d. Management may implement
controls whose costs exceed their
benefits.
22. Which of the following may not be
c. Determine whether the control activities required on a particular audit of a
relevant to audit planning have been nonissuer (nonpublic) company?
implemented. a. Risk assessment procedures.
d. Perform procedures to understand b. Tests of controls.
the design of internal control. c. Substantive procedures.
19. A primary objective of procedures d. Analytical procedures.
performed to obtain an understanding of 23. Control risk should be assessed in terms of
internal control is to provide an auditor with a. Specific controls.
a. Knowledge necessary to b. Types of potential fraud.
assess the risks of material c. Financial statement assertions.
misstatements. d. Control environment factors.
b. Evidence to use in assessing inherent risk.
c. A basis for modifying tests of controls. 24. After assessing control risk, an auditor desires to seek
d. An evaluation of the consistency a further reduction in the assessed level of control risk.
of application of management’s At this time, the auditor would consider whether
policies. a. It would be efficient to obtain an
understanding of the entity’s
20. Which of the following statements information system.
regarding auditor documentation of the b. The entity’s controls have been implemented.
client’s internal control is correct? c. The entity’s controls pertain to any
a. Documentation must include flowcharts. financial statement assertions.
b. Documentation must include procedural d. Additional audit evidence
writeups. sufficient to support a further
c. No documentation is necessary reduction is likely to be
although it is desirable. available.
d. No one particular form of
documentation is necessary, and the 25. Assessing control risk at a low level most
extent of documentation may vary. likely would involve
a. Performing more extensive
21. In obtaining an understanding of an entity’s substantive tests with larger
internal control, an auditor is required to obtain sample sizes than originally
knowledge about the planned.
b. Reducing inherent risk for most of
Operating effectiveness Design
of controls of controls the assertions relevant to
a. Yes Yes significant account balances.
b. No Yes c. Changing the timing of substantive
c. Yes No tests by omitting interimdate
d. No No testing and performing the tests at
yearend.
documented unless control risk is assessed
at the maximum level.
a. Identifying specific controls relevant to d. The lower the assessed level of
specific assertions. control risk, the less assurance
the evidence must provide that
26. An auditor assesses control risk because it the control procedures are
a. Is relevant to the auditor’s operating effectively.
understanding of the control
environment. 31. Regardless of the assessed level of control risk, an
b. Provides assurance that the auditor would perform some
auditor’s materiality levels are a. Tests of controls to determine the
appropriate. effectiveness of internal control
c. Indicates to the auditor where policies.
inherent risk may be the greatest. b. Analytical procedures to verify the
d. Affects the level of detection risk design of internal control.
that the auditor may accept. c. Substantive tests to restrict
detection risk for significant
27. When an auditor increases the assessed level transaction classes.
of control risk because certain control
activities were determined to be ineffective,
the auditor would most likely increase the
a. Extent of tests of controls.
b. Level of detection risk.
c. Extent of tests of details.
d. Level of inherent risk.
28. An auditor uses the knowledge provided by
the understanding of internal control and
the assessed level of the risk of material
misstatement primarily to
a. Determine whether procedures
and records concerning the
safeguarding of assets are
reliable.
b. Ascertain whether the
opportunities to allow any person
to both perpetrate and conceal
fraud are minimized.
c. Modify the initial assessments of
inherent risk and preliminary
judgments about materiality levels.
d. Determine the nature, timing,
and extent of substantive tests
for financial statement
assertions.
29. An auditor may compensate for a weakness
in internal control by increasing the
a. Level of detection risk.
b. Extent of tests of controls.
c. Preliminary judgment about audit risk.
d. Extent of analytical procedures.
30. Which of the following statements is correct
concerning an auditor’s assessment of control risk?
a. Assessing control risk may be
performed concurrently during
an audit with obtaining an under
standing of the entity’s internal
control.
b. Evidence about the operation of
internal control in prior audits may
not be considered during the cur
rent year’s assessment of control
risk.
c. The basis for an auditor’s conclusions about
the assessed level of control risk need not be
implemented.
d. Dualpurpose tests to evaluate c. Detect material misstatements in
both the risk of monetary the account balances of the
misstatement and preliminary financial statements.
control risk. d. Evaluate whether controls operated
effectively.
32. How frequently must an auditor test operating
effectiveness of controls that appear to function as 36. After obtaining an understanding of internal control
they have in past years and on which the auditor and assessing the risk of material misstatement, an
wishes to rely in the current year? auditor decided to perform tests of controls. The
a. Monthly. auditor most likely decided that
b. Each audit. a. It would be efficient to perform
c. At least every second audit. tests of controls that would
d. At least every third audit. result in a reduction in planned
substantive tests.
33. Before assessing control risk at a level lower b. Additional evidence to support a
than the maximum, the auditor obtains further reduction in the risk of
reasonable assurance that controls are in use material misstatement is not
and operating effectively. This assurance is available.
most likely obtained in part by
c. An increase in the assessed
a. Preparing flowcharts. level of the risk of material
b. Performing substantive tests. misstatement is justified for
c. Analyzing tests of trends and ratios. certain financial statement
d. Inspection of documents. assertions.
34. An auditor generally tests the segregation d. There were many internal control
of duties related to inventory by weaknesses that could allow
misstatements to enter the
a. Personal inquiry and observation.
accounting system.
b. Test counts and cutoff procedures.
c. Analytical procedures and invoice 37. In assessing control risk, an auditor
recomputation. ordinarily selects from a variety of
d. Document inspection and reconciliation. techniques, including
a. Inquiry and analytical procedures.
35. The objective of tests of details of
b. Reperformance and observation.
transactions performed as tests of
c. Comparison and confirmation.
controls is to
d. Inspection and verification.
a. Monitor the design and use of
entity documents such as 38. Which of the following types of evidence
prenumbered shipping forms. would an auditor most likely examine to
b. Determine whether determine whether controls are operating
controls have been as designed?
(nonpublic) companies with
more than $100,000,000 of
a. Confirmations of receivables net worth.
verifying account balances. d. All nonissuer companies.
b. Letters of representations
corroborating inventory pricing. 44. The framework most likely to be used by
c. Attorneys’ responses to the auditor’s management in its internal control
inquiries. assessment under requirements of the
d. Client records documenting the SarbanesOxley Act of 2002 is the
use of computer programs. a. COSO internal framework.
b. COSO enterprise risk management
39. Which of the following is not a step in framework.
an auditor’s assessment of control risk? c. FASB 37 internal control definitional
a. Evaluate the effectiveness of framework.
internal control with tests of d. AICPA internal control analysis manager.
controls.
b. Obtain an understanding of the entity’s
information system and control environment.
c. Perform tests of details of
transactions to detect material
misstatements in the financial
statements.
d. Consider whether controls can have
a pervasive effect on financial
40. To obtain audit evidence about control risk,
an auditor selects tests from a variety of
techniques including
a. Inquiry.
b. Analytical procedures.
c. Calculation.
d. Confirmation.
41. Which of the following is least likely to be evidence
the auditor examines to determine whether controls are
operating effectively?
a. Records documenting usage
of computer programs.
b. Canceled supporting documents.
c. Confirmations of accounts receivable.
d. Signatures on authorization forms.
42. Which of the following procedures
concerning accounts receivable would an
auditor most likely perform to obtain
evidence in support of an assessed level of
control risk below the maximum?
a. Observing an entity’s employee
prepare the schedule of past due
accounts receivable.
b. Sending confirmation requests to an entity’s
principal customers to verify the existence
of accounts receivable.
c. Inspecting an entity’s analysis of
accounts receivable for unusual
balances.
d. Comparing an entity’s uncollectible
accounts expense to actual
uncollectible accounts receivable.
43. The internal control provisions of the
SarbanesOxley Act of 2002 apply to which
companies in the United States?
a. All companies.
b. SEC registrants.
c. All issuer (public)
companies and nonissuer
a. Remote.
45. Which of the following is correct b. More than remote.
concerning the level of assistance auditors c. Probable.
may provide in assisting management with d. Not explicitly considered.
its assessment of internal control?
a. No assistance of any type may be provided. 51. Assume that a company has a control deficiency
b. No limitations on assistance exist. regarding the processing of cash receipts.
c. Only very limited assistance may be Reconciliation of cash accounts by a competent
provided. individual otherwise independent of the cash function
might make the likelihood of a significant
d. As less risk is assumed by the
misstatement due to the control deficiency remote. In
auditors, a higher level of
this situation, reconciliation may be referred to as what
assistance is appropriate.
type of control?
46. Which of the following need not be included a. Compensating.
in management’s report on internal control b. Preventive.
under Section 404a of the SarbanesOxley
Act of 2002?
a. A statement that the company’s
auditor has issued an attestation
report on management’s assertion.
b. Identification of the
framework for evaluating
internal control.
c. Management’s assessment of the
effectiveness of internal control.
d. Management’s statement of
responsibility to establish and
maintain internal control that has
no significant deficiencies.
47. Which of the following is an accurate
statement about internal control
weaknesses?
a. Material weaknesses are also control
deficiencies.
b. Significant deficiencies
are also material
weaknesses.
c. Control deficiencies are also material
weaknesses.
d. All control deficiencies must be
communicated to the audit
committee.
48. In an integrated audit, which of the following
is defined as a weakness in internal control
that is less severe than a material weakness
but important enough to warrant attention by
those responsible for oversight of the
financial reporting function?
a. Control deficiency.
b. Unusual weakness.
c. Unusual deficiency.
d. Significant deficiency.
49. A material weakness is a significant
deficiency (or combination of significant
deficiencies) that results in a reasonable
possibility that a misstatement of at least
what amount will not be prevented or
detected?
a. An amount greater than zero.
b. An amount greater than zero, but
at least inconsequential.
c. An amount greater than inconsequential.
d. A material amount.
50. The minimum likelihood of loss involved in
the consideration of a control deficiency is
c. Adjustive. c. No Yes
d. Nonroutine. d. No No
b. Do you believe that you are underpaid?
52. According to Public Company Accounting c. What do you do when you
Oversight Board Standard 5, what type of find a fraudulent
transaction involves establishing a loan transaction?
loss reserve? d. Who trained you for this job?
a. Substantive transaction.
b. Routine transaction. 58. How large must the actual loss identified by
c. Nonroutine transaction. the auditor be for a control deficiency to
d. Estimation transaction. possibly be considered a material weakness?
53. A procedure that involves tracing a transaction from Immaterial Material
a. Yes Yes
its origination through the company’s information
b. Yes No
systems until it is reflected in the company’s financial
report is referred to as a(n)
a. Analytical analysis.
b. Substantive procedure.
c. Test of a control.
d. Walkthrough.
54. For purposes of an audit of internal control
performed under Public Company
Accounting Oversight Board standards,
the “as of date” is ordinarily
a. The first day of the year.
b. The last day of the fiscal period.
c. The last day of the auditor’s fieldwork.
d. The average date for the entire fiscal period.
55. Consider an issuer (public) company
whose purchases are made through the
Internet and by telephone. Which of the
following is correct?
a. These types of purchases
represent control objectives for
the audit of internal control.
b. These purchases are the
assertions related to the
purchase class of transactions.
c. These types of purchases
represent two major classes of
transactions within the
purchases process.
d. These two types of transactions
represent routine transactions
that must always be investigated
in extreme detail.
56. For an issuer (public) company audit of internal control,
walkthroughs provide the auditor with primary evidence
to
Evaluate the Confirm whether
effectiveness of the controls have been
design of controls placed in operation
a. Yes Yes
b. Yes No
c. No Yes
d. No No
57. Which is most likely to be a question
asked of employee personnel during a
walkthrough in an audit of the internal
control of an issuer (public) company?
a. Have you ever been asked to override the
process?
59. For purposes of an audit of internal control a circumstancecaused scope limitation
performed under Public Company relating to a significant account in a
Accounting Oversight Board requirements, SarbanesOxley 404 internal control audit
an account is significant if there is more than is most likely to result in a(n)
a a. Adverse opinion.
a. Reasonably possible likelihood b. Qualified opinion.
that it could contain immaterial c. Unqualified opinion with explanatory
or material misstatements. language.
b. Reasonably possible d. All of the above are equally likely.
likelihood that it could
63. Which of the following is most likely to
contain material
misstatements. indicate a significant deficiency relating to a
c. Remote likelihood that it could client’s antifraud programs?
contain material misstatements. a. A broad scope of internal audit activities.
d. Remote likelihood that it could b. A “whistleblower” program
contain more than inconsequential that encourages anonymous
misstatements. submissions.
c. Audit committee passivity when
60. A control deficiency that is more than a significant conducting oversight functions.
deficiency is most likely to result in what form of d. Lack of performance of
audit opinion relating to internal control? criminal background
a. Adverse. investigations for likely
b. Qualified. customers.
c. Unqualified.
d. Unqualified with explanatory language. 64. An auditor identified a material weakness in
December. The client was informed and corrected it
61. Which of the following is most likely to be considered shortly after the “as of date” (December 31); the
a material weakness in internal control for purposes of auditor agrees that the correction eliminates the
an internal control audit of an issuer (public) material weakness as of January 31. The appropriate
company? report under a PCAOB Standard 5 audit of internal
a. An ineffective oversight of control is
financial reporting by the audit a. Adverse.
committee. b. Unqualified.
b. Restatement of previously issued c. Unqualified with explanatory
financial statements due to a language relating to the material
change in accounting principles. weakness.
c.Inadequate segregation of d. Qualified.
recordkeeping from accounting.
d. Weaknesses in control activities. 65. In an integrated audit, which of the
following lead(s) to an adverse opinion on
62. Inability to evaluate internal control due to internal control?
testing beyond those controls.
b. Starting at the top—controls
Material Significant over specific assertions—the
weaknesses deficiencies auditor should link to major
a. Yes Yes accounts and reporting items.
b. Yes No c. The goal is to focus on details of
c. No Yes accounting controls, while
d. No No
avoiding consideration of overall
66. In an integrated audit, what must the auditor entitylevel controls.
communicate to the audit committee? d. The goal is to focus on all controls
related to assertions, omitting
Known material All control
consideration of controls related to
weaknesses deficiencies
the financial statements.
a. Yes Yes
b. Yes No
c. No Yes
d. No No
67. In which manner are significant deficiencies
communicated by the auditors to the audit
committee under Public Company
Accounting Oversight Board Standard 5?
a. The communication may either be orally or in
written form.
b. The communication must be oral,
and not in written form.
c. The communication must be in written form.
d. No such communication is
required as only material
weaknesses must be
communicated.
68. Which is correct concerning the external
auditors’ use of the work of others in an
audit of internal control performed for a
public company?
a. It is not allowed.
b. The work of internal auditors may
be used, but only when those
internal auditors report directly to
the audit committee.
c. Ordinarily the work of internal
auditors and others is used
primarily in lowrisk areas.
d. There is no limitation and is likely
to reduce auditor liability since
the auditors will then share legal
responsibility with those who have
performed the service.
69. In an integrated audit, which must
the auditor communicate in writing
to management?
a. Only material weaknesses.
b. Material weaknesses and significant
deficiencies.
c. Material weaknesses, significant
deficiencies and other control
deficiencies.
d. Material weaknesses, significant deficiencies,
other control deficiencies, and all suspected
and possible employee law violations.
70. Which of the following is correct when
applying a topdown approach to identify
controls to test in an integrated audit?
a. For certain assertions, strong
entitylevel controls may allow
the auditor to omit additional
were accounted for.
71. Which of the following is not included in a
76. Which of the following controls most likely would re
standard unqualified opinion on internal
duce the risk of diversion of customer receipts by an
control over financial reporting performed
entity’s employees?
under PCAOB requirements?
a. A bank lockbox system.
a. Because of inherent limitations,
b. Prenumbered remittance advices.
internal control over financial
c. Monthly bank reconciliations.
reporting may not prevent or detect
misstatements. d. Daily deposit of cash receipts.
b. In our opinion, [company name] maintained, 77. An auditor suspects that a client’s cashier is
in all material respects, effective internal misappropriating cash receipts for personal
control over financial reporting. use by lapping customer checks received in
c. Our audit included obtaining an the mail. In attempting to uncover this
understanding of internal control
over financial reporting.
d. The [company name] management
and audit committee is responsible
for maintaining effective internal
control over financial reporting.
72. Walkthroughs ordinarily provide evidence
that helps the auditor to
Confirm whether
Evaluate design controls have been
effectiveness of placed in
controls Operation
a. Yes Yes
b. Yes No
c. No Yes
d. No No
73. Which of the following procedures would an
auditor most likely perform to test controls
relating to management’s assertion about the
completeness of cash receipts for cash sales
at a retail outlet?
a. Observe the consistency of the
employees’ use of cash registers
and tapes.
b. Inquire about employees’ access
to recorded but undeposited cash.
c. Trace deposits in the cash
receipts journal to the cash
balance in the general ledger.
d. Compare the cash balance in the
general ledger with the bank
confirmation request.
74. Sound internal control dictates that
immediately upon receiving checks from
customers by mail, a responsible employee
should
a. Add the checks to the daily cash summary.
b. Verify that each check is
supported by a prenumbered sales
invoice.
c. Prepare a duplicate listing of checks received.
d. Record the checks in the cash receipts
journal.
75. Tracing shipping documents to
prenumbered sales invoices provides
evidence that
a. No duplicate shipments or billings occurred.
b. Shipments to customers were properly
invoiced.
c. All goods ordered by customers were
shipped.
d. All prenumbered sales invoices
entity’s authorized price list.
d. Inquire about the entity’s credit
embezzlement scheme, the auditor most likely would granting policies and the
compare the consistent application of credit
a. Dates checks are deposited per checks.
bank statements with the dates
remittance credits are recorded. 81. Which of the following controls most likely
b. Daily cash summaries with the sums of the would assure that all billed sales are
cash receipts journal entries. correctly posted to the accounts receivable
c. Individual bank deposit slips with ledger?
the details of the monthly bank a. Daily sales summaries are
statements. compared to daily postings to the
d. Dates uncollectible accounts are authorized to accounts receivable ledger.
be written off with the dates the writeoffs are b. Each sales invoice is supported by
actually recorded. a prenumbered shipping
document.
78. Upon receipt of customers’ checks in the c. The accounts receivable ledger is
mailroom, a responsible employee should reconciled daily to the control
prepare a remittance listing that is forwarded account in the general ledger.
to the cashier. A copy of the listing should be d. Each shipment on credit is
sent to the supported by a prenumbered sales
a. Internal auditor to investigate invoice.
the listing for unusual
transactions.
b. Treasurer to compare the listing
with the monthly bank statement.
c. Accounts receivable bookkeeper to
update the subsidiary accounts
receivable records.
d. Entity’s bank to compare the
listing with the cashier’s deposit
slip.
79. Which of the following procedures most
likely would not be a control designed to
reduce the risk of misstatementsin the billing
process?
a. Comparing control totals for
shipping documents with
corresponding totals for sales
invoices.
b. Using computer programmed
controls on the pricing and
mathematical accuracy of sales
invoices.
c. Matching shipping documents with
approved sales orders before
invoice preparation.
d. Reconciling the control totals
for sales invoices with the
accounts receivable subsidiary
ledger.
80. Which of the following audit procedures would an
auditor most likely perform to test controls relating to
management’s assertion concerning the completeness
of sales transactions?
a. Verify that extensions and
footings on the entity’s sales
invoices and monthly customer
statements have been recomputed.
b. Inspect the entity’s reports of
prenumbered shipping documents
that have not been recorded in the
sales journal.
c. Compare the invoiced prices on
prenumbered sales invoices to the
invoices are matched by an
82. An auditor tests an entity’s policy of employee who does not have au
obtaining credit approval before shipping thority to write off bad debts.
goods to customers in support of c. Employees involved in the creditgranting
management’s financial statement function are separated from the sales
assertion of function.
a. Valuation or allocation. d. Subsidiary accounts receivable
b. Completeness. records are reconciled to the
c. Existence or occurrence. control account by an employee
d. Rights and obligations. independent of the authorization of
credit.
83. Which of the following controls most likely
would help ensure that all credit sales 85. Proper authorization of writeoffs of
transactions of an entity are recorded? uncollectible accounts should be
a. The billing department supervisor approved in which of the following de
sends copies of approved sales partments?
orders to the credit department for a. Accounts receivable.
comparison to authorized credit b. Credit.
limits and current customer c. Accounts payable.
account balances. d. Treasurer.
b. The accounting department
supervisor independently 86. Employers bond employees who handle
reconciles the accounts receivable cash receipts because fidelity bonds reduce
subsidiary ledger to the accounts the possibility of employing dishonest
receivable control account individuals and
monthly. a. Protect employees who make
c. The accounting department supervisor controls unintentional misstatements
the mailing of monthly statements to customers from possible monetary damages
and investigates any differences reported by resulting from their
customers. misstatements.
d. The billing department supervisor b. Deter dishonesty by making
matches prenumbered shipping employees aware that insurance
documents with entries in the companies may investigate and
sales journal. prosecute dishonest acts.
c. Facilitate an independent
84. Which of the following controls most likely monitoring of the receiving and
would be effective in offsetting the depositing of cash receipts.
tendency of sales personnel to maximize d. Force employees in positions of
sales volume at the expense of high bad trust to take periodic vacations and
debt writeoffs? rotate their assigned duties.
a. Employees responsible for
authorizing sales and bad debt 87. During the consideration of a small business
writeoffs are denied access to client’s internal control, the auditor
cash. discovered that the accounts receivable clerk
b. Shipping documents and sales approves credit memos and has access to
and receiving reports.
cash. Which of the following controls would be most 93. With properly designed internal control, the

effective in offsetting this weakness? same employee most likely would match
a. The owner reviews errors in vendors’ invoices with receiving reports
billings to customers and postings and also
to the subsidiary ledger. a. Post the detailed accounts payable records.
b. The controller receives the monthly bank b. Recompute the calculations on vendors’
statement directly and reconciles the checking invoices.
accounts. c. Reconcile the accounts payable ledger.
c. The owner reviews credit memos d. Cancel vendors’ invoices after payment.
after they are recorded. 94. An entity’s internal control requires for
d. The controller reconciles the total every check request that there be an
of the detail accounts receivable approved voucher, supported by a
accounts to the amount shown in
the ledger.
88. When a customer fails to include a remittance advice
with a payment, it is common practice for the person
opening the mail to prepare one. Consequently, mail
should be opened by which of the following four
company employees?
a. Credit manager.
b. Receptionist.
c. Sales manager.
d. Accounts receivable clerk.
89. To provide assurance that each voucher is
submitted and paid only once, an auditor
most likely would examine a sample of paid
vouchers and determine whether each
voucher is
a. Supported by a vendor’s invoice.
b. Stamped “paid” by the check signer.
c. Prenumbered and accounted for.
d. Approved for authorized purchases.
90. In testing controls over cash disbursements,
an auditor most likely would determine that
the person who signs checks also
a. Reviews the monthly bank reconciliation.
b. Returns the checks to accounts payable.
c. Is denied access to the supporting
documents.
d. Is responsible for mailing the checks.
91. In assessing control risk for purchases, an
auditor vouches a sample of entries in the
voucher register to the supporting
documents. Which assertion would this
test of controls most likely support?
a. Completeness.
b. Existence or occurrence.
c. Valuation or allocation.
d. Rights and obligations.
92. Which of the following controls is not
usually performed in the vouchers
payable department?
a. Matching the vendor’s invoice
with the related receiving report.
b. Approving vouchers for payment
by having an authorized employee
sign the vouchers.
c. Indicating the asset and
expense accounts to be debited.
d. Accounting for unused
prenumbered purchase orders
accounts.
prenumbered purchase order and a prenumbered d. Sending written quarterly
receiving report. To determine whether checks are confirmations to all vendors.
being issued for unauthorized expenditures, an auditor
most likely would select items for testing from the
99. With welldesigned internal control,
population of all
employees in the same department most
likely would approve purchase orders,
a. Purchase orders.
and also
b. Canceled checks.
a. Reconcile the open invoice file.
c. Receiving reports.
b. Inspect goods upon receipt.
d. Approved vouchers.
c. Authorize requisitions of goods.
95. Which of the following questions would d. Negotiate terms with vendors.
most likely be included in an internal
control questionnaire concerning the 100. In obtaining an understanding of a
completeness assertion for purchases? manufacturing entity’s internal control
a. Is an authorized purchase order over inventory balances, an auditor most
required before the receiving likely would
department can accept a shipment
or the vouchers payable
department can record a voucher?
b. Are purchase requisitions
prenumbered and independently
matched with vendor invoices?
c. Is the unpaid voucher file
periodically reconciled with
inventory records by an employee
who does not have access to
purchase requisitions?
d. Are purchase orders, receiving
reports, and vouchers prenumbered
and periodically accounted for?
96. For effective internal control, the accounts
payable department generally should
a. Stamp, perforate, or otherwise
cancel supporting documentation
after payment is mailed.
b. Ascertain that each requisition is
approved as to price, quantity,
and quality by an authorized
employee.
c. Obliterate the quantity ordered on
the receiving department copy of
the purchase order.
d. Establish the agreement of the
vendor’s invoice with the
receiving report and purchase
order.
97. Internal control is strengthened when the
quantity of merchandise ordered is
omitted from the copy of the purchase
order sent to the
a. Department that initiated the requisition.
b. Receiving department.
c. Purchasing agent.
d. Accounts payable department.
98. A client erroneously recorded a large
purchase twice. Which of the following
internal control measures would be most
likely to detect this error in a timely and
efficient manner?
a. Footing the purchases journal.
b. Reconciling vendors’ monthly statements
with subsidiary payable ledger accounts.
c. Tracing totals from the
purchases journal to the ledger
b. Purchasing clerk.
c. Receiving clerk.
a. Analyze the liquidity and turnover d. Inventory control clerk.
ratios of the inventory.
b. Perform analytical procedures 105. Alpha Company uses its sales invoices for posting per
designed to identify cost variances. petual inventory records. Inadequate controls over the
c. Review the entity’s descriptions of invoicing function allow goods to be shipped that are
inventory policies and not invoiced. The inadequate controls could cause an
procedures. a. Understatement of revenues,
d. Perform test counts of inventory receivables, and inventory.
during the entity’s physical count. b. Overstatement of revenues and
receivables, and an understatement
101. Which of the following controls most likely of inventory.
would be used to maintain accurate c. Understatement of revenues and
inventory records? receivables, and an overstatement
a. Perpetual inventory records are of inventory.
periodically compared with the d. Overstatement of revenues,
current cost of individual receivables, and inventory.
inventory items.
b. A justintime inventory ordering
system keeps inventory levels to a
desired minimum.
c. Requisitions, receiving reports,
and purchase orders are
independently matched before
payment is approved.
d. Periodic inventory counts are
used to adjust the perpetual
inventory records.
102. A client maintains perpetual inventory
records in both quantities and dollars. If the
assessed level of control risk is high, an
auditor would probably
a. Insist that the client perform
physical counts of inventory
items several times during the
year.
b. Apply gross profit tests to ascertain
the reasonableness of the physical
counts.
c. Increase the extent of tests of
controls of the inventory cycle.
d. Request the client to schedule the
physical inventory count at the
end of the year.
103. Which of the following controls most likely
addresses the completeness assertion for
inventory?
a. Work in process account is
periodically reconciled with
subsidiary records.
b. Employees responsible for
custody of finished goods do
not perform the receiving
function.
c. Receiving reports are
prenumbered and periodically
reconciled.
d. There is a separation of duties
between payroll department and
inventory accounting personnel.
104. Sound internal control dictates that defective
merchandise returned by customers should
be presented initially to the
a. Salesclerk.
computed at authorized rates.
106. Which of the following is a question that b. Employees work the number of
the auditor would expect to find on the hours for which they are paid.
production cycle section of an internal c. Segregation of duties exist between
control questionnaire? the preparation and distribution of
a. Are vendors’ invoices for raw the payroll.
materials approved for payment by d. Controls relating to unclaimed
an employee who is independent of payroll checks are operating
the cash disbursements function? effectively.
b. Are signed checks for the
purchase of raw materials mailed 109. Which of the following is a control that
directly after signing without most likely could help prevent employee
being returned to the person who payroll fraud?
authorized the invoice a. The personnel department
processing? promptly sends employee
c. Are all releases by storekeepers termination notices to the payroll
of raw materials from storage supervisor.
based on approved requisition b. Employees who distribute payroll
documents? checks forward unclaimed payroll
d. Are details of individual checks to the absent employees’
disbursements for raw materials supervisors.
balanced with the total to be posted c. Salary rates resulting from new
to the appropriate general ledger hires are approved by the payroll
account? supervisor.
d. Total hours used for determination
107. The objectives of internal control for a of gross pay are calculated by the
production cycle are to provide assurance payroll supervisor.
that transactions are properly executed and
recorded, and that 110. In determining the effectiveness of an entity’s
a. Production orders are prenumbered and controls relating to the existence or occurrence
signed by a supervisor. assertion for payroll transactions, an auditor
b. Custody of work in process and most likely would inquire about and
of finished goods is properly a. Observe the segregation of duties
maintained. concerning personnel
c. Independent internal verification of responsibilities and payroll
activity reports is established. disbursement.
d. Transfers to finished goods are b. Inspect evidence of accounting
documented by a completed for prenumbered payroll checks.
production report and a quality c. Recompute the payroll
control report. deductions for employee fringe
benefits.
108. An auditor vouched data for a sample of d. Verify the preparation of the
employees in a payroll register to approved monthly payroll account bank
clock card data to provide assurance that reconciliation.
a. Payments to employees are
unclaimed cash payroll should be
a. Deposited in a safedeposit box.
111. An auditor most likely would assess control b. Held by the payroll custodian.
risk at a high level if the payroll department c. Deposited in a special bank account.
supervisor is responsible for d. Held by the controller.
a. Examining authorization forms for new
employees. 117. The auditor may observe the distribution of
b. Comparing payroll registers paychecks to ascertain whether
with original batch transmittal a. Pay rate authorization is properly
data. separated from the operating
c. Authorizing payroll rate changes for all function.
employees. b. Deductions from gross pay are
d. Hiring all subordinate payroll calculated correctly and are
department employees. properly authorized.
c. Employees of record actually
112. Which of the following controls most exist and are employed by the
likely would prevent direct labor hours client.
from being charged to manufacturing
overhead?
a. Periodic independent counts of
work in process for comparison to
recorded amounts.
b. Comparison of daily journal
entries with approved production
orders.
c. Use of time tickets to record
actual labor worked on
production orders.
d. Reconciliation of workinprocess
inventory with periodic cost
budgets.
113. In meeting the control objective of
safeguarding of assets, which department
should be responsible for
Distribution Custody of
of paychecks unclaimed paychecks
a. Treasurer Treasurer
b. Payroll Treasurer
c. Treasurer Payroll
d. Payroll Payroll
114. Proper internal control over the cash
payroll function would mandate which of
the following?
a. The payroll clerk should fill the
envelopes with cash and a
computation of the net wages.
b. Unclaimed pay envelopes should be retained
by the paymaster.
c. Each employee should be asked to sign a
receipt.
d. A separate checking account for
payroll be maintained.
115. The purpose of segregating the duties of
hiring personnel and distributing payroll
checks is to separate the
a. Authorization of transactions
from the custody of related assets.
b. Operational responsibility from
the recordkeeping responsibility.
c. Human resources function from
the controllership function.
d. Administrative controls from the
internal accounting controls.
116. To minimize the opportunities for fraud,
mergers, acquisitions, and the sale
d. Paychecks agree with the payroll of treasury stock.
register and the time cards. d. Verify that stock is issued in
accordance with the authorization
118. Which of the following departments most likely would of the board of directors and the
approve changes in pay rates and deductions from articles of incorporation.
employee salaries?
a. Personnel. 121. Where no independent stock transfer agents
b. Treasurer. are employed and the corporation issues its
c. Controller. own stocks and maintains stock records,
d. Payroll. canceled stock certificates should
a. Be defaced to prevent reissuance
119. Which of the following questions would an and attached to their
auditor most likely include on an internal corresponding stubs.
control questionnaire for notes payable? b. Not be defaced but segregated
a. Are assets that collateralize notes from other stock certificates and
payable critically needed for the retained in a canceled certificates
entity’s continued existence? file.
b. Are two or more authorized c. Be destroyed to prevent fraudulent
signatures required on checks that reissuance.
repay notes payable? d. Be defaced and sent to the secretary of state.
c. Are the proceeds from notes
payable used for the purchase of 122. Which of the following is not a
noncurrent assets? control that is designed to protect
d. Are direct borrowings on notes investment securities?
payable authorized by the board of a. Custody over securities should be
directors? limited to individuals who have
recordkeeping responsibility over
120. The primary responsibility of a bank acting as registrar the securities.
of capital stock is to b. Securities should be properly
a. Ascertain that dividends declared controlled physically in order to
do not exceed the statutory prevent unauthorized usage.
amount allowable in the state of c. Access to securities should be
incorporation. vested in more than one individual.
b. Account for stock certificates by d. Securities should be registered in
comparing the total shares the name of the owner.
outstanding to the total in the
shareholders subsidiary ledger. 123. Which of the following controls would a
c. Act as an independent third party company most likely use to safeguard
between the board of directors and marketable securities when an independent
outside investors concerning trust agent is not employed?
a. The investment committee of the board of directors 128. Which of the following controls would an entity most
periodically reviews the investment investments are executed on the
decisions delegated to the treasurer. specific authorization of the board
b. Two company officials have joint of directors.
control of marketable securities, d. The recorded balances in the
which are kept in a bank safe investment subsidiary ledger are
deposit box. periodically compared with the
c. The internal auditor and the controller contents of the safedeposit box by
independently trace all purchases and sales independent personnel.
of marketable securities from the subsidiary
ledgers to the general ledger. 127. A company holds bearer bonds as a short
d. The chairman of the board verifies term investment. Responsibility for custody
the marketable securities, which are of these bonds and submission of coupons
kept in a bank safedeposit box, for periodic interest collections probably
should be delegated to the
each year on the balance sheet date.
a. Chief Accountant.
124. A weakness in internal control over b. Internal Auditor.
recording retirements of equipment may c. Cashier.
cause an auditor to d. Treasurer.
a. Inspect certain items of equipment
in the plant and trace those items to
the accounting records.
b. Review the subsidiary ledger to
ascertain whether depreciation was
taken on each item of equipment
during the year.
c. Trace additions to the “other
assets” account to search for
equipment that is still on hand
but no longer being used.
d. Select certain items of
equipment from the ac
counting records and locate
them in the plant.
125. Which of the following questions would an
auditor least likely include on an internal
control questionnaire concerning the
initiation and execution of equipment
transactions?
a. Are requests for major repairs
approved at a higher level than the
department initiating the request?
b. Are prenumbered purchase orders
used for equipment and
periodically accounted for?
c. Are requests for purchases of
equipment reviewed for
consideration of soliciting
competitive bids?
d. Are procedures in place to
monitor and properly restrict
access to equipment?
126. Which of the following controls would be
most effective in assuring that the proper
custody of assets in the investing cycle is
maintained?
a. Direct access to securities in the safedeposit
box is limited to only one corporate officer.
b. Personnel who post investment
transactions to the general ledger
are not permitted to update the in
vestment subsidiary ledger.
c. The purchase and sale of
likely use to assist in satisfying the completeness tests of property and equipment
assertion related to longterm investments? balances at the end of the year.
a. Senior management verifies that b. Analytical procedures for current year
securities in the bank safedeposit property and equipment transactions.
box are registered in the entity’s c. Tests of controls and limited tests
name. of current year property and
b. The internal auditor compares the equipment transactions.
securities in the bank safedeposit d. Analytical procedures for property
box with recorded investments. and equipment balances at the end
c. The treasurer vouches the of the year.
acquisition of securities by
comparing brokers’ advices with 131. In general, material fraud perpetrated by
canceled checks. which of the following are most difficult to
detect?
d. The controller compares the
current market prices of recorded a. Cashier.
investments with the brokers’ b. Keypunch operator.
advices on file. c. Internal auditor.
d. Controller.
129. Which of the following controls would an
entity most likely use in safeguarding 132. Which of the following is not an accurate
against the loss of marketable securities? statement about communication of internal
a. An independent trust company that has no control related matters to management on
direct contact with the employees who have a nonissuer (nonpublic) company?
recordkeeping responsibilities has possession a. The auditor must communicate
of the securities. both material weaknesses and
b. The internal auditor verifies the significant deficiencies.
marketable securities in the b. The auditor must communicate in writing.
entity’s safe each year on the c. Previously communicated
balance sheet date. weaknesses that have not been
c. The independent auditor traces all corrected need not be
purchases and sales of marketable recommunicated.
securities through the subsidiary d. A communication indicating that
ledgers to the general ledger. no significant deficiencies were
d. A designated member of the board identified should not be issued.
of directors controls the securities
133. Which of the following matters would an
in a bank safedeposit box.
auditor most likely consider to be a material
130. When there are numerous property and weakness to be communicated to those
equipment transactions during the year, an charged with governance of an audit client?
auditor who plans to assess control risk at a a. Management’s failure to
low level usually performs renegotiate unfavorable long
a. Tests of controls and extensive term purchase commitments.
b. Recurring operating losses that may indicate going 138. Which of the following representations should not be
concern problems. a. Significant deficiencies are material weaknesses
c. Ineffective oversight of financial in the design or operation of specific internal
reporting by those charged with control components.
governance. b. The auditor is obligated to search for
d. Management’s current plans to reduce significant deficiencies that could
its ownership equity in the entity. adversely affect the entity’s ability to
record and report financial data.
134. Which of the following statements is correct c. Significant deficiencies need not be
concerning significant deficiencies in an audit? recommunicated each year if
a. An auditor is required to search for management has acknowledged its
significant deficiencies during an understanding of such deficiencies.
audit. d. The auditor should separately
b. All significant deficiencies are also communicate those significant
considered to be material weaknesses. deficiencies considered to be material
c. An auditor may communicate weaknesses.
significant deficiencies during an
audit or after the audit’s
completion.
d. An auditor may report that no
significant deficiencies were
noted during an audit.
135. An auditor’s letter issued on significant
deficiencies relating to an entity’s internal
control observed during a financial statement
audit should
a. Include a brief description of the tests
of controls performed in searching for
significant deficiencies and material
weaknesses.
b. Indicate that the significant deficiencies
should be disclosed in the annual report
to the entity’s shareholders.
c. Include a paragraph describing
management’s assertion concerning
the effectiveness of internal control.
d. Indicate that the audit’s purpose was
to report on the financial statements
and not to express an opinion on
internal control.
concerning an auditor’s required
communication of significant deficiencies?
a. A significant deficiency previously
communicated during the prior year’s
audit that remains uncorrected causes a
scope limitation.
b. An auditor should perform tests of
controls on significant deficiencies
before communicating them to the
client.
c. An auditor’s report on significant
deficiencies should include a
restriction on the distribution of the
report.
d. An auditor should communicate
significant deficiencies after tests
of controls, but before
commencing substantive tests.
concerning significant deficiencies noted in an
audit?
included in a report on internal control related matters a. Consider the weakness a scope
noted in an audit? limitation and therefore disclaim
a. Significant deficiencies related to an opinion.
internal control exist. b. Consider the effects of the condition on the audit.
b. There are no significant deficiencies c. Suspend all audit activities pending
in the design or operation of internal directions from the client’s audit
control. committee.
c. Corrective followup action is d. Withdraw from the engagement.
recommended due to the relative
significance of material weaknesses 141. In identifying matters for communication with
discovered during the audit. those charged with governance of an audit
d. The auditor’s consideration of client, an auditor most likely would ask
internal control would not management whether
necessarily disclose all significant a. The turnover in the accounting
deficiencies that exist. department was unusually high.
b. It consulted with another CPA firm
139. Which of the following statements concerning material about accounting matters.
weaknesses and significant deficiencies is correct? c. There were any subsequent events of
a. An auditor should not identify and which the auditor was unaware.
communicate material weaknesses d. It agreed with the auditor’s assessed
separately from significant level of control risk.
deficiencies.
b. Compensating controls may limit the
severity of a material weakness or concerning an auditor’s required communication
significant deficiency. with those charged with governance of an audit
c. Upon discovery an auditor should client?
immediately report all material a. This communication is required to occur
before the auditor’s report on the
weaknesses and significant
financial statements is issued.
deficiencies identified during an
b. This communication should include
audit.
discussion of any significant
d. All significant deficiencies are disagreements with management
material weaknesses. concerning the financial statements.
140. During the audit the independent auditor c. Any significant matter communicated
identified the existence of a weakness in the to the audit committee also should be
client’s internal control and communicated this communicated to management.
finding in writing to the client’s senior d. Significant audit adjustments proposed
management and those charged with governance. by the auditor and recorded by
The auditor should management need not be communicated
to those charged with governance.
that describes the
a. Documentary evidence regarding the control
143. An auditor would least likely initiate a discussion with environment factors.
those charged with governance of an audit client b. Changes in internal control since the prior report.
concerning c. Potential benefits from the practitioner’s
a. The methods used to account for suggested improvements.
significant unusual transactions. d. Inherent limitations of any internal control.
b. The maximum dollar amount of
misstatements that could exist without
causing the financial statements to be
materially misstated.
c. Indications of fraud and illegal acts
committed by a corporate officer that
were discovered by the auditor.
d. Disagreements with management as to
accounting principles that were
resolved during the current year’s audit.
about an auditor’s required communication with
those charged with governance of an audit
client?
a. Any matters communicated to the entity’s audit
committee also are required to be communicated
to the entity’s management.
b. The auditor is required to inform
those charged with governance about
significant misstatements discovered
by the auditor and subsequently cor
rected by management.
c. Disagreements with management about
the application of accounting
principles are required to be
communicated in writing to those
charged with governance.
d. Weaknesses in internal control
previously reported to those charged
with governance need not be re
communicated.
145. Which of the following matters is an auditor
required to communicate to an entity’s audit
committee?
I. Disagreements with management about matters
significant to the entity’s financial statements that
have been satisfactorily resolved.
AI. Initial selection of significant accounting
policies in emerging areas that lack
authoritative guidance.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.
146. Should an auditor communicate the following
mattersto those charged with governance of an audit
client?
Management’s consulta
Significant audit tion with other accoun
adjustments recorded tants about significant
by the entity accounting matters
a. Yes Yes
b. Yes No
c. No Yes
d. No No
147. In reporting on an entity’s internal control over finan
cial reporting, a practitioner should include a paragraph
audit?
148. Which of the following best describes a CPA’s Scope Procedures Purpose
engagement to report on an entity’s internal a. Similar Different Similar
control over financial reporting? b. Different Similar Similar
a. An attestation engagement to form an c. Different Different Different
opinion on the effectiveness of its d. Different Similar Different
internal control.
b. An audit engagement to provide 151. When an independent auditor reports on internal
negative assurance on the entity’s control based on criteria established by
internal control. governmental agencies, the report should
c. A prospective engagement to project, for a. Not include the agency’s name in the report.
a period of time not to exceed one year, b. Indicate matters covered by the study and
whether the auditor’s study included tests
and report on the expected benefits of
of controls with the procedures covered
the entity’s internal control.
by the study.
d. A consulting engagement to provide
constructive advice to the entity on its c. Not express a conclusion based on
the agency’s criteria.
internal control.
d. Assume responsibility for the
149. An engagement to examine internal control will comprehensiveness of the criteria
gener established by the agency and include
ally recommendations for corrective action.
a. Require procedures that duplicate those already
152. When an examination has been performed on the
applied in assessing control risk during a
financial statement audit. effectiveness of entity’s internal control over
financial reporting and a material weakness has
b. Increase the reliability of the financial
been noted, the practitioner’s report should
statements that have already been
express an opinion on
audited.
a. The assertion.
c. Be more extensive in scope than the
assessment of control risk made during b. The subject matter to which the assertion relates.
a financial statement audit. c. Neither of the above.
d. Be more limited in scope than the d. Both of the above.
assessment of control risk made during 153. In assessing the competence of an internal
a financial statement audit. auditor, an independent CPA most likely would
150. How do the scope, procedures, and purpose of an obtain information about the
examination of internal control compare to a. Quality of the internal auditor’s
those for obtaining an understanding of internal working paper documentation.
control and assessing control risk as part of an b. Organization’s commitment to integrity
and ethical values.
c. Influence of management on the scope of the inter 160. If the independent auditors decide that the work per
nal auditor’s duties. formed by the internal auditor may have a bearing on their
d. Organizational level to which the own procedures, they should consider the internal auditor’s
internal auditor reports. a. Competence and objectivity.
b. Efficiency and experience.
154. For which of the following judgments may an independent
c. Independence and review skills.
auditor share responsibility with an entity’s internal auditor
d. Training and supervisory skills.
who is assessed to be both competent and objective?
Assessment of Assessment of obtained from
inherent risk control risk a. Discussions with management personnel.
a. Yes Yes b. External quality reviews of the
b. Yes No internal auditor’s activities.
c. No Yes c. Previous experience with the internal auditor.
d. No No d. The results of analytical procedures.
155. The work of internal auditors may affect the
independent auditor’s
I. Procedures performed in obtaining an
understanding of internal control.
AI. Procedures performed in assessing the risk of
material misstatement.
BI. Substantive procedures performed in
gathering direct evidence.
a. I and II only.
b. I and III only.
c. II and III only.
d. I, II, and III.
156. An internal auditor’s work would most likely
affect the nature, timing, and extent of an
independent CPA’s auditing procedures when
the internal auditor’s work relates to assertions
about the
a. Existence of contingencies.
b. Valuation of intangible assets.
c. Existence of fixed asset additions.
d. Valuation of relatedparty transactions.
157. During an audit an internal auditor may provide
direct assistance to an independent CPA in
Obtaining an Performing Performing
understanding of tests of substantive
internal control controls tests
a. No No No
b. Yes No No
c. Yes Yes No
d. Yes Yes Yes
158. When assessing the internal auditor’s
competence, the independent CPA should obtain
information about the
a. Organizational level to which the
internal auditors report.
b. Educational background and
professional certification of the
internal auditors.
c. Policies prohibiting the internal
auditors from auditing areas where
relatives are employed.
d. Internal auditors’ access to records and
information that is considered sensitive.
159. In assessing the competence and objectivity of
an entity’s internal auditor, an independent
auditor would least likely consider information
161. In assessing the objectivity of internal retailer. Cook, CPA, is engaged to express an opinion on a
auditors, an independent auditor should description of PDC’s internal controls implemented as of a
a. Evaluate the quality control program specific date. These controls are relevant to the retailer’s
in effect for the internal auditors. internal control, so Cook’s report may be useful in providing
b. Examine documentary evidence of the retailer’s independent auditor with information necessary
the work performed by the internal to plan a financial statement audit. Cook’s report should
auditors. a. Contain a disclaimer of opinion on
c. Test a sample of the transactions and the operating effectiveness of PDC’s
balances that the internal auditors controls.
examined. b. State whether PDC’s controls were
d. Determine the organizational level to suitably designed to achieve the
which the internal auditors report. retailer’s objectives.
c. Identify PDC’s controls relevant to
162. Dunn, CPA, is auditing the financial statements of Taft Co. specific financial statement assertions.
Taft uses Quick Service Center (QSC) to process its d. Disclose Cook’s assessed level of
payroll. Price, CPA, is expressing an opinion on a descrip control risk for PDC.
tion of the controls implemented at QSC regarding the
processing of its customers’ payroll transactions. Dunn ex 164. The auditor who audits the processing of
pects to consider the effects of Price’s report on the Taft transactions by a service organization may issue a
engagement. Price’s report should contain a(n) report on controls
a. Description of the scope and nature of
Price’s procedures. Implemented Operating effectiveness
b. Statement that Dunn may assess control a. Yes Yes
b. Yes No
risk based on Price’s report.
c. No Yes
c. Assertion that Price assumes no d. No No
responsibility to determine whether
QSC’s controls are suitably designed. 165. Computer Services Company (CSC) processes
d. Opinion on the operating payrolltransactions for schools. Drake, CPA, is engaged to
effectiveness of QSC’s internal report on CSC’s policies and procedures implemented as of a
controls. specific date. These policies and procedures are relevant to
the schools’ internal control, so Drake’s report will be useful
163. Payroll Data Co. (PDC) processes payroll transactions for a
in providing the schools’ independent auditors with infor
mation necessary to plan their audits. Drake’s report
expressing an opinion on CSC’s policies and
procedures implemented as of a specific date should
contain a(n)
a. Description of the scope and nature of
Drake’s procedures.
b. Statement that CSC’s management has
disclosed to Drake all design
deficiencies of which it is aware.
c. Opinion on the operating
effectiveness of CSC’s policies and
procedures.
d. Paragraph indicating the basis for
Drake’s assessment of control risk.
166. Lake, CPA, is auditing the financial statements
of Gill Co. Gill uses the EDP Service Center,
Inc. to process its payroll transactions. EDP’s
financial statements are audited by Cope, CPA,
who recently issued a report on EDP’s internal
control. Lake is considering Cope’s report on
EDP’s internal control in assessing control risk
on the Gill engagement. What is Lake’s
responsibility concerning making reference to
Cope as a basis, in part, for Lake’s own opin
ion?
a. Lake may refer to Cope only if Lake
is satisfied as to Cope’s professional
reputation and independence.
b. Lake may refer to Cope only if
Lake relies on Cope’s report in
restricting the extent of substantive
tests.
c. Lake may refer to Cope only if
Lake’s report indicates the division
of responsibility.
d. Lake may not refer to Cope
under the circumstances above.
SIMULATIONS
Cash Receipts
and Billing
Authoritative
Literature Help
An auditor’s working papers include the narrative description of the cash receipts and billing portions of Southwest
Medical Center’s internal control. Evaluate the information in the situation as being either (1) a strength, (2) a weakness, (3) not
a strength or a weakness.
Southwest is a healthcare provider that is owned by a partnership of five physicians. It employs eleven physicians, in
cluding the five owners, twenty nurses, five laboratory and Xray technicians, and four clerical workers. The clerical workers
perform such tasks as reception, correspondence, cash receipts, billing, accounts receivable, bank deposits, and appointment
scheduling. These clerical workers are referred to in the situation as office manager, clerk #1, clerk #2, and clerk #3. Assume
that the narrative is a complete description of the system.
About twothirds of Southwest’s patients receive medical services only after insurance coverage is verified by the office
manager and communicated to the clerks. Most of the other patients pay for services by cash or check when services are
rendered, although the office manger extends credit on a casebycase basis to about 5% of the patients.
When services are rendered, the attending physician prepares a prenumbered service slip for each patient and gives the
slip to clerk #1 for pricing. Clerk #1 completes the slip and gives the completed slip to clerk #2 and a copy to the patient.
Using the information on the completed slip, clerk #2 performs one of the following three procedures for each patient:
• Clerk #2 files an insurance claim and records a receivable from the insurance company if the office manager has
verified the patient’s coverage, or
• Clerk #2 posts a receivable from the patient on clerk #2’s PC if the office manager has approved the patient’s credit, or
• Clerk #2 receives cash or a check from the patient as the patient leaves the medical center, and clerk #2 records the
cash receipt.
At the end of each day, clerk #2 prepares a revenue summary.
Clerk #1 performs correspondence functions and opens the incoming mail. Clerk #1 gives checks from insurance compa
nies and patients to clerk #2 for deposit. Clerk #2 posts the receipt of patients’ checks on clerk #2’s PC patient receivable rec
ords and insurance companies’ checks to the receivables from the applicable insurance companies. Clerk #1 gives mail re
quiring correspondence to clerk #3.
Clerk #2 stamps all checks “for deposit only” and each day prepares a list of checks and cash to be deposited in the bank.
(This list also includes the cash and checks personally given to clerk #2 by patients.) Clerk #2 keeps a copy of the deposit list
and gives the original to clerk #3.
Clerk #3 personally makes the daily bank deposit and maintains a file of the daily bank deposits. Clerk #3 also performs
appointment scheduling for all of the doctors and various correspondence functions. Clerk #3 also maintains a list of patients
whose insurance coverage the office manager has verified.
When insurance claims or patient receivables are not settled within sixty days, clerk #2 notifies the office manager. The of
fice manager personally inspects the details of each instance of nonpayment. The office manger converts insurance claims that
have been rejected by insurance companies into patient receivables. Clerk #2 records these patient receivables on clerk #2’s PC
and deletes these receivables from the applicable insurance companies. Clerk #2 deletes the patient receivables that appear to be
uncollectible from clerk #2’s PC when authorized by the office manager. Clerk #2 prepares a list of patients with uncollectible
balances and gives a copy of the list to clerk #3, who will not allow these patients to make appointments for future services.
Once a month an outside accountant posts clerk #2’s daily revenue summaries to the general ledger, prepares a monthly
trial balance and monthly financial statements, accounts for prenumbered service slips, files payroll forms and tax returns, and
reconciles the monthly bank statements to the general ledger. This accountant reports directly to the physician who is the man
aging partner.
All four clerical employees perform their tasks on PCs that are connected through a local area network. Each PC is acces
sible with a password that is known only to the individual employee and the managing partner. Southwest uses a standard soft
ware package that was acquired from a software company and that cannot be modified by Southwest’s employees. None of the
clerical employees have access to Southwest’s check writing abilities.
For each of the following conditions indicate whether it is a strength, weakness, or neither.
(checks) from patients
Condition
and records the cash
1. Southwest is involved only in medical services and has not receipt.
diversified its operations.
2. Insurance coverage for patients is verified and communicated to the
clerks by the office manager before medical services are rendered.
3. The physician who renders the medical services documents the services on a
prenumbered slip that is used for recording revenue and as a receipt for the
patient.
4. Cash collection is centralized in that Clerk #2 receives the cash
Strength Weakness Neither


Condition
5. Southwest extends credit rather than requiring cash or insurance in all cases.
6. The office manager extends credit on a casebycase basis rather than
using a formal credit search and established credit limits.
7. The office manager approves the extension of credit to patients and
also approves the writeoffs of uncollectible patient receivables.
8. Clerk #2 receives cash and checks and prepares the daily bank deposit.
9. Clerk #2 maintains the accounts receivable records and can add or
delete information on the PC.
10. Prenumbered service slips are accounted for on a monthly basis by
the outside accountant who is independent of the revenue
generating and revenue recording functions.
11. The bank reconciliation is prepared monthly by the outside accountant who is
independent of the revenue generating and revenue recording functions.
12. Computer passwords are only known to the individual employees and the
managing partner who has no duties in the revenue recording functions.
13. Computer software cannot be modified by Southwest’s employees.
14. None of the employees who perform duties in the revenue generating
and revenue recording are able to write checks.
Purchases and
Disbursements Authoritative
Literature Help
The following flowchart depicts part of a client’s purchases and cash disbursements cycle. Some of the flowchart symbols
are labeled to indicate operations, controls, and records. For each symbol numbered 1 through 12, select one response from the
answer lists below. Each response in the lists may be selected once or not at all.
Connectors, documents, departments, and files
Operations and controls
J. Accounts payable O. Purchase order No. 5
A. Approve receiving report
K. Canceled voucher P. Receiving report No. 1
B. Prepare and approve voucher
C. Prepare purchase order package Q. Stores
D. Prepare purchase requisition L. From purchasing R. To vendor
E. Prepare purchases journal M. From receiving S. Treasurer
F. Prepare receiving report N. From vouchers T. Unpaid voucher file,
G. Prepare sales journal payable filed by due date
H. Prepare voucher
I. Sign checks and cancel voucher package documents
RECEIV VOUCHERS 10
PURCHASING ING PAYABLE
From From From

Stores Purch. 4 5 Ven- From
dor Vouchers
Payable
Pur. Order 4
Requisition 1
Approved
Requisition
1 7 Invoice Voucher Package
6 Requisition 1
Pur. Order 5
Receive Rec. Report 1
Goods Invoice
1 Match with By Approved 1
Pur. Order File Pending Voucher
Name
Arrival of all
Documents
Requisition 1
Pur. Order 5
Pur. Order 4
3
Match
Pur. Order 3 Review
Pur. Order 2
Purchase 1
Order
To
Stores
By
Num-
ber
1.
2.
3.
4.
5.
6.
To
Receiv-
ing
To
Vouchers
Payable
7.
8.
9.
10.
11.
12.
Pur. Order 4
Rec. Report 4
Rec. Report 3
Rec. Report 2
Receiving 1
Report
To Vouchers
Payable
For Receipts and

Returns To
Stores
By
Num-
ber
Docu-
ments
Vouc
her 2
R
e
q
ui
si
ti
o
n 1
Pur.
Ord
er 5
R
e
c.
R
e
p
o
rt 1
In
voi
ce
A
pp
ro
ve
d 1
Vouche
r
General
Accoun
By
9 ing
To Trea- On Due
surer Date
Documents,
Prepare Check &
Remittance Advice
11
Check Copy
12 Remittance 2
Signed Check
Remittance 1
Advice
By
Num-
ber
To
Cancelled To General
Voucher Ven- Account-
dor
Package File ing
Research
Authoritative
Literature Help
Internal Control Limitations
In a discussion with the controller of Gemcon, the topic of limitations of internal control arose. Relatedly, the Professional
Standards acknowledge that internal control has certain limitations that affect financial statement audits. Search the
Professional Standards to find the location at which a number of limitations are discussed together.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
1. Which title of the Professional Standards addresses this issue?
2. Enter the exact section and paragraph numbers that describe the limitations.
Sales/Shipping
Process
Authoritative
Literature Help
You are working for Smith & Co. CPAs. The following partially completed flowchart depicts part of Welcore Inc., your
client’s revenue cycle. Some of the flowchart symbols are labeled to indicate controls and records. For each symbol numbered
1 though 13, select one response from all the answer lists below. Each response in the lists may be selected once or not at all.
WAREHOUSE
COMPUTER
&
PROCESSING
SHIPPING
DEPARTMENT
SALES DEPT. DEPARTMENT
From From
Custome Computer
r COMPUTERIZED SHIPPING Processing
COMPUTERIZED ORDER PROGRAM:
Cust. Dept.
PROGRAM:
Credit 2 Retrieve Open Orders;
1 and perform edit checks Add Shipping Data;
File
and prepare sales order Transfer to Shipping File; and
Prepare Shipping Documents
Sales Order
Customer
Purchase
3
Order
Sales Order To
Sales Order Warehouse Shipping Doc.
3 and Shipping
Sales Order Shipping
Dept. 2
Transmit 2 Document
Customer 1 1
Data to
Computer
Customer
Purchase
Order
Customer P.O.
Sales Order
Sales Order
2
1
To
Customer
4
Accounts
Rec. Shipping 6
Master File
File
COMPUTERIZED BILLING
Sales PROGRAM;
Inventory Retrieve Shipping Data;
Trans Enter Price Data;
Master 10 action 5
Prepare Sales
File File Transaction File; and
2
COMPUTERIZED UPDATE
8 1
PROGRAM;
Update master files;
Prepare G/L Transaction
Summary, Prepare Accounts To Transmit Shipping
Receivable Ledger, Prepare Information
Customer 9 to Computer
Aged T/B, and 11
Sales Order
Shipping Doc. 3
General Shipping
Ledger Accounts Document 2
Transaction 12 Receivable 13 1
Summary Ledger
To
Customer
To To To To with
Accounts
Accounting Accounting Receivable Customer Goods
Credit
1. 8.
2. 9.
3. 10.
4. 11.
5. 12.
6. 13.
7.
Operations and controls Documents, journals, ledgers, and files
A. Enter shipping data P. Shipping document
B. Verify agreement of sales order and shipping document Q. General ledger master file
C. Write off accounts receivable R. General journal
D. To warehouse and shipping department S. Master price file
E. Authorize account receivable writeoff T. Sales journal
F. Prepare aged trial balance U. Sales invoice
G. To sales department V. Cash receipts journal
H. Release goods for shipment W. Uncollectible accounts file
I. To accounts receivable department X. Shipping file
J. Enter price data Y. Aged trial balance
K. Determine that customer exists Z. Open order file
L. Match customer purchase order with sales order
M. Perform customer credit check
N. Prepare sales journal
O. Prepare sales invoice
Research
Authoritative
Literature Help
Internal Control Reporting
The president of Welcore Inc., a nonpublic audit client of your firm, has indicated to you that he believes that
he may “take the company public in a year or two.” He asked you whether, in addition to your report on the
financial staments, your firm can issue a report on internal control that he could make available to any individual or
organization he so desired. He indicated that he would like to have two reports—as do public companies—one on
the financial statements and one on the company’s internal control.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
helpful in responding to him?
2. Enter the exact section number that provides the appropriate guidance.
Purchasing Receiving,
and Accounts Payable Authoritative
Literature Help
The following flowchart depicts the activities relating to the purchasing, receiving, and accounts payable
departments of Model Company, Inc. Assume that you are a supervising assistant assigned to the Model
Company audit.
PURCHASIN RECEIVIN
G G ACCOUNTS PAYABLE
From From
Fro
Dept. From From m Vendor
Head Purchasing Purchasing Receiving
4
Purchase Order
1 2
with Quantity Requisition Rec. Report
Approved P.O.3 Invoice
BlackedOut
Requisition
Form in
Duplicate
Goods Rec'd
Matches 4
Assures Best & Counted By Vendor Doc
Price is Independently Pending &
Recomputes
Obtained & in Secure Invoice
Receipt Math
Request is Facility Accuracy
of
within Budget Invoices
Limits
Prepares Approves & Compares Invoice

Verifies Adequacy
Prepares 3 Quantity
4Copy Copy &
of Vendor's Past
Price to
Receiving Voucher P.O.
Record &
& Rec.
Prepares 5 Report (Prenumbered) Report
Copy Purchase Quantity
Order
Rec.
4
6 Report
2
Requisition 4 Rec. Report
P.O. 5 P.O. Vo 3 1
uch
er Vouche Requisition
3
P. Rec. Report r
2
O. P.O.
2
P.O.3 Rec. Report Invoice
1
Requisition Receiving
1
Report
Vou
cher
2 1
P.O. (Prenumbered) To
Purchase Order1 Purchasing
(Prenumbered) By P.O.# To
Recorded in Voucher
General
Register &
Acctg. Independently
To Reconciled Monthly
Accounts to Control Accounts
Payable
To
Vendor
To Dept. By P.O.#
To To Head for
Accounts Count & By
Receiving Quality
Payable Dept. Check
Voucher#
To
Dept.
Head
Joe Werell, a beginning assistant, analyzed the flowchart and has supplemented the flowchart by making certain inquiries
of the controller. He has concluded that the internal control over purchasing, receiving, and accounts payable is strong and has
provided the following list of what he refers to as internal control strengths. Review his list and for each internal control
strength indicate whether you agree or disagree that each represents a strength.
I
nP
r
P
1. T
h
2. P
r
3. P
4. P
u
5. T
6. S
7. R
e
8. A
9. T
h
10. R
A
g
13. A
l
14. A
l
15. T
Research
Authoritative
Literature Help
Internal Control Communications
On the Adams audit your firm discovered certain immaterial audit judgments that the client’s management chose
not to record. Management has now asked you not to communicate anything regarding these omitted entries to the audit
committee—after all, they are immaterial.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
2. Enter the exact section number and paragraphs that address communication
of these uncorrected misstatements to the audit committee.
Internal Control Related
Matters Communication Authoritative
Literature Help
You have been asked to the audit partner to draft a letter to the client on internal control related matters. You were
informed that the written communication regarding significant deficiencies and material weaknesses indentified during an
audit of financial statements should include certain statements.
For each of the significant deficiencies and material weaknesses reflected in the table below, doubleclick on each of
the associated shaded cells and select from the list provided the appropriate disposition of each statement in regard to the
letter to the client on internal control related matters. Each selection may be used once, more than once, or not at all.
Selection List
• Included
• Excluded
• Included, but only with client management’s approval
• Communicated orally with no need to document the communication
Internal controls Related matters
State that the purpose of the audit was to express an
opinion on the financial statements, and to express an
opinion on the effectiveness of the entity’s internal
control over financial reporting.
Identify, if applicable, items that are considered to be
material weaknesses.
State that the author is not expressing an opinion on the
effectiveness of internal control.
Include the definition of the term significant deficiency.
Include the definition of the term material weakness,
where relevant.
State that the author is expressing an unqualified opinion
on the effectiveness of internal control.
State that the communication is intended solely for
management and external parties.
Identify the matters that are considered to be significant
deficiencies.
Research
Authoritative
Literature Help
Integrated audits
Assume that you are assigned to the audit of Regis Corporation, an issuer company. Your firm is performing its first
integrated audit for the company, and the partner on the engagement has asked you to research professional standards to
identify the controls that address the risk of fraud.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
1. a __ __ 35. d __ __ 69. c __ __ 103. c __ __ 137. d __ __

2. d __ __ 36. a __ __ 70. a __ __ 104. c __ __ 138. b __ __
3. b __ __ 37. b __ __ 71. d __ __ 105. c __ __ 139. b __ __
4. b __ __ 38. d __ __ 72. a __ __ 106. c __ __ 140. b __ __
5. c __ __ 39. c __ __ 73. a __ __ 107. b __ __ 141. b __ __
6. b __ __ 40. a __ __ 74. c __ __ 108. b __ __ 142. b __ __
7. d __ __ 41. c __ __ 75. b __ __ 109. a __ __ 143. b __ __
8. a __ __ 42. a __ __ 76. a __ __ 110. a __ __ 144. b __ __
9. d __ __ 43. b __ __ 77. a __ __ 111. c __ __ 145. a __ __
10. a __ __ 44. a __ __ 78. c __ __ 112. c __ __ 146. a __ __
11. d __ __ 45. c __ __ 79. d __ __ 113. a __ __ 147. d __ __
12. b __ __ 46. d __ __ 80. b __ __ 114. c __ __ 148. a __ __
13. a __ __ 47. a __ __ 81. a __ __ 115. a __ __ 149. c __ __
14. a __ __ 48. d __ __ 82. a __ __ 116. c __ __ 150. d __ __
15. b __ __ 49. d __ __ 83. d __ __ 117. c __ __ 151. b __ __
16. b __ __ 50. d __ __ 84. c __ __ 118. a __ __ 152. b __ __
17. b __ __ 51. a __ __ 85. d __ __ 119. d __ __ 153. a __ __
18. a __ __ 52. d __ __ 86. b __ __ 120. d __ __ 154. d __ __
19. a __ __ 53. d __ __ 87. c __ __ 121. a __ __ 155. d __ __
20. d __ __ 54. b __ __ 88. b __ __ 122. a __ __ 156. c __ __
21. b __ __ 55. c __ __ 89. b __ __ 123. b __ __ 157. d __ __
22. b __ __ 56. a __ __ 90. d __ __ 124. d __ __ 158. b __ __
23. c __ __ 57. a __ __ 91. b __ __ 125. d __ __ 159. d __ __
24. d __ __ 58. a __ __ 92. d __ __ 126. d __ __ 160. a __ __
25. d __ __ 59. c __ __ 93. b __ __ 127. d __ __ 161. d __ __
26. d __ __ 60. a __ __ 94. b __ __ 128. b __ __ 162. a __ __
27. c __ __ 61. a __ __ 95. d __ __ 129. a __ __ 163. a __ __
28. d __ __ 62. b __ __ 96. d __ __ 130. c __ __ 164. a __ __
29. d __ __ 63. c __ __ 97. b __ __ 131. d __ __ 165. a __ __
30. a __ __ 64. a __ __ 98. b __ __ 132. c __ __ 166. d __ __
31. c __ __ 65. b __ __ 99. d __ __ 133. c __ __
32. d __ __ 66. b __ __ 100. c __ __ 134. c __ __
33. d __ __ 67. c __ __ 101. d __ __ 135. d __ __ 1st: __/166= __%
34. a __ __ 68. c __ __ 102. d __ __ 136. c __ __ 2nd: __/166= __%
because ongoing monitoring involves assessing the design
A.1. Definition of Internal Control and operation of controls on a timely basis and taking
1. (a) The requirement is to identify the reply that most likely necessary corrective actions and such an approach may be
followed in reviewing the purchasing function. Answer (a)
would not be considered an inherent limitation of the
is incorrect because periodic audits are not ordinarily per
potential effectiveness of an entity’s internal control. An
formed by the audit committee, a subcommittee of the
swer (a) is correct because incompatible duties may gener Board of Directors. Answer (c) is incorrect because the
ally be divided among individuals in such a manner as to audit of the annual financial statements is not ordinarily
control the problem. Answers (b), (c), and (d) are all incor considered monitoring as presented in the professional
rect because management override, mistakes of judgment, standards. Answer (d) is incorrect because the meaning of
and collusion among employees are all inherent limitations the reply, control risk assessment in conjunction with
of internal control. quarterly reviews, is uncertain.
2. (d) The requirement is to identify the meaning of the 5. (c) The requirement is to identify where the
concept of reasonable assurance. Answer (d) is correct be overall attitude and awareness of an entity’s board
cause reasonable assurance recognizes that the cost of inter of directors concerning the importance of internal
nal control should not exceed the benefits expected to be control is normally reflected. Answer (c) is
derived. correct because the control environment reflects
3. (b) The requirement is to identify the functions the overall attitude, awareness, and actions of the
that should be segregated for effective internal board of directors, management, owners, and
control. Answer (b) is correct because others concerning the importance of control and
authorizing transactions, recording transactions, its emphasis in the entity.
and maintaining custody of assets should be 6. (b) The requirement is to identify the
segregated. circumstance in which management philosophy
A.2. Major Components of Internal Control and operating style would have a significant
influence on an entity’s control environment.
4. (b) The requirement is to identify the most likelytype Answer (b) is correct because management
of ongoing monitoring activity. Answer (b) is correct philosophy and operating style, while always
important, is particu
have been implemented. Answer (a) is
incorrect because reperforming the activities
larly so when management is dominated by one or a is a test of control to help assess the
few individuals because it may impact numerous operating effectiveness of a control. Answer
other factors. Answer (a) is incorrect because the (b) is incorrect because analytical procedures
impact of the internal auditor reporting directly to are not performed to determine whether
management is likely to be less than that of answer controls are suitably designed. Answer (c) is
(a). Answer (c) is incorrect because while accurate incorrect because vouching a sample of
management job descriptions are desirable, they do transactions is a substantive test not directly
not have as significant of an effect on management aimed at determining whether controls are
philosophy and operating style as does domination by suitably designed. See SAS 109 for a
an individual. Answer (d) is incorrect because an discussion of an auditor’s responsibility for
active audit committee might temper rather than lead determining whether controls have been
to a more significant influence of management implemented vs. their operating
philosophy and operating style. effectiveness.
7. (d) The requirement is to determine which of the
factors listed are included in an entity’s control
environment. Answer (d) is correct because the audit
committee, integrity and ethical values, and
organization structure are all included.
8. (a) The requirement is to identify the reply
that is not a component of an entity’s
internal control. Answer (a)is correct
because while auditors assess control risk as
a part of their consideration of internal
control, it is not a component of an entity’s
internal control. Answers (b), (c), and (d) are
incorrect because the control environment,
risk assessment, control activities,
information and communication, and
monitoring are the five components of an
entity’s internal control (SAS 109).
A.3. Related Topics
9. (d) The Foreign Corrupt Practices Act makes pay
ment of bribes to foreign officials illegal and requires
publicly held companies to maintain systems of
internal control sufficient to provide reasonable
assurances that internal control objectives are met.
B.1. Obtain Understanding of the Client and Its
Internal Control
10. (a) The requirement is to determine the most
likely population from which an auditor would
sample when vendors’ invoices and related
vouchers relating to purchases made by
employees have been destroyed. Answer (a) is
correct because the disbursement will be
recorded and the auditor may thus sample from
that population. Answers (b) and (d) are
incorrect because the related vouchers and ven
dors’ invoices are destroyed. Answer (c) is
incorrect because there is no recording of the
receipt of the merchandise.
procedure an auditor would perform to
provide evidence about whether an entity’s
internal control activities are suitably
designed to prevent or detect material
misstatements. Answer (d) is correct because
SAS 109 indicates an auditor will observe
the entity’s personnel applying the
procedures to determine whether controls
whether the client has placed those controls in
• (b) The requirement is to identify the correct state operation. Answers (b) and (c) are incorrect
ment relating to the relevance of various types of because auditors may choose not to obtain
controls to a financial statement audit. Answer (b) is information on operating effectiveness of
correct because, generally, controls that are relevant to controls and their consistency of application.
an audit pertain to the entity’s objective of preparing Answer (d) is incorrect because there is no
financial statements for external purposes. Answer (a) such explicit requirement relating to controls;
is incorrect because SAS 109 makes clear that an see SAS 109 for the necessary understanding of
auditor may not ignore consideration of controls under internal control.
any audit approach. Answer (c) is incorrect because
control over financial reporting are of primary im • (b) SAS 109 states that the auditor should
portance. Answer (d) is incorrect because many obtain sufficient knowledge of the
operational and compliance related controls are not information (including accounting) system
ordinarily relevant to an audit. to understand the financial reporting process
used to prepare the entity’s financial
• (a) The requirement is to identify the statement statements, including significant accounting
that represents a requirement when an audit estimates and disclosures. It also states that
of financial statements in accordance with this knowledge is obtained to help the
generally accepted accounting principles is auditor to understand (1) the entity’s classes
performed. Answer (a) is correct because of transactions, (2) how transactions are
SAS 109 requires that the auditor document initiated, (3) the accounting records and
the understanding of the entity’s internal support, and (4) the accounting processing
control. Answer (b) is incorrect because involved from initiation of a transaction to
while an auditor might find significant its inclusion in the financial statements.
deficiencies in the operation of internal
control, no such search is re • (b) The requirement is to determine why an
quired. Answer (c) is incorrect because an auditor auditor should concentrate on the substance of
might use a substantive approach in performing an procedures rather than their form when
audit and thereby perform few (if any) tests of obtaining an understanding of an entity’s
controls. Answer (d) is incorrect because while controls. Answer (b) is correct because
auditors must obtain knowledge of internal control management may establish appropriate
sufficiently to identify types of potential mis controls but not act on them, thus creating a
statements, they are not required to obtain the detailed situation in which the form differs from the
knowledge of internal control suggested by this reply. substance. Answer (a) is incorrect because
documentation is not directly related to the
• (a) The requirement is to identify the knowledge
issue of substance over form. Answer (c) is
that an auditor must obtain when obtaining an
incorrect because inappropriate controls is
understanding of an entity’s internal control
only a part of an auditor concern; for example,
sufficient for audit planning. Answer (a) is
a control may be appropriate, but it may not be
correct because an auditor must obtain an un
operating effectively. Answer (d) is incorrect
derstanding that includes knowledge about the
because while an auditor might suggest
design of relevant controls and records and
client’s internal control. An auditor may
document his/her understanding of the
to management that the cost of certain controls structure and his/her conclusions about the
seems to exceed their likely benefit, this is not the design of that structure in the form of
primary reason auditors are concerned with the answers to a questionnaire, narrative
substance of controls. memorandums, flowcharts, decision tables,
or any other form that the auditor considers
17. (b) Decision tables include various appropriate in the circumstances. Answers
combinations of conditions that are matched to (a) and (b) are, thus, incorrect because they
one of several actions. In an internal control suggest restrictions which do not exist in
setting, the various important controls are practice. Answer (c) is incorrect since at a
reviewed and, based on the combination of minimum a list of reasons for nonreliance
answers received, an action such as a decision must be provided.
on whether to perform tests of controls is
determined. Program flowcharts simply 21. (b) In obtaining an understanding of internal
summarize the steps involved in a program. control, the auditor should perform
Answer (a) is incorrect because decision tables procedures to provide sufficient knowledge
do not emphasize the ease of manageability for of the design of the relevant controls and
complex programs. Answer (c) is incorrect whether they have been implemented.
because while decision tables may be designed Information on
using various cost benefit factors relating to the
various conditions and actions, they do not
justify the program. Answer (d) is incorrect
because program flowcharts, not decision
tables, emphasize the sequence in which
operations are performed.
18. (a) The requirement is to identify the procedure that is
not required to be included in an auditor’s
consideration of internal control. Answer (a) is correct
because the auditor need not obtain evidence relating
to operating effectiveness when control risk is to be
assessed at the maximum level. Answer (b) is incorrect
because an auditor must obtain an understanding of the
internal control environment and the information
system. Answers (c) and (d) are incorrect because an
auditor is obligated to obtain information on the design
of internal control and on whether control activities
have been implemented.
19. (a) The requirement is to identify the primary
objective of procedures performed to obtain
an understanding of internal control. Answer
(a) is correct because the auditor obtains a
sufficient understanding of internal control to
assess the risks of material misstatement and
to design the nature, timing, and extent of
further audit procedures. Answer (b)
addresses inherent risk, the susceptibility of
an assertion to material misstatement,
assuming that there are no related controls.
Answer (b) is incorrect since the concept of
inherent risk assumes no internal control and
is therefore not the primary objective.
Answer (c) is incorrect because answer (a) is
more complete and because decisions on
modifying tests of controls are often made at
a later point in the audit. Answer (d) is
incorrect because the consistency of
application of management’s policies relates
more directly to tests of controls than to
obtaining an understanding of internal
control.
20. (d) The requirement is to determine the
correct statement with respect to the
auditor’s required documentation of the
(1) identifying specific controls relevant to specific
operating effectiveness need not be obtained unless assertions that are likely to prevent or detect
control risk is to be assessed at a level below the material misstatements in those assertions, and (2)
maximum. performing tests of controls to evaluate the
effectiveness of such controls.
B.2. Assess the Risk of Material Answer (a) is incorrect because assessing control risk
Misstatement and Design Further Audit at a low level may lead to less extensive, not more
Procedures extensive substantive tests. Answer (b) is incorrect
because the actual level of inherent risk is not
22. (b) Answer (b) is correct because tests of affected by the level of control risk. Also, one would
controls are only required when the auditor not expect a change in the assessed level of control
relies on the controls or substantive tests risk to result in a change in the assessed level of
alone are not sufficient to audit particular inherent risk. Answer (c) is incorrect because as
assertions. Answers (a), (c), and (d) are sessing control risk at a low level may lead to interim
incorrect because these procedures are date substantive testing rather than yearend testing.
required on every audit.
26. (d) The requirement is to determine why an
23. (c) The requirement is to identify the terms in which auditor assesses control risk. Answer (d) is
control risk should be assessed. Answer (c) is correct correct because the assessed levels of
because SAS 109 requires that control risk be control risk and inherent risk are used to
assessed in terms of financial statement assertions. determine the acceptable level of detection
risk for financial statement assertions.
24. (d) The requirement is to identify a situation
in which an auditor may desire to seek a 27. (c) Increases in the assessed level of the risk
further reduction in the assessed level of of material misstatement lead to decreases in
control risk. Answer (d) is correct because the acceptable level of detection risk.
such a reduction is only possible when Accordingly, the auditor will need to
additional evidence, evaluated by increase the extent of substantive tests such
performing additional tests of controls, is as tests of details. Answer (a) is incorrect
available. Answer (a) is incorrect because because tests of controls are performed to
auditors at this point will ordinarily already reduce the assessed level of control risk only
have obtained the understanding of the when controls are believed to be effective.
information system to plan the audit. Answer (b) is incorrect because the level of
Furthermore, an understanding of internal detection risk must be decreased, not
control is needed on all audits. Answer (b) is increased. Answer (d) is incorrect because
incorrect because auditors must determine the level of inherent risk pertains to the
that controls have been implemented in all susceptibility of an account to material
audits. Answer (c) is incorrect because a misstatement independent of related
significant number of controls always controls.
pertain to financial statement assertions.
28. (d) The requirement is to determine the
25. (d) Assessing control risk at a low level primary purpose for which an auditor uses
involves the knowledge provided by the understanding
of internal control and the assessed
control risk is assessed at the maximum level. Answer
(b) is incorrect because analytical procedures are not
level of the risk of material misstatement. Answer (d) designed to verify the design of internal control.
is correct because the auditor uses such knowledge in Answer (d) is incorrect because dualpurpose tests
determining the nature, timing, and extent of (i.e., those that serve as both substantive tests and tests
substantive tests for financial statement assertions. of controls) are not required to be performed, and
Answer (a) is incorrect because it is incomplete. For because the term “preliminary control risk” is unclear.
example, while auditors are concerned with the
safeguarding of assets, they also need to determine
whether the financial statement information is
accurate. Answer (b) is incorrect for reasons similar
to (a) in that determining whether opportunities are
available for committing and concealing fraud is
incomplete since this knowledge is also used to
ascertain whether the chance of errors is minimized.
Answer (c) is incorrect because knowledge provided
by the understanding of internal control and the
assessed level of control risk is not used to modify
initial assessments of inherent risk and preliminary
judgments about materiality levels. This knowledge is
unrelated to those processes.
29. (d) The requirement is to identify a way that anauditor
may compensate for a weakness in internal control.
Answer (d) is correct because increasing analytical
procedures decreases detection risk in a manner
which may counterbalance the condition in internal
control. In effect, the weakness in internal control is
compensated for by increased substantive testing. See
the outline of SAS 107 for the relationships among
audit risk and its component risks— inherent risk,
control risk, and detection risk. Answer (a) is incorrect
because increasing both control risk (through a
weakness in internal control) and detection risk
increases audit risks. In addition, control risk and
detection risk do not compensate for one another.
Answer (b) is incorrect because increasing the extent
of tests of controls is unlikely to be effective since the
condition is known to exist. Answer (c) is incorrect
because it is not generally appropriate to increase the
judgment as to audit risk based on the results obtained.
30. (a) The requirement is to identify the correct statement
concerning an auditor’s assessment of control risk.
Answer (a) is correct because SAS 109 indicates that
assessing control risk may be performed concurrently
during an audit with obtaining an understanding of
internal control. Answer (b) is incorrect because
evidence about the operation of internal control
obtained in prior audits may be considered during the
current year’s assessment of control risk. Answer (c) is
incorrect because the basis for an auditor’s conclusions
about the assessed level of control risk needs to be
documented when control risk is assessed at
levels other than the maximum level. Answer (d) is
incorrect because a lower level of control risk
requires more assurance that the control procedures
are operating effectively.
31. (c) The requirement is to determine the
correctstatement concerning the assessed level of
control risk. Answer (c) is correct because ordinarily
the assessed level of control risk cannot be
sufficiently low to eliminate the need to perform any
substantive tests to restrict detection risk for
significant transaction classes. Answer (a) is incorrect
because tests of controls are unnecessary when
duties) an auditor should use the
B.3. Perform Further Audit Procedures—Tests of observation and inquiry techniques.
Controls
35. (d) The requirement is to identify the objective of tests
32. (d) The requirement is to identify how of details of transactions performed as tests of
frequently controls that the auditor wishes to controls. Answer (d) is correct because the purpose of
rely upon must be tested. Answer (d) is tests of controls is to evaluate whether internal control
correct because the professional standards operates effectively. Answer (a) is incorrect because
require auditors to test controls at least every while monitoring the design and use of entity
third year. Answer (a) is incorrect because documents may be viewed as a test of controls, it is
controls need not be tested monthly. Answer not the objective. Answer (b) is incorrect because
(b) is incorrect because ordinarily controls determining whether internal control is implemented is
need not be tested with each audit. Answer not directly related to tests of controls; see SAS 109
(c) is incorrect because auditors may test for the distinction between “implemented” and
such controls every third year, not every “operating effectiveness.” Answer (c) is incorrect
second year. because substantive tests, not tests of controls, are
focused on detection of material misstatements in the
33. (d) The requirement is to identify the type of account balances of the financial statements.
audit test most likely to provide assurance
that controls are in use and operating 36. (a) The requirement is to identify a
effectively. Answer (d) is correct because circumstance in which an auditor may
inspection of documents is a form of a test of decide to perform tests of controls. Answer
controls, and such tests are used to obtain (a) is correct because tests of controls will
reasonable assurance that controls are in use be performed when they are expected to
and operating effectively. Answer (a) is in result in a cost effective reduction in planned
correct because auditors prepare flowcharts substantive tests. Answer (b) is incorrect
to document a company’s internal control, because tests of controls are only performed
not to obtain assurance that controls are in when they are likely to support a further
use and operating effectively. Answer (b) is reduction in the assessed level of the risk of
incorrect because substantive tests relate to material misstatement. Answer (c) is
the accuracy of accounts and assertions incorrect because tests of controls are
rather than testing controls directly. Answer designed to decrease the assessed level of
(c) is incorrect because analyzing tests of the risk of material misstatement, not
trends and ratios is an analytical procedure increase it. Answer (d) is incorrect because
that does not directly test controls. internal control weaknesses normally result
in more substantive testing and less tests of
34. (a) The requirement is to identify the controls.
appropriate procedures for testing the
segregation of duties related to inventory. 37. (b) The requirement is to identify the most
Answer (a) is correct because SAS 109 appropriate procedures for assessing control
suggests that when no audit trail exists (as risk. Auditors perform tests of controls to
is often the case for the segregation of obtain evidence on the operating effec
operating effectively. Answer (c) is correct
because confirmation of accounts receivable
tiveness of controls to assess control risk. Answer (b) is a substantive test, not a test of a control.
is correct because tests of controls include inquiries of Answer (a) is incorrect because records
appropriate entity personnel, inspection of documents documenting the usage of computer
and reports, observation of the application of the programs may be tested to determine
policy or procedure, and reperformance of the whether access is appropriately controlled.
application of the policy or procedure. Answer (b) is incorrect because examining
38. (d) The requirement is to identify the type of evidence canceled supporting documents may help
an auditor most likely would examine to determine the auditor to determine that the structure
whether controls are operating as designed. Answer (d) will not allow duplicate billing to result in
is correct because inspection of client records multiple payments. Answer (d) is incorrect
documenting the use of computer programs will because proper signatures will help the
provide evidence to help the auditor evaluate the auditor to determine whether the
effectiveness of the design and operation of internal authorization controls are functioning
control; the client’s control over use of its computer adequately.
programs in this case is documentation of the use of
the programs. In order to test this control, the auditor
will inspect the documentation records. See SAS 110
for information on the nature of tests of controls.
Answer (a) is incorrect because the confirmation
process is most frequently considered a substantive
test, not a test of a control. Answer (b) is incorrect
because letters of representations provide
corroborating information on various management rep
resentations obtained throughout the audit and
therefore only provides limited evidence on internal
control. Answer (c) is incorrect because attorneys’
responses to auditor inquiries most frequently pertain
to litigation, claims, and assessments.
procedure that is not a step in an auditor’s
assessment of control risk. Answer (c) is
correct because performing tests of details of
transactions to detect material misstatements
pertains more directly to detection risk rather
than inherent or control risk. Answer (a) is
incorrect because auditors evaluate the effec
tiveness of internal control with tests of
controls. An
swer (b) is incorrect because obtaining an
understanding of the entity’s information system and
control environment is a preliminary step for
considering control risk. Answer (d) is incorrect
because auditors will consider the effect of internal
control on the various financial statement assertions.
40. (a) The requirement is to identify an
approach that auditors use to obtain audit
evidence about control risk. Answer (a) is
correct because auditors test controls to pro
vide evidence for their assessment of control
risk through inquiries of appropriate
personnel, inspection of documents and
records, observation of the application of
controls, and reperformance of the
application of the policy or procedure.
Answers (b), (c), and (d) are incorrect
because analytical procedures, calculation,
and confirmation relate more directly to
substantive testing and are not primary
methods to test controls for purposes of
assessing control risk.
41. (c) The requirement is to identify the least
likely type of evidence the auditor will
examine to determine whether controls are
its internal control assessment. Answer (a) is
42. (a) The requirement is to identify the accounts re correct as the COSO internal control
ceivable auditing procedure that an auditor would most framework is by far the most frequently used
likely perform to obtain support for an assessed level one. Answer (b) is incorrect because while a
of control risk below the maximum. Since an auditor COSO enterprise risk management framework
uses the results of tests of controls to support an does exist, it is not ordinarily used by
assessed level of control risk below the maximum, we management in its internal control assessment.
are attempting to identify a test of a control. Answer Answers (c) and (d) are incorrect because
(a) is correct because observing an entity’s employee there is no such thing as a “FASB 37 internal
prepare the schedule of past due accounts receivable is control definitional framework” or an “AICPA
a test of a control to evaluate the effectiveness the internal control analysis manager.”
process of preparing an accurate schedule of past due
accounts; if the process is found to be effective it may C.2. Management’s Assessment
lead to a reduction in the assessed level of control risk.
Answer (b) is incorrect because the confirmation of 45. (c) The requirement is to identify the correct
accounts receivable is a substantive test, not a test of a statement concerning the level of assistance
control. Answer (c) is incorrect because the inspection that auditors may provide in assisting
of accounts receivable for unusual balances and management with its assessment of internal
comparing uncollectible accounts expense to actual control. Answer (c) is correct since only
accounts expense is ordinarily an analytical procedure limited assistance may be provided so as
performed as a substantive test. Answer (d) is not to create a situation in which the
incorrect because comparing uncollectible accounts auditors are auditing their own work.
expense to actual uncollectible accounts is ordinarily a Answer (a) is incorrect since some
substantive test. assistance may be provided. Answer (b) is
incorrect because there are limitations on
C.1. Management’s Responsibility the level of assistance. Answer (d) is
incorrect because the tie between risk and
43. (b) The requirement is to identify the type of assistance seems inappropriate and in the
companies to which the internal control provisions of wrong direction; also, this type of tradeoff
the SarbanesOxley Act of 2002 apply. Answer (b) is between risk and assistance is not included
correct because the provisions apply to public in PCAOB Standard 5.
companies that are registered with the Securities and
Exchange Commission. Answer (a) is incorrect 46. (d) The requirement is to identify which of
because nonissuer companies are not directly affected the following need not be included in
by the control provisions. Answer (c) is incorrect; management’s report on internal control
there is no $100,000,000 requirement. Answer (d) is under Section 404a of the SarbanesOxley
incorrect because nonissuer companies are not directly Act of 2002. Answer (d) is correct because,
affected by the internal control provisions of the Act. while the report must indicate that it is
management’s responsibility to establish
44. (a) The requirement is to identify the most and maintain adequate internal control, it
likely framework to be used by management in need not
prevents errors or fraud from occurring. Answer (c) is
incorrect because the term “adjustive” control is not
also indicate that such control has no significant ordinarily used. Answer (d) is incorrect because
deficiencies. Answers (a), (b), and (c) are all incorrect “nonroutine” is ordinarily considered a type of
because they include information that must be transaction (e.g., the yearend close process), not a
contained in management’s report. type of control.
C.3. Control Definitions 52. (d) The requirement is to identify the type
of transaction that establishing loan loss
47. (a) Answer (a) is correct because all material
reserves is. Answer (d) is correct because
weaknesses are control deficiencies. Answer estimation transactions are activities
(b) is incorrect because a significant involving management’s judgments or
deficiency may or may not be a material assumptions, such as determining the
weakness. Answer (c) is incorrect because allowance for doubtful accounts,
not all control deficiencies are material
weaknesses. Answer (d) is incorrect because
only significant deficiencies and material
weaknesses must be communicated.
48. (d) The requirement is to identify the term
that is defined as a weakness in internal
control that is less severe than a material
weakness but important enough to warrant
attention by those responsible for oversight
of the financial reporting function. Answer
(d) is correct because this is the definition of
a significant deficiency. Answer (a) is incor
rect because a control deficiency exists
when the design or operation of a control
does not allow management, or employees,
in the normal course of performing their
functions to prevent or detect misstatements
on a timely basis. Answer (b) is incorrect
because an unusual weakness is not used in
the standards for integrated audits. Answer
(c) is incorrect because the term unusual
deficiency is not used in the standards for
integrated audits.
amount involved with a material weakness.
Answer (d) is correct because a material
amount is involved. Answers (a), (b), and
(c) are all incorrect because they suggest smaller
amounts.
50. (d) The requirement is to identify the minimum
likelihood of loss involved in the consideration of a
control deficiency. Answer (d) is correct because a
control deficiency is a condition in which the
operation of a control does not allow management, or
employees, in the normal course of performing their
functions to prevent or detect misstatements on a
timely basis—it does not explicitly consider likelihood
of loss. Answer (a) is incorrect because the minimum
likelihood of loss is not considered. Answer (b) is
incorrect because the control deficiency occurrence of
loss need not be more than remote. Answer (c) is
incorrect because whether the minimum likelihood of
loss is probable is not considered.
C.4. Evaluating Internal Control
51. (a) The requirement is to identify the type of control
that reconciliation of cash accounts represents. Answer
(a) is correct in that it is a compensating control which
supplements a basic underlying control, in this case
basic information processing controls related to cash.
Answer (b) is incorrect because a preventive control
appropriate date on which to evaluate inter
establishing warranty reserves, and assessing assets nal control. Answer (d) is incorrect because
for impairment. Answer (a) is incorrect because the the “as of date” is a particular date, not an
term substantive transaction is not used in PCAOB average.
standards. Answer (b) is incorrect because routine
transactions are those for recurring activities, such as 55. (c) The requirement is to identify the correct state
sales, purchases, cash receipts and disbursements, and ment concerning a company that makes purchases
payroll. Answer (c) is incorrect because nonroutine both through the Internet and by telephone. Answer (c)
transactions occur only periodically, such as the taking is correct because both types of purchases are a part of
of physical inventory, calculating depreciation the purchases process and represent major classes of
expense, or adjusting for foreign currencies; non transactions, as per PCAOB Standard 5. Answer (a) is
routine transactions generally are not a part of the incorrect because the purchase types themselves are
routine flow of transactions. not control objectives for internal control (control
objectives address issues such as the completeness of
C.5. The Audit of Internal Control the recording of sales). Answer (b) is incorrect
53. (d) The requirement is to identify the because purchases are not assertions. Answer (d) is
incorrect because purchase transactions may or may
procedure that involves tracing a transaction
not be investigated in extreme detail.
from origination through the company’s
information systems until it is reflected in the 56. (a) The requirement is to identify the circum
company’s financial report. Answer (d) is stance(s) in which walkthroughs provide the
correct because this is the approach followed auditor with primary evidence. A walk
in a walkthrough. Answer (a) is incorrect through involves literally tracing a
because analytical analysis is a general term transaction from its origination through the
that simply suggests a general analysis. company’s information systems until it is
Answer (b) is incorrect because a substantive reflected in the financial reports. Answer (a)
procedure addresses the correctness of a is correct because a walkthrough provides
particular financial statement amount or evidence to (1) confirm the auditor’s
disclosure. Answer (c) is incorrect because a understanding of the flow of transactions and
test of a control addresses the operating the design of controls, (2) evaluate the
effectiveness of a control. effectiveness of the design of controls, and
(3) to confirm whether controls have been
54. (b) The requirement is to identify the “as of placed in operation. Answer (b) is incorrect
date” for purposes of an audit of internal because walkthroughs provide the auditors
control performed under PCAOB standards. with primary evidence to confirm whether
Answer (b) is correct because the “as of controls have been placed in operation.
date” is the last day of the fiscal period; it is Answer (c) is incorrect because walk
this date on which the auditor concludes as throughs provide primary evidence to
to the effectiveness of internal control. evaluate the effectiveness of design in
Answers (a) and (c) are incorrect because internal control. Answer (d) is incorrect both
neither the first day of the year nor the last because walkthroughs provide primary evi
day of the auditor’s fieldwork is the dence to (1) evaluate the effectiveness of the
design of con
material weakness exists. Answer (d) is incorrect
because explanatory language added to an unqualified
trols and (2) confirm whether the controls have been report is not appropriate when a material weakness
placed in operation. exists.
57. (a) The requirement is to identify the most likely 61. (a) The requirement is to identify the
question to be asked of employee personnel during a deficiency that is most likely to be
walkthrough. Answer (a) is correct because a question considered a material weakness in internal
on whether an employee has ever been asked to control for purposes of an internal control
override the process is included in the example audit of a public company. Answer (a) is
questions to be asked by the auditor. Answer (b) is correct because ineffective oversight of
incorrect because auditors do not in general ask financial reporting by the audit committee is
whether the employee believes he or she is underpaid. among the list of circumstances that PCAOB
Answer (c) is incorrect because a direct question on Standard 5 suggests are strong indicators of
fraudulent transactions like this, while possible, the existence of a material weakness.
ordinarily is not suggested. Answer (d) is incorrect Restatement of previously issued financial
because the auditor will not usually ask who trained statements as a result of a change in
the person. Note that all four questions might be asked, accounting principles is
but only one is among those recommended in Standard
5.
58. (a) The requirement is to identify how large
the actual loss identified must be for a
control deficiency to possibly be considered
a material weakness. Answer (a) is correct
because a material weakness is determined
by whether there is more than a remote
likelihood of a material loss occurring due
to the control deficiency; the actual loss
identified need not be material. Answer (b)
is incorrect because it suggests that a
material amount identified will not be con
sidered a material weakness. Answer (c) is
incorrect because it states that when the
identified amount is immaterial it is never a
material weakness. Answer (d) is incorrect
because it suggests that when an immaterial
or material actual loss is discovered, the
situation would not be assessed as a possible
material weakness.
circumstance that makes an account
significant for purposes of a PCAOB audit of
internal control. Answer (c) is correct
because Standard 5 requires only more than a
remote likelihood of material misstatement.
Answer (a) is incorrect because the standard
requires only a remote likelihood and
because it is limited to material
misstatements. Answer (b) is incorrect
because the standard requires more than a
remote likelihood, not more than a
reasonably possible likelihood. Answer (d) is
incorrect because material misstatements are
involved, not misstatements that are more
than inconsequential.
60. (a) The requirement is to identify the appropriate
report when a control deficiency that is more than a
significant deficiency is identified. Answer (a) is
correct because a control deficiency that is more than a
significant deficiency is a material weakness, and
because a material weakness leads to an adverse
opinion on internal control. Answer (b) is incorrect
because qualified opinions are not issued when a
material weakness exists. Answer (c) is incorrect
because an unqualified opinion is not issued when a
end, but before the audit report is issued.
ordinarily not considered even a significant deficiency. Answer (a) is correct because PCAOB
Answer (c) is incorrect because the reply “inadequate Standard 5 requires an adverse audit report
segregation of recordkeeping from accounting” makes when a material weakness exists at year
no real sense because accounting is involved with end, the “as of date.” Answer (b) is incorrect
recordkeeping. Answer (d) is incorrect because control because an unqualified opinion is not
activity weaknesses often do not represent material appropriate. Answer (c) is incorrect because
weaknesses. an unqualified opinion with explanatory
language is not adequate. Answer (d) is
62. (b) The requirement is to identify the most appropri incorrect because a qualified opinion is not
ate report when a circumstancecaused scope appropriate when a material weakness
limitation results in inability to evaluate internal exists at yearend.
control for a significant account involved in the audit.
Answer (b) is correct because PCAOB Standard 5 65. (b) The requirement is to specify whether material
indicates that either a qualified opinion or a disclaimer weaknesses and/or significant deficiencies lead to an
is appropriate, and because the disclaimer is not listed adverse opinion on internal control in an integrated audit.
as an option. Answer (a) is incorrect because an An
adverse opinion is not appropriate. Answer (c) is swer (b) is correct because only material weaknesses
incorrect because an unqualified opinion with lead to an adverse opinion. Answer (a) is incorrect
explanatory language is not appropriate when the because significant deficiencies do not result in an
auditor is unable to evaluate internal control for a adverse opinion. Answer (c) is incorrect because
significant account. Answer (d) is incorrect because material weaknesses do result in adverse opinions but
answers (a) and (c) are not appropriate. significant deficiencies do not. Answer (d) is incorrect
because material weaknesses do result in adverse
63. (c) The requirement is to identify the most opinions.
likely significant deficiency relating to a
client’s antifraud programs. Answer (c) is 66. (b) The requirement is to specify what types
correct because an active audit committee, of deficiencies must be communicated by
not a passive audit committee is needed. the auditor to the audit committee. Answer
Answer (a) is incorrect because a broad (b) is correct because the auditor must
scope of internal audit activities is ordinarily communicate material weaknesses and other
a strength, not a deficiency. Answer (b) is in significant deficiencies, but not all control
correct because a whistleblower program deficiencies. Answer (a) is incorrect because
that encourages anonymous submissions is control deficiencies that are not significant
required. Answer (d) is incorrect because it is need not be communicated to the audit
not ordinarily necessary to perform criminal committee (unless the auditor has made an
background investigations for likely agreement to communicate them). Answers
customers. (c) and (d) are incorrect because known
material weaknesses must be communicated
64. (a) The requirement is to identify the to the audit committee and control
appropriate audit report when a material deficiencies that are not significant
weakness is corrected subsequent to year deficiencies need not be communicated.
over financial reporting, not management
and the audit committee. Answers (a), (b)
67. (c) The requirement is to determine the manner in and (c) are all incorrect because they
which significant deficiencies are communicated by represent statements included in the audit
the auditor to the audit committee under PCAOB report.
Standard 5. Answer (c) is correct because the Standard
requires a written communication. Answer (a) is 72. (a) The requirement is to identify the correct
incorrect because a written communication is required. statement relating to walkthroughs.
Answer (b) is incorrect because the communication Answer (a) is correct because walk
must be in a written form, not in an oral form. Answer throughs—literally tracing transactions from
(d) is incorrect because both material weaknesses and their origination through the company’s
significant deficiencies must be communicated. information system until they are reflected
in the company’s financial reports— are
68. (c) The requirement is to identify the correct often effective procedures for evaluating
statement concerning the external auditors’ both the design effectiveness of controls and
use of the work of others when performing whether those controls have been placed in
an audit of internal control of a public operation. Answer (b) is incorrect because
company. Answer (c) is correct because, walkthroughs help auditors to confirm
after assuring themselves as to the whether controls have been placed in
competence and objectivity of the internal operation. Answer (c) is incorrect
auditors and others, the external auditors
may use their work—particularly in lowrisk
areas and when that work is supervised
and/or reviewed. Answer (a) is incorrect
because using the work of internal auditors
and others is allowed. Answer (b) is
incorrect because there is no such
requirement of reporting to the audit
committee, although this is one indication of
internal auditor objective. Answer (d) is
incorrect because there are limitations, and
because it is uncertain whether liability will
be shared.
information that must be communicated in
writing to management. Answer (c) is
correct because in an integrated audit all
material weaknesses, significant
deficiencies, and other control deficiencies
must be reported to management. Answers
(a) and
(b) are incorrect because they are incomplete. Answer
(d) is incorrect because “all suspected and possible
employee law violations” need not be communicated.
70. (a) The requirement is to identify a correct statement
about applying a topdown approach to identify con
trols to test in an integrated audit. Answer (a) is correct
because certain effective entitylevel controls may
allow the auditor to omit additional testing beyond
those controls. Answer (b) is incorrect because starting
with assertions does not represent starting at the top
(starting at the top includes consideration of the
financial statements and entitylevel controls first).
Answer (c) is incorrect because consideration of
entitylevel controls cannot be avoided. Answer (d) is
incorrect because not all controls related to assertions
need to be focused upon, and because one may not
omit controls related to the financial statements.
statement not included in a standard
unqualified opinion on internal control
performed under PCAOB requirements.
Answer (d) is correct because the report
indicates that management is responsible
for maintaining effective internal control
(a) is incorrect because the daily cash summary
because walkthroughs help auditors to evaluate the will ordinarily be prepared at the end of the day
design effectiveness of controls. Answer (d) is when all checks have been received. Answer
incorrect because walkthroughs help auditors (b) is incorrect because checks need not be
evaluate the design effectiveness of controls and to compared to a sales invoice. Answer (d) is
confirm whether controls have been placed in incorrect because the employee opening the
operation. mail should not also perform the recordkeeping
D.1. Sales, Receivables, and Cash Receipts function of recording the checks in the cash
receipts journal.
73. (a) The requirement is to identify the procedure an
75. (b) The requirement is to determine the type of evi
auditor most likely would perform to test controls relating
dence obtained when tracing shipping documents to
to management’s assertion about the completeness of
prenumbered sales invoices. Answer (b) is correct
cash receipts for cash sales at a retail outlet. Answer (a) is
because the shipping documents relate to shipments to
correct because the use of cash registers and tapes helps customers, and tracing them to sales invoices will
assure that all such sales are recorded. Answer (b) is provide evidence on whether sales invoices were
incorrect because the cash has already been recorded. prepared. Answer (a) is incorrect because duplicate
Answer (c) is incorrect because the procedure only deals shipments or billings will not in general be detected
with recorded deposits, and therefore the completeness by tracing individual shipping documents to
assertion is not addressed as directly as in answer (a). prenumbered sales invoices. Answer (c) is incorrect
Answer (d) is incorrect because one would not expect the because an auditor will trace from customer orders to
cash balance in the general ledger to agree with the bank shipping documents to determine whether all goods
confirmation request amount due to items in transit and ordered were shipped. Answer (d) is incorrect because
outstanding at the point of reconciliation. an auditor will account for the sequence of sales
invoices to determine whether all sale invoices were
74. (c) The requirement is to identify the proper accounted for.
procedure to be performed immediately upon
receipt of checks by mail. Sound internal 76. (a) The requirement is to identify the control
control requires the use of adequate most likely to reduce the risk of diversion of
documentation to ensure that all transactions customer receipts by an entity’s employees.
are properly recorded. This helps the company Answer (a) is correct because a bank lockbox
attain the financial statement assertion of system eliminates employee contact with
cash receipts, and thereby greatly reduces
completeness. Answer (c) is correct because
the risk of diversion by employees. Answer
the preparation of a duplicate listing of checks
(b) is incorrect because remittance advices
received provides the company with a source are ordinarily prenumbered using the
document of all the checks received that day. numbering schemes of the various customers
One list is then forwarded to the employee and not of the client; also, even if a
responsible for depositing the checks at the end prenumbering system is instituted,
of the day and the other list is sent to the difficulties remain in assuring that all
accounting department so that they can post the receipts are recorded. Answer (c) is
amount to the cash receipts journal. Answer
not been recorded in the sales journal will possibly
reveal items that have been sold (as evidenced by a
incorrect because a monthly bank reconciliation is shipping document) but for some reason have not
only likely to be effective when receipts are deposited been recorded as sales. Answers (a), (c), and (d) are
and then abstracted. Answer (d) is incorrect because all incorrect because verification of extension and
while the daily deposit of cash receipts may reduce footings, comparing invoiced prices, and inquiring
the risk of employee diversion of receipts, the about credit granting policies all relate more di
procedure is not as effective as the bank lockbox rectly to the valuation assertion than to the
system, which eliminates employee contact with the completeness assertion.
receipts.
77. (a) The requirement is to identify the best listed
procedure for detecting the lapping of cash receipts by
the client’s cashier through use of customer checks
received in the mail. Answer (a) is correct because
lapping will result in a delay in the recording of
specific remittance credits on the financial records, but
the checks will be deposited in the bank as they are
received. Answer (b) is incorrect because the daily
cash summaries will include the same sums as the cash
receipts journal entries. Answer (c) is incorrect be
cause the bank deposit slips will be identical to any
details included in the monthly bank statements.
Answer (d) is incorrect because while the writeoff of
a receivable may help the individual involved in the
lapping to avoid repayment, no lag is to be expected
between authorization of the writeoff and the date it is
actually recorded.
individual or organization to which a list of
remittances should be forwarded to in
addition to the cashier. Answer (c) is
correct because the accounts receivable
bookkeeper will use the listing to update the
subsidiary accounts receivable records.
Answer (a) is incorrect because internal
auditors will not normally investigate each
day’s listing of remittances for unusual
transactions. Answer (b) is incorrect
because the treasurer will not in general
compare daily listings to the monthly bank
statement. Answer (d) is incorrect because
the list will not be sent to the bank.
79. (d) The requirement is to identify the procedure that
most likely would not be a control designed to reduce
the risk of errors in the billing process. Answer (d) is
correct because the reconciliation of the control totals
for sales invoices with the accounts receivable
subsidiary ledger will follow billing; thus billing errors
will have already occurred. Answer (a) is incorrect
because identification of differences in shipping
documents and sales invoices will allow for a
correction of any errors and proper billing. Answer (b)
is incorrect because computer programmed controls
will assure the accuracy of the sales invoice. Answer
(c) is incorrect because the matching of shipping
documents with the approved sales orders will allow
the preparation of a correct invoice.
80. (b) The requirement is to identify the audit
procedure an auditor most likely would
perform to test controls relating to
management’s assertion concerning the
completeness of sales transactions.
Answer (b) is correct be
cause inspection of shipping documents that have
liabilities are the obligations of the entity at
81. (a) The requirement is to identify the control a given date.
that most likely would assure that all billed
83. (d) The requirement is to identify the control
sales are correctly posted to the accounts
receivable ledger. Answer (a) is correct that most likely would help ensure that all
because the daily sales summary will include credit sales transactions are recorded.
all “billed” sales for a particular day. Answer (d) is correct because the matching
Comparing this summary to the postings to of shipping documents with entries in the
the accounts receivable ledger will provide sales journal will provide assurance that all
evidence on whether billed sales are shipped items (sales) have been completely
correctly posted. Answer (b) is incorrect recorded. Answer (a) is incorrect because
because comparing sales invoices to shipping comparison of approved sales orders to
documents provides evidence on whether authorized credit limits and balances will
invoiced sales have been shipped. Answer (c) help ensure that customer credit limits are
is incorrect because reconciling the accounts not exceeded, rather than the complete re
receivable ledger to the control account will cording of credit sales. Answer (b) is
not provide assurance that all billed sales incorrect because reconciliation of the
were posted in that both the receivable ledger accounts receivable subsidiary ledger to the
and the control account may have omitted accounts receivable control account will
the sales. Answer (d) is incorrect because provide only a limited amount of control
comparing shipments with sales invoices over the complete recording of sales. The
provides evidence on whether all shipments control is incomplete since, for example, a
have been invoiced, not on whether all billed sale that has not been recorded in either the
sales are correctly posted. subsidiary or control accounts will not be
detected. Answer (c) is incorrect because
82. (a) The requirement is to determine the monthly statements generally will not be
financial statement assertion being most sent to customers to whom no sales have
directly tested when an auditor tests an been recorded.
entity’s policy of obtaining credit approval
before shipping goods to customers. Answer 84. (c) The requirement is to identify the control that will be
(a) is correct because testing credit approval most effective in offsetting the tendency of sales
helps assure that goods are shipped to personnel to maximize sales volume at the expense of
customers who are likely to be able to pay; high bad debt writeoffs. Answer (c) is correct because
accordingly the valuation assertion for segregation of the authorization of credit from the sales
receivables is being directly tested. Answer function will allow an independent review of the
(b) is incorrect because completeness deals creditworthiness of customers. Answer (a) is incorrect
with whether all transactions and accounts because while denying access to cash by employees
are recorded. Answer (c) is incorrect responsible for sales and bad debt writeoffs may deter
because existence deals with whether assets embezzlements, the problem of high bad debt writeoffs
exist at a given date and whether recorded is likely to remain. Answer (b) is incorrect because while
transactions have occurred during a given so segregating the matching of shipping documents and
period. Answer (d) is incorrect because sales invoices may help assure that items are shipped
rights and obligations deal with whether properly and subsequently recorded, it will
assets are the rights of the entity and
reconciliation of checking accounts with the monthly
bank statement will not reflect cash that has been
not significantly affect bad debts. Answer (d) is improperly diverted by the accounts receivable clerk.
incorrect because while independent reconciliation Answer (d) is incorrect because the accounts
of control and subsidiary accounts receivable receivable clerk should be able to maintain the detail
records may defer embezzlements, bad debt write and ledger amount in balance and thereby avoid
offs will not be affected. detection.
85. (d) The requirement is to determine the 88. (b) The requirement is to determine who should
department that should approve bad debt prepare a remittance advice when the customer fails to
writeoffs. The department responsible for include one with a remittance. Remittances should be
bad debt writeoffs should be independent of opened by an individual such as a receptionist who is
the sales, credit, and the recordkeeping for independent of the sales function. That individual will
that function, and should have knowledge prepare any needed remittance advices. The credit
relating to the accounts. Answer (d) is manager [answer (a)], and the sales manager [answer
correct because, in addition to being (c)], are incorrect because they
independent of the various functions, the
treasurer’s department is likely to have
knowledge to help make proper decisions of
this nature. Answers (a) and (b), accounts
receivable and the credit department, are
incorrect because neither department is in
dependent of this function. Answer (c) is
incorrect because while accounts payable is
independent of the function, its personnel are
less likely than those of the treasurer’s de
partment to have the necessary information
relating to the accounts that should be
written off.
86. (b) The requirement is to identify a reason
that employers bond employees who
handle cash receipts. Answer (b) is correct
because employee knowledge that bonding
companies often prosecute those accused of
dishonest acts may deter employees’
dishonest acts. Answer (a) is incorrect
because bonding protects the employer
from dishonest acts, not the employee from
unintentional errors. Answer (c) is incorrect
because the bonding company does not
serve the role of independent monitoring of
cash. Answer (d) is incorrect because while
rotation of positions and forcing employees
to take periodic vacations are effective
controls for preventing fraud, they are not
accomplished through bonding.
87. (c) The requirement is to identify the control which
would offset a weakness that allowed the accounts
receivable clerk to approve credit memos and to have
access to cash. Note that such a weakness may lead to
a fraud in which the accounts receivable clerk receives
and keeps cash payments while issuing a fraudulent
credit memo as the basis for a credit to the customer’s
account. Answer (c) is correct because the owner’s
review of credit memos could help establish that
fraudulent memos had not been issued for receivables
which had in actuality been collected by the clerk; for
example, when reviewing credit memos the owner
would expect to see a receiving report for sales returns
for which credit memos have been generated. Answer
(a) is incorrect because the bookkeeper may be able to
maintain the records in such a manner as to avoid
billing errors related to the fraud, and therefore a
review of billings and postings may not reveal such
fraud. Answer (b) is incorrect because monthend
ments most directly addresses. Answer (b) is
perform an authorization function related to sales. correct because the existence or occurrence
Answer (d) is incorrect because the accounts assertion addresses whether recorded entries
receivable clerk performs a recordkeeping function are valid and the direction of this test is from
for sales. the recorded entry in the voucher register to
the supporting documents. Answer (a) is
D.2. Purchases, Payables, and Cash Disbursements incorrect because completeness addresses
89. (b) The requirement is to identify the audit whether all transactions and accounts are
procedure relating to paid vouchers that included and would involve tests tracing
will provide assurance that each voucher is from support for purchases to the recorded
submitted and paid only once. Answer (b) entry. Answers (c) and (d) are incorrect
is correct because when the check signer because vouching the entries provides only
stamps vouchers “paid” it is unlikely to be limited evidence on valuation and rights.
paid a second time since that individual will 92. (d) The requirement is to determine the
notice the stamp on the voucher the second control that is not usually performed in the
time it is submitted for payment.
vouchers payable department. Answer (d)
90. (d) The requirement is to determine the is correct because the vouchers payable
appropriate responsibility for the person who department will not in general have access
signs checks. Answer (d) is correct because to unused prenumbered purchase orders
the individual who signs checks should be and receiving reports. An
responsible for mailing them so as to avoid a swer (a) is incorrect because the vouchers payable
variety of fraud in which the checks are department will match the vendor’s invoice with
improperly converted into cash by company the related receiving report to determine that the
employees. Answer (a) is incorrect because item for which the company has been billed has
the individual who reconciles the bank been received. Answer (b) is incorrect because the
accounts should have no other vouchers payable department will approve vouchers
responsibilities with respect to cash. Answer for payment when all documentation is proper and
(b) is incorrect because accounts payable present. Answer (c) is incorrect because the
does not need the checks and, if they receive vouchers payable department will code the voucher
them, those checks may be converted into with accounts to be debited.
cash which is then stolen. Answer (c) is 93. (b) The requirement is to identify the function that is
incorrect because the person who signs the consistent with matching vendors’ invoices with
checks should determine that proper receiving reports. Answer (b) is correct because while
supporting documents exist and should matching invoices and receiving reports, the
cancel that documentation after the payment employee might effectively recompute the calculations
is made. on the vendors’ invoices to determine that the
91. (b) The requirement is to determine the amounts are proper. Answers (a) and (c) are incorrect.
financial statement assertion that a test of The individual who matches the invoices and receiving
controls of vouching a sample of entries in reports will often also approve them for payment.
the voucher register to the supporting docu Therefore, this individual should not also post
accounts pay
of merchandise ordered. Answer (b) is correct because
if the receiving department personnel are unaware of
able records or reconcile the accounts payable ledger. the quantities ordered, they will provide an
Answer (d) is incorrect because the individual who independent count of quantities received. Answer (a) is
controls the signing of the checks should cancel the incorrect because the department that initiated the
invoices after payment. requisition needs the merchandise, and therefore,
should know what has been ordered. Answer (c) is
incorrect because the purchasing agent is involved
population from which items should be with purchasing the items and therefore must be aware
selected to determine whether checks are of the quantity involved. Answer (d) is incorrect
being issued for unauthorized expenditures. because the ac
Answer (b) is correct because a sample of
canceled checks should be selected and
compared with the approved vouchers, a
prenumbered purchase order and
prenumbered receiving reports. A canceled
check that does not have such support may
have been unauthorized. Answers (a), (c),
and (d) are all incorrect because selecting
items from purchase orders, receiving
reports, or approved vouchers will not
reveal circumstances in which a check was
issued with
out that supporting document. For example, when
selecting a sample from purchase orders, one would
not discover a situation in which a check had been
issued without a purchase order.
95. (d) The requirement is to determine which question
would most likely be included in an internal control
questionnaire concerning the completeness assertion
for purchases. Answer (d) is correct because
prenumbering and accounting for purchase orders,
receiving reports, and vouchers will allow a company
to determine that purchases are completely recorded.
For example, in examining a receiving report the
client might discover that the purchase was not
recorded. Answer (a) is incorrect because requiring a
purchase order before a shipment is accepted will
address whether or not the shipment has been ordered.
Answer (b) is incorrect because matching purchase
requisitions with vendor invoices does not directly
address whether the purchase is recorded. Answer (c)
is incorrect because the unpaid voucher file represents
items that have already been recorded, and thus will
not directly address the completeness of the recording
of purchases.
96. (d) The requirement is to identify the proper control
pertaining to the accounts payable department. Answer
(d) is correct because the accounts payable department
should establish the agreement of the vendor’s invoice
with the purchase order and receiving report to provide
assurance that the item was both ordered and received.
Answer (a) is incorrect because the individual signing
the check (e.g., the treasurer), not the accounts payable
department, should stamp, perforate, or otherwise
cancel supporting documentation after a check is
signed. Answer (b) is incorrect because purchase
requisitions will not normally include detailed price
information. Answer (c) is incorrect because the
quantity ordered on the receiving department copy of
the purchase order will already be obliterated when the
purchase order is completed by the purchasing
department.
97. (b) The requirement is to determine which copy of the
purchase order should omit indication of the quantity
authorization, and custodial functions should all be
counts payable department must reconcile the segregated.
quantity received and the quantity billed to the
quantity that was authorized to be purchased per D.3. Inventories and Production
the purchase order. 100. (c) The requirement is to identify the most
98. (b) The requirement is to identify the audit likely procedure an auditor would perform
procedure which would most likely detect a in obtaining an understanding of a
client error in recording a large purchase. manufacturing entity’s internal control for
Answer (b) is correct because reconciling inventory balances. Answer (c) is correct
the vendors’ monthly statements with the because a review of the entity’s descriptions
subsidiary ledger for payables should of inventory policies and procedures will
disclose a difference in the month following help the auditor to obtain the necessary
the error. Answer (a), footing the purchases understanding about the design of relevant
journal, is unlikely to detect the error since policies, procedures, and records, and
the journal’s totals will have been whether they have been implemented by the
mathematically accumulated properly. entity. Answers (a) and (b) are incorrect
Answer (c) is incorrect because the incorrect because analyses of liquidity and turnover
total will be reflected in both the purchases ratios are analytical procedures designed to
journal and in the ledger accounts. Answer identify cost variances that will help the
(d) is incorrect because such confirmations auditor primarily to determine the nature,
will only detect the error quarterly which is timing and extent of auditing procedures that
neither timely nor efficient. will be used to obtain evidence for specific
account balances or classes of transactions.
99. (d) The requirement is to identify a function Answer (d) is incorrect because test counts
that is compatible with the approval of of inventory are generally obtained as a
purchase orders. Answer (d) is correct substantive procedure.
because the purchases department will
normally approve purchase orders (generated 101. (d) The requirement is to identify the control that most
from user departments or stores) and likely would be used to maintain accurate inventory
negotiate terms of purchase with vendors. records. Answer (d) is correct because periodic
Answer (a) is incorrect because while the pur inventory counts will assure that perpetual inventory
chases department may reconcile the open
records are accurate and, because employees will
know that inventory differences are investigated, they
invoice file, this is primarily a recordkeeping
will be less likely to steal any inventory. Answer (a) is
function that will often be performed by the
incorrect because comparing the perpetual inventory
accounting department. Answer (b) is incor
records with current costs of items will reveal
rect because most frequently the receiving
situations in which costs have changed, but is unlikely
department will to help in the maintenance of accurate inventory
inspect goods upon receipt. Answer (c) is incorrect records. Answer (b) is incorrect because while a just
because user groups or stores will authorize intime inventory ordering system may help assure
requisitions of goods. Keep in mind the principle of that inventory records are accurate (as well as kept at
segregation of functions. Recordkeeping, low levels), such a system
typically involved in the receiving function and thus
involve a higher risk relating to establishing
generally also requires periodic inventory counts to accountability.
maintain accurate inventory records. Answer (c) is
incorrect because matching requisitions, receiving 105. (c) The requirement is to identify the effect
reports, and purchase orders only helps assure that items on revenues, receivables, and inventory of
received are paid for; the matching process does not inadequate controls over the invoicing
assure accurate inventory records. function that allows goods to be shipped
without being invoiced. Items shipped
102. (d) The requirement is to determine a likely effect on without invoicing will result in a situation in
the audit of inventory if the assessed level of control which the accounting department is unaware
risk is high. Answer (d) is correct because a high of the sale. Therefore, debits to accounts
assessed level of control risk may result in changing receivable and credits to sales will not be
the timing of substantive tests to yearend rather than recorded, resulting in an understatement of
at an interim date. If the assessed level of control risk both revenues and receivables. Similarly,
is low, the auditor could perform interim substantive
tests and rely upon internal control to provide valid
yearend records. However, because the assessed level
of control risk is high, the controls cannot be relied
upon. Also, the nature of substantive tests may change
from less effective to more effective procedures (e.g.,
use of independent parties outside the entity rather
than internal) and an increase in the extent of
procedures (e.g., larger sample sizes). Answer (a) is
incorrect because, as indicated, an auditor will
generally seek a yearend count of inventory. Answer
(b) is incorrect because gross profit tests will not in
general have the required precision when control risk
is high. Answer (c) is incorrect because tests of
controls are likely to substantiate an auditor’s view
that control risk is high, and it is therefore unlikely that
their performance will be costeffective.
103. (c) The requirement is to identify the control
which is most likely to address the
completeness assertion for inventory.
Answer (c) is correct because by
prenumbering receiving reports and by
reconciling them with inventory records, one
is able to test completeness by determining
whether all receipts have been recorded.
Answer (a) is incorrect because reconciling
the subsidiary records with the work in
process will only identify discrepancies
between the records, it will not identify
whether all transactions that should be in the
inventory records are represented in the
records. Answer (b) is incorrect because
while the segregation of receiving from
custody of finished goods is important, it
less directly addresses completeness than
does answer (a). Answer (d) is incorrect
because separating the duties between the
payroll department and inventory ac
counting personnel does not directly address
completeness of inventory.
104. (c) The requirement is to determine the proper inter
nal control for handling customer returns of defective
merchandise. Answer (c) is correct because the
receiving department can count the goods, and list
them on a sales return notice to determine that all such
returns are properly recorded. This serves as a control
because the normal procedures of the receiving
function include establishing the original
accountability and recordkeeping for items received.
Answers (a), (b), and (d) all represent functions not
swer (a) is incorrect because clock card data often does
because accounting is unaware of the sale, no entry not include authorized pay rates. Answer (c) is incorrect
to reduce inventory will be made, resulting in an because the procedure does not directly address the
overstatement of inventory. segregation of duties since no information is provided
concerning the distribution of the payroll. Answer (d) is
incorrect because unclaimed payroll checks are not being
question that an auditor would expect to find
analyzed.
on the production cycle section of an
internal control questionnaire. Answer (c) is 109. (a) The requirement is to identify the control
correct because approved requisitions will that most likely could help prevent employee
help maintain control over raw materials payroll fraud. Answer (a) is correct because
released to be used in the production cycle. prompt notification of the payroll supervisor
Answers (a), (b), and (d) are all incorrect be concerning terminations will lead to timely re
cause approval of vendors’ invoices for moval of terminated employees from the
payment, mailing of checks after signing, payroll. Accordingly, no payroll checks will be
and comparing individual disbursements to prepared for such terminated employees.
totals all pertain more directly to the Answer (b) is incorrect because unclaimed pay
disbursement cycle. roll checks should not be returned to the
107. (b) The requirement is to determine an supervisors who might inappropriately cash
objective of internal control for a production them. Answer (c) is incorrect because since the
cycle in addition to providing assurance that payroll department is involved in record
transactions are properly executed and keeping, it should not approve salary rates.
recorded. Answer (b) is correct because, in Answer (d) is incorrect because calculation of
addition to providing assurance as to proper total hours by the payroll supervisor is unlikely
execution and recording, an objective for the to prevent employee payroll fraud.
production cycle (as well as other cycles) is
110. (a) The requirement is to determine the best
the safeguarding of assets, here work in
process and finished goods. Answers (a), (c), procedure for determining the effectiveness
and (d) are incorrect because they represent of an entity’s controls relating to the
detailed controls established to help achieve existence or occurrence assertion for payroll
the overall objectives. They are all much transactions. Answer (a) is correct because
more specific than the overall objectives. proper segregation of duties between
personnel and payroll disbursement
D.4. Personnel and Payroll eliminates many frauds in which “phantom”
employees are being paid. Answer (b) is
108. (b) The requirement is to identify a purpose of vouching incorrect because accounting for the
data for a sample of employees in a payroll register to prenumbered payroll checks addresses
approved clock card data. Answer (b) is correct because completeness more directly than it does
the clock card data provides the auditor with evidence on existence or occurrence. Answer (c) is
whether employees worked the number of hours for incorrect because recomputing payroll
which the payroll register indicates they were paid. An deductions for employee fringe benefits,
without additional analysis,
required to sign a receipt for the amount of
pay received. Thus, there would be control
provides only a very limited test of existence or over the total amount disbursed as well as
occurrence. Answer (d) is incorrect because verifying amounts disbursed to each individual
the preparation of the monthly payroll account bank employee. Answer (a) is incorrect because if
reconciliation is unlikely to provide evidence on the a signed receipt is not received from each
existence or occurrence assertion, although some employee paid, there would be no proof of
possibility does exist if signatures on checks are payment. Even though the pay envelopes
analyzed in detail. include both cash and a computation of net
wages, the employees should have the
opportunity to count the cash received before
situation in which it is most likely that an
signing a payroll receipt. Answer (b) is
auditor would assess control risk for payroll
incorrect because unclaimed pay envelopes
at a high level. Answer (c) is correct be
should not be retained by the paymaster, but
cause the payroll department, which is
rather deposited in a bank account by the
essentially a recordkeeping function,
cashier. An
should not also authorize payroll rate
changes. Under strong internal control
recordkeeping, authorization, and custody
over assets should be segregated. Answer
(a) is incorrect because examining
authorization forms for new employees is
consistent with the payroll department’s
recordkeeping function. Answer (b) is
incorrect because comparing payroll
registers with original batch transmittal data
is a control relating to recordkeeping. An
swer (d) is incorrect because while the
actual hiring of employees is normally
done in the personnel department, allowing
the payroll department supervisor to hire
subordinates, with proper approval, is not as
inconsistent with payroll’s recordkeeping
function as is authorizing rate changes for
all employees.
112. (c) The requirement is to identify the control most
likely to prevent direct labor hours from being charged
to manufacturing overhead. Answer (c) is correct
because time tickets may be coded as to whether direct
labor on various projects was involved. Accordingly,
using time tickets will help identify direct labor costs.
Answer (a) is incorrect because while periodic counts
of work in process may provide a control over physical
units of production, the counts will not in general
provide assurance that direct labor hours are properly
charged to the product rather than to manufacturing
overhead. Answer (b) is incorrect because comparing
daily journal entries with production orders will not in
general identify costs that have been omitted from
direct labor due to the level of aggregation of the
entries. Answer (d) is incorrect because the
reconciliation of work in process inventory with
budgets will provide only very limited detection ability
relating to the charging of direct labor to
manufacturing overhead.
113. (a) The requirement is to determine the individual(s)
who should distribute paychecks and have custody of
unclaimed paychecks. Answer (a) is correct because
these custody functions should not be performed by
the payroll department which is a recordkeeping
function. Under proper internal control recordkeeping,
custody, and authorization of transactions should be
segregated.
114. (c) If payment of wages were to be in cash,
each employee receiving payment should be
auditor may observe the distribution of paychecks. An
swer (d) is incorrect because the wage payment will be swer (c) is correct because an employee’s presence to
made in cash and not by check. Accordingly, a receipt collect the paycheck provides evidence that the
must be obtained for each cash payment. employee actually exists and is currently employed by
the client. Answer (a) is incorrect because the
115. (a) The requirement is to identify the purpose
distributions of payroll checks would not reveal
of segregating the duties of hiring personnel whether payrate authorization is properly separated
and of distributing payroll checks. Answer (a) from the operating function. Answer (b) is incorrect
is correct because the hiring of personnel is an because the paycheck distribution does not provide
authorization function while the distribution of information on whether deductions from gross pay
checks is a custody function. Thus, in order to have been calculated properly. Answer (d) is incorrect
properly segregate authorization from custody, because observation of the paycheck distribution
these duties should not be performed by the process does not of itself provide assurance that the
same individual. The combination of these two paychecks agree with the related payroll register and
functions in the same position would create the time cards.
possibility of the addition of a fictitious
employee to the payroll and subsequent 118. (a) The requirement is to determine the
misappropriation of paychecks. Answer (b) is department most likely to approve change in
incorrect because the functions involved are pay rates and deductions from employee
not primarily operational or recordkeeping. salaries. Answer (a) is correct because the
Answer (c) is incorrect because the treasury personnel department, which has the primary
function, and not the controllership function, objective of planning, controlling and
will normally be responsible for distributing coordinating employees, will determine that
payroll checks. Answer (d) is incorrect because proposed salary increases (often
recommended by supervisors of employees)
segregation of duties does not directly address
are consistent with the company’s salary
administrative controls vs. internal accounting
guidelines and will approve changes in
controls.
deductions. Answers (b) and (c) are
116. (c) The requirement is to determine the best incorrect because the treasurer and
method to minimize the opportunities for controller will in general initiate the pay rate
fraud for unclaimed cash change process for only those employees
in a cash payroll system. For a cash payroll the best within their departments and will not
control is to get the unclaimed cash out of the firm’s generally approve changes for employees
physical control and into the bank. Answer (a) is outside their departments. Answer (d) is
incorrect because maintaining the accountability for incorrect because the payroll functions is a
cash which is in a safedeposit box is difficult. recordkeeping function which will modify
Answers (b) and (d) are incorrect because the cash employee pay rates based on approved
need not be kept by the firm. changes from personnel. Payroll should not
have authority regarding pay rates and
117. (c) The requirement is to identify a reason why an deductions.
controlled physically in order to prevent
unauthorized usage. Answer (c) is incorrect
D.5. Financing because access to securities should
ordinarily be vested in two individuals so as
119. (d) The requirement is to determine the most likely to assure their safekeeping. Answer (d) is
question that would be included on an internal control incorrect because securities should be
questionnaire for notes payable. Answer (d) is correct registered in the name of the owner.
because companies frequently require that direct
borrowings on notes payable be authorized by the 123. (b) The requirement is to identify the best
board of directors; accordingly, auditors will control for safeguarding marketable
determine whether proper policy has been followed. securities when an independent trust agent is
Answer (a) is incorrect because internal control not employed. Answer (b) is correct because
questionnaires do not in general include questions on requiring joint control over securities
whether assets that collateralize notes payable are maintained in a safedeposit box assures
critically needed. Answer (b) is incorrect because the that, absent collusion, assets are safe
internal control questionnaire for disbursements is guarded. Answer (a) is incorrect because a
more likely to address the required authorized review of in
signatures on checks than will the internal control
questionnaire for notes payable. Answer (c) is
incorrect because while it is often good business
practice to use proceeds from longterm notes to
purchase noncurrent assets, this is not required and is
not included on an internal control questionnaire.
primary responsibility of a bank acting as
registrar for capital stock. Answer (d) is
correct because the primary responsibility of
the stock registrar is to prevent any
overissuance of stock, and thereby verify
that the stock is issued properly. Answer (a)
is incorrect because registrar will not in
general determine that the dividend amounts
are proper. Answer (b) is incorrect because
the transfer agent will maintain records of
total shares outstanding as well as detailed
stockholder records, and carry out transfers
of stock ownership. Answer (c) is incorrect
because registrars do not perform the role
described relating to mergers, acquisitions,
and the sale of treasury stock.
121. (a) Canceled stock certificates should be defaced and
attached to corresponding stubs as is done with voided
checks. The objective of the control is to prevent
reissuance. Answer (b) is incorrect because failure to
deface permits reissuance. Answer (c) is incorrect
because destruction of the certificates would preclude
their control (i.e., their existence after defacing
provides assurance that they cannot be reissued). If the
certificates were destroyed, one or more might be
reissued without any proof that such occurred. Answer
(d) is incorrect because the Secretary of State has no
interest in receiving defaced and canceled stock
certificates.
D.6. Investing
122. (a) The requirement is to identify the reply
which is not a control that is designed to
protect investment securities. Answer (a) is
not a control since the custody of securities
should be assigned to individuals who do
not have accounting responsibility for
securities; as with other assets,
authorization, recordkeeping, and custody
should be separated. Answer (b) is incorrect
because securities should be properly
Answer (b) is incorrect because pre
vestment decisions by the investment committee will numbered purchase orders may be used to
have a very limited effect on safeguarding control all purchases, including purchases of
marketable securities. Answer (c) is incorrect because equipment. Answer (c) is incorrect because
the simple tracing of marketable securities from the the significant amounts of money involved
subsidiary ledgers to the general ledger does not with purchases of equipment suggest the
directly safeguard marketable securities since, for need for the solicitation of competitive bids.
example, unrecorded transactions may occur. Answer
(d) is incorrect because, even if the chairman of the 126. (d) The requirement is to identify the control that
board did verify marketable securities on the balance would be most effective in assuring that the proper
sheet date, the control will only be effective at that custody of assets in the investing cycle is maintained.
point in time. Answer (d) is correct because comparing recorded
balances in the investment subsidiary ledger with
124. (d) The requirement is to identify the best physical counts will help assure that recorded assets
audit procedure when a weakness in internal are those over which the company has custody. This is
control over reporting of retirements exists. an example of the control activity of comparison of
Answer (d) is correct because selecting assets with recorded accountability. Answer (a) is
certain items of equipment from the incorrect because internal control is improved when
accounting records and attempting to locate two individuals, not one, must be present for entry to
them will reveal situations in which the the safedeposit box. Answer (b) is incorrect because
accounting records still have them recorded while the segregation of duties within the
subsequent to their retirement. Answer (a) is recordkeeping may in certain circumstances be
incorrect because inspecting items that still desirable, it does not directly address custody over
exist is not likely to lead to discovery of un assets. Answer (c) is incorrect because only extremely
recorded retirements. Answer (b) is incorrect major investments generally need be authorized by the
because depreciation may continue to be board of directors.
taken on equipment that has been retired, but
not recorded. Answer (c) is incorrect be 127. (d) The requirement is to determine who
cause it is doubtful that such retirements should have responsibility for custody of
have been reclassified as “other assets.” shortterm bearer bond investments and the
submission of coupons for periodic
125. (d) The requirement is to identify the collections of interest. The treasurer
question that is least likely to be included on authorizes such transactions. Answer (a) is
an internal control questionnaire concerning incorrect because the chief accountant, who
the initiation and execution of equipment is in charge of the recordkeeping function,
transactions. Answer (d) is correct because should not also maintain custody of the
procedures to monitor and properly restrict bonds. Answer (b) is incorrect because the
access to equipment do not relate directly to internal auditor should not be directly in
the initiation and execution of equipment volved as such involvement would make an
transactions. Answer (a) is incorrect because independent review of the system
requests for major repairs relate to initiation impossible. Answer (c) is incorrect
of a transaction which should be controlled.
131. (d) The requirement is to determine the type
offraud which is most difficult to detect. Answer (d),
because the cashier function is more directly a fraud committed by the controller, is most difficult
involved with details such as endorsing, depositing, to detect because the controller is in control of the
and maintaining records of cash receipts. recordkeeping function and thus may be able to
commit a fraud and then manipulate the accounting
128. (b) The requirement is to identify the control that
records so as to make its discovery unlikely. Answer
would be most likely to assist an entity in satisfying
(a) is incorrect because while a cashier may be able
the completeness assertion related to longterm
to embezzle funds, s/he will not have access to the
investments. Answer (b) is correct because
accounting records and thus discovery of the
completeness deals with whether all transactions are
embezzlement will be likely. Answer (b) is incorrect
recorded, and the comparison of securities in the bank
because a key
safedeposit box with recorded investments may
reveal securities which are in the safedeposit box but
are not recorded. Answer (a) is incorrect because
verification of security registration helps establish the
rights assertion not the completeness assertion. Answer
(c) is incorrect because vouching the acquisition of
securities by comparing brokers’ advices with
canceled checks helps to establish the existence
assertion not the completeness assertion. Answer (d)
is incorrect because a comparison of the current
market prices of recorded investments with brokers’
advices addresses the valuation assertion not the
completeness assertion.
129. (a) The requirement is to identify the best control for
safeguarding marketable securities against loss. An
swer (a) is correct because use of an independent trust
company allows the effective separation of custody
and recordkeeping for the securities. Answer (b) is
incorrect because a verification of marketable
securities at the balance sheet date may have only a
limited effect on safeguarding the securities
throughout the year. Answer (c) is incorrect because
tracing all purchases and sales of marketable securities
will not affect securities that have disappeared for
which no entries have been made. Also, it is unlikely
that an entity will rely upon the independent auditor in
this manner. Answer (d) is incorrect because
maintenance of control over custody by a member of
the board of directors may provide less complete
control than the use of an independent trust company.
appropriate combination of audit tests when
there are numerous property and equipment
transactions during the year and the auditor
plans to assess control risk at a low level.
Answer (c) is correct because, to justify an
assessment of control risk at a low level, tests
of controls will be required. This will allow
auditors to perform only limited tests of
current year property and equipment
transactions. Answer (a) is incorrect because
tests of controls will be performed to allow
the auditor to perform limited, not extensive,
tests of property and equipment balances at
the end of the year. Answers (b) and (d) are
incorrect because analytical procedures on
either yearend balances or transactions will
not justify a low assessed level of control
risk.
D.7. Overall Internal Control Questionnaires
(Check
lists)
punch operator will not in general have access to statement that should be included in an
assets. Answer (c) is incorrect because an internal auditor’s letter on significant deficiencies.
auditor will not generally be able to manipulate the Answer (d) is correct because AU 325
accounting records and generally has limited access indicates that such a letter to the audit
to assets. committee should (1) indicate that the
audit’s purpose was to report on the
E.1.a. Communication of Internal Control Related
financial statements and not to express an
Matters
opinion on internal control,
132. (c) Answer (c) is correct because weaknesses that were (2) include the definition of a significant deficiency,
communicated in the past and not corrected must be and
recommunicated to management and those charged (3) restrict distribution of the report.
with governance. Answers (a), (b), and (d) are all 136. (c) The requirement is to identify the correct statement
accurate statements about audit requirements.
concerning an auditor’s required communication of
133. (c) The requirement is to identify the matter an auditor significant deficiencies. Answer (c) is correct because
would most likely consider to be a material weakness distribution of an auditor’s report on significant
to be communicated to those charged with govern deficiencies should be restricted to management and the
ance. Answer (c) is correct because ineffective audit committee. Answer (a) is incorrect because lack of
oversight of financial reporting by those charged with correction of a significant deficiency does not
governance is an indicator of a material weakness (AU necessarily result in a scope limitation. Answer (b) is
325). Answers (a), (b), and (d) are all incorrect incorrect because tests of controls need not be performed
because a failure to renegotiate unfavorable longterm relating to significant deficiencies. Answer (d) is
purchase commitments, recurring operating losses, and incorrect because although timely communication of
plans to reduce ownership equity do not fall within the significant deficiencies may be important, depending
definition of a material weakness. upon the nature of the significant deficiency identified,
the auditor may choose to communicate it either after the
134. (c) The requirement is to identify the correct state
audit is concluded or during the course of the audit.
ment concerning significant deficiencies identified in
an audit. Answer (c) is correct because an auditor may 137. (d) The requirement is to identify the correct
communicate significant deficiencies either during an statement about significant deficiencies noted
audit or after the audit’s completion. Answer (a) is in an audit. Answer (d) is correct because the
incorrect because an auditor need not search for auditor should separately identify and
significant deficiencies. Answer (b) is incorrect communicate material weaknesses and
because all significant deficiencies are not also significant deficiencies (AU 325). Answer (a)
material weaknesses. Answer (d) is incorrect because is incorrect because significant deficiencies are
an auditor may not issue a written report that no sig less severe than material weaknesses. Answer
nificant deficiencies were noted during an audit. (b) is incorrect because the auditor is
with the audit committee his/her views about
significant matters that were the subject of such
not obligated to search for significant deficiencies. consultation; accordingly, such a discussion with
Answer (c) is incorrect because such deficiencies management is to be expected. While the information
should be recommunicated. suggested in answers (a), (c), and (d) may all be
communicated to the audit committee, they are not
138. (b) The requirement is to determine the included as required disclosures under AU 380. See
representation that should not be included AU 380 for the various matters that must be
in a report on internal control related communicated to those charged with governance.
matters noted in an audit. Answer (b) is
correct because the auditors should not issue 142. (b) The requirement is to identify the
a report on internal control stating that no correct statement concerning an auditor’s
significant deficiencies were identified required communication with those charged
during the audit. Answer (a) is incorrect with governance. Answer (b) is correct be
because significant deficiencies should be cause the communication should include
disclosed. Answer (c) is incorrect because an such information on disagreements. See AU
auditor may recommend corrective follow 380 for this and other required
up action. Answer (d) is incorrect because an communications with those charged with
auditor may disclose the fact that the governance. An
consideration of internal control would not
necessarily disclose all significant
deficiencies that exist.
correct statement regarding material
weaknesses and significant deficiencies.
Answer (b) is correct because a
compensating control is a control that
lessens the severity of a deficiency (AU
325). Answer (a) is incorrect because
material weaknesses should be reported
separately from significant deficiencies.
Answer (c) is incorrect because while the
auditor may choose to communicate
material weakness and significant
deficiencies immediately, the
communication may occur at other times.
Answer (d) is incorrect because significant
deficiencies are less severe than material
weaknesses.
140. (b) The requirement is to determine an
auditor’s responsibility after s/he has
discovered and orally communicated
information on a weakness in internal control
to the client’s senior management and those
charged with corporate governance. Answer
(b) is correct because the auditor, as outlined
throughout AU 318, considers and
documents his/her understanding of internal
control to assist in planning and determining
the proper nature, timing, and extent of
substantive tests. Answer (a) is incorrect
because no scope limitation is indicated
although an internal control condition does
exist. Similarly, answers (c) and (d) are
incorrect because audit activities need not
be suspended and the auditor need not
withdraw from the engagement.
E.1.b The Auditor’s Communication with
Those Charged with Governance
141. (b) The requirement is to determine the matter that an
auditor would communicate to those charged with
governance. Answer (b) is correct because AU 380
requires that when the auditor is aware of such
consultation with another CPA, s/he should discuss
is incorrect because direct communication by the
swer (a) is incorrect because the communication may auditor is not required for selection of accounting
occur before or after issuance of the auditor’s report. principles. Management may engage in this
Answer (c) is incorrect because not all matters need be communication with those charged with corporate
communicated to management. Answer (d) is governance. Answer (c) is incorrect because the
incorrect because significant adjustments need to be auditor only needs to make sure that management has
communicated to those charged with governance. communicated with the committee concerning initial
selection of significant accounting policies in
143. (b) The requirement is to identify the emerging areas that lack authoritative guidance.
discussion that it is least likely that an Answer (d) is incorrect because disagreements should
auditor will initiate with those charged with be communicated directly to those charged with
governance. Answer (b) is correct because corporate governance.
auditors do not generally initiate a discussion
on materiality, although they do occasionally 146. (a) The requirement is to determine the
respond to such questions. See AU 380 for information that an auditor should
auditor communications with those charged communicate to those charged with corporate
with governance. governance. Answer (a) is correct because both
significant audit adjustments and
144. (b) The requirement is to identify the correct
management’s consultation with other
statement about an auditor’s required
communication with those charged with accountants about significant accounting
governance. Answer (b) is correct because matters should be communicated to an audit
the communication must include significant committee. See
misstatements discovered, even if corrected AU 380 for these and other matters that should be
by management. Answer (a) is incorrect so communicated.
because while such communications may be E.2. Reporting on Internal Control
communicated to management, there is no
such requirement. Answer (c) is incorrect 147. (d) The requirement is to identify the
because disagreements with management, statement that should be included in a
as well as the other required disclosures, CPA’s report on a client’s internal control
may be communicated either orally or in over financial reporting. Answer (d) is
writing. Answer (d) is incorrect because an correct because AT 501 requires that the
auditor must recommunicate such report include a comment on the inherent
weaknesses in internal control. Also, see AU limitations of any internal control.
380 for the matters communicated to those
charged with governance. 148. (a) The requirement is to identify the
statement that best describes a CPA’s
145. (a) The requirement is to determine whether dis engagement to report on an entity’s internal
agreements with management and initial selection of control over financial reporting. Answer (a)
significant accounting policies need to be is correct because the objective of an
communicated to those charged with corporate attestation engagement is to form an opinion
governance. Answer (a) is correct because on the effectiveness of internal control.
disagreements should be communicated directly to Answer (b) is incorrect because no such
those charged with corporate governance. Answer (b) negative assurance
exists (here a material weakness in internal
control) the CPA should report directly upon
is provided based on an “audit” of the entity’s the subject matter and not upon the
internal control. Answer (c) is incorrect because such assertion.
engagements do not project expected benefits of the
entity’s internal control. Answer (d) is incorrect E.3. Effects of an Internal Audit Function
because such engagements are attestation
153. (a) The requirement is to identify the most
engagements, not consulting engagements.
likelyinformation a CPA would obtain in assessing the
149. (c) The requirement is to determine the correct statement competence of an internal auditor. Answer (a) is
regarding an engagement to examine internal control. correct because in assessing competence, an internal
Answer (c) is correct because the procedures relating to auditor will consider the quality of working paper
internal control will be more extensive when reporting on documentation as well as a variety of other factors
internal control as compared to procedures performed for outlined in AU 322. Answer (b) is incorrect because
a financial statement audit. This difference occurs an organization’s commitment to integrity and ethical
because during financial statement audits the auditor may values, while important, does not bear as directly upon
decide not to perform tests of controls and may simply
assess control risk at the maximum level. Conversely, in
an engagement to report on internal control an auditor
must perform additional tests of controls. Answer (a) is
incorrect because such duplication of procedures may
not be necessary. Answer (b) is incorrect because a report
on internal control will not in general increase the
reliability of the financial statements. Answer (d) is
incorrect because, as indicated, the scope of procedures
relating to internal control is more extensive, not more
limited, than the assessment of control risk made during
a financial statement audit.
relationship between an examination of
internal control and obtaining an
understanding of internal control and
assessing control risk as part of an audit.
Answer (d) is correct because, while the
scope and purpose differ between the two
types of engagements, the procedures
followed are similar. See AT 501 (or
PCAOB Standard 5) for information on
reporting on an audit of internal control.
151. (b) The requirement is to describe the
contents of a report on the study of internal
control that is based on criteria established
by governmental agencies. Answer (b) is
correct because the report should indicate
matters covered by the consideration and
whether the auditor’s consideration included
tests of controls with the procedures covered
by his/her consideration. Additionally, the
report should describe the objectives and
limitations of internal control and the
accountant’s evaluation thereof; state the
accountant’s conclusion, based on the
agency’s criteria; and describe the purpose of
the report and state that it should not be used
for any other purpose. Answer (a) is
incorrect because the agency’s name should
be included. Answer (c) is incorrect because
a conclusion may be made relative to the
agency’s criteria. Answer (d) is incorrect
because the accountant should not assume
responsibility for the comprehensiveness of
the criteria.
152. (b) AT 501 states that when a deviation from
the control criteria being reported upon
degree of subjectivity involved in the
internal auditor competence. Answers (c) and (d) are evaluation of the audit evidence. Answer (c)
incorrect because the influence of management and is correct because the existence of fixed
the organizational level to which the internal auditor asset additions involves little subjectivity.
reports are factors used to assess internal auditor Answers (a) and (b) are incorrect because
objectivity. AU 322 provides overall guidance on the the existence of contingencies and the
use of internal auditors. valuation of intangible assets are subjective
and the risk of misstatement may be high.
154. (d) The requirement is to determine whether
Answer (d) is incorrect because the
the independent auditor may share valuation of relatedparty transactions may
responsibility with an entity’s internal be very subjective due to the lack of an
auditor for assessing inherent risk and “arm’slength” transaction.
control risk. AU 322 requires that
judgments about inherent and control risk 157. (d) AU 322 states that internal auditors may assist the
always be those of the independent auditor. CPA in obtaining an understanding of internal control,
It also requires that judgments about the in performing tests of controls, and in performing
materiality of misstatements, the substantive tests.
sufficiency of tests performed, the valuation
of significant accounting estimates, and 158. (b) The requirement is to identify the type
other matters affecting the auditor’s report of information used by a CPA to assess the
should always be those of the independent competence of internal auditors. Answer (b)
auditor. See AU 322 for information on the is correct because, along with various other
external auditor’s consideration of the factors, AU 322 indicates that the CPA
internal audit function. should obtain evidence on the educational
background and professional certification of
155. (d) The work of internal auditors may affect the internal auditors when considering com
the nature, timing and extent of the audit, petence. Answers (a) and (c) are incorrect
including (1) procedures the auditor because analysis of organizational level to
performs when obtaining an understanding which the internal auditors report and
of the entity’s internal control, (2) policies on relatives are considered when
procedures the auditor performs when assessing internal auditor objectivity.
assessing risk, and (3) substantive proce Answer (d) is incorrect because access to
dures the auditor performs. sensitive records will not provide a CPA
with information on competence.
circumstance in which an internal auditor’s 159. (d) The requirement is to identify the least
work would most likely affect the nature, likely source of information to the CPA on
timing, and extent of a CPA’s auditing an entity’s internal auditor’s competence and
procedures. When considering the effect of objectivity. Answer (d) is correct because
the internal auditors’ work, the CPA analytical procedures do not ordinarily
considers (1) the materiality of financial provide information on the internal auditor.
statement amounts, (2) the risk of material See AU 329 for information on analytical
misstatement of the assertions, and (3) the procedures.
whether an auditor who audits the
processing of transactions by a service
160. (a) The requirement is to identify the organization may issue a report on either,
characteristics of an internal auditor which or both, of whether controls have been
must be considered by an independent implemented and control operating
auditor who decides that the internal auditor’s effectiveness. Answer (a) is correct
work might have a bearing on his/her because AU 324 indicates that such
procedures. Answer (a) is correct because “service auditors” may issue either of the
independent auditors must consider internal two types of reports.
auditor competence, objectivity, and work
performance. Answer (b) is incorrect because 165. (a) The requirement is to identify the
an independent auditor is less concerned proper information to be included in a
about internal auditor efficiency, although service auditor’s report on whether a
internal auditor experience will be considered client’s controls have been implemented.
in the assessment of competence. Answers Answer (a) is correct because such a report
(c) and (d), while partially correct, are less should include a description of the scope
complete than answer (a). and nature of the client’s procedures.
161. (d) The requirement is to determine how a 166. (d) The requirement is to determine the

CPA should assess the objectivity of an propriety of a computer “user” auditor
internal auditor. Answer (d) is correct (Lake) making reference to a ser
because when assessing the objectivity of an
internal auditor the CPA should consider
organizational status and policies for
maintaining objectivity. Answers (a), (b), and
(c) are all incorrect because evaluating the
quality control program, and examining and
testing an internal auditor’s work all relate
more directly to assessing internal auditor
competence rather than to objectivity. See
AU 322 for these and other factors
considered when assessing internal auditor
competence.
E.4. Reports on the Processing of Transactions by
Service Organizations
162. (a) The requirement is to identify the
information provided in a service auditor’s
report which includes an opinion on a
description of controls implemented. An
swer (a) is correct since such a report
includes a description of the scope and
nature of the CPA’s procedures. Answers
(b), (c), and (d) are all incorrect because they
suggest information not included in such a
report. See AU 324 for information on the
audit of service organizations.
163. (a) The requirement is to identify a CPA’s
reporting responsibility when reporting on
internal control implemented for a service
organization that processes payroll
transactions. Answer (a) is correct because
since the CPA is only expressing an opinion
on whether controls have been implemented,
a disclaimer should be provided on operating
effectiveness. Answer (b) is incorrect because
no specific statement is made with respect to
earlier objectives. Answer
(c) is incorrect because controls relevant to financial
statement assertions are not so identified. Answer (d)
is incorrect because the assessed level of control risk is
not disclosed. See AU 324 for information on
processing of transactions by service organizations.
the report of the service auditor. See AU 324 for
vice auditor’s (Cope) report. Answer (d) is correct reports on the processing of transactions by service
because the user auditor should not make reference to organizations.
Cash Receipts
and Billing
Authoritative
Literature
Help
Condition
1. Southwest is involved only in medical services and has not
diversified its operations.
2. Insurance coverage for patients is verified and communicated to
the clerks by the office manager before medical services are
rendered.
3. The physician who renders the medical services documents the
services on a prenumbered slip that is used for recording revenue
and as a receipt for the patient.
4. Cash collection is centralized in that Clerk #2 receives the cash
(checks) from patients and records the cash receipt.
5. Southwest extends credit rather than requiring cash or insurance in all
cases.
6. The office manager extends credit on a casebycase basis rather
than using a formal credit search and established credit limits.
7. The office manager approves the extension of credit to patients
and also approves the writeoffs of uncollectible patient
receivables.
8. Clerk #2 receives cash and checks and prepares the daily bank deposit.
9. Clerk #2 maintains the accounts receivable records and can
add or delete information on the PC.
10. Prenumbered service slips are accounted for on a monthly basis by the
outside accountant who is independent of the revenue generating and
revenue recording functions.
11. The bank reconciliation is prepared monthly by the outside
accountant who is independent of the revenue generating and
revenue recording functions.
12. Computer passwords are only known to the individual employees
and the managing partner who has no duties in the revenue
recording functions.
13. Computer software cannot be modified by Southwest’s employees.
14. None of the employees who perform duties in the revenue
generating and revenue recording are able to write checks.
Purchases and
Disbursements Authoritative
Literature Help
1. (C) Prepare purchase order—A trapezoid represents a manual operation. Here, a purchase order enters
the flowchart after this step; accordingly, a purchase order is being prepared.
2. (R) To vendor—A circle represents a connector, a symbol indicating that a document is entering or leaving that
portion of the flowchart. Here a copy of the purchase order is sent to the vendor to order the goods. This must be the
case, because otherwise the vendor would not be informed of the order.
3. (F) Prepare receiving report—A trapezoid represents a manual operation. Here, a receiving report enters
the flowchart after this step; accordingly, a receiving report is being prepared. Also, note above this step
that goods are received, the point at which one would expect preparation of a receiving report.
4. (L) From purchasing—A circle represents a connector, a symbol indicating that a document is entering or
leaving that portion of the flowchart. The document here is from purchasing because below the connector
is requisition No. 1, which purchasing has sent with the purchase order No. 5 to vouchers payable, as
evidenced by the connector in the bottom far right under purchasing.
5. (M) From receiving—A circle represents a connector, a symbol indicating that a document is entering or leaving that
portion of the flowchart. The document here is from receiving because under the receiving portion of the flowchart,
approximately
3/4 of the way down, we see a connector indicating that receiving report No. 1 is being sent to vouchers payable. Also, toward
the bottom under the vouchers payable portion of the flowchart, we see that receiving report No. 1 is indeed in the system.
6. (O) Purchase order No. 5—We know from item 4 that this document was sent from purchasing, and we know that
purchasing has sent to vouchers payable requisition No. 1 and purchase order No. 5. Since requisition No. 1 is
labeled on the flowchart, this must be purchase order No. 5.
7. (P) Receiving report No. 1—We know from item 5 that this document was sent from receiving, and since we know
that receiving has sent receiving report No. 1 to vouchers payable this must be that document.
8. (B) Prepare and approve voucher—A trapezoid represents a manual operation. Here, an approved voucher enters
the flowchart after this step; accordingly, a voucher is being prepared and approved in this step.
9. (T) Unpaid voucher file, filed by due date—The triangle symbol represents a file. Entering this file are the approved
but unpaid vouchers with the support of their invoices, receiving reports, purchase orders and purchase requisitions.
Because these vouchers are sent to the treasurer in order of due date (the bottom, right symbol under vouchers
payable) this file is the unpaid voucher file, filed by due date.
10. (S) Treasurer—Because the unpaid vouchers (the “voucher package”) was sent from vouchers payable to the
treasurer, this is the treasurer.
11. (I) Sign checks and cancel voucher package documents—A trapezoid represents a manual operation. Here, the
operation prior to 11 involves a review of documents and preparation of a check and a remittance advice. After this
operation the documents changed are a “canceled voucher package file” and a “signed check”; accordingly, checks
are being signed and the voucher package is being canceled.
12. (K) Canceled voucher package—After step 11, the check copy, remittance advice No. 1, the signed check, and remittance
advice No. 2 exit on the far right. Accordingly, item 12 is the voucher package, now canceled as evidenced by the description
below the triangular file symbol.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
2. Enter the exact section and paragraph numbers that describe the limitations. 319 6466
Sales/Shipping Authoritative
Process Literature Help
1. (M) Perform customer credit check—The customer credit file is being accessed, making it likely that a credit check is occurring.
2. (Z) Open order file—The processing to the right of #2 begins with “open orders,” making this an open order file.
3. (L) Match customer purchase order with sales order—Two copies of the sales order are being combined with the
customer purchase order through a manual operation (the trapezoid).
4. (B) Verify agreement of sales order and shipping document—This manual operation (trapezoid) includes two copies
of the shipping document being combined with the sales order.
5. (H) Release goods for shipment—The department is the warehouse and shipping department, and out of this
operation is “shipping information”; accordingly goods are being released for shipment.
6. (S) Master price file—The operation below #6 includes entering price data; since the first two files being accessed are the
accounts receivable master file and the shipping file, this third file must include prices.
7. (O) Prepare sales invoice—Since a document is being prepared through this computerized billing program, it is the
sales invoice.
8. (U) Sales invoice—A sales invoice is normally sent to the customer.
9. (I) To accounts receivable department—This copy of the sales invoice informs accounts receivable that the sale has
been both processed and shipped.
10. (Q) General ledger master file—Because the processing step below includes updating of master files, this is the
general ledger master file.
11. (N) Prepare sales journal—Sales transactions are being processed; accordingly a sales journal is prepared.
12. (T) Sales journal—From above, a sales journal was prepared; the accounting department will receive the sales journal.
13. (Y) Aged trial balance—In the processing step above, an aged trial balance of accounts receivable is prepared; the
credit department will receive such a report.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)

2. Enter the exact section number that provides the appropriate guidance. 501
Purchasing Receiving,
and Accounts Payable Authoritative
Literature Help
1. Disagree. Someone independent of requisitioning should select the supplier.
2. Agree.
3. Disagree. Often, factors in addition to cost are considered (e.g., quality, dependability).
4. Agree.
5. Agree.
6. Agree.
7. Disagree. A comparison of quantities is not possible because quantity is blacked out on the purchase order
provided to receiving.
8. No receiving report is ordinarily necessary for purchases of services.
9. Agree.
10. Agree.
11. Agree.
12. Disagree. The reconciliation should be performed by an independent party.
13. Disagree. Documentation should be marked “paid” by the individual making the payment.
14. Agree.
15. Agree.
R
e
A
u
L
i
(
Internal Control Related Authoritative
Matters Communication Literature Help
AU 325.25 includes the matters required to be included in the written communication regarding significant
deficiencies and material weaknesses indentified during an audit as
• State that the purpose of the audit was to express an opinion on the financial statements, but not to express
an opinion on the effectiveness of the entity’s internal control over financial reporting.
• State that the auditor is not expressing an opinion on the effectiveness of internal control.
• Include the definition of the terms significant deficiency and, where relevant, material weakness.
• Identify the matters that are considered to be significant deficiencies and, if applicable, those that are
considered to be material weaknesses.
• State that the communication is intended solely for the information and use of management, those
charged with governance, and others within the organization and is not intended to be and should not
be used by anyone other than those specified parties. If an entity is required to furnish such auditor
communications to a governmental authority, specific reference to such governmental authorities may
be made.
Internal controls Related matters Comment
State that the purpose of the audit was to express The latter part of the sentence is
an opinion on the financial statements, and to incorrect since no opinion on
express an opinion on the effectiveness of the Excluded internal control effectiveness is
entity’s internal control over financial reporting. issued.
Identify, if applicable, items that are considered to
be material weaknesses. Included Required
State that the author is not expressing an opinion
on the effectiveness of internal control. Included Required
Include the definition of the term significant
deficiency. Included Required
Include the definition of the term material
weakness, where relevant. Included Required
State that the author is expressing an unqualified The auditor expresses no opinion
opinion on the effectiveness of internal control. Excluded on internal control.
State that the communication is intended solely for The communication is not
management and external parties. Excluded intended for external parties.
Identify the matters that are considered to be Included Required
significant deficiencies.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
2. Enter the exact section and paragraph with helpful information. 5 14
MODULE 4 RESPONDING TO RISK ASSESSMENT 113
RESPONDING TO RISK ASSESSMENT:
EVIDENCE ACCUMULATION AND EVALUATION
to the amount of corroborative
evidence obtained.
1. Which of the following best describes d. Effective internal control provides more
what is meant by the term generally assurance about the reliability of audit
accepted auditing standards? evidence.
a. Procedures to be used to 6. Which of the following statements relating
gather evidence to support
to the appropriateness of audit evidence is
always true?
b. Measures of the quality of the
a. Audit evidence gathered by an
auditor’s performance.
auditor from outside an
c. Pronouncements issued by the Auditing enterprise is reliable.
Standards Board.
b. Accounting data developed under
d. Rules acknowledged by the satisfactory conditions of internal
accounting profession because of control are more relevant than data
their universal application. developed under unsatisfactory
2. Which of the following is not an assertion internal control conditions.
relating to classes of transactions? c. Oral representations made by
a. Accuracy. management are not valid
b. Consistency. evidence.
c. Cutoff.
d. Occurrence.
3. Which of the following is a general
principle relating to the reliability of audit
evidence?
a. Audit evidence obtained from
indirect sources rather than directly
is more reliable than evidence
obtained directly by the auditor.
b. Audit evidence provided by
copies is more reliable than
that provided by facsimiles.
c. Audit evidence obtained from
knowledgeable independent sources
outside the client company is more
reliable than audit evidence
obtained from nonindependent
sources.
d. Audit evidence provided by
original documents is more reliable
than audit evidence generated
through a system of effective
controls.
4. Which of the following types of audit
evidence is the most persuasive?
a. Prenumbered client purchase order forms.
b. Client work sheets supporting cost
allocations.
c. Bank statements obtained from the client.
d. Client representation letter.
5. Which of the following presumptions is
correct about the reliability of audit
evidence?
a. Information obtained
indirectly from outside
sources is the most reliable
audit evidence.
b. To be reliable, audit evidence
should be convincing rather
than persuasive.
c. Reliability of audit evidence refers
d. Evidence gathered by auditors key factors or assumptions used in
must be both valid and relevant to preparing the estimates.
be considered appropriate. c. Test the calculations used by
management in developing the
7. Which of the following types of audit estimates.
evidence is the least persuasive? d. Obtain an understanding of how
a. Prenumbered purchase order forms. management developed its
b. Bank statements obtained from the client. estimates.
c. Test counts of inventory
performed by the auditor. 11. In evaluating the reasonableness of an
d. Correspondence from the client’s accounting estimate, an auditor most likely
attorney about litigation. would concentrate on key factors and
assumptions that are
8. In evaluating the reasonableness of an a. Consistent with prior periods.
entity’s accounting estimates, an auditor b. Similar to industry guidelines.
normally would be concerned about c. Objective and not susceptible to bias.
assumptions that are d. Deviations from historical patterns.
a. Susceptible to bias.
b. Consistent with prior periods. 12. In evaluating an entity’s accounting
c. Insensitive to variations. estimates, one of an auditor’s objectives is to
d. Similar to industry guidelines. determine whether the estimates are
a. Not subject to bias.
9. Which of the following is not a basic b. Consistent with industry guidelines.
procedure used in an audit? c. Based on objective assumptions.
a. Risk assessment procedures. d. Reasonable in the circumstances.
b. Substantive procedures.
c. Tests of controls. 13. In testing the existence assertion for an
d. Tests of direct evidence. asset, an auditor ordinarily works from the
a. Financial statements to the
10. Which of the following procedures would potentially unrecorded items.
an auditor ordinarily perform first in b. Potentially unrecorded items to the financial
evaluating management’s accounting statements.
estimates for reasonableness? c. Accounting records to the supporting
a. Develop independent evidence.
expectations of management’s d. Supporting evidence to the accounting
estimates. records.
b. Consider the appropriateness of the
114 MODULE 4 RESPONDING TO RISK ASSESSMENT
b. Adhering to a system of quality
control.
14. A client uses a suspense account c. Preparing auditor working
for unresolved questions whose papers.
final accounting has not been d. Increasing the level of detection
determined. If a balance remains risk.
in the suspense account at year
end, the auditor would be most 18. An entity’s income statements
concerned about were misstated due to the
a. Suspense debits that recording of journal entries that
management believes involved debits and credits to
will benefit future an unusual combination of
operations. expense and revenue accounts.
b. Suspense debits that the The auditor most likely could
auditor verifies will have detected this fraudulent
have realizable value to financial reporting by
the client. a. Tracing a sample of
c. Suspense credits that journal entries to the
management believes should be general ledger.
classified as “Current liability.” b. Evaluating the effectiveness of
d. Suspense credits that internal control.
the auditor determines c. Investigating the
to be customer deposits. reconciliations between
controlling accounts
15. Which of the following would and subsidiary records.
not be considered an analytical d. Performing analytical
procedure? procedures designed to
a. Estimating payroll disclose differences
expense by multiplying from expectations.
the number of
19. Auditors try to identify
employees by the
average hourly wage predictable relationships when
rate and the total hours using analytical procedures.
worked. Relationships involving trans
actions from which of the
b. Projecting an error rate
following accounts most likely
by comparing the
would yield the highest level of
results of a statistical
evidence?
sample with the actual
population a. Accounts receivable.
characteristics. b. Interest expense.
c. Computing accounts receivable c. Accounts payable.
turnover by dividing credit sales d. Travel and entertainment
by the average net receivables. expense.
d. Developing the 20. Analytical procedures used in the
expected current year overall review stage of an audit
sales based on the sales generally include
trend of the prior five
years.
16. What type of analytical
procedure would an auditor most
likely use in developing
relationships among balance
sheet accounts when reviewing
the financial statements of a
nonpublic entity?
a. Trend analysis.
b. Regression analysis.
c. Ratio analysis.
d. Risk analysis.
17. An auditor may achieve audit
objectives related to
particular assertions by
a. Performing analytical
procedures.
sence of known
a. Gathering evidence conditions to the
concerning account contrary.
balances that have not d. These procedures cannot replace
changed from the prior tests of balances and
year. transactions.
b. Retesting control
procedures that 23. For all audits of financial
appeared to be statements made in accordance
ineffective during the with generally accepted auditing
assessment of control standards, the use of analytical
risk. procedures is required to some
c. Considering unusual extent
or unexpected account In the As a In the
balances that were planning stage substantive test review stage
not previously a. Yes No Yes
b. No Yes No
identified.
c. No Yes Yes
d. Performing tests of
d. Yes No No
transactions to
corroborate 24. An auditor’s analytical
management’s procedures most likely would be
financial statement facilitated if the entity
assertions. a. Segregates obsolete
inventory before the
21. Which of the following tends to physical inventory
be most predictable for purposes count.
of analytical procedures applied b. Uses a standard cost
as substantive tests? system that produces
a. Relationships involving balance variance reports.
sheet accounts. c. Corrects material
b. Transactions subject to weaknesses in internal
management discretion. control before the
c. Relationships beginning of the audit.
involving income d. Develops its data from
statement accounts. sources solely within
d. Data subject to audit testing in the entity.
the prior year.
25. Analytical procedures performed
22. A basic premise underlying the in the overall review stage of an
application of analytical audit suggest that several
procedures is that accounts have unexpected
a. The study of financial relationships. The results of these
ratios is an acceptable procedures most likely would
alternative to the indicate that
investigation of a. Irregularities exist
unusual fluctuations. among the relevant
b. Statistical tests of account balances.
financial information b. Internal control
may lead to the activities are not
discovery of material operating effectively.
misstatements in the c. Additional tests of details are
financial statements. required.
c. Plausible relationships d. The communication
among data may with the audit
reasonably be committee should
expected to exist and be revised.
continue in the ab
to
a. Comply with
26. Which of the following generally accepted
comparisons would an auditor auditing standards.
most likely make in evaluating an b. Attain assurance
entity’s costs and expenses? about the reliability
a. The current year’s of the accounting
accounts receivable system.
with the prior year’s c. Detect material
accounts receivable. misstatements in the
b. The current year’s financial statements.
payroll expense with d. Evaluate whether
the prior year’s payroll management’s policies
expense. and procedures
c. The budgeted current operated effectively.
year’s sales with the
prior year’s sales. 30. In the context of an audit of
d. The budgeted current financial statements, substantive
year’s warranty tests are audit procedures that
expense with the a. May be eliminated under certain
conditions.
current year’s
b. Are designed to
contingent liabilities.
discover significant
27. To be effective, analytical procedures in the subsequent events.
overall review stage of an audit engagement c. May be either tests of
should be performed by transactions, direct
a. The staff accountant tests of financial
who performed the balances, or analytical
substantive auditing tests.
procedures. d. Will increase
b. The managing partner proportionately with
who has responsibility the auditor’s reliance
for all audit on internal control.
engagements at that
31. The auditor will most likely
practice office.
perform extensive tests for
c. A manager or partner possible understatement of
who has a
a. Revenues.
comprehensive
knowledge of the b. Assets.
client’s business and c. Liabilities.
industry. d. Capital.
d. The CPA firm’s quality 32. Which of the following
control manager or procedures would an auditor most
partner who has likely perform in auditing the
responsibility for the statement of cash flows?
firm’s peer review a. Compare the amounts included
program. in the statement of cash flows to
28. Which of the following is the similar amounts in the prior
best example of a substantive year’s statement of cash flows.
test?
a. Examining a sample of
cash disbursements to test
whether expenses have
been properly approved.
b. Confirmation of balances of
c. Comparison of
signatures on checks
to a list of authorized
signers.
d. Flowcharting of the client’s cash
receipts system.
29. The objective of tests of
details of transactions per
formed as substantive tests is
relevance to
b. Reconcile the cutoff forthcoming
bank statements to audits.
verify the accuracy of c. Until 3 years after
the yearend bank the client selects
balances. another auditor.
c. Vouch all bank d. Working papers must be
transfers for the last maintained indefinitely.
week of the year and
first week of the 36. Which of the following pairs of
subsequent year. accounts would an auditor most
d. Reconcile the amounts likely analyze on the same
included in the working paper?
statement of cash a. Notes receivable and interest
flows to the other income.
financial statements’ b. Accrued interest
balances and amounts. receivable and
accrued interest
33. In determining whether payable.
transactions have been recorded, c. Notes payable and notes
the direction of the audit testing receivable.
should be from the d. Interest income and interest
a. General ledger balances. expense.
b. Adjusted trial balance.
c. Original source documents. 37. An auditor’s working papers serve
d. General journal entries. mainly to
a. Provide the principal
34. Which statement is correct support for the
concerning the deletion of audit auditor’s report.
documentation? b. Satisfy the auditor’s
a. Superseded audit documentation responsibilities
should always be deleted from concerning the Code
the audit file. of Professional
b. After the audit Conduct.
file has been c. Monitor the
completed, the effectiveness of the
auditor should CPA firm’s quality
not delete or control procedures.
discard audit d. Document the level of
documentation. independence
c. Auditors should use maintained by the
professional skepticism auditor.
in determining which
audit documentation 38. The permanent file of an
should be deleted. auditor’s working papers
d. Audit generally would not include
documentation a. Bond indenture agreements.
should never be b. Lease agreements.
deleted from the c. Working trial balance.
audit file. d. Flowchart of internal control.
35. Ignoring any particular 39. An auditor ordinarily uses a
legal or regulatory working trial balance
requirement, audit resembling the financial
documentation should be statements without footnotes,
retained but containing columns for
a. A minimum of five years. a. Cash flow increases and
b. As long as lead decreases.
schedules have b. Audit objectives and assertions.
42. Which of the following factors
c. Reclassifications and most likely would affect an
adjustments. auditor’s judgment about the
d. Reconciliations and tick marks. quantity, type, and content of
the auditor’s working papers?
40. Which of the following is least a. The assessed level of control
likely to be a factor in the risk.
auditor’s decision about the b. The likelihood of a
extent of the documentation of a review by a
particular audit area? concurring (second)
a. The risk of material partner.
misstatement. c. The number of personnel
b. The extent of the assigned to the audit.
judgment involved in d. The content of the management
performing the representation letter.
procedures.
c. The nature and extent of 43. The audit working paper that
exceptions identified. reflects the major components
d. Whether or not the of an amount reported in the
client has an financial statements is the
internal audit a. Interbank transfer schedule.
function. b. Carryforward schedule.
c. Supporting schedule.
41. Which of the following is d. Lead schedule.
required documentation in an
audit in accordance with 44. Which of the following
generally accepted auditing documentation is required for an
standards? audit in accordance with generally
a. A flowchart or narrative accepted auditing standards?
of the accounting system a.
describing the recording b.
and classification of c.
transactions for financial
reporting.
b. An audit program
setting forth in detail the
procedures necessary to
accomplish the
engagement’s
objectives.
c. A planning
memorandum
establishing the timing
of the audit procedures
and coordinating the as
sistance of entity
personnel.
A flowchart or an internal control questionnaire
that evaluates the effectiveness of the entity’s
controls.
A client engagement letter that summarizes the
timing and details of the auditor’s planned field
work.
An indication in the working papers that the ac
counting records agree or reconcile with the fi
nancial statements.
The basis for the auditor’s conclusions when the
assessed level of control risk is at the maximum
level for all financial statement assertions.
d. An internal control
questionnaire
identifying controls that
assure specific
objectives will be
achieved.
b. Cash in bank and collateral for
45. No deletions of audit documentation loans.
are allowed after c. Inventory on
the consignment and
a. Client’s yearend. contingent liabilities.
b. Documentation completion date. d. Accounts receivable
c. Last date of significant and accrued interest
fieldwork. receivable.
d. Report release date. 49. The usefulness of the standard
46. Under the requirements of the PCAOB, bank confirmation request may
audit documentation must contain sufficient be limited because the bank
information to allow what type of auditor to employee who completes the
understand the nature, timing, extent, and form may
results of procedures performed? a. Not believe that the
a. An experienced audit team bank is obligated to
member. verify confidential
information to a third
b. An experienced
party.
auditor having no
b. Sign and return the
previous
connection with form without
the engagement. inspecting the accuracy
c. Any certified public accountant. of the client’s bank
d. An auditor qualified as a peer reconciliation.
review specialist. c. Not have access to the
client’s cutoff bank
47. Audit documentation for audits statement.
performed under the d. Be unaware of all the
requirements of the Public financial relationships
Company Accounting Oversight that the bank has with
Board should be retained for the client.
a. The shorter of five
years, or the period 50. An auditor most likely would
required by law. limit substantive audit tests of
b. Seven years. sales transactions when control
risk is assessed as low for the
c. The longer of seven
occurrence assertion concerning
years, or the period
sales transactions and the
required by law.
auditor has already gathered
d. Indefinitely.
evidence supporting
48. Which of the following sets of a. Opening and closing inventory
information does an auditor balances.
usually confirm on one form? b. Cash receipts and accounts
a. Accounts payable and purchase receivable.
commitments. c. Shipping and receiving activities.
d. Cutoffs of sales and purchases.
d.
Items 51 and 52 are based on the following:
The information below was taken from the bank transfer schedule prepared during the audit of
Fox Co.’s financial statements for the year ended December 31, 2005. Assume all checks are
dated and issued on December 30, 2005.
Bank accounts Disbursement date Receipt date

Check Per Per Per Per
no. From To books bank books bank
101 National Federal Dec. 30 Jan. 4 Dec. 30 Jan. 3
202 County State Jan. 3 Jan. 2 Dec. 30 Dec. 31
303 Federal American Dec. 31 Jan. 3 Jan. 2 Jan. 2
404 State Republic Jan. 2 Jan. 2 Jan. 2 Dec. 31
indicate kiting?
51. Which of the following checks might a. #101 and #303.
b. #202 and #404. 52. Which of the following checks
c. #101 and #404. illustrate deposits/transfers in transit at
d. #202 and #303. December 31, 2005?
a. #101 and #202.
b. #101 and #303.
c. #202 and #404.
d. #303 and #404.
56. A cash shortage may be concealed
53. An auditor should trace bank by transporting funds from one
transfers for the last part of the location to another or by
audit period and first part of the converting negotiable assets to
subsequent period to detect cash. Because of this, which of
whether the following is vital?
a. The cash receipts a. Simultaneous confirmations.
journal was held open b. Simultaneous bank
for a few days after the reconciliations.
yearend. c. Simultaneous verification.
b. The last checks recorded before d. Simultaneous surprise cash
the yearend were actually count.
mailed by the yearend.
c. Cash balances were overstated 57. The primary purpose of sending a standard
because of kiting. confirmation request to financial
d. Any unusual payments institutions with which the client has done
to or receipts from business during the year is to
related parties occurred. a. Detect kiting activities
that may otherwise not
54. To gather evidence regarding the be discovered.
balance per bank in a bank b. Corroborate
reconciliation, an auditor would information
examine all of the following regarding deposit and
except loan balances.
a. Cutoff bank statement. c. Provide the data
b. Yearend bank statement. necessary to prepare a
c. Bank confirmation. proof of cash.
d. General ledger. d. Request information
about contingent
55. Which of the following cash liabilities and secured
transfers results in a mis transactions.
statement of cash at December
31, 2005? 58. An auditor observes the mailing of monthly
Bank Transfer Schedule statements to a client’s customers and
Disbursement Receipt reviews evidence of followup on errors
reported by the customers. This test of
Recorded Paid by Recorded controls most likely is performed to support
Transfer in books bank in books management’s financial statement
a. 12/31/05 1/4/06 12/31/05 assertion(s) of
b. 1/4/06 1/5/06 12/31/05
c. 12/31/05 1/5/06 12/31/05
d. 1/4/06 1/11/06 1/4/06
Presentation Existence
and disclosure occurrence
a. Yes Yes
b. Yes No
c. No Yes
d. No No
Miles Company
BANK TRANSFER SCHEDULE
December 31, 2005
Check Bank accounts Date disbursed per Date deposited per
no. From To Amount Books Bank Books Bank
2020 1st Natl. Suburban $32,000 12/31 1/5 12/31 1/3
2021 1st Natl. Capital 21,000 12/31 1/4 12/31 1/3
3217 2nd State Suburban 6,700 1/3 1/5 1/3 1/6
0659 Midtown Suburban 5,500 12/30 1/5 12/30 1/3
60. The tick mark most likely indicates that
59. The tick mark most likely indicates that the amountwas traced to the
the amountwas traced to the a. Deposits in transit of the
a. December cash disbursements applicable bank reconciliation.
journal. b. December cash receipts journal.
b. Outstanding check list of the c. January cash receipts journal.
applicable bank reconciliation. d. Yearend bank confirmations.
c. January cash disbursements
journal.
d. Yearend bank confirmations.
misstatements, required
substantial time to resolve. In
61. Which of the following defining the sampling unit for the
statements is correct concerning current year’s audit, the auditor
the use of negative confirmation most likely would choose
requests? a. Individual overdue balances.
a. Unreturned negative b. Individual invoices.
confirmation requests c. Small account balances.
rarely provide d. Large account balances.
significant explicit
evidence. 64. Confirmation is most likely to be
b. Negative confirmation requests a relevant form of evidence with
are effective when detection risk regard to assertions about
is low. accounts receivable when the
c. Unreturned negative auditor has concerns about the
confirmation requests receivables’
indicate that alternative a. Valuation.
procedures are b. Classification.
necessary. c. Existence.
d. Negative confirmation requests d. Completeness.
are effective when
understatements of account 65. An auditor should perform
balances are suspected. alternative procedures to
substantiate the existence of
62. When an auditor does not receive accounts receivable when
replies to positive requests for a. No reply to a positive
yearend accounts receivable confirmation request is
confirmations, the auditor most received.
likely would b. No reply to a negative
a. Inspect the allowance confirmation request is
account to verify received.
whether the accounts c. Collectibility of the receivables
were subsequently is in doubt.
written off. d. Pledging of the receivables is
b. Increase the assessed probable.
level of detection risk
for the valuation and 66. Which of the following
completeness procedures would an auditor most
assertions. likely perform for yearend
c. Ask the client to accounts receivable con
contact the customers firmations when the auditor did
to request that the not receive replies to second
confirmations be requests?
returned.
d. Increase the assessed
level of inherent risk for
the revenue cycle.
63. In confirming a client’s accounts
receivable in prior years, an
auditor found that there were
many differences between the
recorded account balances and the
confirmation replies. These
differences, which were not
a. Review the cash confirmations to be
receipts journal for exceptions.
the month prior to d. Mail second requests to the e
the yearend. mail respondents.
b. Intensify the study of
internal control 69. To reduce the risks associated with
concerning the revenue accepting fax responses to requests for
cycle. confirmations of accounts receivable, an
c. Increase the assessed auditor most likely would
level of detection risk a. Examine the shipping documents
for the existence that provide evidence for the
assertion. existence assertion.
d. Inspect the shipping b. Verify the sources
records and contents of the
documenting the faxes in telephone
merchandise sold to calls to the senders.
the debtors. c. Consider the faxes to be
nonresponses and
67. In which of the following evaluate them as
circumstances would the use of unadjusted differences.
the negative form of accounts d. Inspect the faxes for
receivable confirmation most forgeries or alterations
likely be justified? and consider them to be
a. A substantial number acceptable if none are
of accounts may be in noted.
dispute and the
accounts receivable 70. In auditing accounts receivable,
balance arises from the negative form of
sales to a few major confirmation request most
customers. likely would be used when
b. A substantial number a. The total recorded amount of
of accounts may be in accounts receivable is immaterial
dispute and the to the financial statements taken
accounts receivable as a whole.
balance arises from b. Response rates in prior
sales to many years to properly
customers with small designed positive
balances. confirmation requests
c. A small number of were inadequate.
accounts may be in
dispute and the
accounts receivable
balance arises from
sales to a few major
customers.
d. A small number of
accounts may be in
dispute and the
accounts receivable
balance arises from
sales to many
customers with small
balances.
68. To reduce the risks associated
with accepting email responses
to requests for confirmation of
accounts receivable, an auditor
most likely would
a. Request the senders to
mail the original forms
to the auditor.
b. Examine
subsequent cash
receipts for the ac
counts in question.
c. Consider the email
responses to the
c. Recipients are likely to return positive confirma 75. An auditor most likely would make
inquiries of pro
tion requests without verifying duction and sales personnel concerning
the accuracy of the information. possible obsolete or slowmoving
d. The combined assessed inventory to support management’s
level of inherent risk and financial statement assertion of
control risk relative to a. Valuation.
accounts receivable is b. Rights.
low. c. Existence.
d. Presentation.
71. Under which of the following circumstances
would the use of the blank form of
confirmations of accounts receivable most
likely be preferable to positive
confirmations?
a. The recipients are likely to sign the confirmations76. While observing a client’s annual
physical inventory,
without devoting proper receivable to encourage timely
attention to them. consideration by the recipients?
b. Subsequent cash a. “This is not a request
receipts are unusually for payment;
difficult to verify. remittances should not
c. Analytical be sent to our auditors
procedures indicate in the enclosed
that few exceptions envelope.”
are expected.
b. “Report any differences
d. The combined assessed on the enclosed
level of inherent risk
statement directly to our
and control risk is low.
auditors; no reply is
72. In confirming accounts necessary if this amount
receivable, an auditor decided to agrees with your
confirm customers’ account records.”
balances rather than individual c. “If you do not report
invoices. Which of the following any differences within
most likely would be included fifteen days, it will be
with the client’s confirmation assumed that this
letter? statement is correct.”
a. An auditorprepared d. “The following invoices
letter explaining that a have been selected for
nonresponse may confirmation and
cause an inference that represent amounts that
the account balance is are overdue.”
correct.
b. A clientprepared letter 74. Which of the following
reminding the customer strategies most likely could
that a nonresponse will improve the response rate of
cause a second request the confirmation of accounts
to be sent. receivable?
c. An auditorprepared a. Including a list of items
letter requesting the cus or invoices that
tomer to supply missing constitute the account
and incorrect balance.
information directly to b. Restricting the
the auditor. selection of accounts
d. A clientprepared to be confirmed to
statement of account those customers with
showing the details of relatively large
the customer’s account balances.
balance. c. Requesting customers to
respond to the confirma
73. Which of the following statements would tion requests directly to
an auditor most likely add to the negative the auditor by fax or e
form of confirmations of accounts mail.
d. Notifying the recipients an auditor recorded test counts for several
that second requests items and noticed that certain test counts
will be mailed if they were higher than the recorded quantities
fail to respond in a in the client’s perpetual records. This
timely manner. situation could be the result of the client’s
failure to record
a. Purchase discounts.
b. Purchase returns.
c. Sales.
d. Sales returns.
77. To gain assurance that all
inventory items in a client’s
inventory listing schedule are
valid, an auditor most likely
would trace
a. Inventory tags noted
during the auditor’s
observation to items
listed in the inventory
listing schedule.
b. Inventory tags noted
during the auditor’s
observation to items
listed in receiving
reports and vendors’
invoices.
c. Items listed in the
inventory listing
schedule to inventory
tags and the auditor’s
recorded count sheets.
d. Items listed in
receiving reports and
vendors’ invoices to
the inventory listing
schedule.
78. To measure how effectively an
entity employs its resources, an
auditor calculates inventory
turnover by dividing average
inventory into
a. Net sales.
b. Cost of goods sold.
c. Operating income.
d. Gross sales.
auditing procedures most likely
would provide assurance about
a manufacturing entity’s
inventory valuation?
a. Testing the entity’s
computation of standard
overhead rates.
b. Obtaining confirmation of
inventories pledged under loan
agreements.
c. Reviewing shipping
and receiving cutoff
procedures for
inventories.
d. Tracing test counts to
the entity’s inventory
listing.
80. A client maintains perpetual
inventory records in both c. Insist that the client
quantities and dollars. If the perform physical
assessed level of control risk is counts of inventory
high, an auditor would probably items several times
a. Increase the extent of during the year.
tests of controls of the d. Apply gross profit
inventory cycle. tests to ascertain
b. Request the client to the rea
schedule the physical sonableness of the
inventory count at the physical counts.
end of the year.
examines securities should insist
that a client representative be
81. An auditor concluded that no present in order to
excessive costs for idle plant a. Detect fraudulent securities.
were charged to inventory. This b. Lend authority to the auditor’s
conclusion most likely related to directives.
the auditor’s objective to obtain c. Acknowledge the receipt of
evidence about the financial securities returned.
statement assertions regarding d. Coordinate the return
inventory, including presentation of securities to the
and disclosure and proper locations.
a. Valuation.
b. Completeness. 87. In establishing the existence and
c. Existence. ownership of a longterm
d. Rights. investment in the form of
publicly traded stock, an auditor
82. An auditor selected items for test counts should inspect the securities or
while observing a client’s physical a. Correspond with the
inventory. The auditor then traced the test investee company to
counts to the client’s inventory listing. This verify the number of
procedure most likely obtained evidence shares owned.
concerning management’s assertion of b. Inspect the audited
a. Rights. financial statements of
b. Completeness. the investee company.
c. Existence. c. Confirm the number of shares
d. Valuation. owned that are held by an
independent custodian.
83. An auditor most likely would d. Determine that the
analyze inventory turnover investment is carried
rates to obtain evidence at the lower of cost
concerning management’s as or market.
sertions about
a. Existence. 88. When an auditor is unable to
b. Rights. inspect and count a client’s
c. Presentation. investment securities until after the
d. Valuation. balance sheet date,
84. An auditor usually examines

receiving reports to support
entries in the
a. Voucher register and sales
returns journal.
b. Sales journal and sales returns
journal.
c. Voucher register and sales
journal.
d. Check register and sales journal.
85. When auditing inventories,
an auditor would least likely
verify that
a. The financial
statement presentation
of inventories is
appropriate.
b. Damaged goods and
obsolete items have
been properly
accounted for.
c. All inventory owned
by the client is on
hand at the time of
the count.
d. The client has used proper
inventory pricing.
86. An auditor who physically
a. The estimated
the bank where the securities are held in remaining useful lives
a safedeposit box should be asked to of plant assets were
a. Verify any differences revised upward.
between the contents of b. Plant assets were retired during
the box and the balances the year.
in the client’s subsidiary c. The prior year’s
ledger. depreciation expense
b. Provide a list of was erroneously
securities added and understated.
removed from the box d. Overhead allocations were
between the balance revised at yearend.
sheet date and the
securitycount date. 92. In testing for unrecorded
c. Confirm that there has retirements of equipment, an
been no access to the auditor most likely would
box between the a. Select items of equipment from
balance sheet date and the accounting records and then
the securitycount locate them during the plant tour.
date. b. Compare depreciation
journal entries with
d. Count the securities in
similar prior year
the box so the auditor
will have an entries in search of fully
independent direct depreciated equipment.
verification. c. Inspect items of
equipment observed
89. In testing longterm investments, during the plant tour
an auditor ordinarily would use and then trace them to
analytical procedures to ascertain the equipment
the reasonableness of the subsidiary ledger.
a. Completeness of recorded d. Scan the general
investment income. journal for unusual
b. Classification equipment additions
between current and and excessive debits
noncurrent to repairs and
portfolios. maintenance expense.
c. Valuation of marketable equity
93. An auditor analyzes repairs and
securities.
maintenance accounts primarily
d. Existence of unrealized
to obtain evidence in support of
gains or losses in the
the audit assertion that all
portfolio.
a. Noncapitalizable
90. Analysis of which account is expenditures for repairs
least likely to reveal and maintenance have
evidence relating to recorded been recorded in the
retirement of equipment? proper period.
a. Accumulated depreciation. b. Expenditures for
b. Insurance expense. property and
c. Property, plant, and equipment. equipment have been
recorded in the
d. Purchase returns and allowances.
proper period.
91. Which of the following c. Noncapitalizable
explanations most likely would expenditures for
satisfy an auditor who questions repairs and
management about significant maintenance have
debits to the accumulated been properly
depreciation accounts? charged to expense.
possibility of a(n)
a. Insurance premium due but not
d. Expenditures for recorded.
property and b. Deficiency in the coinsurance
equipment have not provision.
been charged to c. Lien on the plant equipment.
expense. d. Understatement of insurance
expense.
94. The auditor is most likely to seek
information from the plant manager with 99. Which of the following
respect to the procedures would an auditor
a. Adequacy of the most likely perform in searching
provision for for unrecorded liabilities?
uncollectible ac a. Trace a sample of
counts. accounts payable
b. Appropriateness of entries recorded just
physical inventory before yearend to the
observation unmatched receiving
procedures. report file.
c. Existence of obsolete machinery. b. Compare a sample of
d. Deferral of purchase orders issued
procurement of certain just after yearend with
necessary insurance the yearend accounts
coverage. payable trial balance.
c. Vouch a sample of cash
95. Treetop Corporation acquired a disbursements recorded just after
building and arranged mortgage yearend to receiving reports and
financing during the year. vendor invoices.
Verification of the related
mortgage acquisition costs would
be least likely to include an
examination of the related
a. Deed.
b. Canceled checks.
c. Closing statement.
d. Interest expense.
96. In testing plant and equipment balances, an
auditor may inspect new additions listed on
the analysis of plant and equipment. This
procedure is designed to obtain evidence
concerning management’s assertions of
Existence or Presentation and
occurrence disclosure
a. Yes Yes
b. Yes No
c. No Yes
d. No No
97. In auditing intangible assets, an
auditor most likely would
review or recompute
amortization and determine
whether the amortization period
is reasonable in support of
management’s financial
statement assertion of
a. Valuation or allocation.
b. Existence or occurrence.
c. Completeness.
98. When auditing prepaid insurance,
an auditor discovers that the
original insurance policy on plant
equipment is not available for
inspection. The policy’s absence
most likely indicates the
prenumbered purchase orders are
100. When using confirmations to used and accounted for.
provide evidence about the b. Receiving the client’s mail,
completeness assertion for unopened, for a reasonable
accounts payable, the appro period of time after the yearend
priate population most likely to search for unrecorded
would be vendors’ invoices.
a. Vendors with c. Vouching selected entries in the
whom the entity has accounts payable subsidiary
previously done ledger to purchase orders and
business. receiving reports.
b. Amounts recorded in d. Confirming
the accounts payable accounts payable
subsidiary ledger. balances with
c. Payees of checks known suppliers
drawn in the month who have zero
after the yearend. balances.
d. Invoices filed in the entity’s
open invoice file. 103. In auditing accounts payable, an
auditor’s procedures most likely
101. Auditor confirmation of would focus primarily on
accounts payable balances at the management’s assertion of
balance sheet date may be a. Existence.
unnecessary because b. Presentation and disclosure.
a. This is a duplication of cutoff c. Completeness.
tests. d. Valuation.
b. Accounts payable
balances at the 104. When a CPA observes that the
balance sheet date recorded interest expense seems
may not be paid to be excessive in relation to the
before the audit is balance in the bonds payable
completed. account, the CPA might suspect
c. Correspondence with that
the audit client’s a. Discount on bonds payable is
attorney will reveal understated.
all legal action by b. Bonds payable are understated.
vendors for non c. Bonds payable are overstated.
payment. d. Premium on bonds payable is
d. There is likely to be overstated.
other reliable external
evidence to support 105. An auditor most likely would
the balances. inspect loan agreements under
which an entity’s inventories are
102. Which of the following is a pledged to support
substantive test that an auditor management’s financial
most likely would perform to statement assertion of
verify the existence and a. Presentation and disclosure.
valuation of recorded accounts b. Valuation or allocation.
payable? c. Existence or occurrence.
a. Investigating the open purchase d. Completeness.
order file to ascertain that
d. Scan the cash disbursements entries recorded just 106. In auditing longterm bonds
payable, an auditor most
before yearend for indications of likely would
unusual transactions. a. Perform analytical procedures on the
bond premium and discount
accounts.
are approved by
individual
b. Examine departmental
documentation of assets supervisors.
purchased with bond d. A separate payroll bank
proceeds for liens. account is maintained
c. Compare interest on an imprest basis.
expense with the bond
payable amount for 111. In auditing payroll, an auditor most
reasonableness. likely would
d. Confirm the existence a. Verify that checks
of individual bond representing unclaimed
holders at yearend. wages are mailed.
b. Trace individual
107. The auditor can best verify a employee deductions
client’s bond sinking fund to entity journal
transactions and yearend entries.
balance by c. Observe entity
a. Confirmation with employees during a
individual holders of payroll distribution.
retired bonds. d. Compare payroll
b. Confirmation with the bond costs with entity
trustee. standards or budgets.
c. Recomputation of
interest expense, 112. In performing tests concerning
interest payable, and the granting of stock options,
amortization of bond an auditor should
discount or premium. a. Confirm the
d. Examination and count of the transaction with the
bonds retired during the year. Secretary of State
in the state of
108. An auditor usually obtains incorporation.
evidence of stockholders’ b. Verify the existence
equity transactions by of option holders in
reviewing the entity’s the entity’s payroll
a. Minutes of board of directors records or stock
meetings. ledgers.
b. Transfer agent’s records. c. Determine that
c. Canceled stock certificates. sufficient treasury
d. Treasury stock certificate book. stock is available to
cover any new stock
109. When control risk is assessed as issued.
low for assertions related to d. Trace the
payroll, substantive tests of authorization for the
payroll balances most likely transaction to a vote
would be limited to applying of the board of
analytical procedures and directors.
a. Observing the distribution of
paychecks.
b. Footing and crossfooting the
payroll register.
c. Inspecting payroll tax returns.
d. Recalculating payroll accruals.
circumstances most likely would
cause an auditor to suspect an
employee payroll fraud scheme?
a. There are significant
unexplained variances
between standard
and actual labor cost.
b. Payroll checks are
disbursed by the
same employee
each payday.
c. Employee time cards
a. Cutoff tests indicate a
113. During an audit of an entity’s substantial amount of
stockholders’ equity accounts, accrued payroll
the auditor determines whether expense.
there are restrictions on retained b. The assessed level of
earnings resulting from loans, control risk relative to
agreements, or state law. This payroll transactions is
audit procedure most likely is low.
intended to verify management’s c. Analytical procedures
assertion of indicate unusual
a. Existence or occurrence. fluctuations in
b. Completeness. recurring payroll
c. Valuation or allocation. entries.
d. Presentation and disclosure. d. Accrued payroll expense
consists primarily of un
114. When a client company does not paid commissions.
maintain its own stock records, the
auditor should obtain written 117. An auditor usually tests the reasonableness
confirmation from the transfer agent of dividend income from investments in
and registrar concerning publicly held companies by computing the
amounts that should have been received by
a. Restrictions on the payment of
referring to
dividends.
a. Dividend record
b. The number of shares issued and
books produced by
outstanding. investment advisory
c. Guarantees of preferred stock services.
liquidation value. b. Stock indentures
d. The number of shares published by corporate
subject to agreements to transfer agents.
repurchase. c. Stock ledgers
115. An audit program for the maintained by
examination of the retained independent regis
earnings account should include trars.
a step that requires verification d. Annual audited
of the financial statements
issued by the investee
a. Market value used to
charge retained companies.
earnings to account for 118. The most likely risk
a twoforone stock involved with a bill and hold
split. transaction at yearend is
b. Approval of the a(n)
adjustment to the a. Accrued liability may
beginning balance as a be overstated as of
result of a writedown yearend.
of an account re b. Buyer may have made
ceivable. an absolute purchase
c. Authorization for both cash and commitment.
stock dividends. c. Sale may
d. Gain or loss resulting inappropriately have
from disposition of been recorded as of
treasury shares. yearend.
116. An auditor most likely would perform d. Buyer may have
substantive tests of details on payroll assumed the risk and
transactions and balances when reward of the
purchased product.
d. Reductions of obsolete
inventory to net
119. Which of the following realizable value.
accounts is the practice of
“channel stuffing” for sales 123. The date of the management
most likely to most directly af representation letter should
fect, and thereby result in coincide with the date of the
additional audit procedures? a. Balance sheet.
a. Accrued liabilities. b. Latest interim financial
b. Allowance for sales returns. information.
c. Cash. c. Auditor’s report.
d. Marketable investments. d. Latest relatedparty transaction.
120. Recorded entries in which of 124. Which of the following matters

the following accounts are would an auditor most likely
most likely to relate to the include in a management
property, plant, and equipment representation letter?
completeness assertion? a. Communications with
a. Allowance for doubtful accounts. the audit committee
concerning
b. Marketable securities.
weaknesses in internal
c. Property, plant, and equipment. control.
d. Repairs and maintenance b. The completeness and
expense. availability of minutes
121. For which of the following of stockholders’ and
matters should an auditor obtain directors’ meetings.
written management c. Plans to acquire or merge with
representations? other entities in the subsequent
a. Management’s cost year.
benefit justifications d. Management’s
for not correcting acknowledgment of
internal control its responsibility for
weaknesses. the detection of
employee fraud.
b. Management’s
knowledge of future 125. The current chief executive and
plans that may financial officers have only been
affect the price of employed by ABC Company for
the entity’s stock. the past five months of year 2.
c. Management’s ABC Company is presenting
compliance with comparative financial statements
contractual on Years 1 and 2, both of which
agreements that may were audited by William Jones,
affect the financial CPA. For which year(s) should
statements. Jones obtain written
d. Management’s representations from these two
acknowledgment of individuals?
its responsibility for
employees’
violations of laws.
122. To which of the following
matters would materiality limits
not apply in obtaining written
management representations?
a. The availability of
minutes of
stockholders’ and
directors’ meetings.
b. Losses from purchase
commitments at
prices in excess of
market value.
c. The disclosure of
compensating balance
arrangements
involving related
parties.
128. A written representation from a client’s
Year 1 Year 2 management which, among other matters,
a. No No acknowledges responsibility for the fair
b. No Yes presentation of financial statements, should
c. Yes No normally be signed by the
d. Yes Yes a. Chief executive officer
126. Which of the following and the chief financial
statements ordinarily is included officer.
among the written client b. Chief financial
representations obtained by the officer and the
auditor? chairman of the
a. Compensating balances board of directors.
and other arrangements c. Chairman of the audit
involving restrictions on committee of the board
cash balances have been of directors.
disclosed. d. Chief executive officer,
b. Management acknowledges the chairman of the
responsibility for illegal actions board of directors, and
committed by employees. the client’s lawyer.
c. Sufficient audit evidence 129. A limitation on the scope of the
has been made available auditor’s examination sufficient
to permit the issuance of to preclude an unqualified
an unqualified opinion. opinion will always result when
d. Management management
acknowledges that a. Prevents the auditor
there are no material from reviewing the
weaknesses in the working papers of the
internal control. predecessor auditor.
b. Engages the auditor after the
127. When considering the use of yearend physical inventory
management’s written count is completed.
representations as audit evidence c. Fails to correct a
about the completeness assertion, significant deficiency of
an auditor should understand that internal control that had
such representations been identified during
a. Complement, but do not the prior year’s audit.
replace, substantive tests d. Refuses to furnish a
designed to support the management
assertion. representation letter to
b. Constitute sufficient the auditor.
evidence to support the
assertion when 130. A purpose of a management
considered in representation letter is to reduce
combination with reli a. Audit risk to an
ance on internal control. aggregate level of
c. Are not part of the misstatement that
could be considered
audit evidence
material.
considered to support
b. An auditor’s
the assertion.
responsibility to detect
d. Replace reliance on internal material misstatements
control as evidence to support only to the extent that
the assertion. the letter is relied on.
the entity’s ability to
continue as a going
c. The possibility of a concern.
misunderstanding b. Desires to disclose the specialist’s
concerning findings, which imply that a more
management’s thorough audit was performed.
responsibility for the c. Is able to corroborate
financial statements. another specialist’s
d. The scope of an earlier findings that
auditor’s procedures were consistent with
concerning relatedparty management’s
transactions and representations.
subsequent events. d. Discovers significant
deficiencies in the
131. “There have been no design of the entity’s
communications from regulatory internal control that
agencies concerning management does not
noncompliance with, or
correct.
deficiencies in, financial reporting
practices that could have a 134. Which of the following
material effect on the financial statements is correct about the
statements.” The foregoing auditor’s use of the work of a
passage is most likely from a specialist?
a. Report on internal control. a. The specialist should
b. Special report. not have an
c. Management representation understanding of the
letter. auditor’s corroborative
d. Letter for underwriters. use of the specialist’s
132. Which of the following findings.
statements is correct concerning b. The auditor is required
an auditor’s use of the work of a to perform substantive
specialist? procedures to verify
a. The work of a the specialist’s
specialist who is assumptions and
related to the client findings.
may be acceptable c. The client should not
under certain circum have an
stances. understanding of the
b. If an auditor nature of the work to
believes that the be performed by the
determinations specialist.
made by a d. The auditor should obtain
specialist are an understanding of the
unreasonable, only methods and assumptions
a qualified opinion used by the specialist.
may be issued.
c. If there is a material 135. In using the work of a specialist,
difference between a an auditor referred to the
specialist’s findings specialist’s findings in the
and the assertions in the auditor’s report. This would be an
financial statements, appropriate reporting practice if
only an adverse opinion the
may be issued. a. Client is not familiar
d. An auditor may not use with the professional
a specialist in the deter certification, personal
mination of physical reputation, or particular
characteristics relating competence of the
to inventories. specialist.
133. In using the work of a specialist,
an auditor may refer to the
specialist in the auditor’s report
if, as a result of the specialist’s
findings, the auditor
a. Becomes aware of
conditions causing
substantial doubt about
collectively material to the
b. Auditor, as a result of client’s financial statements.
the specialist’s Which parties should reach an
findings, adds an understanding on the limits of
explanatory paragraph materiality for this purpose?
emphasizing a matter a. The auditor and the client’s
regarding the management.
financial statements. b. The client’s audit committee and
c. Client understands the the lawyer.
auditor’s corroborative c. The client’s management and the
use of the specialist’s lawyer.
findings in relation to d. The lawyer and the auditor.
the representations in
139. The refusal of a client’s attorney
to provide information requested
d. Auditor, as a result of
in an inquiry letter generally is
the specialist’s findings,
decides to indicate a considered
division of a. Grounds for an adverse opinion.
responsibility with the b. A limitation on the scope of the
specialist. audit.
c. Reason to withdraw from the
136. In using the work of a specialist, engagement.
an understanding should exist d. Equivalent to a significant
among the auditor, the client, and deficiency.
the specialist as to the nature of
the specialist’s work. The 140. Which of the following is an
documentation of this audit procedure that an auditor
understanding should cover most likely would perform
a. A statement that the concerning litigation, claims,
specialist assumes no and assessments?
responsibility to update a. Request the client’s
the specialist’s report for lawyer to evaluate
future events or whether the client’s
circumstances. pending litigation,
b. The conditions under claims, and as
which a division of sessments indicate a
responsibility may be going concern
necessary. problem.
c. The specialist’s b. Examine the legal
understanding of the documents in the client’s
auditor’s lawyer’s possession
corroborative use of concerning litigation,
the specialist’s claims, and assessments
findings. to which the lawyer has
d. The auditor’s disclaimer as to devoted substantive
whether the specialist’s findings attention.
corroborate the representations in c. Discuss with
the financial statements. management its
policies and proce
137. Which of the following is not a dures adopted for
specialist upon whose work an evaluating and
auditor may rely? accounting for
a. Actuary. litigation, claims, and
b. Appraiser. assessments.
c. Internal auditor. d. Confirm directly with
d. Engineer. the client’s lawyer that
all litigation, claims,
138. A lawyer’s response to an and assessments have
auditor’s inquiry concerning been recorded or
litigation, claims, and assessments disclosed in the
may be limited to matters that are financial statements.
considered individually or
representation.
b. An evaluation of the
141. The primary reason an auditor likelihood of an
requests letters of inquiry be unfavorable outcome of
sent to a client’s attorneys is to the matters disclosed by
provide the auditor with the entity.
a. The probable c. The attorney’s
outcome of asserted opinion of the entity’s
claims and pending historical experience
or threatened in recent similar
litigation. litigation.
b. Corroboration of the d. The probable
information furnished outcome of asserted
by management about claims and pending
litigation, claims, and or threatened
assessments. litigation.
c. The attorneys’ opinions
of the client’s historical 144. A CPA has received an
experiences in recent attorney’s letter in which no
similar litigation. significant disagreements with
the client’s assessments of
d. A description and
contingent liabilities were noted.
evaluation of litigation,
The resignation of the client’s
claims, and assessments
lawyer shortly after receipt of the
that existed at the
letter should alert the auditor that
balance sheet date.
a. Undisclosed unasserted claims
142. Which of the following is not an may have arisen.
audit procedure that the b. The attorney was
independent auditor would unable to form a
perform concerning litigation, conclusion with
claims, and assessments? respect to the
a. Obtain assurance from significance of
management that it has disclosed litigation, claims,
all unasserted claims that the and assessments.
lawyer has advised are probable c. The auditor must
of assertion and must be dis begin a completely
closed. new examination
b. Confirm directly with of contingent
the client’s lawyer that liabilities.
all claims have been d. An adverse opinion will be
recorded in the necessary.
c. Inquire of and discuss
statements extracted from a
with management the
client’s lawyer’s letter
policies and procedures
concerning litigation, claims,
adopted for identifying,
and assessments most likely
evaluating, and
would cause the auditor to
accounting for
request clarification?
litigation, claims, and
assessments. a. “I believe that the
possible liability to
d. Obtain from
the company is
management a
nominal in amount.”
description and
evaluation of b. “I believe that the
litigation, claims, and action can be settled
for less than the
assessments existing
damages claimed.”
at the balance sheet
date.
143. The scope of an audit is not
restricted when an attorney’s
response to an auditor as a result
of a client’s letter of audit
inquiry limits the response to
a. Matters to which the
attorney has given
substantive attention
in the form of legal
indications of possible
6. “I believe that the plaintiff’s case financial difficulties.
against the company is without
merit.” 149. After determining that a related
7. “I believe that the company will party transaction has, in fact,
be able to defend this action occurred, an auditor should
successfully.” a. Add a separate paragraph to the
auditor’s standard report to
146. When auditing the fair value of an explain the transaction.
asset or liability,valuation issues b. Perform analytical
ordinarily arise at the point of procedures to verify
Initial Subsequent to whether similar
recording initial recording transactions occurred,
a. Yes Yes but were not re
b. Yes No corded.
c. No Yes c. Obtain an
d. No No understanding of the
business purpose of the
147. Which of the following is least transaction.
likely to be an approach d. Substantiate that the
followed when auditing the fair transaction was
values of assets and liabilities? consummated on
a. Review and test terms equivalent to
management’s process an arm’slength
of valuation. transaction.
b. Confirm valuations
with audit committee 150. When auditing relatedparty
members. transactions, an auditor places
c. Independently develop primary emphasis on
an estimate of the value a. Ascertaining the rights
of the account. and obligations of the
d. Review subsequent events related parties.
relating to the account. b. Confirming the existence of the
related parties.
148. Which of the following c. Verifying the valuation
auditing procedures most of the relatedparty
likely would assist an auditor transactions.
in identifying relatedparty d. Evaluating the
transactions? disclosure of the
a. Inspecting relatedparty
correspondence with transactions.
lawyers for evidence
of unreported 151. Which of the following
contingent liabilities. statements is correct concerning
b. Vouching accounting relatedparty transactions?
records for recurring a. In the absence of evidence to the
transactions recorded contrary, relatedparty
just after the balance transactions should be assumed
sheet date. to be outside the ordinary course
c. Reviewing of business.
confirmations of loans b. An auditor should
receivable and payable determine whether a
for indications of particular transaction
guarantees. would have occurred if
d. Performing analytical the parties had not been
procedures for related.
d. Investigate changes in
longterm debt
a. An auditor should occurring after year
substantiate that end.
relatedparty
transactions were 154. Which of the following events occurring
consummated on terms after the issuance of an auditor’s report
equivalent to those that most likely would cause the auditor to make
prevail in arm’slength further inquiries about the previously issued
transactions. financial statements?
b. The audit procedures a. An uninsured natural disaster
directed toward occurs that may affect the
identifying relatedparty entity’s ability to continue as a
transactions should going concern.
include considering b. A contingency is
resolved that had been
whether transactions are
disclosed in the audited
occurring, but are not financial statements.
being given proper c. New information is
accounting recognition. discovered concerning
152. An auditor most likely would modify an undisclosed lease
unqualified opinion if the entity’s financial transactions of the
statements include a footnote on related audited period.
party transactions d. A subsidiary is sold
a. Disclosing loans to that accounts for 25%
related parties at interest of the entity’s
rates significantly below consolidated net
prevailing market rates. income.
b. Describing an 155. Zero Corp. suffered a loss that would have
exchange of real estate a material effect on its financial statements
for similar property in on an uncollectible trade account receivable
a nonmonetary related due to a customer’s bankruptcy. This
party transaction. occurred suddenly due to a natural disaster
c. Stating that a particular ten days after Zero’s balance sheet date, but
relatedparty transaction one month before the issuance of the
occurred on terms financial statements and the auditor’s
equivalent to those that report. Under these circumstances,
would have prevailed in
The The event The auditor’s
an arm’slength
financial requires financial report should
transaction. statements statement be modified
d. Presenting the dollar should be disclosure, but for a lack of
volume of relatedparty adjusted no adjustment consistency
transactions and the a. Yes No No
effects of any change in b. Yes No Yes
the method of c. No Yes Yes
establishing terms from d. No Yes No
prior periods.
procedures would an auditor
most likely perform in obtaining
evidence about subsequent
events?
a. Determine that changes
in employee pay rates
after yearend were
properly authorized.
b. Recompute
depreciation charges
for plant assets sold
after yearend.
c. Inquire about payroll
checks that were
recorded before year
end but cashed after
yearend.
after yearend.
156. After an audit report containing an b. Comparing the
unqualified opinion on a nonissuer financial statements
(nonpublic) client’s financial statements being reported on
was issued, the client decided to sell the with those of the
shares of a subsidiary that accounts for prior period.
30% of its revenue and 25% of its net c. Investigating personnel
income. The auditor should changes in the
a. Determine whether the accounting department
information is reliable occurring after yearend.
and, if determined to d. Inquiring as to whether
be reliable, request any unusual
that revised financial adjustments were
statements be issued. made after yearend.
b. Notify the entity that the 159. Which of the following
auditor’s report may no longer procedures should an auditor
be associated with the financial generally perform regarding
statements. subsequent events?
c. Describe the effects of a. Compare the latest
this subsequently available interim
discovered financial statements
information in a with the financial
communication with statements being au
persons known to be dited.
relying on the financial b. Send second requests
statements. to the client’s
d. Take no action because customers who failed
the auditor has no to respond to initial
obligation to make any accounts receivable
further inquiries. confirmation requests.
c. Communicate
157. A client acquired 25% of its material weaknesses
outstanding capital stock after in internal control to
yearend and prior to completion the client’s audit
of the auditor’s fieldwork. The committee.
auditor should
d. Review the cutoff
a. Advise management to bank statements for
adjust the balance sheet several months after
to reflect the the yearend.
acquisition.
b. Issue pro forma financial 160. On February 25, a CPA issued an
statements giving effect auditor’s report expressing an
to the acquisition as if it unqualified opinion on financial
had occurred at yearend. statements for the year ended
c. Advise management to January 31. On March 2, the CPA
disclose the acquisition learned that on February 11, the
in the notes to the entity incurred a material loss on
financial statements. an uncollectible trade receivable
d. Disclose the as a result of the deteriorating
acquisition in the financial condition of the entity’s
opinion paragraph of principal customer that led to the
the auditor’s report. customer's bankruptcy.
Management then refused to
158. Which of the following adjust the financial statements for
procedures would an auditor this subsequent event. The CPA
most likely perform to obtain determined that the information is
evidence about the occurrence of reliable and that there are
subsequent events? creditors currently relying on the
a. Confirming a sample of financial statements. The CPA’s
material accounts next course of action most likely
receivable established would be to
disclose to the
stockholders that
a. Notify the entity’s Kent’s unqualified
creditors that the opinion should not be
financial statements and relied on.
the related auditor’s b. Undertake to apply
report should no longer alternative procedures
be relied on. that would provide a
b. Notify each member of the satisfactory basis for the
entity’s board of directors about unqualified opinion.
management’s refusal to adjust c. Reissue the auditor’s
the financial statements. report and add an
c. Issue revised financial explanatory paragraph
statements and describing the departure
distribute them to each from generally
creditor known to be accepted auditing
relying on the financial standards.
statements. d. Compensate for the
d. Issue a revised auditor’s omitted procedure by
report and distribute it performing tests of
to each creditor known controls to reduce audit
to be relying on the risk to a sufficiently
financial statements. low level.
161. An auditor is considering whether 163. Six months after issuing an
the omission of a substantive unqualified opinion on audited
procedure considered necessary financial statements, an auditor
at the time of an audit may impair discovered that the engagement
the auditor’s present ability to personnel failed to confirm
support the previously expressed several of the client’s material
opinion. The auditor need not accounts receivable balances.
apply the omitted procedure if the The auditor should first
a. Request the permission
a. Financial statements and
auditor’s report were not of the client to undertake
distributed beyond the confirmation of
management and the accounts receivable.
board of directors. b. Perform alternative
b. Auditor’s previously expressed procedures to provide a
opinion was qualified because satisfactory basis for
of a departure from GAAP. the unqualified opinion.
c. Results of other c. Assess the importance
procedures that were of the omitted
applied tend to procedures to the
compensate for the auditor’s ability to
procedure omitted. support the previously
d. Omission is due to expressed opinion.
unreasonable delays by d. Inquire whether there
client personnel in are persons currently
providing data on a relying, or likely to
timely basis. rely, on the unqualified
opinion.
162. On March 15, 2002, Kent, CPA,
issued an unqualified opinion on
a client’s audited financial procedures is least likely to be
statements for the year ended performed before the balance
December 31, 2001. On May 4, sheet date?
2002, Kent’s internal inspection
program disclosed that
engagement personnel failed to
observe the client’s physical
inventory. Omission of this
procedure impairs Kent’s present
ability to support the unqualified
opinion. If the stockholders are
currently relying on the opinion,
Kent should first
a. Advise management to
c. Determine whether
a. Testing of internal control over inadequate provisions
cash. for the safeguarding of
b. Confirmation of receivables. assets have been
c. Search for unrecorded liabilities. corrected.
d. Observation of inventory. d. Consider whether the
results of audit
165. Which of the following most procedures affect the
likely would be detected by an assessment of the risk
auditor’s review of a client’s of material mis
sales cutoff? statement due to fraud.
a. Shipments lacking
sales invoices and 168. Operational auditing is primarily
shipping documents. oriented toward
b. Excessive writeoffs of accounts a. Future improvements
receivable. to accomplish the
c. Unrecorded sales at yearend. goals of management.
d. Lapping of yearend accounts b. The accuracy of data
receivable. reflected in
management’s
166. Cutoff tests designed to detect credit sales financial records.
made before the end of the year that have c. The verification that a
been recorded in the subsequent year company’s financial
provide assurance about management’s statements are fairly
assertion of presented.
a. Presentation. d. Past protection
b. Completeness. provided by existing
c. Rights. internal control.
d. Existence.
169. A typical objective of an
167. Which of the following operational audit is to deter
procedures would an auditor mine whether an entity’s
most likely perform during an a. Internal control is
audit engagement’s overall adequately
review stage in formulating an operating as de
opinion on an entity’s financial signed.
statements? b. Operational
a. Obtain assurance information is in
from the entity’s accordance with
attorney that all generally accepted
material litigation has governmental
been disclosed in the auditing standards.
financial statements. c. Financial statements
b. Verify the clerical present fairly the
accuracy of the results of operations.
entity’s proof of cash d. Specific operating units are
and its bank cutoff functioning efficiently and
statement. effectively.
SIMULATIONS
Audit Investments and
Accounts Receivable Authoritative
Literature Help
Items 1 through 7 represent audit objectives for the investments and accounts receivable. To the right of each set of
auditobjectives is a listing of possible audit procedures for that account. For each audit objective, select the audit procedure
that would primarily respond to the objective. Select only one procedure for each audit objective. A procedure may be selected
only once, or not at all.
Audit procedures for investments
A. Trace opening balances in the subsidiary ledger to prior year’s audit working papers.
B. Determine that employees who are authorized to sell investments do not have access to cash.
C. Examine supporting documents for a sample of investment transactions to verify that prenumbered documents
are used.
D. Determine that any impairments in the price of investments have been properly recorded.
E. Verify that transfers from the current to the noncurrent investment portfolio have been properly recorded.
F. Obtain positive confirmations as of the balance sheet date of investments held by independent custodians.
G. Trace investment transactions to minutes of the Board of Directors meetings to determine that transactions
were properly authorized.
A
u
1. I
2. R
3. T
A
u
A. Analyze the relationship of accounts receivable and sales and compare it with relationships for preceding periods.
B. Perform sales cutoff tests to obtain assurance that sales transactions and corresponding entries for inventories and
cost of goods sold are recorded in the same and proper period.
C. Review the aged trial balance for significant past due accounts.
D. Obtain an understanding of the business purpose of transactions that resulted in accounts receivable balances.
E. Review loan agreements for indications of whether accounts receivable have been factored or pledged.
F. Review the accounts receivable trial balance for amounts due from officers and employees.
G. Analyze unusual relationships between monthly accounts receivable balances and monthly accounts payable
balances.
A
u
4. A
5. T
6. A
7. A
Research
Authoritative
Literature Help
Confirmation of Accounts Receivable
Bill Smith, the president of Alex Inc., a nonpublic audit client, has suggested to you that his previous auditor did not
confirm accounts receivable and he sees no reason why you should do so.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
Illegal Acts and Related
Party Transactions Authoritative
Literature Help
In applying audit procedures and evaluating the results of those procedures, auditors may encounter specific
information that may raise a question concerning the existence of illegal acts and relatedparty transactions. Indicate
whether each of the following is more likely related to an illegal act (IA) or a relatedparty transaction (RP).
S
t
1. A

2. T
h
3. U
4. T
5. L
a
Accounts Receivable
Confirmations
Authoritative
Literature Help
An auditor may use confirmations of accounts receivable. Reply as to whether the following statements are correct or in
correct with respect to the confirmation process when applied to accounts receivable.
S
1. t
T
h
2. A

3. S
e
4. C
5. C
6. A
b
7. A
u
8. A
u
S
t
9. T
h
10. A
c
Auditing
Inventory
Authoritative
Literature Help
Auditors often observe the counting of their clients’ inventories. Reply as to whether the
following statements are correct
or incorrect with respect to the inventory observation.
Statement Correct Incorrect
1. With strong internal control, the inventory count may be at the end of the year or at other
times.
2. When a client has many inventory locations, auditors ordinarily need not be present at
each location.
3. All auditor test counts must be documented in the working papers.
4. Auditors’ observation of the counting of their clients’ inventories addresses the existence
of inventory, and not the completeness of the count.
5. When the client manufactures a product, direct labor and overhead ordinarily become a
part of inventory item costs.
6. Inventory is ordinarily valued at the lower of standard cost or market.
7. Inventory items present as “consigned in” should not be included in the clients’ inventory
value.
8. Auditor recording of test counts ordinarily replaces the need for client “tagging” of in
ventory.
9. Ordinarily, an auditor need not count all items in the inventory.
10. At the completion of the count, an auditor will ordinarily provide the client with copies of
his or her inventory test counts to help assure inventory accuracy.
Research
Authoritative
Literature Help
Auditing Derivatives
The partner in charge of the audit you are currently working on is concerned about
overall risk involved with certain financial derivative transactions the client is involved
with. More specifically, she has asked you to find guidance in the Professional Standards
on determining that all of the client’s derivatives are properly reported.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A)
(B)
(C)
(D)
(E)
(F)
(G)
(H)
helpful in responding to her?
Bank Authoritative
Reconciliation Literature Help
Items 1 through 6 represent the items that an auditor ordinarily would find on a client
prepared bank reconciliation. Theaccompanying List of Auditing Procedures represents
substantive auditing procedures. For each item, select one or more procedures, as indicated,
that the auditor most likely would perform to gather evidence in support of that item. The
procedures on the List may be selected once, more than once, or not at all.
Assume
• The client prepared the bank reconciliation on 10/2/05.
• The bank reconciliation is mathematically accurate.
• The auditor received a cutoff bank statement dated 10/7/05 directly from the bank on
10/11/05.
• The 9/30/05 deposit in transit, outstanding checks #1281, #1285, #1289, and #1292,
and the correction of the error regarding check #1282 appeared on the cutoff bank
statement.
• The auditor assessed control risk concerning the financial statement assertions related
to cash at the maximum.
List of Auditing Procedures
A. Trace to cash receipts F. Inspect bank debit memo.
journal. G. Ascertain reason for unusual delay.
B. Trace to cash disbursements H. Inspect supporting documents for reconciling
journal. item not appearing on cutoff statement.
C. Compare to 9/30/01 general I. Trace items on the bank reconciliation to cutoff
ledger. statement.
D. Confirm directly with bank. J. Trace items on the cutoff statement to bank
E. Inspect bank credit memo. reconciliation.
General Company
BANK RECONCILIATION
1ST NATIONAL BANK OF US BANK ACCOUNT
September 30, 2005
1. Select 2 Procedures — Balance per bank $
28,375
2. Select 5 Procedures — Deposits in transit
9/29/05 $4,500
9/30/05 1,525 6,025
34,400
3. Select 5 Procedures — Outstanding checks
# 988 8/31/05 2,200
#1281 9/26/05 675
#1285 9/27/05 850
#1289 9/29/05 2,500
#1292 9/30/05 7,225 (13,450)
20,950
4. Select 1 Procedure — Customer note collected by bank (3,000)
5. Select 2 Procedures — Error: Check #1282, written on 9/26/05
for $270 was erroneously charged by bank
as $720; bank was notified on 10/2/05 450
6. Select 1 Procedure — Balance per books $ 18,400
Audit
Procedures
Authoritative
Literature Help
Items 1 through 12 represent possible errors and fraud that you suspect may be present at
General Company. The accompanying List of Auditing Procedures represents procedures that
the auditor would consider performing to gather evidence concerning possible errors and
fraud. For each item, select one or two procedures, as indicated, that the auditor most likely
would perform to gather evidence in support of that item. The procedures on the list may be
selected once, more than once, or not at all.
List of Auditing Procedures
A. Compare the details of the cash L. Examine the entity’s shipping
receipts journal entries with the
documents to verify that the
merchandise that produced the
details of the corresponding daily
receivable was actually sent to the
deposit slips.
customer.
B. Scan the debits to the fixed asset M. Inspect the entity’s correspondence
accounts and vouch selected amounts files for indications of customer
to vendors’ invoices and disputes for evidence that certain
management’s authorization. shipments were on consignment.
C. Perform analytical procedures that
N. Perform edit checks of data on the payroll
compare documented authorized pay transaction tapes.
rates to the entity’s budget and
O. Inspect payroll check
forecast. endorsements for similar
D. Obtain the cutoff bank statement and handwriting.
compare the cleared checks to the yearend P. Observe payroll check distribution on a
bank reconciliation. surprise basis.
E. Prepare a bank transfer schedule. Q. Vouch data in the payroll register to
F. Inspect the entity’s deeds to its real estate. documented authorized pay rates in
G. Make inquiries of the entity’s the human resources department’s
attorney concerning the details of files.
real estate transactions. R. Reconcile the payroll checking
H. Confirm the terms of borrowing account and determine if there were
arrangements with the lender. unusual time lags between the
I. Examine selected equipment repair issuance and payment of payroll
orders and supporting documentation to checks.
determine the propriety of the charges. S. Inspect the file of prenumbered
J. Send requests to confirm the entity’s vouchers for consecutive numbering
accounts receivable on a surprise and proper approval by an
basis at an interim date. appropriate employee.
K. Send a second request for T. Determine that the details of
confirmation of the receivable to the selected prenumbered
customer and make inquiries of a vouchers match the related
reputable credit agency concerning vendors’ invoices.
the customer’s creditworthiness. U. Examine the supporting purchase
orders and receiving reports for
selected paid vouchers.
Possible misstatements due to errors and fraud
1. The auditor suspects that a kiting scheme exists because an accounting
department employee who can issue and record checks seems to be leading an
unusually luxurious lifestyle. (Select only 1 procedure)
2. An auditor suspects that the controller wrote several checks and recorded the cash
disbursements just before yearend but did not mail the checks until after the first
week of the subsequent year. (Select only 1 procedure)
3. The entity borrowed funds from a financial institution. Although the transaction
was properly recorded, the auditor suspects that the loan created a lien on the
entity’s real estate that is not disclosed in its financial statements. (Select only
1procedure)
4. The auditor discovered an unusually large receivable from one of the entity’s new
customers. The auditor suspects that the receivable may be fictitious because the
auditor has never heard of the customer and because the auditor’s initial attempt to
confirm the receivable has been ignored by the customer. (Select only 2
procedures)
5. The auditor suspects that fictitious employees have been placed on the payroll by
the entity’s payroll supervisor, who has access to payroll records and to the
paychecks. (Select only 1 procedure)
6. The auditor suspects that selected employees of the entity received unauthorized
raises from the entity’s payroll supervisor, who has access to payroll records. (Select
only 1 procedure)
7. The entity’s cash receipts of the first few days of the subsequent year were properly
deposited in its general operating account after the yearend. However, the auditor
suspects that the entity recorded the cash receipts in its books during the last week of the
year under audit. (Select only 1 procedure)
8. The auditor suspects that vouchers were prepared and processed by an accounting
department employee for merchandise that was neither ordered nor received by
the entity. (Select only 1 procedure)
9. The details of invoices for equipment repairs were not clearly identified or explained to
the accounting department employees. The auditor suspects that the bookkeeper
incorrectly recorded the repairs as fixed assets. (Select only 1 procedure)
10. The auditor suspects that a lapping scheme exists because an accounting
department employee who has access to cash receipts also maintains the accounts
receivable ledger and refuses to take any vacation or sick days. (Select only 2
procedures)
11. The auditor suspects that the entity is inappropriately increasing the cash reported
on its balance sheet by drawing a check on one account and not recording it as an
outstanding check on that account and simultaneously recording it as a deposit in a
second account. (Select only 1 procedure)
12. The auditor suspects that the entity’s controller has overstated sales and accounts
receivable by recording fictitious sales to regular customers in the entity’s books.
(Select only 2 procedures)
Substantive Procedures for Property, Plant and Authoritative
Equipment Literature Help
DietWeb Inc. (hereafter DietWeb) was incorporated and began business in March of
20X1, seven years ago. You are working on the 20X8 audit—your CPA firm’s fifth audit of
DietWeb. For each audit objective, select a substantive procedure that would help to achieve
that objective. Each of the procedures may be used once, more than once, or not at all.
A. Trace opening balances in the summary schedules to the prior year’s audit working
papers.
B. Review the provision for deprecation expense and determine that depreciable lives
and methods used in the current year are consistent with those used in the prior
year.
C. Determine that responsibility for maintaining the property and equipment records is
segregated from the responsibility for custody of property and equipment.
D. Examine deeds and title insurance certificates.
E. Perform cutoff test to verify that property and equipment additions are recorded in
the proper period.
F. Determine that property and equipment is adequately insured.
G. Physically examine all recorded major property and equipment additions.
H. Analyze repairs and maintenance expense.
Audit Objective
(A) (B) (C)
(D) (E) (F)
(G) (H)
1. DietWeb has legal rights to property and equipment acquired during the year.
2. DietWeb recorded property and equipment acquired during the year that did not
actually exist at the balance sheet date.
3. DietWeb’s property and equipment was properly valued at the balance sheet date.
4. DietWeb recorded all property and equipment assets that were purchased
near yearend.
5. DietWeb recorded all property retirements that occurred during the year.
6. DietWeb capitalized all acquisitions that occurred during the period.
Risk Analysis
Authoritative
Literature Help
You are working with William Bond, CPA, and you are considering the risk of material
misstatement in planning the audit of Toxic Waste Disposal (TWD) Company’s financial
statements for the year ended December 31, 20X0.
Assume that you have identified the following risks at the account level relating to
TWD’s property and equipment. Identify the most closely related financial statement
assertion and the audit procedure that might be planned to most likely address the risk.
Financial statement assertions and audit procedures may be used once, more than once, or not
used at all.
Related financial statement assertion Audit procedures
A. Existence or occurrence F. Trace opening balances in the summary schedules to the prior year’s
B. Completeness audit working papers.
C. Rights and obligations G. Review the provision for depreciation expense and determine that de
D. Valuation or allocation preciable lives and methods used in the current year are consistent with
E. Presentation and disclosure those used in the prior year.
H. Determine that the responsibility for maintaining the property and
equipment records is segregated from the responsibility for custody of
property and equipment.
I. Examine deeds and title insurance certificates.
J. Perform cutoffs tests to verify that property and equipment additions
are recorded in the proper period.
K. Determine that property and equipment are adequately insured.
L. Physically examine all major property and equipment additions.
Risk identified
1. TWD may not have legal

title to certain property and
equipment recorded as
acquired during the year.
2. Recorded property and
equipment acquisitions may
include nonexistent assets.
3. Recorded net property and
equipment are for proper
amounts.
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L)
Audit Objectives Authoritative
and Procedures Literature Help
For each audit objective listed below select the most appropriate audit procedure for
raw materials inventory (Items 13) and for Accounts Receivable (Items 46). Audit
procedures may be used once, more than once, or not at all.
List of audit procedures for raw materials inventory
A. Compare standard costs of inventories with standardized market values.
B. Determine that all direct labor and overhead has been expensed and not included in
inventory valuation.
C. Examine vendors’ invoices.
D. Perform analytical procedures comparing inventory to various industry averages.
E. Review drafts of financial statement note disclosures.
F. Select a sample of items during the physical count and determine that the client has
included items on inventory count sheets.
G. Select a sample of recorded items on count sheets and determine that the items are on
hand.
1. D
2. E
3. D
L
i
A. Analyze relationships between accounts receivable balances and changes in the current
portion of longterm debt.
B. Compare accounts receivable on the accounts receivable lead schedule with those on
supporting audit schedules.
C. Compare total 20X8 annual sales with those of 20X7.
D. Examine December 20X8 sales journal and determine that sales are properly recorded in
December.
E. Examine January 20X9 sales journal and determine that sales are properly recorded in
January.
F. Inquire of credit manager about the collectability of various receivables.
G. Review disclosure checklist for recommended and required accounts receivable
disclosures.
4. D
5. D
e
6. N
Inventory Audit Objectives
and Procedures Authoritative
Literature Help
The auditor determines that each of the following objectives will be part of the audit of
Enright Corporation. For each audit objective, select a substantive procedure that would help
to achieve the audit objectives. Each of the procedures may be used once, more than once, or
not at all.
A. Review minutes of board of directors meetings and contracts, and make inquiries of
management.
B. Test inventory transactions between a preliminary physical inventory date and the balance
sheet date.
C. Obtain confirmation of inventories pledged under loan agreement.
D. Review perpetual inventory records, production records, and purchasing records for
indication of current activity.
E. Reconcile physical counts to perpetual records and general ledger balances and
investigate significant fluctuation.
F. Examine sales after yearend and open purchase order commitments.
G. Examine paid vendors’ invoices, consignment agreements, and contracts.
H. Analytically review and compare the relationship of inventory balance to recent
purchasing, production, and sales activity.
1. I
2. D
3. D
4. D
e
5. D
Spreadsheet Authoritative
Completion Literature Help
Analytical procedures are evaluations of financial information made by a study of
plausible relationships among financial and nonfinancial data. Understanding and evaluating
such relationships are essential to the audit process.
The following spreadsheet with the financial statements were prepared by Holiday
Manufacturing Co. for the year ended December 31, 20X1. Also presented are various
financial statement ratios for Holiday as calculated from the prior year’s financial statements.
Sales represent net credit sales. The total assets and the receivables and inventory balances at
December 31, 20X1, were the same as at December 31, 20X0.
A B C D E F G
1 Holiday Manufacturing Co.
2 Balance Sheet
3 December 31, 20X1
4
5 Cash $240,000 Accounts Payable $160,000
6 Receivables 400,000 Notes payable 100,000
7 Inventory 600,000 Other current liabilities 140,000
8 Total current assets $1,240,000 Total current liabilities 400,000
9
10 Plant and equipment—net 760,000 Long-term debt 350,000
11 Common stock 750,000
12 Retained earnings 500,000
13 Total assets $2,000,000 Total liabilities and capital $2,000,000
14
15
16 Income Statement
17 Year ended December 31, 20X1
18
19 Sales $3,000,000
20 Cost of goods sold
21 Materials 800,000
22 Labor 700,000
23 Overhead 300,000 1,800,000
24 Gross margin 1,200,000
25
26 Selling expenses 240,000
27 General and admin. exp. 300,000 540,000
28 Operating income 660,000
29 Less: interest expense 40,000
A B C D E F G
30 Income before taxes 620,000
31 Less: federal income taxes 220,000
32 Net income $400,000
33
34
35
36 Ratios 12/31/X1 12/31/X0
37 Current ratio (1) 2.5
38 Quick ratio (2) 1.3
39 Accounts receivable turnover (3) 5.5
40 Inventory turnover (4) 2.5
41 Total asset turnover (5) 1.2
42 Gross margin % (6) 35%
43 Net operating margin % (7) 25%
44 Times interest earned (8) 10.3
45 Total debt to equity % (9) 50%
Insert spreadsheet formulas into the worksheet to allow the direction calculation of
each ratio (1 through 9). Use cell location rather than amounts.
1. b __ __ 31. c __ __ 61. a __ __ 91. b __ __ 121. c __ __ 151. d __ __

2. b __ __ 32. d __ __ 62. c __ __ 92. a __ __ 122. a __ __ 152. c __ __
3. c __ __ 33. c __ __ 63. b __ __ 93. d __ __ 123. c __ __ 153. d __ __
4. c __ __ 34. b __ __ 64. c __ __ 94. c __ __ 124. b __ __ 154. c __ __
5. d __ __ 35. a __ __ 65. a __ __ 95. a __ __ 125. d __ __ 155. d __ __
6. d __ __ 36. a __ __ 66. d __ __ 96. b __ __ 126. a __ __ 156. d __ __
7. a __ __ 37. a __ __ 67. d __ __ 97. a __ __ 127. a __ __ 157. c __ __
8. a __ __ 38. c __ __ 68. a __ __ 98. c __ __ 128. a __ __ 158. d __ __
9. d __ __ 39. c __ __ 69. b __ __ 99. c __ __ 129. d __ __ 159. a __ __
10. d __ __ 40. d __ __ 70. d __ __ 100. a __ __ 130. c __ __ 160. b __ __
11. d __ __ 41. b __ __ 71. a __ __ 101. d __ __ 131. c __ __ 161. c __ __
12. d __ __ 42. a __ __ 72. d __ __ 102. c __ __ 132. a __ __ 162. b __ __
13. c __ __ 43. d __ __ 73. c __ __ 103. c __ __ 133. a __ __ 163. c __ __
14. a __ __ 44. c __ __ 74. a __ __ 104. b __ __ 134. d __ __ 164. c __ __
15. b __ __ 45. b __ __ 75. a __ __ 105. a __ __ 135. b __ __ 165. c __ __
16. c __ __ 46. b __ __ 76. d __ __ 106. c __ __ 136. c __ __ 166. b __ __
17. a __ __ 47. c __ __ 77. c __ __ 107. b __ __ 137. c __ __ 167. d __ __
18. d __ __ 48. b __ __ 78. b __ __ 108. a __ __ 138. d __ __ 168. a __ __
19. b __ __ 49. d __ __ 79. a __ __ 109. d __ __ 139. b __ __ 169. d __ __
20. c __ __ 50. b __ __ 80. b __ __ 110. a __ __ 140. c __ __
21. c __ __ 51. b __ __ 81. a __ __ 111. d __ __ 141. b __ __
22. c __ __ 52. b __ __ 82. b __ __ 112. d __ __ 142. b __ __
23. a __ __ 53. c __ __ 83. d __ __ 113. d __ __ 143. a __ __
24. b __ __ 54. d __ __ 84. a __ __ 114. b __ __ 144. a __ __
25. c __ __ 55. b __ __ 85. c __ __ 115. c __ __ 145. b __ __
26. b __ __ 56. c __ __ 86. c __ __ 116. c __ __ 146. a __ __
27. c __ __ 57. b __ __ 87. c __ __ 117. a __ __ 147. b __ __
28. b __ __ 58. c __ __ 88. c __ __ 118. c __ __ 148. c __ __
29. c __ __ 59. b __ __ 89. a __ __ 119. b __ __ 149. c __ __ 1st: __/169 = __%
30. c __ __ 60. a __ __ 90. d __ __ 120. d __ __ 150. d __ __ 2nd: __/169 = __%
transactions. Answer (a), (c),
A.1. Sufficient Appropriate Audit and (d) are all incorrect because
Evidence accuracy, cutoff and occurrence
are class of transaction
assertions.
statement thatbest describes the meaning of
generally accepted auditing standards. 3. (c) The requirement is to identify the type
Answer (b) is correct because generally of evidence that is generally most reliable.
accepted auditing standards deal with Answer (c) is correct because audit
measures of the quality of the performance evidence obtained from knowledgeable
of audit procedures. Answer (a) is incorrect independent sources outside the client
because procedures relate to acts to be company is more reliable than audit
performed, not directly to the standards. evidence obtained from nonindependent
Answer (c) is incorrect because generally sources (e.g., company sources who may be
accepted auditing standards have been biased). Answer (a) is incorrect because
issued by predecessor groups, as well as by audit evidence obtained from direct sources
the Auditing Standards Board. Answer (d) is more reliable. Answer (b) is
is incorrect because there may or may not
be universal compliance with the
standards.
identify the reply that is not an
assertion for classes of
transactions. The assertionsfor
classes of transactions are
occurrence, completeness,
accuracy, cutoff and
classification. Answer (b) is
correct since consistency is not
an assertion for classes of
incorrect because it is not clear as to representation letter all represent
whether copies or facsimile copies are internally generated documents,
more reliable. Answer (d) is incorrect generally considered less
because it is unclear whether audit persuasive than externally
evidence provided by original documents generated documents. See SAS
is more reliable than that provided through 106 for information on the
a system of effective controls—indeed, persuasiveness of audit evidence.
they may be one and the same.
5. (d) The requirement is to identify a correct
4. (c) The requirement is to identify presumption about the reliability of audit
the most persuasive type of evidence. Answer (d) is correct because
evidence. Answer (c) is correct SAS 106 indicates that effective internal
because a bank statement control provides more assurance about the
represents evidence prepared reliability of audit evidence than ineffective
outside of the entity and is control. Answer (a) is incorrect because
considered an audit evidence information obtained directly is considered
source which provides the auditor more reliable than that obtained indirectly.
with a high level of assurance. Answer (b) is incorrect because audit
Answers (a), (b), and (d) are evidence is normally persuasive rather than
incorrect because prenumbered convincing. Answer (c) is incorrect because
client purchase order forms, reliability of audit evidence relates to the
client work sheets and a appropriateness of audit evidence.
are subjective and susceptible to bias.
Answer (b) is incorrect because all things
6. (d) The requirement is to being equal, an auditor would expect as
determine the correct statement sumptions that are consistent with prior
with respect to the periods. Answer (c) is incorrect because
appropriateness of audit evi assumptions that are insensitive to
dence. To be appropriate, variations in underlying data have little
evidence must be both reliable predictive ability. Answer (d) is incorrect
and relevant. Answer (a) is because, often, one would expect
incorrect because while exter assumptions similar to industry guidelines.
nally generated evidence is
generally considered to provide A.2. Types of Evidence
greater assurance of reliability, 9. (d) The requirement is to identify
there are important exceptions, the reply that is not a basic
(e.g., the confirmation is procedure used in an audit.
erroneously returned with no Answer (d) is correct because the
exception when one actually term “test of direct evidence” is
exists). Answer (b) is incorrect not used in the professional
because while evidence so standards. Answer (a) is incorrect
gathered is typically considered to because risk assessment
provide greater assurance procedures are used while
concerning reliability, no similar obtaining an understanding of the
generalization can be made about client. Answer (b) is incorrect
its relevance. Answer (c) is because substantive procedures
incorrect because oral test account balances. Answer (c)
representations from man is incorrect because tests of
agement, when corroborated by controls test the operating effec
other forms of evidence, are tiveness of controls.
considered valid evidence.
7. (a) The requirement is to identify the procedure an auditor would
the least persuasive type of perform first in evaluating
evidence. Answer (a) is correct management’s accounting estimates
because evidence secured solely for reasonableness. Answer (d) is
from within the entity, here correct because in evaluating
prenumbered purchase order
reasonableness, the auditor should
forms, is considered less
first obtain an understanding of how
persuasive than evidence
management developed the
obtained from independent
estimate. Answers (a), (b), and (c)
sources. Answer (b) is incorrect
because a bank statement (even are all incorrect because
though received from the client) developing independent
is externally created and expectations, considering
therefore more persuasive than appropriateness of key factors or
audit evidence secured solely assumptions, and testing
from within the entity. Answer calculations occur after obtaining
(c) is incorrect because evidence the understanding. See AU 342 for
obtained directly by the auditor information on auditing accounting
through observation is con estimates.
sidered relatively persuasive.
Answer (d) is incorrect because
correspondence from the client’s
attorney about litigation is
obtained directly from
independent sources and is
therefore more persuasive than
audit evidence secured from
within the entity.
8. (a) The requirement is to identify an area of
concern to auditors when evaluating the
reasonableness of an entity’s accounting
estimates. Answer (a) is correct because
AU 342 states that in evaluating the
reasonableness of estimates auditors
normally concentrate on assumptions that
aggregated nature of the financial
11. (d) The requirement is to identify a factor statements makes the use of
that an auditor would concentrate upon potentially unrecorded items
when evaluating the reasonableness of an unlikely as a method of
accounting estimate. Answer (d) is correct identifying unrecorded items.
because AU 342 states that the auditor Answer (b) is incorrect because
normally concentrates on key factors and testing potentially unrecorded
assumptions that are deviations from items to the financial statements
historical patterns, as well as those that are addresses the completeness
significant to the accounting estimate, assertion. Answer (d) is incorrect
sensitive to variations, and subjective and because testing from the
susceptible to misstatement and bias. supporting evidence to the ac
Answer (a) is incorrect because deviations counting records addresses the
from historical patterns, not consistent completeness assertion. See the
patterns, are concentrated upon. Answer (b) outline of SAS 106 for
is incorrect because factors and information on the financial
assumptions that are similar to industry statement assertions.
guidelines are often reasonable. Answer (c)
is incorrect because subjective factors and 14. (a) The requirement is to
assumptions that are susceptible to bias are determine which balance
concentrated upon, not objective ones that remaining in a “suspense”
are not susceptible to bias. See AU 342 for account would be of most con
cern to an auditor. Answer (a) is
information on the manner in which
correct because suspense debits
auditors consider accounting estimates.
that management believes will
12. (d) The requirement is to benefit future operations must be
identify one of an auditor’s audited carefully to determine
objectives when evaluating an whether they have value and
entity’s accounting estimates. should be classified as an asset.
Answer (d) is correct because Answer (b) is incorrect because
when evaluating accounting when an auditor has already
estimates an auditor’s objectives determined that a suspense debit
are to obtain sufficient has value it becomes a relatively
appropriate audit evidence that straightforward issue of the
(1) all material accounting item’s proper classification.
estimates have been developed, Answer (c) is incorrect because
(2) those accounting estimates the conservative approach taken
are reasonable, and (3) those in audits is likely to cause the
accounting estimates are in auditor to have somewhat more
conformity with GAAP. concern about suspense purported
to be assets [i.e., answer (a)],
13. (c) The requirement is to than for those classified as
determine the proper test for the current liabilities. Answer (d) is
existence assertion of an asset. incorrect because when the
Answer (c) is correct because auditor determines that the
testing from accounting records suspense credits represent
to the supporting evidence customer deposits, establishing a
discloses whether recorded proper accounting will ordinarily
transactions occurred and be relatively simple.
whether the asset exists. Answer
(a) is incorrect because testing B.1.a. Analytical Procedures
for the completeness assertion 15. (b) The requirement is to identify the
addresses whether there are procedure thatwould not be considered an
unrecorded items. Also, the
analytical procedure. Analyti
analytical procedures is
identification of unusual
cal procedures consist of evaluations of transactions and events, and
financial information made by a study of amounts, ratios and trends that
plausible relationships among both might indicate misstatements.
financial and nonfinancial data. Answer (b) Answer (a) is incorrect because
is correct because projecting an error rate the limited number of journal
from a statistical sample to an actual entries traced to the general
population is not a comparison of a ledger in a sample is unlikely to
plausible relationship. Answers (a), (c), include the erroneous journal
and (d) are all incorrect because they all entries. Answer (b) is incorrect
include a study of plausible relationships. because while an evaluation of
16. (c) The requirement is to identify the type the effectiveness of internal
of analytical procedure an auditor would control might help detect such
most likely use in developing relationships misstatements, it is somewhat
among balance sheet accounts when doubtful due to the fact that it is
reviewing the financial statements of a likely that few journal entries are
nonpublic entity. Answer (c) is correct involved. Answer (c) is incorrect
because balance sheet accounts may be because there is no indication
analyzed through a number of ratios (e.g., that the fraud involves
current ratio). Answer (a) is incorrect differences between controlling
because trend analysis is often more accounts and subsidiary records.
appropriate for income statement analysis. 19. (b) The requirement is to
Answer (b) is incorrect because regression identify the account that would
analysis, while used in practice, is not used yield the highest level of
as frequently as is ratio analysis. Answer evidence through the per
(d) is incorrect because risk analysis in and formance of analytical
of itself is not a type of analytical procedures. As higher levels of
procedure. See AR 100 for information on assurance are desired from
reviews of nonissuer (nonpublic) entities. analytical procedures, more pre
17. (a) The requirement is to identify dictable relationships are
how an auditor may achieve audit required to develop the auditor’s
expectation. Relationships
objectives related to particular
assertions. Answer (a) is correct involving income statement ac
counts tend to be more
because an auditor may perform
analytical procedures to achieve predictable than relationships in
volving only balance sheet
an audit objective related to a
particular assertion. Answer (b) is accounts, and relationships in
volving transactions not subject
incorrect because a system of
quality control provides the CPA to management discretion are
generally more predictable.
firm with reasonable assurance
of conforming with professional Answer (b) is correct because
interest expense relates to the
standards. Answer (c) is incorrect
because while working papers income statement, and
provide support for the audit
report and aid in the conduct and
supervision of the audit, they do
not in and of themselves achieve
audit objectives (see SAS 103 for
information on audit working
papers). Answer (d) is incorrect
because increasing the level of
detection risk does not in and of
itself achieve audit objectives.
the procedure most likely to
detect a fraud involving
misstatement of income
statements due to the recording
of journal entries with unusual
combinations of debits and
credits to expense and revenue
accounts. Answer (d) is correct
because an objective of
are often less predictable.
because interest expense is subject to For example, management might incur
only limited management discretion, maintenance expense rather than replace
given the existence of the related debt. plant and equipment, or they may delay
Answers (a) and (c) are incorrect because advertising expenditures. Answer (d) is
accounts receivable and accounts incorrect because prior year data is
payable are balance sheet accounts. An sometimes not a reliable predictor of sub
swer (d) is incorrect because travel and sequent year’s data.
entertainment expense is normally
subject to management discretion. See 22. (c) The requirement is to identify a
AU 329 for more information on the use basic premise underlying the
of analytical procedures. application of analytical
procedures. Answer (c) is correct
20. (c) The requirement is to determine what is because, as indicated in AU 329, a
included when analytical procedures are basic premise underlying the
used in the overall review stage of an audit. application of analytical procedures
Answer (c) is correct because the overall is that plausible relationships
review stage includes reading the financial among data may reasonably be
statements and notes and considering the expected to exist and continue in
adequacy of evidence gathered in response the absence of known conditions to
to unusual or unexpected balances. Answer the contrary. Answer (a) is incorrect
(a) is incorrect because analytical because the study of financial ratios
procedures are not particularly aimed at is an approach to identifying un
gathering evidence on account balances
usual fluctuations, not an acceptable
that have not changed. Answer (b) is
alternative to investigating them.
incorrect because analytical procedures do
Answer (b) is incorrect because
not directly test control procedures. Answer
analytical procedures may be either
(d) is incorrect because tests of transac
statistical or nonstatistical. Answer
tions to corroborate management’s
financial statement assertions are (d) is incorrect because analytical
performed when considering internal procedures may be used as
control and for substantive tests of substantive tests, and may result in
transactions. See AU 329 for information modification of the scope of tests of
on analytical procedures. balances and transactions.
the most predictable relationship 23. (a) The requirement is to identify
for purposes of analytical the stages of an audit for which
procedures applied as substantive the use of analytical procedures
tests. Answer (c) is correct because is required. AU 329 requires the
AU 329 indicates that relationships use of analytical procedures at
involving income statement both the planning and overall
accounts tend to be more review stages of the audit, but not
predictable than relationships
as a substantive test.
involving only balance sheet 24. (b) The requirement is to
accounts. Answer (a) is incorrect determine the reply that would
because, as indicated, relationships facilitate an auditor’s analytical
involving income statements are procedures. Answer (b) is
considered more predictable. correct because use of a standard
Answer (b) is incorrect because cost system (a form of budgeting)
relationships involving transactions produces variance reports that
subject to management discretion will allow
warranty expense with actual
warranty expense.
the auditor to compare the financial
information with the standard cost system 27. (c) The requirement is to identify the best
data to identify unusual fluctuations. See individual to perform analytical procedures
AU 329 for the approach used. Answer (a) in the overall review stage of an audit. At
is incorrect because segregating obsolete this stage of an audit the objective of
inventory before the inventory count is analytical procedures is to assist the
related to the auditor’s physical inventory auditor in assessing the conclusions
observation and will not necessarily affect reached and in the evaluation of the overall
analytical procedures. Answer (c) is financial statement presentation. Answer
incorrect because correcting a material (c) is correct because an experienced
weakness in internal control before the individual with business and industry
beginning of the audit generally will have knowledge is likely to be able to fulfill this
minimal, if any, effect on the historical function. Answer (a) is incorrect because a
information used for analytical procedures. staff accountant who has performed the
Answer (d) is incorrect because data from substantive auditing procedures may not be
independent sources outside the entity is able to objectively perform the analytical
more likely to be reliable than purely procedure and may not have the necessary
internal sources. experience to perform the function. Answer
25. (c) The requirement is to identify (b) is incorrect because the managing
partner of the office may not be close
the most likely effect on an audit of
enough to the audit to perform the function
having performed analytical
effectively. Answer (d) is incorrect
procedures in the overall review
because the individual in charge of quality
stage of an audit which suggest that control and the peer review program should
several accounts have unexpected be as independent as possible of the audits
relationships. Answer (c) is correct he or she is considering. See AU 329 for
because when unexpected guidance on analytical procedures.
relationships exist, additional tests
of details are generally required to B.1.b. Tests of Details of Transactions
determine whether misstatements and Balances
exist. Answer (a) is incorrect be
cause irregularities (fraud) may or 28. (b) The requirement is to identify the
may not exist. An best exampleof a substantive test. Answer
(b) is correct because confir
swer (b) is incorrect because internal
control activities may or may not be
operating effectively. Answer (d) is
incorrect because ordinarily the situation
need not be communicated to the audit
committee.
26. (b) The requirement is to identify
the comparison an auditor most
likely would make in evaluating
an entity’s costs and expenses.
Answer (b) is correct because
payroll expense is an income
statement expense and because it
may be expected to have a
relationship with that of the prior
year. Answer (a) is incorrect
because the accounts receivable
account is not a cost or expense.
comparing budgeted sales with
actual sales of the current year is
more likely to be performed than
comparing budgeted sales with
those of prior years. Answer (d) is
incorrect because comparing the
budgeted current year’s warranty
expense with the current year’s
contingent liabilities is less direct
than that in answer (b), and
because one would be more likely
to compare current year budgeted
mation of balances of accounts receivable B.2. Preparing Substantive Test Audit
will provide a test of the ending account Programs
balance and is therefore a detailed test of a
32. (d) The requirement is to
balance, a type of substantive test. Answers
determine the most likely
(a) and (c) are incorrect because examining approach for auditing the
approval of cash disbursements and statement of cash flows. Answer
comparison of signatures on checks to a list (d) is correct because the
of authorized check signers are tests of statement of cash flows includes
controls. Answer (d) is incorrect because accounts considered during the
flowcharting a client’s cash receipts system is audit of the balance sheet and
a method used to document the auditor’s income statements and,
understanding of internal control. accordingly, the most frequent
29. (c) The requirement is to identify the approach is to reconcile amounts.
Answers (a), (b), and (c) are all
objective of tests of details of transactions
incorrect because they suggest
performed as substantive tests. Answer (c)
approaches not typically followed
is correct because SAS 110 states that the
when auditing the statement of
objective of tests of details of transactions
cash flows.
performed as substantive tests is to detect
material misstatements in the financial 33. (c) The requirement is to determine
statements. Answer (a) is incorrect because the direction of audit testing to
while performing tests of details of determine whether transactions
transactions as substantive tests complies have been recorded. Answer (c) is
with generally accepted auditing standards, correct because to determine
this is not their objective. Answers (b) and whether transactions have been
(d) are incorrect because neither attaining recorded the auditor will test from
assurance about the reliability of the ac
the original source documents to
counting system nor the evaluation of the
operating effectiveness of management’s the recorded entries.Answers (a),
policies and procedures are the objective of (b), and (d) are incorrect because
tests of details of transactions performed as when testing from the general
substantive tests. ledger, the adjusted trial balance, or
from
30. (c) The requirement is to find
the statement which describes
substantive audit tests. Answer
(c) is correct because
substantive tests are defined as
tests of transactions, direct tests
of financial balances, or
analytical procedures.
Answer (a) is incorrect because substantive
tests may not be eliminated due to the
limitations of internal control. Answer (b)
is incorrect since substantive tests
primarily directly test ending financial
statement balances, not subsequent
events. Answer (d) is incorrect because
substantive
tests decrease with increased reliance on
internal control.
account forwhich the auditor is most likely to
perform extensive tests for possible
understatement. An analysis of past audits, in
which existing financial statement errors were
not discovered prior to the issuance of the
financial statements, reveals that the great
majority of the errors resulted in overstated
profits. Therefore, the risk to a CPA is that the
client is overstating profits. Answer (c) is
correct because it is the only item whose
understatement results in overstated profits.
Answers (a), (b), and (d) are incorrect because
understatement of these items would result in
understated profits.
a primary purpose of an auditor’s
general journal entries the auditor is working papers. SAS 103 states
dealing with the entries that have been that working papers serve mainly
recorded, not whether all transactions have to provide the principal support
been recorded. for the auditor’s report and to aid
B.3. Documentation the auditor in the conduct and
supervision of the audit.
38. (c) The requirement is to identify the least
the correct statement concerning
likely item to be included in the permanent
the deletion of audit
file of an auditor’s working papers. Answer
documentation. Answer (b) is
(c) is correct because permanent files
correct because after the audit file
include information affecting a number of
has been completed (ordinarily 60
years’ audits, and the working trial balance
days or less after the issuance of
relates most directly to the current and, to a
the audit report), no portions of
limited extent, the subsequent year’s audit.
audit documentation should be
Answers (a), (b), and (d) are all incorrect
deleted. Answer (a) is incorrect
because bond indenture agreements, lease
because after completion of the
agreements, and a flowchart of internal
audit file no documentation
control affect more years’ audits than does
should be deleted or discarded.
a specific year’s working trial balance.
professional skepticism is not the 39. (c) The requirement is to
basis for determining deletions. determine a difference between
Answer (d) is incorrect because an auditor’s working trial balance
prior to the file completion date and financial statements without
most superseded documentation footnotes. Answer (c) is correct
may be deleted (an exception is because a working trial balance
that information that reflects a includes columns for
disparate point of view should be reclassification and adjustments.
retained). Answers (a), (b), and (d) are all
incorrect because while they
35. (a) The requirement is to
suggest information that might be
determine how long audit
included on a working trial
documentation must be retained.
balance, they will not be included
Answer (a) is correct because
in the form of additional
SAS 103 requires that they be
columns.
maintained a minimum of five
years. Answers (b), (c) and (d) 40. (d) SAS 103 states that the degree
all present other, incorrect time of documentation for a particular
periods. audit area should be affected by
(1) the risk
the most likely pair of accounts to
be analyzed on the same working
paper. Answer (a) is correct
because an auditor will often
consider interest income with
notes receivable because the
interest is earned on those notes
and therefore closely related. An
swer (b) is incorrect because
interest receivable relates to an
asset account (notes receivable)
while accrued interest payable
relates to a liability account
(notes payable) and accordingly
one would expect separate
working papers. Answer (c) is
incorrect because notes payable
and receivable are entirely
separate accounts. Answer (d) is
incorrect because interest
income relates to interestbearing
securities while interest expense
relates to debt accounts.
incorrect because an interbank
of material misstatement, (2) extent of transfer schedule summarizes
judgment, (3) nature of the auditing transfers between banks among
procedures, (4) significance of the accounts. Answer (b) is incorrect
evidence obtained, (5) nature and extent because the term “carryforward
of the exceptions identified, and (6) the schedule” is not frequently used.
need to document a conclusion that is not Answer (c) is incorrect because
obvious from the documentation of the supporting schedules present the
work. details supporting the information
on a lead schedule. For example,
a detailed bank reconciliation for
the required documentation in an
a cash account might serve as a
supporting schedule for an
because
account on the cash lead schedule.
SAS 108 requires a written audit program
setting forth in detail the procedure 44. (c) The requirement is to identify the
necessary to accomplish the engagement’s documentation that is required for an audit
objectives. Answer (a) is incorrect because in accordance with generally accepted
while flowcharts and narratives are auditing standards. Answer (c) is correct
acceptable methods of documenting an because SAS 103 requires that the working
auditor’s understanding of internal control, papers show that the accounting records
they are not required. Answer (c) is agree or reconcile with the financial
incorrect because a planning memorandum statements. Answer (a) is incorrect because
is not required. Answer (d) is incorrect be neither a flowchart nor an internal control
cause completion of an internal control questionnaire is required. Answer (b) is
questionnaire is not required. incorrect because the Professional
42. (a) The requirement is to identify Standards do not require the use of an
a factor that would most likely engagement letter. Answer (d) is incorrect
affect the auditor’s judgment because when control risk is assessed at the
about the quantity, type, and maximum level, the auditor’s
content of the working papers.
understanding of internal control needs to
be documented, but the basis for the
Answer (a) is correct because the
conclusion that it is at the maximum level
Professional Standards state
need not be documented.
that the assessed level of control risk will
affect the quantity, type and content of 45. (b) The requirement is to identify
working papers. SAS 103 provides a listing the point at which no deletions of
of this and other factors. For example, the audit documentation are allowed.
quantity, type and content of working Answer
papers will be affected by whether tests of (b) is correct because the professional
controls have been performed. standards indicate that audit documentation
43. (d) The requirement is to identify may not be deleted after the documentation
the type of audit working paper completion date. Answer (a) is incorrect
that reflects the major components because documentation may be deleted
of an amount reported in the between the client’s yearend date and the
financial statements. Answer (d) documentation completion date. Answer (c) is
is correct because lead schedules incorrect because the last date of significant
aggregate the major components fieldwork is prior to the documentation
to be reported in the financial completion date. Answer (d) is incorrect
statements. Answer (a) is because the report release date is up to 60
days
relationships that the bank has with the
client. Answer (a) is incorrect because bank
prior to the documentation completion employees who complete the form realize
date; 45 days for issuer (public) that they may verify confidential in
company audits. formation with the auditor. Answer (b) is
incorrect because while it is correct that the
46. (b) The requirement is to determine the type
employee who completes the confirmation
of auditor that should be able to understand form will not generally inspect the accuracy
audit documentation of the nature, timing, of the bank reconciliation, this does not
extent, and results of audit procedures limit the confirmation’s usefulness. Answer
performed. Answer (b) is correct because (c) is incorrect because the employee who
PCAOB Standard 3 requires that audit completes the form does not need to have
documentation be understandable to an access to the client’s cutoff bank statement
experienced auditor having no prior to complete the confirmation.
connection with the engagement. Answer
(a) is incorrect because the requirement is 50. (b) The requirement is to
not limited to audit team members. Answer determine the type of evidence
(c) is incorrect because the requirement is that is likely to result in an
more limited than to any certified public auditor limiting substantive
accountant. Answer (d) is incorrect both audit tests of sales transactions
because there is no certification of a peer when control risk is assessed as
review specialist and because this is not a low for the occurrence assertion
requirement. for sales. Answer (b) is correct
because an auditor may analyze
47. (c) The requirement is to identify
the completeness of sales using
the period for which audit cash receipts and accounts
documentation should be retained receivable (for example, an
for issuer (public) company auditor may add yearend re
audits. Answer (c) is correct
ceivables to cash receipts and subtract
because PCAOB Standard 3
beginning receivables to obtain an estimate
requires that audit documentation of sales). Answer (a) is incorrect because
be retained for the longer of the opening and closing inventory balances
seven years or the period required will only provide indirect evidence on sales
by law. Answer (a) is incorrect through calculation of the cost of goods
both because of the sevenyear sold. Answer (c) is incorrect because while
requirement, and because it is the shipping as of yearend will help assure an
longer of seven years or the accurate cutoff of
period required by law. Answer
(b) is incorrect because while
seven years is the general
requirement, a longer period may
be required by law. Answer (d) is
incorrect because audit
documentation need not be
retained indefinitely.
C.1. Evidence—Cash
the information that an auditor
usually confirms on one form.
Answer (b) is correct because the
standard form to confirm account
balance information with
financial institution requests
information on both the cash in
bank and collateral for loans. An
swers (a), (c), and (d) are all
pairs of information that are not
usually confirmed on one form.
49. (d) The requirement is to determine a
reason that the usefulness of the standard
bank confirmation request may be limited.
Answer (d) is correct because the bank
employee who completes the form often
will not have access to all the financial
represent deposits in transit at
sales, the receiving activity has no necessary December 31, 2001. Deposits in
relationship to the sales figure. Answer (d) is transit are those that have been
incorrect because while the cutoff of sales sent to the bank prior to yearend,
will provide evidence on the completeness of but have not been received by the
sales, the purchases portion of the reply is not bank as of yearend. Answer (b)
appropriate. is correct because both check
#101 and check #303 have been
51. (b) The requirement is to determine the two disbursed per books as of year
checks that might indicate kiting, a form of end, but have not yet been
fraud that overstates cash by simultaneously received by the bank as of De
including it in two or more bank accounts. cember 31. Checks #202 and
Answer (b) is correct because checks #202 #404 have been received by the
and #404 include cash in two accounts at bank as of yearend and
yearend. The cash represented by check accordingly are not in transit.
#202 is included in both State Bank and Answer (a) is incorrect because
County Bank cash as of December 31. This check #202 has been received
is because its receipt is recorded prior to before yearend. Answer (c) is
yearend, but its disbursement is recorded incorrect because both checks
after yearend. (For the cash receipts #202 and #404 have been
journal to remain in balance prior to year received before yearend. Answer
end, some account must have been credited (d) is incorrect because check
on December 30 to offset the debit to cash.) #404 has been received before
Check #404 also represents a situation in yearend.
which the cash is included in two accounts
as of yearend; the check may represent a 53. (c) The requirement is to identify why
situation in which a shortage in the account auditors trace bank transfers for the last
is concealed through deposit of the check part of the audit period and the first part of
that is not recorded on the books at year the subsequent period. Answer (c) is
end. Check #101 does not result in a correct because auditors use a bank transfer
misstatement of cash since the books schedule to analyze transfers so as to detect
recorded both the debit and credit portions kiting that overstates cash balances.
of the entry before yearend, while both Answers (a) and (b) are incorrect because
banks recorded them after yearend. Check the process of analyzing transfers is not an
#303 represents a situation in which funds efficient way to determine whether the cash
are disbursed on the Federal account as of receipts journal was held open or when the
yearend, but not received into the year’s final checks were mailed. Auditors
American account (per bank or per books) use a bank cutoff statement rather than a
until after yearend; check #303 bank transfer schedule to help detect these
accordingly understates cash and the nature situations. Answer (d) is incorrect because
of the debit for the entry on December 31 is the process of analyzing transfers is
unknown. Answer (a) is incorrect because unlikely to identify any unusual payments
neither check #101 nor #303 overstates or receipts from related parties.
cash. Answer (c) is incorrect because check
#101 does not overstate cash. Answer (d) is
the source of evidence which does
incorrect because check #303 understates
cash. not contain information on the
balance per bank in a bank
52. (b) The requirement is to reconciliation. Answer (d) is correct
determine the checks which
not request, nor expect, the
financial institution to conduct a
because the general ledger contains only comprehensive, detailed, search
the client’s cash balance, not the balance of its records for other accounts.
per bank. Answer (a) is incorrect because Answer (a) is incorrect because a
the beginning balance on a cutoff statement standard confirmation request
represents the yearend bank balance. will not detect kiting, a
Answer (b) is incorrect because the primary manipulation causing an amount
purpose of a yearend bank statement is to of cash to be included
present information on the balance per simultaneously in the balance of
bank. Answer (c) is incorrect because the two or more bank accounts.
first question on a standard bank Answer (c) is incorrect because
confirmation form requests information on bank statements available from
the yearend balance per bank. the client allow the CPA to
55. (b) The requirement is to identify the cash prepare a proof of cash. Answer
transfer which will result in a misstatement (d) is incorrect because the
of yearend cash. Answer (b) is correct standard form does not request
because the receipt is recorded on the books information about contingent
prior to yearend, while the disbursement is liabilities and secured
recorded subsequent to yearend. Therefore, transactions.
the cash on the books is overstated. 58. (c) The requirement is to determine the
Answers (a), (c), and (d) are incorrect assertion (or assertions) being tested by a
because they do not reveal a cutoff error. test of a control in which an auditor
Answer (a) is incorrect because both the observes the mailing of monthly statements
disbursement and receipt are recorded on to a client’s customers and reviews
the books prior to yearend; note that one evidence of followup on errors reported by
would expect to see an outstanding check the customers. Answer (c) is correct
on the disbursing bank reconciliation as of because observing the mailing of monthly
yearend. Answer (c) is incorrect because statements and followup of errors will
both the disbursement and receipt are provide evidence to the auditor as to
recorded on the books prior to yearend; whether
one would expect the disbursing bank the receivables exist at a given date; the tests
reconciliation to show an outstanding do not directly address the presentation and
check and the receiving bank to show a
disclosure assertion since little evidence is
deposit in transit as of yearend. Answer (d)
obtained about whether financial statement
is incorrect because the entire transaction
components are properly classified,
is recorded after yearend.
described, and disclosed.
56. (c) The requirement is to
determine an approach for
detecting the concealing of a cash
shortage by transporting funds
from one location to another or
by converting negotiable assets
to cash. Answer (c) is correct
because the timing of the
performance of auditing
procedures involves the proper
synchronizing of their application
and thus comprehends the
possible need for simultaneous
examination of, for example, cash
on hand and in banks, securities
owned, bank loans, and other
related items.
the primary purpose of sending a
standard confirmation request to
financial institutions with which
the client has done business
during the year. Answer (b) is
correct because CPAs generally
provide the account information
on the form and ask for balance
corroboration. The form
explicitly states that the CPAs do
the yearend bank confirmations
See SAS 106 for a discussion of the will not include deposits in
various financial statement assertions. transit.
presentation and disclosure assertion is C.2. Evidence—Receivables
not addressed. Answer (b) is incorrect 61. (a) The requirement is to identify the
because the presentation and disclosure
correct statement concerning the use of
assertion is not addressed and because the
negative confirmation requests. Answer (a)
existence or occurrence assertion is
addressed. Answer (d) is incorrect because is correct because AU 330 states that
the existence or occurrence assertion is unreturned negative confirmation requests
addressed. rarely provide significant evidence
concerning financial statements assertions
59. (b) The requirement is to determine the other than certain aspects of the existence
most likely audit step summarized by the assertion. Answer (b) is incorrect because
tick mark placed under “date disbursed per positive, not negative, confirmation
bank.” Answer (b) is correct because the requests are normally used when a low
checks were written in December but level of detection risk is to be achieved.
cleared in January and should therefore be Answer (c) is incorrect because alternative
listed as outstanding on the yearend procedures are not generally performed on
outstanding check list of the applicable unreturned negative confirmation requests
bank reconciliation. Answer (a) is incorrect since it is assumed that the respondent did
because the tick marks are beside the date not reply because of agreement with the
per bank, and not per books. Answer (c) is balance on the confirmation request.
incorrect because the December cash Answer (d) is incorrect because
disbursements journal, and not the January respondents may not reply when
cash disbursements journal, will include misstatements are in their favor.
these disbursements. Answer (d) is
incorrect because the yearend bank
confirmations do not include information the most likely action taken by an
on outstanding checks. auditor when no reply is received
to positive confirmation requests.
60. (a) The requirement is to Answer (c) is correct because
determine the most likely audit asking the client to contact
step summarized by the tick mark customers to ask that confirmation
placed under “date deposited per requests be returned may increase
bank.” Answer (a) is correct response rates. Answer (a) is
because deposits recorded on the incorrect because the lack of a
books as of 12/31 should be reply to a confirmation request
included as deposits in transit on does not necessarily indicate that
the applicable bank the account needs to be written
reconciliation. Answer (b) is off. Answer (b) is incorrect be
incorrect because the tick mark is cause accounts receivable
placed beside the “bank” confirmations deal more directly
column, and not the books with existence than with valuation
column. Answer (c) is incorrect or completeness and because
because the December cash alternative procedures may provide
receipts journal, and not the the auditor with the desired
January cash receipts journal
assurance with respect to the
should include the deposit.
nonrespondents.
debtor is asked to respond only if s/he
disagrees with the information on the
Answer (d) is incorrect because the confirmation; thus, no reply is assumed to
assessed level of inherent risk will not indicate agreement. Answers (c) and (d)
normally be modified due to confirmation are incorrect because while additional
results. procedures may be required when
collectibility isquestionable, alternative
procedures are those used in lieu of
determine the best sampling unit confirmation.
for confirmation of accounts
receivable when many 66. (d) The requirement is to identify
differences between the recorded the most likely alternate
account balances and the procedure when replies have not
confirmation replies have been received to either first or
occurred in the past. Answer (b) second accounts receivable
is correct because the confirmation requests. Answer
misstatements may have oc (d) is correct because the
curred because respondents are inspection of shipping records
not readily able to confirm will provide evidence that the
account balances. AU 330 merchandise was actually shipped
suggests that in such circum to the debtor. Answer (a) is
stances certain respondents’ incorrect because, a review of the
accounting systems may facili cash receipts journal prior to
tate the confirmation of single yearend is unlikely to provide
transactions (individual in evidence on account recorded as
voices) rather than of entire unpaid as of yearend. Also, the
account balances. procedure would only detect one
specific type of misstatement,
64. (c) The requirement is to identify that in which payments were
the assertion most directly recorded in the cash receipts
addressed by accounts receivable journal, but not credited to the
confirmations. SAS 106 presents customers’ accounts. Answer (b)
information on financial statement is incorrect because the lack of a
assertions. Answer (c) is correct reply to the confirmation provides
because a confirmation addresses no particular evidence that the
whether the entity replying to the scope of procedures related to
confirmation believes that a debt internal control should be
exists. Answer (a) is incorrect modified. Answer (c) is incorrect
because while confirmations because the lack of a reply need
provide limited information on not necessarily lead to a
valuation, they do not directly presumption that the account is
misstated. See AU 330 for
address whether the entity replying
procedures typically performed
will pay the debt (or whether the
for yearend accounts receivable
account has been factored). Answer
confirmation requests for which
(b) is incorrect because limited no reply is received.
classification information is
received via confirmations. Answer
(d) is incorrect because
confirmations are generally sent to
recorded receivables, and are of
limited assistance in the determina
tion of whether all accounts are
recorded (completeness).
65. (a) The requirement is to determine when
alternative procedures should be
performed in order to substantiate the
existence of accounts receivable. Answer
(a) is correct because the auditor should
employ alternative procedures for
nonresponses to positive confirmations to
satisfy himself/herself as to the existence of
accounts receivable. Those procedures may
include examination of evidence of
subsequent cash receipts, cash remittance
advices, sales and shipping documents, and
other records. Answer (b) is incorrect
because with negative confirmations the
because verification of the
67. (d) The requirement is to identify the sources and contents through
circumstances in which use of the negative telephone calls will address
form of accounts receivable confirmation whether the information on the
most likely would be justified. Negative fax (which may have been sent
confirmations are used when (1) the from almost anywhere) is correct.
combined assessed level of inherent and Answer (a) is incorrect because
control risk is low, (2) a large number of an examination of the shipping
small balances is involved, and (3) the documents is less complete than
auditor has no reason to believe that the is verification of the entire
recipients of the requests are unlikely to balance. Answer (c) is incorrect
give them consideration. Positive because such faxes need not be
confirmations are used when those treated as nonresponses. Answer
conditions are not met as well as in other (d) is incorrect because inspection
circumstances in which it seems desirable of the faxes is unlikely to reveal
to request a positive response, such as forgeries or alterations, even
when accounts are in dispute. Answer (d) is when such circumstances have
best because small balances are involved occurred.
and few accounts are in dispute. Answer (a)
is incorrect because it refers to a substantial
number of accounts in dispute and sales are identify the circumstance in
to a few major customers. Answer (b) is which the negative form of
incorrect because it refers to a substantial confirmation request most likely
number of accounts in dispute. Answer (c) would be used. Answer (d) is
is incorrect because it refers to sales to a correct because AU
few major customers. 330 states that negative confirmations
may be used when (1) the
68. (a) The requirement is to identify combined assessed level of
a method to reduce the risk inherent and control risk is low
associated with accepting email [answer (d)], (2) a large number
responses to accounts receivable of small balances is involved, and
confirmation requests. Answer (3) the auditor has no reason to
(a) is correct because a response believe that the recipients of the
by mail will confirm the email requests are unlikely to give them
response. Answer (b) is incorrect consideration. Answer (a) is
because while such subsequent incorrect because when the ac
cash receipts will ordinarily be counts receivable are immaterial,
examined, this represents an a decision may be made to send
alternative, complementary no confirmations. Answer (b) is
approach to confirmation. incorrect because an inadequate
Answer (c) is incorrect because rate is not an acceptable reason to
send negative confirmations.
the auditor need not consider e
mail responses to be
negative confirmations are only
confirmations with exception.
of value when the auditor has no
Answer (d) is incorrect because a
reason to believe that the
second request is more likely to recipients of the requests are
elicit either no response or unlikely to give them
another email response. consideration.
69. (b) The requirement is to 71. (a) The requirement is to
determine the most likely identify the circumstance in
procedure to reduce the risks which an auditor would use the
associated with accepting fax blank form of confirmations
responses to requests for (one which includes no amount
confirmations of accounts receiv and asks the respon
able. Answer (b) is correct
confirmation of accounts
receivable. Answer (a) is correct
dent to supply the amount due) rather than because including a list of items
positive confirmations. Answer (a) is or invoices that constitute the
correct because if a recipient simply signs a account balance makes it easier
blank confirmation and returns it the for the potential respondent to
confirmation will have no amount on it and reply. Answer (b) is incorrect
the auditor will know that additional because customers with relatively
procedures are necessary. Answers (b) and large balances may or may not be
(c) are incorrect because there is no more likely to reply. Answers (c)
necessary relationship between the use of and (d) are incorrect because
blank confirmations and subsequent cash there is no research available
receipt verification difficulty and analytical indicating that requesting a fax or
procedures results. Answer (d) is incorrect email reply, or threatening a
because when the combined assessed level second request is likely to
of inherent risk and control risk is low it is improve response rate.
unlikely to lead to the blank form of
confirmation. In fact, when that risk is low, C.3. Evidence—Inventory
and when adequate other substantive tests
of details, no confirmation may be 75. (a) The requirement is to determine the
necessary. See AU 330 for information on financialstatement most directly related to
the confirmation process. the procedure of making inquiries
concerning possible obsolete or slow
72. (d) The requirement is to identify the most moving inventory. Answer (a) is correct
likely information that would be included in a because inquiries concerning possible
client’s confirmation letter that is being used obsolete or slowmoving inventory deal
to confirm accounts receivable balances with whether the inventory is being carried
rather than individual invoices. Answer (d) is at the proper value
correct since including details of the account
is likely to make it easier for the customer to
respond in a meaningful manner. Answer (a)
is incorrect because no such auditorprepared
letter will be included and because only in the
case of the negative form of confirmation does
a nonresponse lead to an inference that the
account balance is correct. Answer (b) is
incorrect because confirmation requests do not
ordinarily include a letter suggesting that a
second request will be sent. Answer (c) is
incorrect because the auditor does not enclose
a letter requesting that the information be
supplied. See AU
330 for information on the confirmation
process.
73. (c) The requirement is to identify a
statement that an auditor would be most
likely to add to the negative form of
confirmation of accounts receivable to
encourage a timely consideration by the
recipient. Answer (c) is correct because
providing such information might increase
timely consideration in that the recipient
may realize the importance of a reply when
the information is incorrect. Answers (a)
and (b) are incorrect because while a
confirmation request may include these
statements, the statements are unlikely to
encourage timely consideration of the
request. Answer (d) is incorrect because
many accounts that are not overdue are
sampled, and because even for those
overdue such a statement is not ordinarily
included with the confirmation request.
the strategy most likely to
improve the response rate for
the auditor’s recorded count sheets will
and this is most directly related to the provide assurance that the listed items
valuation assertion. The other assertions actually exist. Answer (a) is incorrect
are less directly related. Answer (b) is because tracing from inventory tags to
incorrect because the rights assertion deals items in the inventory listing schedule tests
with whether assets are the rights of the the completeness of the inventory listing
entity and liabilities are the obligations of sheet, not whether all of the items it lists
the entity at a given date. Answer (c) is are valid. Answer (b) is incorrect because it
incorrect because the existence assertion does not directly test the client’s inventory
deals with whether assets exist at a given listing schedule. Answer (d) is incorrect
date. Answer (d) is incorrect because the because tracing items listed in receiving
presentation assertion deals with whether reports and vendors’ invoices to the
particular components of the financial inventory listing schedule will provide
statements are properly classified. See SAS assurance on the completeness of the
106 for information on the financial inventory listing sheet; it will also be a
statement assertions. difficult procedure to accomplish due to the
76. (d) The requirement is to identify fact that a number of these items will not be
the type of omitted journal entry in inventory due to sales. See SAS 106 for
that would result in inventory test information on the testing of the various
counts that are higher than the financial statement assertions.
recorded quantities in the client’s 78. (b) The requirement is to identify
perpetual records. Answer (d) is the factor that average inventory
correct because a failure to record is divided into to calculate
sales returns results in a situation inventory turnover. Answer (b) is
in which the item is returned by a correct because the average
customer and included in the inventory is divided into the cost
inventory count, but not recorded of goods sold to calculate the
in the perpetual records; inventory turnover.
accordingly the test counts are
higher than the recorded 79. (a) The requirement is to identify the
quantities. Answer (a) is auditing procedure that most likely would
incorrect because purchase provide assurance about a manufacturing
discounts do not affect quantities entity’s inventory valuation. Answer (a) is
in inventory. Answers (b) and (c) correct because testing the overhead
are incorrect because a failure to computation will provide evidence on
record purchase returns or sales whether inventory has been included in the
result in a situation in which less financial statements at the appropriate
inventory will be counted (since amount. Answer (b) is incorrect because
the items are no longer physically obtaining confirmation of inventories
in inventory) than is recorded on pledged under loan agreements relates more
the perpetual records. directly to the presentation assertion.
Answers (c) and (d) are incorrect because
77. (c) The requirement is to identify a reviewing shipping and receiving cutoff
procedure that will provide assurance that procedures for inventories and tracing test
all inventory items in a client’s inventory counts to the inventory listing relate more
listing schedule are valid. Answer (c) is directly to the existence and completeness
correct because tracing from the inventory assertions.
listing schedule to inventory tags and to
rights of the entity and this is not being
tested when an auditor traces test counts to
80. (b) The requirement is to identify an inventory listing. Answer (c) is
an action that an auditor might take incorrect because existence deals with
when the assessed level of control whether the inventory existed at the date of
risk is high for inventory. Answer the count. To test existence the auditor
(b) is correct because a high level would sample from the inventory listing
of control risk will generally result and compare quantities to the test counts.
in a low acceptable level of Answer (d) is incorrect because valuation
detection risk, which may be deals with whether the inventory is properly
achieved by changing the timing of included in the balance sheet at the
substantive tests to yearend, appropriate dollar amount and this is not
changing the nature of substantive being tested here. See SAS
tests to more effective procedures, 106 for more information on
and/or by changing the extent of management’s financial state
substantive tests. Answer (a) is ment assertions.
incorrect because control risk has 83. (d) The requirement is to determine the
been assessed and tests of controls, assertion most directly related to an
if any, will already have been com auditor’s analysis of inventory turnover
pleted. Answer (c) is incorrect rates. Answer (d) is correct because an
because a yearend count of analysis of inventory turnover rates will
inventory is more appropriate when provide the auditor with evidence on slow
control risk is high. Answer (d) is moving, excess, defective, and obsolete
incorrect because gross profit tests items included in inventories. These items
will generally provide less may be improperly valued.
assurance than is required in
circumstances such as this when 84. (a) The requirement is to
control risk is assessed at a high determine which types of entries
level. will be supported when the
auditor examines receiving
81. (a) The requirement is to identify the reports. Answer (a) is correct
financial statement assertion (other than because receiving reports will be
presentation and disclosure) most directly prepared when goods are
related to an auditor’s conclusion that no received through purchase (as
excessive costs for idle plant were charged recorded in the voucher register)
to inventory. Answer (a) is correct because and when goods are
the assertion deals with whether the inven
tory has been included in the financial
statements at the appropriate amount, and
therefore that no excessive costs were
charged to inventory. Answer (b) is
incorrect because the completeness
assertion deals with whether all inventory
items that should be presented are so
included. Answer (c) is incorrect because
existence deals with whether the inventory
actually exits at the given date. Answer (d)
is incorrect because rights deal with
whether the inventory is owned by the
client. For more information on
management’s financial statement
assertions, see SAS 106.
financial statement assertion most directly
related to an auditor’s tracing of inventory
test counts to the client’s inventory listing.
Answer (b) is correct because the
completeness assertion deals with whether
all transactions are included. Tracing from
the inventory items observed to the
inventory listing will help determine
whether all the transactions are included
and the inventory listing is complete.
Answer (a) is incorrect because the rights
assertion deals with whether assets are the
for any subsequent mis
received through sales returns (as placement or misappropriation of
recorded in the sales returns journal). the securities. Answer (a) is
Answers (b), (c), and (d) are incorrect be incorrect because the client’s
cause entries in sales journals result in representative will not in general
items being shipped, not received. Note, help the CPA to detect fraudulent
however, that answers (b), (c), and (d) are securities. Answers (b) and (d)
partially correct because the sales returns are incorrect because while the
journal, voucher register, and check client’s representative will help
register all result from transactions the CPA to gain access to the
related to the receipt of goods. securities and may coordinate
their return, these are not the
auditor’s primary purpose.
responsewhich does not represent one of
the independent auditor’s objectives 87. (c) The requirement is to identify the best
regarding the examination of inventory. procedure other than inspection to establish
Answer (c) is correct because verifying the existence and ownership of a longterm
that all inventory owned by the client is on investment in a publicly traded stock.
hand at the time of the count is not an Answer (c) is correct because confirmation
objective. For example, purchased items in of the number of shares owned that are held
transit at yearend, for which title has by an independent custodian is effective at
passed, should be included in inventory. testing existence. Answer (a) is incorrect
Similarly, inventory out on consignment because auditors do not in general
should also be included in inventory. correspond with the investee company and
Answer (a) is incorrect because proper because that company may or may not have
presentation of inventory pertains to the detailed information on the identity of
presentation and disclosure assertion and shareholders at any point in time. Answer
therefore would be subject to auditor (b) is incorrect because while inspection of
verification. Answers (b) and (d) are in the audited financial statements of the
correct because proper accounting for investee company may provide limited
damaged and obsolete items and proper information on valuation of the investment,
inventory pricing pertain to the valuation it does not directly address existence; note
assertion and therefore would be subject to that this procedure is of limited use here
auditor verification. See SAS 106 for since the stock is publicly traded and
details on financial statement assertions. obtaining its value through stock price quo
tations should not be difficult. Answer (d)
C.4. Evidence—Investment Securities
is incorrect because this procedure
86. (c) The requirement is to addresses the valuation of the securities. In
determine why an auditor should addition, under SFAS 115, investments are
insist that a client representative no longer carried at the lower of cost or
be present when he or she market. See SAS 106 for more information
physically examines securities. on management’s financial statement
Answer (c) is correct because assertions.
requiring that a client 88. (c) The requirement is to determine
representative acknowledge the the best procedure when an
receipt of the securities will
auditor has been unable to inspect
eliminate any question con
and count a
cerning the CPA’s responsibility
accumulated depreciation expense. Answer
(b) is correct because debits to accumulated
client’s investment securities (held in a depreciation are properly recorded upon
safedeposit box) until after the balance retirement of a plant asset. Answer (a) is
sheet date. Answer (c) is correct because incorrect because changing the useful lives
banks maintain records on access to safe of plant assets does not affect accumulated
deposit boxes. Thus, the confirmation of no depreciation. Answer (c) is incorrect
access during the period will provide the because understatement of the prior year’s
auditor with evidence that the securities in depreciation expense does not result in an
the safedeposit box at the time of the adjustment to accumulated depreciation.
count were those available at yearend. Answer (d) is incorrect because overhead
Answers (a) and (b) are incorrect because allocations do not ordinarily affect accumu
the bank will not generally be able to lated depreciation.
provide a list of securities added and
removed from the box (typically, only 92. (a) The requirement is to identify the best
records on access are maintained by the procedure for testing unrecorded
bank). Therefore, the bank will have no retirements of equipment. Answer (a) is
information on reconciling items between correct because selecting items from the
the subsidiary ledger and the securities on accounting records and attempting to
hand. Answer (d) is incorrect because it is locate them will reveal unrecorded
the responsibility of the auditor and the retirements when the item cannot be
client, not the bank, to count the securities located. Answer (b) is incorrect because
maintained in a safedeposit box. depreciation entries will continue when
retirements have not been recorded. Answer
(c) is incorrect
most likelyuse of analytical procedures
when testing longterm investments.
predictable relationship between longterm
investments and investment income creates
a situation in which analytical procedures
may provide substantial audit assurance.
Answer (b) is incorrect because the
classification between current and non
current portfolios may be expected to
fluctuate in an unpredictable manner as
investment goals and the environment
change. Answers (c) and (d) are incorrect
because the valuation of marketable equity
securities at the lower of cost or market and
unrealized gains or losses do not result in a
predictable relationship on which analytical
procedures may provide effective results.
C.5. Evidence—Property, Plant, and
Equipment
account whose analysis is least likely to
reveal evidence relating to recorded
retirements of equipment. Answer (d) is
correctbecause the purchase returns and
allowances account deals with returns and
allowances for purchases of merchandise,
not equipment. Answer (a) is incorrect
because analysis of accumulated
depreciation will reveal the retirement
through charges made to the accumulated
depreciation account. Answer (b) is
incorrect because companies will ordinarily
modify insurance coverage when assets are
retired. Answer (c) is incorrect because the
property, plant, and equipment account
will reflect the retirement.
91. (b) The requirement is to identify a likely
explanation for a situation in which
significant debits have been posted to the
detailed knowledge as to the ade
because the direction of the test is quacy of the provision for
incorrect since beginning with the item is uncollectible accounts or the
unlikely to reveal a situation in which an amount of insurance which is
unrecorded retirement has occurred. desirable. Answer (b) is in
Answer (d) is incorrect because scanning correct because the plant manager
the general journal for recorded entries is will have limited knowledge
unlikely to reveal unrecorded retirements concerning physical inventory
of equipment. observation procedures and their
appropriateness.
determine why an auditor 95. (a) The requirement is to identify
analyzes repairs and maintenance the document least likely to
accounts. Answer (d) is correct provide evidence regarding
because clients often erroneously mortgage acquisition costs.
charge expenditures for property Deeds generally consist of a legal
and equipment acquisitions as conveyance of rights to use real
expenses rather than capitalize property. Frequently the sales
them as assets. An analysis of price is not even specified and the
repairs and maintenance accounts related mortgage acquisition costs
will reveal such errors. Answer are much less likely to be stated in
(a) is incorrect because while a deed. Answer (b) is incorrect
auditors will want to determine because cancelled checks would
that noncapitalizable expenses provide verification of mortgage
for repairs and maintenance have acquisition costs. Answer (c) is
been recorded in the proper incorrect because the closing
period, analyzing only the statement would provide a
recorded entries is an incomplete detailed listing of the costs of
test since entries occurring after acquiring the real property,
yearend will also need to be including possible mortgage
examined. Answer (b) is acquisition costs. Answer (d) is
incorrect because procedures incorrect because examination of
relating to the property and interest expense would also relate
equipment account will be to the mortgage acquisition costs.
performed to determine whether 96. (b) The requirement is to determine
such entries have been recorded the assertion(s) involved when an
in the auditor is inspecting new additions
proper period. Answer (c) is incorrect on a list of property, plant, and
because analyzing the repairs and
equipment. Answer (b) is correct
maintenance accounts only considers
because an auditor who inspects
recorded entries and not whether all
noncapitalizable expenditures for repairs new additions relating to property
and maintenance have been properly and equipment balances addresses
charged to expense. existence or occurrence, but not
presentation and disclosure;
94. (c) The requirement is to presentation and disclosure relates
determine the information an more directly to proper
auditor is most likely to seek classification and note disclosures
from the plant manager. The rather than account balances.
plant manager comes into dayto
day contact with the machinery C.6. Evidence—Prepaid Assets
when producing a product; that
contact is likely to provide
information on its condition and financialstatement assertion most directly
usefulness. Answers (a) and (d) related to the procedure of reviewing or
are incorrect because the plant recomputing amortization of intangible
manager will generally not have assets.
the appropriate population when
using accounts payable
Answer (a) is correct because the confirmations directed towards
amortization of intangible assets deals with obtaining evidence on the
whether the accounts are properly valued, completeness assertion. Answer (a)
the valuation assertion. The other assertions is correct because to address
are less directly related. Answer (b) is completeness the auditor attempts
incorrect because the existence or to determine that all accounts pay
occurrence assertion deals with whether able are reflected, and a company
assets or liabilities exist at a given date and potentially may be liable to any of
whether recorded transactions have
its vendors. Answer (b) is incorrect
occurred during a given period. Answer (c)
because confirming based on
is incorrect because the completeness
recorded amounts addresses
assertion deals with whether all
transactions and accounts that should be existence more directly than
presented in the financial statements are so completeness. Answer (c) is
included. Answer (d) is incorrect because incorrect because basing the sample
the rights and obligations assertion deals on payees after yearend only deals
with whether assets are the rights of the with those payables that have been
entity and liabilities are the obligations of paid as of that point. Answer (d) is
the entity at a given date. See SAS 106 for incorrect because open invoices are
information on the financial statement a less complete population than are
assertions. vendors. See AU 330 for
information on the confirmation
98. (c) The requirement is to determine the process, and SAS 106 for
most likelyreason for the absence of the information on management’s
original insurance policy on plant financial statement assertions.
equipment. Answer (c) is correct because
the holder of the lien may also in certain 101. (d) The requirement is to
circumstances maintain the original determine why confirmation of
insurance policy. Answer (a) is incorrect accounts payable is unnecessary.
because an insurance premium which is Accounts payable are usually not
due but not recorded is unlikely to account confirmed because there is better
for the lack of the original insurance evidence available to the auditor,
policy. Answer (b) is incorrect because (i.e., examination of cash
while coinsurance provisions are outlined payments subsequent to the
in the policy, they are unlikely to be a balance sheet date). If the auditor
reason that the policy is not available for reviews
inspection. Answer (d) is incorrect
because there is no obvious relationship
between the understatement of insurance
expense and the presence or absence of an
insurance policy.
C.7. Evidence—Payables (Current)
99. (c) The requirement is to identify the best
audit procedures for identifying
unrecorded liabilities. Answer (c) is correct
because unrecorded liabilities eventually
become due and must be paid. Accordingly,
a review of cash disbursements after the
balance sheet date is an effective procedure
for detecting unrecorded payables. Answer
(a) is incorrect because tracing a sample of
accounts payable that have been recorded is
not likely to result in identification of
unrecorded liabilities. Answer (b) is
incorrect because purchase orders issued
after yearend will not result in liabilities as
of yearend. Answer (d) is incorrect
because disbursement entries recorded
before yearend generally relate to accounts
payable that have been paid before year
end.
Answer (a) is incorrect because the existence
all cash payments for a sufficient time assertion deals with whether recorded
after the balance sheet date for items accounts payable are overstated, thereby
pertaining to the period under audit and understating income. Answer (b) is incorrect
finds no such payments which were not because payables often require no particularly
recorded as liabilities at yearend, the troublesome presentations and disclosures.
auditor is reasonably assured that ac Answer (d) is incorrect because payables are
counts payable were not understated. most frequently simply valued at the cost of
Answer (a) is a nonsense answer. Answer the related acquisition. See SAS 106 for more
(b) is incorrect because AP balances could information on management’s financial
be paid during yearend audit work after
the balance sheet date. Answer (c) is
incorrect because whether or not legal C.8. Evidence—LongTerm Debt
action has been taken against the client is
irrelevant to the confirmation procedure. 104. (b) The requirement is to identify
a likely reason for a recorded
102. (c) The requirement is to identify interest expense that seems
the substantive test to be excessive in relation to the
performed to verify the existence balance in the bonds payable
and valuation of recorded account. Answer (b) is correct
accounts payable. Answer (c) is because understated bonds
correct because the vouching of payable will result in a lower
various payable accounts to account balance than is proper
purchase orders and receiving and thereby create a situation in
reports will provide evidence that which the interest expense
the debt was incurred and the appears excessive. Answers (a)
related goods received, thereby and (d) are incorrect because an
providing evidence on the understated discount or an
existence of the debt and its overstated premium on bonds
amount, or valuation. Answer (a) payable result in situations in
is incorrect because determining which the recorded interest
whether prenumbered purchase expense seems lower than
orders are used and accounted expected since the net bonds
for relates more directly to the payable are overstated. Answer
completeness with which (c) is incorrect because
purchases and accounts payable understatements, not
were recorded. Answers (b) and overstatements, of bonds payable
(d) are incorrect because the will result in what appears to be
question addresses the existence an excessive rate of interest
and valuation of recorded expense.
accounts payable, not unrecorded
payables or payables with a zero 105. (a) The requirement is to determine the
balance. financial statement assertion most directly
related to an auditor’s inspection of loan
103. (c) The requirement is to determine agreements under which an entity’s in
management’s accounts payable assertion that ventories are pledged. Answer (a) is correct
an auditor will primarily focus on. Experience because the presentation and disclosure
has indicated that overstated income is more assertion deals with whether particular
of a risk than is understated income. Answer components of the financial statements—such
(c) is correct because the completeness as loan agreement covenants—are properly
assertion focuses upon whether payables have classified, described, and disclosed. The other
been omitted, thereby overstating income. assertions are less directly related.
answer (c) in that it is desirable
but does not address the actual
Answer (b) is incorrect because the bond sinking fund transactions
valuation or allocation assertion deals with and yearend balance.
whether asset, liabilities, revenue, and
expense components have been included in C.9. Evidence—Owners’ Equity
the financial statements at the appropriate
amounts. Answer (c) is incorrect because
the existence or occurrence assertion deals determine how an auditor
with whether assets or liabilities exist at a ordinarily obtains evidence of
given date and whether recorded stockholders’ equity transac
transactions have occurred during a given tions. Answer (a) is correct
period. Answer (d) is incorrect because the because the board of directors
completeness assertion deals with whether will, in general, authorize
all transactions and accounts that should be changes in stockholders’ equity.
presented in the financial statements are so Answer (b) is less complete in
included. See SAS 106 for information on that for small clients there may
the financial statement assertions. be no transfer agent, and because
the transfer agent deals most
106. (c) The requirement is to identify a directly with transfers of
procedure an auditor would perform in outstanding stock. Answer (c) is
auditing longterm bonds payable. Answer incorrect because canceled stock
(c) is correct because comparing interest certificates are ordinarily
expense with the bond payable amount will available only for small clients.
provide evidence as to reasonableness. Such Answer (d) is incorrect because
a procedure may reveal either interest not companies do not ordinarily
expensed or debt not properly recorded. have a “treasury stock
Answer (a) is incorrect because analytical certificate book.”
procedures will not in general be performed
on bond premiums and discounts since 109. (d) The requirement is to identify
these accounts may easily be verified by the most likely audit procedure,
examining details of the entry recording the in addition to analytical
debt issuance and any subsequent amor procedures, when control risk for
tization. Answer (b) is incorrect because an payroll is assessed as low.
examination of the documentation of assets Answer (d) is correct because
purchased with bond proceeds is only accrual of payroll at yearend is
necessary when such a use of the funds is a not an entry made frequently
requirement of the debt issuance. Answer throughout the year and
(d) is incorrect because confirmation of accordingly recording of the
bonds outstanding will often be with the entry is often not controlled by
trustee rather than with individual the payroll
bondholders.
determine how an auditor can best
verify a client’s bond sinking fund
transactions and yearend balance.
confirmation with the bond
trustee represents externally
generated evidence received
directly by the auditor. Such
evidence is considered very
reliable. Answer (a) is incorrect
because individual holders of
retired bonds will have no
information on actual bond
sinking fund transactions or year
end balances. Answer (c) is
incorrect because, while
recomputing interest expense,
interest payable, and amortization
of bond discount or premiums are
desirable procedures, they do not
directly address bond sinking fund
transactions and yearend
balances. Answer (d) is similar to
portion of the internal control structure. the procedure that is most likely
Answers (a), (b), and (c) are incorrect when an auditor is performing tests
because observing the distribution of concerning the granting of stock
paychecks, the footing and crossfooting of options. Answer (d) is correct be
the payroll register, and inspection of cause authorizing the issuance of
payroll tax returns are recurring op stock options is ordinarily a
erations that will have been considered decision made by the board of
when assessing control risk at a low level.
directors. Answer (a) is incorrect
110. (a) The requirement is to identify because the Secretary of State of
the circumstance that most likely the state of incorporation will not
would cause an auditor to suspect have this information on stock
an employee payroll fraud options. Answer (b) is incorrect
scheme. Answer (a) is correct because the existence of the option
because significant unexplained holders is not ordinarily a
variances between standard and significant question. Answer (c) is
actual labor cost may lead an incorrect because stock to be issued
auditor to suspect fraud. Answer relating to options may be either
(b) is incorrect because one would from treasury stock or new
expect payroll checks to be issuances; accordingly, sufficient
distributed by the same employees treasury stock need not be
each payday. Answer (c) is available.
incorrect because time cards are
ordinarily approved by individual 113. (d) The requirement is to identify
departmental supervisors. An the assertion to which determining
swer (d) is incorrect because the whether there are restrictions on
maintenance of a separate payroll retained earnings relates most
bank account is considered a directly. Answer (d) is correct be
control, not an indication of cause such restrictions will result in
fraud. disclosures and thus the
presentation and disclosure
assertion is most directly being
procedure that an auditor most likely would
verified. Answer (a) is incorrect
perform when auditing payroll. Answer (d)
because the existence or occurrence
is correct because a comparison of payroll
assertion addresses whether assets
costs with entity standards or budgets will
or liabilities of the entity exist at a
generally be included in the audit program
as a test of overall payroll reasonableness. given date and whether recorded
Answer (a) is incorrect because unclaimed transactions have occurred during a
wages will not be mailed unless an given period. An
employee so requests and this often will not swer (b) is incorrect because the
be tested by an auditor. Answer (b) is completeness assertion addresses whether
incorrect because total employee deductions all transactions and accounts that should
will be traced to journal entries. Answer (c) be presented in the financial statements
is incorrect because observing entity are so included. Answer (c) is incorrect
employees during a payroll distribution is because the valuation or allocation
generally only included in an audit program assertion addresses whether asset,
when internal control is weak; accordingly, liability, revenue, and expense
it is more likely that a comparison of components have been included in the
financial statements at appropriate
payroll costs with entity standards or
amounts. See SAS 106 for a discussion
budgets [answer (d)] will be included.
of financial statement assertions.
less substantive testing. Answer
(d) is incorrect because the nature
114. (b) The requirement is to identify of accrued payroll expense being
the information an auditor should unpaid commissions need not
confirm with a client’s transfer necessarily result in more
agent and registrar. Answer (b) is substantive testing.
correct because when a client em
ploys a transfer agent and 117. (a) The requirement is to determine a
registrar, there will be no stock source an auditor uses to test the
certificate book to examine, and reasonableness of dividend income from
accordingly, information on investments in publicly held companies.
shares issued and outstanding Answer (a) is correct because dividend
should be confirmed. Answers record books produced by investment
(a), (c), and (d) are incorrect advisory services provide summaries of
because the transfer agent and dividends paid for various securities, and an
registrar often will not have auditor is able to compare the
information on dividend reasonableness of a client’s recorded
restrictions, guarantees of dividend income from investments with this
preferred stock liquidation values, information. Answers (b) and (c) are
and the number of shares subject incorrect because auditors do not, in
to agreements to repurchase. general, determine the reasonableness of
dividend income by examining stock “in
115. (c) The requirement is to dentures” or “stock ledgers.” Answer (d) is
determine a likely step in the incorrect because while annual financial
audit program for retained statements of investee companies may
earnings. The legality of a include such information, examining such
dividend depends in part on financial statements is not generally an
whether it has been properly efficient approach for testing the
authorized (state laws differ on reasonableness of dividend income. Also,
specific requirements). Thus, the the current year financial statements of the
auditor must determine that investees often are not available when the
proper authorization exists, as auditor is performing the current audit.
both cash and stock dividends
affect retained earnings. Answer C.10. Revenue
(a) is incorrect since only a memo 118. (c) The requirement is to identify the
entry is required for a stock split. most likelyrisk involved with a bill and
Answer (b) is incorrect because hold transaction at yearend. Answer (c) is
the writedown of an account correct because a bill and hold transaction
receivable will not, in general, be results in the recording of a sale prior to
recorded in retained earnings. delivery of the goods—accordingly, sales
Answer (d) is incorrect because may be inappropriately recorded.
gains from the disposition of
treasury shares are recorded in
paidin capital accounts.
determine when an auditor would
be most likely to perform
substantive tests of details on
payroll transactions and balances.
Answer (c) is correct because
analytical procedures result in
further investigation when
unexpected differences occur.
This investigation will generally
involve substantive tests of details
of transactions and balances. AU
329 provides detailed information
on analytical procedures. Answer
(a) is incorrect because a
substantial amount of accrued
payroll expense as indicated by a
cutoff test will not necessarily
result in additional substantive
tests. Answer (b) is incorrect
because a low assessed level of
control risk is likely to result in
equipment.
Answer (a) is incorrect because accrued
liabilities are not ordinarily affected by C.12. Client Representation Letters
bill and hold transactions. An 121. (c) The requirement is to identify
swers (b) and (d) are incorrect because an the matter on which an auditor
absolute purchase commitment and the should obtain written
assuming of risk and reward relating to the
management representations.
product represent conditions which
increase the likelihood that recording of a
written representations are
sale for such a transaction is appropriate.
ordinarily obtained on
119. (b) The requirement is to identify the noncompliance with aspects of
most likelylisted effect of “channel contractual agreements that may
stuffing.” Answer (b) is correct because affect the financial statements.
channel stuffing is a marketing practice that Answer (a) is incorrect because
suppliers sometimes use to boost sales by auditors do not ordinarily obtain
inducing distributors to buy substantially a costbenefit justification from
more inventory than they can promptly management related to internal
resell; accordingly, increased sales returns control weaknesses. Answer (b)
in the future are likely. Answers (a), (c) and is incorrect because written
(d) are incorrect because accrued representations are not ordinarily
liabilities, cash, and marketable obtained on such future plans.
investments are less likely to be affected by Answer (d) is incorrect because
channel stuffing, which results in entries management may or may not be
increasing accounts receivable, cost of responsible for employee
good sold, and sales, while decreasing violations of laws, and because
inventory. such a representation is not
ordinarily obtained. See AU 333
C.11. Expenses for information on client
representations.
account inwhich a recorded entry is most 122. (a) The requirement is to determine
likely to relate to the property, plant, and a matter to which materiality limits
equipment completeness assertion. The do not apply in obtaining written
completeness assertion addresses whether management representations.
all transactions have been recorded in an Answer (a) is correct because
account (here, property, plant, and materiality considerations do not
equipment). Answer (d) is correct because apply to management’s
the purchase of property, plant, and acknowledgment of its
equipment may inappropriately have been
responsibility for fair presentation
recorded in the repairs and maintenance
of financial statements, the
account rather than in property, plant, and
availability of all financial records,
equipment; this is a frequent bookkeeping
the completeness and availability
error since the individual recording the
entry may frequently see similar invoices of all minutes and meetings of
which do represent repairs and stockholders, directors, and
maintenance expense. Answers (a), (b), committees of directors, and
and (c) are all incorrect because the communication from regulatory
allowance for doubtful accounts, agencies. Answers (b), (c), and (d)
marketable securities, and sales has no are all incorrect because
apparent relationship to the completeness materiality considerations relate to
of recording of property, plant, and losses from purchase
commitments, compen
meant to complement, but not
replace, substantive tests.
sating balances, and obsolete inventory. Answer (b) is incorrect because
AU 333 discusses client representations. the comple
mentary nature of such representations is not
considered sufficient, even when combined
determine the proper date for a
with reliance upon internal control. The
client’s representation letter. AU
333 states that the representation inherent limitations of internal control do not
letter should be dated as of the permit the auditor to replace substantive tests
date of the auditor’s report. with complete reliance on internal control.
Answer (c) is incorrect because the written
124. (b) The requirement is to identify the representations are considered complementary
matter that an auditor most likely would evidence in support of various assertions.
include in a management representation Answer (d) is incorrect because such written
letter. Auditors will generally request representations are not considered to be
assurance as to the completeness and replacements for reliance upon internal
availability of minutes of stockholders’ control.
and directors’ meetings. See AU 333 for
written representations ordinarily obtained 128. (a) The requirement is to
by the auditor. determine who should sign a
letter of representation. AU 333
125. (d) The requirement is to states that, normally, the chief
determine the year(s) on which a executive officer and the chief
CPA must obtain written financial officers should sign the
representations from man letter of representation.
agement, when comparative
financial statements are being 129. (d) The requirement is to identify
issued, but current management the scope limitation which in all
has only been employed for a cases is sufficient to preclude an
portion of one of those years. AU unqualified opinion. Answer (d)
333 states that if current is correct because the professional
management was not present standards state that management
during all periods reported upon, refusal to furnish written
the auditor should nevertheless representations constitutes a
obtain written representations limitation on the scope of the
from current management on all auditor’s examination sufficient
such periods. to preclude an unqualified
opinion. Answer (a) is incorrect
because management’s refusal to
the information ordinarily included
allow the auditor to review the
among the written client
predecessor’s work may not
representations obtained by the necessarily result in report
auditor. Answer (a) is correct modification. An
because
AU 333 includes information on
compensating balances in the list of
representations normally obtained. Answer
(b) is incorrect because management need
not acknowledge a responsibility for
employee illegal actions. Answer (c) is in
correct because the auditor, not the client,
determines whether sufficient audit
evidence has been made available. Answer
(d) is incorrect because, for purposes of a
financial statement audit, management
need not attempt to determine whether
material weaknesses in internal control
exist.
determine the correct statement
with respect to the use of a
letter as audit evidence about the
completeness assertion. Answer
(a) is correct because such
written representations are
correct statement concerning an auditor’s
swer (b) is incorrect because alternate use of the work of a specialist. Answer (a)
procedures may be available that will make is correct because the work of a specialist
report modification unnecessary when the who is related to the client may be
auditor has been engaged after completion acceptable under certain circumstances.
of the yearend physical count. Answer (c) Answer (b) is incorrect because if the
is incorrect because management may auditor believes that the findings of the
choose not to correct a significant specialist are unreasonable, it is generally
deficiencies in internal control without a appropriate to obtain the findings of
resulting limitation on the scope of the another specialist. Answer (c) is incorrect
audit. because a material difference between a
specialist’s findings and those included in
130. (c) The requirement is to identify a purpose
the financial statements may result in the
of a management representation letter.
need for an explanatory paragraph, a
Answer (c) is correct because a
qualified opinion, a disclaimer, or an
management representation letter is meant
adverse opinion. Answer (d) is incorrect
to reduce the possibility of a
because an auditor may use a specialist in
misunderstanding concerning
the determination of various physical
management’s responsibility for the
characteristics of assets.
incorrect because reducing audit risk to an 133. (a) The requirement is to identify
aggregate level of misstatement that could a circumstance in which an
be considered material is not a logically auditor may refer to the findings
sound statement. Answer (b) is incorrect of a specialist in the auditor’s
because the management representation report. Answer (a) is correct
letter does not modify an auditor’s because the auditor may refer to
responsibility to detect material mis the specialist when the
statements. Answer (d) is incorrect because specialist’s findings result in
management representation letters are not a inclusion of an explanatory
substitute for other procedures. paragraph to an audit report, in
this case on going concern status.
Answers (b), (c), and (d) are all
the most likely source of a
incorrect because a specialist is
statement suggesting that there
only referred to in an audit report
have been no communications
when that specialist’s findings
from regulatory agencies.
identify a circumstance requiring
modification of the audit report.
information such as this is
Auditors do not modify audit
ordinarily included in a
reports to simply inform the user
that a specialist was involved.
letter. Answers (a), (b), and (d)
are incorrect because such a 134. (d) The requirement is to identify
disclosure is not ordinarily the statement that is correct about
included in a report on internal the auditor’s use of the work of a
control, a special report, or a specialist. Answer (d) is correct
letter for an underwriter. See AU because the auditor should obtain
333 for guidance on an understanding of the nature of
representation letters. the work performed by the
specialist. Answer (a) is incorrect
C.13. Using the Work of a Specialist
because ordinarily a specialist
132. (a) The requirement is to identify the will have a basic understanding
of the auditor’s cor
report.
roborative use of the findings. Answer (b) is 137. (c) The requirement is to

incorrect because the auditor need not determine which individual is
perform substantive procedures to verify the not considered a specialist upon
specialist’s assumptions and findings. Answer whose work an independent
(c) is incorrect because the client may have an auditor may rely. The
understanding of the nature of the work professional standards relating to
performed by the specialist. See using the work of a specialist do
AU 336 (revised in 1994 by SAS 73) for not apply to using the work of an
information on the auditor’s use of the internal auditor. Answers (a), (b),
work of a specialist. and (d), actuary, appraiser, and
engineer, respectively, are all
135. (b) The requirement is to examples of specialists per the
identify the circumstance in professional standards. Note here
which an auditor may that the question and its reply do
appropriately refer to the not imply that a CPA cannot use
findings of a specialist. Answer the work of an internal auditor.
(b) is correct because an auditor What is being suggested is that
may refer to a specialist when an internal auditor is not
the report is being modified due considered a specialist under the
to the specialist’s findings. professional standards.
Answers (a) and (c) are
incorrect because a client’s C.14. Inquiry of a Client’s Lawyer
familiarity with a specialist or 138. (d) The requirement is to identify
understanding of the auditor’s which partiesshould reach an understanding
use of the findings of a spe on the limits of materiality for purposes of a
cialist does not result in lawyer’s response to an auditor’s inquiry
modification of the audit report. concerning litigation, claims, and
Answer (d) is incorrect because assessments. Answer (d) is correct because
an auditor does not divide AU 337 states that a lawyer’s response to
responsibility with a specialist. an inquiry may be limited to material items,
136. (c) The requirement is to identify provided the lawyer and the auditor have
the statement that an auditor must reached an understanding on the limits of
document when using the work materiality for this purpose. Answer (a) is
of a specialist. Answer (c) is incorrect because it includes the client’s
correct because the specialist’s management. An
understanding of the auditor’s swer (b) is incorrect because it includes
corroborative use of his or her the client’s audit committee and omits
findings must be documented. the auditor. Answer (c) is incorrect
See AU 336 for this and other because it includes the client’s
documentation requirements. management and omits the auditor.
Answer (a) is incorrect because
no statement concerning an
update of the specialist’s report
is required to be documented.
Answer (b) is incorrect because a
division of responsibility relates
to circumstances in which other
auditors, not specialists, are in
volved. Answer (d) is incorrect
because an auditor will not
normally issue a disclaimer
related to whether the special
ist’s findings corroborate the
representations in the financial
statements. The specialist’s
report is only referred to when
there is a material difference
between the specialist’s findings
and the representations in the
financial statements. See AU 336
for information on the effect of a
specialist’s work on an auditor’s
the client’s attorney is the
139. (b) The requirement is to identify auditor’s primary means of
the correct statement concerning obtaining corroboration of the
the refusal of a client’s attorney to information furnished by
provide information requested in management concerning
an inquiry letter. Answer (b) is litigation, claims, and
correct because AU 337 indicates assessments. Answer (a) is
that this is a limitation on the incorrect because it will often be
scope of the audit. Answer (a) is impossible to determine the
incorrect because the lack of probable outcome of asserted
information is unlikely to lead to claims and pending or threatened
an adverse opinion since no litigation. Answer (c) is incorrect
information has been provided because no such opinions on
indicating that the financial historical experiences are
statements are misstated. Answer
generally available. Answer (d) is
incorrect because the description
(c) is incorrect because withdrawal
of litigation, claims, and
is not generally necessary due to
assessments is generally prepared
the client’s attorney’s failure to
by the client.
provide information. An
swer (d) is incorrect because significant 142. (b) The requirement is to identify
deficiencies pertain to weaknesses in the procedure that is not performed
internal control. regarding litigation, claims, and
140. (c) The requirement is to identify the audit assessments. Answer (b) is correct
procedure that an auditor most likely because the CPA does not confirm
would perform concerning litigation, directly with the client’s lawyer
claims, and assessments. Answer (c) is that all claims have been recorded
correct because auditors must discuss with in the financial statements.
management its policies and procedures for Answers (a), (c), and (d) are all
evaluating and accounting for litigation, incorrect because they represent
claims and assessments. See AU 337 for information obtained from
this and other requirements. Answer (a) is management regarding litigation,
incorrect because the client’s lawyer is not claims, and assessments as
ordinarily asked to make an assessment summarized in AU 337.
about whether the client has a going
concern problem (see AU 341 for 143. (a) The requirement is to identify
information on an auditor’s consideration the appropriate limitation for an
of a client’s ability to continue as a going attorney’s response to a client’s
concern). Answer (b) is incorrect because letter of audit inquiry. Answer (a) is
an auditor will not ordinarily examine legal correct because AU 337 states that
documents in the client’s lawyer’s an attorney may appropriately limit
possession. Answer (d) is incorrect because his response to matters to which
an auditor will not ordinarily confirm with s/he has given substantive attention
the client’s lawyer that all litigation, in the form of legal consultation or
claims, and assessment have been recorded. representation. Answers (b), (c),
and (d) are incorrect because AU
141. (b) The requirement is to identify 337 presents a variety of other
the primary reason that an requests in addition to information
auditor should request a client to on the likelihood of an unfavorable
send a letter of inquiry to its
outcome of the matters disclosed by
attorneys. Answer (b) is correct
the entity, similar litigation, and
because a letter of audit inquiry to
probable outcomes.
147. (b) The requirement is to identify the least
likely approach for auditing the fair values
1. (a) If a client’s lawyer resigned of assets and liabilities. Answer (b) is
shortly after the receipt of an correct because it is doubtful that audit
attorney’s letter which indicated committee members will have information
no significant disagreements with on the valuation. Answers (a), (c), and (d)
the client’s assessment of are all incorrect because they represent the
contingent liabilities, the auditor three approaches presented for auditing fair
should inquire why the attorney values (as well as other estimates).
resigned. The auditor’s concern
is whether any undisclosed C.16. RelatedParty Transactions
unasserted claims have arisen. Per
AU 337, a lawyer may be 148. (c) The requirement is to identify the
required to resign if his advice auditing procedure that would most likely
concerning reporting for assist an auditor in identifying relatedparty
litigation, claims, and transactions. Answer (c) is correct because
assessments is disregarded by the reviewing confirmations of loans receivable
client. Accordingly, the and payable for indications of guarantees
resignation shortly after issuance may reveal unusual transactions that
of an attorney’s letter may involve related parties. See AU 334 for
indicate a problem. Answer (b) is procedures related to identifying
incorrect because the attorney transactions with related parties. Answer
issued a letter indicating no (a) is incorrect because inspecting the
significant disagreement with the correspondence with lawyers for evidence
client’s assessment of contingent of unreported contingent liabilities does
liabilities. Answers (c) and (d) are not generally relate directly to relatedparty
incorrect because AU 337 only transactions. Answer (b) is incorrect
suggests that the auditor should because nonrecurring transactions are more
consider the need for inquiries indicative of relatedparty transactions.
(i.e., AU 337 does not require a Answer (d) is incorrect because analytical
complete new exam of procedures performed to identify possible
contingent liabilities or an financial difficulties do not relate directly to
adverse opinion). relatedparty transactions.
2. (b) The requirement is to identify 149. (c) The requirement is to determine an
the lawyer’s letter comment that auditor’s responsibility after having
is most likely to cause the auditor determined that a relatedparty transaction
to request clarification. Answer has occurred. Answer (c) is correct because
(b) is correct because a statement after
that the action can be settled for
less than the damages claimed is
unclear as to the details of the
attorney’s belief. An
swers (a), (c), and (d) are all incorrect because
they represent responses that may be clearly
interpreted by the auditor. See AU 337,
interpretation 7, for information on assessing
lawyer’s evaluations of the likely outcome of
litigation.
C.15. Fair Values
determine whether valuation
issues arise at initial recording,
subsequent to initial recording, or
at both times when considering
fair value of an asset or liability.
Answer (a) is correct because AU
328 makes clear that valuation
issues arise at both times. An
swers (b), (c), and (d) are all
that there are no valuation issues
at one or both of these time
periods.
identifying the existence of such an act, the the auditor will not in general be
auditor should obtain an understanding of the able to determine whether a
business purpose of the transaction. See AU particular transaction would have
334 for this and other responsibilities. An occurred if the parties had not
swer (a) is incorrect because the mere been related. Answer (c) is
existence of a relatedparty transaction may or incorrect because, if proper
may not lead to audit report modification. disclosures are made, the related
Answer (b) is incorrect because the perfor party transactions are not required
mance of analytical procedures is not to be recorded on terms
required. Answer (d) is incorrect because equivalent to arm’slength
except for routine transactions, it will transactions.
generally not be possible to determine
whether the transaction would have taken
place, or whether it was consummated on
the circumstance in which an
terms equivalent to an arm’slength
auditor most likely would modify
an unqualified opinion if the
transaction.
entity’s financial statements
150. (d) The requirement is to include a footnote on related
identify the correct statement party transactions. Answer (c) is
concerning relatedparty correct because it generally will
transactions. Answer (d) is not be possible to determine
correct because AU 334 requires whether a particular transaction
that the auditor should place was consummated on terms
primary emphasis on the equivalent to those with unrelated
adequacy of disclosure. Answer parties. Therefore, the auditor
(a) is incorrect because may be required to express a
ascertaining rights and obliga qualified or an adverse opinion
tions is only part of the auditor’s when such an unsubstantiated
total responsibility and not the disclosure is included. Answers
primary emphasis. Answer (b) is (a), (b), and (d) are all incorrect
incorrect because while auditors because they represent situations
attempt to determine the that may be disclosed in related
existence of related parties, this party transaction disclosures.
is not the primary emphasis.
Answer (c) is incorrect because C.17. Subsequent Events
verifying the valuation of
relatedparty transactions will 153. (d) The requirement is to identify the
often not be possible. most likelyprocedure to be performed in
obtaining evidence about subsequent
151. (d) The requirement is to identify events. Answer (d) is correct because
the correct statement concerning changes in longterm debt occurring after
relatedparty transactions. yearend may require note disclosure.
Answer (d) is correct because AU Answers (a) and (b) are incorrect because
334 requires that procedures auditors will not generally test changes in
directed toward identifying employee pay rates after yearend or
relatedparty transactions should recompute depreciation expense for plant
be performed, even if the auditor assets sold. Answer (c) is incorrect
has no reason to suspect their because payroll checks issued near year
existence. Answer (a) is incorrect end may frequently be cashed after year
because, in the absence of end and their investigation will not in
evidence to the contrary, related general be directly related to obtaining
party transactions need not be evidence about subsequent events. See
assumed to be outside the AU 560 for the responsibilities of auditors
ordinary course of business. with respect to subsequent events.
completion of the auditor’s fieldwork.
Answer (c) is correct because the
154. (c) The requirement is to identify the event transaction described is a type 2 subsequent
occurring after the issuance of an auditor’s event (since the acquisition provided
report that would most likely cause the evidence of a condition which came into
auditor to make further inquiries about the existence after yearend) and therefore the
previously issued financial statements. proper accounting approach would be note
Answer (c) is correct because when an disclosure rather than adjustment. Answer
auditor becomes aware of information (a) is incorrect because adjustments are
which relates to the financial statements only appropriate for type 1 subsequent
previously reported upon, but which was events (events which provide evidence that
not known at the date of the report, he or the condition was in existence at yearend).
she should undertake to determine whether Answer (b) is incorrect because the auditor
the information is reliable and whether the does not issue financial statements for the
facts existed at the date of the audit report; client. Answer (d) is incorrect because the
in this circumstance it seems that the lease opinion paragraph of the report need not be
transactions existed as of the date of the modified; if any report modification were
audit report. Answer (a) is incorrect considered necessary, it would be an
because the natural disaster occurred explanatory paragraph emphasizing the
subsequent to the issuance of the audit matter.
report. Answer (b) is incorrect because the
contingency had been properly disclosed. 158. (d) The requirement is to identify a
Answer (d) is incorrect because the sale of procedure that an auditor would perform to
the subsidiary occurred subsequent to the obtain evidence about the occurrence of
issuance of the audit report. subsequent events. Answer (d) is correct
because an auditor will inquire of officers
155. (d) The requirement is to and other executives having responsibility
determine proper accounting and for financial and accounting matters
auditing treatment of whether any unusual adjustments have been
uncollectibility of an account made during the period from the balance
receivable resulting from a sheet date to the date of inquiry. See AU
customer’s bankruptcy due to a 560 for auditing procedures performed to
natural disaster occurring after a identify subsequent events.
client’s balance sheet date.
Answer (d) is correct because a
customer’s major casualty loss
after yearend will result in a
financial statement note
disclosure with no adjustment and
no audit report modification due
to consistency.
determine an auditor’s
responsibility when subsequent to
issuance of an audit report a
client sells the shares of a major
subsidiary. Answer (d) is correct
because no action need be taken
since the event arose after the
issuance of the auditor’s report.
Answers (a), (b), and (c) are all
incorrect because they outline
responsibilities which are not
appropriate in this circumstance.
See AU 561 for a discussion of
auditor responsibility when
subsequent to the issuance of the
auditor’s report the auditor
becomes aware of a fact that
existed at the dateof the
auditor’s report.
auditor’s responsibility with respect to a
client acquisition of 25% of its outstanding
capital stock after yearend and prior to the
informed. Answer (c) is incorrect
159. (a) The requirement is to determine a because the financial statements
procedure thatan auditor should generally are the responsibility of manage
perform regarding subsequent events. ment, and the auditor will not
Answer (a) is correct because the revise or distribute them. Answer
ProfessionalStandards state that the auditor (d) is incorrect because no
generally should comparethe latest revised report will be issued.
available interim financial statements with 161. (c) The requirement is to identify the
the financial statements being audited. See circumstance in which an auditor who finds
AU 560 for this and other requirements.
that he or she has omitted a substantive
Answer (b) is incorrect because second procedure at the time of an audit may
accounts receivable confirmation requests
decide not to apply that procedure. Answer
will be sent well before the auditor’s (c) is correct because when results of other
review of subsequent events. An
procedures tend to compensate for the pro
swer (c) is incorrect because the cedure it may be omitted. Answer (a) is
communication of material weaknesses is not incorrect because, even when distribution
a subsequent event procedure. See of the financial statement has been limited
AU 325 for the required communication to management and the board of directors,
of significantdeficiencies. Answer (d) it may be necessary to perform the
is incorrect because auditorsgenerally procedure. Answer (b) is incorrect because
only receive cutoff statements for the the type of report issued does not affect the
period immediately after yearend, not need to perform the procedure. Answer (d)
for multiple months. is incorrect because delays by the client in
providing data are not an acceptable reason
C.18. Omitted Procedures Discovered not to perform that procedure.
After the Report
Date 162. (b) The requirement is to
determine professional
160. (b) The requirement is to identify responsibility when, subsequent
an auditor’s responsibility when a to issuance of an audit report, an
client refuses to adjust recently auditor has determined that a
issued financial statements for a necessary audit procedure has
subsequent event related to the been omitted. Answer (b) is
bankruptcy of the entity’s principal correct because an auditor must
customer. Answer (b) is correct apply procedures that would
because if the client refuses to make provide a satisfactory basis for
disclosures, AU the opinion issued. Answer (a) is
561 requires the auditor to notify each incorrect because stockholders
member of the board of directors need not be informed at this point
of such refusal and that he or she that the audit report should not be
will take steps to prevent future relied upon. Answer (c) is
reliance upon the audit report. incorrect because the auditor’s
Ordinarily the auditor will then report will not be reissued unless
notify the clients and regulatory the financial statements are
agencies that the report should restated. Answer (d) is incorrect
no longer be associated with the because tests of controls will not
financial statements, and when compensate for the omitted
possible, notify persons known to procedure. See AU 390 for
be relying upon the financial overall procedures relating to
statements. Answer (a) is considering omitted procedures
incorrect because it is less likely after an audit report has been
that all of the creditors will be issued.
Answer (a) is incorrect because
shipments lacking sales invoices
163. (c) The requirement is to identify an and shipping documents will be
auditor’s firstresponsibility upon very difficult to identify; also,
discovering six months after completion of this reply is more limited than
an audit that engagement personnel failed answer (c). Answer (b) is
to confirm several of the client’s material incorrect because excessive
accounts receivable balances. Answer (c) is writeoffs of accounts receivable
correct because the auditor must first will not usually be detected when
assess the importance of the omitted testing the sales cutoff. Answer
procedures to the auditor’s ability to (d) is incorrect because it is
support the previously expressed opinion. unlikely that lapping in the
Answers (a) and (b) are incorrect because application of cash receipts will
prior to attempting any such confirmation be detected by sales cutoff
or performing alternative procedures, an testing. More frequently, proce
assessment of whether the procedures are dures such as confirmations,
needed is to be performed. Answer (d) is analytical procedures, and an
incorrect because a consideration of analysis of deposit tickets reveal
whether anyone is relying on, or is likely to lapping.
rely on, the unqualified opinion is made
after assessing the importance of the 166. (b) The requirement is to identify the
omitted procedure. assertion being tested by cutoff tests
designed to detect credit sales made before
D. Completing the Audit the end of the year that have improperly
been recorded in the subsequent year.
164. (c) The requirement is to Answer (b) is correct because the
determine the procedure least completeness assertion deals with whether
likely to be performed before the all transactions have been included in the
balance sheet date.Answer (c) is proper period. Answer (a) is incorrect
correct because the search for because the presentation or disclosure
unrecorded liabilities relies assertion deals with whether particular
upon a review of documents components of the financial statements are
unrecorded at yearend, as well properly classified, described, and
as inspection of purchases and disclosed. Answer (c) is incorrect because
disbursements recorded after the rights and obligations assertion deals
yearend, to determine whether a with whether assets are the rights of the
proper cutoff of transactions entity and liabilities are the obligations of
between periods has occurred. the entity at a given date. Answer (d) is
Answer (a) is incorrect because incorrect because the existence or
auditors are able to test internal occurrence assertion deals with whether
control over cash prior to year assets or liabilities of the entity exist at a
end. Answers (b) and (d) are given date and whether recorded
incorrect because in cases of
good internal control,
receivables may be confirmed
and inventory observed prior to
yearend.
determine the most likely type of
transaction that would be
detected by an auditor’s review
of a client’s sales cutoff. Answer
(c) is correct because the
auditor’s review will include a
study of sales recorded late in
December and early in January.
This will be accomplished by
reviewing the period when the
revenue was earned by shipment
of goods or performance of ser
vices, as compared to the period
in which the revenue was
recorded. Accordingly, the
review of sales recorded in
January may reveal unrecorded
sales for the preceding year.
well after the conclusion of the audit.
transactions have occurred during a
given period. In this question, the F. Operational Auditing
existence assertion would be tested if 168. (a) The requirement is to identify the
the auditor sampled from sales recorded correct statement with respect to the
prior to yearend to determine whether
primary orientation of operational auditing.
the sale occurred before or after year
Answer (a) is correct because operational
end.
audits deal primarily with evaluating the
D.1. Procedures Completed near the efficiency and effectiveness with which
End of the Audit operations function, often with the
intention of making improvements to
167. (d) The requirement is to identify the accomplish the goals of management.
procedure anauditor would most likely Answers (b) and (c) are incorrect because
perform during the overall review stage of financial statement audits are oriented
formulating an opinion on an entity’s toward such determinations, not
financial statements. Answer (d) is correct operational audits. Answer (d) is incorrect
because a consideration of results relating because examinations of internal control
to the assessment of the risk of material are not performed on operational audits.
misstatement due to fraud may reveal that
the audit has inadequately addressed that 169. (d) The requirement is to identify a typical
risk; in such a case additional procedures objective of an operational audit. Answer
would be required. Answer (a) is incorrect (d) is correct because operational audits
because such assurance from the entity’s typically address efficiency and effective
attorney is ordinarily obtained prior to the ness. Answer (a) is incorrect because while
overall review stage of an audit. Answer the adequacy of internal control design may
(b) is incorrect because the verification of be addressed during an operational audit,
the accuracy of the proof of cash is this is less complete than answer (d). An
ordinarily performed prior to the overall swer (b) is incorrect because operational
review and because little verification of the audits may or may not be related to
bank cutoff statement is usually necessary compliance with generally accepted gov
since it is ordinarily received directly by ernmental auditing standards. Answer (c)
the auditor from the bank. Answer (c) is is incorrect because financial statement
incorrect because such provisions for the audits, not operational audits, address
safeguarding of assets may be corrected whether results of operations are fairly
presented.
Audit Investments and
Accounts Receivable Authoritative
Literature Help
A
u
1. I
2. R
3. T
E
1. (E) The verification of transfers from the current to the noncurrent investment portfolio will
provide assurance that the investments are properly classified in the financial statements.
2. (F) Positive confirmation replies as of the balance sheet date for investments held by
independent custodians will provide assurance that the recorded investments are in
fact owned by the audit client.
3. (D) Because trading investments should be valued at fair market value,
determining whether any impairments in the price of investments have been
recorded will provide assurance that investments are properly valued.
A
u
4. A
5. T
6. A
7. A
E
4. (B) Performance of sales cutoff tests will provide assurance that sales
transactions and the related receivables are recorded in the proper period. Thus,
sales cutoff tests will provide assurance that all amounts owed to the entity at the
balance sheet date are recorded in that period.
5. (E) A review of loan agreements, paying special attention to accounts receivable
that have been factored, will provide assurance as to whether the entity has a legal
right to all accounts receivable at the balance sheet date.
6. (C) An analysis of the aged trial balance for significant past due accounts will
provide evidence with respect to accounts that may be uncollectible. Accordingly,
the procedure will address the net realizable value of accounts receivable.
7. (F) Because material amounts due from officers and employees should be segregated from other
receivables, a review of the trial balance for amounts due from officers and employees will
provide assurance that accounts receivable are properly described and presented in the financial
statements.
R
e
A
u
L
i
1. W
h
2. E
TaskBased
Simulation 3
Authoritati
Illegal Acts and ve
Related Literature
Party Help IA
Transactions RP
Statement
1. A note payable has an interest rate well below the market rate at the time at which the
loan was obtained.
2. The company has a properly documented loan but the loan has no scheduled repayment
terms.
3. Unexplained payments have been made to government officials.
4. The company exchanged certain real estate property for similar real estate property.
5. Large cash receipts near yearend have been received based on cash sales for which
there is no documentation.
Accounts Receivable
Confirmations Authoritative
Literature Help
S
1. t
T
h
2. A

3. S
e
4. C
5. C
6. A
b
7. A
u
8. A
9. T
h
10. A
c
T
A
Iu
n
L
i
S
t
1. W
i
2. W
h
3. A
4. A
u
S
t
5. W
h
6. I
7. I
n
8. A
9. O
10. A
t
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)

helpful in responding to her?
2. Enter the exact section and paragraph with helpful information. 332 22
Bank
Reconciliation Authoritative
Literature Help
1. (D, I) The balance per bank may be traced to a standard form used to confirm
account balance information with financial institutions and to the cutoff statement
(on which will appear the beginning balance).
2. (A, G, H, I, J) One of the deposits in transit does not appear on the cutoff bank
statement (the 9/29/05 deposit for
$4,500). Accordingly, that deposit should be traced to the cash receipts journal (procedure A),
the reason for the delay should be investigated (procedure G), and supporting documents
should be inspected (procedure H). Both deposits should be traced to and from the bank
reconciliation and the cutoff statement (procedures I and J).
3. (B, G, H, I, J) One of the checks does not appear on the cutoff statement (check
#988 dated 8/31/05 for $2,200). Accordingly, that check should be traced to the
cash disbursements journal (procedure B), the reason for the delay should be in
vestigated (procedure G), and supporting documents should be inspected
(procedure H). All checks should be traced to and from the bank reconciliation
and cutoff statement (procedures I and J).
4. (E) The credit memo from the bank for the note collected should be investigated.
5. (E, I) The credit for the check that was charged by the bank for an incorrect
amount should be investigated on both the bank credit memo and on the cutoff
statement.
6. (C) The only source of the balance per books is the cash general ledger account as of
9/30/05.
Audit Authoritative
Procedures Literature Help
1. (E) Kiting involves manipulations causing an amount of cash to be included simultaneously in
the balance of two or more bank accounts. Kiting schemes are based on the float period—the
time necessary for a check deposited in one bank to clear the bank on which it was drawn. To
detect kiting, a bank transfer schedule is prepared to determine whether cash is improperly
included in two accounts.
2. (D) A comparison of the cleared checks to the yearend bank reconciliation will identify checks
that were not mailed until after the first week of the subsequent year because most of those
checks will not be returned with the cutoff statement and will appear to remain outstanding an
abnormally long period of time.
3. (H) Among the terms confirmed for such a borrowing arrangement will be information
on liens.
4. (K, L) A reply to the second request, or information from the credit agency, may
confirm the existence of the new customer. Also, examination of shipping
documents will reveal where the goods were shipped, and ordinarily to which
party.
5. (P) Observing the payroll check distribution on a surprise basis will assist in
detection since the auditor will examine details related to any paychecks not
picked up by employees.
6. (Q) Vouching data in the payroll register to document authorized pay rates will
reveal situations in which an employee is earning income at a rate that differs from
the authorized rate.
7. (A) A comparison of the details of the cash receipts journal to the details on the
daily deposit slips will reveal a circumstance since the details will have been
posted to accounts during the last week of the year under audit.
8. (U) When vouchers are processed for merchandise not ordered or received, there
will be no supporting purchase orders and receiving reports and this will alert the
auditor to the problem.
9. (B) Scanning the debits to the fixed asset accounts and vouching selected amounts
will reveal repairs that have improperly been capitalized.
10. (A, J) Lapping involves concealing a cash shortage by delaying the recording of
journal entries for cash receipts. Since lapping includes differences between the
details of postings to the cash receipts journal and corresponding deposit slips, com
paring these records will reveal it. Also, confirmation requests may identify lapping
when payments of receivables (as indicated by confirmation replies) appear to have
taken too much time to be processed.
11. (E) Increasing cash by drawing a check in this manner is a form of kiting (see
answer 1). Preparation of a bank transfer schedule will assist the auditor in
identifying such transactions.
12. (J, L) Confirmations will identify overstated accounts receivable when customers
disagree with the recorded balance due. Also, the related overstated sales will not
have shipping documents indicating that a shipment has occurred.
Substantive Procedures for
Property, Plant and Equipment Authoritative
Literature Help
1. D
2. D
i
3. D
i
4. D
i
5. D
6. D
E
1. (D) The requirement is to identify the best substantive procedure to determine that DietWeb has
legal rights to the property and equipment acquired during the year. Answer (D) is correct
because the deeds and title insurance certificates will provide evidence that the company owns
the property and equipment.
2. (G) The requirement is to identify the best substantive procedure to determine that
DietWeb recorded property and equipment actually exists. Answer (G) is correct
because physically examining the items will provide this evidence.
3. (B) The requirement is to identify a substantive procedure to test whether
DietWeb’s net property and equipment wasproperly valued at the balance sheet
date. Answer (B) is correct because reviewing depreciation expense (and the
related allowance for doubtful accounts) will indicate whether the net value is
proper.
4. (E) The requirement is to identify how an auditor may test whether DietWeb
recorded all property and equipment assetsthat were purchased during the year.
Answer (E) is correct because performance of a cutoff test will indicate whether
additions made during the year were properly recorded.
5. (G) The requirement is to identify a substantive procedure to test whether DietWeb
recorded all property retirements thatoccurred during the year. Answer (G) is
correct because examining the major recorded property and equipment items may
identify situations in which an item has been retired (often due to its replacement)
and is no longer available for physical examination.
6. (H) The requirement is to identify a substantive procedure to test whether DietWeb capitalized acquisitions. Answer (H)
iscorrect because an analysis of repairs and maintenance accounts will reveal a situation in which such an acquisition has
inappropriately been recorded as an expense and not capitalized.
Risk Analysis
Authoritative
Literature Help
Risk identified
1. TWD may not have legal title to certain
property and equipment recorded as
acquired during the year.
2. Recorded property and equipment acquisitions
may include nonexistent assets.
3. Recorded net property and equipment are
for proper amounts.
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L)
1. (C, I) Legal titles relates most directly to the client having rights over the assets; an examination of deeds and title
insurance certificates will provide assurance that the client has a legal right to the property and equipment acquired
during the year.
1. D
2. E
3. D
1. (C) Because ownership information is included on invoices, examining vendors’ invoices will provide evidence that
the company legally owns inventory raw material items.
2. (F) Selecting a sample of items and agreeing to the physical count sheet will establish that those items have been included in the
count, and this will address completeness of inventories.
3. (C) Examining vendors’ invoices will provide evidence as to the cost of the inventory items.
4. D
5. D
6. N
E
4. (E) When examining the January 20X9 sales journal the auditor may identify sales that should have been recorded
inDecember of 20X8.
5. (F) Auditors will generally inquire of the credit manager as to his or her beliefs concerning the collectability of
cariousreceivables, and thereby obtain evidence on the net realizable value of accounts receivable. Often one would
expect an answer such as “analyze aging of receivables.” Since that was not present here, (F) is the best reply.
6. (G) A disclosure checklist is used to determine that the disclosure requirements of generally accepted accounting
principleshave been met.
Inventory Audit Objectives
and Procedures Authoritative
Literature Help
1. I
2. D
3. D
4. D
e
5. D
E
1. (A) The requirement is to identify a procedure for identifying inventory transactions involving related parties. The best
procedure listed is review minutes of Board of Directors’ meeting and contracts, and to make inquiries of management; these
are all procedures used to identify relatedparty transactions.
2. (E) The requirements is to identify a procedure for determining that items counted are included in the count sheet.
The best procedure is to reconcile physical counts to perpetual records and general ledger balances and investigate
significant fluctuations. This will allow the auditor to identify items not included.
3. (F) The requirement is to determine that a proper cutoff of purchases has occurred at year end. The best procedure
listedis to review sales after yearend and open purchase order commitments—this will help determine whether
transactions recorded after yearend should have been recorded prior to yearend. Another procedure, not listed, is to
perform the procedure on transactions recorded right before yearend.
4. (C) The requirement is to determine that the financial statements include proper disclosures relating to inventory.
AnswerC is correct because inventories pledged under loan agreement should be disclosed.
5. (G) The requirement is to determine that recorded inventory is owned. Examining invoices is best because invoice
willpresent information on the purchase.
Spreadsheet
Completion
Authoritative
Literature Help
A B C D E F G
1 Holiday Manufacturing Co.
2 Balance Sheet
3 December 31, 20X1
4
5 Cash $240,000 Accounts Payable $160,000
6 Receivables 400,000 Notes payable 100,000
7 Inventory 600,000 Other current liabilities 140,000
8 Total current assets $1,240,000 Total current liabilities 400,000
9
10 Plant and equipment—net 760,000 Long-term debt 350,000
11 Common stock 750,000
13 Total assets $2,000,000 Total liabilities and capital $2,000,000
14
15
MODULE
162 4 RESPONDING TO RISK ASSESSMENT
A B C D E F G
16 Income Statement
17 Year ended December 31, 20X1
18
19 Sales $3,000,000
20 Cost of goods sold
21 Materials 800,000
22 Labor 700,000
23 Overhead 300,000 1,800,000
24 Gross margin 1,200,000
25
26 Selling expenses 240,000
27 General and admin. exp. 300,000 540,000
28 Operating income 660,000
29 Less: interest expense 40,000
30 Income before taxes 620,000
31 Less: federal income taxes 220,000
32 Net income $400,000
33
34
35
36 Ratios 12/31/X1 12/31/X0
37 Current ratio (1) 2.5
38 Quick ratio (2) 1.3
39 Accounts receivable turnover (3) 5.5
40 Inventory turnover (4) 2.5
41 Total asset turnover (5) 1.2
42 Gross margin % (6) 35%
43 Net operating margin % (7) 25%
44 Times interest earned (8) 10.3
45 Total debt to equity % (9) 50%
Ratio Spreadsheet Formula Calculation

1. (H) Current assets $1,240,000
Current ratio = =C8/G8 = 3.1
Current liabilities $400,000
2. (E) Quick assets* $240,000 + $400,000 $1,240,000
Quick ratio = =(C5+C6)/G8 = = 3.1
Current liabilities $400,000 $400,000
* Cash + Accounts receivable. Also marketable
securities would be included if the company owned
any.
Sales
3. (K) Accounts receivable Accounts receivable
turnover =
Cost of goods sold
4. (G)
Inventory turnover = Inventory
Sales
5. (D)
Total asset turnover = Total assets
Gross margin
6. (T) Gross margin
Sales
percentage =
Operating income
7. (P) Net operating
Sales
margin % =
8. (N) Operating income
Times interest earned = Interest expense
$3,000,000
=E19/C6 = 7.5
$400,000
$1,800,000
=E23/C7 = 3.0
$600,000
$3,000,000
=E19/C13 = 1.5
$2,000,000
$1,200,000
=E24/E19 = 40%
$3,000,000
$660,000
=E28/E19 = 22%
$3,000,000
$660,000
=E28/E29 = 16.5
$40,000
9. (U) Total debt to equity Total debt*
percentage = Owners’ equity**
* Total current liabilities + Longterm debt.
** Common stock + Retained earnings
=(G8+G10)/(G11+G12) $400,000 + $350,000 $750,000
= = 60%
$750,000 + $500,000 $1,250,000
MODULE 5 REPORTING 163
REPORTING
that the client not duplicate the restricteduse
report for any purposes.
1. The objective of an accountant’s compilation of d. An auditor is not responsible for
the financial statements of a nonissuer controlling the distribution of such
(nonpublic company) is to provide what type of reports.
assurance? 6. Which of the following statements is a basic
a. Absolute assurance. element of the auditor’s standard report?
b. Limited assurance.
c. No assurance.
d. Reasonable assurance.
2. The existence of audit risk is recognized by the
statement in the auditor’s standard report that
the auditor
a. Obtains reasonable assurance about
whether the financial statements are free
of material misstatement.
b. Assesses the accounting principles used
and also evaluates the overall financial
statement presentation.
c. Realizes some matters, either
individually or in the aggregate, are
important while other matters are not
important.
d. Is responsible for expressing an opinion
on the financial statements, which are
the responsibility of management.
3. When an accountant performs more than one level
of service (for example, a compilation and a
review, or a compilation and an audit)
concerning the financial statements of a nonissuer
(nonpublic) entity, the accountant generally
should issue the report that is appropriate for
a. The lowest level of service rendered.
b. The highest level of service rendered.
c. A compilation engagement.
d. A review engagement.
4. Which of the following is least likely to be a
restricted use report?
a. A report on internal control significant
deficiencies noted in an audit.
b. A required communication with the
audit committee.
c. A report on financial statements prepared
following a comprehensive basis of
accounting other than generally accepted
d. A report on compliance with aspects of
contractual agreements.
concerning an auditor’s responsibility for
controlling the distributionby the client of a
restricteduse report?
a. An auditor must inform the client that a
restricteduse report is not intended for
distribution to nonspecified parties.
b. When an auditor is aware that a client
has distributed a restricteduse report to
inappropriate third parties, the auditor
should immediately inform the client to
cease and desist.
c. An auditor controls distribution through insisting
a. The disclosures provide reasonable
assurance that the financial statements
are free of material misstatement.
b. The auditor evaluated the overall internal control.
c. An audit includes assessing significant
estimates made by management.
d. The financial statements are consistent
with those of the prior period.
7. In May 2009, an auditor reissues the auditor’s
report on the 2007 financial statements at a
continuing client’s request. The 2007 financial
statements are not restated and the auditor does
not revise the wording of the report. The auditor
should
a. Dual date the reissued report.
b. Use the release date of the reissued report.
c. Use the original report date on the reissued report.
d. Use the current period auditor’s report
date on the reissued report.
8. Which paragraphs of an auditor’s standard report
on financial statements should refer to generally
accepted auditing standards (GAAS) and
generally accepted accounting principles
(GAAP)?
GAAS GAAP
a. Opening Scope
b. Scope Scope
c. Scope Opinion
d. Opening Opinion
9. An auditor expressed a qualified opinion on the
prior year’s financial statements because of a lack
of adequate disclosure. These financial statements
are properly restated in the current year and
presented in comparative form with the current
year’s financial statements. The auditor’s up
dated report on the prior year’s financial
statements should
a. Be accompanied by the auditor’s original
report on the prior year’s financial
statements.
b. Continue to express a qualified
opinion on the prior year’s financial
statements.
c. Make no reference to the type of
opinion expressed on the prior year’s
d. Express an unqualified opinion on the
restated financial statements of the
prior year.
10. An auditor’s responsibility to express an opinion
on the financial statements is
a. Implicitly represented in the auditor’s
standard report.
b. Explicitly represented in the opening
paragraph of the auditor’s standard
report.
c. Explicitly represented in the scope paragraph of
the auditor’s standard report.
d. Explicitly represented in the opinion
paragraph of the auditor’s standard
report.
11. Which of the following phrases should be
included in the opinion paragraph when an auditor
expresses a qualified opinion?
When read in
conjunction with With the foregoing
Note X Explanation
a. Yes No
b. No Yes
164 MODULE 5 REPORTING
a. It applies
equally to a
c. Yes complete set
d. No of financial
statements
12. How does an auditor make
and to each
the following representations individual
when issuing the standard financial
auditor’s report on comparative statement.
financial statements? b. It applies only
Examination of Consistent to a complete
evidence on a application of set of financial
test basis accounting principles statements.
a. Explicitly c. It applies
b. Implicitly equally to
c. Implicitly each item in
d. Explicitly each
13. The fourth standard of financial
reporting requires the statement.
auditor’s report to d. It applies
contain either an equally to each
expression of opinion material item
regarding the financial in each fi
statements taken as a nancial
whole or an assertion to statement.
the effect that an opinion 15. Wilson, CPA, completed the
cannot be expressed. fieldwork of the audit of Abco’s
The objective of the December 31, 2009 financial
fourth standard is to statements on March 6, 2010. A
prevent subsequent event requiring
a. An auditor adjustment to the 2009 financial
from statements occurred on April 10,
expressing 2010, and came to Wilson’s
different attention on April 24, 2010. If the
opinions on adjustment is made without
each of the disclosure of the event, Wilson’s
basic financial report ordinarily should be dated
statements. a. March 6, 2010.
b. Restrictions on b. April 10, 2010.
the scope of the c. April 24, 2010.
audit, whether
d. Using dual dating.
imposed by the
client or by the 16. An auditor issued an audit report
inability to that was dual dated for a subsequent
obtain evidence. event occurring after the completion
c. Misinterpretatio of fieldwork but before issuance of
ns regarding the the auditor’s report. The auditor’s
degree of responsibility for events occurring
responsibility subsequent to the completion of
the auditor is fieldwork was
assuming. a. Extended to
d. An auditor subsequent
from reporting events
on one basic occurring
financial through the
statement and date of
not the others. issuance of the
report.
14. Which of the following b. Extended to
best describes the include all
reference to the events
expression “taken as a occurring since
whole” in the fourth the completion
generally accepted of fieldwork.
auditing standard of c. Limited to the specific
reporting? event referenced.
d. Limited to
include only 17. A financial statement
events audit report issued for the
occurring up to audit of an issuer (public)
the date of the company concludes that
last subsequent the financial statements
event follow
referenced. a. Generally accepted
b. Public
Company
Accounting
Oversight
Board
standards.
c. Generally accepted
auditing standards.
d. International accounting
standards.
18. Which of the
following is not
correct concerning
information
included in an audit
report of financial
statements issued
under the
requirements of the
Public Company
Accounting
Oversight Board?
a. The report
should include
the title “Report
of Independent
Registered
Public
Accounting
Firm.”
b. The report
should refer
to the
standards
of the
PCAOB.
c. The report
should include
a paragraph
referring to the
auditor’s report
on compliance
with laws and
regulations.
d. The report
should
contain the
city and
state or
country of
the office
that issued
the report.
19. A principal auditor
decides not to refer to the
audit of another CPA who
audited a subsidiary of the
principal auditor’s client.
After making inquiries 20. The introductory
about the other CPA’s paragraph of an auditor’s
professional reputation report contains the
and independence, the following sentences:
principal auditor most We did not audit the financial
likely would statements of EZ Inc., a
a. Add an wholly owned subsidiary,
which statements reflect total
explanatory assets and revenues
paragraph to constituting 27% and 29%,
the auditor’s respectively, of the related
report consolidated totals. Those
statements were audited by
indicating that other auditors whose report
the subsidiary’s has been furnished to us, and
financial our opinion, insofar as it
statements are relates to the amounts
not material to included for EZ Inc., is based
solely on the report of the
the other auditors.
consolidated fi
nancial These sentences
statements. a. Indicate a division of
b. Document in the responsibility.
engagement b. Assume responsibility for
letter that the the other auditor.
principal c. Require a departure from
auditor assumes an unqualified opinion.
no d. Are an improper form of
responsibility reporting.
for the other
21. In which of the
CPA’s work and
opinion. following situations
c. Obtain written would an auditor
ordinarily issue an
permission from
unqualified audit opinion
the other CPA to
without an explanatory
omit the paragraph?
reference in the
a. The auditor wishes to
principal emphasize that the entity
auditor’s report. had significant related
d. Contact the party transactions.
other CPA b. The auditor
and review the decides to make
audit pro reference to the
grams and report of another
working auditor as a
papers basis, in part, for
pertaining to the auditor’s
the sub opinion.
sidiary.
opinion on the
subsidiary’s
c. The entity financial
issues financial statements.
statements that c. Is unable to
present financial review the
position and audit programs
results of and working
operations, but papers of the
omits the other CPA.
statement of d. Is satisfied as to
cash flows. the
independence
d. The auditor has substantial
and professional
doubt about the entity’s
reputation of the
ability to continue as a
other CPA.
going concern, but the cir
cumstances are fully 24. When financial
disclosed in the financial statements of a company
statements. that follows GASB
22. An auditor may issue the standards would be
misleading due to
standard audit report when the unusual circumstances
a. Auditor refers to the depart from those
findings of a specialist. standards, the auditor
b. Financial statements are should explain the
derived and condensed unusual circumstances in
from complete audited a separate paragraph and
financial statements that express an opinion that is
are filed with a regulatory a. Unqualified.
agency. b. Qualified.
c. Financial c. Adverse.
statements are d. Qualified or adverse,
prepared on
depending on materiality.
the cash re
ceipts and 25. An auditor concludes that
disbursements there is substantial doubt
basis of about an entity’s ability
accounting. to continue as a going
d. Principal concern for a reasonable
auditor period of time. If the
assumes entity’s financial state
responsibilit ments adequately disclose
y for the its financial difficulties,
work of the auditor’s report is
another required to include an
auditor. explanatory paragraph
23. In the auditor’s report, the that specifically uses the
principal auditor decides phrase(s)
not to make reference to “Reasonable period of
another CPA who audited time, not to
a client’s subsidiary. The exceed 1 year” “Going concern”
principal auditor could a. Yes Yes
justify this decision if, b. Yes No
among other c. No Yes
requirements, the d. No No
principal auditor 26. Mead, CPA, had substantial
a. Issues an doubt about Tech Co.’sability to
unqualified continue as a going concern
opinion on the when reporting on Tech’s
consolidated audited financial statements for
financial
the year ended
statements.
June 30, 2009. That doubt has been
b. Learns that
removed in 2010. What is Mead’s
the other CPA
reporting responsibility if Tech is
issued an
presenting its financial statements
unqualified
for the year ended June 30, 2010, on
a comparative basis with those of
2010? c. A different
a. The explanatory explanatory
paragraph included in paragraph
the 2010 auditor’s describing
report should not be Mead’s reasons
repeated. for the removal
b. The explanatory of doubt should
paragraph included in the be included.
2010 auditor’s report d. A different
should be repeated in its explanatory
entirety. paragraph
describing
Tech’s plans
for financial
recovery
should be in
cluded.
27. When an auditor
concludes there is
substantial doubt about a
continuing audit client’s
going concern for a
reasonable period of
time, the auditor’s
responsibility is to
a. Issue a qualified
or adverse
opinion,
depending upon
materiality, due
to the possible
effects on the
financial
statements.
b. Consider the
adequacy of
disclosure about
the client’s
possible
inability to
continue as a
going concern.
c. Report to the
client’s audit
committee
that man
agement’s
accounting
estimates may
need to be
adjusted.
d. Reissue the prior year’s
auditor’s report and add
an explanatory paragraph
that specifically refers to
“substantial doubt” and
“going concern.”
28. Green, CPA, concludes
that there is substantial
doubt about JKL Co.’s
going concern. If JKL’s
financial statements
adequately disclose its
financial difficulties, management’s
Green’s auditor’s report records
should retention
Include an policy.
explanatory
paragraph Specifically
30. After considering an
following the use the entity’s negative trends
opinion words “going and financial
paragraph concern” difficulties, an auditor
a. Yes Yes has substantial doubt
b. Yes Yes about the entity’s ability
c. Yes No to continue as a going
d. No Yes concern. The auditor’s
considerations relating to
29. In which of the following management’s plans for
circumstances would an auditor most dealing with the adverse
likely add an explanatory paragraph effects of these
to the standard report while not conditions most likely
affecting the auditor’s unqualified would include
opinion? management’s plans to
a. The auditor is a. Increase current dividend
asked to report on distributions.
the balance sheet, b. Reduce existing lines of
but not on the credit.
other basic c. Increase ownership equity.
financial d. Purchase assets formerly
statements. leased.
b. There is 31. Which of the following conditions
substantial doubt or events most likely would cause
about the an auditor to have substantial doubt
entity’s ability to about an entity’s ability to continue
continue as a as a going concern?
going concern. a. Signi
c. Management’ fican
s estimates of t
the effects of relate
future events d
are party
unreasonable. trans
d. Certain actio
transactions ns
cannot be are
tested because perva
of sive.
conditions and events that
may indicate substantial
b. Usual trade credit from doubt about an entity’s
suppliers is denied. ability to continue as a
c. Arrearages in preferred going concern?
stock dividends are paid. a. Inspecting title
d. Restrictions on documents to
the disposal of verify whether
principal assets any assets are
are present. pledged as
collateral.
47. Cooper, CPA, believes there is b. Confirming
substantial doubt about the ability with third
of Zero Corp. to continue as a going parties the
concern for a reasonable period of details of ar
time. In evaluating Zero’s plans for rangements
dealing with the adverse effects of to maintain
future conditions and events, financial
Cooper most likely would consider, support.
as a mitigating factor, Zero’s plans c. Reconciling the
to cash balance per
a. Discuss with books with the
lenders the cutoff bank
terms of all statement and the
debt and bank
loan confirmation.
agreements. d. Comparing the
b. Strengthen controls over entity’s
cash disbursements. depreciation
c. Purchase and asset
production capitalization
facilities policies to
currently other entities
being leased in the in
from a dustry.
related
party. 50. Which of the following
d. Postpone audit procedures would
expenditures most likely assist an
for research auditor in identifying
and develop conditions and events
ment projects. that may indicate there
could be substantial
48. Which of the following conditions doubt about an entity’s
or events most likely would cause ability to continue as a
an auditor to have substantial doubt going concern?
about an entity’s ability to continue a. Review
as a going concern? compliance with
a. Cash flows from the terms of
operating activities are debt agree
negative. ments.
b. Research b. Confirmation of
and accounts
developmen receivable from
t projects principal
are post customers.
poned. c. Reconciliation
c. Significant of interest
relatedparty expense with
transactions debt out
are pervasive. standing.
d. Stock dividends replace d. Confirmation of bank
annual cash dividends. balances.
49. Which of the following 51. Davis, CPA, believes
auditing procedures most there is substantial
likely would assist an doubt about the ability
auditor in identifying of Hill Co. to continue
as a going concern for a
reasonable period of c. Purcha
time. In evaluating se
Hill’s plans for dealing equipm
with the adverse effects ent and
of future conditions and produc
events, Davis most tion
likely would consider, faciliti
as a mitigating factor, es cur
Hill’s plans to rently
a. Accelerate being
research and leased.
development d. Negot
projects related iate
to future reduct
products. ions
b. Accumulate in
treasury stock requir
at prices ed
favorable to divide
Hill’s historic nds
price range. being
paid
on
prefer
red
stock.
37. The adverse effects of
events causing an auditor
to believe there is
substantial doubt about
an entity’s ability to
continue as a going
concern would most
likely be mitigated by
evidence relating to the
a. Abi
lity
to
exp
and
ope
rati
ons
into
ne
w
pro
duc
t
line
s in
the
fut
ure.
b. Feasib
ility of
plans
to
purcha
se
leased
equip
ment
at less
than
market
value.
c. Marke auditor’s report for
tabilit An unjustified A material weakness
y of accounting change in the internal control
assets a. Yes Yes
that b. Yes No
manag c. No Yes
ement d. No No
plans
to sell. 40. Under which of the
d. Co following
m circumstances would a
mit disclaimer of opinion
ted not be appropriate?
arr a. The auditor is
an unable to
ge determine the
me amounts as
nts sociated with an
to employee fraud
co scheme.
nv
b. Management does not
ert
pre provide reasonable
fer justification for a change
red in accounting principles.
sto c. The client
ck refuses to
to permit the
lon auditor to
g confirm certain
ter accounts
m receivable or
de apply
bt. alternative
procedures to
38. For which of the verify their
following events balances.
would an auditor issue d. The chief
a report that omits any executive
reference to officer is
consistency? unwilling to
a. A change in the sign the
method of management
accounting for representation
inventories. letter.
b. A change from
41. Digit Co. uses the FIFO
an accounting
method of costing for its
principle that is
international subsidiary’s
not generally
inventory and LIFO for its
accepted to one
domestic inventory. Under
that is
generally ac these circumstances, the
cepted. auditor’s report on Digit’s
c. A change in financial statements should
the useful express an
life used to a. Unqualified opinion.
calculate the b. Opinion qualified because
provision for of a lack of consistency.
depreciation c. Opinion
expense. qualified
d. Management’s lack of because of
reasonable justification for a departure
a change in accounting from
principle. GAAP.
d. Adverse opinion.
39. An auditor would express
an unqualified opinion 42. In the first audit of a new
with an explanatory client, an auditor was
paragraph added to the able to extend auditing
procedures to gather a. Not report on the client’s
sufficient evidence about income statement.
consistency. Under these b. Not refer to consistency in
circumstances, the the auditor’s report.
auditor should
c. State the
auditor’s explicit
c. State that the consistency concurrence
standard does not apply. with or op
d. State that the position to the
accounting change.
principles have d. Refer to the
been applied financial
consistently. statement note
that discusses
43. When management does not the change in
provide reasonable justification detail.
that a change in accounting
principle is preferable and it 45. An entity changed from
presents comparative financial the straightline method
statements, the auditor should to the declining balance
express a qualified opinion method of depreciation
a. Only in for all newly acquired
the year assets. This change has no
of the material effect on the
accountin current year’s financial
g statements, but is
principle reasonably certain to have
change. a substantial effect in
b. Each year that later years. If the change
the financial is disclosed in the notes to
statements the financial statements,
initially re the auditor should issue a
flecting the report with a(n)
change are a. “Except for” qualified
presented. opinion.
c. Each year b. Explanatory paragraph.
until c. Unqualified opinion.
management d. Consistency modification.
changes back
to the 46. When reporting on
accounting comparative financial
principle statements, an auditor
formerly used. ordinarily should change
d. Only if the the previously issued
opinion on the prior year’s
change is to
financial statements if the
an
a. Prior year’s
accounting
financial
principle that statements are
is not restated to
generally conform with
accepted. generally
accepted
44. When an entity changes
accounting
its method of accounting
principles.
for income taxes, which
b. Auditor is a
has a material effect on
predecessor
comparability, the
auditor who has
auditor should refer to
been requested
the change in an
by a former
explanatory paragraph
client to reissue
added to the auditor’s
the previously
report. This paragraph
issued report.
should identify the nature
c. Prior year’s
of the change and
opinion was
a. Explain why the change is
justified under generally unqualified and
accepted accounting the opinion on
principles. the current
b. Describe the cumulative year’s financial
effect of the change on the statements is
audited financial modified due to
statements. a lack of
consistency.
d. Prior year’s BI. Indicate the substantive reasons
financial for Jewel’s qualification.
statements are a. I only.
restated fol b. I and II only.
lowing a c. II and III only.
pooling of d. I, II, and III.
interests in the
current year. 48. Before reissuing the prior
year’s auditor’s report on
47. Jewel, CPA, audited the financial statements
Infinite Co.’s prior year of a former client, the
financial statements. predecessor auditor
These statements are should obtain a letter of
presented with those of representations from the
the current year for
comparative purposes Former client’s management Successor auditor
without Jewel’s auditor’s a. Yes Yes
b. Yes No
report, which expressed a
c. No Yes
qualified opinion. In
d. No No
drafting the current year’s
auditor’s report, Crain, 49. When singleyear
CPA, the successor financial statements are
auditor, should presented, an auditor
I. Not name Jewel as the ordinarily would express
predecessor auditor. an unqualified opinion in
II. Indicate the type of report issued an unmodified report if
by Jewel. the
a. Audit
or is
unable
to
obtain
audite
d
financ
ial
state
ments
suppor
ting
the
entity’
s
invest
ment
in a
for
eign
affiliat
e.
b. Entity
decline
s to
present
a
stateme
nt of
cash
flows
with its
balance
sheet
and
related
stateme
nts of
in
come
and auditor
retaine should
d issue
earning one
s. audit
c. Audito report
r that is
wishes on
to both
empha present
size an ed
accoun years.
ting b. The
matter audito
affecti r
ng the should
compa issue
rability two
of the audit
financi report
al s, one
state on
ments each
with year.
those c. The
of the auditor
prior should
year. issue
d. Prior one
year’ audit
s report,
finan but
cial only
state on the
ment most
s recent
were year.
audit d. The
ed by audit
anoth or
er may
CPA issue
whos either
e one
repor audit
t, report
whic on
h both
expre prese
nted
ssed
years,
an
or
unqu
two
alifie
audit
d report
opini s, one
on, is on
not each
prese year.
nted.
51. The predecessor auditor,
50. A client is presenting who is satisfied after
comparative (twoyear) properly communicating
financial statements. with the successor auditor,
Which of the following is has reissued a report
correct concerning because the audit client
reporting responsibilities desires comparative
of a continuing auditor? financial statements. The
a. The predecessor auditor’s
report should make succ
a. Ref esso
ere r
nce audit
to or
the only
rep in
ort the
of opin
the ion
suc para
ces
grap
sor
h.
aud
itor d. No
onl refer
y in ence
the to the
sco repor
pe t or
par the
agr work
aph of the
. suc
b. Refer cesso
ence r
to the audit
work or.
of the 52. Unaudited financial statements for
succe the prior year presented in
ssor comparative form with audited
audit financial statements for the current
or in year should be clearly marked to
the indicate their status and
scope
and I. The report
opini on the
on prior
period
parag should be
raphs reissued to
. accompan
c. Refe y the
renc current
e to period
both report.
the 19. The report on the
wor current period should
k include as a separate
and paragraph a description
of the responsibility
the
assumed for the prior
repo
period’s financial
rt of
statements.
the
Board (GASB), the
auditor should issue a(n)
a. I only. a. Adverse opinion.
b. II only. b. Qualified opinion with an
c. Both I and II. explanatory paragraph.
d. Either I or II. c. Unqualified opinion.
d. Unqualified
53. In an audit of a nonissuer opinion with an
company, which additional
statement is correct explanatory
concerning required paragraph.
supplementary
information by a 55. If an auditor is asked to
designated accounting provide an opinion
standards setter? relating to information
a. The auditor has accompanying the
no financial statements in a
responsibility document, the opinion
for required will ordinarily be upon
supplementary whether the information
information as is fairly stated in
long as it is a. Accordance
outside the with US
basic financial generally
statements. accepted
b. The auditor’s auditing
only standards.
responsibility b. Conformity with US
for required generally accepted
supplementary accounting principles.
information is c. All material
to determine respects in
that such relation to the
information has basic financial
not been statements
taken as a
omitted.
whole.
c. The auditor
d. Accordance with
should apply
attestation
certain limited
standards
procedures to
expressing a
the required conclusion about
supplementary management’s
information, and assertions.
report
deficiencies in, 56. An auditor concludes
or omissions of, that there is a material
such in inconsistency in the
formation. other information in an
d. The auditor annual report to share
should apply holders containing
tests of details of audited financial
transactions and statements. If the
balances to the auditor concludes that
required the financial statements
supplementary do not require revision,
information, and but the client refuses to
report any revise or eliminate the
material material inconsistency,
misstatements in the auditor may
such a. Revise the auditor’s report
information. to include a separate ex
planatory paragraph
54. If management declines to describing the material
present supplementary inconsistency.
information required by b. Issue an “except
the Governmental for” qualified
Accounting Standards
opinion after
discussing the a. Perform inquiry
matter with the and analytical
client’s board of procedures to
directors. ascertain whether
c. Consider the the other
matter closed information is
since the other reasonable.
information is b. Add an
not in the explanatory
audited financial paragraph to
statements. the auditor’s re
d. Disclaim an port without
opinion on the changing the
financial opinion on the
statements after financial
explaining the statements.
material c. Perform the appropriate
inconsistency in substantive auditing proce
a separate dures to corroborate the
explanatory other information.
paragraph. d. Read the other
information to
57. When audited financial determine that
statements are presented
it is consistent
in a client’s document
with the
containing other
information, the auditor audited
should financial
statements.
58. An auditor includes a
separate paragraph in an
otherwise unmodified
report to emphasize that
the entity being reported
on had significant
transactions with related
parties. The inclusion of
this separate paragraph
a. Is considered
an “except
for”
qualification
of the opinion.
b. Violates
generally
accepted
auditing
standards if this
information is
already
disclosed in
footnotes to the
financial
statements.
c. Necessitates a
revision of the
opinion
paragraph to
include the
phrase “with the
foregoing
explanation.”
d. Is appropriate
and would not
negate the
unqualified
opinion. discussed in
the
59. An auditor concludes that preceding
a client’s illegal act, paragraph.
which has a material d. Does not present fairly in
effect on the financial
all material respects.
statements, has not been
properly accounted for or 61. In which of the following
disclosed. Depending on circumstances would an
the materiality of the auditor be most likely to
effect on the financial express an adverse
statements, the auditor opinion?
should express either a(n) a. The chief
a. Adverse opinion or a executive
disclaimer of opinion. officer refuses
b. Qualified opinion or an the auditor ac
adverse opinion. cess to minutes
c. Disclaimer of of board of
opinion or an directors’
unqualified
meetings.
opinion with
b. Tests of
a separate
explanatory controls show
paragraph. that the
d. Unqualified entity’s
opinion with internal
a separate control is so
explanatory poor that it
paragraph or cannot be
a qualified relied upon.
opinion. c. The financial
60. Which of the following statements are
phrases would an auditor not in
most likely include in conformity
the auditor’s report when with the FASB
expressing a qualified Statements
opinion because of regarding the
inadequate disclosure? capitalization
a. Subject to the of leases.
departure from d. Information
US generally comes to the
accepted auditor’s
accounting attention that
raises
principles, as
substantial
described
doubt about the
above. entity’s ability
b. With the to continue as a
foregoing going concern.
explanation
of these 62. When an auditor qualifies
omitted an opinion because of
disclosures. inadequate disclosure, the
c. Except for auditor should describe
the omission the nature of the omission
of the in a separate explanatory
information paragraph and modify the
cause the
auditor to have
Introductory Scope substantial
paragraph paragraph doubt about the
a. Yes No entity’s ability
b. Yes Yes to continue as a
c. No Yes going concern.
d. No No
65. In which of the following
63. If a publicly held situations would an
company issues financial auditor ordinarily choose
statements that purport to between expressing a
present its financial qualified opinion or an
position and results of adverse opinion?
operations but omits the a. The auditor did
statement of cash flows,
not observe
the auditor ordinarily will
the entity’s
express a(n)
physical
a. Disclaimer of opinion.
inventory and
b. Qualified opinion.
is unable to
c. Review report.
become
d. Unqualified satisfied about
opinion with its balance by
a separate
other auditing
explanatory
procedures.
paragraph.
b. Conditions that
64. In which of the following cause the
situations would an auditor to have
auditor ordinarily choose substantial
between expressing an doubt about the
“except for” qualified entity’s ability
opinion or an adverse to continue as a
opinion? going concern
a. The auditor are inadequately
did not disclosed.
observe the c. There has been
entity’s a change in
physical accounting
inventory and principles that
is unable to has a material
become effect on the
satisfied as to comparability
its balance by of the entity’s
other auditing financial
procedures. statements.
b. The financial d. The auditor is
statements fail unable to apply
to disclose necessary
information procedures
that is required
concerning an
by generally
investor’s share
accepted ac
counting of an inves
principles. tee’s earnings
c. The auditor is recognized on
asked to report the equity
only on the method.
entity’s
66. In the first audit of a client, an
balance sheet
and not on the auditor was not able to gather
other basic sufficient evidence about the
financial consistent application of accounting
statements. principles between the current and
the prior year, as well as the
d. Events
amounts of assets or liabilities at the
disclosed in the
beginning of the current year. This
financial
was due to the client’s record re
statements
tention policies. If the amounts in
question could materially affect 67. In which of the following
current operating results, the auditor circumstances would an auditor
would not express an unqualified opinion?
a. Be unable to a. There has been
express an a material
opinion on change between
the current periods in
year’s accounting
results of principles.
operations b. Quarterly
and cash financial data
flows. required by
b. Express a the SEC has
qualified been omitted.
opinion on the c. The auditor
financial state wishes to
ments because emphasize an
of a client unusually im
imposed scope portant
limitation. subsequent
c. Withdraw event.
from the d. The auditor is
engagement unable to
and refuse to obtain audited
be associated financial
with the statements of
financial a consolidated
statements.
investee.
d. Specifically
state that the 68. Due to a scope limitation,
financial an auditor disclaimed an
statements are opinion on the financial
not statements taken as a
comparable to whole, but the auditor’s
the prior year report included a
due to an statement that the current
uncertainty. asset portion of the
entity’s balance sheet was
fairly stated. The
inclusion of this statement
is
a. Not
appropriate
because it
may tend
to over
shadow the
auditor’s
disclaimer
of opinion.
b. Not
appropriate
because the
auditor is
prohibited
from reporting
on only one
basic financial
statement.
c. Appropriate
provided the
auditor’s scope
paragraph
adequately
describes the
scope
limitation. sufficiency of evidential matter
d. Appropriate should describe the limitations in
provided the an explanatory paragraph. The
statement is in a auditor should also refer to the
separate limitation in the
paragraph Scope Opinion Notes to the
preceding the paragraph paragraph financial statements
disclaimer of a. Yes No Yes
opinion b. No Yes No
paragraph. c. Yes Yes No
d. Yes Yes Yes
69. Park, CPA, was engaged
to audit the financial state 71. Harris, CPA, has been asked
ments of Tech Co., a new to audit and report on thebalance
client, for the year ended sheet of Fox Co. but not on the
December 31, 2009. Park statements of income, retained
obtained sufficient audit earnings, or cash flows. Harris
evidence for all of Tech’s will have access to all information
financial statement items underlying the basic financial
except Tech’s opening statements. Under these
inventory. Due to circumstances, Harris may
inadequate financial a. Not accept the
records, Park could not engagement because it
verify Tech’s January 1, would constitute a
2009 inventory balances. violation of the
Park’s opinion on Tech’s profession’s ethical stan
2009 financial statements dards.
most likely will be b. Not accept the
Balance sheet Income statement engagement because it
a. Disclaimer Disclaimer would be tantamount to
b. Unqualified Disclaimer rendering a piecemeal
c. Disclaimer Adverse opinion.
d. Unqualified Adverse
c. Accept the engagement
70. An auditor who qualifies an because such engagements
opinion because of an in merely involve limited
reporting objectives.
ventory is
completed.
d. Accept the c. Requests that
engagement but certain material
should disclaim accounts
an opinion receivable not
because of an be confirmed.
inability to d. Refuses to
apply the proce acknowledge its
dures responsibility
considered for the fair
necessary. presentation of
72. When disclaiming an the financial
opinion due to a client statements in
imposed scope limitation, conformity with
an auditor should indicate GAAP.
in a separate paragraph 75. An auditor may not issue a
why the audit did not
qualified opinion when
comply with generally
accepted auditing a. An accounting
standards. The auditor principle at
should also omit the variance with
GAAP is used.
Scope Opinion b. The auditor
paragraph paragraph lacks
a. No Yes independence
b. Yes Yes
with respect to
c. No No
the audited
d. Yes No
entity.
73. An auditor decides to issue a c. A scope
qualified opinion on an entity’s limitation
financial statements because a prevents the
major inadequacy in its auditor from
computerized accounting records completing an
prevents the auditor from applying important audit
necessary procedures. The opinion procedure.
paragraph of the auditor’s report d. The auditor’s
should state that the qualification report refers to
pertains to the work of a
a. A clientimposed scope specialist.
limitation. 76. An auditor may express
b. A departure an opinion on an entity’s
from generally accounts receivable
accepted balance even if the
auditing stan auditor has disclaimed an
dards. opinion on the financial
c. The possible effects on the statements taken as a
financial statements. whole provided the
d. Inadequate disclosure of a. Report on the
necessary information. accounts
74. A scope limitation receivable
sufficient to preclude an discloses the
unqualified opinion reason for the
always will result when disclaimer of
management opinion on the
a. Prevents the financial
auditor from statements.
reviewing the b. Distribution of
working the report on
papers of the the accounts
predecessor receivable is
auditor. restricted to
b. Engages the internal use
auditor after the only.
yearend c. Auditor also
physical in reports on the
current asset
portion of the
entity’s balance audited financial statements with
sheet. March’s auditor’s report to 1st
d. Report on the Federal Bank to obtain financing in
accounts Monday’s attempt to purchase
receivable is Wall. In these circumstances,
presented March’s auditor’s report would
separately from usually be addressed to
the disclaimer of a. Monday Corp., the client
opinion on the that engaged March.
financial b. Wall Corp., the entity
statements. audited by March.
77. March, CPA, is engaged c. 1st Federal Bank.
by Monday Corp., a d. Both Monday Corp. and
client, to audit the 1st Federal Bank.
financial statements of 78. When an auditor
Wall Corp., a company expresses an adverse
that is not March’s client. opinion, the opinion
Monday expects to paragraph should
present Wall’s include
a. The principal
effects of the
departure from
generally
accepted
accounting
principles.
b. A direct
reference to a
separate
paragraph
disclosing the
basis for the
opinion.
c. The
substantive
reasons for
the financial
statements
being
misleading.
d. A description of
the uncertainty
or scope
limitation that
prevents an
unqualified
opinion.
79. An auditor should
disclose the substantive
reasons for expressing an
adverse opinion in an
a. Preceding the scope
paragraph.
b. Preceding the opinion
paragraph.
c. Following the opinion
paragraph.
d. Within the notes to the
80. When an independent
CPA assists in preparing
the financial statements
of a publicly held entity,
but has not audited or
reviewed them, the CPA a. I only.
should issue a disclaimer b. II only.
of opinion. In such c. Both I and II.
situations, the CPA has d. Either I or II.
no responsibility to
apply any procedures
beyond
a. Documenting
that internal
control is not
being relied
on.
b. Reading the
financial
statements for
obvious mate
rial
misstatements.
c. Ascertaining
whether the
financial
statements are
in conformity
with GAAP.
d. Determining
whether
management
has elected to
omit
substantially
all required
disclosures.
81. When an independent
CPA is associated with
of a publicly held entity
but has not audited or
reviewed such
statements, the
appropriate form of
report to be issued must
include a(n)
a. Regulation SX
exemption.
b. Report on pro forma
c. Unaudited association
report.
d. Disclaimer of opinion.
82. Green, CPA, is aware that Green’s
name is to be included in the
interim report of National
Company, a publicly held entity.
National’s quarterly financial
statements are contained in the
interim report. Green has not
audited or reviewed these interim
financial statements. Green should
request that
I. Green’s name not be included in
the communication.
AI. The financial statements
be marked as unaudited
with a notation that no
opinion is expressed on
them.
accordance with
standards
83. The objective of a review established by
of interim financial the Securities
information of a public and Exchange
entity (issuer) is to Commission.
provide an accountant d. Accountant
with a basis for reporting obtained
whether corroborating
a. Material evidence to de
modifications termine whether
should be made material
to conform with modifications are
generally needed for such
accepted information to
accounting conform with
principles. GAAP.
b. A reasonable basis exists
for expressing an updated 85. A modification of the
opinion regarding the CPA’s report on a review
financial statements that of the interim financial
were previously audited. statements of a publicly
c. Condensed financial held company would be
statements or pro forma necessitated by which of
financial information the following?
should be included in a a. An uncertainty.
registration statement. b. Lack of consistency.
d. The financial c. Reference to another
statements are accountant.
presented fairly d. Inadequate disclosure.
in accordance
with generally 86. Which of the following
accepted procedures ordinarily
accounting prin should be applied when
ciples. an independent
accountant conducts a
84. An independent review of interim
accountant’s report is financial information of
based on a review of a publicly held entity?
interim financial a. Verify changes in key
information. If this account balances.
report is presented in a b. Read the
registration statement, a minutes of the
prospectus should in board of
clude a statement directors’
clarifying that the meetings.
a. Accountant’s c. Inspect the open purchase
review report is order file.
not a part of the d. Perform
registration cutoff tests
statement within for cash
the meaning of receipts and
the Securities dis
Act of 1933. bursements.
b. Accountant 87. Which of the following is
assumes no least likely to be a proce
responsibility dure included in an
to update the accountant’s review of
report for interim financial
events and information of a public
circumstances entity?
occurring after a. Compare
the date of the disaggregated
report. revenue data by
c. Accountant’s month to that
review was of the previous
performed in
interim period.
b. Read available a. Statement that
minutes of the interim
meetings of financial
stockholders. information was
c. Observe counting of examined in
physical inventory. accordance with
d. Inquire of standards of the
managemen Public Company
t concerning Accounting
significant Oversight Board.
journal
b. Statement that
entries and
the interim
other
financial
adjustments
. information is
the
88. An accountant’s review responsibility
report on interim of the entity’s
financial information of shareholders.
a public entity is most c. Description of the
likely to include a procedures for a review.
d. Statement that
a review of
interim
financial infor
mation is less
in scope than a
compilation
conducted in
accordance
with AICPA
standards.
89. An auditor may report on
condensed financial state
ments that are derived
from complete financial
statements if the
a. Condensed
financial
statements are
distributed to
stockholders
along with the
complete
financial
statements.
b. Auditor
described the
additional
procedures
performed on
the condensed
financial
statements.
c. Auditor indicates whether
the information in the
condensed financial
statements is fairly stated in
all material respects in
relation to the complete
financial statements from
which it has been derived.
d. Condensed
financial
statements are
presented in
comparative
form with the accountancy to
prior year’s perform the
condensed engagement.
financial
statements. 92. The financial statements of KCP
America, a US entity, are prepared
90. An auditor is engaged to for inclusion in the consolidated
report on selected financial statements of its nonUS
financial data that are parent. These financial statements
included in a client are prepared in conformity with the
prepared document con accounting principles generally
taining audited financial accepted in the parent’s country and
statements. Under these are for use only in that country.
circumstances, the report How may KCP America’s auditor
on the selected data report on these financial
statements?
should
a. Be limited to I. A USstyle report (unmodified).
data derived AI. A USstyle report
from the modified to report on
audited finan the accounting
cial statements. principles of the
parent’s country.
b. Be distributed
III. The report form of the parent’s
only to senior country.
management
and the board
of directors.
c. State that the
presentation is a
comprehensive
basis of
accounting other
than GAAP.
d. Indicate that the data are
not fairly stated in all ma
terial respects.
91. Before reporting on the
financial statements of a
US entity that have been
prepared in conformity
with another country’s
accounting principles, an
auditor practicing in the
US should
a. Understand the
accounting
principles
generally ac
cepted in the
other country.
b. Be certified by
the appropriate
auditing or
accountancy
board of the
other country.
c. Notify
management
that the auditor
is required to
disclaim an
opinion on the
financial
statements.
d. Receive a
waiver from the
auditor’s state
board of
I II III c. Application of accounting principles to specified
a. Yes No No transactions.
b. No Yes No d. Limited use prospective financial statements such
c. Yes No Yes as a financial projection.
d. No Yes Yes 98. Delta Life Insurance Co. prepares its financial state
93. Field is an employee of Gold Enterprises. Hardy, ments on an accounting basis insurance companies use pur
CPA, is asked to express an opinion on Field’s profit par suant to the rules of a state insurance commission. If Wall,
ticipation in Gold’s net income. Hardy may accept this en CPA, Delta’s auditor, discovers that the statements are not
gagement only if suitably titled, Wall should
a. Hardy also audits Gold’s complete financial state a. Disclose any reservations in an explanatory para
ments. graph and qualify the opinion.
b. Gold’s financial statements are prepared in confor b. Apply to the state insurance commission for an ad
mity with GAAP. visory opinion.
c. Hardy’s report is available for distribution to c. Issue a special statutory basis report that clearly
Gold’s other employees. disclaims any opinion.
d. Field owns controlling interest in Gold. d. Explain in the notes to the financial statements the
94. When an auditor reports on financial statements pre terminology used.
pared on an entity’s income tax basis, the auditor’s report 99. A CPA is permitted to accept a separate engagement
should (not in conjunction with an audit of financial statements) to
a. Disclaim an opinion on whether the statements audit an entity’s
were examined in accordance with generally ac
Schedule of Schedule of
cepted auditing standards. accounts receivable royalties
b. Not express an opinion on whether the statements
a. Yes Yes
are presented in conformity with the comprehen b. Yes No
sive basis of accounting used. c. No Yes
c. Include an explanation of how the results of opera d. No No
tions differ from the cash receipts and disburse
ments basis of accounting. 100. Financial information is presented in a printed form
d. State that the basis of presentation is a comprehen that prescribes the wording of the independent auditor’s
sive basis of accounting other than GAAP. report. The form is not acceptable to the auditor because the
form calls for statements that are inconsistent with the audi
95. Helpful Co., a nonprofit entity, prepared its financial tor’s responsibility. Under these circumstances, the auditor
statements on an accounting basis prescribed by a regulatory most likely would
agency solely for filing with that agency. Green audited the a. Withdraw from the engagement.
financial statements in accordance with generally accepted b. Reword the form or attach a separate report.
auditing standards and concluded that the financial state c. Express a qualified opinion with an explanation.
ments were fairly presented on the prescribed basis. Green d. Limit distribution of the report to the party who de
should issue a signed the form.
a. Qualified opinion.
b. Standard threeparagraph report with reference to 101. A registration statement filed with the SEC contains
footnote disclosure. the reports of two independent auditors on their audits of
c. Disclaimer of opinion. financial statements for different periods. The predecessor
d. Special report. auditor who audited the prior period financial statements
generally should obtain a letter of representation from the
96. An auditor’s special report on financial statements a. Successor independent auditor.
prepared in conformity with the cash basis of accounting b. Client’s audit committee.
should include a separate explanatory paragraph before the c. Principal underwriter.
opinion paragraph that d. Securities and Exchange Commission.
a. Justifies the reasons for departing from generally
accepted accounting principles. 102. Which of the following statements is correct concern
b. States whether the financial statements are fairly ing letters for underwriters, commonly referred to as comfort
presented in conformity with another comprehen letters?
sive basis of accounting. a. Letters for underwriters are required by the Securi
c. Refers to the note to the financial statements that ties Act of 1933 for the initial public sale of regis
describes the basis of accounting. tered securities.
d. Explains how the results of operations differ from b. Letters for underwriters typically give negative as
financial statements prepared in conformity with surance on unaudited interim financial information.
generally accepted accounting principles. c. Letters for underwriters usually are included in the
registration statement accompanying a prospectus.
97. An auditor’s report would be designated a special re d. Letters for underwriters ordinarily update auditors’
port when it is issued in connection with opinions on the prior year’s financial statements.
a. Interim financial information of a publicly held
103. Comfort letters ordinarily are signed by the client’s
company that is subject to a limited review.
b. Compliance with aspects of regulatory require a. Independent auditor.
ments related to audited financial statements. b. Underwriter of securities.
supplementary
disclosures.
c. Audit committee. c. A limited
d. Senior management. opinion on
pro forma
104. Comfort letters ordinarily are financial
addressed to statements.
a. Creditor financial d. A disclaimer on
institutions. prospective financial
b. The client’s audit statements.
committee.
c. The Securities and 106. When an independent
Exchange Commission. audit report is
d. Underwriters of securities. incorporated by reference
in a SEC registration
105. When an accountant issues to an statement, a prospectus
underwriter a comfort letter that includes a statement
containing comments on data that about the independent
have not been audited, the accountant’s involvement
underwriter most likely will receive
should refer to the
a. Negative assurance on
independent accountant
capsule information.
as
b. Positive assurance on
a. Auditor of the financial d. No Yes No
reports.
109. In connection with a
b. Management’s designate
proposal to obtain a new
before the SEC.
auditclient, a CPA in public
c. Certified preparer of the practice is asked to prepare a
report. report on the application of
d. Expert in auditing and accounting principles to a specific
accounting. transaction. The CPA’s report
107. Which of the following should include a statement that
matters is covered in a a. The engagement was
typical comfort letter? performed in accordance
a. Negative assurance with Statements on
concerning whether the Standards for
entity’s internal control Accounting and Review
procedures operated as Services.
designed during the period b. Responsibility for the
being audited. proper accounting
b. An opinion treatment rests with the
regarding preparers of the financial
whether the statements.
entity complied c. The evaluation of the
with laws and application of accounting
regulations principles is hypothetical
under and may not be used for
Government Au opinionshopping.
diting Standards
and the Single
Audit Act of
1984.
c. Positive
assurance
concerning
whether
unaudited
condensed
financial
information
complied with
generally
accepted
accounting
principles.
d. An opinion as to
whether the
audited financial
statements
comply in form
with the
accounting re
quirements of
the SEC.
108. When unaudited
financial statements are
presented in comparative
form with audited
financial statements in a
document filed with the
Securities and Exchange
Commission, such
statements should be
Withheld
Marked as until
“unaudited” audited
a. Yes No
b. Yes No
c. No Yes
entity’s audit
d. The guidance is committee,
provided for the continuing
management’s CPA, and
use only and management.
may not be c. Disclaim any opinion that
communicated the hypothetical applica
to the prior or tion of accounting
continuing principles conforms with
auditor. generally accepted
110. In connection with a d. Notify the entity
proposal to obtain a new that the report is
client, an accountant in for the restricted
public practice is asked to use of
prepare a written report on management and
the application of outside parties
accounting principles to a who are aware
specific transaction. The of all relevant
accountant’s report should facts.
include a statement that
a. Any difference 112. Which of the following statements
in the facts, is not included in an accountant’s
circumstances, report on the application of
or as accounting principles?
sumptions a. The engagement was
presented may performed following stan
change the dards established by the
report. American Institute of Cer
b. The tified Public Accountants.
engagement b. The report is
was performed based on a
in accordance hypothetical
with Statements transaction not
on Standards involving facts
for Consulting or
Services. circumstances
c. The guidance provided is of this par
for management use only ticular entity.
and may not be c. The report is
communicated to the prior intended
or continuing auditors. solely for the
d. Nothing came information
to the and use of
accountant’s specified
attention that parties.
caused the d. Responsibility for
accountant to the proper
believe that the accounting
accounting treatment rests
principles with the preparers
violated GAAP. of the financial
111. Blue, CPA, has been asked to statements.
render an opinion on the application 113. Which of the following
of accounting principles to a services would be most
specific transaction by an entity that likely to be structured as
is audited by another CPA. Blue an attest engagement?
may accept this engagement, but a. Advocating a client’s
should position in tax matter.
a. Consult with b. A consulting
the continuing engagement to
CPA to obtain develop a new
information database
relevant to the system for the
transaction. revenue cycle.
b. Report the c. An engagement
engagement’s to issue a report
findings to the addressing an
entity’s report ordinarily may refer
compliance with to
requirements of a. Only the assertion.
specified laws. b. Only the
d. The compilation of a subject
client’s forecast matter to
information. which the
assertion
114. An unqualified attestation
relates.
suitable only
for a limited
c. Either the number of par
assertion or the ties.
subject matter b. Subject matter available
to which the only to specified parties.
assertion c. A written assertion has not
relates. been obtained.
d. Neither the d. Criteria developed by an
assertion industry association.
nor the
subject 120. Which of the following is least likely
matter to to be included in an agreedupon
which the procedures attestation engagement
assertion report?
relates. a. The specified
party takes
115. A practitioner is issuing a responsibility for
standard unqualified the sufficiency
examination report under of procedures.
the attestation standards. b. Use of the report is
The CPA’s conclusion restricted.
may be on c. Limited assurance on the
Management’s information presented.
Subject matter written assertion d. A summary of procedures
a. Yes Yes performed.
b. Yes No
c. No Yes 121. A summary of findings
d. No No rather than assurance is
most likely to be
116. Conditions exist that result in a included in
material deviationfrom the criteria a. Agreedupon procedures
against which the subject matter report.
was evaluated during an b. Compilation report.
examination. The CPA’s conclusion c. Examination report.
may be on d. Review report.
Subject matter Written assertion
a. Yes not correct concerning
b. Yes “specified parties” of an
c. No agreedupon procedures
d. No report under either the
auditing or attestation
117. When performing an standards?
attestation engagement,
which of the following is
least likely to be present?
a. Assertion.
b. Practitioner independence.
c. Subject matter.
d. Suitable criteria.
118. Suitable criteria in an
attestation engagement
may be available
Publicly In CPA’s report
a. Yes Yes
b. Yes No
c. No Yes
d. No No
119. Which of the
following is least
likely to result in a
restricted use attest
report?
a. Criteria
prospective
a. They must financial
agree on statements are
the also ex
procedures amined.
to be per c. Responsibility
formed. for the
b. They must take adequacy of the
responsibility procedures
for the performed is
adequacy of the taken by the
procedures accountant.
performed. d. Negative
c. They must sign an assurance is
engagement letter. expressed on the
d. After prospective
completion of financial
the engagement, statements taken
another party as a whole.
may be added as
a specified user. 125. An accountant’s
compilation report on
123. When an accountant a financial forecast
examines projected should include a
financial statements, the statement that
accountant’s report should a. The forecast
include a separate should be
paragraph that read only in
a. Describes the conjunction
limitations on with the
the usefulness audited
of the historical
presentation. financial
b. Provides an statements.
explanation of b. The accountant expresses
the differences only limited assurance on
between an the forecasted statements
examination and and their assumptions.
an audit. c. There will
c. States that the usually be
accountant is differences
responsible for between the
events and forecasted and
circumstances actual results.
up to one year d. The
after the report’s hypothetical
date. assumptions
d. Disclaims an used in the
opinion on forecast are
whether the reasonable in
assumptions the
provide a circumstances.
reasonable
basis for the 126. Accepting an
projection. engagement to examine
an entity’s financial
124. An accountant may projection most likely
accept an engagement to would be appropriate if
apply agreedupon the projection were to
procedures to prospective be distributed to
financial statements a. All employees who work
provided that for the entity.
a. Use of the b. Potential
report is stockholders
restricted to the who request a
specified par prospectus or a
ties. registration
b. The statement.
c. A bank with
which the
entity is
negotiating for
a loan.
d. All stockholders of record
as of the report date.
127. A CPA in public practice is required
to comply with the provisions of the
Statements on Standards for
Attestation Engagements (SSAE)
when
Testifying as an procedures to prospective
Compiling a client’s
expert witness in financial projection
128. An accounting and
accountant’s that presents a
provided that
auditing matters given
compilation report on hypothetical course ofa. The
stipulated facts
a financial forecast Action prospective
a. should Yes include a Yes financial
b. statement that the
Yes No statements are
c. No Yes also ex
a.
d. Compilation does not
No No
include evaluation of the amined.
MODULE 5 REPORTING b. Responsibility175
support of the assumptions
underlying the forecast. for the
b. Hypothetical adequacy of the
assumptions procedures
used in the performed is
forecast are taken by the
reasonable. accountant.
c. Range of c. Negative
assumptions assurance is
selected is one expressed on the
in which one prospective
end of the range financial
is less likely to statements taken
occur than the as a whole.
other. d. Distribution of
d. Prospective the report is
statements are restricted to the
limited to specified
presenting, in parties.
the form of a 132. When an accountant
forecast,
examines a financial
information that
forecast that fails to
is the ac
disclose several
countant’s
significant assumptions
representation.
used to prepare the
129. Which of the following is a forecast, the accountant
prospective financial statement for should describe the as
general use upon which an sumptions in the
accountant may appropriately accountant’s report and
report? issue a(n)
a. Financial projection. a. “Except for” qualified
b. Partial presentation. opinion.
c. Pro forma financial b. “Subject to” qualified
statement. opinion.
d. Financial forecast. c. Unqualified
opinion with a
130. Given one or more separate
hypothetical explanatory
assumptions, a re paragraph.
sponsible party may d. Adverse opinion.
prepare, to the best of its
knowledge and belief, an 133. An accountant’s report
entity’s expected on a review of pro
financial position, results forma financial
of operations, and information should
changes in financial include a
position. Such pro a. Statement that
spective financial the entity’s
statements are known as internal control
a. Pro forma financial was not relied
statements. on in the review.
b. Financial projections. b. Disclaimer of
opinion on the
c. Partial presentations.
financial
d. Financial forecasts.
statements from
131. An accountant may which the pro
accept an engagement to forma financial
apply agreedupon information is
derived.
c. Caveat that it is 134. Which of the following is
uncertain not an objective of a
whether the CPA’s examination of a
transaction or client’s management
event reflected discussion and analysis
in the pro forma (MD&A) prepared
financial infor pursuant to Securities and
mation will Exchange Commission
ever occur. rules and regulations?
d. Reference to a. The historical
the financial amounts have
statements been accurately
from which the derived, in all
historical material
financial respects, from
information is the entity’s fi
derived.
nancial
statements.
b. The
presentation
is in
conformity
with rules and
regulations
adopted by
the Securities
and Ex
change
Commission.
c. The underlying
information,
determinations,
estimates and
assumptions of
the entity
provide a rea
sonable basis for
the disclosures
contained herein.
d. The
presentation
includes the
required
elements of
MD&A.
is an assertion
embodied in
management’s
discussion and analysis
(MD&A)?
a. Valuation.
b. Reliability.
c. Consistency with the
statements is correct
relating to an auditor’s
review engagements on
an entity’s management
discussion and analysis
(MD&A)?
a. A review
consists Standards.
principally of b. Statements on
applying Standards for
analytical Attestation
procedures and Engagements.
search and c. Statements on Standards
verification for Trust Engagements
procedures. d. Statements on Auditing
b. The review Standards.
report of a
public entity 139. The WebTrust seal of
should be re assurance relates most directly
stricted to the to
use of a. Financial statements
specified maintained on the Internet.
parties. b. Health care facilities.
c. No consideration of c. Risk assurance
internal control is procedures.
necessary. d. Web sites.
d. The report
issued will 140. A CPA’s examination
ordinarily report relating to a
include a WebTrust engagement
summary of is most likely to
findings, but include
no negative a. An opinion on whether the
assurance. site is “hackproof.”
b. An opinion
137. Which of the following is a term for on whether
an attest engagement in which a CPA the site
assesses a client’s commercial meets the
Internet site for predefined criteria WebTrust
such as those over online privacy? criteria.
a. ElectroNet. c. Negative assurance on
whether the site is
b. EDIFACT. electronically secure.
c. TechSafe. d. No opinion or
d. WebTrust. other
138. Trust Service assurance, but
a summary of
engagements are
findings
performed under the relating to the
provisions of Web site.
a. Statements on Assurance
plied by Modern Co.
regarding Modern’s
141. An engagement in which written assertion about
a CPA considers security, its compliance with
availability, processing contractual requirements
integrity, online privacy, to pay royalties. Mill’s
and/or confidentiality report on these agreed
over any type of defined upon procedures should
electronic system is most contain a(n)
likely to considered a. Disclaimer of opinion
which of the following about the fair presentation
types of engagements? of Modern’s financial
a. Internal control over statements.
financial reporting. b. List of the
b. SysTrust. procedures
c. Web siteAssociate. performed
d. WebTrust. (or
reference
142. A client’s refusal to thereto) and
provide a written Mill’s
assertion in a Trust findings.
Services engagement is c. Opinion about
most likely to result in the effectiveness
which of the following of Modern’s
types of opinions? internal control
a. Adverse. activities
b. Disclaimer. concerning
c. Qualified. royalty
d. Unqualified with payments.
explanatory language.
types of engagements is
not permitted under the
professional standards
for reporting on an
entity’s compliance?
a. Agreedupon
procedures on
compliance
with the
specified
requirements
of a law.
b. Agreedupon
procedures on
the effectiveness
of internal
control over
compliance with
a law.
c. Review on
compliance with
specified
requirements of
a law.
d. Examination on
compliance with
specified
requirements of
a law.
144. Mill, CPA, was engaged
by a group of royalty
recipients to apply
agreedupon procedures
to financial data sup
agencies.
147. In auditing a notforprofit c. Have a direct
entity that receives and material
governmental financial effect on the
assistance, the auditor has amounts in the
a responsibility to organization’s
a. Issue a separate report that financial
describes the expected statements.
benefits and related costs d. Demonstrate the existence
of the auditor’s suggested of material weaknesses.
changes to the entity’s
149. A governmental audit may extend
internal control.
beyond an examination leading to
b. Assess whether
the expression of an opinion on the
management
fairness of financial presentation to
has identified
include
laws and
regulations that
have a direct
and material ef
fect on the
entity’s
financial
statements.
c. Notify the
governmental
agency
providing the fi
nancial
assistance that
the audit is not
designed to
provide any
assurance of
detecting
misstatements
and fraud.
d. Render an
opinion
concerning the
entity’s contin
ued eligibility
for the
governmental
financial as
sistance.
148. Hill, CPA, is auditing the financial
statements of Helping Hand, a not
forprofit organization that receives
financial assistance from
governmental agencies. To detect
misstatements in Helping Hand’s
financial statements resulting from
violations of laws and regulations,
Hill should focus on violations that
a. Could result in
criminal
prosecution
against the or
ganization.
b. Involve
significant
deficiencies to
be communi
cated to the
organization’s
trustees and the
funding
Program Economy &
results Compliance efficiency
a. Yes Yes No
b. Yes Yes Yes
c. No Yes Yes
d. Yes No Yes
2. Acknowledgment that the sufficiency of the proce 150. When auditing an
entity’s financial statements in ac
dures is solely Mill’s cordance with Government
responsibility. Auditing Standards (the
“YellowBook”), an auditor is
145. A CPA’s report on required to report on
agreedupon procedures
related to an entity’s I. Noteworthy accomplishments
compliance with of the program.
specified requirements II. The scope of the auditor’s
should contain testing of internal controls.
a. A statement of limitations a. I only.
on the use of the report. b. II only.
b. An opinion about whether c. Both I and II.
management’s assertion is d. Neither I nor II.
fairly stated.
c. Negative 151. When auditing an entity’s
assurance that financial statements in accordance
control risk with Government Auditing
has not been Standards (the “YellowBook”), an
assessed. auditor is required to report on
d. An acknowledgment of
I. Recommendations for actions to
responsibility for the suffi
improve operations.
ciency of the procedures.
AI. The scope of the
146. When reporting on an auditor’s tests of
examination of a compliance with laws
company’s compliance and regulations.
with requirements of a. I only.
specified laws, the practi b. II only.
tioner has identified an c. Both I and II.
instance of material d. Neither I nor II.
noncompliance.
Management has agreed
to include this instance in
its written assertion. The
examination report should
include
a. No modification from the
standard form.
b. An opinion
paragraph that
is unqualified,
and an
explanatory
paragraph.
c. A qualified or adverse
opinion.
d. A disclaimer of opinion.
c. An auditor
should report
152. Which of the following the views of
statements is a standard responsible
applicable to financial officials
statement audits in concerning the
accordance with Gov auditor’s
ernment Auditing findings.
Standards (the “Yellow d. Internal control
Book”)? activities
a. An auditor designed to
should report detect or pre
on the scope of vent fraud
the auditor’s should be
testing of reported to the
compliance inspector gen
with laws and eral.
regulations.
b. An auditor 154. In reporting under
should assess Government Auditing
whether the Standards, an auditor most
entity has re likely would be required
portable to report a falsification of
measures of accounting records
economy and directly to a federal
efficiency that inspector general when the
are valid and falsification is
reliable. a. Discovered after
c. An auditor the auditor’s
should report report has been
recommendatio made available
ns for actions to the federal
to correct inspector general
problems and and to the
improve public.
operations. b. Reported by the
d. An auditor auditor to the
should audit committee
determine the as a significant
extent to deficiency in
which the internal control.
entity’s c. Voluntarily
programs disclosed to
achieve the the auditor by
desired results. lowlevel
personnel as a
153. Which of the following result of the
statements is a standard auditor’s
applicable to financial inquiries.
statement audits in d. Communicate
accordance with Gov d by the
ernment Auditing auditor to the
Standards (the “Yellow auditee and
Book”)? the auditee
a. An auditor fails to make
should report a required
on the scope of report of the
the auditor’s matter.
testing of
internal 155. Although the scope of
controls. audits of recipients of
b. All instances of federal financial
abuse, waste, and assistance in accordance
mismanagement with federal audit regula
should be tions varies, these audits
reported to the generally have which of
audit committee. the following elements
in common?
a. The auditor is b. To specific
to determine legislative and
whether the regulatory
federal fi bodies when
nancial reporting under
assistance has Government
been Auditing
administered in Standards.
accordance c. To a court
with applicable appointed
laws and creditors’
regulations. committee when
b. The materiality levels are the client is
lower and are determined operating under
by the government entities Chapter 11 of
that provided the federal the Federal
financial assistance to the Bankruptcy
recipient. Code.
c. The auditor should obtain d. To shareholders
written management rep with significant
resentations that the influence (more
recipient’s internal than 20% equity
auditors will report their
ownership) when
findings objectively
significant defi
without fear of political
repercussion. ciencies are
d. The auditor is deemed to be
required to material
express both weaknesses.
positive and 157. Wolf is auditing an entity’s
negative
compliance with requirements
assurance that
governing a major federal financial
illegal acts that
assistance program in accordance
could have a
with Government Auditing
material effect
Standards. Wolf detected
on the recipient’s
noncompliance with requirements
financial state
that have a material effect on the
ments are
program. Wolf’s report on
disclosed to the
compliance should express
inspector
a. No assurance on the
general.
compliance tests.
156. An auditor most likely b. Reasonable assurance on
would be responsible for the compliance tests.
communicating c. A qualified or adverse
significant deficiencies in opinion.
the design of internal d. An adverse or disclaimer
control of opinion.
a. To the Securities
and Exchange 158. Which of the following
Commission is a specific
when the client documentation
is a publicly requirement that an
held entity. auditor should follow
when auditing in
accordance with
Government Auditing
Standards?
a. The auditor
should obtain
written
representations
from
management
acknowledging
responsibility for
correcting
instances of the auditor
fraud, abuse, and does not
waste. possess
b. Before the report legal skills
is issued, and cannot
evidence of make legal
supervisory judgments.
review of the
audit. 160. In reporting under
c. The auditor Government Auditing
should Standards, an auditor most
document the likely would be required
procedures that to communicate man
assure agement’s
discovery of all misappropriation of assets
illegal acts and directly to a federal
contingent inspector general when the
liabilities fraudulent activities are
resulting from a. Concealed by
noncompliance. management by
d. The auditor’s circumventing
working papers specific
should contain internal
a caveat that controls
all instances of designed to
material safeguard those
misstatements assets.
and fraud may b. Reported to
not be the entity’s
governing
identified.
body and the
159. In performing a governing
financial statement audit body fails to
in accordance with make a
Government Auditing required report
Standards, an auditor is to the federal
required to report on the inspector
entity’s compliance with general.
laws and regulations. c. Accompanied by
This report should fraudulent
a. State that financial
compliance reporting that
with laws and results in material
regulations is misstatements of
the asset balances.
responsibility d. Perpetrated by
of the entity’s several levels
management. of management
b. Describe the in a scheme
laws and that is likely to
regulations continue in
that the entity
future years.
must comply
with. 161. In auditing compliance
c. Provide an with requirements
opinion on governing major federal
overall financial assistance
compliance programs under the Single
with laws Audit Act, the auditor’s
and
consideration of materiality
regulations.
differs
d. Indicate that
from materiality under generally accepted auditing stan
dards. Under the Single Audit Act, materiality is
a. Calculated in relation to the financial
statements taken as a whole.
b. Determined separately for each major
federal financial assistance program.
c. Decided in conjunction with the
auditor’s risk assessment.
d. Ignored, because all account balances,
regardless of size, are fully tested.
162. Kent is auditing an entity’s compliance with
requirements governing a major federal financial
assistance program in accordance with the Single
Audit Act. Kent detected noncompliance with
requirements that have a material effect on that
program. Kent’s report on compliance should
express a(n)
a. Unqualified opinion with a separate
explanatory paragraph.
b. Qualified opinion or an adverse opinion.
c. Adverse opinion or a disclaimer of opinion.
d. Limited assurance on the items tested.
163. When performing an audit of a city that is
subject to the requirements of the Uniform
Single Audit Act of 1984, an auditor should
adhere to
a. Governmental Accounting Standards
Board General Standards.
b. Governmental Finance Officers
Association Governmental
Accounting, Auditing, and Financial
Reporting Principles.
c. General Accounting Office
Government Auditing Standards.
d. Securities and Exchange Commission
RegulationSX.
164. A CPA has performed an examination of the
generalpurpose financial statements of Big City.
The examination scope included the additional
requirements of the Single Audit Act. When
reporting on Big City’s internal accounting and
administrative controls used in administering a
federal financial assistance program, the CPA
should
a. Communicate those weaknesses that
are material in relation to the general
purpose financial statements.
b. Express an opinion on the systems used
to administer major federal financial
assistance programs and express
negative assurance on the systems used
to administer nonmajor federal financial
assistance programs.
c. Communicate those weaknesses that
are material in relation to the federal
financial assistance program.
d. Express negative assurance on the
systems used to administer major federal
financial assistance programs and
express no opinion on the systems used
to administer nonmajor federal financial
assistance programs.
SIMULATIONS
Accounting
Changes
Authoritative
Literature Help
The audit of Park Publishing Co., for the year ended September 30, 20X2,
is near completion. Your senior, Dave Moore, at Tyler & Tyler CPAs, has
asked you to draft the audit report, considering the following:
• During fiscal year 20X2, Park changed its depreciation
method. The engagement partner concurred with this
change in accounting principle and its justification, and
Moore wants it properly reflected in the auditors’ report;
the change is discussed in Note 7 to the financial
statements.
• The 20X2 financial statements are affected by an
uncertainty concerning a lawsuit over patent infringement,
the outcome of which cannot presently be estimated. Moore
has suggested the need for an explanatory paragraph in the
auditors’ report related to this matter which is discussed in
Note 4 to the financial statements.
• The financial statements for the year ended September 30,
20X1, are to be presented for comparative purposes.
Wilson & Wilson previously audited these statements and
expressed a standard unqualified opinion.
2. Identify the paragraphs in the Professional Standards that provide
guidance regarding the modification of the audit report for the
change in accounting principle.
3. Identify the paragraph in Professional Standards that provides the
guidance regarding the modification of the audit report for the
uncertainty.
4. Identify the paragraphs in the Professional Standards that provide
the guidance regarding the effect of Wilson & Wilson’s opinion on
the 20X1 financial statements on Tyler & Tyler’s audit report on
the 20X2 financial statements.
Report
Authoritative
Modifications
Literature Help
Assume that items 1 through 8 are situations that Jones, CPA, has
encountered during his audit of Welles Incorporated.List A represents the
types of opinions the auditor ordinarily would issue and List B represents the
report modifications (if any) that would be necessary. For each situation, select
one response from List A and one from List B. Select as the best answers for
each item the action the auditor would normally take. The types of opinions in
List A and the report modifications in List B may be selected once, more than
once, or not at all.
Assume
• The auditor is independent.
• The auditor previously expressed an unqualified opinion on the prior
year’s financial statements.
• Only singleyear (not comparative) statements are presented for the
current year.
• The conditions for an unqualified opinion exist unless contradicted by
the facts.
• The conditions stated in the items to be answered are material, unless
otherwise indicated.
• Each item to be answered is independent of the others.
• No report modifications are to be made except in response to the factual
situation.
• The auditor will not treat a situation as an “emphasis of a matter” in
what remains an unqualified audit report unless it is one of those
circumstances specifically illustrated in the Professional Standards as an
example of a matter an auditor may wish to emphasize.
180 REPORTING
MODULE 5
List B
List A Report modifications
Types of opinions H. Describe the
A. Either an “except for” circumstances in an
qualified opinion or an explanatory paragraph
adverse opinion without modifying the
B. Either a disclaimer of three standard para
opinion or an “except graphs.
for” qualified opinion I. Describe the
C. Either an adverse circumstances in an
opinion or a disclaimer explanatory paragraph
of opinion and modify the opinion
D. An “except for” qualified paragraph.
opinion J. Describe the
E. An unqualified opinion circumstances in an
F. An adverse opinion explanatory paragraph
G. A disclaimer of opinion and modify the scope and
opinion paragraphs.
K. Describe the
circumstances in an
and modify the
introductory, scope, and
opinion paragraphs.
L. Describe the
circumstances within the
scope paragraph without
adding an explanatory
paragraph.
M. Describe the circumstances
within the opinion paragraph
without adding an explanatory
paragraph.
N. Describe the
circumstances within the
scope and opinion
paragraphs without
adding an
explanatoryparagraph.
O. Describe the circumstances
within the introductory,
scope, and opinion
paragraphs without
addingan explanatory
paragraph.
P. Issue the standard auditor’s
report without modifi
cation.
Types of Report
opinions modifications
(AG) (HP)
1. Jones hired an actuary to assist in corroborating Welles’ complex
pension calculations concerning accrued pension liabilities that
account for 35% of the client’s total liabilities. The actuary’s findings
are reasonably close to Welles’ calculations and support the financial
statements.
2. Welles holds a note receivable consisting of principal and accrued
interest payable in 20X4. The note’s maker recently filed a
voluntary bankruptcy petition, but Welles failed to reduce the
recorded value of the note to its net realizable value, which is
approximately 20% of the recorded amount.
3. Jones was engaged to audit a client’s financial statements after the annual
physical inventory count. The accounting records were not sufficiently
reliable to enable him to become satisfied as to the yearend inventory
balances.
4. Jones found an immaterial adjustment relating to inventory. Welles
has refused to adjust the financial statements to reflect this
immaterial item.
5. Welles’ financial statements do not disclose certain longterm lease
obligations. Jones determined that the omitted disclosures are
required by FASB.
6. Jones decided not to take responsibility for the work of another CPA
who audited a wholly owned subsidiary of Welles. The total assets
and revenues of the subsidiary represent 27% and 28%, respectively,
of the related consolidated totals.
7. Welles changed its method of accounting for the cost of
inventories from FIFO to LIFO. Jones concurs with the change
although it has a material effect on the comparability of the
8. Due to losses and adverse key financial ratios, Jones has substantial
doubt about Welles’ ability to continue as a going concern for a
reasonable period of time. The client has adequately disclosed its
financial difficulties in a note to its financial statements, which do
not include any adjustments that might result from the outcome of
this uncertainty. Also, Jones has ruled out the use of a disclaimer of
opinion.
Research
Authoritative
Literature Help
Contacting a Predecessor Auditor
You recently graduated from college and have worked with Tice &
Co. CPAs for several months. A partner in Tice has indicated that the firm
has a potential nonpublic new audit client and that he would like to
research the matters that are ordinarily addressed by a successor auditor’s
inquiry of the predecessor auditor prior to accepting a new engagement.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
2. Enter the exact section and paragraph with the appropriate guidance.
Research
Authoritative
Literature Help
Standard Report Elements
The senior on your job has pointed out to you that the CPA firm
always signs the report both with its signature and its location (Yuma,
Arizona) and that she suggests that she thinks it isn’t necessary to
provide the location.
1. Identify the title, section, and paragraph of the auditing standards
that provide the basic elements that must be included in the
auditor’s standard report.
2. Is she correct or incorrect concerning inclusion of the location?
Yes No

Audit Report
Authoritative
Details Literature Help
On September 30, 20X2, White & Co. CPAs was engaged to audit the
consolidated financial statements of National Motors Inc. for the year ended
December 31, 20X2. The consolidated financial statements of National had not
been audited the prior year. National’s inadequate inventory records precluded
White from forming an opinion as to the proper application of generally
accepted accounting principles to inventory balances on January 1, 20X2.
Therefore, White decided not to express an opinion on the results of operations
for the year ended December 31, 20X2. National decided not to present
comparative financial statements.
Rapid Parts Company, a consolidated subsidiary of National, was audited
for the year ended December 31, 20X2, by Green & Co. CPAs. Green
completed its audit procedures on February 28, 20X3, and submitted an
unqualified opinion on Rapid’s financial statements on March 7, 20X3. Rapid’s
statements reflect total assets and revenues constituting $700,000 and
$2,000,000, respectively, of the consolidated totals of National. White decided
not to assume responsibility for the work of Green. Green’s report on Rapid
does not accompany National’s consolidated statements.
The following lists potential effects on White’s audit report.
Effect on the Audit Report
A. Disclaim on balance sheet, income statement and statement of cash flows.
B. Disclaim only on results of operations.
C. Qualified audit opinion on results of operations.
D. Modification of report to set forth a division of responsibility for the audit.
E. Issuance of two separate reports.
F. Date the report March 28, 20X3.
G. Date the report April 4, 20X3.
H. Management of National Motors.
I. National Motors’ Board of Directors.
J. Managements of both National Motors and Rapid Parts.
K. White & Co. only.
L. White & Co. and Green & Co.
For each circumstance described below select the most appropriate statement that reflects the effect or details of the
audit report.
1. N
a
2. R
a
3. W
h
4
5
1. c __ __ 35. a __ __ 69. b __ __ 103. a __ __ 137. d __ __

2. a __ __ 36. d __ __ 70. c __ __ 104. d __ __ 138. b __ __
3. b __ __ 37. c __ __ 71. c __ __ 105. a __ __ 139. d __ __
4. c __ __ 38. c __ __ 72. d __ __ 106. d __ __ 140. b __ __
5. d __ __ 39. d __ __ 73. c __ __ 107. d __ __ 141. b __ __
6. c __ __ 40. b __ __ 74. d __ __ 108. a __ __ 142. b __ __
7. c __ __ 41. a __ __ 75. b __ __ 109. b __ __ 143. c __ __
8. c __ __ 42. b __ __ 76. d __ __ 110. a __ __ 144. b __ __
9. d __ __ 43. b __ __ 77. a __ __ 111. a __ __ 145. a __ __
10. b __ __ 44. d __ __ 78. b __ __ 112. b __ __ 146. c __ __
11. d __ __ 45. c __ __ 79. b __ __ 113. c __ __ 147. b __ __
12. d __ __ 46. a __ __ 80. b __ __ 114. c __ __ 148. c __ __
13. c __ __ 47. d __ __ 81. d __ __ 115. a __ __ 149. b __ __
14. a __ __ 48. a __ __ 82 d __ __ 116. b __ __ 150. b __ __
15. a __ __ 49. d __ __ 83. a __ __ 117. a __ __ 151. b __ __
16. c __ __ 50. a __ __ 84. a __ __ 118. a __ __ 152. a __ __
17. a __ __ 51. d __ __ 85. d __ __ 119. d __ __ 153. a __ __
18. c __ __ 52. d __ __ 86. b __ __ 120. c __ __ 154. d __ __
19. d __ __ 53. c __ __ 87. c __ __ 121. a __ __ 155. a __ __
20. a __ __ 54. d __ __ 88. c __ __ 122. c __ __ 156. b __ __
21. b __ __ 55. c __ __ 89. c __ __ 123. a __ __ 157. c __ __
22. d __ __ 56. a __ __ 90. a __ __ 124. a __ __ 158. b __ __
23. d __ __ 57. d __ __ 91. a __ __ 125. c __ __ 159. a __ __
24. a __ __ 58. d __ __ 92. d __ __ 126. c __ __ 160. b __ __
25. c __ __ 59. b __ __ 93. a __ __ 127. c __ __ 161. b __ __
26. a __ __ 60. c __ __ 94. d __ __ 128. a __ __ 162. b __ __
27. b __ __ 61. c __ __ 95. d __ __ 129. d __ __ 163. c __ __
28. a __ __ 62. d __ __ 96. c __ __ 130. b __ __ 164. c __ __
29. b __ __ 63. b __ __ 97. b __ __ 131. d __ __
30. c __ __ 64. b __ __ 98. a __ __ 132. d __ __
31. b __ __ 65. b __ __ 99. a __ __ 133. d __ __
32. d __ __ 66. a __ __ 100. b __ __ 134. b __ __
33. a __ __ 67. d __ __ 101. a __ __ 135. c __ __ 1st: __/164 = __%
34. b __ __ 68. a __ __ 102. b __ __ 136. b __ __ 2nd: __/164 = __%
(d) is
A.1. Overall Issues
1. (c) The requirement is to identify the type of assurance (if
any) provided in a financial statement compilation report.
Answer (c) is correct because the objective of a
compilation is to present in the form of financial statements
information that is the presentation of management
(owners) without undertaking to express any assurance on
the statements. Answer (a) is incorrect because accountants
never provide absolute assurance. Answer (b) is incorrect
because reviews result in limited (negative) assurance.
Answer (d) is incorrect because audits, not compilations,
provided reasonable assurance.
2. (a) The requirement is to identify the statement in
the standard audit report that indicates the
existence of audit risk. Answer (a) is correct
because the existence of audit risk is recognized
by the statement in the auditor’s standard report
that the auditor obtained “reasonable assurance.”
Answer (b) is incorrect because while the
standard report does indicate that the CPA
assesses the accounting principles used and the
overall financial statement presentation, this does
not indicate the existence of audit risk. Answer
(c) is incorrect because while the standard report
does indicate that the audit relates to whether the
financial statements are free of material
misstatement, it does not discuss materiality and
the audit risk associated with materiality. Answer
incorrect because while the financial statements are the re level is reported on. Answer (c) is incorrect
sponsibility of management and the CPA’s responsibility because regardless of the other type of service
is to express an opinion, the indication that the CPA performed, the compilation level is always the
expresses an opinion does not address audit risk and is less lowest level and therefore should not be the basis
precise than the statement that the auditor obtains of the report. Answer (d) is incorrect because in
reasonable assurance. circumstances in which an audit has been
performed, an audit report, not a review report, is
3. (b) The requirement is to determine an
appropriate.
accountant’s reporting responsibility when more
than one level of service concerning the financial 4. (c) The requirement is to identify the report that is least likely
statements of a nonissuer (nonpublic) entity has to be a restricteduse report. Answer (c) is correct because
been performed. Answer (b) is correct because AU 623 indicates that reports on most comprehensive basis
AR 100 requires that the accountant report on the financial statements are not restricted. Answers (a) and (b)
highest level of service rendered. Answer (a) is are incorrect because reports on significant deficiencies and
incorrect because the highest, and not the lowest, reports to audit committees are restricted
standards and generally accepted ac
counting principles. Answer (c) is
under AU 325 and AU 380, correct because the scope paragraph
respectively. Answer (d) is indicates that generally accepted
incorrect because AU 623 auditing standards have been
restricts such reports on compli followed, while the opinion
ance. Also, see AU 532 for paragraph indicates that the
information on restricting the use financial statements follow
of an audit report. generally accepted accounting
principles.
determine an 9. (d) The requirement is to determine
auditor’sresponsibility for auditor reporting responsibility
controlling the distribution by the when prior period financial
client of a restricteduse report. statements which received a
Answer (d) is correct because AU qualified opinion due to a lack of
532 states that an auditor is not adequate disclosure have been
responsible for controlling the restated to eliminate the lack of
distribution of such reports. disclosure. Answer (d) is correct
Answer (a) is incorrect because because AU 508 states that an
while an auditor should consider auditor should express an
informing a client that restricted unqualified opinion on the restated
use reports are not intended for financial statements of the prior
such distribution, there is no such year (with an explanatory paragraph
requirement. Answer (b) is describing the circumstance).
incorrect because the auditor need Answer (a) is incorrect because the
not inform the client to cease and auditor’s original report is not
desist. Answer (c) is incorrect reissued. Answer (b) is incorrect
because an auditor need not insist because the qualified opinion is
that the client not duplicate the eliminated. Answer (c) is incorrect
restricteduse report. because reference to the type of
opinion expressed is included in the
A.2. Financial Statement Audit
reissued report’s explanatory
Reports—Nonissuer paragraph.
(Nonpublic) Companies
6. (c) The requirement is to identify the correct state
identify the statement that ment concerning an
is included in the auditor’s responsibility to
auditor’s standard report. express an opinion on the
Answer (c) is correct financial statements.
because the auditor’s Answer (b) is correct
standard report states that because the opening
an audit includes (introductory) paragraph
assessing significant of the auditor’s standard
estimates made by man report states that the
agement; see AU 508 for auditor’s responsibility is
this and other required to express an opinion on
elements included in a the financial statements
standard report. based on the audit.
7. (c) The requirement is to Answer (a) is incorrect
because of the explicit
determine the proper date
statement in the
of a reissued audit report
introductory paragraph.
on financial statements
Answers (c) and
that have
(d) are incorrect because the
not been restated. Answer (c) is
introductory paragraph, not the
correct because use of theoriginal
date on the reissued audit report
removes any implication that
records, transactions or events after
the date of the audit report have
been examined or reviewed.
which paragraph of an auditor’s
standard audit report should refer to
scope or opinion paragraphs, (e.g., if the count of the
includes the statement on the beginning inventory has
auditor’s responsibility. not been observed, an
auditor may disclaim an
11. (d) The requirement is to opinion on the income
determine whether theterms “when statement and yet express
read in conjunction with Note X,” an unqualified opinion on
and “with the foregoing the balance sheet). Answer
explanation” should be included in (b) is incorrect because the
the opinion paragraph of a qualified objective does not relate
opinion. AU 508 states that an au directly to scope limi
dit report with a qualified opinion tations. Answer (d) is
should not include either phrase in incorrect because an
the opinion paragraph. auditor may report on only
one statement.
determine the 14. (a) The requirement is to
representations made determine the meaning
explicitly and implicitly of the expression “taken
when issuing the stan as a whole” in the fourth
dard auditor’s report on generally accepted
comparative financial auditing standard of
statements. reporting. AU 508 states
Answer (d) is correct because the that “taken as a whole”
standard audit report explicitly applies equally to a
states that the examination of complete set of financial
evidence is made on a test basis statements and to an
and implicitly assumes consistent individual financial
application of accounting statement.
principles. Answer (a) is incorrect
because consistency of application 15. (a) The requirement is to
of accounting principles is not indi determine the appropriate
cated explicitly. Answer (b) is date for an audit report
incorrect because examination of when a subsequent event
evidence on a test basis is referred requiring adjustment of
to explicitly. Answer (c) is financial statements,
incorrect because examination of without disclosure of the
evidence on a test basis is explicitly event, comes to the
referred to and because consistent auditor’s attention. AU
application of accounting principles 530 states that the date of
is not explicitly referred to. completion of fieldwork
should be used in such
circumstances.
determine the objective of
the fourth reporting 16. (c) The requirement is to determine
standard which requires an auditor’s responsibility for
either an opinion subsequent events when an audit
regarding the financial report has been dual dated for a
statements taken as a subsequent event. Answer (c) is cor
whole or an assertion to rect because, when dual dating is
the effect that an opinion used, auditor responsibility for
cannot be expressed. events subsequent to the completion
Answer (c) is correct of fieldwork is limited to the
because the standard specific event referred to in the
states that the objective is notes to the financial statement.
to prevent Answers (a), (b), and (d) are all
misinterpretation of the incorrect because they establish
degree of responsibility more responsibility than required by
that the auditor is the professional standards. Note,
assuming when his/her however, that if the auditor chooses
name is associated with to date the report as of the date of
financial statements. the subsequent event, his/her
Answer (a) is incorrect responsibility for other subsequent
because differing opinions events extends to the date of the
may be issued on each of audit report.
(3) reviewing the working papers
of the other auditor, and (4)
A.3. Financial Statement Audit performing additional audit
Reports—Issuer procedures. Answer (a) is incorrect
(Public) Companies because no explanatory paragraph
is added to the audit report. Answer
17. (a) The requirement is to determine (b) is incorrect because the principal
the accounting principles that an auditor is assuming responsibility
issuer (public) company audit report for the other auditor’s work when a
refers to. Answer (a) is correct decision is made not to refer to the
because the financial statements other auditor’s report. Answer (c) is
follow generally accepted incorrect because written
accounting principles. Answer (b) is permission is not required when the
incorrect because, while the audit is principal auditor is taking
performed in accordance with responsibility for the work of the
PCAOB standards, the financial other auditor.
statements do not follow those
standards. Answer (c) is incorrect 20. (a) The requirement is to
because the financial statements do determine the meaning of
not follow generally accepted sentences added to an
auditing standards. Answer (d) is introductory paragraph of
incorrect because the financial an auditor’s report that
statements ordinarily follow states that another auditor
generally accepted accounting audited a portion of the
principles, not International entity. Answer (a) is
Accounting Standards. correct because AU 508
provides that such a
18. (c) The requirement is to identify statement indicates a
the incorrect statement concerning division of responsibility.
information included in an audit Answer (b) is incorrect
report of financial statements issued because when the other
under the requirements of the auditor is referred to the
PCAOB. Answer (c) is correct since CPA, the CPA is not
the report should refer to the assuming responsibility
auditor’s report on internal control, for the other auditor.
not on compliance with laws and Answer (c) is incorrect
regulations. Answer (a) is incorrect because an unqualified
because the report should include opinion may be issued.
the title “Report of Independent Answer (d) is incorrect
Registered Public Accounting because the sentences are
Firm.” Answer (b) is incorrect proper.
because the report should refer to
the standards of the PCAOB.
Answer (d) is incorrect because the the situation in which an auditor
report should contain the city and would ordinarily issue an unqualified
state or country of the office that audit opinion without an explanatory
issued the report. paragraph. Answer (b) is correct
because when an auditor makes
B.1.a. Opinion Based, in reference to the report of another
Part, on Report of auditor, each of the three standard
Another Auditor paragraphs of the report are modified,
but no additional paragraph is
determine a principal auditor’s
responsibility, in addition to making
inquiries of the other auditor’s
reputation and independence, after
having decided not to refer to the
audit of the other auditor. Answer
(d) is correct because when a
decision is made not to make
reference to the other audit—that is,
to take responsibility for that
auditor’s work—the principal
auditor should consider (1) visiting
the other auditor, (2) reviewing the
audit programs of the other auditor,
another CPA who has audited a
added to the report. Answer (a) is client’s subsidiary. Answer (d) is
incorrect because emphasizing that correct because, regardless of
the entity had significant related whether the other auditor is referred
party transactions is normally to, the principal auditor must be
accomplished through the addition satisfied as to the independence and
of an explanatory paragraph. professional reputation of the other
Answer (c) is incorrect because the CPA. Answer (a) is incorrect
omission of a statement of cash because the principal auditor need
flows when an entity issues not issue an unqualified opinion on
financial statements that present the consolidated financial
financial position and result of statements. An
operations results in a qualified swer (b) is incorrect because it is
audit opinion with an explanatory not necessary that the other CPA
paragraph. Answer (d) is incorrect issue an unqualified opinion on the
because substantial doubt about the subsidiary’s financial statements.
entity’s ability to continue as a Answer (c) is incorrect because the
going concern normally results in principal auditor should consider
either an unqualified opinion with reviewing the audit programs and
an explanatory paragraph or a working papers of the other CPA
disclaimer of opinion. when a decision is made to not
22. (d) The requirement is to make reference to that CPA.
identify the situation in B.1.b. Unusual Circumstances
which an auditor may issue Requiring a Departure
the standard audit report.
from Promulgated
Answer (d) is correct
GAAP
because a standard report
may be issued in 24. (a) The requirement is to
circumstances in which the determine the type ofopinion to be
principal auditor assumes issued when financial statements of
responsibility for the work an entity that follows GASB
of another auditor. Answer standards include a justified
(a) is incorrect because the departure from GAAP. Answer (a)
standard report does not is correct because the auditor
include reference to a should issue an unqualified opinion
specialist. Thus, reference and should include a separate
to a specialist within a explanatory paragraph explaining
report by definition causes the departure from GAAP. Answers
modification of the (b), (c), and (d) are incorrect
standard report. Answer because when the auditor believes
(b) is incorrect because the that the departure is justified,
auditor is required to issue neither a qualified nor adverse
a modified report on opinion is appropriate.
condensed financial
B.1.c. Substantial Doubt
statements per AU 552.
about Ability to
Answer (c) is incorrect
because audit reports on Remain a Going
financial statements Concern
prepared on a 25. (c) The requirement is to
comprehensive basis other
determine whether theterm
than GAAP are considered “reasonable period of time, not to
to be “special reports” exceed one year” and/or “going
which require departures concern” is included in an
from the standard form. explanatory paragraph relating to
23. (d) The requirement is to determine going concern status. Answer (c) is
a principal auditor’s reporting correct because while the term
responsibility when a decision has “going concern” must be included,
been made to not make reference to the first term is not included in such
a report.
reporting responsibility
when there is substantial
26. (a) The requirement is to doubt about a client’s
determine an auditor’s ability to continue as a
reporting responsibility going concern. Answer
when reporting on (a) is correct because the
comparative financial audit report must include
statements in which the an explanatory paragraph
first year presented origi following the opinion
nally received a going paragraph, and must use
concern modification on a the terms “going concern”
matter that has now been and “substantial doubt.”
resolved, thus removing
the auditor’s substantial 29. (b) The requirement is to identify
doubt. Answer (a) is the situation in which an
correct because if explanatory paragraph may be
substantial doubt has been added to an unqualified report.
removed in the current Answer (b) is correct because
period, the explanatory substantial doubt about the entity’s
paragraph included in the ability to continue as a going con
auditor’s report on the cern leads to either an unqualified
financial statements of the report with an explanatory
prior period should not be paragraph or a disclaimer of
repeated. Answers (b), opinion. Answer (a) is incorrect
(c), and (d) are all because an auditor may issue an
incorrect because they opinion on a balance sheet without
suggest the need for an reporting on the other basic
explanatory paragraph. financial statements. Answer (c) is
incorrect because unreasonable esti
27. (b) The requirement is to mates lead to either a qualified or an
determine the auditor’s adverse opinion. Answer (d) is
responsibility when s/he incorrect because inadequate
concludes that there is management record retention
substantial doubt about an policies are a scope limitation that
entity’s ability to continue may result in a qualified opinion or
as a going concern for a a disclaimer.
reasonable period of time.
Answer (b) is correct 30. (c) The requirement is to identify
because when the auditor the management plan an auditor
concludes there is would most likely positively
substantial doubt, s/he consider when a question
should consider the concerning an entity’s ability to
possible effects on the continue as a going concern exists.
financial statements, and Answer (c) is correct because
the adequacy of the increasing the ownership equity will
related disclosures. bring in funds to possibly overcome
Answer (a) is incorrect the negative trends and financial
because either an difficulties. Answers (a), (b), and
unqualified opinion with (d) are all incorrect because
an explanatory paragraph increasing dividend distributions,
or a disclaimer is gener reducing lines of credit, and
ally appropriate, not a purchasing assets will all use funds,
qualified or adverse they will not provide funds. See AU
opinion. Answer (c) is 341 for guidance on an auditor’s
incorrect because the consideration of an entity’s ability
substantial doubt of going to continue as a going concern.
concern status does not 31. (b) The requirement is to
require adjusting identify the condition or
accounting estimates. event most likely to cause
Answer (d) is incorrect an auditor to have
because the prior year’s substantial doubt about an
audit report need not be entity’s ability to continue
reissued with an as a going concern.
explanatory paragraph. Answer (b) is correct
28. (a) The requirement is to because denial of usual
determine an auditor’s trade from suppliers is
ordinarily an indicator that
the company is in weak while such relatedparty transactions
financial condition. may be considered risky, there is
Answer (a) is incorrect less likely to be a question
because concerning going concern status
than suggested by answer (a).
Answer (c) is incorrect because the
payment of such stock dividends
does not indicate financial
weakness. Answer (d) is incorrect
because restrictions on the disposal
of principal assets is a condition
often present in various loan
agreements.
the most likely mitigating factor a
CPA would consider when a
client’s ability to continue as a
going concern is in question. An
swer (d) is correct because the
ability to postpone expenditures for
research and development projects
may mitigate the circumstance. See
AU 341 for this and other
mitigating factors. Answer (a) is
incorrect because there is no
guarantee that Zero’s discussions
with its lenders will lead to a
restructuring of the debt and loan
agreements. Only existing or
committee agreements to restructure
the debt would be considered a
mitigating factor. Answer (b) is
incorrect because weak internal
control over cash disbursements
may or may not have caused the
going concern problem. An
swer (c) is incorrect because an
entity with a going concern
problem is unlikely to be able to
purchase such production
facilities.
the condition or event that is most
likely to cause an auditor to have
substantial doubt about an entity’s
ability to continue as a going
concern. Answer (a) is correct
because AU 341 includes negative
cash flows as one of its examples of
such conditions and events.
while the postponement of research
and development projects may
sometimes be due to extreme
financial difficulties, often it is not.
Answers (c) and (d) are incorrect
because neither significant related
party transactions nor stock
dividends need not indicate
substantial doubt about an entity’s
ability to continue as a going
concern. See AU 341 for
information on an auditor’s
consideration of an entity’s ability
to continue as a going concern.
status. Answer (c) is
34. (b) The requirement is to incorrect because rec
identify the condition or onciling the cash balances
event that might indicate with the cutoff bank
to an auditor substantial statement is an acceptable
doubt about an entity’s audit procedure, but will
ability to continue as a not normally identify a
going concern. Answer going concern question.
(b) is correct because Answer (d) is incorrect
confirmation with related because comparing an
and third parties of the entity’s depreciation and
details of arrangements to asset capitalization
provide or maintain policies will not normally
financial support is a indicate a question of
procedure that would going concern status.
assist an auditor in
identifying a question 35. (a) The requirement is to
concerning going con identify the audit proce
cern status. See AU 341 dure most likely to assist
for this and other such an auditor in identifying
conditions and events conditions and events that
indicating doubt about an may indicate there could
entity’s ability to con be substantial doubt about
tinue as a going concern. an entity’s ability to
Answer (a) is incorrect continue as a going
because the pledging of concern. Answer (a) is
assets as collateral is a correct because a review
normal business of compliance with terms
transaction and it need not of debt and loan
necessarily indicate a agreements may reveal
question of going concern conditions of
because it also requires cash
resources which may not be
noncompliance due to poor available. Answer (d) is incorrect
financial condition. See the outline because converting preferred stock
of AU 341 for a list of procedures to longterm debt will not generally
that may identify such conditions alleviate a question concerning an
and events. Answers (b), (c), and entity’s ability to continue as a
(d) are all incorrect because, while going concern.
they might in some circumstances
reveal a question concerning the B.1.d. Inconsistency in
company’s ability to continue as a Application of GAAP
going concern, they are not
considered to be as effective as 38. (c) The requirement is to identify
answer (a). the circumstances in which an
auditor would issue a report that
36. (d) The requirement is to omits any reference to consistency.
identify the factor which Answer (c) is correct because, as
a CPA would most likely discussed in AU 508, a change in
consider as mitigating the useful life of assets is a change
substantial doubt about in estimate, and a change in
the ability of an entity to estimate does not result in a
continue as a going consistency modification. Answers
concern. Answer (d) is (a) and (b) are incorrect because
correct because they both represent a change in
management’s ability to accounting principle, and a change
negotiate reductions of in accounting principle requires a
required dividends will consistency modification. Answer
decrease required cash (d) is incorrect because
outflows, and thereby management’s lack of reasonable
increase the likelihood justification for a change in
that the entity will be able accounting principle is a departure
to continue as a going from generally accepted accounting
concern. AU 341 provides principles, and the description of the
examples of information departure will discuss the
that might mitigate such inconsistency.
concern. Answers (a), (b),
and (c) are all incorrect 39. (d) The requirement is to
because they involve determine whether an un
spending cash, rather than justified accounting
reducing outflows of change, a material
cash. weakness in internal
control, or both, would
37. (c) The requirement is to cause an auditor to
identify the circumstance express an unqualified
most likely to mitigate an opinion with an
auditor’s substantial explanatory paragraph.
doubt about an entity’s An
ability to continue as a swer (d) is correct because an
going concern. Answer unjustified accounting change will
(c) is correct because the result in either a qualified or an
marketable assets that adverse opinion and a material
management intends to weakness will ordinarily result in
sell may potentially no report modification (see AU
provide the necessary 325 for information on the
financial resources to treatment of material weaknesses);
mitigate the substantial accordingly, an unqualified opinion
doubt about the entity’s with an explanatory paragraph
ability to continue as a added to the auditor’s report is not
going concern. Answer appropriate in either case.
(a) is incorrect because 40. (b) The requirement is to
the ability to expand
identify the circumstance
opera
in which a disclaimer of
tions into new product lines is a
suspect circumstance, given the opinion is not
substantial doubt about the entity’s appropriate. Answer (b)
ability to continue as a going is correct because when
concern. Answer (b) is incorrect management does not
pro
vide reasonable justification of a
change in accounting principles
either a qualified or an adverse
opinion is appropriate, not a
disclaimer. Answers (a), (c), and
(d) are all incorrect because they
represent scope limitations that
lead to either a qualified opinion or
a disclaimer of opinion.
determine the effect on an
audit report of a client’s
decision to use differing
inventory costing methods
for various portions of its
inventory. Answer (a) is
correct because a standard
unqualified opinion may
ordinarily be issued (see
AU 420 for a discussion
of the consistency
standard). Answer (b) is
incorrect because there is
no lack of consistency
between accounting
periods. Answer (c) is
incorrect because there is
no departure from GAAP.
Answer (d) is incorrect
because adverse opinions
are only issued when a
departure from GAAP
exists that makes the
misleading.
identify an auditor’s re
porting responsibility when
performing a first audit of a
new client and when the
auditor was able to extend
auditing procedures to
gather sufficient evidence
about consistency. Answer
(b) is correct because, when
the auditor has obtained
assurance as to the
consistency of application
of accounting principles
between the current and
preceding year, no mention
of consistency is included
in the audit report. An
swer (a) is incorrect because the
auditor may report on the client’s
income statement. Answer (c) is
incorrect because the consistency
standard does apply. Answer (d) is
incorrect because the auditor does
not refer to consistency when ac
counting principles have been
applied consistently.
auditor reporting responsibility
when management does not provide statement note that
reasonable justification for a discusses the change in
change in accounting principle and detail. Answer (a) is
presents comparative financial incorrect because while the
statements. Answer (b) is correct auditor must believe that
because the auditor should continue the change is justified, it is
to express his/her exception with not necessary to explain it
the financial statements for the year in the report. Answer (b) is
of change as long as they are incorrect because the
presented and reported on. Answer cumulative effect of the
(a) is incorrect because the auditor
change need not be
must express his/her exception for
described in the audit
as long as the financial statements
for the year of change are presented report. Answer (c) is
and reported on. An incorrect because the
swer (c) is incorrect because the auditor need not make
auditor need not qualify the report explicit concurrence with
until management changes back to the change.
the accounting principle formerly
used. Answer (d) is incorrect
because the qualification is determine the proper re
necessary despite the fact that the porting option for a change
principle is generally accepted. in accounting principles
with an immaterial current
44. (d) The requirement is to year effect, but which is
determine the information expected to have a
that must be presented substantial effect in
when a client has changed subsequent years. Answer
accounting principles. (c) is correct because the
Answer (d) is correct auditor need not recognize
because in addition to the change in the audit
identifying the nature of the report and may issue a
change, the auditor must standard unqualified
refer to the financial opinion.
management, the
successor auditor, or both,
B.1.e. Certain Circumstances before reissuing the prior
Affecting Comparative year’s audit record.
Financial Statements Answer (a) is correct
because the predecessor
46. (a) The requirement is to identify auditor should obtain a
the circumstance in which an representation letter from
auditor reporting on comparative both management (AU
financial statements would 333) and the successor
ordinarily change the previously auditor (AU 508).
issued opinion on the prior year’s
financial statements. Answer (a) is 49. (d) The requirement is to identify
correct because when an auditor has the circumstance in which a
previously expressed a qualified or standard unqualified report may be
an adverse opinion on financial issued when singleyear financial
statements of a prior period and statements are presented. Answer
those financial statements have been (d) is correct because when the prior
restated, the auditor’s updated year’s financial statements are not
report is changed. Answer (b) is being presented, the CPA need not
incorrect because, ordinarily, the refer to them or include the
reissued report by a predecessor predecessor auditor’s report. See
auditor will be the same as that AU 508 for information on
originally issued. Answer (c) is reissuance of a predecessor’s report
incorrect because the prior year’s when comparative financial
opinion will remain unqualified if statements are being issued. An
the current year’s audit report is swer (a) is incorrect because
modified due to a lack of inability to audit an investment in a
consistency. Answer (d) is in foreign affiliate is a scope limitation
correct because restatement of prior that is likely to result in either a
year’s financial statements qualified opinion or a disclaimer.
following a pooling of interest will An
not lead to a change in the swer (b) is incorrect because a
previously issued opinion. qualified opinion is appropriate
when an entity declines to present a
47. (d) The requirement is to statement of cash flows with its
determine the information balance sheet and related statements
to be included in an audit of income and retained earnings.
report on comparative Answer (c) is incorrect because the
financial statements when emphasis of an accounting matter
a predecessor auditor’s by an auditor results in inclusion of
report is not being an explanatory paragraph to the
reissued. Answer (d) is unqualified audit report.
correct because the
introductory paragraph of
identify the correct form
the successor’s report
of an audit report on
should indicate (1) that
comparative financial
statements when a
of the prior period were
continuing auditor has
audited by another
audited the two years of
auditor (whose name is
not presented), (2) the
being presented. Answer
date of the predecessor’s
(a) is correct because one
report, (3) the type of
audit report should be
report issued by the
issued that includes the
predecessor, and (4) if the
years involved. Answer
report was other than a
(b) is incorrect because
standard report, the
one report, not two
substantive reasons
reports, should be issued.
therefor.
48. (a) The requirement is to because both years
determine whether the should be reported upon.
predecessor auditor Answer (d) is
should obtain a
representation letter from
is incorrect because the
incorrect because auditors do not auditor does have some
have the option of issuing two responsibility for the
audit reports in this circumstance. supplementary
information. Answer (b)
51. (d) The requirement is to is incorrect because the
determine the manner in auditor must apply
which a predecessor limited procedures to
auditor who has reissued information presented
a report for comparative and report deficiencies in
financial statements the information in
should refer to the addition to determining
successor auditor. AU whether it has been
508 indicates that the omitted. Answer (d) is
predecessor auditor incorrect because tests of
should not refer in the details of transactions and
reissued report to the balances need not be
report or work of the performed.
successor auditor.
determine the proper audit
determine the proper re report when management
porting procedure for declines to present
comparative financial supplementary
statements for which the information required by
prior year is unaudited, and the Governmental
the current year is audited. Accounting Standards
AU 504 states that when Board. Answer (d) is
unaudited financial state correct because omission
ments are presented in of required supplementary
comparative form with information, which when
audited financial presented is not
statements, the report on considered audited, leads
the prior period may be to an unqualified opinion
reissued to accompany the with an explanatory
current period report. In paragraph. Answers (a)
addition, the report on the and (b) are incorrect
current period may include because neither an adverse
a separate paragraph opinion nor a qualified
describing responsibility opinion is appropriate
assumed for the prior since the supplementary
period financial statements. information is not audited.
If these statements are filed Answer (c) is incorrect
with the SEC, the because it is incomplete
statements should be since an unqualified
clearly marked as “un opinion with an additional
audited” but should not be explanatory paragraph is
referred to in the auditor’s required.
report. B.1.h. Other Information
B.1.g. Required Supplementary with Audited
Information Financial
Statements
identify an auditor’s re 55. (c) The requirement is to
sponsibility for required identify the correct statement that
supplementary may be included in an auditor’s
information that is placed report when an auditor provides an
outside the basic financial opinion on information
statements. Answer (c) is accompanying the basic financial
correct because AU 558 statements. Answer (c) is correct
requires that the auditor because the report indicates whether
apply limited procedures the accompanying information is
to the information and fairly stated in all material respects
report deficiencies in, or in relation to the basic financial
the omission of, the statements taken as a whole.
information. Answer (a) Answer (a) is incorrect because the
information is not presented in in addition to that required by
accordance with generally accepted generally accepted accounting
auditing standards. Answer (b) is principles. An
incorrect because the information is
identify the proper statement about
swer (d) is incorrect because it an audit report that includes a
is not in accordance with separate paragraph in an otherwise
attestation standards. unmodified report that emphasizes
that the entity being reported on had
significant transactions with related
the auditor’s reporting
parties. Answer (d) is correct
responsibility for a material
because AU 508 allows such
inconsistency between the audited
emphasis of a matter and states that
financial statements and the other
it does not negate the unqualified
information in an annual report to
opinion. Answer (a) is incorrect be
shareholders containing audited
cause the report is considered
unqualified. Answer (b) is incorrect
correct because AU 550 states that
because such emphasis of a matter
if a material inconsistency exists
does not violate generally accepted
and the client refuses to revise the
auditing standards if this
other information, the auditor
information is disclosed in notes to
should include an explanatory
the financial statements. Answer (c)
paragraph that explains the
is incorrect because the report
inconsistency. The auditor may also
should not include the phrase “with
withhold the use of the audit report
or the auditor may withdraw from the foregoing explanation.”
the engagement. Answer (b) is B.1.j. Departures from GAAP
incorrect because the financial
statements are not misstated. 59. (b) The requirement is to
Answer (c) is incorrect because the identify the appropriate
auditor must review the other types of audit reports when
information to ensure that it is an illegal act with a
consistent with the financial material effect on the
statements. Answer (d) is incorrect financial statements has not
because the financial statements been properly accounted
are not misstated and therefore a for or disclosed. Answer
disclaimer of opinion is (b) is correct because
inappropriate. omission of required
57. (d) The requirement is to disclosures, a departure
from generally accepted
determine an auditor’s
responsibility when accounting principles, leads
audited financial to either a qualified or an
statements are presented adverse opinion. Answer
in a document containing (a) is incorrect because a
other information. An disclaimer of opinion is
swer (d) is correct because not appropriate when the
the auditor is required to auditor knows of such
read the other information misstatements. Answer (c)
to determine that it is is incorrect because
consistent with the neither a disclaimer of
audited financial opinion nor an unqualified
statements. Answers (a) opinion with a separate
and (c) are incorrect explanatory paragraph is
because no such inquiry, appropriate. Answer (d) is
analytical procedures, or incorrect because an
other substantive auditing unqualified opinion with a
procedures are required. separate explanatory
Answer (b) is incorrect paragraph is not
because, unless the appropriate.
information seems
incorrect or inconsistent 60. (c) The requirement is to
with the audited financial identify the phrase that an
statements, no ex auditor would include in
planatory paragraph needs an audit report with a
to be added to the qualified
auditor’s report.
B.1.i. Emphasis of a Matter
financial statements that
opinion because of inadequate purport to present its
disclosure. AU 508 indicates that financial position and
the phrase “except for the omission results of operations but
of the information discussed in the omits the statement of
opinion paragraph” is the proper cash flows. Answer (b) is
phrase. Answers (a), (b), and (d) correct because failure to
are all incorrect because they are include a statement of
phrases not allowed in reports with cash flows will lead the
qualified opinions. auditor to qualify the
opinion.
identify the circumstance 64. (b) The requirement is to
that would most likely identify the circumstance
result in an auditor in which an auditor will
expressing an adverse choose between expressing
opinion. Answer (c) is an “except for” qualified
correct because opinion and an adverse
departures from GAAP, opinion. Answer (b) is
such as inappropriately correct because omissions
reporting leases, result in of required information, a
either a qualified or an departure from generally
adverse opinion. Answer accepted accounting princi
(a) is incorrect because ples, leads to either a
client refusal to provide
qualified or an adverse
access to minutes is a
opinion. Answer (a) is
client imposed scope
incorrect because a scope
limitation that will
limitation such as the
normally result in a
failure to observe a client’s
disclaimer of opinion.
Answer (b) is incorrect physical inventory leads to
because weak internal either a qualified opinion
control will not in general or a disclaimer of opinion.
result in an adverse Answer (c) is incorrect
opinion; if controls are so because an auditor may
weak that an audit cannot issue an unqualified
effectively be completed, opinion on one statement.
a disclaimer of opinion or Answer (d) is incorrect
withdrawal may be because substantial doubt
appropriate. Answer (d) about an entity’s ability to
is incorrect because sub continue as a going
stantial doubt about going concern leads to either an
concern status results in unqualified report with
either an unqualified explanatory language or a
opinion with an disclaimer of opinion.
explanatory paragraph or
a disclaimer of opinion. 65. (b) The requirement is to identify
the situation in which an auditor
62. (d) The requirement is to will ordinarily choose between
identify the paragraphs of expressing a qualified opinion or an
an audit report that are adverse opinion. Answer (b) is
modified when an auditor correct because departures from
qualifies an opinion generally accepted accounting
because of inadequate principles result in either a qualified
disclosure. In addition to opinion or an adverse opinion—
requiring the inclusion of such lack of disclosure is a
a separate explanatory departure from generally accepted
paragraph, AU 508 accounting principles. Answer (a) is
indicates that only the incorrect because the inability to
opinion paragraph should observe the physical inventory and
be modified. inability to become satisfied about
its balance represents a scope
63. (b) The requirement is to limitation that will result in either a
determine the appropriate qualified opinion or a disclaimer of
report modification that opinion. Answer (c) is incorrect
results when the because a change in accounting
management of a publicly principles leads to an unqualified
held company issues opinion with an explanatory
paragraph added to the report. inability to apply
because an auditor’s
necessary procedures represents a emphasis of an unusually
scope limitation that will result in important subsequent
either a qualified opinion or a event results in a report
disclaimer of opinion. See AU 508 with an unqualified
for information on audit reports. opinion with an
B.1.k. Scope Limitations
determine the propriety of
the type of opinion that should be
including a statement that
issued on the financial statements
the current asset portion of
when an auditor has been unable to
an entity’s balance sheet
obtain sufficient evidence relating
was fairly stated in an
to the consistent application of
audit report that disclaims
accounting principles between the
an opinion on the overall
current and prior year. Answer (a) is
correct because the scope
Answer (a) is correct
limitation will affect the year’s
because expressions of
beginning balances and thereby
opinion as to certain
affect the current year’s results of
identified items in
operations and cash flows. Answer
(b) is incorrect because the yearend
(referred to as “piecemeal
balance sheet will be unaffected by
opinions”) should not be
the scope limitation (any retained
expressed when the
earnings misstatement of the
auditor has disclaimed an
preceding year will be offset in the
opinion or has expressed
current year). Answer (c) is incor
an adverse opinion. Such
rect because the auditor need not
opinions tend to
withdraw in such circumstances.
overshadow or contradict
Answer (d) is incorrect because this
the disclaimer or adverse
situation represents a scope
opinion. Answer (b) is
limitation, and not an uncertainty.
incorrect because an
67. (d) The requirement is to auditor may report on one
identify the circumstance basic financial statement.
in which an auditor would Answers (c) and (d) are
not express an unqualified incorrect because pro
opinion. Answer (d) is viding such assurance is
correct because an not appropriate.
inability to obtain the
audited financial
the type of opinion that should be
statements of a
issued on the balance sheet and the
consolidated investee
income statement when an auditor
represents a scope
did not observe a client’s taking of
limitation, and a
the beginning physical inventory
significant scope limita
and was unable to become satisfied
tion results in either a
about its accuracy by using other
qualified opinion or a
auditing procedures. Answer (b) is
disclaimer of opinion.
correct because the scope limitation
Answer (a) is incorrect
will not affect the yearend balance
because a material change
sheet account balances. However,
between periods in
because evidence with respect to the
accounting principles will
beginning inventory is lacking,
result in an explanatory
verification of cost of goods sold, an
paragraph being added to
income statement element, is
a report with an un
impossible. Although yearend
qualified opinion. Answer
retained earnings will not be
(b) is incorrect because
affected, both the current and prior
the omission of the SEC
years’ retained earnings statements
required quarterly
will be affected (by an offsetting
financial data, which is
amount) by the cost of goods sold
considered “unaudited,”
misstatement. If no other problems
results in a report with an
arise, the auditor will be
unqualified opinion with
an explanatory paragraph.
Answer (a) is incorrect
able to issue an unqualified opinion because it suggests that
on the balance sheet and a disclaimer the scope paragraph is
on the income statement (and on the not omitted but that the
retained earnings statement). Answer opinion paragraph is
(a) is incorrect because an omitted. Answer (b) is
unqualified opinion may be issued on incorrect because it states
the balance sheet. Answer (c) is that the opinion
incorrect because an unqualified paragraph is omitted.
opinion may be issued on the balance Answer (c) is incorrect
sheet with a disclaimer on the in because it states that the
come statement. Answer (d) is scope paragraph is not
incorrect because a disclaimer omitted.
should be issued on the income 73. (c) The requirement is to identify the
statement. information included in the opinion
70. (c) The requirement is to paragraph of an auditor’s report that is
determine whether the qualified due to a major inadequacy in
scope paragraph, opinion the computerized accounting records.
paragraph, and/or notes to Answer (c) is correct because the
the financial statements opinion paragraph indicates that the
should refer to an audit exception is due to the possible
scope limitation. Answer effects on the financial statements.
(c) is correct because the Answer (a) is incorrect because the
suggested report opinion paragraph will not include a
presented for a scope reference to clientimposed scope
limitation includes limitations. Answer (b) is incorrect
modification of both the because no indication of a departure
scope and opinion from generally accepted auditing
paragraphs. In addition, it standards is provided in the opinion
is not appropriate for the paragraph and this situation is not a
scope of the audit to be departure from GAAS. Answer (d) is
explained in a note to the incorrect because there is no
financial statements. indication that there is inadequate
disclosure of necessary information.
71. (c) The requirement is to identify a
CPA’s responsibility when asked 74. (d) The requirement is to
to report on only one financial identify the circumstance
statement. Answer (c) is correct in which a scope
because the auditor may accept the limitation is sufficient to
engagement because the situation preclude an unqualified
involves limited reporting opinion. Answer (d) is
objectives, not a limitation on the correct because AU 333
scope of audit procedures. Answers states that management’s
(a), (b), and (d) are incorrect refusal to furnish such a
because the auditor is able to accept written representation
such an engagement and because constitutes a limitation
the auditor is able to apply the on the scope of an audit
procedures considered necessary. sufficient to preclude an
unqualified opinion. An
swers (a), (b), and (c) are
determine whether either
all incorrect because
the scope paragraph, the
while they represent
opinion paragraph, or
scope limitations, they
both should be deleted
may sometimes not
when an auditor is
result in a report that is
disclaiming an opinion
other than unqualified.
due to a clientimposed
scope limitation. Answer B.1.l. Lack of Independence
(d) is correct because the
scope paragraph is 75. (b) The requirement is to
omitted in this situation identify the situation inwhich an
and the opinion auditor may not issue a
paragraph is modified to qualified opinion. An
disclaim an opinion.
the opinion paragraph
should include a direct
swer (b) is correct because the reference to a separate
auditor who lacks independence paragraph disclosing the
must disclaim an opinion, not basis for the opinion.
qualify an opinion. Answer (a) is Answer (a) is incorrect
incorrect because a departure from because the principal ef
GAAP will result in either a fects, if available, should
qualified opinion or an adverse be described in a separate
opinion. Answer (c) is incorrect explanatory paragraph,
because scope limitations result in and not in the opinion
either a qualified opinion or a paragraph. Answer (c) is
disclaimer of opinion. Answer (d) incorrect because while a
is incorrect because a specialist may separate explanatory
be referred to when an auditor is paragraph provides a
issuing a qualified opinion, an description of the
adverse opinion, or a disclaimer of substantive reasons for
opinion. the adverse opinion, the
B.2. Report Preparation opinion paragraph does
not. Answer (d) is
76. (d) The requirement is to identify incorrect because neither
the manner in which an auditor may an uncertainty nor a
express an opinion on an entity’s scope limitation leads to
accounts receivable when that an adverse opinion.
auditor has disclaimed an opinion
on the financial statements taken as 79. (b) The requirement is to
a whole. Answer (d) is correct determine the proper
because such a report is considered placement of an explanatory
a “specified elements, accounts, or paragraph disclosing the
items report,” and should include substantive reasons for
the opinion on the accounts expressing an adverse
receivable separately from the dis opinion. AU 508 requires
claimer of opinion on the financial that such paragraphs
statement. Answer (a) is incorrect precede the opinion
because reason for the disclaimer of paragraph.
opinion need not be provided.
Answer (b) is incorrect because C.1.a. Unaudited Statements
distribution of such a report is not 80. (b) The requirement is to
restricted to internal use only. determine the CPA’s re
Answer (c) is incorrect because the sponsibility when s/he assists in
auditor need not report on the preparing financial statements of
current asset portion of the entity’s a publicly held entity, but has not
balance sheet to issue such a report.
audited or reviewed them. Answer
77. (a) The requirement is to determine (b) is correct because the CPA
the proper addressee of a report in must, at a minimum, read the
a circumstance in which one financial statements for obvious
company has hired a CPA to audit material misstatements. Answer
another company’s financial state (a) is incorrect because no
ments. Answer (a) is correct documentation with respect to
because while audit reports are internal control is necessary.
ordinarily addressed to the company Answer (c) is incorrect because the
whose financial statements are limited scope of procedures being
being audited, when a CPA audits performed does not allow the CPA
the financial statements of a to ascertain
company that is not his or her client
(as is the case here) the report is
addressed to the company that hired
the CPA.
identify the information
that should be included
in the opinion paragraph
of an audit report with an
adverse opinion. Answer
(b) is correct because
accounting principles. Answer (b)
whether the financial statements are is incorrect because no updated
in conformity with generally opinion is being issued. Answer (c)
accepted accounting principles. is incorrect because condensed
Answer (d) is incorrect because statements or pro forma financial
omitting all required disclosures is information are not being
not expected for a publicly held considered in this question. An
entity in these circumstances. swer (d) is incorrect because the
statements may or may not be
presented in conformity with
identify the appropriateform of generally accepted accounting
report to issue when the CPA is principles.
associated with the financial
statements of a publicly held entity 84. (a) The requirement is to
but has not audited or reviewed identify the correct state
such statements. Answer (d) is ment with respect to an
correct because the standards independent accountant’s
require the CPA to disclaim an review report on interim
opinion on the financial statements financial information
when the accountant has not audited presented in a registration
or reviewed such statements. statement. Answer (a) is
Answer (a) is incorrect because correct because an
Regulation SX exemption is not a accountant’s review
form of audit report. Answer (b) is report is not a part of the
incorrect because pro forma registration statement
information is not involved. within the meaning of
Answer (c) is incorrect because Section 11 of the
there is no such report as an Securities Act of 1933.
unaudited association report. Answer (b) is incorrect
because under certain
82. (d) The requirement is to conditions an accountant
identify a CPA’s responsibility is required to update the
when his/her name is to be report. Answers (c) and
included in the interim report of a (d) are incorrect because
publicly held entity and the CPA the prospectus includes
has not audited or reviewed the neither a statement that
interim financial statements. the review was performed
Answer (d) is correct because when in accordance with SEC
an accountant is aware that his/her standards, nor a statement
name is to be included in a client that the accountant
prepared written communication obtained corroborating
of a public entity containing evidence.
financial statements that have not
been audited or reviewed, he/she 85. (d) The requirement is to
should request (1) that his/her determine the circum
name not be included in the stances which will lead to
communication or (2) that the a modification of an
statements be marked as unaudited interim report. Departures
and note that there is no opinion from generally accepted
expressed on them. accounting principles,
which include adequate
C.1.c. Reviewed Interim disclosure, require
(Quarterly) Statements modification of the
accountant’s report.
Normally neither an
the objective of a review of interim uncertainty [answer (a)]
financial information. Answer (a) is nor a lack of consistency
correct because AU 722 states that [answer (b)] would cause
the objective of a review of interim a report modification.
financial information is to provide a Reference to another
basis for reporting on whether accountant [answer (c)] is
material modification should be not considered a
made for such information to modification.
conform with generally accepted
review is less in scope
than an audit, not than a
86. (b) The requirement is to identify compilation.
the procedure that would ordinarily
be applied when an accountant C.1.d. Condensed Financial
conducts a review of the interim Statements
financial information of a publicly
held entity. Answer (b) is correct
the circumstance under which an
because the accountant will
auditor may report on condensed
ordinarily read the minutes of
financial statements that are derived
meetings of stockholders, the board
from complete audited financial
of directors, and committees of the
statements. Answer (c) is correct
board of directors to identify actions
because a report may be issued
that may affect the interim financial
when the information in the
information. AU 722 describes the
condensed financial statements is
nature of procedures for conducting
fairly stated in all material respects
a review of interim financial
in relation to the financial
information. Answers (a), (c), and
statements. Answer (a) is incorrect
(d) are all incorrect because they
because the condensed financial
represent verification procedures
statements need not be distributed
typically beyond the scope of a re
with the complete financial
view of interim financial
statements. Answer (b) is incorrect
information.
because the report need not indicate
87. (c) The requirement is to the nature of any additional
identify the least likely procedures. Answer (d) is incorrect
procedure to be included because prior year condensed
in an accountant’s review financial information is not
of interim financial necessary. See AU 552 for
information of an issuer information on condensed financial
(public) entity. Answer statements.
(c) is correct because a 90. (a) The requirement is to determine
review consists the appropriate response relating to
principally of performing selected financial data that are
analytical procedures and included in a client’s prepared
making inquiries, not document containing audited
procedures such as financial statements. Answer (a) is
observation, inspection, correct because the selected data
and confirmation. should be limited to data derived
Answers (a), (b), and (d) from the audited financial
are all incorrect because statements. Answer (b) is incorrect
they include review because distribution of the report
procedures, as presented need not be limited to senior
in AU 722. management and the board of
directors. Answer (c) is incorrect
because the selected data need not
identify the most likely
follow a comprehensive basis of ac
information included in a
counting other than GAAP. Answer
review report. Answer
(d) is incorrect because the report
(c) is correct because
will ordinarily state that the selected
AU 722 requires that the
data are fairly stated in all material
report include a de
respects in relation to the
scription of procedures
consolidated financial statements.
performed. Answer (a) is
incorrect because the
information was
reviewed, not examined,
in accordance with
standards of the PCAOB.
Answer (b) is incorrect
because the interim
financial information is
the responsibility of the
entity’s management, not
the shareholders. Answer
(d) is incorrect because a
because the financial statements
C.1.e. Financial Statements need not be prepared in conformity
Prepared for Use in with GAAP, as other bases of
Other Countries accounting may be followed.
91. (a) The requirement is to report need not be made available
identify audit reporting for distribution to other employees.
requirements when Answer (d) is incorrect because the
reporting on financial individual in the profit participation
statements of a US entity plan need not own a controlling
prepared in accordance interest in the company.
with another country’s ac
counting principles. 94. (d) The requirement is to
Answer (a) is correct determine the information
because AU 534 states that should be included in
that the auditor should an audit report on
understand the accounting financial statements
principles generally prepared on the income
accepted in the other tax basis of accounting.
country. Answer (b) is AU
incorrect because the 623 presents the form of the
auditor does not have to report to be issued.
obtain certification outside Answer (d) is correct
of the United States. because AU 623 requires
Answer (c) is incorrect that the report indicate
because the auditor does that the income tax basis
of accounting is a
not have to disclaim an
comprehensive basis of
opinion. Answer (d) is
accounting other than
incorrect because the
GAAP.
auditor does not have to
receive a waiver from the 95. (d) The requirement is to
auditor’s State Board of identify the appropriate
Accountancy. type of audit report to be
issued for a nonprofit
entity’s financial
determine the appropriate
statements prepared
types of reports that may
be issued when the following an accounting
financial statements of a basis prescribed by a
US subsidiary are regulatory agency solely for
prepared following the filing with that agency.
principles of a nonUS Answer (d) is correct
parent company’s country because audit reports for
for inclusion in that parent such financial statements
company’s nonUS are considered special
consolidated financial reports. Answer (a) is
statements. AU 534 incorrect because an
allows either a modified unqualified report may be
US style report or the issued if there are no
report form of the parent’s departures from the
country. A US style prescribed basis. The report
unmodified report is not would not be qualified
appropriate. because the financial
statements were prepared
C.2.a. Special Reports using an accounting basis
93. (a) The requirement is to identify a prescribed by a regulatory
requirement for a CPA to express an agency. Answer (b) is
opinion on a profit participation incorrect because the
plan relating to an entity’s net report issued has five
income. Answer (a) is correct paragraphs. Answer (c) is
because if a specified element is, or incorrect because a
is based upon, an entity’s net disclaimer of opinion need
income or stockholders’ equity, the not be issued.
CPA should have audited the
complete financial statements in
order to express an opinion on the disclosure included in a separate
element. Answer (b) is incorrect explanatory paragraph of an auditor’s
special report on financial statements prepared in conformity
insurance commission is
necessary. Answer (c) is
with the cash basis of accounting. incorrect because a
Answer (c) is correct because the disclaimer of opinion is
explanatory paragraph refers to the not appropriate when
note to the financial statements that known misstatements
describes the basis of accounting. exist. Answer (d) is
AU 623 presents complete details incorrect because, as
on such special reports. Answer (a) indicated, more than
is incorrect because the report need describing the
not justify the reasons for terminology is necessary.
following a basis other than
generally accepted accounting 99. (a) The requirement is to
principles. Answer (b) is incorrect determine whether a CPA
because the explanatory paragraph is permitted to accept an
contains no statement on fair engagement to audit either
presentation, and because the a schedule of accounts
opinion paragraph states whether receivable, a schedule of
the presentation is in conformity royalties, or both.
with the basis described in the Answer (a) is correct because
appropriate financial statement auditors may audit “specified
note. Answer (d) is incorrect elements, accounts or items of a
because no explanation of how the financial statement,” including
results of operations differ from either a schedule of accounts
financial statements prepared in receivable or a schedule of
conformity with generally accepted royalties. Answer (b) is incorrect
accounting principles is necessary. because an auditor may audit a
schedule of royalties. Answer (c) is
incorrect because an auditor may
identify the example of a audit a schedule of accounts
“special report.” AU 623 receivable. Answer (d) is incorrect
defines reports on because an auditor may audit both
compliance with aspects a schedule of accounts receivable
of regulatory and a schedule of royalties.
requirements related to
audited financial 100. (b) The requirement is to identify an
statements as special auditor’s reporting responsibility
reports. [The other types when a printed form prescribes the
of special reports include wording of the independent
(1) other comprehensive auditor’s report that will accom
basis financial pany it, but that wording is not
statements, (2) specified acceptable to the auditor. AU 623
elements, (3) financial suggests that the auditor reword the
presentations to comply report (or attach a separate report)
with contracts, and (4) when involved with this type of
financial information “special report.”
presented in prescribed
forms.] C.2.b. Letters for Underwriters
98. (a) The requirement is to 101. (a) The requirement is to

determine the type of re determine a predecessorauditor’s
port to issue when a client responsibility when the financial
who uses a comprehensive statements he or she audited are
basis of accounting has being included in an SEC
not appropriately titled its registration statement filing.
financial statements. Answer (a) is correct because AU
Answer (a) is correct 711 requires that the predecessor
because any such (1) read pertinent portions of the
exceptions or reservation docu
should be described in an
explanatory paragraph and
possibly a qualified (or
adverse) opinion should
be issued. Answer (b) is
incorrect because no such
application to the state
will be included on the pro
ment, and (2) obtain a letter of spective financial statements.
representation from the successor
auditor. 106. (d) The requirement is to
102. (b) The requirement is to identify reference to an
the statement that is correct independent accountant
concerning letters for underwriters. in a prospectus (relating
Answer (b) is correct because letters to an SEC registration
for underwriters typically provide statement) that includes a
negative assurance on unaudited statement about his/her
interim financial information. involvement with an
Answer (a) is incorrect because independent audit report.
letters for underwriters are not AU 711 indicates that the
required by the Securities Act of independent accountant
1933. Answer (c) is incorrect is an expert in auditing
because letters for underwriters are and accounting.
not included in registrations
statements. Answer (d) is incorrect 107. (d) The requirement is to identify
because auditors’ opinions on the the information included in a typical
prior year’s financial statement are comfort letter. Answer (d) is correct
not updated. because in a comfort letter auditors
provide an opinion as to whether
103. (a) The requirement is to the audited financial statements
determine who ordinarily comply in form with the accounting
signs a comfort letter. requirements of the SEC. Answer
Answer (a) is correct (a) is incorrect because negative
because a comfort letter assurance concerning whether the
(also known as letter to an entity’s internal control procedures
underwriter) is sent by the operated as designed during the
independent auditor to the period is not provided. Answer (b)
underwriter. is incorrect because a comfort letter
does not include an opinion on
104. (d) The requirement is to whether the entity complied with
identify to whom comfort Government Auditing Standards
letters are ordinarily and the Single Audit Act. Answer
addressed. Answer (d) is (c) is incorrect because negative,
correct because comfort not positive, assurance is provided
letters, also referred to as on unaudited condensed financial
letters for underwriters, information.
are ordinarily addressed
to underwriters. 108. (a) The requirement is to
determine the proper treat
ment of unaudited
the type of opinion or assurance financial statements
provided by an accountant who issues presented in comparative
a form with audited
comfort letter containing financial statements in a
comments on data that have not document filed with the
been audited. Answer (a) is correct Securities and Exchange
because when procedures short of Commission. Answer (a)
an audit are applied to information is correct because those
such as capsule information, a statements should be
comfort letter will generally marked “unaudited,” not
provide negative assurance. withheld until they are
Answer (b) is incorrect because audited, and not referred
CPAs do not provide positive to in the auditor’s report.
assurance on supplementary
disclosures. Answer (c) is 109. (b) The requirement is to
incorrect because no “limited identify the requirement
opinion” is issued on pro forma or relating to a CPA’s report
other information. Answer (d) is when reporting on the
incorrect because no disclaimer application
action. Answer (b) is incorrect
because the engagement’s findings
of accounting principles to a need not be reported to all of the
specific transaction. Answer (b) is groups listed—the entity’s audit
correct because AU 625 requires committee, the continuing CPA, and
that the report include a statement management. Answer (c) is incorrect
that responsibility for the proper because the accountant need not
accounting treatment rests with the disclaim an opinion. Answer (d) is
preparers of the financial incorrect because the report’s
statements. Answer (a) is incorrect distribution need not be restricted to
because the report states that the management and outside parties who
engagement was performed in are aware of all relevant facts.
accordance with applicable AICPA
standards, not Statements on 112. (b) Answer (b) is correct because
Standards for Accounting and AU 625 indicates that an accountant
Review Services. Answer (c) is should not undertake such an
incorrect as no such statement about engagement when the report would
opinionshopping is included. An be based on such a hypothetical
swer (d) is incorrect because the transaction. Answers (a), (c), and
information may be communicated (d) are all incorrect because they
to a prior or continuing auditor. include information included in an
accountant’s report on the
C.2.c. Application of Accounting
application of accounting principles.
Principles
C.3.a. Attestation Engagements
110. (a) The requirement is to determine —General
an auditor’s reporting responsibility
when asked by a prospective client 113. (c) The requirement is to select
to render an opinion on the the service that ismost likely to be
application of accounting princi structured as an attest engagement.
ples to a specific transaction. Answer (c) is correct because
Answer (a) is correct because AU CPAs may provide assurance as to
625 indicates that the report must compliance with requirements of
include a statement that any specified laws through a variety of
difference in the facts, services, including agreedupon
circumstances, or assumptions procedures engagements and
presented may change the report, as various compliance audits. Answers
well as various other disclosures. (a)
Answer (b) is incorrect because the and (b) are incorrect because
report indicates that the engagement advocating a client’s tax position
was performed in accordance with and consulting on a new database
AICPA standards, not Statements system are examples of
on Standards for Consulting professional services not typically
Services. Answer (c) is incorrect structured as attest services.
because the report need not indicate Answer (d) is incorrect because
that the guidance is for management compilations are not a form of
use only and may not be attest engagement.
communicated to the prior or con
tinuing auditors. Answer (d) is
incorrect because the report does
not include negative assurance
(“nothing came to our attention”).
See AU 625 for performance and
reporting standards relating to
reports on the application of
an auditor’s responsibility when
asked to render an opinion on the
application of accounting principles
to a specific transaction by an entity
that is audited by another CPA.
accountant must consult with the
continuing CPA to attempt to obtain
information relevant to the trans
because it states that the
114. (c) Answer (c) is correct conclusion may not be
because AT 101 upon the subject matter
indicatesthat an and may be upon the
unqualified may written assertion. Answer
ordinarily refer to that (d) is incorrect because it
assertion or to the states that the conclusion
subject matter to which may not be upon the
the assertion relates. subject matter.
Answer
(a) is incorrect because it suggests
reporting only on the assertion.
determine the element that
Answer (b) is incorrect because it
is least likely to be
suggests reporting only on the subject present when a
practitioner performs an
matter. Answer (d) is incorrect
attest engagement.
because it suggests that reporting on
neither the assertion nor the subject
because while an assertion
matter is appropriate. Note, however,
is generally present, it is
that AT
not ordinarily required.
101 also states that when a Answers (b), (c), and (d)
deviation from the are all incorrect because
criteria being reported practitioner
upon exits (e.g., a independence, subject
material weakness in
matter, and suitable
internal control” the
criteria are all required.
CPA should report
directly upon the subject 118. (a) The requirement is to determine
matter and not upon the whether suitable criteria in an
assertion. attestation engagement may be
115. (a) The requirement is to available publicly, and/or in the
identify the correct state CPA’s report. Answer (a) is correct
ment. When a standard because suitable criteria may be
unqualified examination available publicly in the CPA’s
report is being issued, report, included with the subject
that report may be upon matter or in the assertion, well
the subject matter or the understood by users (e.g., the
written assertion. distance between A and B is twenty
Answers (b), (c), and (d) feet) or available only to specified
are all incorrect because parties. Answers (b), (c), and (d) are
they suggest that the all incorrect because they suggest
report may not be upon that suitable criteria may not be
either the subject matter, available publicly, in the CPA’s
the written assertion, or report, or both.
both. 119. (d) The requirement is to
116. (b) The requirement is to identify the situation that
determine whether a is least likely to result in
CPA’s conclusion may be a restricted use attest
upon the subject matter, report. Answer (d) is
the written assertion, or correct because criteria
both when conditions developed by an industry
exist that result in a association may or may
material deviation from not result in a restricted
the criteria against which use attest report. Answers
the subject matter was (a), (b), and (c) always
evaluated during an result in a restricted use
examination. Answer (b) report.
is correct because in such 120. (c) The requirement is to
circumstances the identify the information
conclusion should be that is least likely to be
directly upon the subject
included in an agreed
matter. Answer (a) is
upon procedures
incorrect because it
attestation report.
suggests that the
Answer (c) is correct
conclusion may be upon
because an agreedupon
the written assertion.
procedures report
provides a summary of
procedures performed specified party does not
and findings, not limited take responsibility for the
assurance. Answer (a) is sufficiency of
incorrect because the procedures. An
statements. An
swer (b) is incorrect because the
swer (b) is incorrect because the report includes no such statement
report’s use is restricted. Answer attempting to distinguish between
(d) is incorrect because a an examination and an audit.
summary of procedures Answer (c) is incorrect because the
performed is included. report includes no such disclosure
121. (a) The requirement is to and because the accountant is not
identify the type of reportthat is responsible for events and
most likely to include a summary circumstances up to one yearafter
of findings rather than assurance. the report’s date. Answer (d) is
Answer (a) is correct because incorrect because the report
agreedupon procedures reports suggests that the assumptions do
include a summary of findings. An provide a reasonable basis.
swer (b) is incorrect because a 124. (a) The requirement is to
compilation report does not provide identify the circumstancein
a summary of findings. Answer (c) which an accountant may
is incorrect because an accept an engagement to
examination report includes apply agreedupon
positive assurance and not a procedures to prospective
summary of findings. Answer (d) is financial statements.
incorrect because a review report Answer (a) is correct
includes limited (negative)
because AT 301 states that
assurance, not a summary of
an accountant may accept
findings.
an engagement to apply
C.3.b. AgreedUpon Procedures agreedupon procedures to
Engagements prospective financial
statements provided that (1)
122. (c) The requirement is to the specified parties
identify the statement thatis not involved have participated
correct concerning “specified in establishing the nature
parties” of an agreedupon and scope of the
procedures report under either the engagement and take
auditing or attestation standards. responsibility for the
Answer (c) is correct because while adequacy of the procedures
a practitioner should establish a to be performed,
clear understanding regarding the (2) use of the report is to be
terms of the engagement, preferably restricted to specified parties
in an engagement letter, no such involved, and (3) the prospective
engagement letter is required. financial statements include a
Answers (a) and (b) are incorrect summary of significant
because the specified parties must assumptions. Answer (b) is
agree on the procedures to be incorrect because the prospective
performed and take responsibility financial statements need not be
for their adequacy. Answer (d) is examined. Answer (c) is incorrect
incorrect because an additional because responsibility for the
party may be added as a specified adequacy of the procedures is taken
party after completion of the by the specified parties. Answer (d)
engagement. is incorrect because a summary of
findings may be provided based on
C.3.c. Financial Forecasts and the agreedupon procedures.
Projections
the information to be included in a
separate paragraph included in an
accountant’s report on the
examination of projected financial
statements. Answer (a) is correct
because AT 301 requires that such a
report include a separate paragraph
that describes the limitations on the
usefulness of the presentation. See
AT 301 for information that should
be included in an examination
report of prospective financial
financial projection, or
125. (c) The requirement is to both are engagements
identify the statement governed by the
which should be provisions of the
included in an Statement on Standards
accountant’s for Attestation Statements.
compilation report on Answer (c) is correct
financial forecasts. because the attestation
Answer (c) is correct standards explicitly
because when the exclude expert witness
accountant is preparing a work, but include the
standard compilation compilation of a financial
report on prospective projection; note that in
financial statements, AT most areas compilations
301 requires that the are not included in
accountant include a attestation standard
statement indicating that coverage, but in the area
the prospective results of prospective financial
may not be achieved. statement (forecasts as
well as projections)
126. (c) The requirement is to coverage is included.
identify the appropriate Answer (a) is incorrect
distribution of an entity’s because it states that
financial projection. A expert witness work is in
financial projection is cluded. Answer (b) is
sometimes prepared to incorrect both because it
present one or more states that expert witness
hypothetical courses of work is included and that
action for evaluation in compiling a projection is
response to a question not included. Answer (d)
such as “What would is incorrect because it
happen if...?” It is based states that compilations of
on a responsible party’s projections are not
assumptions reflecting included.
conditions it expects
would exist and the 128. (a) The requirement is to
course of action it expects identify the statement that
would be taken, given one should be included in a
or more hypothetical compilation report on a
assumptions. Projections financial forecast.
are “limited use” financial Answer (a) is correct
statements meant for the because the report should
responsible party state that the compilation
(generally management) does not include
and third parties with evaluation of the support
whom the responsible of the assumptions
party is negotiating underlying the forecast.
directly. Answer (c) is Answer (b) is incorrect
correct because a bank because no such
might be expected to statement is included in a
receive such a projection. compilation report, and
Answers (a), (b), and (d) because hypothetical
are all incorrect because assumptions pertain to
projections are meant for financial projections, not
“limited use” and not to financial forecasts.
be broadly distributed to Answer (c) is incorrect
groups such as all em because the report makes
ployees or potential or no statement concerning
current stockholders. AT the range of assumptions.
301 provides overall Answer (d) is incorrect
guidance on the area of because the statement is
financial forecasts and not included in the report,
projections. and because the
prospective statements
127. (c) The requirement is to are management’s, not
determine whether either the accountant’s,
testifying as an expert representation.
witness, compiling a
129. (d) The requirement is to identify for general use. Answer (a) is
the type of general use prospective incorrect because financial
financial statement on which the projections are only appropriate for
accountant may appropriately the party responsible for preparing
report. Answer (d) is correct them or for third parties with whom
because financial forecasts are the responsible party is negotiating
considered prospective financial directly. Answers (b) and (c) are
statements, and they are appropriate incorrect because
procedures is taken by the specified
parties, not by the accountant.
partial presentations and pro Answer (c) is incorrect because
forma financial statements are not when the accountant reports on the
considered prospective financial results of applying agreedupon
statements. procedures he or she should not
express any form of negative
assurance on the prospective
identify the type of pro financial statements taken as a
spective financial whole.
statement that includes
one or more hypothetical 132. (d) The requirement is to determine
(“what if?”) assumptions. the appropriate type of audit report
Answer (b) is correct to be issued when an accountant
because financial examines a financial forecast that
projections include one or fails to disclose several significant
more hypothetical assumptions used to prepare the
assumptions. Answer (a) forecast. AT 301 states that an
is incorrect because pro adverse opinion is appropriate when
forma financial significant assumptions are not
presentations are designed disclosed.
to demonstrate the effect
of a future or hypothetical C.3.d. Pro Forma Financial
transaction by showing Information
how it might have
affected the historical 133. (d) The requirement is to
financial statements if it determine the statementthat should
had been consummated be included in an accountant’s
during the period covered report on a review of pro forma
by those statements. financial information. Answer (d) is
Answer (c) is incorrect correct because the report must
because partial presen include a reference to the financial
tations are presentations statements from which the historical
that do not meet the financial information is derived and
minimum presentation a statement as to whether such
guidelines of AT 301. financial statements were audited
Answer (d) is incorrect or reviewed.
because financial C.3.e. Management Discussion
forecasts present, to the
and Analysis
best of the responsible
party’s knowledge and 134. (b) The requirement is to
belief, an entity’s determine the reply that is
expected financial not an objective of a
position, results of CPA’s examination of a
operations, and changes in client’sMD&A. Answer
financial information. (b) is correct because an
131. (d) The requirement is to determine examination of a client’s
an accountant’s responsibility when MD&A does not directly
he or she accepts an engagement to address overall
apply agreedupon procedures to conformity with such
prospective financial statements. rules and regulations.
Answer (d) is correct because Answers (a), (c), and (d)
distribution of such a report is to be are the three objectives of
restricted to the specified parties an MD&A examination
involved. AT 301 also requires that agreement.
the specified parties participate in 135. (c) The requirement is to
establishing and taking identify an assertion em
responsibility for the adequacy of bodied in MD&A. Answer
the procedures, and that the (c) is correct because the
prospective financial statements
attestation standards on
include a summary of significant
MD&A indicate that
assumptions. Answer (a) is incorrect
consistency with
because the prospective financial
statements need not be examined.
Answer (b) is incorrect because re
sponsibility for the adequacy of the
www.aicpa.org. Answers
the financial statements is an (a) and (c) are incorrect
assertion—in addition, occurrence, because such standards do
completeness, and presentation and not exist. Answer (d) is
disclosure are embodied assertions. incorrect because
Answers (a), (b), and (d) are all Statements on Auditing
incorrect because valuation, Standards do not address
reliability, and rights and obligations Trust Services
are not considered to be assertions engagements.
embodied in the MD&A.
136. (b) Answer (b) is correct what the WebTrust seal of
because the MD&A review of an assurance relates most directly to.
issuer (public) entity should be Answer (d) is correct because the
restricted to the use of specified WebTrust seal is designed to
parties. Answer (a) is incorrect provide assurance on Web site
because a review consists security, availability, processing in
principally of applying analytical tegrity, online privacy and
procedures, rather than also confidentiality. Answers (a), (b),
including search and verification and (c) are all incorrect since
procedures. Answer (c) is incorrect WebTrust isn’t specially aimed at
because a consideration of relevant financial statements, health care
portion of internal control is facilities, or risk assurance
necessary to identify types of procedures.
potential misstatements and to 140. (b) The requirement is to
select the inquiries and analytical
determine the type of
procedures. Answer (d) is incorrect
opinion or assurance most
because a review report ordinarily
likely to be included in a
provides negative assurance, not a
CPA’s report relating to
summary of findings.
WebTrust engagements.
C.3.f. Trust Services Answer (b) is correct
because the WebTrust
137. (d) The requirement is to examination report
identify the proper term provides an opinion on
for an attest engagement whether the site meets the
in which a CPA assesses a Trust Services criteria
client’s commercial for one or more of the
Internet site for predefined Trust Services Principles.
criteria such as those over Answer (a) is incorrect
online privacy. Answer because no opinion on
(d) is correct because the being “hackproof” is
AICPA’s Trust Services issued. Answer (c) is
Principles relate to this incorrect because
area, and WebTrust is the negative assurance is not
most likely product—see provided. Answer (d) is
www.aicpa.org. Answers incorrect because an
(a), (b), and (c) all agreedupon procedures
represent names of engagement, not an
products not included in examination engagement
the professional standards. results in a summary of
findings.
identify the standards un 141. (b) The requirement is to
der which Trust Services identify the type of en
engagements are gagement that considers
performed. Answer (b) is security, availability,
correct because the processing integrity,
Statements on Standards online privacy and/or
for Attestation confidentiality over any
engagements address such type of defined electronic
engagements. More system. Answer (b) is
information on Trust correct because SysTrust
Services engagements engagements consider any
(WebTrust and SysTrust) type of defined electronic
is available on the system. Answer (a) is
AICPA’s Web site— incorrect because an en
of the procedures. See AT 201 for
guidance on agreedupon
gagement to consider internal procedures engagements.
control over financial reporting
does not directly address these 145. (a) The requirement is to
attributes. Answer (c) is incorrect identify the statement that
because there is no such is included in a CPA’s
engagement as a Web site report on agreedupon
Associate. Answer (d) is incorrect procedures on
because WebTrust deals more management’s assertion
directly with company Web sites. about an entity’s
compliance with
142. (b) The requirement is to specified requirements.
identify the most likelyreport when Answer (a) is correct
a client refuses to provide a written because such an agreed
assertion in a Trust Services upon procedures report
engagement. Answer (b) is correct includes a statement of
because this represents a scope limitations on the use of
limitation, and client imposed scope the report because it is
limitations are most likely to result intended solely for the
in a disclaimer of opinion. Answer use of specified parties.
(a) is incorrect because an adverse See AT 601 for in
opinion is appropriate when a CPA formation that should be
believes that the information is so included in such an
misstated as to be misleading. agreedupon procedures
Answer (c) is incorrect because report. Answer (b) is
client imposed scope limitations incorrect because no
generally result in disclaimers, not “opinion” is included.
qualified opinions. Answer (d) is Answer (c) is incorrect
incorrect because an unqualified because a summary of
opinion is most likely not findings, not negative
appropriate in such a circumstance. assurance is provided.
D.1.a. Compliance Attestation Answer (d) is incorrect
because the CPA makes
Engagements—Agreed
no representation
Upon Procedures regarding the sufficiency
Engagements of procedures.
143. (c) The requirement is to D.1.b. Compliance Attestation
identify the type of asso Engagements—
ciation not permitted Examination
under the compliance Engagements
attestation standards. AT
601 does not allow the 146. (c) The requirement is to
CPA to perform a review identify the correct statement
over compliance. concerning an examination report
when management has properly
disclosed an instance of material
the information provided in an noncompliance. AT 601 states
agreedupon procedures report on that the opinion should be
compliance with contractual qualified or adverse. Note that AT
requirements to pay royalties. 601 requires the CPA’s report to
Answer (b) is correct because relate directly to the subject
agreedupon procedures reports matter when the opinion is
include a list of the procedures modified.
performed (or reference thereto) and
findings. Answer (a) is incorrect
because no such disclaimer of
opinion is provided in an agreed
upon procedures report. Answer (c)
is incorrect because no opinion is
included in an agreedupon
procedures report. Answer (d) is
incorrect because an agreedupon
procedures report includes a
statement disclaiming an opinion on
the sufficiency of procedures, not an
acknowledgement of the sufficiency
“Yellow Book” suggests
D.2.a. Compliance Auditing of that in addition to
Federal Financial Assis financial statements, such
tance Programs— an audit may include
consideration of
GAAS Audits
(1) program results, (2)
147. (b) The requirement is to determine compliance with laws and
an auditor’s responsibility when regulations, and (3) economy
auditing a notforprofit entity that re and efficiency.
ceives governmental financial 150. (b) The requirement is to identify
assistance. Answer (b) is correct whether an auditor performing an
because AU 801 requires that the audit in accordance with
auditor assess whether management Government Auditing Standards
has identified laws and regulations (the “Yellow Book”) is required to
that have a direct and material effect report on noteworthy
on the entity’s financial statements; accomplishments of the program,
AU 801 also presents procedures to the scope of the auditor’s testing of
be followed in assessing such laws internal controls, or both. Answer
and regulations. Answer (a) is incor (b) is correct because the “yellow
rect because such a separate report book” requires reporting only upon
describing expected benefits and costs the scope of the auditor’s testing of
does not need to be issued. Answer internal controls. Answers (a), (c),
and (d) all include an incorrect
(c) is incorrect because the CPA will
combination of reporting replies.
not notify the governmental agency
that the audit is not designed to 151. (b) The requirement is to
provide assurance. Answer (d) is identify whether an auditor
incorrect because the CPA does not performing an audit in
express an opinion on the entity’s accordance with
continued eligibility for governmen Government Auditing
tal financial assistance. AU 801 Standards (the “Yellow
presents requirements relating to Book”) is required to report
compliance auditing for governmental on recommendations for
entities and recipients of actions to improve
governmental financial assistance. operations, the scope of
tests of compliance with
148. (c) The requirement is to laws and regulations, or
determine the focus of an both. Answer (b) is correct
auditor’s attention in because the “yellow book”
detecting misstatements requires reporting upon the
resulting from violations of scope of the auditor’s tests
laws and regulations when of compliance with laws
auditing a notforprofit and regulations. Answers
organization that receives (a), (c), and
financial assistance from (d) all include an incorrect
governmental agencies. combination of reporting replies.
Answer (c) is correct
because the focus of such D.2.b. Compliance Auditing of
procedures should be on Federal Financial Assis
violations that have a direct tance Programs—
and material effect on the GAGAS Audits
amounts in the organiza
tion’s financial statements 152. (a) The requirement is to
(AU 801). Answers (a), (b), identify the correct statement with
and (d) all represent a focus that respect to a financial statement audit
is not as accurate as that conducted in accordance with
provided in answer (c). Government Auditing Standards (the
“Yellow Book”). Answer (a) is
149. (b) The requirement is to correct because the auditor issuesa
determine the proper report on compliance with laws and
scope of a governmental internal control, and a report on the
audit. The General financial information. Answer (b) is
Accounting Office’s incorrect
general.
Answers (a),
because a financial statement audit (b), and
does not address economy and (c) all provide inaccurate
efficiency in the manner suggested. descriptions of auditor
Answer (c) is incorrect because reporting responsibility.
recommendations for actions to See Government
correct problems and improve Auditing Standards (the
operations are not ordinarily in “Yellow Book”) for
cluded. Answer (d) is incorrect information on reporting
because a financial statement audit under Government
does not address whether programs Auditing Standards.
are achieving the desired results.
155. (a) The requirement is to identify a
153. (a) The requirement is to identify common aspect of various types of
the correct statement with respect audits of recipients of federal
to a financial statement audit financial assistance in accordance
conducted in accordance with with federal audit regulations. An
Government Auditing Standards swer (a) is correct because audits of
(the “Yellow Book”). Answer (a) is recipients of federal financial
correct because the auditor issuesa assistance include reports on (1) the
report on compliance with laws and financial statements, and (2) a
internal control, and a report on the separate or combined report on
financial information. Answer (b) is internal control and on compliance
incorrect because not all instances with laws and regulations. Answer
of abuse, waste and mismanage (b) is incorrect because materiality
ment are so reported. Answer (c) is levels are not ordinarily lower or
incorrect because the views of
always determined by the
officials are not reported. Answer
governmental entity. Answer (c) is
(d) is incorrect because internal
incorrect because the auditor need
control activities designed to detect
not obtain such written management
or prevent fraud are not reported to
the inspector general. representations. An
swer (d) is incorrect because
154. (d) The requirements for reporting illegal
requirement is acts may vary depending upon the
to identify the type of audit being performed. AU
circumstance in 801 provides requirements related
which an to auditing entities that have
auditor is received governmental financial
required to assistance. In addition, guidance is
report a provided by Government Auditing
falsification of Standards (GAS), also referred to
accounting as the “YellowBook,” published by
records directly the Comptroller General of the
to a federal UnitedStates.
inspector
general. Answer 156. (b) The requirement is to identify to
(d) is correct whom an auditor most likely would
because under be responsible for communicating
Government significant deficiencies in the design
Auditing of internal control. Answer (b) is
Standards a correct because in audits under
falsification of Government Auditing Standards,
accounting significant deficiencies in the design
records must of internal control are
ordinarily be communicated to legislative and
communicated regulatory bodies (AU 801).
by the auditor Answer (a) is incorrect because the
to the auditee Securities and Exchange
and, if the Commission does not ordinarily
auditee fails to receive information on such
make deficiencies. Answer (c) is incorrect
appropriate because while a courtappointed
disclosure, by creditors’ committee might in some
the auditor to a circumstances receive information
federal on such deficiencies, this practice is
inspector not as frequent as is done under
Government Auditing Standards.
Answer (d) is incor rect because shareholders do not
normally receive reports on
significant deficiencies or material
weaknesses (see AU 325).
the opinion which an auditor should
express in a report on compliance
when s/he has detected material
instances of noncompliance within
the program. AU 801 defines these
instances of material
noncompliance as failures to follow
requirements, or violations of
regulations or grants which cause
the auditor to conclude that the total
of the misstatements resulting from
these failures or violations is
material to the financial statements.
Therefore, answer (c) is correct
because the auditor should issue a
qualified or an adverse opinion.
auditor is required under
Governmental Auditing Standards
to provide reasonable assurance on
the entity’s compliance with the
applicable laws and regulations.
auditor must disclose the instances
of noncompliance. Answer (d) is
incorrect because the auditor
should not disclaim an opinion as a
result of noncompliance.
determine a documenta
tion requirement that an
auditor should follow
when auditing in
accordance with (also
referred to as the
“YellowBook”). Answer
(b) is correct because
Government Auditing
Standards require
documentation of
supervisory review
before the report is
issued.
identify the statement that
should be included in an
auditor’s report on an
entity’s compliance with
laws and regulations
when performing an audit
in accordance with
Government Auditing
Standards. Answer (a) is
correct because such
compliance reports re
quire a statement that
management is
responsible for com
pliance with laws,
regulations, contracts, Answer (d) is incorrect
and grants. See AU 801 because the expected
for this requirement and duration of the scheme is
others. not what leads to reporting
to a federal inspector
160. (b) The requirement is to general.
determine when an
auditor reporting under D.2.c. Compliance Auditing of
would most likely be Federal Financial Assis
required to communicate tance Programs—Single
management’s Audit Act
misappropriation of assets
directly to a federal 161. (b) The requirement is to
inspector general. Answer identify the auditor’s
(b) is correct because proper measure of
Government Auditing materiality for major
Standards requires that federal financial
when a governing body assistance programs
fails to make a required under the Single Audit
report on such acts the Act. AU 801 requires
auditors should that it be determined
communicate the matter separately for each major
to the external body program.
specified in the law or
regulation. Answer (a) is 162. (b) The requirement is to
incorrect because such identify the appropriate
concealment will not compliance report under
necessarily lead to com the Single Audit Act
munication to a federal when a CPA has detected
inspector general. Answer noncompliance with
(c) is incorrect because requirements that have a
material misstatement material effect on that
does not necessarily lead program. AU 801 states
to such communication. that under
such
circumstan
ces the
auditor
should
express a
qualified
or adverse
opinion.
163. (c
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Accounting
Authoritative
Changes
Literature Help
1. The appropriate guidance regarding reporting on consistency is found in
AU 508.16.18
2. The appropriate guidance regarding emphasis of a matter is found in AU
508.19
3. The appropriate guidance regarding reporting on comparative financial
statements is found in AU 508.65.66
Authoritative
Report
Literature Help
Modifications
1. (E, P) When an auditor hires a specialist to assist in corroborating a
client estimate (here complex pension calculations), and that
specialist’s findings are reasonably close to those of the client, no
report modification is required or permitted. Since the specialist’s
findings support the financial statements in this situation, a standard
unqualified audit report is appropriate.
When major unresolved differences between the findings of
management and the specialist exist, report modification is
appropriate.
2. (A, I) When the client’s financial statements materially depart from generally
accepted accounting principles, either a qualified opinion or an adverse opinion
is appropriate, depending on the magnitude of the misstatement. The value of
the client’s note receivable has been impaired and therefore the client should
write the note receivable down to its net realizable value. The auditor will have
to determine whether to issue a qualified opinion or an adverse opinion on the
basis of the materiality of the misstatement. Factors the auditor will consider
include the significance of the account, the pervasiveness of the misstatement
and the misstatement’s effect on the financial statement taken as whole. The
audit report, for either opinion, will include an explanatory paragraph to
describe the substantive reasons for the modification, and the opinion
paragraph will be modified.
3. (B, J) A situation where the auditor is unable to obtain sufficient
competent evidential matter is referred to as a scope limitation. A
scope limitation may require the auditor to either qualify his or her
opinion or to disclaim an opinion altogether. Since the auditor was
unable to observe the inventory count or to obtain evidence through
alternative procedures, the auditor will have to decide whether to
issue a qualified opinion or a disclaimer of opinion. The decision will
be based on the auditor’s judgment as to the nature and magnitude of
the potential effects of the matters in question and by their
significance to the financial statements. A qualified opinion will
describe the circumstances in an explanatory paragraph and will
modify the scope and opinion paragraphs. A disclaimer of opinion
will omit the scope paragraph and will include modification of the
opinion paragraph.
4. (E, P) An auditor need not modify a report for an immaterial item that
the client declines to reflect.
5. (A, I) Since the client’s financial statements omitted required
disclosures on certain longterm lease obligations, they are not
prepared in accordance with generally accepted accounting
principles. As a result, the auditor should express either a qualified
opinion or an adverse opinion. The decision to express either a
qualified or adverse opinion is based on the significance of the lack
of disclosure, the pervasiveness of the misstatement, and the overall
effect the lack of disclosure has on the financial statements. The audit
report, for either opinion, will include an explanatory paragraph to
describe the substantive reasons for the modification, and the opinion
paragraph will be modified.
6. (E, O) When a principal auditor decides not to take responsibility for
the work of another auditor, the principal auditor should make
reference to the work of the other auditor in the audit report. The
audit report should clearly indicate the division of responsibility
between the two auditors in the introductory, scope, and opinion
paragraphs. Reference to the other auditor in the audit report does
not prevent the principal auditor from issuing an unqualified opinion.
The reference to the other auditor is designed to emphasize the
divided responsibilities between the two auditors.
7. (E, H) When an auditor agrees with a change in accounting
principles, a lack of consistency results in an unqualified opinion
with an explanatory paragraph following the opinion paragraph.
There is no modification of the three standard paragraphs.
8. (E, H) The auditor has substantial doubt about the client’s ability to
remain a going concern for a reasonable period of time. The audit
report should emphasize this concern to the financial statement
users. As a result, the auditor’s report will include an unqualified
opinion with an explanatory paragraph following the opinion
paragraph.
Research
Authoritative
Literature Help
(A) (B) (C) (D) (E) (F) (G) (H)
1. Which section of the Professional Standards addresses this issue and will
be helpful in responding to the partner?
2. Enter the exact section and paragraph with the appropriate guidance. 315 09
Research
Authoritative
Literature Help
1. AU 508 08
2. She is correct, as including the location is not required (although it is
acceptable).
Li
Audit Report
te
Details
Authoritative ra
ture
Help
(A) (B) (C) (D) (E) (F) (G)
1. National’s inadequate inventory records (I) (J) (K) (L)
precluded White from forming an opinion
as to the proper application of generally
accepted accounting principles to
inventory balances on January 1, 20X2.
2. Rapid Parts Company, a consolidated subsidiary of National, was audited
for the year ended December 31, 20X2, by Green & Co. CPAs.
3. White has completed its audit procedures on March 28, 20X3, and
planned to submit its auditor’s report to National on April 4, 20X3.
4. The most appropriate addressee of the audit report.
5. National’s audit report should be signed by
1. (B) The lack of evidence about the beginning inventory affects only the
results of operations (the income statement).
2. (D) The involvement of the other audit firm results in a division of
responsibility because White does not want to take responsibility for the
other auditor’s work.
3. (F) The report should be dated as of the date that all substantive audit
evidence has been obtained.
4. (I) Ordinarily the report should be addressed to the board of
directors, audit committee, or the company itself, not
management.
5. (K) Only White & Co. will sign the audit report.
202 MODULE 6 ACCOUNTING AND REVIEW SERVICES
ACCOUNTING AND REVIEW SERVICES
reviewing the financial
statements?
1. Statements on Standards for Compilation Review
Accounting and Review Services a. No No
establish standards and procedures b. Yes No
for which of the following c. No Yes
engagements? d. Yes Yes
a. Assisting in adjusting
5. Which of the following statements
the books of account
is correct concerning both an
for a partnership.
engagement to compile and an
b. Reviewing interim
engagement to review a
financial data
nonissuer’s financial statements?
required to be filed
with the SEC. a. The accountant
does not
c. Processing financial
contemplate
data for clients of
obtaining an
other accounting
understanding
firms.
of internal
d. Compiling an control.
individual’s personal
b. The
financial statement to
accountant
be used to obtain a
must be
mortgage. independent
2. The authoritative body designated in fact and
to promulgate standards appearance.
concerning an accountant’s c. The
association with unaudited accountant
financial statements of an entity that is not expresses no
required to file financial statements with assurance on
an agency regulating the issuance of the the financial
entity’s securities is the statements.
a. Financial Accounting Standards d. The
Board. accountant
b. General Accounting Office. should obtain
c. Accounting and Review Services a written
Committee. management
d. Auditing Standards Board. representation
letter.
accounting services may an 6. An accountant is required to comply with
accountant perform without the provisions of Statements on Standards
for Accounting and Review Services when
being required to issue a com
pilation or review report under I. Reproducing client
the Statements on Standards for prepared financial
Accounting and Review statements, without
Services? modification, as an
accommodation to a
I. Preparing a working trial balance. client.
AI. Preparing standard monthly journal
entries.
a. I only.
b. II only.
c. Both I and II.
4. May an accountant accept an
engagement to compile or review
the financial statements of a not
forprofit entity if the accountant
is unfamiliar with the specialized
industry accounting principles, but
plans to obtain the required level
of knowledge before compiling or
AI. Preparing standard monthly journal by the client
entries for depreciation and expiration of that change
prepaid expenses. client
a. I only. prepared
b. II only. financial
c. Both I and II. statements.
d. Neither I nor II. d. Generated,
through the use
7. Kell engaged March, CPA, to submit to Kell of computer
a written personal financial plan containing software,
unaudited personal financial statements. financial
March anticipates omitting certain disclo statements
sures required by GAAP because the prepared in
engagement’s sole purpose is to assist Kell accordance
in developing a personal financial plan. For with a
March to be exempt from complying with comprehensive
the requirements of Statements on Standards basis of
for Accounting and Review Services. Kell is accounting
required to agree that the other than
a. Financial GAAP.
statements will
9. Davis, CPA, accepted an
not be
engagement to audit the financial
presented in statements of Tech Resources, a
comparative nonissuer. Before the completion
form with of the audit, Tech requested Davis
those of the to change the engagement to a
prior period. compilation of financial
b. Omitted statements. Before Davis agrees to
disclosures change the engagement, Davis is
required by required to consider the
GAAP are
Additional audit Reason given
not effort necessary to for
material. complete the audit Tech’s request
c. Financial statements will not be a. No No
disclosed to a nonCPA financial b. Yes Yes
planner. c. Yes No
d. Financial d. No Yes
statements 10. An accountant may compile a
will not be nonissuer’s financialstatements that omit all
used to of the disclosures required by GAAP only if
obtain the omission is
credit.
I. Clearly indicated in the accountant’s
8. Statements on Standards for report.
Accounting and Review AI. Not undertaken with the
Services (SSARS) apply when intention of misleading the
an accountant has financial statement users.
a. Typed clientprepared financial a. I only.
statements, without modification, b. II only.
as an accommodation to the client. c. Both I and II.
b. Provided a d. Either I or II.
client with a
financial
statement
format that
does not
include dollar
amounts, to be
used by the
client in
preparing
financial
statements.
c. Proposed
correcting
journal entries
to be recorded
MODULE 6 ACCOUNTING AND REVIEW SERVICES 203
corroborate
management’s
11. When engaged to compile the assertions that
financial statements of a are embodied
nonissuer (nonpublic) entity, an in the financial
accountant is required to possess statement
a level of knowledge of the components.
entity’s accounting principles and
practices. This requirement most 13. One of the conditions required for
likely will include obtaining a an accountant to submit a written
general understanding of the personal financial plan containing
a. Stated qualifications of the entity’s unaudited financial statements to a
accounting personnel. client without complying with the
b. Design of the entity’s requirements of Statements on
internal controls Standards of Accounting and
placed in operation. Review Services, is that the
c. Risk factors relating to a. Client agrees that the
misstatements arising financial statements will
from illegal acts. not be used to obtain
d. Internal control credit.
awareness of the b. Accountant compiled
entity’s senior or reviewed the client’s
management. financial statements for
the immediate prior
12. Which of the following year.
procedures is ordinarily per c. Engagement letter
formed by an accountant in a acknowledges that the
compilation engagement of a financial statements will
nonissuer (nonpublic) entity? contain departures from
a. Reading the generally accepted
financial accounting principles.
statements to d. Accountant expresses
consider limited assurance that
whether they the financial
are free of statements are free of
obvious any material
mistakes in misstatements.
the
application of 14. While performing a compilation of financial
accounting statements, information indicating that the
principles. entity whose information is being compiled
b. Obtaining may lack the ability to continue as a going
written concern has come to the accountant’s
representations attention. The client agrees that such a
from manage situation does exist, but refuses to add
ment disclosures relating to it. What effect is this
indicating that most likely to have on the accountant’s
the compiled review report?
financial state a. No effect, a
ments will not standard
be used to unqualified
obtain credit. report is
c. Making appropriate.
inquiries of b. The report should
management indicate a departure from
concerning generally accepted
actions taken accounting principles,
at meetings of with modification of the
the report’s third paragraph
stockholders and addition of an
and the board explanatory paragraph.
of directors. c. An adverse opinion
d. Applying should be issued, with
analytical modification of the
procedures opinion paragraph and
designed to addition of an
d. A qualified opinion
should be issued, with 15. When compiled financial
modification of the statements are accompanied by an
opinion paragraph and accountant’s report, that report
addition of an should state that
explanatory paragraph. a. A compilation
includes assessing the
accounting principles
used and significant
management esti
mates, as well as
evaluating the overall
financial statement
presentation.
b. The accountant
compiled the financial
statements in
accordance with
Statements on
Standards for
Accounting and
Review Services.
c. A compilation is
substantially less in
scope than an audit in
accordance with GAAS,
the objective of which is
the expression of an
opinion.
d. The accountant is not
aware of any material
modifications that
should be made to the
financial statements to
conform with GAAP.
16. Miller, CPA, is engaged to
compile the financial statements
of Web Co., a nonissuer
(nonpublic) entity, in conformity
with the income tax basis of
accounting. If Web’s financial
statements do not disclose the
basis of accounting used, Miller
should
a. Disclose the basis of
accounting in the
accountant’s
compilation report.
b. Clearly label each page
“Distribution Restricted
— Material
Modifications
Required.”
c. Issue a special report
describing the effect
of the incomplete
presentation.
d. Withdraw from the
engagement and
provide no further
services to Web.
17. When an accountant is engaged
to compile a nonissuer’s
financial statements that omit
substantially all disclosures
required by GAAP, the
accountant should indicate in in the subsequent year, the
the compilation report that the unaudited financial statements
financial statements are should be clearly marked to
a. Not designed for those indicate their status and
who are uninformed I. The report on the unaudited
about the omitted financial statements should be
disclosures. reissued.
b. Prepared in conformity with a AI. The report on the audited financial
comprehensive basis of accounting statements should include a
other than GAAP. separate paragraph describing the
c. Not compiled in responsibility assumed for the
accordance with unaudited financial statements.
Statements on a. I only.
Standards for b. II only.
Accounting and c. Both I and II.
Review Services. d. Either I or II.
d. Specialpurpose
financial statements 19. Clark, CPA, compiled and properly
that are not reported on thefinancial statements of
comparable to those of Green Co., a nonissuer, for the year ended
prior periods. March 31, 2008. These financial
statements omitted substantially all
18. When unaudited financial disclosures required by generally accepted
statements of a nonissuer are accounting principles (GAAP). Green
presented in comparative form asked Clark to compile the statements for
with audited financial statements the year ended March 31, 2009,
of financial statements,
information that is the
and to include all GAAP disclosures for the representation of
2009 statements only, but otherwise present management.
both years’ financial statements in
comparative form. What is Clark’s 21. How does an accountant make the following
responsibility concerning the proposed representations when issuing the standard
engagement? report for the compilation of a nonissuer’s
a. Clark may not report on financial statements?
the comparative The financial The accountant
financial statements statements have has compiled the
because the 2008 not been audited financial statements
statements are not a. Implicitly Implicitly
b. Explicitly Explicitly
comparable to the 2009
c. Implicitly Explicitly
statements that include d. Explicitly Implicitly
the GAAP disclosures.
b. Clark may report on 22. An accountant’s compilation
the comparative report should be dated as of the
financial statements date of
provided the 2009 a. Completion of fieldwork.
statements do not b. Completion of the compilation.
contain any obvious c. Transmittal of the compilation
material report.
misstatements. d. The latest subsequent
c. Clark may report on the event referred to in the
comparative financial notes to the financial
statements provided an statements.
is added to Clark’s 23. An accountant has compiled the
report on the financial statements of a
comparative financial nonissuer in accordance with
statements. Statements on Standards for
d. Clark may report on the Accounting and Review Services
comparative financial (SSARS). Does SSARS require
statements provided that the compilation report be
Clark updates the report printed on the accountant’s
on the 2008 statements letterhead and that the report be
that do not include the manually signed by the
accountant?
GAAP disclosures.
Printed on the Manually signed
20. Which of the following accountant’s letterhead by the accountant
statements should not be in a. Yes Yes
cluded in an accountant’s b. Yes No
standard report based on the com c. No Yes
pilation of an entity’s financial d. No No
statements?
a. A statement that the
compilation was
performed in accordance
with standards
established by the
American Institute of
CPAs.
b. A statement that the
accountant has not
audited or reviewed the
c. A statement that the
accountant does not
express an opinion but
expresses only limited
assurance on the
d. A statement that a
compilation is limited to
presenting, in the form
c. Not independent and, therefore, may
24. Which of the following is correct issue a review report, but may not
relating to compiled financial issue an auditor’s opinion.
statements when thirdparty d. Independent because the
reliance upon those statements is financial interest is im
anticipated? material and, therefore,
a. A compilation report must be may issue a review
issued. report.
b. Omission of note disclosures is
unacceptable. 28. Moore, CPA, has been asked to issue a
review report on the balance sheet of Dover
c. A written engagement letter is
Co., a nonissuer. Moore will not be
required.
reporting on Dover’s statements of income,
d. Each page of the
retained earnings, and cash flows. Moore
may issue the review report provided the
should have a restriction
such as “Restricted for a. Balance sheet is
presented in a
Management’s Use
prescribed form of an
Only.”
industry trade
25. Which communication option(s) association.
may be used when an accountant b. Scope of the inquiry and
submits compiled financial analytical procedures
statements to be used only by has not been restricted.
management? c. Balance sheet is not to
be used to obtain credit
Compilation report Written engagement letter
or distributed to
a. Yes Yes
b. Yes No
creditors.
c. No Yes d. Specialized accounting
d. No No principles and practices
of Dover’s industry are
26. A compilation report is not disclosed.
required when compiled
financial statements are expected 29. Baker, CPA, was engaged to
to be used by review the financial statements of
Hall Co., a nonissuer. During the
a. Management only.
engagement Baker uncovered a
b. Management and third parties.
complex scheme involving client
c. Third parties only.
illegal acts that materially affect
d. A compilation report is Hall’s financial statements. If
required whenever
Baker believes that modification
of the standard review report is
are compiled.
not adequate to indicate the
27. If requested to perform a review deficiencies in the financial
engagement for a nonissuer in statements, Baker should
which an accountant has an a. Disclaim an opinion.
immaterial direct financial b. Issue an adverse opinion.
interest, the accountant is c. Withdraw from the engagement.
a. Not independent and, therefore, d. Issue a qualified opinion.
may not be associated with the
financial statements. 30. Which of the following is not
b. Not independent and, therefore, generally considered a
procedure followed by an
may not issue a review report.
accountant in obtaining a
d. No Yes
reasonable basis for the expression of 34. Which of the following inquiry or
limited assurance for a review of financial analytical proceduresordinarily is
statements? performed in an engagement to review a
a. Apply analytical procedures. nonissuer’s financial statements?
b. Assess fraud risk.
c. Make inquiries of management.
d. Obtain written representations
from management.
31. Which of the following procedures would an
accountant least likely perform during an
engagement to review thefinancial
statements of a nonissuer?
a. Observing the
safeguards over access
to and use of assets and
records.
b. Comparing the
with anticipated
results in budgets and
forecasts.
c. Inquiring of
management about
actions taken at the
board of directors’
meetings.
d. Studying the
relationships of
financial statement
elements expected to
conform to predictable
patterns.
procedures should an ac
countant perform during an
engagement to review the
financial statements of a
nonissuer?
a. Communicating
significant deficiencies
discovered during the
assessment of control
risk.
b. Obtaining a client representation
letter from members of
management.
c. Sending bank
confirmation letters to
the entity’s financial
institutions.
d. Examining cash
disbursements in the
subsequent period for
unrecorded liabilities.
33. An accountant should perform
analytical procedures during an
engagement to
Compile a Review a
nonissuer’s nonissuer’s
financial statements financial statements
a. No No
b. Yes Yes
c. Yes No
engagement can proceed
a. Sales returns and allowances. only if distribution of the
b. Credit sales. accountant’s report is
c. Sales of consigned goods. restricted to internal use.
d. Cash sales. 3 Determine the effects of the
departures from GAAP and
1. When performing an issue a special report on the
engagement to review a financial statements.
nonissuer’s financial statements, 4 Issue a modified review
an accountant most likely would report provided the entity
1 Confirm a agrees that the financial
sample of statements will not be used
significant to obtain credit.
accounts
receivable 3. When providing limited
balances. assurance that the financial
2 Ask about actions statements of a nonissuer
taken at board of (nonpublic entity) require no
directors’ meetings. material modifications to be in
3 Obtain an understanding of accordance with generally
internal control. accepted accounting principles,
4 Limit the distribution of the the accountant should
accountant’s report. 1 Assess the risk that a
2. An accountant has been engaged material misstatement
to review a nonissuer’s financial could occur in a financial
statement assertion.
statements that contain several
2 Confirm with the entity’s lawyer
departures from GAAP. If the
that material loss contingencies
financial statements are not are disclosed.
revised and modification of the 3 Understand the
standard review report is not accounting principles
adequate to indicate the of the industry in
deficiencies, the accountant should which the entity
1 Withdraw from the operates.
engagement and provide 4 Develop audit programs
no further services to determine whether the
concerning these financial entity’s financial
statements are fairly
statements. presented.
2 Inform management that the
a. Analytical procedures designed to test the ac
counting records by obtaining corroborating audit 40. Smith, CPA, has been asked to issue
a review report on
evidence. purchases transactions.
b. Inquiries concerning
the entity’s procedures 36. Which of the following would the
for recording and accountant most likely investigate
summarizing during the review of financial
transactions. statements of a nonissuer if
c. Analytical procedures accounts receivable did not
designed to test manage conform to a predictable pattern
ment’s assertions during the year?
regarding continued
existence.
d. Inquiries of the entity’s attorney
concerning contingent
liabilities.
procedures would most likely be
included in a review engagement
of a nonissuer?
a. Preparing a bank transfer
schedule.
b. Inquiring about relatedparty
transactions.
c. Assessing internal control.
d. Performing cutoff
tests on sales and
the balance sheet of Cone Company, a c. The scope of Smith’s
nonissuer, and not on the other related inquiry and analytical
financial statements. Smith may do so only procedures is not
if restricted.
a. Smith compiles and d. Cone is a new client
reports on the related and Smith accepts the
statements of engagement after the
income, retained end of Cone’s fiscal
earnings, and cash year.
flows.
b. Smith is not aware of 41. In reviewing the financial
any material statements of a nonissuer, an
modifications needed accountant is required to modify
for the balance sheet to the standard report for which of
conform with GAAP. the following matters?
45. Gole, CPA, is engaged to review
Inability to assess Discovery of significant the 20X8 financial statements of
the risk of material deficiencies in the design North Co., a nonissuer.
misstatement of the entity’s Previously, Gole audited North’s
due to fraud internal control 20X7 financial statements and
a. Yes Yes expressed an unqualified opinion.
b. Yes No Gole decides to include a separate
c. No Yes paragraph in the 20X8 review
d. No No report because North plans to
present comparative financial
42. Each page of a nonissuer’s statements for 20X8 and 20X7.
financial statements reviewed This separate paragraph should
by an accountant should indicate that
include the following a. The 20X8 review report
reference: is intended solely for
a. See Accompanying Accountant’s the information of
Footnotes. management and the
b. Reviewed, No Material board of directors.
Modifications Required. b. The 20X7 auditor’s
c. See Accountant’s Review Report. report may no longer be
d. Reviewed, No Accountant’s relied on.
Assurance Expressed. c. No auditing procedures
43. Financial statements of a were performed after
nonissuer that have been the date of the 20X7
reviewed by an accountant auditor’s report.
should be accompanied by a d. There are justifiable
report stating that a review reasons for changing the
a. Provides only limited level of service from an
assurance that the audit to a review.
financial statements are 46. An accountant’s standard report
fairly presented. on a review of the financial
b. Includes examining, on statements of a nonissuer should
a test basis, state that the accountant
information that is the a. Does not express an
representation of opinion or any form of
management. limited assurance on
c. Consists principally of the financial
inquiries of company statements.
personnel and
analytical procedures
applied to financial
data.
d. Does not contemplate obtaining
corroborating evidential matter or
applying certain other procedures
ordinarily performed during an
audit.
44. An accountant who had begun an
audit of the financial statements
of a nonissuer was asked to
change the engagement to a
review because of a restriction on
the scope of the audit. If there is
reasonable justification for the
change, the accountant’s review
report should include reference to
the
Scope limitation Original
that caused the engagement
changed engagement that was agreed to
a. Yes No
b. No Yes
c. No No
d. Yes Yes
d. A review is greater in scope than a
b. Is not aware of any compilation, the objective of
material which is to present financial state
modifications that ments that are free of material
should be made to misstatements.
the financial 48. During a review of the financial
statements for them statements of a nonissuer, an
to conform with accountant becomes aware of a
GAAP. lack of adequate disclosure that
c. Obtained reasonable is material to the financial
assurance about statements. If management
whether the financial refuses to correct the financial
statements are free of statement presentations, the
material misstate accountant should
ment. a. Issue an adverse opinion.
d. Examined evidence, on b. Issue an “except for” qualified
a test basis, supporting opinion.
the amounts and
c. Disclose this departure from
disclosures in the
generally accepted accounting
principles in a separate paragraph
47. Financial statements of a of the report.
nonissuer that have been re d. Express only limited
viewed by an accountant should assurance on the
be accompanied by a report financial statement
stating that presentations.
a. The scope of the inquiry 49. An accountant who reviews the
and analytical financial statements of a
procedures performed nonissuer should issue a report
by the accountant has stating that a review
not been restricted. a. Is substantially less in scope than
b. All information an audit.
included in the
b. Provides negative
financial statements is assurance that internal
the representation of control is functioning as
the management of the designed.
entity. c. Provides only limited
c. A review includes assurance that the
examining, on a test financial statements are
basis, evidence fairly presented.
supporting the amounts d. Is substantially more in scope than
and disclosures in the a compilation.
SIMULATIONS
Research
Authoritative
Literature Help
Auditors who audit public nonpublic companies must be familiar with professional
standards developed by a variety of sources. For each of the types of services below indicate
the proper source of professional requirements. Each source may be used once, more than
once, or not at all.
S
o
A.
Acc
B.
Aud
C.
PC
1. A
2. A
3. A
4. A
5. A
6. A
7. A
8. A
9. A
Research
Authoritative
Literature Help
Review Reports
The president of Enright Corporation, a nonpublic client, asked you to perform a review of
the financial statements for the current year only. You have now completed your inquiry and
other review procedures and find that you can issue a standard review report.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(A) (B) (C) (D) (E) (F) (G) (H)
1. Which title of the Professional Standards presents a standard review report
on one year?
2. Enter the exact section and paragraph with the needed information.
1. d __ __ 10. c __ __ 19. a __ __ 28. b __ __ 37. b __ __ 46. b __ __

2. c __ __ 11. a __ __ 20. c __ __ 29. c __ __ 38. a __ __ 47. b __ __
3. c __ __ 12. a __ __ 21. b __ __ 30. b __ __ 39. c __ __ 48. c __ __
4. d __ __ 13. a __ __ 22. b __ __ 31. a __ __ 40. c __ __ 49. a __ __
5. a __ __ 14. b __ __ 23. d __ __ 32. b __ __ 41. d __ __
6. d __ __ 15. b __ __ 24. a __ __ 33. d __ __ 42. c __ __
7. d __ __ 16. a __ __ 25. a __ __ 34. b __ __ 43. c __ __
8. d __ __ 17. a __ __ 26. a __ __ 35. b __ __ 44. c __ __ 1st: __/49 = __%
9. b __ __ 18. d __ __ 27. b __ __ 36. b __ __ 45. c __ __ 2nd: __/49 = __%
procedures. Answer (d) is correct
Compilation and Review—General because the Statements apply
1. (d) The requirement is to identify when a CPA either compiles or
the engagement for which reviews the financial statements of
Statements on Standards for a nonissuer. Answer (a) is
Accounting and Review Services incorrect because the Statements
establish standards and do not apply when the CPA is
assisting in adjusting the books of 5. (a) The requirement is to determine the
account for a partnership or other correctstatement concerning both an
organization. engagement to compile and an engagement
Answer (b) is incorrect because the to review a nonissuer’s financial
Statements only apply to nonissuer statements. Answer (a) is correct because
(nonpublic) entities. Answer (c) is incorrect neither a compilation nor a review
because the Statements do not apply when contemplates obtaining an understanding of
processing the financial data for clients of internal control. Answer (b) is incorrect
other accounting firms. because when performing a compilation the
accountant need not be independent;
independence is required for reviews.
authoritative body designated to promulgate
Answer (c) is incorrect because a review
standards concerning an accountant’s
provides limited assurance. Answer (d) is
association with unaudited financial
incorrect because the accountant is not
statements of an entity that is not required to required to obtain a written management
file financial statements with an agency representation letter for a compilation; a
regulating the issuance of the entity’s management representation letter is
securities. Answer (c) is correct because the required for a review.
Accounting and Review Services
Committee is so designated. Answer (a) is Compilation—General
incorrect because the Financial Accounting
Standards Board is the authoritative body 6. (d) The requirement is to
designated to promulgate financial determine whether reproducing
accounting standards. Answer (b) is clientprepared financial
incorrect because Government statements without modification
Accountability Office is not one of the and preparing standard monthly
bodies designated by the AICPA to journal entries are included in the
promulgate technical standards. Answer (d) provisions of Statements on
is incorrect because the Auditing Standards Standards for Accounting and
Board is the authoritative body designated to Review Services. Answer (d) is
promulgate statements on auditing correct because AR 100 allows
standards. ET Appendix A presents the these services as long as the ac
bodies designated to promulgate technical countant’s name is not associated
standards. with the financial statements.
3. (c) The requirement is to 7. (d) The requirement is to identify the
determine which of the two correct statement about unaudited personal
listed accounting services an financial statements included in a personal
accountant may perform financial plan. Answer (d) is correct because
without being required to issue a AT 600 requires that the financial
compilation or reviewreport under the statements be used solely to assist the client
Statements on Standards for Accounting and and the client’s advisor and not be used to
Review Services. Answer (c) is correct obtain credit. Answer (a) is incorrect
because the Statements on Standards for because financial statements may be
Accounting and Review Services do not presented in comparative form. Answer (b)
apply to preparing a working trial balance or is incorrect because omitted disclosures may
to preparing standard monthly journal be material. Answer (c) is incorrect because
entries. See SSARS for these and additional such financial statements may be disclosed
circumstances in which the standards do not to a nonCPA financial planner.
apply. Accordingly, no compilation or 8. (d) The requirement is to identify
review report needs to be issued when these the circumstance in which
services are provided. Statements on Standards for
4. (d) The requirement is to determine Accounting and Review Services
whether an accountant can accept a apply. The Standards apply when
compilation or a review engagement when a CPA submits unaudited financial
statements of a nonissuer (non
s/he is unfamiliar with a prospective client’s
public) entity to his or her client
specialized industry accounting principles,
or others. Accordingly, answer (d)
but s/he plans to obtain the required level of
is correct. Answers (a), (b), and
knowledge prior to the engagement.
(c) are all incorrect because they
Answer (d) is correct because an accountant are all included as services that do
may accept either a compilation or a review not constitute a submission of
engagement in such circumstances. financial statements to a client.
determine whether either or both
of (1) the additional audit effort
necessary to complete the audit engagement be changed to a
and (2) the reason for the change compilation. Answer (b) is
in the engagement should be correct because SSARS states
considered by a CPA whose that additional necessary audit
client has requested that an audit effort and the reason for the
when the plan
(1) is to be used to assist the client and the
change—as well as the additional client’s advisors in developing financial
cost to complete the audit—be goals and objectives, (2) will not be used
considered. to obtain credit, and (3) when nothing
comes to the accountant’s attention that
10. (c) The requirement is to determine would lead him/her to believe that the
when a CPAmay compile and be associated statements will be used for credit or for
with financial statements that omit any other purposes. Answer (b) is incorrect
disclosures required by GAAP. Answer (c) because any work performed on the prior
is correct because the CPA may compile year statements is not applicable to the
such financial statements provided that the statements of the current year. Answer (c)
omission of substantially all disclosures (1) is incorrect because the engagement letter
is clearly indicated in the audit report and need not acknowledge departures from
(2) is not, to the CPA’s knowledge, GAAP. Answer (d) is incorrect because no
undertaken with the intention of misleading assurance is provided in such reports.
those who might reasonably be expected to
use the financial statements. 14. (b) The requirement is to identify
an accountant’s reporting
Compilation Procedures responsibility when performing a
compilation and he or she
11. (a) The requirement is to determine an
determines that a going concern
accountant’s responsibility relating to
uncertainty has not been properly
knowledge of the client’s accounting
principles and practices when performing a disclosed by a client. Answer (b) is
compilation. Answer (a) is correct because correct because this is a departure
to compile financial statements the from GAAP and results in
accountant should possess a general modification of the report’s third
understanding of the nature of the entity’s paragraph and addition of an
business transactions, the form of its explanatory paragraph. Answer (a)
accounting records, the stated qualifications is incorrect because the information
of its accounting personnel, the accounting on the client’s ability to continue as
basis on which the financial statements are a going concern should be included
to be presented, and the form and content of in the financial statements; if it is
the financial statements. Answer (b) is not, a departure from GAAP exists.
incorrect because the accountant need not Answer (c) is incor
have a general understanding of the entity’s
controls. Answer (c) is incorrect because no
such consideration of risk factors is
envisioned in a compilation. Answer (d) is
incorrect because no such consideration of
internal control awareness of senior
management is made.
the procedure an accountant
ordinarily performs in a
compilation engagement of a
nonissuer. Answer (a) is correct
because the accountant is required,
at a minimum, to read the financial
statements to consider whether
they are free from obvious
material errors.
Compilation Reporting
13. (a) The requirement is to identify a
condition required for an
accountant to submit a written
personal financial plan containing
unaudited financial statements to a
client without complying with the
compilation and review
requirements presented in SSARS.
SSARS allow such an exception
accountant must clearly indicate
rect because adverse opinions are not issued in the compilation report that
based on compilations. Answer (d) is substantially all disclosures
incorrect because qualified opinions are not required by GAAP have been
issued based on compilations. omitted. Answer (b) is incorrect
because the financial statements
15. (b) The requirement is to identify are not compiled on a comprehen
the statement that should be sive basis other than GAAP.
included in a compilation report. Answer (c) is incorrect because a
Answer (b) is correct because compilation may be performed on
compilation reports indicate that financial statements lacking such
the accountant compiled the disclosures. Answer (d) is
financial statements in accordance incorrect because these financial
with Statements on Standards for statements are not considered
Accounting and Review Services. “specialpurpose financial
16. (a) The requirement is to statements.”
determine how a CPA should 18. (d) The requirement is to
indicate that a client’s compiled determine the proper reporting
financial statements were procedure for comparative
prepared in conformity with the financial statements for which the
income tax basis of accounting prior year is unaudited, and the
when the financial statements current year is audited. AU 504
provide no such disclosure. states that when unaudited
Answer (a) is correct because if financial statements are presented
the basis of accounting is not in comparative form with audited
disclosed in the financial financial statements, the report on
statements, the accountant should the prior period may be reissued
disclose the basis in the to accompany the current period
compilation report. Answer (b) is report. In addition, the report on
incorrect because each page of the the current period may also
financial statements should only include a separate paragraph
include the reference “See describing responsibility assumed
Accountant’s Compilation for the prior period financial
Report.” Answer (c) is incorrect statements. If these statements are
because the auditor is not required filed with the SEC, the statements
to issue a special report. See AU should be clearly marked as
623 for information on special “unaudited” but should not be
reporting. Answer (d) is incorrect referred to in the auditor’s report.
because the auditor does not have
to withdraw from the 19. (a) The requirement is to determine a CPA’s
engagement. responsibility when the first year of
compiled comparative financial statements
17. (a) The requirement is to omit substantially all disclosures required
determine how the compilation by generally accepted accounting principles,
report should be modified to while the second year’s statements include
indicate that the entity’s financial such disclosures. Answer (a) is correct
statements do not include all because the CPA may not report on the
disclosures required by GAAP. comparative financial statements because of
Answer (a) is correct because AR a lack of comparability. Answers (b), (c),
100 states that while the and (d) are all incorrect because they allow
accountant may compile such such reporting to occur under certain
financial statements, the circumstances.
appropriate communication
option(s) when compiled financial
20. (c) The requirement is to identify statements are only going to be used
the statement that should not be by management. Answer (a) is
included in a CPA’s financial correct because when an ac
statement compilation report. countant submits to a client
Answer (c) is correct because a compiled financial statements that
compilation report provides no are not expected to be used by a
assurance on the financial third party, either a compilation
statements. report or a written engagement letter
(or both) may be used. Answer (b),
21. (b) The requirement is to (c), and (d) are all incorrect be
determine the representations cause they suggest that either a
made explicitly and implicitly compilation report, a written
when issuing a standard engagement letter, or both are
compilation report on a
unacceptable.
nonissuer’s financial statements.
Answer (b) is correct because the 26. (a) The requirement is to identify the
report explicitly states that the circumstance in which a compilation report
financial statements have not been is not required. Answer (a) is correct
audited and that the accountant has because when financial statements are only
compiled them. for management, no compilation report is
required. Answers (b) and
22. (b) The requirement is to determine the
(c) are incorrect because when third
appropriate date for an auditor’s compilation
parties are expected to use compiled
report. SSARS require that the date of
financial statements, a compilation report
completion of the compilation should be
is required. Answer (d) is incorrect
used. because a compilation report is not always
23. (d) The requirement is to required.
determine whether an ac Review—General
countant’s compilation report
must be printed on the ac 27. (b) The requirement is to determine the
countant’s letterhead, manually effect of animmaterial direct financial
signed by the accountant, or both. interest on accountant independence.
Answer (d) is correct because the Answer (b) is correct because even
professional standards require immaterial direct financial interests impair
neither that the report be printed the independence that is required for the
on the accountant’s letterhead, performance of reviews and other
nor that it be manually signed by attestation services. Answer (a) is incorrect
the accountant. Answers (a), (b), because a CPA who lacks independence
and (c) are all incorrect because may compile those financial statements
they include an inappropriate when this lack of independence is disclosed
“yes” to one or both issues. See in the compilation
SSARS for information on
reporting on a compilation of
compiled financial statements that
are to be made available to third
parties. Answer (a) is correct be
cause a compilation report must be
issued when thirdparty reliance
upon compiled financial
statements is anticipated. Answer
(b) is incorrect because note
disclosures may be omitted.
while advisable, use of an
engagement letter is not required
in such circumstances. Answer
(d) is incorrect because no such
restriction is necessary.
procedures. Answer (c) is
report. Answer (c) is incorrect because a incorrect because a review in
review report may not be issued. Answer cludes inquiries of management.
(d) is incorrect because the CPA is not Answer (d) is incorrect because
independent. auditors obtain written
representation from management
28. (b) The requirement is to identify the when performing a review.
circumstance in which a CPA may issue a
review report on a single financial 31. (a) The requirement is to identify
statement. Answer (b) is correct because an the procedure least likely to be
accountant may issue a review report on a performed in a review of the
financial statement, such as a balance sheet, financialstatements of a
and not report on the other related financial nonissuer. Answer (a) is correct
statements if the scope of his or her inquiry because a review of a nonissuer
and analytical procedures has not been financial statements does not
restricted. Answer (a) is incorrect because specifically address observing the
the balance sheet need not be presented in safeguards over access to and use
prescribed form. Answer (c) is incorrect of assets and records. Answers
because the balance sheet may be used to (b), (c), and (d) are all incorrect
obtain credit or to distribute to creditors. because they are included in the
Answer (d) is incorrect because specialized procedures suggested for a review
accounting principles and practices in an by SSARS.
industry may or may not need to be
disclosed depending upon the 32. (b) The requirement is to identify
circumstances. the procedures that an accountant
would perform during an
29. (c) The requirement is to identify a CPA’s engagement to review the
responsibility when he or she believes that financial statements of a
modification of the standard review report nonissuer. Answer (b) is correct
is not adequate to indicate deficiencies in because AR 100 requires that the
financial statements affected by illegal acts. CPA obtain a representation letter.
Answer (c) is correct because whenever a Answers (a), (c), and (d) are
CPA believes that modification of the incorrect because they are not
standard report is not adequate to indicate included in SSARS which present
the deficiencies in the financial statements, a list of procedures performed
he or she should withdraw from the review during a review.
engagement and provide no further services
with respect to those financial statements. 33. (d) The requirement is to
determine whether analytical
Review Procedures procedures need to be performed
on a compilation and/or a review
30. (b) The requirement is to identify engagement. Answer (d) is correct
the procedure not followed by an because a compilation does not
accountant in obtaining a require performance of analytical
reasonable basis for the procedures, while a review does.
expression of limited assurance
for a review of financial 34. (b) The requirement is to
statements. Answer (b) is correct determine the type of inquiry or
because reviews ordinarily do not analytical procedures ordinarily
include an assessment of the risk performed in an engagement to
of fraud. Answer (a) is incorrect review a nonissuer’s financial
because reviews include analytical statements. Answer (b) is correct
because an accountant will make
is incorrect because reviews
consist primarily of inquiry and
inquiries concerning the entity’s procedures analytical procedures and do not
for recording, classifying, and summarizing generally include confirmation of
transactions, and accumulating information for accounts receivable. Answer (c) is
disclosure in the financial statements. Answer incorrect because a review of a
(a) is incorrect because the analytical nonpublic entity does not
procedures and other procedures involved in a normally include obtaining an
review do not in general obtain corroborating understanding of internal control
audit evidence as do the procedures of an or assessing control risk. Answer
audit. Answer (c) is incorrect because the (d) is incorrect because distri
procedures for reviews are not specially bution of a review report need not
designed to test management’s assertion be limited. See SSARS for
regarding continued existence. Answer (d) is specific procedures included in
incorrect because inquiries of the entity’s reviews.
attorney are not normally required when a Review Reporting
review is being performed.
38. (a) The requirement is to determine a
CPA’sresponsibilities when performing a
determine the most likely review of a nonissuer’s financial statements
procedures to be included in a that contain uncorrected departures from
review engagement of a nonissuer. GAAP and the CPA believes that the review
Answer (b) is correct because a report is not adequate to indicate the
review consists primarily of deficiencies. Answer (a) is correct because
inquiries and analytical SSARS state that in such circumstances the
procedures. Answer (a) is incorrect CPA should withdraw from the engagement
because a bank transfer schedule is and provide no further services with respect
generally not prepared for a review to those financial statements. Answers (b)
engagement. Answer (c) is and (d) are incorrect because restricting
incorrect because a review does distribution is not adequate or appropriate
not include assessing the control in such a circumstance. Answer (c) is
structure. Answer (d) is incorrect incorrect because the standards on special
because cutoff tests on sales and reports do not apply in this circumstance.
purchases are not normally
performed on a review. Note that
the procedures included in answers
(a), (c), and (d) are typically
performed in an audit.
36. (b) The requirement is to determine the type
of transaction the accountant is most likely
to investigate during a review when the
year’s accounts receivable did not conform
to a predictable pattern. Answer (b) is
correct because accounts receivable are
generated from credit sales and an
accountant would therefore investigate them.
Answer (a) is incorrect because sales
returns and allowances would be less likely
to cause large shifts in accounts receivable
than credit sales. Answer (c) is incorrect
because it is less complete than answer (b)
since sales of consigned goods represent
only one possible type of sale that might
impact accounts receivable. Answer (d) is
incorrect because cash sales do not affect
the most likely procedure to be
included in a review of a
nonissuer’s financial statements.
SSARS state that reviews
ordinarily include inquires
concerning actions taken at board
of directors’ meetings. Answer (a)
deficiencies, or both. Answer (d) is
39. (c) The requirement is to correct because neither of these
determine the listed requirement circumstances requires modification
when an accountant is providing of a review report. Answers (a), (b),
limited assurance that the and (c) are all incorrect because
financial statements of a nonissuer they suggest that one or the other of
require no material modifications these circumstances results in
to be in accordance with generally modification of a review report. A
accepted accounting principles. departure from GAAP is the
Accountants perform reviews to primary cause of a review report
provide such limited assurance. modification. SSARS provide
Answer (c) is correct because guidance on review reports.
obtaining an understanding of the
accounting principles in the 42. (c) The requirement is to identify
industry is required for reviews. the reference that should be
See SSARS for this and other included in each page of a
requirements. Answer (a) is nonissuer’s reviewed financial
incorrect because reviews do not statements. SSARS require that
require the accountant to assess the each page of the financial
risk of material misstatement. statements include a reference
Answer (b) is incorrect because such as “See Accountant’s
reviews generally do not include Review Report.”
any communication with the
entity’s lawyer. Answer (d) is
incorrect because an “audit” the statement that is included in an
program is not required since a accountant’s review report on the
review is being performed. financial statements of a
nonissuer. Answer (c) is correct
40. (c) The requirement is to identify the because a review report includes a
circumstances in which a CPA may issue a statement that a review consists
review report on the balance sheet of a principally of inquires of company
nonissuer, and not report on the related personnel and analytical
financial statements. Answer (c) is correct procedures applied to financial
because an accountant may issue a review data. See SSARS for information
report on one financial statement and not on that should be included in a
the other related statements if the scope of review report.
the inquiry and analytical procedures has not
been restricted.
a CPA’s reporting responsibility
Answer (a) is incorrect because the CPA
when an audit engagement for a
need not compile or report on the related
statements of income, retained earnings, and nonissuer has been changed to a
cash flows when reviewing only the balance review engagement because of what
sheet. Answer (b) is incorrect because, when the CPA believes to be a reasonable
material modifications are needed, a CPA restriction on the scope of the audit.
may still report on the balance sheet, but Answer (c) is correct because in
must indicate the modifications in the such circumstances the CPA should
review report. Answer (d) is incorrect neither include reference to the
because the client need not be new. original engagement nor to the
scope limitation.
whether a review report is modified 45. (c) The requirement is to identify
due to either inability to assess the the correct statement relating to
risk of material misstatement due to a CPA’s report on comparative
fraud, a discovery of internal control statements
when the current year has been reviewed and the previous
year has been audited. Answer (c) is correct because when a
separate paragraph is being added to the CPA’s review re
port the CPA should clearly indicate the difference in the
levels of assurance for the two years. In this situation,
SSARS require the auditor to indicate that the previous
year’s financial statements were audited, the date of the re
port, the type of opinion expressed and if the opinion was
other than unqualified, the substantive reasons for that
opinion, and that no auditing procedures were performed
after the date of the previous report. Answer (a) is incorrect
because the review report is not solely intended for man
agement or the board of directors. Answer (b) is incorrect
because the prior year’s audit report may still be appropriate.
Answer (d) is incorrect because this statement does not need
to be included within the review report.
46. (b) The requirement is to identify the statement
included in the standard report issued by an
accountant after reviewing the financial
statements of a nonissuer. Answer (b) is correct
because the report states that the accountant is
not aware of any material modifications that
should
be made to the financial statements in order for them to be in
conformity with generally accepted accounting principles.
SSARS present the required disclosures for a review report.
47. (b) The requirement is to identify the information
presented in a review report of financial statements
of a nonissuer. Answer (b) is correct because the
report indicates that all information included in the
financial statements is the representation of the
management of the entity.
48. (c) The requirement is to determine an
accountant’sreporting responsibility when
associated with a nonissuer’s reviewed statements
which contain a material departure from generally
accepted accounting principles. Answer (c) is
correct because SSARS require the inclusion of a
separate paragraph describing the departure.
Answers (a) and (b) are incorrect because an
adverse opinion or an “except for” qualified
opinion may only be issued when an audit has been
performed. Answer (d) is incorrect because
expressing limited assurance (as is normally
provided in reviews) on the financial statements is
not adequate to disclose the departure.
49. (a) The requirement is to identify the reply which
is correct concerning the content of a review
report. An
swer (a) is correct because a review report indicates that a
review is substantially less in scope than an audit. Answer (b)
is incorrect because a review report provides no information on
internal control. Answer (c) is incorrect because while a review
report states that the accountant is not aware of any material
modifications that should be made to the financial statements, it
does not provide limited assurance that the financial
statements are fairly presented. An
swer (d) is incorrect because while a review report does state
that a review is substantially less in scope than an audit, it
does not refer to a compilation.
S
O
T
R
e
A
u
L
i
1. A
2. A
3. A
4. A
5. A
6. A
7. A
8. A
9. A
T
Research
Authoritative
Literature
1. W
h
2. E
214 MODULE 7 AUDIT SAMPLING
AUDIT SAMPLING
justifies such an
MULTIPLECHOICE QUESTIONS (1
58)
assessment.
b. Contains
1. An advantage of using misstatements that
statistical over could be material
nonstatistical sampling to the financial
methods in tests of statements when
controls is that the aggregated with
statistical methods misstatements in
a. Can more other account
easily convert balances or
the sample into transactions
a dualpurpose classes.
test useful for c. Contains
substantive proportionately
testing. fewer monetary
b. Eliminate the errors or
need to use deviations from
judgment in prescribed
determining controls than exist
appropriate in the balance or
sample sizes. class as a whole.
c. Afford greater d. Does not support
assurance than a the tolerable error
nonstatistical sam for some or all of
ple of equal size. management’s
d. Provide an assertions.
objective basis for
quantitatively 4. The risk of incorrect
evaluating sample acceptance and the
risk. likelihood of assessing
control risk too low relate
2. An advantage of statistical to the
sampling over nonstatistical a. Allowable risk of tolerable
sampling is that statistical misstatement.
sampling helps an auditor to b. Preliminary estimates of
a. Eliminate the risk of materiality levels.
nonsampling errors. c. Efficiency of the audit.
b. Reduce the level d. Effectiveness of the audit.
of audit risk and
materiality to a 5. Which of the following
relatively low best illustrates the
amount. concept of sampling risk?
c. Measure the a. A randomly
sufficiency of chosen sample
the evidential may not be
matter representative of
obtained. the population as a
d. Minimize the failure to whole on the
detect errors and fraud. characteristic of
interest.
3. The likelihood of b. An auditor may
assessing control risk too select audit
high is the risk that the procedures that are
sample selected to test not appropriate to
controls
achieve the
a. Does not support
specific objective.
the auditor’s
c. An auditor may fail to
planned assessed
recognize errors in the docu
level of control ments examined for the
risk when the true chosen sample.
operating effec
d. The documents
tiveness of the
related to the
control structure
chosen sample Items 7 and 8 are based on the
may not be following information:
available for
The diagram below depicts the
inspection.
auditor’s estimated deviation rate
6. In assessing sampling compared with the tolerable rate,
risk, the risk of incorrect and also depicts the true population
rejection and the risk of deviation rate compared with the
assessing control risk too tolerable rate.
high relate to the True State of
a. Efficiency of the audit. Population
b. Effectiveness of the audit. Deviation rate Deviation rate is
c. Selection of the sample. exceeds tolerable less than tolerable
d. Audit quality controls. rate rate
Auditor’s
estimate
based on
sample results
Deviation rate I. II.
exceeds
tolerable
rate
Deviation rate
is less than
tolerable III. IV.
rate
7. In which of the situations
would the auditor have
properly concluded that
control risk is at or below
the planned assessed level?
a. I.
b. II.
c. III.
d. IV.
8. As a result of tests of
controls, the auditor
assesses control risk too
high and thereby increases
substantive testing. This is
illustrated by situation
a. I.
b. II.
c. III.
d. IV.
9. While performing a test of
details during an audit, an
auditor determined that the
sample results supported
the conclusion that the
recorded account balance
was materially misstated. It
was, in fact, not materially
misstated. This situation
illustrates the risk of
a. Assessing control risk too
high.
b. Assessing control risk too
low.
c. Incorrect rejection.
d. Incorrect acceptance.
10. The size of a sample
designed for dual purpose
testing should be
a. The larger of the samples that
samples that would otherwise
would otherwise have been
have been designed for the
designed for the two separate
two separate purposes.
purposes. d. More than the larger of the
b. The smaller of the samples that would oth
samples that erwise have been designated
would otherwise for the two separate
have been purposes, but less than the
combined total of the
designed for the
samples that would
two separate
otherwise have been
purposes. designed for the two
c. The combined separate purposes.
total of the
MODULE 7 AUDIT SAMPLING 215
c. Item in the
accounting
11. The expected population population
deviation rate of client should have an
billing errors is 3%. The opportunity to be
auditor has established a selected.
tolerable rate of 5%. In the d. Item must be
review of client invoices the systematically
auditor should use selected using
a. Stratified sampling. replacement.
b. Variable sampling. 15. Which of the following
c. Discovery sampling. statistical selection
d. Attribute sampling. techniques is least
12. Which of the following desirable for use by an
sampling methods would auditor?
be used to estimate a a. Systematic selection.
numerical measurement of b. Stratified selection.
a population, such as a c. Block selection.
dollar value? d. Sequential selection.
a. Attribute sampling.
b. Stoporgo sampling.
statistical sampling plans
c. Variables sampling.
does not use a fixed
d. Randomnumber sampling.
sample size for tests of
13. For which of the following controls?
audit tests would an auditor a. Dollarunit sampling.
most likely use attribute b. Sequential sampling.
sampling? c. PPS sampling.
a. Making an independent d. Variables sampling.
estimate of the amount of a
LIFO inventory. 17. If certain forms are not
b. Examining consecutively numbered
invoices in a. Selection of a
support of the random sample
valuation of probably is not
fixed asset possible.
additions. b. Systematic sampling may be
c. Selecting appropriate.
accounts c. Stratified sampling should
receivable for be used.
confirmation of d. Random number tables
account cannot be used.
balances.
d. Inspecting 18. When performing a test of
employee a control with respect to
time cards for control over cash receipts,
proper ap an auditor may use a
proval by systematic sampling
supervisors. technique with a start at
any randomly selected
14. An underlying feature item. The biggest
of randombased disadvantage of this type
selection of items is that of sampling is that the
each items in the population
a. Stratum of a. Must be
the systematically
accounting replaced in the
population be population after
given equal sampling.
representation
in the sample.
b. Item in the
accounting
population be
randomly or
dered.
d. More than the
b. May deviation rate in
systematically the auditor’s
occur more sample.
than once in the
sample. 21. Which of the following
c. Must be recorded factors is(are)
in a systematic considered in
pattern before the determining the sample
sample can be size for a test of
drawn. controls?
d. May occur in a Expected Tolerable
systematic deviation rate deviation rate
pattern, thus a. Yes Yes
destroying the b. No No
sample c. No Yes
randomness. d. Yes No
19. What is the primary objective of 22. Which of the following statements is

using stratification as a sampling correct concerning statistical
method in auditing? sampling in tests of controls?
a. To increase the a. Deviations from
confidence level control procedures
at which a deci at a given rate
sion will be usually result in
reached from the misstatements at a
results of the higher rate.
sample selected. b. As the
b. To determine the population size
occurrence rate doubles, the
for a given char sample size
acteristic in the should also
population being double.
studied. c. The qualitative
c. To decrease the effect of aspects of
variance in the total popu deviations are
lation. not considered
d. To determine the by the auditor.
precision range of d. There is an
the sample se inverse
lected. relationship
between the sam
20. As a result of tests of ple size and the
controls, an auditor tolerable rate.
assessed control risk too
low and decreased 23. In determining the sample
substantive testing. This size for a test of controls,
assessment occurred an auditor should consider
because the true deviation the likely rate of
rate in the population was deviations, the allowable
a. Less than the risk risk of assessing control
of assessing risk too low, and the
control risk too a. Tolerable deviation rate.
low, based on the b. Risk of incorrect
auditor’s sample. acceptance.
b. Less than the deviation rate in c. Nature and cause of
the auditor’s sample. deviations.
c. More than the d. Population size.
risk of
assessing 24. Which of the following
control risk combinations results in a
too low, based decrease in sample size
on the in a sample for
auditor’s attributes?
sample.
Risk of
assessing Expected
control risk Tolerable population
too low rate deviation rate
a. Increase Decrease Increase
b. Decrease Increase Decrease
c. Increase Increase Decrease d. Unrelated to the expected rate of errors in the re

d. Increase Increase Increase lated accounting records.
deviations from control
25. An auditor is testing internal control procedures increase the
procedures that are evidenced on an risk of material
entity’s vouchers by matching misstatements, such
random numbers with voucher deviations do not
numbers. If a random number necessarily result in errors.
matches the number of a voided This explains why
voucher, that voucher ordinarily
a. A recorded
should be replaced by another
disbursement
voucher in the random sample if the
that does not
voucher
a. Constitutes a deviation. show evidence
of required
b. Has been properly voided.
approval may
c. Cannot be located.
nevertheless be a
d. Represents an immaterial
transaction that
dollar amount.
is properly
26. An auditor plans to examine authorized and
a sample of twenty pur recorded.
chase orders for proper b. Deviations would
approvals as prescribed by result in errors in
the client’s control the accounting
procedures. One of the records only if the
purchase orders in the deviations and the
chosen sample of twenty errors occurred
cannot be found, and the on different
auditor is unable to use transactions.
alternative procedures to c. Deviations from
test whether that purchase pertinent control
order was properly procedures at a
approved. The auditor given rate
should ordinarily would
a. Choose another be expected to
purchase order to result in errors at a
replace the miss higher rate.
ing purchase order d. A recorded
in the sample. disbursement
b. Consider this test that is properly
of control invalid authorized may
and proceed with nevertheless be
substantive tests a transaction
since internal that contains a
control cannot be material error.
relied upon. 28. The objective of the
c. Treat the missing tolerable rate in sampling
purchase order as for tests of controls of
a deviation for the internal control is to
purpose of a. Determine the
evaluating the probability of the
sample. auditor’s conclu
d. Select a sion based upon
completely new reliance factors.
set of twenty b. Determine
purchase orders. that financial
27. When assessing the statements
tolerable rate, the auditor taken as a
should consider that, while whole are not
materially in
error. 30. If the auditor is concerned
c. Estimate the reliability of that a population may con
substantive tests. tain exceptions, the
d. Estimate the determination of a sample
range of size sufficient to include at
procedural least one such exception is a
deviations in the characteristic of
population.
a. Discovery sampling.
29. The tolerable rate of b. Variables sampling.
deviations for a test of a c. Random sampling.
control is generally d. Dollarunit sampling.
a. Lower than the
expected rate 31. In determining the number
of errors in the of documents to select for a
related test to obtain assurance that
accounting all sales have been properly
records. authorized, an auditor
b. Higher than the should consider the
expected rate of tolerable rate of deviation
errors in the re from the control activity.
lated The auditor should also
accounting consider the
records. I. Likely rate of deviations.
c. Identical to the AI. Allowable risk of assessing control
expected rate of risk too high.
errors in related a. I only.
accounting b. II only.
records. c. Both I and II.
d. Either I or II.
An auditor should consider the tolerable
rate of deviation when determining the
number of check requests to select for
a test to obtain assurance that all check
requests have been properly authorized.
The auditor should also consider
The allowable
The average dollar value risk of assessing
of the check requests control risk too low
a. Yes Yes
b. Yes No
c. No Yes
d. No No
correct concerning statistical
sampling in tests of controls?
a. As the
population size
increases, the
sample size
should increase
proportionately.
b. Deviations from
specific internal
control proce
dures at a given
rate ordinarily
result in
misstatements
at a lower rate.
c. There is an
inverse
relationship
between the
expected
population
deviation rate expected
and the sample population de
size. viation rate.
d. In determining b. Accept the
tolerable rate, an sample results as
auditor considers support for the
detection risk planned assessed
and the sample level of control
size. risk because the
sample deviation
34. What is an auditor’s rate plus the
evaluation of a statistical allowance for
sample for attributes when sampling risk
a test of fifty documents exceeds the
results in three deviations tolerable rate.
if tolerable rate is 7%, the c. Accept the sample
expected population results as support
deviation rate is 5%, and for the planned
the allowance for assessed level of
sampling risk is 2%?
control risk
a. Modify the
because the
planned assessed
tolerable rate less
level of control
the allowance for
risk because the
tolerable rate plus sampling risk
the allowance for equals the
sampling risk expected
exceeds the population
deviation rate.
b. 4 1/2%
c. 3 1/2%
d. Modify the planned d. 1%
assessed level of control
risk because the sample 37. Which of the following statements is
deviation rate plus the correct concerning statistical
allowance for sampling sampling in tests of controls?
risk exceeds the tolerable a. The population
rate. size has little or
no effect on deter
Items 35 and 36 are based on the mining sample
following: size except for
An auditor desired to test very small popula
credit approval on 10,000 sales tions.
invoices processed during the b. The expected
year. The auditor designed a population
statistical sample that would deviation rate has
provide 1% risk of assessing little or no effect
control risk too low (99% on determining
confidence) that not more than 7% sample size except
of the sales invoices lacked forvery small
approval. The auditor estimated populations.
from previous experience that c. As the
about population size
2 1/2% of the sales invoices lacked doubles, the
approval. A sample of 200 invoices sample size
was examined and 7 of them were also should
lacking approval. The auditor then double.
determined the achieved upper d. For a given
precision limit to be 8%. tolerable rate, a
larger sample
35. In the evaluation of this size should be
sample, the auditor selected as the
decided to increase the expected
level of the preliminary population de
assessment of control risk viation rate
because the decreases.
a. Tolerable rate
(7%) was less 38. When an auditor has
than the achieved chosen a random sample
upper precision and is using
limit (8%). nonstatistical attributes
b. Expected sampling, that auditor
deviation rate a. Need not consider
(7%) was more the risk of
than the assessing control
percentage of risk too low.
errors in the b. Has committed a
sample (3 nonsampling error.
1/2%). c. Will have to
c. Achieved use discovery
upper precision sampling to
limit (8%) was evaluate the
more than the results.
percentage of d. Should compare
errors in the the deviation rate
sample of the sample to
(3 1/2%). the tolerable
d. Expected deviation rate.
deviation rate (2 39. How would increases in
1/2%) was less
tolerable misstatement and
than the tolerable
rate (7%).
risk affect the sample size
36. The allowance for sampling risk in a substantive test of
was details?
a. 5 1/2% Increase in tolerable Increase in assessed
misstatement level of control risk
a. Increase sample size Increase sample size
c. Decrease sample size Increase sample size
b. Increase sample size Decrease sample size
d. Decrease sample size Decrease sample size
courses of action would an
auditor most likely follow
in planning a sample of
cash disbursements if the
auditor is aware of several
unusually large cash
disbursements?
a. Set the tolerable
rate of deviation
at a lower level
than originally
planned.
b. Stratify the cash
disbursements
population so that
the unusually
large
disbursements are
selected.
c. Increase the
sample size to
reduce the effect
of the unusually
large
disbursements.
d. Continue to draw
new samples until
all the unusually
large
disbursements
appear in the
sample.

sample planning factors
would influence the sample
size for a substantive test of
details for a specific
account?
Expected Measure of
amount of tolerable
misstatements misstatement
a. No No
b. Yes Yes
c. No Yes
d. Yes No
42. When planning a sample
for a substantive test of
details, an auditor should
consider tolerable
misstatement for the
sample. This
consideration should
a. Be related to the auditor’s
business risk.
b. Not be adjusted for
qualitative factors.
c. Be related to
preliminary
judgments about
materiality
levels.
d. Not be changed during the the population.
audit process. c. The acceptable level of risk.
d. The estimated
43. A number of factors rate of
influences the sample size misstatements in
for a substantive test of the population.
details of an account
balance. All other factors 45. An auditor established a $60,000
being equal, which of the tolerable misstatement for an asset
following would lead to a with an account balance of
larger sample size? $1,000,000. The auditor selected a
a. Greater reliance on internal sample of every twentieth item from
control. the population that represented the
b. Greater reliance on asset account balance and discovered
analytical procedures. overstatements of $3,700 and
c. Smaller expected frequency understatements of $200. Under these
of errors. circumstances, the auditor most likely
d. Smaller measure of would conclude that
tolerable misstatement. a. There is an
unacceptably high
44. In estimation sampling for risk that the actual
variables, which of the misstatements in
following must be known the population
in order to estimate the exceed the toler
appropriate sample size able misstatement
required to meet the because the total
auditor’s needs in a given
projected mis
situation?
statement is more
a. The qualitative aspects of
than the tolerable
errors.
misstatement.
b. The total dollar amount of
218 distribution.
MODULE 7 b. Overstated units have
a lower probability of
sample selection than
b. There is an units that are
unacceptably high understated.
risk that the toler c. The auditor controls the
able misstatement risk of incorrect accep
exceeds the sum of tance by specifying that
actual over risk level for the
statements and sampling plan.
understatements. d. The sampling interval is
c. The asset account calculated by dividing
is fairly stated the number of physical
because the total units in the population
projected by the sample size.
misstatement is 47. Hill has decided to use
less than the probabilityproportionaltosize
tolerable
(PPS) sampling, sometimes called
misstatement.
dollarunit sampling, in the audit
d. The asset account is
of a client’s accounts receivable
fairly stated because
balances. Hill plans to use the
the tolerable
following PPS sampling table:
misstatement
exceeds the net of TABLE
projected actual Reliability Factors for Overstatements
Number
overstatements and of over Risk of incorrect acceptance
understatements. statements 1% 5% 10% 15% 20%
0 4.61 3.00 2.31 1.90 1.61
46. Which of the following statements is 1 6.64 4.75 3.89 3.38 3.00
correct concerning probability 2 8.41 6.30 5.33 4.72 4.28
proportionaltosize (PPS) sampling, 3 10.05 7.76 6.69 6.02 5.52
4 11.61 9.16 8.00 7.27 6.73
also known as dollar unit sampling?
a. The sampling
distribution should
approximate the
normal
AUDIT SAMPLING 51. The use of the ratio estimation
sampling technique is most
effective when
Variability in the dollar a.The calculated audit
amounts of inventory items amounts are
a. Yes approximately
b. Yes proportional to the
c. No client’s book
d. No
amounts.
50. In statistical sampling b. A relatively small
methods used in substantive number of
testing, an auditor most differences exist in
likely would stratify a the population.
population into meaningful c.Estimating populations
groups if whose records
a.Probability consist of quantities,
proportionalto but not book values.
size (PPS) d. Large overstatement
sampling is used. differences and large
b. The understatement
population differences exist in
has highly the population.
variable
recorded 52. In the application of statistical
amounts. techniques to the estimation of
c.The auditor’s dollar amounts, a preliminary
estimated sample is usually taken primarily
tolerable for the purpose of estimating the
misstatement is population
extremely small. a. Variability.
d. The standard deviation b. Mode.
of recorded amounts is c. Range.
relatively small. d. Median.
Additional information ple size, the auditor
Tolerable misstatements
usually determines the
(net of effect of expected misstatements)
Risk of incorrect acceptance
Number of misstatements
Recorded amount of accounts receivable
Number of accounts
What sample size should Hill use?
a. 120
b. 108
c. 60
d. 30
48. In a probabilityproportionaltosize
sample with a sampling interval of
$5,000, an auditor discovered that a
selected account receivable with a
recorded amount of $10,000 had an
audit amount of $8,000. If this were
the only error discovered by the
auditor, the projected error of this
sample would be
a. $1,000
b. $2,000
c. $4,000
d. $5,000
49. An auditor is determining
the sample size for an in
ventory observation using
meanperunit estimation,
which is a variables
sampling plan. To
calculate the required sam
53. Using statistical sampling to assist and corresponds
in verifying the yearend accounts to the sum of all
payable balance, an auditor has the individual
accumulated the following data: book values.
b. A book value for each
Number of Book sample item is unknown.
accounts balance c. There are some
Population 4,100 $5,000,000 observed
Sample 200 $ 250,000 differences
Using the ratio estimation between audited
technique, the auditor’s estimate of values and book
yearend accounts payable balance values.
would be d. The audited
a. $6,150,000 values are
b. $6,000,000 nearly
c. $5,125,000 proportional to
d. $5,050,000 the book values.
54. Use of the ratio estimation 55. An auditor is performing

sampling technique to substantive tests of pricing
estimated dollar amounts and extensions of perpetual
is inappropriate when inventory balances consisting
a. The total book of a large number of items.
value is known Past experience indicates
numer
ous pricing
and
extension
errors.
Which of
the
following
statistical
sampling
approaches
is most
appropriate
?
a. Unstratified meanperunit.
b. Probabilityproportionaltosize.
c. Stop or go.
d. Ratio estimation.
56. The
maj
or
reas
on
that
the
diffe
renc
e
and
ratio
esti
ma
tion
met
hods
wou
ld
be
expe
cted
to
prod
uce
audi
t
effic
ienc
y is
that
the
a.
Num
b
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r

o
f

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e
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b. Beta risk may be completely ignored.
c.
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57. Whic
h of
the
follo
wing
state
ment
s is
corre
ct
conc
ernin
g the
audit
or’s
use
of
statis
tical
samp
ling?
a.
An
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b.
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.
SIMULATIONS
Analyzing PPS
Authoritative
Results
Literature Help
The following is a computer printout generated by audit software using probability
proportionaltosize (PPS) sampling:
Winz Corporation
Receivable Sampling Evaluation Results
December 31, 20X2
Population book value = $2,400,000; Tolerable misstatement = $280,000
Projected Misstatement
Tainting Projected
Book value Audited value Misstatement percentage Sampling interval misstatement
$1,000 $ 0 $1,000 100% $80,000 $ 1,000
750 600 150 20% $80,000 16,000
85,000 60,000 25,000 NA NA 25,000
$42,000
Basic Precision = 3.0 * $80,000 $240,000
Incremental Allowance
Reliability factor Increment (Increment –1) Projected misstatement Incremental allowance
3.00
4.75 1.75 .75 $16,000 $12,000
6.30 1.55 .55 1,000 __550
$12,550
The software uses factors from the following PPS sampling table:
TABLE
Reliability Factors for Overstatements
Number of Risk of incorrect acceptance
overstatements 1% 5% 10% 15% 20%
0 4.61 3.00 2.31 1.90 1.61
1 6.64 4.75 3.89 3.38 3.00
2 8.41 6.30 5.33 4.72 4.28
3 10.05 7.76 6.69 6.02 5.52
4 11.61 9.16 8.00 7.27 6.73
Answer the following questions relating to the above worksheet:
Answers
Questions
A. 30 items
1. What was the planned sample size?
B. 60 items
2. What is the total misstatement in the sample? C. 76 items
D. 90 items
3. What is the most likely total misstatement in the E. 0
population? F. $ 12,550
4. Calculate the upper limit on misstatement. G. $ 26,150
H. $ 42,000
5. Calculate the allowance for sampling risk.
I. $ 54,550
6. Would one “accept” or “reject” the population as being J. $ 80,000
materially correct? K. $252,550
7. What is the risk of incorrect acceptance? L. $280,000
M. $294,550
N. $354,550
O. Accept
P. Reject
Q. 5%
R. 20%
S. 100%
PPS Sampling
Concepts
Authoritative
Literature Help
Reply as to whether you believe the following statements are correct or
incorrect concerning PPS sampling:
1. S
2. P
3. I
4. P
5. I
f
6. O
7. A
8. P
Tolerable misstatement
Sample size
Expected of misstatement
Recorded amount of accounts receivable
9. The sampling interval is $500.
10. Increasing the expected misstatement to $10,000 will increase the sample size.
Research
Authoritative
Literature Help
Sampling vs. nonsampling risk
As a new assistant with Webber & Co. CPAs you have been asked to perform
research on the nature of sampling risk versus nonsampling risk.
Selections
A. AU
B. PCAOB
C. AT
D. AR
E. ET
F. BL
G. CS
H. QC
(
A
)
(
B
)
(
C
)
(
D
)
(
E
)
(
F
)
(
G
)
(
H
)
2. Enter the exact

section and
paragraph(s) which
distinguish between
sampling and
nonsampling risk.
1. d __ __ 13. d __ __ 25. b __ __ 37. a __ __ 49. a __ __

2. c __ __ 14. c __ __ 26. c __ __ 38. d __ __ 50. b __ __
3. a __ __ 15. c __ __ 27. a __ __ 39. c __ __ 51. a __ __
4. d __ __ 16. b __ __ 28. d __ __ 40. b __ __ 52. a __ __
5. a __ __ 17. b __ __ 29. b __ __ 41. b __ __ 53. b __ __
6. a __ __ 18. d __ __ 30. a __ __ 42. c __ __ 54. b __ __
7. d __ __ 19. c __ __ 31. a __ __ 43. d __ __ 55. d __ __
8. b __ __ 20. d __ __ 32. c __ __ 44. c __ __ 56. d __ __
9. c __ __ 21. a __ __ 33. b __ __ 45. a __ __ 57. a __ __
10. a __ __ 22. d __ __ 34. d __ __ 46. c __ __ 58. c __ __
11. d __ __ 23. a __ __ 35. a __ __ 47. d __ __ 1st: __/58 = __%
12. c __ __ 24. c __ __ 36. b __ __ 48. b __ __ 2nd: __/58 = __%
MULTIPLECHOICE ANSWER
EXPLANATIONS
require the use of judgment, al
A.2. General Approaches though that judgment is quantified
to Audit Sampling when statistical sampling is used.
— Nonstatistical Answer (c) is incorrect because
and Statistical either statistical or nonstatistical
sampling may provide equal
1. (d) The requirement is to assurance to the auditor.
identify an advantage of
statistical sampling over 2. (c) The requirement is to identify an
nonstatistical sampling. advantage of statistical sampling over
Answer (d) is correct nonstatistical sampling. Answer (c) is
because statistical correct because statistical sampling
sampling helps the auditor helps the auditor to:
to: (1) design an efficient (1) design an efficient sample, (2)
sample, (2) measures the measure the sufficiency of the
sufficiency of the evidential matter obtained, and (3)
evidential matter obtained, evaluate the sample results (AICPA
and Audit Sampling Guide). Answer (a) is
(3) evaluate the sample results incorrect because the risk of
(AICPA Audit SamplingGuide). nonsampling errors is not directly
Answer (a) is incorrect because dual affected by whether statistical or
purpose tests,which both test a nonstatistical sampling is used.
control and serve as substantive test, Answer (b) is incorrect because either
may be performed with either a statistical or nonstatistical sampling
statistical or a nonstatistical sample. can be used to reduce the level of
Answer (b) is incorrect because both audit risk to a low level; the
statistical and nonstatistical sampling materiality level should not be
affected by the type of sampling used. sampling applied to substantive
Answer (d) is incorrect because testing and not to tests of controls
either statistical or nonstatistical and because the meaning of
sampling may be used to minimize “support the tolerable error” is
the failure to detect errors and fraud. uncertain.
A.3. Uncertainty and Audit 4. (d) The requirement is to determine
Sampling the nature of the risk of incorrect
acceptance and the risk of assessing
3. (a) The requirement is to determine control risk too low. Answer (d) is
the meaning ofthe likelihood of correct because the risk of incorrect
assessing control risk too high in a test acceptance and the risk of assessing
of controls. Answer (a) is correct control risk too low relate to the
because the risk of assessing control effectiveness of an audit in detecting
risk too high is the risk that the sample an existing material misstatement or
does not support the auditor’s planned deviation. Answer (a) is incorrect
assessed level of control risk when the because the term “allowable risk of
true operating effectiveness of the tolerable misstatement” is not used in
control structure justifies such an the professional standards. Answer
assessment. Answer (b) is incorrect be (b) is incorrect because preliminary
cause the risk of assessing control risk estimates of materiality levels relate
too high relates to the deviation rate most directly to the risk of incorrect
from a control procedure in a acceptance, and only indirectly to the
population, not to monetary
risk of assessing control risk too low.
misstatements. Answer (c) is incorrect
risk of incorrect rejection and the
because the risk of assessing control
risk of assessing control risk too high
risk too high does not directly relate to
relate to the efficiency of the audit.
monetary misstatements. Answer (d) is
incorrect because tolerable error 5. (a) The requirement is to determine
(misstatement) relates to variables which answer represents the concept
of sampling risk. Sampling risk arises
from the possibility that an auditor’s
conclusions based upon a sample
would differ from the conclusions
which would be drawn from
examining the entire population (i.e.,
the risk that the sample examined is
not representative of the population).
Answers (b), (c), and (d) are all
incorrect because they relate to errors
which could occur even if 100% of
the population were examined, that is,
nonsampling risk.
determine what is related to
the risk of incorrect
rejection and the risk of
assessing control risk too
high. Answer (a) is correct
because AU 350 states that
the risk of incorrect
rejection and the risk of as
sessing control risk too high
relate to the efficiency of
the audit. These two errors
generally result in an
auditor performing
unnecessary additional
procedures. Answer (b) is
incorrect because the risk of
incorrect acceptance and the
risk of assessing control
risk too low relate to the
effectiveness of an audit. which an auditor has
Answer (c) is incorrect properly concluded that
because the risks do not control risk is at or below
relate directly to the actual the planned assessed level.
selection of the sample. Answer (d) is correct
Answer (d) is incorrect because to support the
because the audit quality planned level, the deviation
controls do not directly rate must be less than the
mention either of these tolerable rate and the auditor
risks. must conclude that the
7. (d) The requirement is to deviation rate is less than the
determine the situation in tolerable
is not misstated. Answers
(a) and (b) are incorrect
rate. Answer (a) is incorrect because because the risk of
it represents a situation in which the assessing control risk too
auditor appropriately decides that the high and the risk of
deviation rate exceeds the tolerable assessing control risk too
rate. Answer (b) is incorrect because low relate to tests of
it represents a situation in which an controls, and not to
auditor erroneously concludes that substantive tests of details.
the deviation rate exceeds the Answer (d) is incorrect
tolerable rate when it actually does because the risk of
not. Answer (c) is incorrect because incorrect acceptance is the
the auditor erroneously concludes that risk that the sample support
the deviation rate is less than the the conclusion that the
tolerable rate when it actually exceeds account is not misstated
it. when in fact it is misstated.
8. (b) The requirement is to A.4. Types of Audit Tests in Which
determine the situation in
Sampling May Be
which the auditor assesses
control risk too high and Used
thereby increases 10. (a) The requirement is to
substantive testing. Answer identify the correct statement with
(b) is correct because to respect to the size of a sample
assess control risk too high, required for dual purpose testing.
an auditor must estimate Answer (a) is correct because the
that the deviation rate auditor should select the larger of
exceeds the tolerable rate the required sample sizes.
when it actually is less than
the tolerable rate. Answer A.5. Types of Statistical Sampling
(a) is incorrect because it Plans
represents a situation in
which the auditor appropri 11. (d) The requirement is to identify the
ately decides that the type of sampling involved in a
deviation rate exceeds the review of client invoices in which an
tolerable rate. Answer (c) is expected population deviation rate
incorrect because the and an established tolerable rate are
auditor erroneously provided. Answer (d) is correct
concludes that the deviation because attribute sampling is used to
rate is less than the toler reach a conclusion about a popula
able rate when it actually tion in terms of a rate of occurrence
exceeds the tolerable rate. (Audit Sampling Guide). Answer (a)
Answer (d) is incorrect is incorrect because stratified
because to properly rely on sampling is generally used to reach a
internal control, the dollarbased conclusion in variables
deviation rate must be less sampling approaches. Answer (b) is
than the tolerable rate and incorrect because, as indicated,
the auditor must conclude variables sampling deals with a dollar
that the deviation rate is less amount conclusion, not deviation
than the tolerable rate. rates. Answer (c) is incorrect because
discovery sampling is only used in
9. (c) The requirement is to cases in which the auditor expects
determine the type of risk deviation rates to be extremely low
demonstrated when an (approaching zero).
auditor concludes that an
account is misstated when 12. (c) The requirement is to
in fact it is not. Answer (c) identify the sampling
is correct because the risk method that would be used
of incorrect rejection is the to estimate a numerical
risk that the sample measurement such as a
supports the conclusion dollar value of a
that the recorded account population. Answer (c)
balance is materially
misstated when the account
systematic. Additionally,
is correct because sampling for random sampling may be
variables addresses such numerical performed without re
measurements. Answer (a) is placement.
incorrect because attributes sampling
deals with deviation rates. Answer (b) 15. (c) The requirement is to
is incorrect because stoporgo determine the least desir
sampling (also referred to as able statistical selection
sequential sampling) is a form of technique. Answer (c),
attributes sampling. Answer (d) is block selection, is correct
incorrect because randomnumber because, ideally, a sample
sampling is simply a sample selection should be selected from
technique that may be used with the entire set of data to
either an attributes or a variables which the resulting
form of sampling; accordingly, a conclusions are to be
numerical measurement such as a applied. When block
dollar value is not necessary for sampling is used, the
randomnumber sampling. selection of blocks often
precludes items from being
13. (d) The requirement is to so selected. In most cases,
determine the audit testfor which an systematic [answer (a)],
auditor would most likely use stratified [answer (b)], and
attribute sampling. Answer (d) is sequential [answer (d)]
correct because attribute sampling is selection techniques all
used to reach a conclusion about a provide a better
population in terms of a rate of representation of the entire
occurrence. Here the rate of population than does block
occurrence will be the rate of selection.
(un)approved time cards. Answers
(a), (b), and (c) are all incorrect 16. (b) The requirement is to identify the
because they all relate more directly type of sampling plan that does not use
to variables sampling which is a fixed sample size for tests of controls.
generally used to reach conclusion Answer (b) is correct because
about a population in terms of a sequential sampling results in the
dollar amount. See the AICPA Audit selection of a sample in several steps,
and Accounting Guide, Audit with each step conditional on the result
Sampling and AU 350 for more of the previous steps. Therefore, sample
information on audit sampling. size will vary depending upon the
General Sampling Questions number of stages that prove necessary.
Answers (a), (c), and (d) are all
14. (c) The requirement is to incorrect because dollarunit sampling,
determine the correct PPS sampling, and variables sampling
statement with respect to all use a fixed sample size.
random sampling. Answer
(c) is correct because every 17. (b) The requirement is to
item in the accounting identify the correct state
population should have an ment concerning a statistical
opportunity to be selected. sampling application where
Answer (a) is incorrect the population consists of
because with stratified forms which are not
random sampling, each consecutively numbered.
stratum need not be given Answer (b) is correct because
equal representation. systematic sampling is a
Answer (b) is incorrect procedure where a random
because while sample units start is obtained and then
should be randomly every nth item is selected.
selected, there is no For example, a sample of
requirement that the forty from a population of a
accounting population be thousand would require
randomly ordered. Answer selecting every 25th item
(d) is incorrect because after obtaining a random start
random sampling, by its between
very nature, is not
subpopulations to reduce
the effect of dispersion in
items 1 through 25. Answer (a) is the population.
incorrect because selection of a
random sample is possible even B.1. Tests of Controls—Sampling
though the population is not Risk
consecutively numbered. Answer (c)
is incorrect because there is no 20. (d) The requirement is to
special reason for using stratified identify the circumstance
sampling. Stratified sampling breaks that would cause an
down the population into auditor to assess control
subpopulations and applies different risk too low and decrease
selection methods to each substantive testing
subpopulation. This selection method inappropriately. Answer
is used when the population consists (d) is correct because when
of different types of items (e.g., large the true deviation rate in
balances and small balances). the population exceeds that
Answer (d) is incorrect because in the sample, the auditor
random number tables can be used may assess control risk too
even though the forms are not low. The AICPA Audit
consecutively numbered. If random SamplingGuide discusses
numbers are selected for which there tests of controls and
are no forms, they are ignored. This attributes sampling inits
is the same as if there were 86,000 second chapter. Answers
items in a consecutively numbered (a) and (c) are incorrect be
population and random numbers cause the true deviation rate and the
selected between 86,000 and 99,999 risk of assessing control risk too low
are ignored. do not have such a relationship, either
positive or negative. Answer (b) is
18. (d) Answer (d) is correct because
incorrect because a deviation rate in
systematic items occurrence in a the population that is less than the
population may destroy a sample’s deviation rate in the auditor’s sample
randomness. Answer (a) is incorrect may lead the auditor to assess control
because items need not be replaced in risk too high.
the population, and therefore is not a
disadvantage of systematic sampling. 21. (a) The requirement is to determine
Answer (b) is incorrect because an whether the expected deviation rate,
individual item will not occur more the tolerable deviation rate, or both
than once in a sample when affect the sample size for a test of
systematic sampling is being used controls. Answer (a) is correct
(because the auditor selects every nth because attribute sampling formulas
item). Answer (c) is incorrect be and tables used in auditing generally
cause systematic sampling refers to require the auditor to specify an ex
the type of sampling selection plan pected deviation rate, a tolerable
used and not the manner in which deviation rate and the risk of
items in the population are recorded. assessing control risk too low. See
Also, as indicated in (d) above, a AICPA Audit Sampling Guide and
systematic pattern in the population is AU 350 for more information on audit
a hindrance to systematic sampling. sampling.
19. (c) Stratified sampling is a
technique of breaking the
population down into
subpopulations and
applying different sample
selection methods to the
subpopulations. Stratified
sampling is used to
minimize the variance
within the overall
population [answer (c)].
Recall that as variance
increases, so does the
required sample size
(because of the extreme
values). Thus, stratification
allows the selection of
22. (d) The requirement is to identify the correct state
identify the correct state ment with respect to
ment about sampling for treatment of a voided
attributes. Answer (d) is voucher that has been
correct because the sample selected in a sample.
size increases as the Answer (b) is correct
tolerable rate decreases, an because the AICPA Audit
inverse relationship. Sampling Guide states that
Answer (a) is incorrect the auditor should obtain
because many deviations do reasonable assurance that
not necessarily result in a the voucher has been prop
misstatement. Answer (b) erly voided, and should then
is incorrect because a replace it with another
doubling of the population voucher. Answer (a) is
size will result in less than a incorrect because the
doubling of the required voided voucher is not
sample size. Answer (c) is normally considered to be a
incorrect because auditors deviation. Answer (c) is
must consider the incorrect because the
qualitative aspects of auditor must obtain
deviations. reasonable assurance that
the misplaced voucher has
23. (a) The requirement is to identify the been voided. Answer (d) is
information needed in addition to the incorrect because the level
likely rate of deviations and the of materiality normally does
allowable risk of assessing control not directly affect the
risk too low to determine the sample decision.
size for a test of controls in an
attributes sampling plan. Answer (a) 26. (c) The requirement is to
is correct because the tolerable de determine the proper
viation rate is also needed. Answer method of handling a
(b) is incorrect because the risk of sample item which cannot
incorrect acceptance relates to be located for evaluation
variables sampling applied to purposes. Answer (c) is
substantive testing, not attributes correct because an auditor
sampling applied to tests of controls. would ordinarily consider
Answer (c) is incorrect because the the selected item to be a
auditor will examine the nature and deviation. Answers (a) and
cause of deviations after the sample (d) are incorrect since a
has been selected. Answer (d) is possible cause for the
incorrect because auditors often do missing purchase order
not consider population size when could be a breakdown in
performing attributes sampling one of the controls of the
applied to tests of controls. system. Thus, in selecting a
new sample item(s) the
24. (c) The requirement is to auditor may be ignoring a
determine when a sample portion of the population
size would be decreased which is in error and may
when sampling for be artificially skewing the
attributes. Answer (c) is results of the tests
correct because the sample performed on the sample.
size will decrease when Answer (b) is incorrect
the risk of assessing because there is no reason
control risk too low is to believe that the entire test
increased, the tolerable is invalid and cannot be
rate is increased, and the relied upon.
expected population
deviation rate is decreased 27. (a) The requirement is to
(Audit and Accounting determine why deviations
Guide Audit Sampling). from control procedures do
Answers (a), (b), and (d) not necessarily result in
are all incorrectbecause errors. Answer (a) is
they include combinations correct because it provides
of changes that would not an example of a situation
necessarily decrease in which a deviation from a
sample size. control procedure exists
(lack of documentation of authorized and proper.
transaction approval), al Thus, such a
though the entry was
the type of sampling which is most
directly related to finding at least one
deviation does not necessarily result exception. Discovery sample sizes
in an error in the financial and related discovery sampling tables
statements. Answer (b) is incorrect are constructed to measure the
because a deviation from control probability of at least one error
procedure and an error may occur in occurring in a sample if the error rate
the same transaction. Answer (c) is in the population exceeds the
incorrect since the fact that all tolerable rate. Answer (b) is incorrect
deviations do not lead to errors will because variables sampling need not
result in a lower error rate. Answer include at least one exception (mean
(d) is incorrect because while it per unit sampling, for example, needs
represents a correct statement, it does no errors). Answer (c) is incorrect
not follow from the point of the since random sampling only deals
question which is based on the idea with the technique used to select
that deviations do not directly result items to be included in the sample.
in errors. Answer (d) is incorrect because
28. (d) The requirement is to dollarunit sampling results are not
determine the objective of directly related to finding at least one
the tolerable rate in exception.
sampling. Tolerable rate is 31. (a) The requirement is to determine
calculated to determine the whether an auditor should consider
range of procedural the likely rate of deviation, the al
deviations in the popula lowable risk of assessing control risk
tion. Answer (a) is incorrect too high, or both, when performing a
because probabilities relate test of a control. Answer (a) is correct
more directly to reliability. because an auditor will consider the
Answer (b) is incorrect likely rate of deviations, but will not
because errors on financial ordinarily consider the allowable risk
statements in materiality of assessing control risk too high
terms relate to variables when following the approach out
sampling. Answer (c) is lined in the AICPA Audit Sampling
incorrect because the Guide.
tolerable rate does not relate
directly to substantive tests. 32. (c) The requirement is to determine
whether an auditor would consider the
29. (b) The requirement is to determine average dollar value of check
the correct relationship between the requests, the allowable risk of
tolerable rate of deviations and the assessing control risk too low, or
expected rate of deviations for a test both, when testing whether check
of a control. The tolerable rate of requests have been properly
deviations is the maximum rate of authorized. Answer (c) is correct
deviations from a prescribed control because a test of authorization such as
procedure that an auditor would be this is an attributes test which requires
willing to accept and, unless the
expected error rate is lower, reliance
on internal control is not justified.
Answer (a) is incorrect because if the
tolerable rate of deviations is less
than the expected rate, the auditor
would not plan to rely on internal
control and would therefore omit tests
of controls. Answer (c) is incorrect
because testing of controls is inap
propriate if the expected rate of errors
equals the tolerable rate of deviations
(mathematically, the precision of zero
makes the sample size equal to
population size). Answer (d) is
incorrect because, as indicated above,
to perform tests of controls one must
assume that the tolerable rate of
deviations is more than the expected
error rate.
assessed level of control risk
the auditor to determine an may increase. Here the
allowable risk of assessing control deviation rate of 6% (3
risk too low, but does not deal deviations/50 documents)
directly with dollar values. plus the allowance for
Answers (a), (b) and (d) are all sampling risk of 2% equals
incorrect because they include 8% and exceeds the tolerable
incorrect combinations of the rate of 7%. Answer (a) is
replies. See AU 350 and the AICPA incorrect because the
Audit Sampling Guide for tolerable rate plus the
information on sampling. allowance for sampling risk
B.2. Statistical (Attributes) will always exceed the
Sampling for Tests of expected population deviation
Controls rate when tests of controls are
being performed. Answer (b)
33. (b) The requirement is to identify the is incorrect because when the
correct statement concerning statistical sample deviation rate plus
sampling in tests of controls. Answer the allowance for sampling
(b) is correct because while deviations risk exceeds the tolerable
from pertinent control procedures rate the sample results do not
increase the risk of material mis support the planned assessed
statements, any specific deviation need level of control risk. Answer
not necessarily result in a misstatement. (c) is incorrect because the
For example, a recorded disbursement tolerable rate less the
that does not show evidence of required allowance for sampling risk
approval might nevertheless be a should be compared with the
transaction that is properly authorized actual deviation rate.
and recorded (AICPA Audit Sampling
Guide). Answer (a) is incorrect because
increases in population size result in
the circumstance in which an auditor
would decide to increase the level of
small increases in sample size. Answer
the preliminary assessment of control
(c) is incorrect because a direct
risk. Answer (a) is correct because the
relationship, not an inverse relationship,
assessment of control risk will
exists between the expected population
increase when the achieved upper
deviation rate and the sample size—that
precision limit (here 8%) exceeds the
is, increases in the expected population tolerable rate (here 7%). Answer (b)
deviation rate result in an increase in is incorrect because the expected
the required sample size. Answer (d) is deviation rate was 2 1/2%, not 7%.
incorrect because when determining the Also, if the expected deviation rate is
tolerable rate, the auditor does not yet higher than the percentage of error in
have the required sample size. the sample, the preliminary
34. (d) The requirement is to assessment does not need to be
increased. Answer (c) is incorrect
determine the proper
because the achieved upper precision
evaluation of a statistical
limit will always exceed the
sample for attributes when a
percentage of errors in the sample.
test of Answer (d) is incorrect because, in
50 documents results in 3 circumstances in which the auditor
deviations, given a tolerable decides to sample the population, the
rate of 7%, an expected expected deviation rate will always be
population deviation rate of less than the tolerable rate.
5%, and an allowance for
sampling risk of 2%. Answer 36. (b) The requirement is to
(d) is correct because when determine the allowance
the deviation rate plus the for sampling risk of the
allowance for sampling risk presented sample. When
exceeds the tolerable rate, the consider
correct because while an
increase in tolerable
ing the allowance for sampling risk, misstatement decreases
one may consider both the planned sample size for a
allowance for sampling risk or the substantive test of details,
adjusted allowance based on the an increase in the
sample results. Answer (b) is correct assessed level of control
because both the planned and risk increases the sample
adjusted allowance for sampling risk size for a substantive test
are 4 1/2% (7% – 2.5% for planning of details because a lower
purposes, and 8% – 3.5% [7/200] as level of detection risk is
adjusted). required.
37. (a) The requirement is to identify 40. (b) The requirement is to
the correct statement concerning determine the proper course
statistical sampling for tests of of action when an auditor is
controls. Answer (a) is correct planning a sample of cash
because population size has little or disbursements and he or she
no effect on sample size. Answer (b) is aware of several unusu
is incorrect because the population ally large cash
deviation rate has a significant effect disbursements. Given the
on sample size. Answer (c) is description of the several
incorrect because sample size disbursements as “unusually
increases to a much lesser extent than large,” an auditor will
doubling as the population size generally test them. Answer
doubles. Answer (d) is incorrect (b) is therefore correct
because for a given tolerable rate, a because stratifying the
smaller, and not a larger, sample size population will allow the
should be selected as the expected auditor to ensure inclusion
population deviation rate decreases. of the disbursements. The
sampling procedure
B.3. Nonstatistical Sampling for
(selecting less than all
Tests of Controls items) will then be applied
38. (d) The requirement is to identify only to the smaller
the proper statement concerning a disbursements. Answer (a)
random sample when nonstatistical is incorrect because the
attributes sampling is being used. existence of the large
Answer (d) is correct because the disbursements will have no
deviation rate of the sample should be necessary relationship to the
compared to the tolerable deviation tolerable rate of deviation
rate regardless of whether statistical when attributes sampling is
or nonstatistical sampling is being being used. Answer (c) is
used. Answer (a) is incorrect because incorrect because while
the risk of assessing control risk too increasing the sample size
low should be considered, although it might be appropriate in
may be done judgmentally. Answer some variables sampling
(b) is incorrect because nonsampling applications (we are not told
error relates to “human” type errors in this problem whether
such as not identifying a deviation, attributes or variables
and not specifically to the use of sampling is being followed),
nonstatistical sampling. Answer (c) the fact that the
is incorrect because discovery disbursements are described
sampling will not be used to evaluate as “unusually large” leads
the results. one to include them.
Answer (d) is incorrect
C.1. Tests of Details—Sampling because an auditor will not
Risk draw numerous samples to
assure inclusion of the large
39. (c) The requirement is to disbursements.
determine whether either
or both of an increase in
tolerable misstatement and
an increase in the
risk increase sample size
in a substantive test of
details. Answer (c) is
given risk of incorrect
41. (b) The requirement is to acceptance increases as the
determine whether either auditor’s assessment of
or both of the expected tolerable misstatement for
amount of misstatement the balance or class
and the measure of decreases. Answer (a) is
tolerable misstatement incorrect because a greater
influence sample size for a reliance on internal control
substantive test of details. will lead to a smaller
Answer (b) is correct sample size in a substantive
because both the expected test of details. Answer (b) is
amount of misstatement incorrect because greater
and the tolerable reliance upon analytical
misstatement affect sample procedures will result in a
size (AICPA Audit need for less reliance on
SamplingGuide). Increases substantive tests of details
in the expected amount of and therefore will result in a
misstatementsincrease smaller sample. Answer (c)
sample size, while is incorrect because a
increases in the tolerable smaller expected frequency
misstatement decrease of errors will generally
sample size. include properly
functioning internal control
42. (c) The requirement is to and will therefore result in
determine the correct a smaller sample for
statement concerning the substantive tests of details.
auditor’s consideration of
tolerable misstatement. 44. (c) The requirement is to
Answer (c) is correct because identify the factor which
the consideration of must be known in order to
tolerable misstatement is estimate the appropriate
related to preliminary sample size when using
judgments in a manner such variables sampling. Answer
that when the auditor’s (c) is correct because the
preliminary judgments about auditor must set an
tolerable misstatement levels acceptable level of risk for
for accounts or transaction both variables sampling and
types are combined for the attribute sampling. Answer
entire audit plan, the (a) is incorrect because while
preliminary judgments about the auditor will consider the
materiality levels for the qualitative aspects of errors
financial statements are not when evaluating the sample,
exceeded. Answer (a) is they need not be considered
incorrect because the in determining an appropriate
auditor’s judgment of sample size. Answer (b) is
business risk related to a incorrect because a primary
client is not directly related to objective of variables
tolerable misstatement. sampling is to estimate the
Answer (b) is incorrect audited dollar amount of the
because tolerable mis population. Also, in some
statement may be adjusted for forms of variables sampling,
qualitative factors. An knowledge of book values is
swer (d) is incorrect because not necessary (e.g., mean
tolerable misstatement may be perunit). Answer (d) is
changed during the audit process, incorrect because a rate of
especially as misstatements are error in the population relates
identified and the auditor considers to attribute sampling.
the nature of the misstatements.
45. (a) The requirement is to identify an
43. (d) The requirement is to auditor’s most likely response to a
determine the factor that circumstance in which there is a toler
would lead to larger sample able misstatement of $60,000, and the
size in a substantive test of auditor has discovered misstatement of
details. Answer (d) is a net overstatement of $3,500 ($3,700 –
correct because the sample $200) when 1/20 of the account has
size required to achieve the been included in the sample. Because
auditor’s objective at a auditors must project the misstatements
to the entire population, one would expect a misstatement of
misstatement already
adjusted for expected
approximately $70,000 (20 times the misstatements (as is the
misstatement of $3,500). Since this situation in this problem),
exceeds the tolerable misstatement, one divides that total by the
there is little question that the risk of number of expected
material misstatement is too high and misstatements column for
that the misstatement in the the appropriate risk of
population exceeds the tolerable incorrect acceptance (the
misstatement, therefore answer (a) is fact that some over
correct. Answer (b) is incorrect statements are expected is
because it seems that the sum of not used). Here that
actual overstatement and computation is
understatement is likely to exceed the $24,000/1.61 = $14,906.83.
tolerable misstatement. Also, answer Sample size is computed by
(b) makes little sense since there dividing the recorded
probably is no such thing as “an amount by the sampling
unacceptably high risk” that the interval, here
tolerable misstatement exceeds the $240,000/14,906.83, for a
sum of actual overstatements and sample size of 16. An
understatements; in such a cir
alternate approach is to use
cumstance the auditor simply accepts
the reliability factor for the
the population as being materially
expected number of
correct. Answers (c) and (d) are
overstatements. In that case
incorrect because the total projected
misstatement must be calculated as the computations become
indicated above. See AU 350 and the $24,000/3.00 = $8,000.
Audit SamplingGuide for information Sample size is
on sampling. $240,000/$8,000 = 30. In
either case answer (d) is the
C.2. ProbabilityProportionalto closest and therefore the
Size (PPS) Sampling correct reply.
46. (c) The requirement is to 48. (b) The requirement is to

identify the correct state determine the projected
ment regarding probability error (misstatement) of a
proportionaltosize (PPS) probabilityproportional
sampling. Answer (c) is tosize (PPS) sample with
correct because when using a sampling interval of
PPS sampling, the auditor $5,000, when an auditor
controls the risk of incorrect has discovered that an
acceptance by specifying a account with a recorded
risk level when planning the amount of $10,000 had
sample. An an audit amount of
swer (a) is incorrect because PPS $8,000. Answer (b) is
sampling does not assume a normal correct since, when an
distribution. Answer (b) is incorrect account’s recorded
because the book value of the unit amount exceeds the
determines how probable it is that it sampling interval, the
will be included in the sample, not projected error equals the
whether it is over or understated. actual misstatement, here
Answer (d) is incorrect because the $2,000 ($10,000 –
sampling interval is calculated by $8,000).
dividing the book value of the
population by the sample size. C.3. Classical Variables Sampling
47. (d) The requirement is to 49. (a) The requirement is to

determine the sample size determine whether anauditor uses the
that should be used in a variability in dollar values, the risk of
probabilityproportionalto incorrect acceptance, or both, in a
size (PPS) sample. One meanperunit estimation variables
approach is to first calculate sampling plan. Answer (a) is correct
a sampling interval and use because both
it to determine an
appropriate sample size.
Using this approach, when
provided with the tolerable
swer (c) is incorrect because
factors are included in a sampling while the ratio estimation
plan. Answers (b), (c) and (d) are all sampling technique may be
incorrect because they suggest that used with quantities, it offers
one or both factors are not considered. no particular advantage over
See AU 350 and the AICPA Audit other methods. Answer (b) is
Sampling Guide for information on incorrect because the
sampling. absolute size of differences
50. (b) The requirement is to does not make the ratio
identify the circumstance in estimation method most
which an auditor most effective.
likely would stratify a 52. (a) The requirement is to
population into meaningful determine the purpose of
groups. Answer (b) is taking a preliminary sample
correct because stratified
when one uses statistical tech
sampling is used to
niques. It is necessary to
minimize the effect on
obtain an estimate of a
sample size of variation
population’s standard
within the overall
population and results in the deviation (variability) when
largest savings for calculating the required
populations with high sample size and when using
variability. Answer (a) is sampling techniques.
incorrect because while PPS Answers (b), (c), and (d) are
sampling may in essence incorrect because, in most
stratify a population, the statistical techniques used by
items selected, other than auditors, the mode (most
those larger than the frequent balance), the median
sampling interval, are not in (middle balance) and the
“meaningful groups.” range (difference between
Answer (c) is incorrect the highest and lowest values)
because the tolerable are not used.
misstatement in and of itself
will not lead to 53. (b) The requirement is to
stratification. Answer (d) is determine the estimated
incorrect because audited accounts payable
stratification is used pri balance using the ratio
marily when there is a estimation technique.
relatively large standard Answer (b) is correct
deviation, not a relatively because the ratio estima
small standard deviation. tion technique estimates
the audited value by
51. (a) The requirement is to multiplying the audited
determine when ratio esti value/book value of the
mation sampling is most sample times the popu
effective. The ratio lation book value. In this
estimation sampling case, ($300,000/$250,000)
technique uses the ratio × $5,000,000 =
between the audited to book $6,000,000.
amounts as a measure of
54. (b) The ratio estimation sampling
standard deviation in its sam
technique is based on comparing the
ple size computation. Answer
ratio of the book value to the audited
(a) is correct because when
value of the sampled items. Answer
audit differences are
(b) is correct because this method
approximately proportional
cannot be used when there is no book
to account size the standard
value to make the comparison. The
deviation of the ratio is small circumstances described in answers
and this results in a (a) and (c) are necessary for ratio
relatively small required point and interval estimation. Answer
sample size. Answer (b) is (d) describes the circumstances in
incorrect because a relatively which the use of ratio estimation will
large number of differences be efficient in terms of required
between book and audited sample size.
values must exist to calculate
a reliable standard deviation 55. (d) The requirement is to
under the ratio method. An determine the most appro
priate sampling approach for and
substantive tests of pricing
identify the correct state
extensions of perpetual inventory ment concerning the
balances consisting of a large auditor’s use of statistical
number of items for which past sampling. Answer (a) is
experience indicates numerous correct because an estimate
expected pricing and extension of the variation of the
errors. Answer (d) is correct population, the standard
because ratio estimation is deviation, is needed to use
appropriate classical variables
when testing a population for which a sampling (AICPA Audit
large number of errors of this nature and Accounting Guide,
is expected (Audit and Accounting Audit Sampling). Answer
Guide, Audit Sampling). Answer (a) (b) is incorrect because PPS
is incorrect because the unstratified sampling does not make an
meanperunit method will typically assumption that the under
provide a larger sample size than the lying population is
ratio estimation method to achieve the normally distributed.
same level of sampling risk. Thus, the Answers (c)
ratio estimation method would be and (d) are incorrect because
more appropriate. Answer (b) is classical variables sample selected
incorrect because probability accounts and therefore need not
proportionaltosize sampling is most include special considerations to
efficient for testing populations with those with a negative balance.
relatively low expected error rates.
Answer (c) is incorrect because “stop C.4. Comparison of PPS
or go” or “sequential” sampling is Sampling to
most frequently used in attribute Classical Variables
sampling. Sampling
56. (d) Difference and ratio estimation 58. (c) The requirement is to identify
methods are statistical sampling an advantage inusing classical
methods. They measure the difference variables sampling rather than
between audit and book values or the probabilityproportionaltosize
ratio of audit to book values. As these sampling. Answer (c) is correct be
differences should not be great, the cause the inclusion of zero and
population of these differences will negative balances generally does not
have little variance. In statistical require special design considerations
sampling, the less variation in a when using classical sampling, while
population, the smaller the required it does when using probability
sample to provide an estimate of the proportionaltosize sampling
population. In other words, difference (AICPA Audit SamplingGuide).
and ratio estimation methods are Answer (a) is incorrect because
more efficient because the differences classical variablessampling does
between audit and book values are require an estimate of the standard
expected to vary less than the actual deviation of the population’s
items in the population. Answer (a) is recorded amounts. Answer (b) is
incorrect because the number of incorrect because the computational
members in the population for process involved with classi
differences or ratio methods would be
the same as the number of items in
the population for a direct estimation
method. In difference sampling, many
items would be zero because audit
and book are the same, and in ratio
sampling, many of the members
would be one for the same reason.
Answer (b) is incorrect because beta
risk can never be ignored, as beta risk
is the risk of accepting an incorrect
(unacceptable) population. Answer
(c) is incorrect because the
calculations required in difference
and ratio sampling are similar to
those used in direct estimation
sampling.
(d) is incorrect because probability
cal variables sampling may make use of proportionaltosize sampling, not
a computer program desirable. Answer classical sampling, automatically
stratifies individually significant items.
Analyzing PPS
Results
Authoritative
Literature Help
1. (A) Thirty items. Calculated by dividing the population book value

($2,400,000) by the sampling interval size ($80,000). Accordingly
$2,400,000/80,000 = 30 items.
2. (G) $26,150. Calculated by summing the misstatements ($1,000 + $150 +
$25,000 = $26,150).
3. (H) $42,000. Projected misstatement represents the most likely total
misstatement in the population ($42,000).
4. (M) $294,550. The upper limit on misstatement is the sum of projected
misstatement, basic precision, and the incremental allowance ($42,000 +
$240,000 + $12,550 = $294,550).
5. (K) $252,550. The allowance for sampling risk is the sum of basic
precision and the incremental allowance ($240,000 + $12,550 =
$252,550).
6. (Reject) Reject because the upper limit on misstatement ($294,550) exceeds
the tolerable misstatement ($280,000).
7. (5%) Because basic precision uses a 3.0 factor, the test is being performed at
5%.
PPS Sampling
Authoritative
Concepts
Literature Help
Correct Incorrect
1. Size of a PPS sample is not based on the estimated variation of audited
amounts.
2. PPS sampling results in a stratified sample.
3. Individually significant items are automatically identified.
4. PPS sampling results in a smaller sample size when numerous small
misstatement are expected.
5. If no misstatements are expected, PPS sampling will usually result in a smaller
sample size than classical variables sampling methods.
6. One does not need a book value for individual items to evaluate a PPS sample.
7. A PPS sample eliminates the need to project results to the overall population.
8. PPS sampling is “preferred” by the professional standards.
9. The sampling interval is $500.*
10. Increasing the expected misstatement to $10,000 will increase the sample size.
* It is the recorded amount divided by sample size: $300,000 / 100= $3,000
Research
Authoritative
Literature Help
1. W
2. E
n
230 MODULE 8 AUDITING WITH TECHNOLOGY
AUDITING WITH TECHNOLOGY
replaced by online
realtime
1. An advantage of using systems processing in all
flowcharts to document but legacy
information about internal control systems.
instead of using internal control c. It is more likely to
questionnaires is that systems result in an easyto
follow audit trail than
flowcharts
is online transaction
a. Identify internal processing.
control weaknesses d. It is used only in nondatabase
more prominently.
applications.
b. Provide a visual depiction of
clients’ activities. 5. An auditor would be most likely to assess
c. Indicate whether control risk at the maximum level in an
control procedures electronic environment with automated
are operating systemgenerated information when
effectively. a. Sales orders are
d. Reduce the need to observe initiated using
clients’ employees performing predetermined,
routine tasks. automated
decision rules.
2. A flowchart is most
b. Payables are based on
frequently used by an auditor many transactions and
in connection with the large in dollar
a. Preparation of amount.
generalized
c. Fixed asset
computer audit transactions are
programs. few in number, but
b. Review of the client’s internal large in dollar
control. amount.
c. Use of statistical sampling in d. Accounts
performing an audit. receivable records
d. Performance of are based on many
analytical transactions and
procedures of are large in dollar
account balances. amount.
3. Matthews Corp. has changed from a 6. In a highly automated
system of recording time worked on information processing
clock cards to a computerized payroll system tests of control
system in which employees record time in a. Must be performed in all
and out with magnetic cards. The circumstances.
computer system automatically updates all b. May be required in some
payroll records. Because of this change circumstances.
a. A generalized c. Are never required.
computer audit
d. Are required in first year audits.
program must be
used.
b. Part of the audit trail is altered.
c. The potential for
payrollrelated
fraud is dimin
ished.
d. Transactions must be processed
in batches.
correct concerning batch pro
cessing of transactions?
a. Transactions are
processed in the order
they occur, regardless
of type.
b. It has largely been
7. Which of the following is least a. May enable
likely to be considered by an unauthorized
auditor considering changes to data files
engagement of an information if not properly
technology (IT) specialist on an controlled.
audit? b. Are very versatile
a. Complexity of client’s systems programs that can
and IT controls. be used on
b. Requirements to assess going hardware of many
concern status. manufacturers.
c. Client’s use of emerging c. May be significant
technologies. components of a
d. Extent of entity’s client’s application
participation in programs.
electronic com d. Are written
merce. specifically to
enable auditors to
8. Which of the following extract and sort
strategies would a CPA most data.
likely consider in auditing an
entity that processes most of its 11. An auditor would most likely
financial data only in electronic be concerned with which of the
form, such as a paperless following controls in a
system? distributed data processing
a. Continuous monitoring system?
and analysis of a. Hardware controls.
transaction processing b. Systems documentation
with an embedded audit controls.
module. c. Access controls.
b. Increased reliance on internal d. Disaster recovery controls.
control activities that emphasize
12. Which of the following types
the segregation of duties.
c. Verification of of evidence would an auditor
most likely examine to
encrypted digital
determine whether internal
certificates used to
control is operating as
monitor the designed?
authorization of
a. Gross margin information
transactions. regarding the client’s industry.
d. Extensive testing of b. Confirmations of
firewall boundaries receivables
that restrict the verifying account
recording of outside balances.
network traffic. c. Client records
documenting the use
9. Which of the following is not a
of computer
major reason for maintaining programs.
an audit trail for a computer d. Anticipated results
system? documented in budgets
a. Deterrent to fraud. or forecasts.
b. Monitoring purposes.
c. Analytical procedures. 13. An auditor anticipates
d. Query answering. assessing control risk at a low
level in a computerized
10. Computer systems are typically environment. Under these
supported by a variety of utility circumstances, on which of
software packages that are the following activities would
important to an auditor because the auditor initially focus?
they
MODULE 8 AUDITING WITH TECHNOLOGY 231
output.
b. A system that affects
a. Programmed control activities. a number of essential
b. Application control activities. master files and
c. Output control activities. produces a limited
d. General control activities. output.
c. A system that
14. After the preliminary phase of updates a few
the review of a client’s essential master files
computer controls, an auditor and produces no
may decide not to perform printed output other
tests of controls related to the than final balances.
controls within the computer d. A system that performs
portion of the client’s internal relatively complicated
control. Which of the processing and
following would not be a valid produces very little
reason for choosing to omit detailed output.
such tests?
a. The controls 17. An auditor who wishes to
duplicate operative capture an entity’s data as
controls existing transactions are processed and
elsewhere in the continuously test the entity’s
structure. computerized information
b. There appear to be system most likely would use
major weaknesses which of the following
that would preclude techniques?
reliance on the a. Snapshot application.
stated procedure. b. Embedded audit module.
c. The time and dollar costs of c. Integrated data check.
testing exceed the time and d. Test data generator.
dollar savings in substantive
testing if the tests of controls 18. Which of the following
show the controls to be computerassisted auditing
operative. techniques processes client
d. The controls appear adequate. input data on a controlled pro
gram under the auditor’s
15. Auditing by testing the input and control to test controls in the
output of a computer system computer system?
instead of the computer program a. Test data.
itself will b. Review of program logic.
a. Not detect program errors which c. Integrated test facility.
do not show up in the output d. Parallel simulation.
sampled.
19. To obtain evidence that
b. Detect all program
errors, regardless of online access controls are
the nature of the properly functioning, an
output. auditor most likely would
c. Provide the auditor a. Create checkpoints at
with the same type of periodic intervals
evidence as tests of after live data
application controls. processing to test for
unauthorized use of
d. Not provide the
the system.
auditor with
confidence in the re
sults of the auditing
procedures.
16. Which of the following client
information technology (IT)
systems generally can be
audited without examining or
directly testing the IT computer
programs of the system?
a. A system that
performs relatively
uncomplicated
processes and
produces detailed
units of measure.
b. Examine the d. Illogical entries in
transaction log to fields whose logic is
discover whether any tested by
transactions were lost programmed
or entered twice due to consistency checks.
a system malfunction.
c. Enter invalid 23. Which of the following
identification numbers computerassisted auditing
or passwords to techniques allows fictitious
ascertain whether the and real transactions to be pro
cessed together without client
system rejects them.
operating personnel being
d. Vouch a random aware of the testing process?
sample of processed
a. Integrated test facility.
transactions to assure
proper authorization. b. Input controls matrix.
c. Parallel simulation.
20. An auditor most likely would d. Data entry monitor.
introduce test data into a
computerized payroll system to 24. Which of the following
test controls related to the methods of testing application
controls utilizes a generalized
a. Existence of
audit software package pre
unclaimed payroll
pared by the auditors?
checks held by su
pervisors. a. Parallel simulation.
b. Early cashing of payroll checks b. Integrated testing facility
by employees. approach.
c. Test data approach.
c. Discovery of invalid employee
I.D. numbers. d. Exception report tests.
d. Proper approval of overtime by 25. In creating lead schedules for an
supervisors. audit engagement, a CPA often
21. When an auditor tests a computerized uses automated workpaper
software. What client
accounting system, which of the following
information is needed to begin
is true of the test data approach?
this process?
a. Several transactions of each type a. Interim financial
must be tested. information such as
b. Test data are third quarter sales, net
processed by the income, and
client’s computer inventory and
programs under the receivables balances.
auditor’s control.
b. Specialized journal
c. Test data must consist information such as the
of all possible valid invoice and purchase
and invalid order numbers of the
conditions. last few sales and
d. The program tested purchases of the year.
is different from the c. General ledger
program used information such as
throughout the year account numbers,
by the client. prior year account
22. Which of the following is not balances, and current
among the errors that an year unadjusted
auditor might include in the information.
test data when auditing a cli d. Adjusting entry
ent’s computer system? information such as
a. Numeric characters in deferrals and
alphanumeric fields. accruals, and
b. Authorized code. reclassification
journal entries.
c. Differences in description of
a. Compiler programs.
b. Supervisory programs.
26. Using microcomputers in auditing c. Utility programs.
may affect the methods used to d. User programs.
review the work of staff assistants
because 30. Smith Corporation has
a. The audit fieldwork numerous customers. A cus
standards for supervision tomer file is kept on disk
may differ. storage. Each customer file
contains name, address,
b. Documenting the
credit limit, and account
supervisory review may
balance. The auditor wishes
require assistance of
consulting services to test this file to determine
personnel. whether credit limits are
being exceeded. The best
c. Supervisory personnel
procedure for the auditor to
may not have an
follow would be to
understanding of the
a. Develop test data that would
capabilities and cause some account balances
limitations of mi to exceed the credit limit and
crocomputers. determine if the system
d. Working paper properly detects such
documentation may situations.
not contain readily b. Develop a
observable details of program to
calculations. compare credit
27. An auditor would least likely use limits with
computer software to account balances
a. Access client data files. and print out the
details of any
b. Prepare spreadsheets.
account with a
c. Assess computer control risk. balance exceeding
d. Construct parallel simulations. its credit limit.
28. A primary advantage of using c. Request a printout
generalized audit software of all account
packages to audit the financial balances so they
statements of a client that uses a can be manually
computer system is that the checked against the
auditor may credit limits.
a. Access information d. Request a printout
stored on computer files of a sample of
while having a limited account balances so
understanding of the they can be
client’s hardware and individually checked
software features. against the credit
b. Consider increasing the limits.
use of substantive tests 31. An auditor most likely
of transactions in place would test for the presence
of analytical of unauthorized computer
procedures. program changes by
c. Substantiate the running a
accuracy of data a. Program with test data.
through self b. Check digit verification
checking digits and program.
hash totals.
c. Source code comparison
d. Reduce the level of
program.
required tests of
controls to a relatively d. Program that computes
small amount. control totals.
32. An entity has the following
29. Auditors often make use of
computer programs that perform invoices in a batch:
routine processing functions such
as sorting and merging. These
programs are made available by
electronic data processing
companies and others and are
specifically referred to as
Invoice # Product Quantity Unit price
201 F10 150 $ 5.00
202 G15 200 $10.00
203 H20 250 $25.00
204 K35 300 $30.00
Which of the following numbers represents
the record count?
a. 1
b. 4
c. 810
d. 900
SIMULATION
Computer Audit
Techniques and Terms Authoritative
Literature Help
Computer processing has become the primary means used to process financial
accounting information in most businesses. Consistent with this situation, CPAs must
have knowledge of audit techniques using computers and of computer terminology.
Select the type of audit technique being described in items 1 through 5. Computer
audit techniques may be used once,
more than once, or not at all.
Computer audit technique
A. Auditing “around” the computer E. Processing output control
B. I/O audit approach F. Test data
C. Integrated test facility G. Write extract routine
D. Parallel simulation
D
e
1. A
2. D
u
3. F
i
4. M
a
5. U
For items 6 through 10 select the type of computer control that is described in the
definition that is presented. Each control may be used once, more than once, or not at all.
Control
H. Backup and recovery M. Hash total
I. Boundary protection N. Missing data check
J. Check digit O. Personal identification codes
K. Control digit P. Visitor entry logs
L. File protection ring
Description (H) (I) (J) (K) (L) (M) (N) (O) (P)
6. A control that will detect blanks existing in input data when they should not.
7. A control to ensure that jobs run simultaneously in a multiprogramming
environment cannot change the allocated memory of another job.
8. A digit added to an identification number to detect certain types of data
transmission or transposition errors.
9. A terminal control to limit access to programs or files to authorized users.
10. A total of one field for all the records of a batch where the total is
meaningless for financial purposes.
1. b __ __ 7. b __ __ 13. d __ __ 19. c __ __ 25. c __ __ 31. c __ __

2. b __ __ 8. a __ __ 14. d __ __ 20. c __ __ 26. d __ __ 32. b __ __
3. b __ __ 9. c __ __ 15. a __ __ 21. b __ __ 27. c __ __
4. c __ __ 10. a __ __ 16. a __ __ 22. a __ __ 28. a __ __
5. c __ __ 11. c __ __ 17. b __ __ 23. a __ __ 29. c __ __ 1st: __/32 = __%
6. b __ __ 12. c __ __ 18. d __ __ 24. a __ __ 30. b __ __ 2nd: __/32 = __%
because while a flowchart
A. Auditor’s Consideration of describes a system, the
Internal Control When a flowchart alone does not
Computer Is Present indicate whether that system is
operating effectively. Answer
1. (b) The requirement is to (d) is incorrect because auditors
identify an advantage of using still need to determine whether
systems flowcharts to document the system has been placed in
information about internal operation and therefore the need
control instead of using internal to observe employees
control questionnaires. Answer performing routine tasks re
(b) is correct because mains.
flowcharts provide a visual
depiction of clients’ activities 2. (b) The requirement is to
which make it possible for determine when a flowchart is
auditors to quickly understand most frequently used by an
the design of the system. auditor. Answer (b) is correct
Answer (a) is incorrect because because flowcharts are
while the flow of operations is suggested as being appropriate
visually depicted, internal for documenting the auditor’s
control weaknesses are not as consideration of internal control.
obvious. Answer (c) is incorrect Answer (a) is incorrect because
auditors do not frequently write rect because batch processing may be
their own generalized computer used for database applications.
audit programs, the most likely
time a flowchart would be used 5. (c) The requirement is to
with respect to such software. determine when an auditor
Answers (c) and (d) are would be most likely to assess
incorrect because statistical control risk at the maximum
sampling and analytical level in an electronic
procedures do not in general environment with automated
require the use of flowcharts. systemgenerated information.
3. (b) The requirement is to the few transactions involved in
identify the correct statement fixed assets make it most likely
with respect to a computerized, to be one in which a substantive
automatically updating payroll approach of restricting de
system in which magnetic cards tection risk is most likely to be
are used instead of a manual effective and efficient. Answer
payroll system with clock cards. (a) is incorrect because an
Answer (b) is correct because auditor might be expected to
the automatic updating of perform tests of controls to
payroll records alters the audit assess control risk below the
trail which, in the past, included maximum when automated
steps pertaining to manual decision rules are involved for
updating. Answer (a) is an account (sales) which
incorrect because although an ordinarily has many
auditor may choose to use a transactions. Answers (b) and
generalized computer audit (d) are incorrect because the
program, it is not required. numerous transactions in
Answer (c) is incorrect because payables and receivables make it
no information is presented that likely that control risk will be
would necessarily indicate a assessed below the maximum.
change in the likelihood of
fraud. Answer (d) is incorrect 6. (b) The requirement is to
because given automatic identify the most accurate
updating, a large portion of the statement with respect to tests of
transactions are not processed in controls of a highly automated
batches. information processing system.
4. (c) The requirement is to identify the SAS 110 states that in some
correct statement concerning the batch such circumstances substantive
processing of transactions. Batch tests alone will not be sufficient
processing involves processing to restrict detection risk to an
transactions through the system in groups acceptable level. Answer (a) is
of like transactions (batches). Answer (c) incorrect because tests of
is correct because the similar nature of controls need not be performed
transactions involved with batch in all such circumstances.
processing ordinarily makes it relatively Answer (c) is incorrect because
easy to follow the transactions throughout such tests are sometimes
the system. Answer (a) is incorrect required. Answer (d) is incorrect
because transactions are processed by because tests of controls are not
type, not in the order they occur in such circumstances in all first
regardless of type. Answer (b) is incor year audits.
rect because many batch applications still
exist and might be expected to exist well 7. (b) The requirement is to
into the future. Answer (d) is incor identify the least likely
circumstance in which an
auditor would consider engage
ments of an IT specialist on an
because the requirement to
assess going concern status re
mains the same on all audits,
and thus does not directly af
fect engagement of an IT
specialist. Answers (a), (c), and
(d) are all incorrect because complexity,
the use of emerging technologies, and
participation in electronic commerce are
all factors which SAS 110 suggests make
it more likely that an IT specialist will be exists as to how many embedded audit
engaged. modules CPAs have actually used in prac
tice. Answer (b) is incorrect because there
8. (a) The requirement is to identify a strategy
may well be a decrease in reliance on
that a CPA most likely would consider in internal control activities that emphasize
auditing an entity that processes most of its this segregation of duties since so many
financial data only in electronic form. controls are in the hardware and software of
Answer (a) is correct because continuous the application. Answer (c) is incorrect
monitoring and analysis of transaction because digital certificates deal with
processing with an embedded audit module electronic commerce between companies, a
might provide an effective way of auditing topic not directly addressed by this
these processes—although some question question, and because such certificates pro
while requiring concern, are normally
considered less critical than proper access
vide limited evidence on authorization. controls for this situation.
Answer (d) is incorrect because while
firewalls do control network traffic, this 12. (c) The requirement is to
is not the most significant factor in the identify the type of evidence an
audit of electronic form financial data. auditor would examine to
determine whether internal
9. (c) The requirement is to identify the reply control is operating as designed.
that is not a major reason for maintaining Answer (c) is correct because
an audit trail for a computer system. the inspection of documents and
Answer (c) is correct because analytical records such as those related to
procedures use the outputs of the system, computer programs represents
and therefore the audit trail is of limited an approach for obtaining an
importance. Answer (a) is incorrect be understanding of internal
cause an audit trail may deter fraud since control. Answer (a) is incorrect
because examining gross
the perpetrator may realize that his or her
margin information is more
act may be detected. Answer (b) is
likely to be performed during
incorrect because an audit trail will help the performance of analytical
management to monitor the computer procedures. Answer (b) is
system. Answer (d) is incorrect because incorrect because confirming of
an audit trail will make it much easier to receivables is a substantive test.
answer queries. Answer (d) is incorrect because
anticipated results documented
10. (a) The requirement is to in budgets or forecasts are much
identify a reason that utility more frequently used in the
software packages are performance of analytical
important to an auditor. An procedures.
swer (a) is correct because 13. (d) The requirement is to
client use of such packages re determine the procedures on
quires that the auditor include which the auditor would
tests to determine that no initially focus when anticipating
unplanned interventions using assessing control risk at a low
utility routines have taken place level. Answer (d) is correct
during processing (Audit and because auditors usually begin
Accounting Guide, by considering general control
Computer Assisted Audit Techniques). procedures. Since the
Answer (b) isincorrect because a client’s effectiveness of specific
use of such programs implies that they applica
are useful on his/her computer hardware,
and therefore any flexibility is not of
immediate relevance to the auditor.
primary purpose of utility programs is to
support the computer user’s applications
(Computer Assisted Audit Techniques).
Answer (d) is incorrect because utility
software programs have a variety of uses
in addition to enabling auditors to extract
and sort data (Computer Assisted Audit
Techniques).
types of controls with which an auditor
would be most likely to be concerned in a
distributed data processing system. A
distributed data processing system is one
in which there is a network of remote
computer sites, each having a computer
connected to the main computer system,
thus allowing access to the computers by
various levels of users. Accordingly,
answer (c) is correct because numerous
individuals may access the system,
thereby making such controls of extreme
importance. Answers (a), (b), and (d),
be different than the evidence
tion controls is often dependent on the obtained by testing the program
existence of effective general controls itself. Answer (d) is incorrect
over all computer activities, this is usually because such auditing of inputs
an efficient approach. Answers (a), (b), and outputs may well satisfy the
and (c) are all incorrect because they auditor.
represent controls that are usually tested
subsequent to the general controls. 16. (a) The requirement is to identify the type
of computer system that can be audited
14. (d) The requirement is to without examining or directly testing
determine an inappropriate computer programs (i.e., auditing around
reason for omitting tests of the system). Auditing around the system
controls related to is possible if the system performs
computercontrol procedures. uncomplicated processes and produces
Answer (d) is correct because detailed output (i.e., is a fancy
the fact that the controls appear bookkeeping machine). Answers (b), (c),
adequate is not sufficient and (d) all describe more complicated
justification for reliance; tests computer systems that produce only
of controls must be performed limited output. In these more complicated
before the auditor can actually systems, the data and related controls are
rely upon a control procedure to within the system, and thus the auditor
reduce control risk. Answer (a) must examine the system itself. Auditors
is incorrect because when must identify and evaluate the ac
controls duplicate other controls counting controls in all computer systems.
the auditor who wishes to rely Further, complex computer systems
upon internal control need not require auditor specialized expertise to
test both sets. An perform the necessary procedures.
swer (b) is incorrect because if weak 17. (b) The requirement is to
controls are not to be relied upon, the determine an audit technique to
auditor need not test their effectiveness. determine whether an entity’s
Answer (c) is incorrect because tests of transactions are processed and to
controls may be omitted if their cost continuously test the
exceeds the savings from reduced sub computerized information
stantive testing resulting from reliance system. Answer (b) is correct
upon the controls. because an embedded audit
module is inserted within the
client’s information system to
determine the correct statement
with respect to testing inputs continuously test the processing of
and outputs of a computer transactions. Answer (a) is
system instead of testing the incorrect because a snapshot
actual computer program itself. application analyzes the
Answer (a) is correct because information system at one point in
portions of the program which time. Answer (c) is incorrect
have errors not reflected on the because an integrated data check
output will be missed. Thus, if a simply tests data at one point in
“loop” in a program is not used time. Answer (d) is incorrect
in one application, it is not because a test data generator
tested. Answer (b) is incorrect provides a sample of possible
because the lack of an circumstances in which data might
understanding of the entire be improperly processed.
program precludes the detection
of all errors. Answer (c) is
incorrect because while auditing the computerassisted audit
inputs and outputs can provide technique that processes client
valuable evidence, it will often input data on a
must then determine whether supervisors
are following those criteria; it is less
controlled program under the auditor’s likely that this will all be included in a
control to test controls in a computer computer program than a test for invalid
system Answer (d) is correct because employee ID numbers.
parallel simulation processes actual client
data through an auditor’s generalized 21. (b) The requirement is to
audit software program. Answer (a) is identify the correct statement
incorrect because test data is a set of regarding the test data approach.
dummy transactions developed by the Answer (b) is correct because
auditor and processed by the client’s pro the test data approach consists
grams to determine whether the controls of processing a set of dummy
which the auditor intends to test are transactions on the client’s
operating effectively. Answer (b) is incor computer system. The test data
rect because a review of program logic is approach is used to test the
an approach in which an auditor reviews operating effectiveness of
the steps by which the client’s program controls the auditor intends to
processes data. Answer (c) is incorrect rely upon to assess control risk
because an integrated test facility at a level lower than the
introduces dummy transactions into a maximum. Answer (a) is in
client’s system in the midst of live correct because only one
transactions. transaction of each type is
generally tested. Answer (c) is
B. Computerized Audit Tools
incorrect because it is not
19. (c) The requirement is to determine the possible
best way to obtain evidence that online to include all possible valid and invalid
access controls are properly functioning. conditions. Answer (d) is incorrect
Answer (c) is correct because entering because the program that should be
invalid identification numbers or tested is the client’s program which is
passwords will provide the auditor with used throughout the year.
evidence on whether controls are
operating as designed. Answer (a) is
incorrect because directly testing access which reply isnot among the errors
controls is more direct than testing data which are generally detected by test
through checkpoints at intervals. Answer
(b) is incorrect because a transaction log
will not in general, by itself, identify
whether transactions were lost or entered
twice. Answer (d) is incorrect because
vouching proper authorization is only one
measure of whether controls are properly
functioning.
situation in which it is most likely that an
auditor would introduce test data into a
computerized payroll system. Test data is
a set of dummy transactions developed by
the auditor and processed by the client’s
computer programs. These dummy
transactions are used to determine
whether the controls which the auditor
tests are operating effectively. Answer (c)
is correct because test data with invalid
employee I.D. numbers could be
processed to test whether the program
detects them. Answer (a) is incorrect
because the unclaimed payroll checks are
held by the supervisors and no testing of
the computer program is involved.
Answer (b) is incorrect because no
computer processing is generally involved
when payroll checks are “cashed early” by
employees. Answer (d) is incorrect
because to test whether the approval of
overtime is proper, one must determine
what criteria are used for the decision and
because the parallel simulation
data. An auditor uses test data to method processes the client’s
determine whether purported controls data using the CPA’s software.
are actually functioning. Answer (a) is Answers (b) and (c) are
correct because one would not use test incorrect because the client’s
data to test numeric characters in hardware and software are
alphanumeric fields; numeric characters tested using test data designed
are accepted in alphanumeric fields and by the CPA. Answer (d) is
thus do not represent error conditions. incorrect because although a
Answer (b) is incorrect because CPA may test a client’s
authorization codes may be tested by exception reports in various
inputting inappropriate codes. Answer (c) manners, generalized software is
is incorrect because differing descriptions unlikely to be used. Exception
of units of measure may be inputted to reports are generally tested via
test whether they are accepted. Answer CPAprepared test data
(d) is incorrect because illogical combi containing all the possible error
nations may be inputted to test whether conditions. The test data are
they are detected by the system. then run on the client’s
23. (a) The requirement is to hardware and software to
identify the computerassisted ascertain whether the exception
auditing technique which allows reports are “picking up” the
fictitious and real transactions to CPA’s test data.
be processed together without 25. (c) The requirement is to
client operating personnel being identify the information that
aware of the testing process. An must be available to begin
swer (a) is correct because the creating automated lead
integrated test facility approach schedules. A lead schedule is
introduces dummy transactions used to summarize like ac
into a system in the midst of live counts (e.g., if a client has five
transactions. Accordingly, client cash accounts those accounts
operating personnel may not be may be summarized on a lead
aware of the testing process. An schedule). Answer (c) is cor
swer (b) is incorrect because an rect because lead schedules
input control matrix would include information such as
simply indicate various controls account numbers, prior year
in the form of a matrix. account balances, and current
Answer (c) is incorrect because the year unadjusted information.
parallel simulation technique requires the Answer (a) is incorrect because
processing of actual client data through an interim information is not
auditor’s software program. In this case, necessary. Answer (b) is
the client would be aware of the testing incorrect because invoice and
process since the auditor would need to purchase order numbers are not
request copies of data run on the actual summarized on lead schedules.
system so that the data could then be run Answer (d) is incorrect because
on the auditor’s software program. adjusting entry information is
Additionally, only valid transactions identified subsequent to the
would be tested under parallel simulation. creation of lead schedules.
Answer (d) is incorrect because the client
would generally be aware of an auditor 26. (d) The requirement is to identify
using a data entry monitor (screen) to an effect on audit work review
input transactions. methods of using microcomputers
in auditing. Answer (d) is correct
24. (a) The requirement is to because microcomputers typically
determine the auditing technique produce a number of the
which utilizes generalized audit “working papers” in computer
software. Answer (a) is correct disk
such as sorting and merging. Answer (c)
is correct because a utility program is a
form and because many computations, etc. standard routine for performing
will be performed directly by the commonly required processing such as
computer with few details of the cal sorting, merging, editing, and
culations conveniently available. Answer mathematical routines. Answer (a) is
(a) is incorrect because the fieldwork incorrect because compiler programs
standards remain the same regardless of translate programming languages such as
whether or not computers are being COBOL or FORTRAN to machine
utilized. Answer (b) is incorrect because language. Answer (b) is incorrect because
one would not normally expect consulting supervisory programs or “operating
services personnel to help with systems” consist of a series of programs
documentation. Answer (c) is incorrect that perform functions such as scheduling
because supervisory personnel must have and supervising the application programs,
an understanding of the capability and allocating storage, controlling peripheral
limitations of microcomputers before they devices, and handling errors and restarts.
are utilized on audits. Answer (d) is incorrect because user or
“application programs” perform specific
27. (c) The requirement is to data processing tasks such as general
determine an auditor’s least ledger, accounts payable, accounts
likely use of computer software. receivable, and payroll. Application
Answer (c) is correctbecause an programs make use of utility routines.
auditor will judgmentally assess
control risk related to both the
computer and manual systems determine the best approach
after having performed the for determining whether credit
various tests of controls. limits are being exceeded
Answer (a) is incorrect because when accounts receivable
computer software will be used information is stored ondisk.
to access client data files. Answer (b) is correct because
Answers (b) and (d) are a program to compare actual
incorrect because software is account balances with the
used to prepare spreadsheets predetermined credit limit and
and to perform parallel thereby prepare a report on
simulations. whether any actual credit
limits are being exceeded will
28. (a) The requirement is to accomplish the stated objec
identify a primary advantage tive. Answer (a) is incorrect
of using generalized audit because while test data will
software packages to audit the indicate whether the client’s program
financial statements of a client allows credit limits to be exceeded, it
that uses a computer system. will not indicate whether credit limits
areactually being exceeded. Answer (c)
generalized audit software
is incorrect because amanual check of all
allows an auditor to perform
audits tests on a client’s account balances will be very time con
computer files. Answer (b) is suming. Answer (d) is incorrect because
incorrect because generalized a sample will pro
audit software packages may
assist the auditor with either
substantive tests of transactions
or analytical procedures.
while generalized audit
software might be used to
perform such operations, this is
not their primary advantage.
Answer (d) is incorrect be
cause generalized audit
software packages have no
direct relationship to the
performance of tests of
controls.
type of computer programs which
auditors use to assist them in functions
detecting unauthorized changes than will
vide less complete information than source code comparison. Answer (b) is
the audit of the entire population incorrect because check digits are
which is indicated in answer (b). primarily used as an input control to
determine that input data is proper.
31. (c) The requirement is to identify how an Answer (d) is incorrect because properly
auditor would test for the presence of computing control totals is only one
unauthorized computer program changes. possible unauthorized change that might
Answer (c) is correct because comparing be made to a program.
source code of the program with a correct
version of the program will disclose 32. (b) The requirement is to identify the
unauthorized computer program changes. number that represents the record count.
Answer (a) is incorrect because test data Answer (b) is correct because the record
is generally used to test specific controls count represents the number of records in
and it will generally be less effective for a file, in this case 4.
SOLUTION TO SIMULATION
Computer Audit Authoritative
Techniques and Terms Literature Help
D
e
1. A
2. D
u
3. F
i
4. M
a
5. U
E
1. (A) Auditing “around” the computer involves examining inputs into and
outputs from the computer while ignoring processing, as contrasted to
auditing “through” the computer which in some manner directly utilizes the
computer’s processing ability.
2. (F) Test data is a set of dummy transactions developed by the auditor and
processed by the client’s computer programs to determine whether the controls
that the auditor intends to rely upon are functioning as expected.
3. (C) An integrated test facility introduces dummy transactions into a system in
the midst of live transactions and is often built into the system during the
original design.
4. (C) An integrated test facility approach may incorporate a simulated division or subsidiary
into the accounting system with the sole purpose of running test data through it.
5. (D) Parallel simulation involves processing actual client data through an
auditor’s software program to determine whether the output equals that obtained
when the client processed the data.
D
e
6. A
7. A

8. A

9. A
10. A

E
6. (N) A missing data check tests whether blanks exist in input data where they
should not (e.g., an employee’s division number). When the data is missing, an
error message is output.
7. (I) Boundary protection is necessary because most large computers have more
than one job running simultaneously (a multiprogramming environment). To
ensure that these simultaneous jobs cannot destroy or change the allocated
memory of another job, the systems software contains boundary protection
controls.
8. (J) A check digit is an extra digit added to an identification number to detect certain types
of data transmission or transposition errors. It is used to verify that the number was entered
into the computer system correctly; one approach is using a check digit that is calculated as
a mathematical combination of the other digits.
9. (O) Personal identification codes require individuals to in some manner identify
themselves to determine that only authorized users access programs or files.
10. (M) A hash total is the total of one field for all the records of a batch where the
total is a meaningless total for financial purposes, such as a mathematical sum of
employee social security numbers to determine that all employees have been
processed.
FINANCIAL ACCOUNTING
AND REPORTING
The Financial Accounting and Reporting Exam is scheduled for four hours. Based on information released by the
AICPA, candidates should expect three multiplechoice testlets of approximately thirty questions each, and two
simulations.
The Uniform CPA Examination Content Specifications appear in Volume 1, Outlines and Study Guides.
Module 9/Basic Theory and Financial Reporting (TREP)
A. Basic Concepts
B. Error Correction
C. Accounting Changes
D. Financial Statements
Module 10/Inventory (INVY)
Module 11/Fixed Assets (FA)
Module 12/Monetary Current Assets and Current Liabilities (CACL)
Module 13/Present Value (PV)
A. Fundamentals
B. Bonds
C. Debt Restructure
D. Pensions
E. Leases
239
240 CH 3 FINANCIAL ACCOUNTING AND REPORTING
Module 14/Deferred Taxes (DETX)
Module 15/Stockholders’ Equity (STK)
Module 16/Investments (IVES)
Module 17/Statement of Cash Flows (SCF)
Module 18/Business Combinations and Consolidations (BCC)
Module 19/Derivative Instruments and Hedging Activities (DIHA)
Module 20/Miscellaneous (MISC)
A. Personal Financial Statements
B. Interim Reporting
C. Segment Reporting
D. Partnership Accounting
E. Foreign Currency Translation
Module 21/Governmental (State and Local) Accounting
Module 22/NotforProfit Accounting (NFP)
Financial Accounting and Reporting Sample Examination 1233
Financial Accounting and Reporting AICPA Sample Testlets 1306
Financial Accounting and Reporting 2011 Released AICPA Questions 1344
MODULE 9 BASIC TH. & FIN. REP.: A. BASIC CONCEPTS 241
BASIC CONCEPTS
Accounting Concepts intended to establish?
a. Generally accepted accounting
1. What are the Statements of Financial principles in financial reporting by
business enterprises. comprehensive income for an enterprise in an
b. The meaning of “Present fairly in industry not having specialized accounting principles?
accordance with generally accepted
accounting principles.”
c. The objectives and concepts for use in
developing standards of financial
accounting and reporting.
d. The hierarchy of sources of generally
accepted accounting principles.
2. According to the FASB conceptual framework,
the objectives of financial reporting for business
enterprises are based on
a. Generally accepted accounting principles.
b. Reporting for regulators.
c. The need for conservatism.
d. The needs of the users of the information.
3. According to the FASB conceptual framework, the
relevance of providing information in financial statements
is subject to the constraint of
a. Comparability.
b. Costbenefit.
c. Reliability.
d. Faithful representation.
4. The enhancing qualitative characteristics of
financial reporting are
a. Relevance, reliability, and faithful
representation.
b. Costbenefit and materiality.
c. Comparability, verifiability,
timeliness, and
understandability.
d. Completeness, neutrality, and freedom from
error.
5. According to Statements of Financial
Accounting Concepts, neutrality is an
ingredient of
Faithful
representation Relevance
a. Yes Yes
b. Yes No
c. No Yes
d. No No
6. According to the FASB conceptual framework,
which of the following is an enhancing quality
that relates to both relevance and faithful
representation?
a. Comparability.
b. Confirmatory value.
c. Predictive value.
d. Freedom from error.
7. According to the FASB conceptual framework, the
process of reporting an item in the financial statements of
an entity is
a. Allocation.
b. Matching.
c. Realization.
d. Recognition.
8. Under FASB Statement of Financial Accounting
Concepts 5, which of the following items
would cause earnings to differ from
a. Unrealized loss on investments c. Cash was collected on accounts receivable.
classified as availableforsale d. Product unit costs were assigned to
securities. cost of goods sold when the units
b. Unrealized loss on investments were sold.
classified as trading securities.
c. Loss on exchange of similar assets. 12. What is the underlying concept that supports
d. Loss on exchange of dissimilar assets. the immediate recognition of a contingent
loss?
9. Under FASB Statement of Financial a. Substance over form.
Accounting Concepts 5, comprehensive b. Consistency.
income excludes changes in equity resulting c. Matching.
from which of the following? d. Conservatism.
a. Loss from discontinued operations.
b. Prior period error correction. 13. What is the underlying concept governing the
c. Dividends paid to stockholders. generally accepted accounting principles
d. Unrealized loss on securities pertaining to recording gain contingencies?
classified as availablefor a. Conservatism.
sale. b. Relevance.
c. Consistency.
10. The fundamental qualitative characteristic of d. Faithful representation.
faithful representation has the components of
a. Predictive value and confirmatory value. 14. FASB’s conceptual framework explains both
b. Comparability, consistency, and financial and physical capital maintenance
confirmatory value. concepts. Which capital maintenance concept is
c. Understandability, predictive value, and applied to currently reported net income, and
reliability. which is applied to comprehensive income?
d. Completeness, neutrality, and freedom from Currently
error. reported net income Comprehensive income
a. Financial capital Physical capital
11. According to the FASB conceptual framework, b. Physical capital Physical capital
which of the following statements conforms to c. Financial capital Financial capital
the realization concept? d. Physical capital Financial capital
a. Equipment depreciation was assigned to
a production department and then to 15. According to the FASB conceptual framework, an
product unit costs. entity’s revenue may result from
b. Depreciated equipment was sold in a. A decrease in an asset from primary operations.
exchange for a note receivable. b. An increase in an asset from incidental
transactions.
242 MODULE 9 BASIC TH. & FIN. REP.: A. BASIC CONCEPTS
with probabilities of 20%, 50%,
and 30%, respectively. The rate of
c. An increase in a liability interest on default riskfree
from incidental transac investments is 5%. The present
tions. value factors are
d. A decrease in a liability from PV of 1, at 5%, for 1 year is .95238
primary operations. PV of 1, at 5%, for 2 years is .90703
PV of 1, at 5%, for 3 years is .86384
16. According to the FASB conceptual
framework, which of the following What is the expected present value of
is an essential characteristic of an Lydia Nickels’ cash flow (in whole
asset? dollars)?
a. The claims to an a. $181,406
asset’s benefits are b. $180,628
legally enforceable. c. $ 90,703
b. An asset is tangible. d. $ 89,925
c. An asset is obtained at a cost.
d. An asset provides future benefits.
statements regarding interest
17. According to the FASB conceptual methods of allocations is not
framework, which of the following true?
attributes would not be used to a. The term “interest methods
measure inventory? of allocation” refers both to
a. Historical cost. the convention for periodic
b. Replacement cost. reporting and to
c. Net realizable value.
d. Present value of future cash flows.
18. According to SFAC 7, Using Cash
Flow Informationand Present Value
in Accounting Measurements, the
mostrelevant measurement of an
entity’s liabilities at initial rec
ognition and freshstart
measurements should always reflect
a. The expectations of the entity’s
management.
b. Historical cost.
c. The credit standing of the entity.
d. The single mostlikely
minimum or maximum
possible amount.
19. Which of the following is not covered by
SFAC 7, Using Cash Flow Information and
Present Value in Accounting Measurements?
a. Measurements at initial recognition.
b. Interest method of amortization.
c. Expected cash flow approach.
d. Determining when
freshstart
measurements are
appropriate.
20. In calculating present value in a
situation with a range of possible
outcomes all discounted using the
same interest rate, the expected
present value would be
a. The mostlikely outcome.
b. The maximum outcome.
c. The minimum outcome.
d. The sum of probabilityweighted
present values.
21. A cash flow of $200,000 may be
received by Lydia Nickels, Inc. in
one year, two years, or three years,
delivery, and the remaining 25%
the several approaches to dealing due on second delivery. What
with changes in estimated future amount of revenue should Acme
cash flows. recognize from this sale during
b. Interest methods of 2010?
allocation are reporting a. $ 75,000
conventions that use b. $150,000
present value techniques c. $225,000
in the absence of a fresh d. $300,000
start measurement to
compute changes in the 27. Amar Farms produced 300,000 pounds of
carrying amount of an cotton during the 2010 season. Amar sells all
asset or liability from of its cotton to Brye Co., which has agreed to
one period to the next. purchase Amar’s entire production at the
c. Interest methods of prevailing market price. Recent legislation
allocation are grounded in assures that the market price will not fall
the notion of current cost. below $.70 per pound during the next two
d. Holding gains and losses years. Amar’s costs of selling and distributing
are generally excluded the cotton are immaterial and can be
from allocation systems. reasonably estimated. Amar reports its
inventory at expected exit value. During 2010,
23. Which of the following is not an Amar sold and delivered to Brye 200,000
objective of using present value pounds at the market price of $.70. Amar sold
in accounting measurements? the remaining 100,000 pounds during 2011 at
a. To capture the value of an the market price of $.72. What amount of
asset or a liability in the revenue should Amar recognize in 2010?
context of a particular a. $140,000
entity. b. $144,000
b. To estimate fair value.
c. To capture the economic
difference between sets
of future cash flows.
d. To capture the elements
that taken together would
comprise a market price if
one existed.
24. On December 31, 2010, Brooks Co.
decided to end operations and
dispose of its assets within three
months. At December 31, 2010, the
net realizable value of the equip
ment was below historical cost.
What is the appropriate
measurement basis for equipment
included in Brooks’ December 31,
2010 balance sheet?
a. Historical cost.
b. Current reproduction cost.
c. Net realizable value.
d. Current replacement cost.
25. Which of the following accounting
literature is not included in the
FASB Accounting Standards
Codification?
a. AICPA Statements of Position.
b. FASB Statements.
c. Accounting Research Bulletins.
d. Statements of Auditing Standards.
26. On October 1, 2010, Acme Fuel Co.
sold 100,000 gallons of heating oil
to Karn Co. at $3 per gallon. Fifty
thousand gallons were delivered on
December 15, 2010, and the
remaining 50,000 gallons were
delivered on January 15, 2011.
Payment terms were: 50% due on
October 1, 2010, 25% due on first
December 31, 2010, revealed the follow
ing:
c. $210,000
• An opening balance of $1,500 for
d. $216,000 Thrift’s comprehensive
28. Lin Co., a distributor of machinery, insurance policy. Thrift had paid
bought a machine from the an annual premium of $3,000 on
manufacturer in November 2010 for July 1, 2009.
$10,000. On December 30, 2010, • A $3,200 annual insurance
Lin sold this machine to Zee premium payment made July 1,
Hardware for $15,000, under the 2010.
following terms: 2% discount if paid • A $2,000 advance rental payment for a
within thirty days, 1% discount if warehouse Thrift leased for one year
paid after thirty days but within sixty beginning January 1, 2011.
days, or payable in full within ninety In its December 31, 2010 balance sheet,
days if not paid within the discount what amount should Thrift report as prepaid
periods. However, Zee had the right expenses?
to return this machine to Lin if Zee a. $5,200
was unable to resell the machine b. $3,600
before expiration of the ninetyday
c. $2,000
payment period, in which case Zee’s
d. $1,600
obligation to Lin would be can
celed. In Lin’s net sales for the year 32. Roro, Inc. paid $7,200 to renew
ended December 31, 2010, how its only insurance policy for
much should be included for the sale three years on March 1, 2010, the
of this machine to Zee? effective date of
a. $0
b. $14,700
c. $14,850
d. $15,000
29. Under a royalty agreement with
another company, Wand Co. will
pay royalties for the assignment of
a patent for three years. The
royalties paid should be reported
as expense
a. In the period paid.
b. In the period incurred.
c. At the date the royalty agreement
began.
d. At the date the royalty agreement
expired.
30. Clark Co.’s advertising expense
account had a balance of $146,000
at December 31, 2010, before any
necessary yearend adjustment
relating to the following:
• Included in the $146,000 is the
$15,000 cost of printing catalogs
for a sales promotional campaign in
January 2011.
• Radio advertisements broadcast
during December 2010 were billed
to Clark on January 2, 2011. Clark
paid the $9,000 invoice on January
11, 2011.
What amount should Clark report as advertising
expense in its income statement for the year
ended December 31, 2010?
a. $122,000
b. $131,000
c. $140,000
d. $155,000
31. An analysis of Thrift Corp.’s
unadjusted prepaid expense account at
merchandise, that expire one year
the policy. At March 31, 2010, Roro’s after their issuance. Regal has the
unadjusted trial balance showed a balance of following information pertaining to
$300 for prepaid insurance and $7,200 for its gift certificates sales and
insurance expense. What amounts should be redemptions:
reported for prepaid insurance and insurance Unredeemed at 12/31/09 $ 75,000
expense in Roro’s financial statements for the 2010 sales 250,000
three months ended March 31, 2010? 2010 redemptions of prior year sales 25,000
2010 redemptions of current year sales 175,000
Prepaid insurance Insurance expense
a. $7,000 $300 Regal’s experience indicates that 10% of
b. $7,000 $500 gift certificates sold will not be redeemed.
c. $7,200 $300 In its December 31, 2010 balance sheet,
d. $7,300 $200 what amount should Regal report as
unearned revenue?
33. Aneen’s Video Mart sells one and two a. $125,000
year mail ordersubscriptions for its videoof b. $112,500
themonth business. Subscriptions are
c. $100,000
collected in advance and credited to sales. An
analysis of the recorded sales activity revealed d. $ 50,000
the following: 74. Wren Corp.’s trademark was licensed
2009 to Mont Co. for royalties of 15% of
Sales $420,000 $500,000
Less cancellations 20,000 30,000 sales of the trademarked items.
Net sales $400,000 $470,000 Royalties are payable semiannually
Subscriptions expirations: on March 15 for sales in July through
2009 $120,000 December of the prior year, and on
2010 155,000 $130,000 September 15 for sales in January
2011 125,000 200,000 through June of the same year. Wren
2012 140,000
$400,000 $470,000 received the following royalties from
Mont:
In Aneen’s December 31, 2010 balance March 15 September 15
sheet, the balance for unearned subscription 2009 $10,000 $15,000
revenue should be 2010 12,000 17,000
a. $495,000
b. $470,000 Mont estimated that sales of the
c. $465,000 trademarked items would total $60,000 for
July through December 2010. In Wren’s
d. $340,000
2010 income statement, the royalty revenue
34. Regal Department Store sells gift should be
certificates, redeemable for store a. $26,000
b. $29,000
39. Cooke Company acquires patent
c. $38,000 rights from other enterprises and
d. $41,000 pays advance royalties in some
cases, and in others, royalties are
36. In 2009, Super Comics Corp. sold a paid within ninety days after year
comic strip to Fantasy, Inc. and end. The following data are
will receive royalties of 20% of included in Cooke’s December 31
future revenues associated with the balance sheets:
comic strip. At December 31, 2010, 2009 2010
Super reported royalties receivable Prepaid royalties $55,000 $45,000
of $75,000 from Fantasy. During Royalties payable 80,000 75,000
2011, Super received royalty
During 2010 Cooke remitted royalties of
payments of $200,000. Fantasy
$300,000. In its income statement for the
reported revenues of $1,500,000 in
year ended December 31, 2010, Cooke
2011 from the comic strip. In its
should report royalty expense of
2011 income statement, what
a. $295,000
amount should Super report as
royalty revenue? b. $305,000
a. $125,000 c. $310,000
b. $175,000 d. $330,000
c. $200,000
d. $300,000
37. Rill Co. owns a 20% royalty interest
in an oil well. Rill receives royalty
payments on January 31 for the oil
sold between the previous June 1
and November 30, and on
July 31 for oil sold between December 1 and
May 31. Production reports show the
following oil sales:
June 1, 2009 November 30, 2009
December 1, 2009 December 31, 2009
December 1, 2009 May 31, 2010
June 1, 2010 November 30, 2010
What amount should Rill report as royalty
revenue for 2010?
a. $140,000
b. $144,000
c. $149,000
d. $159,000
38. Decker Company assigns some of its
patents to other enterprises under a
variety of licensing agreements. In
some instances advance royalties are
received when the agreements are
signed, and in others, royalties are
remitted within sixty days after each
license yearend. The following data
are included in Decker’s December
31 balance sheet:
2009 2010
Royalties receivable $90,000 $85,000
Unearned royalties 60,000 40,000
During 2010 Decker received royalty
remittances of $200,000. In its income
statement for the year ended December
31, 2010, Decker should report royalty
income of
a. $195,000
b. $215,000
c. $220,000
d. $225,000
ferred revenue account be affected
40. The premium on a threeyear insurance policy by each of the following
expiring on December 31, 2012, was paid in transactions?
total on January 1, 2010. The original Redemption of certificates Lapse of certificates
payment was initially debited to a prepaid a. No effect Decrease
asset account. The appropriate journal entry b. Decrease Decrease
has been recorded on December 31, 2010. The c. Decrease No effect
balance in the prepaid asset account on d. No effect No effect
December 31, 2010, should be
a. Zero. 43. Jersey, Inc. is a retailer of home
b. The same as it would have been if appliances and offers a service
the original payment had been contract on each appliance sold.
debited initially to an expense ac Jersey sells appliances on
count. installment contracts, but all service
c. The same as the original payment. contracts must be paid in full at the
time of sale. Collections received
d. Higher than if the original
for service contracts should be
payment had been deb
ited initially to an expense recorded as an increase in a
account. a. Deferred revenue account.
b. Sales contracts receivable valuation
41. On January 1, 2010, Sip Co. signed account.
a fiveyear contract enabling it to c. Stockholders’ valuation account.
use a patented manufacturing d. Service revenue account.
process beginning in 2010. A
royalty is payable for each product 44. Ward, a consultant, keeps her
produced, subject to a minimum accounting records on a cash basis.
annual fee. Any royalties in excess During 2010, Ward collected
of the minimum will be paid $200,000 in fees from clients. At
annually. On the contract date, Sip December 31, 2009, Ward had
prepaid a sum equal to two years’ accounts receivable of $40,000. At
minimum annual fees. In 2010, only December 31, 2010, Ward had
minimum fees were incurred. The accounts receivable of $60,000, and
royalty prepayment should be unearned fees of $5,000. On an
reported in Sip’s December 31, accrual basis, what was Ward’s
2010 financial statements as service revenue for 2010?
a. An expense only. a. $175,000
b. A current asset and an expense. b. $180,000
c. A current asset and noncurrent asset. c. $215,000
d. A noncurrent asset. d. $225,000
42. A retail store received cash and 45. Zeta Co. reported sales revenue

issued gift certificates that are of $4,600,000 in its income
redeemable in merchandise. The statement for the year ended
gift certificates lapse one year after December 31, 2010. Additional
they are issued. How would the de information is as follows:
49. Class Corp. maintains its accounting
records on the cash basis but restates
12/31/09 its financial statements to the
Accounts receivable $1,000,000 accrual method of accounting. Class
Allowance for uncollectible accounts (60,000)
had $60,000 in cashbasis pretax
Zeta wrote off uncollectible accounts income for 2010. The following
totaling $20,000 during 2010. Under the information pertains to Class’s
cash basis of accounting, Zeta would have operations for the years ended
reported 2010 sales of December 31, 2010 and 2009:
a. $4,900,000 2010 2009
b. $4,350,000 Accounts receivable $40,000 $20,000
Accounts payable 15,000 30,000
c. $4,300,000
d. $4,280,000
46. Marr Corp. reported rental revenue
of $2,210,000 in its cash basis
federal income tax return for the
year ended November 30, 2010.
Additional information is as
follows:
Rents receivable—November 30, 2010
Rents receivable—November 30, 2009
Uncollectible rents written off during the fiscal year
Under the accrual basis, Marr should report
rental revenue of
a. $1,920,000
b. $1,980,000
c. $2,440,000
d. $2,500,000
47. The following information pertains to
Eagle Co.’s 2010sales:
Cash sales
Gross $ 80,000
Returns and allowances 4,000
Credit sales
Gross 120,000
Discounts 6,000
On January 1, 2010 customers owed Eagle
$40,000. On December 31, 2010, customers
owed Eagle $30,000. Eagle uses the direct
writeoff method for bad debts. No bad debts
were recorded in 2010. Under the cash basis
of accounting, what amount of net revenue
should Eagle report for 2010?
a. $ 76,000
b. $170,000
c. $190,000
d. $200,000
48. The following balances were
reported by Mall Co. at
December 31, 2010 and 2009:
12/31/10 12/31/09
Inventory $260,000 $290,000
Accounts payable 75,000 50,000
Mall paid suppliers $490,000 during the year
ended December 31, 2010. What amount
should Mall report for cost of goods sold in
2010?
a. $545,000
b. $495,000
c. $485,000
d. $435,000
d. No Yes
Under the accrual method, what amount of
52. White Co. wants to convert its 2010
income before taxes should Class report in
its December 31, 2010 income statement? financial statements from the accrual basis
a. $25,000 of accounting to the cash basis. Both supplies
inventory and office salaries payable in
b. $55,000
creased between January 1, 2010, and
c. $65,000
December 31, 2010. To obtain 2010 cash
d. $95,000
basis net income, how should these increases
50. On February 1, 2011, Tory began a service be added to or deducted from accrualbasis
proprietorship with an initial cash investment net income?
of $2,000. The proprietorship provided Supplies inventory Office salaries payable
$5,000 of services in February and received a. Deducted Deducted
full payment in March. The proprietorship b. Deducted Added
incurred expenses of $3,000 in February, c. Added Deducted
which were paid in April. During March, Tory d. Added Added
drew $1,000 against the capital account. In
the proprietorship’s financial statements for 53. Before 2010, Droit Co. used the cash
the two months ended March 31, 2011, basis of accounting. As of December 31,
prepared under the cash basis method of 2010, Droit changed to the accrual basis.
accounting, what amount should be reported Droit cannot determine the beginning balance
as capital? of supplies inventory. What is the effect of
a. $1,000 Droit’s inability to determine beginning
b. $3,000 supplies inventory on its 2010 accrualbasis
c. $6,000 net income and December 31, 2010 accrual
d. $7,000 basis owners’ equity?
2010 net income 12/31/10 owners’ equity
51. Compared to the accrual basis of a. No effect No effect
accounting, the cash basis of b. No effect Overstated
accounting understates income by c. Overstated No effect
the net decrease during the d. Overstated Overstated
accounting period of
54. Gant Co., which began operations on
Accounts receivable Accrued expenses
January 1, 2010,appropriately uses the
a. Yes Yes
b. Yes No installment method of accounting. The
c. No No following information pertains to Gant’s
operations for the year 2010:
Gross profit percentages 30% 40%
What amount of installment accounts
Installment sales $500,000
receivable should Dolce report in its
Regular sales
Cost of installment sales December 31, 2011 balance sheet?
Cost of regular sales a. $1,225,000
General and administrative expenses b. $1,300,000
Collections on installment sales c. $1,700,000
In its December 31, 2010 balance sheet, what d. $1,775,000
amount should Gant report as deferred gross
profit?
a. $250,000
b. $200,000
c. $160,000
d. $ 75,000
55. Since there is no reasonable
basis for estimating the degree
of collectibility, Astor Co. uses
the installment method of
revenue recognition for the
following sales:
2010 2009
Sales $900,000 $600,000
Collections from:
2009 sales 100,000 200,000
2010 sales 300,000
Accounts written off:
2009 sales 150,000 50,000
2010 sales 50,000
Gross profit percentage 40%
What amount should Astor report as deferred
gross profit in its December 31, 2010 balance
sheet for the 2009 and 2010 sales?
a. $150,000
b. $160,000
c. $225,000
d. $250,000
56. Luge Co., which began operations
on January 2, 2010, appropriately
uses the installment sales method
of accounting. The following
information is available for 2011:
Installment accounts receivable, December 31, 2011
Deferred gross profit, December 31, 2011 (before
recognition of realized gross profit for 2011)
Gross profit on sales
For the year ended December 31, 2011, cash
collections and realized gross profit on sales
should be
Cash collections Realized gross profit
a. $400,000 $320,000
b. $400,000 $240,000
c. $600,000 $320,000
d. $600,000 $240,000
57. Dolce Co., which began operations on
January 1, 2010,appropriately uses the
installment method of accounting to record
revenues. The following information is
available for the years ended December 31,
2010 and 2011:
2010
Sales $1,000,000
Gross profit realized on sales
made in:
2010 150,000
2011
cost of sales
58. On December 31, 2010, Mill Co. have been
sold construction equipment to received.
Drew, Inc. for $1,800,000. The 62. Income recognized using the
equipment had a carrying amount of
installment method of accounting
$1,200,000. Drew paid $300,000
cash on December 31, 2010, and generally equals cash collected
signed a $1,500,000 note bearing multiplied by the
interest at 10%, payable in five a. Net operating profit percentage.
annual installments of $300,000. b. Net operating
Mill appropriately accounts for the profit
sale under the installment method. percentage
On December 31, 2011, Drew paid adjusted for
$300,000 principal and $150,000 expected
interest. For the year ended uncollectible
December 31, 2011, what total accounts.
amount of revenue should Mill c. Gross profit percentage.
recognize from the construction d. Gross profit
equipment sale and financing? percentage
a. $250,000 adjusted for
b. $150,000 expected un
c. $120,000 collectible
d. $100,000 accounts.
59. On January 2, 2010, Blake Co. sold a used 63. It is proper to recognize

machine to Cooper, Inc. for $900,000, revenue prior to the sale of
resulting in a gain of $270,000. On that date, merchandise when
Cooper paid $150,000 cash and signed a I. The revenue will be reported as an
$750,000 note bearing interest at 10%. The installment sale.
note was payable in three annual installments AI. The revenue will be reported
of $250,000 beginning January 2, 2011. Blake under the cost recovery method.
appropriately accounted for the sale under the a. I only.
installment method. Cooper made a timely b. II only.
payment of the first installment on January 2,
c. Both I and II.
2011, of $325,000, which included accrued
interest of $75,000. What amount of deferred d. Neither I nor II.
gross profit should Blake report at December
31, 2011?
a. $150,000
b. $172,500
c. $180,000
d. $225,000
60. For financial statement
purposes, the installment
method of accounting may be
used if the
a. Collection
period extends
over more than
twelve months.
b. Installments are due in different
years.
c. Ultimate amount collectible is
indeterminate.
d. Percentageofcompletion method is
inappropriate.
61. According to the installment method
of accounting, gross profit on an
installment sale is recognized in
income
a. On the date of sale.
b. On the date the final cash collection
is received.
c. In proportion to the cash collection.
d. After cash
collections
equal to the
agreement, the nonrefundable down payment
represents a fair measure of the services
64. The following information pertains to already performed by Rice; however,
a sale of realestate by Ryan Co. to Sud substantial future services are required of
Co. on December 31, 2010: Rice. Collectibility of the note is reasonably
certain. In Rice’s December 31, 2010 balance
Carrying amount $2,000,000
Sales price: sheet, unearned franchise fees from Graf’s
Cash $ 300,000 franchise should be reported as
Purchase money mortgage 2,700,000 a. $132,000
b. $100,000
The mortgage is payable in nine annual
c. $ 90,000
installments of $300,000 beginning December
31, 2011, plus interest of 10%. The December d. $ 72,000
31, 2011, installment was paid as scheduled, 68. Each of Potter Pie Co.’s twentyone
together with interest of $270,000. Ryan uses new franchisees contracted to pay
the cost recovery method to account for the an initial franchise fee of $30,000.
sale. What amount of income should Ryan By December 31, 2010, each
recognize in 2011 from the real estate sale franchisee had paid a nonrefund
and its financing? able $10,000 fee and signed a note
a. $570,000 to pay $10,000 principal plus the
b. $370,000 market rate of interest on December
c. $270,000 31, 2011, and December 31, 2012.
d. $0 Experience indicates that one
franchisee will default on the
65. Wren Co. sells equipment on additional payments. Services for
installment contracts. Which of the the initial fee will be performed in
following statements best justifies 2011. What amount of net
Wren’s use of the cost recovery
method of revenue recognition to
account for these installment
sales?
a. The sales contract
provides that title to the
equipment only passes
to the purchaser when all
payments have been
made.
b. No cash payments are
due until one year from
the date of sale.
c. Sales are subject to a high rate of
return.
d. There is no reasonable basis for
estimating collectibility.
66. According to the cost recovery
method of accounting, gross profit
on an installment sale is
recognized in income
a. After cash collections
equal to the cost of
sales have been
received.
b. In proportion to the cash collections.
c. On the date the final cash collection
is received.
d. On the date of sale.
67. On December 31, 2010, Rice, Inc. authorized
Graf to operate as a franchisee for an initial
franchise fee of $150,000. Of this amount,
$60,000 was received upon signing the
agreement and the balance, represented by a
note, is due in three annual payments of
$30,000 each beginning December 31, 2011.
The present value on December 31, 2010, of
the three annual payments appropriately
discounted is $72,000. According to the
lle
unearned franchise fees would Potter report at cti
December 31, 2010? on
a. $400,000 ha
b. $600,000 s
c. $610,000 oc
d. $630,000 cu
rre
69. In which of the following examples d
of real estate transactions would for
the seller not transfer the usual risks all
and rewards of ownership? of
I. The buyer can compel the seller to th
repurchase the property. e
AI. The seller guarantees the return of the se
buyer’s investment. pa
BI. The seller is required to rat
support operations of the e
buyer and will be un
reimbursed on a cost plus its.
5% basis. d. The
a. I. sep
arat
b. II.
e
c. III. unit
d. I and II. s
70. Esker Inc. specializes in real estate mu
st
transactions other than retail land
be
sales. On January 1, 2011, Esker
deli
consummated a sale of property to
ver
Kame Ltd. The amount of profit on
ed
the sale is determinable and Esker is wit
not obligated to perform any hin
additional activities to earn the 90
profit. Kame’s initial and day
continuing investments were s of
adequate to demonstrate a the
commitment to pay for the property. end
However, Esker’s receivable may of
be subject to future subordination. the
Esker should account for the sale acc
using the oun
a. Deposit method. ting
b. Reduced recovery method. peri
c. Cost recovery method. od.
d. Full accrual method.
72. The milestone method of
71. Which of the following is one of accounting may be used to
the conditions that must exist for a recognize revenue for
company to recognize revenue on a. Multipledeliverable products or
separate units under a multiple services.
deliverables arrangement? b. Research and development
a. The arrangements.
deliver c. Longterm construction contracts.
ed d. Franchise arrangements.
item
has 73. The milestone method of revenue
value recognition provides that if a
on a substantive milestone is achieved,
stand what amount of revenue is
alone recognized?
basis a. Rev
and enue
can be is
sold reco
separat gniz
ely. ed
b. The delivered item is not returnable. up to
c. Co the
amo upon
unt the
of percen
cash tage
colle deliver
cted. ed to
b. A date.
provisi c. Contingent revenue is recognized in
ons its entirety.
rata d. A percentage of total revenue based
share on the separate units delivered.
of
revenu 74. Which of the following
e organizations is responsible for
based setting International Financial
Reporting Standards?
rewards of ownership of
goods are transferred.
a. Financial Accounting Standards 2 Payment has been received.
Board. 3 The entity does not retain either
b. International Accounting Standards a continuing managerial
Committee. involvement or control over the
c. Financial Accounting Committee. goods.
d. International Accounting Standards 4 The costs incurred can be measured
Board. reliably.
• According to the IASB Framework • Upon firsttime adoption of IFRS, an entity
for the Preparationand may elect to use fair value as deemed cost for
Presentation of Financial 1 Biological assets related to
Statements, the agricultural activity for which
fundamentalqualitative there is no active market.
characteristic of relevance includes 2 Intangible assets for which
1 Predictive value and feedback value. there is no active market.
2 Verifiability, neutrality, and 3 Any individual item of
representational faithfulness. property, plant, and equip
3 Predictive value and confirmatory ment.
value.
4 Financial liabilities that are not held
4 Comparability and timeliness.
for trading.
• According to the IASB Framework,
• Under IFRS, which of the
the financial statement element that
following is the first step within
is defined as increases in economic
the hierarchy of guidance to
benefits during the accounting
which management refers, and
period in the form of inflows or
whose applicability it considers,
enhancements of assets or decreases
when selecting accounting
of liabilities that result in increases
policies?
in equity, other than those relating
to contributions from equity
participants, is
1 Revenue.
2 Income.
3 Profits.
4 Gains.
• According to the IASB Framework, the two
criteria required for incorporating items into
the income statement or statement of financial
position are that
1 It meets the definition of
relevance and faithful
representation.
2 It meets the definition of an
element and can be
measured reliably.
3 It satisfies the criteria of capital
maintenance.
4 It meets the requirements of
comparability and
consistency.
• If the outcome of rendering
services cannot be estimated
®
reliably, IFRS requires the use
of which revenue recognition
method?
1 Percentageofcompletion method.
2 Completed contract method.
3 Cost recovery method.
4 Installment method.
• Which of the following is not
one of the criteria for revenue
recognition for sales of goods
under IFRS?
1 The significant risks and
a. January 1, year 1.
a. Consider the most recent b. January 1, year 2.
pronouncements of other c. July 1, year 2.
standardsetting bodies to d. December 31, year 2.
the extent they do not
83. How should a firsttime adopter of
conflict with the IFRS or the
IFRS recognize the adjustments
IASB Framework.
required to present its opening
b. Apply a standard from IFRS statement of financial
IFRS if it specifically re position?
lates to the transaction, a. All of the adjustments
other event, or condition. should be recognized
c. Consider the applicability in profit or loss.
of the definitions, rec b. Adjustments that are
ognition criteria, and capital in nature should be
measurement concepts in recognized in retained
the IASB Framework. earnings and adjustments
d. Apply the requirements in IFRS that are revenue in nature
dealing with similar and related should be recognized in
issues. profit or loss.
82. On July 1, year 2, a company c. Current adjustments should be
recognized in profit or loss and
decided to adopt IFRS. The
noncurrent adjustments should be
company’s first IFRS reporting
recognized in retained earnings.
period is as of and for the year
ended December 31, year 2. The d. All of the adjustments
company will present one year of should be recognized
comparative information. What is directly in retained
the company’s date of transition to earnings or, if
IFRS? appropriate, in another
category of equity.
SIMULATIONS
Account
Classifications Authoritative
Literature Help
Suppose Winston incorporated and had the following accounts. Indicate how each of the
following is classified on the financial statements. Below is a list of classifications.
Balance sheet classification Income statement classifications
A. Current asset H. Revenue
B. Noncurrent asset I. Expense
C. Current liability J. Contra revenue
D. Noncurrent liability
E. Owner’s equity
F. Contra asset
G. Contra equity
Balance sheet classification Income statement classification
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J)
1. Bonds payable, due in 2018
2. Treasury stock
3. Accounts payable
4. Sales discounts
5. Notes payable, due in nine months
6. Inventory
7. Accounts receivable
8. Common stock
9. Cost of goods sold
10. Allowance for uncollectible accounts
Accrual Basis Authoritative
Worksheet Literature Help
The following information pertains to Baron Flowers, a calendaryear sole proprietorship,
which maintained its books on the cash basis during the year.
Baron Flowers
TRIAL BALANCE
December 31, 2010
Dr. Cr.
Cash $ 25,600
Accounts receivable, 12/31/09 16,200
Inventory, 12/31/09 62,000
Furniture & fixtures 118,200
Land improvements 45,000
Accumulated depreciation, 12/31/09 $ 32,400
Accounts payable, 12/31/09 17,000
Baron, Drawings
Baron, Capital, 12/31/09 124,600
Sales 653,000
Purchases 305,100
Salaries 174,000
Payroll taxes 12,400
Insurance 8,700
Rent 34,200
Utilities 12,600
Living expenses 13,000 ______
$827,000 $827,000
Baron has developed plans to expand into the wholesale flower market and is in the process of negotiating a bank loan to
finance the expansion. The bank is requesting 2010 financial statements prepared on the accrual basis of accounting from
Baron. During the course of a review engagement, Muir, Baron’s accountant, obtained the following additional information.
1. Amounts due from customers totaled $32,000 at December 31, 2010.
2. An analysis of the above receivables revealed that an allowance for uncollectible accounts of $3,800 should be pro
vided.
3. Unpaid invoices for flower purchases totaled $30,500 and $17,000, at December 31, 2010, and December 31, 2009, re
spectively.
4. The inventory totaled $72,800 based on a physical count of the goods at December 31, 2010. The inventory was
priced at cost, which approximates market value.
5. On May 1, 2010, Baron paid $8,700 to renew its comprehensive insurance coverage for one year. The premium on the
previous policy, which expired on April 30, 2010, was $7,800.
6. On January 2, 2010, Baron entered into a twentyfiveyear operating lease for the vacant lot adjacent to Baron’s retail
store for use as a parking lot. As agreed in the lease, Baron paved and fenced in the lot at a cost of $45,000. The
improvements were completed on April 1, 2010, and have an estimated useful life of fifteen years. No provision for
depreciation or amortization has been recorded. Depreciation on furniture and fixtures was $12,000 for 2010.
7. Accrued expenses at December 31, 2009 and 2010, were as follows:
2009 2010
Utilities $ 900 $1,500
Payroll taxes 1,100 1,600
$2,000 $3,100
8. Baron is being sued for $400,000. The coverage under the comprehensive insurance policy is limited to $250,000. Baron’s
attorney believes that an unfavorable outcome is probable and that a reasonable estimate of the settlement is $300,000.
9. The salaries account includes $4,000 per month paid to the proprietor. Baron also receives $250 per week for living
expenses.
Using the worksheet below, prepare the adjustments necessary to convert the trial balance of Baron Flowers to the accrual
basis of accounting for the year ended December 31, 2010. Formal journal entries are not required to support your adjustments.
However, use the numbers given with the additional information to crossreference the postings in the adjustment columns on
the worksheet.
Baron Flowers
WORKSHEET TO CONVERT TRIAL BALANCE TO ACCRUAL BASIS
December 31, 2010
Cash basis Adjustments Accrual basis*
*
Account title Dr. Cr. Dr. Cr. Dr. * Cr.
Cash 25,600
Accounts receivable 16,200
Inventory 62,000
Furniture & fixtures 118,200
Land improvements 45,000
Accumulated depreciation
& amortization 32,400
Accounts payable 17,000
Baron, Drawings
Baron, Capital 124,600
Sales 653,000
Purchases 305,100
Salaries 174,000
Payroll taxes 12,400
Insurance 8,700
Rent 34,200
Utilities 12,600
Living expenses 13,000
827,000 827,000
*Completion of these columns is not required.
Concepts
Authoritative
Literature Help
This question consists of ten items that represent descriptions or definitions of the various elements of the FASB’s
Statements of Financial Accounting Concepts. Select thebestanswer for each item from the terms listed in A – L. A term
may beused once, more than once, or not at all.
Terms
A. Recognition G. Gains
B. Comprehensive Income H. Net Income
C. Faithful representation I. Earnings
D. Revenues J. Realization
E. Predictive Value K. Replacement Cost
F. Comparability L. Current Market Value
C
o
1. C
2. I
n
3. T
h
4. E
n
5. T
h
6. All changes in net assets of an entity during a period except those resulting from investments by owners and distributions to
owners.
7. Inflows or other enhancements of assets of an entity or settlements of its liabilities from delivering or producing goods,
rendering services, or other activities that constitute the entity’s ongoing operations.
8. The amount of cash, or its equivalent, that could be obtained by selling an asset in orderly liquidation.
9. The quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or
present events.
10. A performance measure concerned primarily with cashtocash cycles.
Trial Balance Authoritative
Worksheet Literature Help
The accounts listed below appeared in the December 31 trial balance of Jane Alexander Theater.
Equipment 192,000
Accumulated depreciation equipment 60,000
Notes payable 90,000
Admissions revenue 380,000
Advertising expense 13,680
Salaries expense 57,600
Interest expense 1,400
Additional information follows:
1. The equipment has an estimated life of 16 years and a salvage value of $40,000 at the end of that time. (Use straightline
method.)
2. The note payable is a 90day note given to the bank October 20 and bearing interest at 10%. (Use 360 days for de
nominator.)
3. In December, two thousand (2,000) coupon admission books were sold at $25 each. They could be used for admission
any time after January 1.
4. Advertising expense paid in advance and included in Advertising Expense, $1,100.
5. Salaries accrued but unpaid, $4,700.
Using the attached Excel file, complete the adjustments, adjusted trial balance, and the income statement columns of the
worksheet. For the # column, insert the number of adjustments. Add accounts as needed.
Jane Alexander Theater
December 31, 200X
a) Trial balance # Adjustments Adjusted trial balance Income statement
Debit Credit Debit Credit Debit Credit Debit Credit
Equipment 192,000
Accumulated depreciation—
equipment 60,000
Notes payable 90,000
Admissions revenue 380,000
Advertising expense 13,680
Salaries expense 57,600
Interest expense 1,400
Depreciation expense
Interest payable
Unearned admissions revenue
Revenue
Prepaid advertising
Salaries payable
Concepts
Authoritative
Literature Help
SFAC 5 provides guidance on measuring assets and liabilities. The following measurement methods are available to
measure assets and liabilities, as shown in the list below. Identify the appropriate valuation method for each item.
1. L
2. A
3. E
4. W
5. S
6. A
7. B
8. T
Adjusting Authoritative
Entries Literature Help
Indicate whether each of the following adjusting entries is an accrual or a deferral type entry.
Accrual Deferral
1. Depreciation expense xx
Accumulated deprecation xx
2. Interest receivable xx
Interest revenue xx
3. Rent expense xx
Prepaid rent xx
4. Unearned revenue xx
Rent revenue xx
5. Wage expense xx
Wages payable xx
Revenue and Expense Authoritative
Recognition Literature Help
Emco has the following transactions in 2010. Indicate the amount of revenue or expense recognized in 2010, 2011, and
2012 for each of these items. You may show expense recognitions in parentheses (xx).
Amounts to be recognized 2010
2011 2012
1. Emco sells $5,000 of goods to a customer, FOB shipping point on 12/30/10.
2. Emco sells three pieces of equipment on a contract over a threeyear period.
The sales price of each piece of equipment is $10,000. Delivery of each
piece of equipment is on February 10 of each year. In 2010, the customer
paid a $20,000 down payment, and paid $5,000 per year in 2011 and 2012.
Collectibility is reasonably assured.
3. In 1/1/10, Emco pays $9,000 for a membership to Wholesalers Association
for a twoyear membership in the trade association.
4. On 6/1/10, Emco signs a contract for $20,000 for goods to be sold on
account. Payment is to be made in two installments of $10,000 each on
12/1/11 and 12/1/12. The goods are delivered on 10/1/10. Collection is
reasonably assured, and the goods may not be returned.
5. Emco sells goods to a customer on July 1, 2010, for $50,000. If the customer
does not sell the goods to retail customers by December 31, 2011, the goods
can be returned to Emco. The customer sells the goods to retail customers on
October 1, 2011.
*
1. c __ __ 19. d __ __ 37. c __ __ 55. d __ __ 73. c __ __
2. d __ __ 20. d __ __ 38. b __ __ 56. d __ __ 74. d __ __
3. b __ __ 21. b __ __ 39. b __ __ 57. c __ __ 75. c __ __
4. c __ __ 22. c __ __ 40. b __ __ 58. a __ __ 76. b __ __
5. b __ __ 23. a __ __ 41. b __ __ 59. a __ __ 77. b __ __
6. a __ __ 24. c __ __ 42. b __ __ 60. c __ __ 78. c __ __
7. d __ __ 25. d __ __ 43. a __ __ 61. c __ __ 79. b __ __
8. a __ __ 26. b __ __ 44. c __ __ 62. c __ __ 80. c __ __
9. c __ __ 27. c __ __ 45. d __ __ 63. d __ __ 81. b __ __
10. d __ __ 28. a __ __ 46. d __ __ 64. d __ __ 82. a __ __
11. b __ __ 29. b __ __ 47. d __ __ 65. d __ __ 83. d __ __
12. d __ __ 30. c __ __ 48. a __ __ 66. a __ __
13. a __ __ 31. b __ __ 49. d __ __ 67. d __ __
14. c __ __ 32. b __ __ 50. c __ __ 68. c __ __
15. d __ __ 33. c __ __ 51. d __ __ 69. d __ __
16. d __ __ 34. d __ __ 52. b __ __ 70. c __ __
17. d __ __ 35. a __ __ 53. c __ __ 71. a __ __ 1st: __/83 = __%
18. c __ __ 36. d __ __ 54. b __ __ 72. b __ __ 2nd: __/83 = __%
components of faithful representation include information to
A.1. Basic Accounting Theory be verifiable and free from error. Neutrality is not an ingre
1. (c) The Statements of Financial Accounting Con dient of relevance because relevance requires information to
cepts (SFAC) were issued to establish a have predictive value and confirmatory value, or both.
framework from which financial accounting and 6. (a) Per SFAC 8, comparability is an enhancing
reporting standards could be developed. The quality of financial reporting which relates to both
SFAC provide the theory behind accounting and relevance and faithful representation.
reporting and provide guidance when no GAAP Confirmatory value and predictive value only
exists. The SFAC are not included as GAAP. relate to relevance. Freedom from error only re
2. (d) Per SFAC 8, the objectives of financial lates to faithful representation.
reporting focus on providing present and potential 7. (d) Per SFAC 5, recognition is the process of for
investors and creditors with information useful in mally recording or incorporating an item into the
making investment decisions. Financial statement financial statements as an asset, liability, revenue,
users do not have the authority to prescribe the
expense, or the like. According to SFAC 6, allocation
data they desire. Therefore, they must rely on ex
is the process of assigning or distributing an amount
ternal financial reporting to satisfy their
according to a plan or formula, matching is the
information needs, and the objectives must be
simultaneous recognition of revenues with expenses
based on the needs of those users.
that are related directly or jointly to the same trans
3. (b) The FASB conceptual framework has identified the cost actions or events, and realization is the process of
benefit constraint to the relevance of providing financial converting noncash resources and rights into money.
reports. Information is not disclosed if the costs of
8. (a) Per SFAC 5, earnings and comprehensive income have the
disclosure outweigh the benefits of providing the informa
tion. Comparability is an enhancing qualitative characteris same broad components—revenues, expenses, gains, and losses
tic. Reliability is no longer part of the conceptual framework —but are not the same because certain classes of gains and
according to SFAC 8. Faithful representation is a fundamen losses are excluded from earnings. Changes in market values of
tal qualitative characteristic. investments in marketable equity securities classified as
availableforsale securities are included in comprehensive
4. (c) The enhancing qualitative characteristics of financial income, but are excluded from earnings until realized. Answers
reporting are comparability (including consistency), (b), (c), and (d) are incorrect because they would be included in
verifiability, timeliness, and understandability. Answer (a) is both earnings and comprehensive income. Note that unrealized
incorrect because relevance and faithful representation are gains and losses on marketable equity securities classified as
fundamental qualitative characteristics of financial informa trading securities are included in earnings. This treatment is in
tion. Reliability is no longer listed as a fundamental quality. accordance with SFAS 115.
Answer (b) is incorrect because costbenefit is a constraint,
and materiality is a threshold for reporting useful informa 9. (c) Per SFAC 6, comprehensive income includes
tion. Answer (d) is incorrect because completeness, neutral all changes in equity during a period except those
ity, and freedom from error are characteristics of faithful resulting from investments by owners and
representation, a fundamental qualitative characteristic. distributions to owners. Dividends paid to
stockholders is a change in equity resulting from a
5. (b) SFAC 8 defines neutrality as the quality of distribution to owners, so it is excluded from com
information which requires freedom from bias prehensive income. Answers (a), (b), and (d) are
toward a predetermined result. Unbiased all included in comprehensive income because
information would always be more faithfully they are changes
represented than biased information. Other
*
Explanation of how to use this performance record appears on page 2.
MODULE 9 BASIC TH. & FIN. REP. : A. BASIC CONCEPTS 255
because understandability is an enhancing
characteristic, predictive value is a component of
in equity, but are not investments by, or distributions relevance, and reliability is no longer a
to, owners. characteristic in the concept statements.
10. (d) The fundamental qualitative characteristic of 11. (b) According to SFAC 6, realization is the process
faithful representation has the components of of converting noncash resources and rights into
completeness, neutrality, and freedom from error. money through the sale of assets for cash or claims
Answer (a) is incorrect because predictive value to cash. When equipment is sold for a note
and confirmatory value are the components of receivable, money is realized since a note qualifies
relevance. Answer (b) is incorrect because as a claim to cash. Answers (a) and (d) relate to
comparability and consistency are enhancing cost allocation. Answer (c) is incorrect because
characteristics, and confirmatory value is a accounts receivable represents a claim to cash.
component of relevance. Answer (c) is incorrect, Realization occurs at the time of sale rather than
when cash is collected.
12. (d) A loss contingency is accrued by a charge to expense if it of an entity’s major or primary operations. Two essential
is reasonably estimable and it is probable thata liability characteristics of revenues are that revenues (1) arise from a
has been incurred as of the balance sheet date.The cause of company’s primary earnings activities and (2) are recurring
the liability must have occurred on or beforethe date of or continuing in nature. Therefore, answer (d) is correct
the financial statements if the liability is to beaccrued, because it meets the above criteria. Answers (b) and (c) are
because the intention is to recognize the loss in the same incorrect because they result from incidental transactions.
period that the underlying cause took place. Therefore, some Answer (a) is incorrect because a decrease of an asset is not
authorities would say that matching is the underlying a revenue.
concept supporting the immediate recognition of a contin 16. (d) Per SFAC 6, the common quality shared by
gent loss. A larger number, however, would mention con all assets is “service potential” or “future
servatism as the more pervasive underlying concept sup economic benefit.” Per SFAC 6, assets
porting the immediate recognition of these losses. commonly have other distinguishing features,
13. (a) Conservatism means that when in doubt, ac such as being legally enforceable, tangible or ac
countants should choose the procedure that will be quired at a cost. These features, however, are not
least likely to overstate assets and income. This essential characteristics of assets.
concept underlies the GAAP pertaining to 17. (d) Per SFAC 5, five different attributes are used to measure
recording gain contingencies. In an effort to not assets and liabilities in present practice: historical cost,
overstate assets or income, gain contingencies are current (replacement) cost, current market value, net
not recorded until they are no longer realizable value, and present value of future cash flows.
contingencies, and are disclosed only when Three of these (historical cost, replacement cost, and net
probabilities are high that a gain contingency will realizable value) are used in measuring inventory at lower of
become reality. cost or market. Present value of future cash flows is not used
14. (c) Per SFAC 6, the major difference between to measure inventory.
financial and physical capital maintenance is Cash Flow Information and Present Value (SFAC 7)
related to the effects of price changes on assets
held and liabilities owed during a period. The 18. (c) The most relevant measure of a liability
financial capital concept is applied in current always reflects the credit standing of the entity
GAAP. Under this concept, the effects of the price obligated to pay, according to SFAC 7. Those
changes described above are considered “holding who hold the entity’s obligations as assets
gains and losses,” and are included in computing incorporate the entity’s credit standing in de
return on capital. Comprehensive income, which termining the prices they are willing to pay.
is described in SFAC 5, is “the change in equity of
a business enterprise during a period from 19. (d) SFAC 7 provides a framework for using future
transactions and other events and circumstances cash flows as the basis for accounting measurements
from nonowner sources.” It is also a measure of at initial recognition or freshstart measurements and
return on financial capital. The concept of for the inter
physical capital maintenanceseeks to measure the est method of amortization. FASB limited SFAC 7
effects of price changes that are not currently tomeasurement issues (how to measure) and chose not to
captured under GAAP (e.g., replacement costs of address recognition questions (when to measure). SFAC
nonmonetary assets). Under this concept, holding 7introduces the expected cash flow approach, which differs
gains and losses are considered “capital from the traditional approach by focusing on explicit as
maintenance adjustments” which would be sumptions about the range of possible estimated cash flows
included directly in equity and excluded from and their respective probabilities.
return on capital.
20. (d) The expected cash flow approach uses all ex
15. (d) Per SFAC 6, revenues are inflows of assets or pectations about possible cash flows in developing
settlements of liabilities, or both, during a period a measurement, rather than just the single most
as a result likely cash flow. By incorporating a range of
possible outcomes (with their respective timing
differences), the expected cash flow approach
accommodates the use of present value techniques
when the timing of cash flows is uncertain. Thus,
the expected cash flow is likely to provide a
better estimate of fair value than the minimum,
mostlikely, or maximum taken alone. According
to SFAC 7, expected present value refers to the
sum of probabilityweighted present values in a
range of estimated cash flows, all discounted
using the same interest rate convention.
21. (b) The computation of expected present value
using a single interest rate is as follows:
PV of $200,000 in one year at 5% $190,476
Probability 20% $38,095
PV of $200,000 in two years at 5% $181,406
Probability 50% 90,703
PV of $200,000 in three years at 5% $172,768
Probability 30% 51,830
$180,628
Interpretations, AICPA Statements
of Position, AICPA Audit and
According to SFAC 7, expected present Accounting Guides, and Practice
value refers to the sum of probability Bulletins. The FASB Accounting
weighted present values in a range of Standards Codification does not
estimated cash flows, all discounted using include the AICPA Statements of
the same interest rate convention. Auditing Standards. The auditing
standards are included in the
22. (c) Like depreciation and
Professional Standards issued by the
amortization conventions, interest AICPA.
methods are grounded in notions of
historical cost, not current cost. A.2. Income Determination
23. (a) According to SFAC 7, the 26. (b) Generally, sales revenue is recognized at
objective of using present value in an the date of delivery, because that generally is
accounting measurement is to the time at which a sale has occurred. At that
capture, to the extent possible, the point the two criteria for revenue recognition
economic difference between sets of were met; the revenue is (1) realized or
future cash flows. The objective of realizable and (2) it is earned (SFAC 6).
present value, when used in Therefore, the amount of sales revenue
accounting measurements at initial recognized in 2010 is $150,000 (50,000 × $3 =
recognition and freshstart $150,000).
measurements, is to estimate fair
value. Stated differently, present 27. (c) Income generally accrues only at the time
value should attempt to capture the of sale, and gains may not be anticipated by
elements that taken together would reflecting assets at their current sales prices.
comprise a market price, if one Exception to this general rule isgranted,
existed, that is fair value. Valuein however, for agricultural products that are
use and entityspecific measurements homogenous and have an immediate
attempt to capture the value of an marketability at quoted prices such as the
asset or liability in the context of a cotton in this problem (ASC. 905330301).
particular entity. An entityspecific When these inventories are stated at sales
measurement substitutes the entity’s prices, they should be reduced by expenditures
assumptions for those that to be incurred in disposal. Amar Farms should,
marketplace participants would therefore, recognize revenue on the entire
make.
24. (c) The Codification provides
guidance on the determination of
gain or loss on disposal of a
component of a business. According
to this guidance, such determination
should be based on estimates of the
net realizable value of the
component. Since Brooks Co. plans
to discontinue its entire operations,
the appropriate measurement basis
for its equipment is net realizable
value. Historical cost and current
reproduction and replacement costs
are not appropriate measurement
bases for assets once an entity has
decided to discontinue its operations
because these amounts do not reflect
the entity’s probable future benefit,
which is a characteristic of assets per
SFAC 6.
25. (d) The FASB Accounting Standards
Codification includes all previous
level A–D GAAP. The Codification
includes the authoritative literature
of the Financial Accounting
Standards Board, the Emerging
Issues Task Force Abstracts,
Accounting Principles Board
Opinions, Accounting Research
Bulletins, Accounting
even though they were not billed to
300,000 pound crop in 2010 at the guaranteed Clark or paid until 2011. The $9,000
(and prevailing) market price of $.70 per must be accrued as an expense and a
pound. This amounts to $210,000 (300,000 liability at 12/31/10. Therefore, 2010
pounds × $.70 per pound = $210,000). Note advertising expense should total
that the additional $.02 per pound for the $140,000 ($146,000 – $15,000 +
cotton sold in 2011 would be recognized in $9,000).
2011, since its selling price exceeded the
current (2010) market price. 31. (b) The opening balance in prepaid
expenses
28. (a) Revenue from the sale of a product ($1,500) results from a oneyear insurance
may berecognized at the time of sale only premium paid on 7/1/09. Since this policy
if all of the following conditions are met: would have expired by 6/30/10, no part of the
1. The seller’s price is fixed or readily $1,500 is included in 12/31/10 prepaid
determinable. expenses. The insurance premium paid on
2. The buyer has paid the seller or is 7/1/10 ($3,200) would be partially expired
obligated to pay the seller, the (6/12) by 12/31/10. The remainder (6/12 ×
obligation not being contingent on $3,200 = $1,600) would be a prepaid expense
resale of the product. at yearend. The entire advance rental payment
3. The buyer’s obligation to the seller ($2,000) is a prepaid expense at 12/31/10
remains unchanged in the event of because it applies to 2011. Therefore, total
damage or destruction of the 12/31/10 prepaid expenses are $3,600.
product.
4. The buyer is independent from the
seller.
5. The seller does not have any
significant obligations regarding
resale of the product by the buyer.
6. The amount of future returns can be
reasonably estimated.
Because the buyer, Zee, has the right to
return the machine to the seller, Lin,
condition (2) above has not been met.
Therefore, the recognition of sales revenue
and cost of sales is not allowable for this
transaction.
A.3. Accruals and Deferrals
29. (b) Under accrual accounting, events
that change an entity’s financial
position are recorded in the period in
which the events occur. This means
revenues are recognized when earned
rather than when cash is received,
and expenses are recognized when
incurred rather than when cash is
paid. Therefore, when the royalties
are paid, Wand should debit an asset
account (prepaid royalties) rather
than an expense account. The
royalties paid should be reported as
expense in the period incurred (by
debiting royalty expense and credit
ing prepaid royalties).
30. (c) The balance in the advertising
expense account on 12/31/10 before
adjustment is $146,000. Since the
sales promotional campaign is to be
conducted in January, any associated
costs are an expense of 2011. Thus,
the $15,000 cost of printing catalogs
should be removed from the adver
tising expense account and recorded
as a prepaid expense as of 12/31/10.
In addition, advertising expense
must be increased by the $9,000
cost of December’s radio advertise
ments, which are an expense of 2010
Prepaid insurance ($3,200 × 6/12) $1,600 revenue because this amount
Prepaid rent 2,000 pertains to revenues earned for July
Total prepaid expenses $3,600
32. (b) Apparently Roro records policy through December of 2009 and
MODULE 9 BASIC TH. & FIN. REP. : A. BASIC CONCEPTS
payments as charges to insurance would have been accrued as revenue 257
expense and records prepaid on 12/31/09. On 9/15/10, Wren
insurance at the end of the quarter received $17,000 in royalties for the
through an adjusting entry. The first half of 2010. Royalties for the
unadjusted trial balance amounts at second half of 2010 will not be
3/31/10 must represent the final two received until 3/15/11. However, the
months of the old policy ($300 of royalty payment to be received for
prepaid insurance) and the cost of the second six months (15% ×
the new policy ($7,200 of insurance $60,000 = $9,000) has been earned
expense). An adjusting entry must and should be accrued at 12/31/10.
be prepared to reflect the correct Therefore, 2010 royalty revenue is
3/31/10 balances. Since the new $26,000 ($17,000 + $9,000).
policy has been in force one month
(3/1 through 3/31), thirtyfive 36. (d) The agreement states that Super is to
months remain unexpired. receive royalties of 20% of revenues
Therefore, the balance in prepaid associated with the comic strip. Since
insurance should be $7,000 ($7,200 Fantasy’s 2011 revenues from the strip were
× 35/36). Insurance expense should $1,500,000, Super’s royalty revenue is
include the cost of the last two $300,000 ($1,500,000 × 20%). The other
months of the old policy and the first information in the problem about the
month of the new policy [$300 + receivable and cash payments is not needed to
($7,200 × 1/36) = $500]. Roro’s compute revenues. Super’s 2011 summary
adjusting entry would transfer entries would be
$6,700 from insurance expense to Cash 200,000
prepaid insurance to result in the Royalties rec. 75,000
Royalty revenue 125,000 ($200,000 – $75,000)
correct balances. Royalties rec. 175,000
Royalty revenue 175,000 ($300,000 – $125,000)
33. (c) At 12/31/10, the liability account
unearned subscription revenue 37. (c) Royalty revenues should be
should have a balance which reflects recognized whenearned, regardless of
all unexpired subscriptions. Of the when the cash is collected. Royalty
2009 sales, $125,000 expires
during 2011 and would still be a
liability at 12/31/10. Of the 2010
sales, $340,000 ($200,000 +
$140,000) expires during 2011 and
2012, and therefore is a liability at
12/31/10. Therefore, the total
liability is $465,000 ($125,000 +
$340,000). This amount would have
to be removed from the sales
account and recorded as a liability in
a 12/31/10 adjusting entry.
34. (d) Regal’s unredeemed gift
certificates at 12/31/09 are $75,000.
During 2010, these certificates are
either redeemed ($25,000) or expire
by 12/31/10 ($75,000 – $25,000 =
$50,000). Therefore, none of the
$75,000 affects the 12/31/10
unearned revenue amount. During
2010, additional certificates totaling
$250,000 were sold. Of this amount,
$225,000 is expected to be redeemed
in the future [$250,000
– (10% × $250,000)]. Since $175,000 of
2010 certificates were redeemed in 2010,
12/31/10 unearned revenue is $50,000
($225,000 – $175,000).
35. (a) The requirement is to calculate
Wren’s royalty revenue for 2010.
The 3/15/10 royalty receipt
($12,000) would not affect 2010
($40,000) is subtracted since this amount was
revenue earned from 12/1/09 to 5/31/10 is collected, but not earned as revenue, by
$80,000 ($400,000 × 20%). Of this amount, 12/31/10.
$10,000 ($50,000 × 20%) was earned in 39. (b) The requirement is to determine the
December of 2009, so the portion earned in
amount ofroyalty expense to be recognized
the first five months of 2010 is $70,000
in 2010. Cash paid for royalties totaled
($80,000 – $10,000). Royalty revenue earned
from 6/1/10 to 11/30/10 is $65,000 ($325,000 $300,000 in 2010. However, this amount
× 20%). The amount earned from 12/1/10 to must be adjusted for changes in the related
12/31/10, which would be accrued at 12/31, is accounts, as follows:
$14,000 ($70,000 × 20%). Therefore, 2010 2010 cash paid $300,000
royalty revenue is $149,000. Royalties payable 12/31/09 (80,000)
Royalties payable 12/31/10 75,000
1/1/10 5/31/10 $70,000 Prepaid royalties 12/31/09 55,000
6/1/10 11/30/10 65,000 Prepaid royalties 12/31/10 (45,000)
12/1/10 12/31/10 14,000 $305,000
$149,000
The beginning payable balance ($80,000) is
38. (b) The requirement is to calculate the subtracted because that portion of the cash
amount ofroyalty income to be recognized in paid was recognized as expense during the
2010. Cash collected for royalties totaled previous year. The ending payable balance
$200,000 in 2010. However, this amount ($75,000) is added because that amount has
must be adjusted for changes in the related been accrued as 2010 expense, even though it
accounts, as follows: has not yet been paid. The beginning balance
2010 cash received of prepaid royalties ($55,000) is added
$200,000
Royalties receivable 12/31/09 because that amount is assumed to have
(90,000)
Royalties receivable 12/31/10 expired during the year. Finally, the ending
Unearned royalties 12/31/09 balance of prepaid royalties ($45,000) is
Unearned royalties 12/31/10 (40,000
subtracted since this amount was paid, but not
Royalty income $215,000
incurred as an expense, by 12/31/10.
The beginning receivable balance ($90,000) is 40. (b) When the insurance policy was
subtracted because that portion of the cash
initially purchased, the entire balance was
collected was recognized as revenue last year.
debited to a prepaid asset account (i.e.,
The ending receivable balance ($85,000) is
prepaid insurance). The adjusting entry at
added because that amount is 2010 revenue,
even though it has not yet been collected. The December 31, 2010, to recognize the
beginning balance of unearned royalties expiration of one year of the policy would be
($60,000) is added because that amount is Insurance expense (1/3 of original pymt.)
assumed to be earned during the year. Finally, Prepaid insurance (1/3 of original
the ending balance of unearned royalties pymt.)
Service Revenue Acct . Receivable

After the adjusting entry, the prepaid asset
1/1/ 10 40,000
account would contain 2/3 of the original 220,000 200,000 Cash
payment. If the original payment had instead 5,000 220,000 received
been debited to an expense account (i.e.,
insurance expense), then the adjusting entry 215,000 12/ 31/ 10 60,000
at December 31, 2010 would be
Prepaid insurance (2/3 of original pymt.) Unearned Revenue
Insurance expense (2/3 of original 0 1/1/ 10
pymt.)
5,000
This alternate approach would also result in
1/3 of the original payment being expensed in 5,000 12/ 31/ 10
2010 and 2/3 of the original payment being
carried forward as a prepaid asset. Thus, 45. (d) To determine cash basis revenue, the
answer (b) is correct. Answer (a) is incorrect
solutionsapproach is to prepare a Taccount
because the premium paid was for a threeyear
policy, 2/3 of which had not yet expired and for accounts receivable.
would therefore be carried forward in the Accounts Receivable
prepaid asset account. Answer (c) is incorrect 12/31/09 1,000,000
because 1/3 of the original payment was Sales 4,600,000 20,000 Writeoffs
? Collections
already expensed. Answer (d) is incorrect
12/31/10 1,300,000
because the amount would be the same as it
would have been if the original payment had The missing amount for cash collections is
been debited initially to an expense account $4,280,000. Another approach is to use the
(as explained for answer (b) above). following formula:
Sales + Decrease (– increase) in AR – Writeoffs = Collections
41. (b) Current assets are identified as $4,600,000 – $300,000 – $20,000 = $4,280,000
resources that are reasonably
expected to be realized in cash or The increase in receivables ($300,000) means
sold or consumed during the that cash collected during the period was less
than sales during the period and therefore is
normal operating cycle of the
deducted from sales revenue. The writeoffs
business.These resources include ($20,000) represent recognized sales that will
prepaid expenses such as royalties. never be collected in cash and therefore must
Since the balance remaining in Sip also be deducted to compute collections.
Co.’s royalty prepayment (the
payment relating to 2011 royalties) 46. (d) To determine rental revenue, the
will be consumed within the next solutions approach is to prepare a Taccount
year, it should be reported as a for rents receivable and rent revenues.
current asset. Additionally, the Rent Receivable Rent Revenues
payment relating to 2010 should be a a
11/30/09 800,000 800,000 800,000 2,210,000
reported as an expense. b c b
1,090,000 30,000 1,090,000
42. (b) At the time the gift certificates
were issued, the following entry Bal 1,060,000 1,060,000 + 30,000 Bal 2,500,000
was made, reflecting the store’s a
To remove 2009 revenue from the $2,210,000 of cash
future obligation to honor the collected and relieve rent receivable of collections
from 2009 receivables.
certificates: b
To recognize unrecorded rent earned including writeoffs.
c
Cash xx To recognize writeoffs. Debit would be to the
Deferred revenue xx allowance account.
Upon redemption of the certificates, the
obligation recorded in the deferred revenue
account becomes satisfied and the revenue is
earned. Similarly, as the certificates expire,
the store is no longer under any obligation to
honor the certificates and the deferred
revenue should be taken into income. In both
instances, the deferred revenue account must
be reduced (debited) to reflect the earning of
revenue. This is done through the following
entry:
Deferred revenue xx
Revenue xx
43. (a) The revenues from service contracts 47. (d) Under the cash basis method of
should berecognized on a pro rata basis over the accounting, revenue is recognized as it is
term of the contract. This treatment allocates the collected. Cash sales after returns and
contract revenues to the period(s) in which they allowances totaled $76,000 ($80,000 –
are earned. Since the sale of a service contract $4,000). Net credit sales for 2010 were
does not culminate in the completion of the $114,000 ($120,000 credit sales – $6,000
earnings process (i.e., does not represent the discounts). As made evident by the following
seller’s performance of the contract), payments Taccount, cash collections from credit sales
received for such a contract should be recorded must equal $124,000 ($40,000 + $114,000 –
initially in a deferred revenue account. $30,000), since $10,000 in excess of current
credit sales was received and reduced
A.4. Cash to Accrual Accounts Receivable by this amount.
44. (c) The following formula is used to Accounts Receivable
adjust servicerevenue from the cash basis to Bal. 1/1 40,000
Net credit sales 114,000 ? Collections
the accrual basis:
Bal. 12/31 30,000
Beg. End.
Cash fees End. Beg.
collected
+
AR
–
AR
+ unearned – unearned = A summary journal entry would be
fees fees
$200,000 + $60,000 – $40,000 + 0 – $5,000
= $215,000
As an alternative, Taccounts can be used.
Cash 124,000
March 31). Therefore, cash basis income is
Sales discounts 6,000
$5,000. Drawings are $1,000. Therefore,
Total cash basis revenue for 2010 is ending capital is $6,000 ($2,000 + $0 + $5,000
$200,000 as shown below. – $1,000). 259
Cash sales ($80,000 – $4,000)
51. (d) The requirement of this question is to
Collections of credit sales [($40,000 + $120,000 –
$30,000) – $6,000] determineif a decrease in accounts receivable
Total cash received and/or a decrease in accrued expenses
would result in cashbasis income being
48. (a) Cost of goods sold is computed as
lower than accrualbasis income.
follows:
A decrease in the accounts receivable balance
Beg. inv. + Net purchases – End. inv. = would generally mean that cash was collected.
CGS
In accordance with the cash basis of accounting
Net purchases must be computed from the when cash is received it is recorded as revenue
information given using a Taccount or a (Dr. Cash, Cr. Revenue), whereas under the ac
formula. crual basis the revenue would have been
AP recorded when the
50,000 12/31/09
Payments 490,000 ? Purchases
75,000 12/31/10
The missing amount for purchases is
$515,000. Another approach is to use the
following formula:
Payments + Ending AP – Beginning AP = Purchases
$490,000 + $75,000 –$50,000= $515,000
This amount can be used to determine cost of
goods sold
Beg. inventory $290,000
+ Net purchases 515,000
Cost of goods available 805,000
– End. inventory 260,000
Cost of goods sold $545,000
49. (d) Cashbasis income of $60,000 must
be adjustedfor changes in accounts
receivable and accounts payable to compute
accrual income
Cashbasis income $ 60,000
12/31/09 AR (20,000)
12/31/10 AR
12/31/09 AP
12/31/10 AP (15,000
Accrual income $
The beginning AR ($20,000) is subtracted
because although this amount was collected
in 2010, it is properly accrued as 2009
revenue. The ending AR is added because
although not collected in 2010, it should be
accrued as 2010 revenue. The beginning AP
is added because although this amount was
paid in 2010, it is properly accrued as 2009
expense. The ending AP is subtracted
because although not paid in 2010, it should
be accrued as 2010 expense.
50. (c) The ending balance in Tory’s capital
account oneither the accrual or cash basis is
computed as follows:
Beginning
+ Investments + Income – Drawings =
capital
Tory’s beginning capital is his initial cash
investment of $2,000. No other investments
were made. Under the cash basis method of
accounting, income is the excess of cash
revenues ($5,000) over cash expenses ($0,
since the expenses were not paid until after
unused supplies at each yearend
receivable was recorded (Dr. AR, Cr. would have been carried as an asset
Revenue). Thus, a decreased accounts and, therefore, excluded from the
receivable balance would result in increased current year’s supplies expense. In
revenue/income. Therefore, the answer for this 2010, the year Droit adopted the
account is No. accrual basis of accounting, Droit
A decrease in the accrued expenses account would have inventoried unused
would generally mean cash was paid on some supplies at December 31 and
expenses. Under the cash basis, when the cash is excluded those costs from 2010 net
paid the expense is recorded (Dr. income. Since the cost of 2010’s
Expense, Cr. Cash), whereas under the beginning balance of supplies was
accrual basis the expense would have been expensed during 2009, even though
recorded when the accrued expense was the supplies were not used until
recorded (Dr. Expense, Cr. Accrued 2010, Droit’s inability to determine
Expense). Thus, a decreased accrued the beginning supplies inventory
expenses account would result in increased would result in an understatement of
expenses/lower income for the cash basis. supplies expense and overstatement
Thus, the answer for this account is Yes. of 2010 net income. However, since
Droit properly inventoried supplies
52. (b) When a company operates on the at December 31, 2010, its
accrual basis, supplies are cumulative (inceptiontodate)
inventoried and expensed as they are supplies expense would be properly
used. Under the cash method, stated. Therefore, Droit’s inability to
however, supplies are expensed as determine 2010’s beginning supplies
they are paid for. Therefore if White expense would have no impact on
Co. experiences an increase in Droit’s December 31, 2010 retained
supplies inventory during the year, earnings.
this increase must be deducted from
accrual income to get to the cash A.5. Installment Sales
basis, because the cost of the
supplies would be expensed at the 54. (b) Under the installment method, gross
time of purchase. profit isdeferred at the time of sale and is
Office salaries payable works the opposite recognized by applying the gross profit rate to
way. Under the accrual method, a liability subsequent cash collections. At the time of
would have been established resulting in sale, gross profit of $250,000 is deferred
additional expense over the amount of cash ($500,000 installment sales less $250,000
paid to employees. Under the cash method, no cost of installment sales). The gross profit rate
liability is accrued and the unpaid salaries are is 50% ($250,000 ÷ $500,000). Since 2010
not expensed. Therefore, the increase must be collections on installment sales were
added to the accrual basis net income. $100,000, gross profit of $50,000 (50% ×
$100,000) is recognized in 2010. This would
53. (c) Prior to 2010, Droit Co. used the decrease the deferred gross profit account to a
cash basis of accounting. 12/31/10 balance of $200,000 ($250,000 –
Accordingly, Droit would have $50,000). Note that regular sales, cost of
expensed all purchases of supplies as regular sales, and general and administrative
incurred. In contrast, under the ac expenses do not affect the deferred gross
crual basis of accounting, the cost of profit account.
recognized is $250,000 ($100,000
gross profit+ $150,000 interest
55. (d) Under the installment sales method, revenue).
gross profitis deferred to future periods and
recognized proportionately to collection of the 59. (a) The machine sale is accounted
receivables. Therefore, at each yearend, for using the installment method,
deferred gross profit can be computed by where gross profit is deferred and
multiplying the gross profit percentage by the recognized in proportion to cash
accounts receivable balance, as indicated collected. Initially, the entire
below. $270,000 gain is deferred. In 2010,
$150,000 of the sales price was
2010
collected, and the gross profit
Sales $900,000
2009 Collections percentage is 30% ($270,000 ÷
2010 Collections (300,000) $900,000), so gross profit recognized
2009 Writeoffs was $45,000 (30% × $150,000). In
2010 Writeoffs (50,000) 2011, $250,000 of the sales price
12/31/10 AR $550,000 $100,000 was collected, so gross profit
Gross profit % ×40%
12/31/10 Deferred GP $220,000 $ recognized was $75,000 (30% ×
$250,000). Therefore, at 12/31/11,
Thus, total deferred gross profit at deferred gross profit is $150,000
12/31/10 is $250,000 ($220,000 + ($270,000 – $45,000 – $75,000). As
$30,000). a shortcut, you can compute the
56. (d) Under the installment sales method, 12/31/11 note receivable balance
gross profitis deferred to future periods and is ($750,000 – $250,000 = $500,000),
recognized proportionately as cash is and multiply by the 30% gross profit
collected. To determine cash collections in this percentage (30% × $500,000 =
case, first compute the 2011 installment sales $150,000).
by dividing deferred gross profit by the gross
profit percentage ($560,000  40% =
$1,400,000). Then, the 12/31/11 installment
accounts receivable is subtracted to determine
cash collections ($1,400,000 – $800,000 =
$600,000). Realized gross profit is then
computed by multiplying cash collections by
the gross profit percentage ($600,000 × 40% =
$240,000).
57. (c) When using the installment method,
gross profitrealized is computed as indicated
below.
Cash collections × GP% = GP
realized
This equation can be rearranged as follows:
GP realized ÷ GP% = Cash
collections
Therefore, cash collected to date on 2010
sales is $800,000 [($150,000 + $90,000) ÷
30%], and on 2011 sales is $500,000
($200,000 ÷ 40%). Installment accounts
receivable at 12/31/11 is computed by
subtracting cash collections from the original
sales amount.
Installment AR – 2010 ($1,000,000 – $800,000)
Installment AR – 2011 ($2,000,000 – $500,000)
Total 12/31/11 installment AR
58. (a) The equipment sale is accounted
for using the installment method.
The gross profit percentage on the
sale is 33 1/3% ($600,000 profit ÷
$1,800,000 selling price). Since
$300,000 of the sales price is
collected in 2011, gross profit of
$100,000 is recognized (33 1/3% ×
$300,000). The total revenue
recognized after the sale, in
Note that the interest collected ($75,000) proportion to cash collected. Under
does not affect the computation because it is the cost recovery method (case II),
not a collection of sales price. revenue (gross profit) is again
recognized after the sale, when
60. (c) The profit on a sale in the ordinary course
cumulative receipts exceed the cost
of business is considered to be realized at the of the asset sold. Therefore, revenue
time of sale unless it is uncertain whether the
is not recognized prior to the sale of
sale price will be collected. The Board
merchandise in either case I or case
concluded that use of the installment method
II.
of accounting is not acceptable unless this
uncertainty exists. Answers (a), (b), and (d) A.6. Cost Recovery Method
are incorrect because they do not involve the
element of uncertainty regarding the 64. (d) Under the cost recovery method
collectibility of the sale price. no profit of anytype is recognized
until the cumulative receipts
61. (c) According to the installment (principaland interest) exceed the
method of accounting, gross profit on cost of the asset sold. This means
an installment sale is recognized in that the entire gross profit
income in proportion to the cash ($3,000,000 – $2,000,000 =
collection. The cash collected from a $1,000,000) and the 2011 interest
given year’s sales is multiplied by that received ($270,000) will be deferred
year’s gross profit percentage to until cash collections exceed
compute the amount of gross profit $2,000,000. Therefore, no income is
to be recognized. Answer (a) describes the recognized in 2011.
pointofsale recognition basis, while answer
65. (d) The installment method is used
(d) describes the cost recovery method. when collection of the selling price
Answer (b) does not describe any is not reasonably assured. However,
recognitionbasis currently used. when the uncertainty of collection is
62. (c) The installment method of accounting is used so great that even the use of the
when there is a high degree of uncertainty installment method is precluded,
regarding the collectibility of the sale price.
then the cost recovery method may
be used. Having no reasonable basis
Under this method, sales revenues and the
for estimating collectibility would
related cost of goods sold are recognized in the
provide a great enough uncertainty
period of the sale. However, the gross profit is
to use the cost recovery method. It is
deferred to the periods in which cash is collected.
important to note that anytime the
Income recognized in the period of collection is
installment method is used, some
generally computed by multiplying the cash risk of 100% collection exists, but
collected by the gross margin percentage. The in the risk must be extreme before the
stallment method is based upon deferral of the cost recovery method is employed.
gross profit, not the net operating profit. The
installment method is generally only applicable 66. (a) Installment methods of
when the reporting company is unable to recognizing revenue are appropriate
estimate the amount of uncollectible accounts. only when “collection of the sale
price is not reasonably assured.”
63. (d) Under the installment method Under the cost recovery method,
(case I) revenue (gross profit) is gross
at its own risk.
profit is deferred and recognized only when 70. (c) The problem states that the sale has
the cumulative receipts exceed the cost of been consummated and that Kame’s initial
the asset sold. and continuing investments are adequate to
demonstrate a commitment to pay for the
A.7. Franchise Agreements property. However, the fact that Esker’s
receivable is subject to future subordination
67. (d) Franchise fee revenue is recognized
precludes recognition of the profit in full.
when allmaterial services have been
Instead, the cost recovery method must be
substantially performed by the franchiser.
used to account for the sale. The deposit
Substantial performance means the franchiser
method is to be used
has performed substantially all of required
initial services and has no remaining 1. Until the sale is consummated, when
obligation to refund any cash received. The all activities necessary for closing
$60,000 nonrefundable down payment applies have been performed.
to the initial services already performed by 2. If the buyer’s initial and continuing
Rice. Therefore, the $60,000 may be investments are not adequate to demonstrate a
recognized as revenue in 2010. The three commitment to pay for the property and the
remaining $30,000 installments relate to seller is not reasonably as
substantial future services to be performed by
Rice. The present value of these payments
($72,000) is recorded as unearned franchise
fees and recognized as revenue once
substantial performance of the future services
has occurred.
Cash 60,000
Notes receivable 90,000
Discount on notes receivable
Franchise revenue
Unearned franchise fees
68. (c) Initial franchise fees are not recognized
as revenue until the franchisor makes
substantial performance of the required
services, and collection is reasonably assured.
Since Potter Pie has not yet performed the
required services, the initial franchise fee (21
× $30,000 = $630,000) is reported as
unearned franchise fees at 12/31/10. The
estimated uncollectible amount ($20,000)
normally would be recorded as a debit to bad
debt expense and a credit to allowance for
uncollectible accounts. However, since
norevenue has yet been recognized, it is
inappropriate to record bad debt expense.
Instead, unearned franchise fees is debited,
because an unearned revenue should not be
recorded when, in effect, no related asset has
been received. Therefore, the net unearned
franchise fees is $610,000 ($630,000
– $20,000).
A.8. Real Estate Transactions
69. (d) Items I and II do not transfer the risks
and rewards of ownership to the buyer since
both scenarios entitle the buyer to a return of
his/her initial investment. Thus, the risks of
ownership still remain with the seller. The
economic substance of such arrangements is
that of financing, leasing, or profitsharing
transactions. Item III transfers the risks and
rewards of ownership since the seller will be
reimbursed for cost plus a 5% profit on the
support provided. Therefore, the seller is not
required to support operations of the property
delivered item, the undelivered item must be
sured of recovering the cost of the substantially in the control of the vendor.
property if the buyer defaults. Therefore answer (a) is correct.
The problem states that the sale has been A.10. Research or Development
consummated and that Kame’s initial and Accounted for on the Milestone
continuing investments are adequate.
Method
Therefore, the deposit method will not be used
to account for the sale. The reduced profit 72. (b) The requirement is to identify the
method is used only when the initial subject matter of milestone
investment is adequate to demonstrate a accounting. Answer (b) is correct
commitment to pay for the property but the
because the milestone method of
continuing investments are not. The
accounting may be used to recognize
continuing investments must also meet certain
additional requirements for the reduced profit revenue for research and development
method to be used. Since Kame’s continuing arrangements. Note that the milestone
investments are adequate, the reduced profit method is an option, but it is not
method will not be used to account for the required.
sale. The full accrual method may be used
73. (c) The requirement is to identify the amount
only if profit on the sale is determinable, the
of revenue recognized under the milestone
earning process is virtually complete, and all
of the following: method. Answer (c) is correct because
contingent revenue may be recognized in its
1. A sale is consummated. entirety in the period the milestone is
2. The buyer’s initial and continuing achieved.
investments are adequate to
demonstrate a commitment to pay A.15. International Financial Reporting
for the property. Standards
3. The seller’s receivable is not subject (IFRS)
to future subordination.
4. The seller has transferred to the buyer 74. (d) The requirement is to identify
the usual risks and rewards of the body that sets international
ownership in a transaction that is, in accounting standards. Answer (d) is
substance, a sale and does not have a correct because the International
substantial continuing involvement in Accounting Standards Board
the property. (IASB) issues International
Financial Reporting Standards.
A.9. MultipleDeliverable Revenue
Arrangements 75. (c) The requirement is to identify the
qualitative characteristics of relevance.
71. (a) The requirement is to identify the Answer (c) is correct because the IASB
condition thatmust be met to apply separate Framework provides that relevance includes
accounting. For a multipledeliverables the qualities of predictive value and
arrangement, two conditions must be met for confirmatory value. Answer (a) is incorrect
an item to be considered a separate unit of because feedback value is not a characteristic
accounting: (1) The delivered item has value of relevance. Answer (b) is incorrect because
on a standalone basis, and (2) if the these qualities are the characteristics of
arrangement includes a right of return for the reliability in FASB Concept Statement 1,
which is superseded by SFAC 8.
Answer (d) is incorrect because comparability and timeliness
are enhancing characteristics in the IASB Framework.
76. (b) The requirement is to identify the element that
is defined as increases in economic benefits in the
form of inflows or enhancements of assets or
decreases of liabilities that result in increases in
equity other than those resulting from
contributions from equity participants. Answer (b)
is correct because the IASB Framework has five
elements: asset, liability, equity, income, and
expense. The definition given is that of income.
Note that income includes both revenues and
gains.
77. (b) The requirement is to identify the criteria under
IFRS that must be met for an item to be included
in financial statements. Answer (b) is correct
because in order for an item to be recognized in
the financial statements, IFRS requires that it meet
the definition of an element and can be measured
reliably.
78. (c) The requirement is to identify the revenue rec
ognition method that must be used if the outcome
of rendering services cannot be estimated
reliably. Answer (c) is correct because if the
outcome of rendering services cannot be measured
reliably, IFRS requires use of the cost recovery
method. Answer (a) is incorrect because the
percentageofcompletion method is used when
reliable estimates can be made. Answer (b) is
incorrect because the completed contract method
is not permissible under IFRS. Answer (d) is
incorrect because the installment method is a
revenue recognition method used under US
GAAP, not IFRS.
79. (b) The requirement is to identify the item that is
not one of the criteria for revenue recognition for
sales of goods under IFRS. Answer (b) is correct
because it is not required that payment has been
received.
80. (c) The requirement is to identify the assets for
which the entity may use fair value as deemed cost
upon adoption of IFRS. Answer (c) is correct
because the entity may use fair value as deemed
cost for any individual item of property plant and
equipment.
81. (b) The requirement is to identify the first step
within the hierarchy of guidance to which
management refers when selecting accounting
policies. Answer (b) is correct because the
highest level in the hierarchy is an IFRS standard
applicable to the transaction. Answer (a), (c), and
(d) are incorrect because they all represent lower levels in
the hierarchy.
82. (a) The requirement is to identify the transition
date. Answer (a) is correct because the “date of
transition to IFRS” is defined as the beginning of
the earliest period for which an entity presents full
comparative information under IFRS.
83. (d) The requirement is to identify how
adjustments are reflected upon adoption of IFRS.
Answer (d) is correct because upon firsttime
adoption of IFRS, any adjustments required to
present the opening balances of the statement of
financial position should be recognized directly in
retained earnings or, if appropriate, in another
category of equity.
Account
Classifications Authoritative
Literature Help
Balance sheet classification Income statement classification
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J)
1. Bonds payable, due in 2018
2. Treasury stock
3. Accounts payable
4. Sales discounts
5. Notes payable, due in nine months
6. Inventory
7. Accounts receivable
8. Common stock
9. Cost of goods sold
10. Allowance for uncollectible accounts
Accrual Basis
Worksheet Authoritative
Literature Help
Baron Flowers
WORKSHEET TO CONVERT TRIAL BALANCE TO ACCRUAL BASIS
December 31, 2010
Cash basis Adjustments Accrual basis*
Account title Dr. Cr. Dr. Cr. Dr.* Cr.*
Cash 25,600 25,600
Accounts receivable 16,200 (1) 15,800 32,000
Inventory 62,000 (4) 10,800 72,800
Furniture & fixtures 118,200 118,200
Land improvements 45,000 45,000
& amortization 32,400 (6) 14,250 46,650
Accounts payable 17,000 (3) 13,500 30,500
Baron, Drawings (9) 61,000 61,000
Baron, Capital 124,600 (7) 2,000 (5) 2,600 125,200
Allowance for uncollectible
accounts (2) 3,800 3,800
Prepaid insurance (5) 2,900 2,900
Accrued expenses (7) 3,100 3,100
Estimated liability from lawsuit (8) 50,000 50,000
Sales 653,000 (1) 15,800 668,800
Purchases 305,100 (3) 13,500 318,600
Salaries 174,000 (9) 48,000 126,000
Payroll taxes 12,400 (7) 500 12,900
Insurance 8,700 (5) 300 8,400
Rent 34,200 34,200
Utilities 12,600 (7) 600 13,200
Living expenses 13,000 (9) 13,000
Income summary—inventory (4) 62,000 (4) 72,800 10,800
Uncollectible accounts (2) 3,800 3,800
Depreciation & amortization (6) 14,250 14,250
Estimated loss from lawsuit (8) 50,000 50,000
827,000 827,000 237,150 237,150 938,850 938,850
*
Completion of these columns was not required.
264 MODULE 9 BASIC TH. & FIN. REP. : A. BASIC CONCEPTS
Explanations of Adjustments [6] To record 2010 depreciation and
[1] To convert 2010 sales to accrual basis. amortization expense.
Accounts receivable balances:
December 31, 2010
December 31, 2009
Increase in sales
Cost of leasehold improvement $45,000
Estimated life 15 years
Amortization ($45,000 × 1/15 × 9/12) 2,250
Depreciation expense on fixtures and equipment 12,000
$14,250
[2] To record provision for uncollectible [7] To convert expenses to accrual basis.
accounts.
[3] To convert 2010 purchases to accrual

basis.
Accounts payable balances:
December 31, 2010 $30,500
December 31, 2009
Increase in purchases $
Balances
December 31, Increase
2010 2009 in expenses
Utilities $1,500 $ 900 $ 600
Payroll taxes 1,600 1,100 500
$3,100 $2,000 $1,100
[4] To record increase in inventory from [8] To record lawsuit liability at 12/31/10.
12/31/09 to 12/31/10. Attorney’s estimate of probable loss $300,000
Inventory balances: Amount covered by insurance 250,000
December 31, 2010 Baron’s estimated liability $ 50,000
December 31, 2009 [9] To record Baron’s drawings for 2010.
Increase in inventory
[5] To adjust prepaid insurance.
Prepaid balances:
December 31, 2010 ($8,700 × 4/12)
December 31, 2009 ($7,800 × 4/12)
Decrease in insurance expense
Salary ($4,000 × 12) $48,000
Living expenses 13,000
$61,000
C
o
A
u
L
i
C
o
1. C
2. I
n
3. T
h
4. E
n
5. T
h
6. A
l
7. I
n
8. T
h
9. T
h
10. A

1. (E) SFAC 5 states that “Relevance is a primary qualitative characteristic. To be
relevant, information about an item must have feedback value or predictive value (or
both) for users and must be timely.”
2. (G) SFAC 6 states that “Gains are increases in equity (net assets) from peripheral or
incidental transactions of an entity and from all other transactions and other events and
circumstances affecting the entity except those that result from revenues or investments
by owners.”
3. (J) SFAC 5 states that “Revenues and gains are realized when products (goods or services),
merchandise, or other assets are exchanged for cash or claims to cash.”
4. (F) SFAC 8 states that “Comparability, including consistency, is an enhancing quality that
interacts with relevance and faithful representation to contribute to the usefulness of
information.”
5. (A) SFAC 5 states that “Recognition is the process of formally recording or incorporating
an item into the financial statements of an entity as an asset, liability, revenue, expense,
or the like.” SFAC 5 continues the recognition concept by stating, “An item and
information about it should meet four fundamental recognition criteria to be recognized
and should be recognized when the criteria are met, subject to a costbenefit constraint
and a materiality threshold.”
6. (B) SFAC 5 states that “Comprehensive income is a broad measure of the effects of
transactions and other events on an entity, comprising all recognized changes in equity
(net assets) of the entity during a period from transactions and other events and
circumstances except those resulting from investments by owners and distributions to
owners.”
7. (D) SFAC 6 defines revenues as “inflows or other enhancements of assets of an entity or
settlements of its liabilities (or a combination of both) from delivering or producing
goods, rendering services, or other activities that constitute the entity’s ongoing major or
central operations.”
8. (L) SFAC 5 defines current market value as “the amount of cash, or its equivalent, that
could be obtained by selling an asset in orderly liquidation.”
9. (E) Predictive value is the quality of information that helps users to increase the
likelihood of correctly forecasting the outcome of past or present events (SFAC 8).
10. (I) SFAC 5 states that “Earnings is a measure of performance during a period that is
concerned primarily with the extent to which asset inflows associated with cashtocash
cycles substantially completed (or completed) during the period exceed (or are less than)
asset outflows associated, directly or indirectly, with the same cycles.”
Trial Balance
Worksheet Authoritative
Literature Help
Jane Alexander Theater
December 31, 200X
a) Trial balance # Adjustments Adjusted trial balance Income statement
Debit Credit Debit Credit Debit Credit Debit Credit
Equipment 192,000 192,000
Accumulated depreciation—
equipment 60,000 1 9,500 69,500
Notes payable 90,000 90,000
Admissions revenue 380,000 3 50,000 330,000 330,000
Advertising expense 13,680 4 1,100 12,580 12,580
Salaries expense 57,600 5 4,700 62,300 62,300
Interest expense 1,400 2 1,800 3,200 3,200
Depreciation expense 1 9,500 9,500 9,500
Interest payable 2 1,800 1,800
Unearned admissions revenue 3 50,000 50,000
Prepaid advertising 4 1,100 1,100
Salaries payable 5 4,700 4,700
266 MODULE 9 BASIC TH. & FIN. REP. : A. BASIC CONCEPTS

Concepts
Authoritative
Literature Help
Account (A) (B) (C) (D) (E)
1. Longterm receivables
2. Availableforsale securities
3. Equipment
4. Warranty obligations
5. Shortterm payables
6.Accounts receivable
7. Bonds payable, due in ten years
8.Trading securities
Adjusting
Entries Authoritative
Literature Help
Accrual Deferral
1. Depreciation expense xx
Accumulated deprecation xx
2. Interest receivable xx
Interest revenue xx
3. Rent expense xx
Prepaid rent xx
4. Unearned revenue xx
Rent revenue xx
5. Wage expense xx
Wages payable xx
Revenue and Expense
Recognition Authoritative
Literature Help
Amounts to be recognized
2010 2011 2012
1. Emco sells $5,000 of goods to a customer, FOB shipping point on 12/30/10. 5,000
2. Emco sells three pieces of equipment on a contract over a threeyear period.
The sales price of each piece of equipment is $10,000. Delivery of each
piece of equipment is on February 10 of each year. In 2010, the customer 10,000 10,000 10,000
paid a $20,000 down payment, and paid $5,000 per year in 2011 and 2012.
Collectibility is reasonably assured.
3. In 1/1/10, Emco pays $9,000 for a membership to
Wholesalers Association for a twoyear membership in
the trade association.
4. On 6/1/10, Emco signs a contract for $20,000 for
goods to be sold on account. Payment is to be made
in two installments of $10,000 each on 12/1/11 and
12/1/12. The goods are delivered on 10/1/10.
Collection is reasonably assured, and the goods may
not be returned.
5. Emco sells goods to a customer on July 1, 2010, for $50,000.
If the customer does not sell the goods to retail customers by
December 31, 2011, the goods can be returned to Emco. The
customer sells the goods to retail customers on October 1,
2011.
(4,500) (4,500)
20,000
50,000
1. When goods are sold FOB shipping point, title passes at the time the goods are shipped.
Therefore, Emco may recognize revenue on 12/30/10 at the time the goods are shipped.
2. Revenue is recognized when earned and realizable. This sale is not complete until each
piece of equipment is delivered. Therefore, Emco should recognize $10,000 each year
as the equipment is delivered, regardless of payment terms.
3. Emco should match expenses to the year in which the benefits are received, which is over the
twoyear period.
4. Because Emco delivered the goods in 2010, and collectibility is reasonably assured,
Emco should recognize all revenue in 2010.
5. Because there is a sale with a right of return, and the buyer may return the merchandise if
it is not sold to a retail customer, recognition should be delayed until the right of return
has expired.
268 MODULE 9 BASIC TH. & FIN. REP.: B. ERROR CORRECTION
ERROR CORRECTION
30% income tax rate. What amount
should Conn report as adjusted
1. Loeb Corp. frequently borrows from the beginning retained earnings in its
bank in orderto maintain sufficient operating 2011 statement of retained
cash. The following loans were at a 12% earnings?
interest rate, with interest payable maturity. a. $420,000
Loeb repaid each loan on its scheduled b. $428,000
maturity date. c. $440,000
Date of loan Amount Maturity date Term of loan
d. $442,000
11/1/10 $ 5,000 10/31/11 1 year
2/1/11 15,000 7/31/11 6 months
5. Lore Co. changed from the cash
5/1/11 8,000 1/31/12 9 months basis of accounting to the accrual
basis of accounting during 2011.
Loeb records interest expense when the loans The cumulative effect of this
are repaid. As a result, interest expense of change should be reported in Lore’s
$1,500 was recorded in 2011. If no correction 2011 financial statements as a
is made, by what amount would 2011 interest
expense be understated?
a. $540
b. $620
c. $640
d. $720
2. During 2011, Paul Company
discovered that the ending
inventories reported on its financial
statements were incorrect by the
following amounts:
2009 $60,000 understated
2010 75,000 overstated
Paul uses the periodic inventory system to
ascertain yearend quantities that are converted
to dollar amounts using the FIFO cost method.
Prior to any adjustments for these errors and
ignoring income taxes, Paul’s retained earnings
at January 1, 2011, would be
a. Correct.
b. $ 15,000 overstated.
c. $ 75,000 overstated.
d. $135,000 overstated.
3. Tack, Inc. reported a retained earnings
balance of
$150,000 at December 31, 2010. In June
2011, Tack discovered that merchandise
costing $40,000 had not been included in
inventory in its 2010 financial statements.
Tack has a 30% tax rate. What amount
should Tack report as adjusted beginning
retained earnings in its statement of retained
earnings at December 31, 2011?
a. $190,000
b. $178,000
c. $150,000
d. $122,000
4. Conn Co. reported a retained
earnings balance of $400,000 at
December 31, 2010. In August
2011, Conn determined that
insurance premiums of $60,000 for
the threeyear period beginning
January 1, 2010, had been paid and
fully expensed in 2010. Conn has a
a. Prior period adjustment excluded from the depreciation
resulting from the correc computation when using the
tion of an error.
Straightline method Production or use method
b. Prior period adjustment
a. Yes No
resulting from the change b. Yes Yes
in accounting principle. c. No No
c. Component of income before d. No Yes
extraordinary item.
d. Component of income after 9. At the end of 2010, Ritzcar Co. failed to
extraordinary item. accrue salescommissions earned during 2010
but paid in 2011. The error was not repeated
6. Bren Co.’s beginning inventory at in 2011. What was the effect of this error on
January 1, 2011, was understated by 2010 ending working capital and on the 2011
$26,000, and its ending inventory ending retained earnings balance?
was overstated by $52,000. As a
result, Bren’s cost of goods sold for 2010 ending 2011 ending
2011 was working capital retained earnings
a. Understated by $26,000. a. Overstated Overstated
b. Overstated by $26,000. b. No effect Overstated
c. No effect No effect
c. Understated by $78,000.
d. Overstated No effect
d. Overstated by $78,000.
10. On December 31, 2011, special insurance
7. On January 2, 2011, Air, Inc. agreed to pay its costs wereincurred and unpaid, but were not
former president $300,000 under a deferred recorded. If these insurance costs were
compensation arrangement. Air should have related to a particular job order in work in
recorded this expense in 2010 but did not do
process that was not completed during the
so. Air’s reported income tax expense would
period, what is the effect of the omission on
have been $70,000 lower in 2010 had it
accrued liabilities and retained earnings in the
properly accrued this deferred compensation.
December 31, 2011 balance sheet?
In its December 31, 2011 financial statements,
Air should adjust the beginning balance of its Accrued liabilities Retained earnings
retained earnings by a a. No effect No effect
a. $230,000 credit. b. No effect Overstated
b. $230,000 debit. c. Understated No effect
c. $300,000 credit. d. Understated Overstated
d. $370,000 debit. 11. Which of the following errors could
8. Net income is understated if, in the result in an overstatement of both current
first year, estimated salvage value is assets and stockholders’ equity?
MODULE 9 BASIC TH. & FIN. REP.: B. ERROR CORRECTION 269
balance in 2012 by
$10,000.
a. An understatement of accrued sales b. Restate the
expenses. financial statements
b. Noncurrent note receivable with corrected bal
principal is misclassified as a ances for all
current asset. periods presented.
c. Annual depreciation on c. Adjust the
manufacturing machinery is ending balance
understated. in the 2012
d. Holiday pay expense for retained
administrative employees is earnings
misclassified as manufacturing account.
overhead. d. Make no entry because the
error will selfcorrect.
12. Galaxy Corporation had the following
financial statement information: 15. Jackson Company uses
2011 2010 IFRS to report its financial
Revenue $135,000 $100,000 results. During the current
Expenses 98,000 65,000 year, the company
Net income 37,000 35,000 discovered it had overstated
12/31/11 12/31/10 sales in the prior year. How
Total assets $157,000 $105,000 should the company handle
Total liabilities 50,000 35,000 this issue?
Total owners’ equity 107,000 70,000
a. Adjust sales for the current
Galaxy failed to record $12,000 of accrued wages period.
at the end of 2010. The wages were recorded and b. Spread the
paid in January 2011. Assuming that the correct adjustment over
accruals were made on December 31, 2011, what the current and
are the corrected balances in the 2010 and 2011 future periods.
restated financial statements? c. Present the
Dec. 31, 2011 cumulative effect
2010 Dec. 31, 2010 total owners’ of the
net income total liabilities equity overstatement as
a. $23,000 $23,000 $ 95,000 an item in the
b. $47,000 $47,000 $107,000 current period
c. $23,000 $35,000 $ 95,000 income statement.
d. $23,000 $47,000 $107,000
13. Justin Corporation discovered an error
in their 2011 financial statements after
the statements were issued. This
requires that
a. The cumulative effect of the
error is reported on the 2012
income statement as a
cumulative effect of change in
accounting principle.
b. The cumulative effect of the error is
reported in the 2012 beginning balance of
each related account.
c. The financial statements are
restated to reflect the correction
of periodspecific effects of the
error.
d. An adjustment to beginning
retained earnings in 2012 with
a footnote disclosure
describing the error.
14. During 2012, Kelly Corporation
discovered that ending inventory
reported in its 2011 financial statements
was understated by $10,000. How
should Kelly account for this
understatement?
a. Adjust the beginning inventory
presented for comparative purposes.
d. Restate the prior year financial statements
SIMULATIONS
Corrected Financial
Statements
Authoritative
Literature Help
Situation
Cord Corp., a nonpublic enterprise, requires audited financial statements for credit purposes. After making normal adjust
ing entries, but before closing the accounting records for the year ended December 31, 2011, Cord’s controller prepared the
following financial statements for 2011:
Cord Corp.
STATEMENT OF FINANCIAL POSITION
December 31, 2011
Assets
Cash $1,225,000
Marketable equity securities 125,000
Allowance for doubtful accounts (55,000)
Inventories 530,000
Property and equipment 620,000
Accumulated depreciation (280,000)
Total assets $2,625,000
Liabilities and Stockholders’ Equity
Accounts payable and accrued liabilities $ 1,685,000
Income tax payable 110,000
Common stock, $20 par 300,000
Additional paidin capital 75,000
Retained earnings 455,000
Total liabilities and stockholders’ equity $ 2,625,000
Cord Corp.
STATEMENT OF INCOME
For the Year Ended December 31, 2011
Net sales $1,700,000
Operating expenses:
Cost of sales 570,000
Selling and administrative 448,000
Depreciation 42,000
Total operating expenses 1,060,000
Income before income tax 640,000
Income tax expense 192,000
Net income $ 448,000
Cord’s tax rate for all income items was 30% for all affected years, and it made estimated tax payments when due. Cord
has been profitable in the past and expects results in the future to be similar to 2011. During the course of the audit, the
following additional information (not considered when the above statements were prepared) was obtained:
1. The investment portfolio consists of shortterm investments, classified as availableforsale, for which total market
value equaled cost at December 31, 2010. On February 2, 2011, Cord sold one investment with a carrying value of
$100,000 for $130,000. The total of the sale proceeds was credited to the investment account.
2. At December 31, 2011, the market value of the remaining securities in the portfolio was $142,000.
3. The $530,000 inventory total, which was based on a physical count at December 31, 2011, was priced at cost. Subse
quently, it was determined that the inventory cost was overstated by $66,000. At December 31, 2011, the inventory’s
market value approximated the adjusted cost.
4. Pollution control devices costing $48,000, which is high in relation to the cost of the original equipment, were
installed on December 29, 2010, and were charged to repairs in 2010.
5. The original equipment referred to in Item 4, which had a remaining useful life of six years on December 29, 2010,
is being depreciated by the straightline method for both financial and tax reporting.
6. A lawsuit was filed against Cord in October 2011 claiming damages of $250,000. Cord’s legal counsel believes that
an unfavorable outcome is probable, and a reasonable estimate of the court’s award to the plaintiff is $60,000,
which will be paid in 2012 if the case is settled.
7. Cord determined that its accumulated benefits obligation under the pension plan exceeded the fair value of plan
assets by $40,000 at December 31, 2011. Cord has unrecognized prior service cost of $50,000 at December 31, 2011.
Cord funds the total pension expense each year.
Complete the following amounts in the corrected financial statements for Cord Corp.
Cord Corp.
December 31, 2011
Assets
Cash
Marketable equity securities
Accounts receivable
Allowance for doubtful accounts
Inventories
Deferred tax asset
Property and equipment
Total assets
Accounts payable and accrued liabilities
Income tax payable
Estimated liability from lawsuit
Pension liability
Common stock, $20 par
Additional paidin capital
Retained earnings
Other comprehensive income
Total liabilities and stockholders’ equity
Net sales
Operating expenses:
Cost of sales
Selling and administrative
Depreciation
Pension cost
Total operating expenses
Other income/loss:
Gain (loss) on marketable securities
Estimated loss from lawsuit
Income before income tax
Income tax expense
Net income
Effect of
Error
Authoritative
Literature Help
Situation
Klaus Corporation had $580,000 in inventory, which was based on a physical count at December 31, 2011. The inventory
was priced at cost. In February 2012, it was determined that the inventory cost was overstated by $50,000.
Indicate the effects of the inventory overstatement in the 2011 and 2012 financial statements by completing the
following table. Mark each item overstate, understate, or OK.
2011 Effects 2012 Effects
(Overstate) (Understate) (OK) (Overstate) (Understate) (OK)
Inventory on balance sheet
Cost of goods sold
Net income
Retained earnings
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Young Corporation. Young has determined that it issued financial statements
in the prior year with a material error in the application of an accounting principle. Which section of the Professional Standards
addresses the issue of how to account for this situation?
Enter your response in the answer fields below.
Concepts
Authoritative
Literature Help
Situation
T
h
1. A
c
2. A
3. A

4. A
5. A

T
Analysis of Authoritative
Error Literature Help
Situation
The auditors of Cardiff Company have found the following errors in the company’s accounting
records.
Indicate how the error will affect the current year’s financial statements by choosing an “O” in
the column for overstate and “U” in the column for understate.
1. Cardiff fails to
record a sale on
account for
$8,000.
2. The inventory was
miscounted at yearend
and overstated by
$5,000.
3. Cardiff fails to record
depreciation expense
of $3,500 for the
year.
4. The company
receives a utility bill
for $400 on
December 29, but
fails to record the bill.
5. Availableforsale
securities were not marked
to market. Later analysis
reveals that the securities
increased in value by
$4,000 as of the end of the
current year. Cardiff does
not elect the fair value
option for any of its
availableforsale se
curities.
Retained Other
Assets Liabilities earnings Net income comprehensive income
(O) (U) (O) (U) (O) (U) (O) (U) (O) (U)
6. Cardiff fails to
accrue wages of
$17,000 at the end
of the year.
7.Trading securities were not
marked to market. Later
analysis reveals that the
securities declined in value
by $8,000 as of the end of
the current year.
Retained Other
(O) (U) (O) (U) (O) (U) (O) (U) (O) (U)
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Hughes Corporation. Hughes is attempting to
determine whether an error in the prior year’s financial statement is material. Which section of the
Professional Standards provides guidance on this matter?
1. a __ __ 5. a __ __ 8. b __ __ 11. d __ __ 14. b __ __
2. c __ __ 6. c __ __ 9. d __ __ 12. d __ __ 15. d __ __
3. b __ __ 7. b __ __ 10. c __ __ 13. c __ __ 1st: __/15 = __%
4. b __ __ 2nd: __/15 = __%
[$40,000 – ($30% × $40,000)]. This
B. Error Correction
should increase beginning retained
1. (a) The correct amount of 2011 interest expense is earnings because the
$2,040, as computed below. understatement of 12/31/10
11/1/10 note
inventory would have resulted in an
Interest from 1/1/11 to 10/31/11 overstatement of cost of goods sold
($5,000 × 12% × 10/12) and therefore an understatement of
2/1/11 note retained earnings. Thus, the
Interest from 2/1/11 to 7/31/11 adjustment 1/1/11 retained earnings
($15,000 × 12% × 6/12)
is $178,000 ($150,000 + $28,000).
5/1/11 note
Interest from 5/1/11 to 12/31/11 Tack’s journal entry to record the
($8,000 × 12% × 8/12) adjustment is
Total 2011 interest Inventory 40,000
Since interest expense of $1,500 was Retained earnings 28,000
Taxes payable 12,000
recorded, 2011 interest expense was
understated by $540 ($2,040 – $1,500). 4. (b) A correction of an error is
2. (c) The error in understating the treated as a prior period
adjustment and is reported in the
2009 ending inventory would have
financial statements as an
selfcorrected by 1/1/11 (2009
adjustment to the beginning
income understated by $60,000;
balance of retained earnings in
2010 income overstated by
the year the error is discovered.
$60,000). The error in overstating
The adjustment is reported net of
the 2010 ending inventory would
the related tax effect. In 2010,
not have been corrected by 1/1/11.
insurance expense of $60,000 was
This error overstates both 2010
recorded. The correct 2010
income and the 1/1/11 retained
insurance expense was $20,000
earnings balance by $75,000.
($60,000 × 1/3). Therefore,
3. (b) A correction of an error is before taxes, 1/1/11 retained
treated as a prior period adjustment, earnings is understated by
recorded in the year the error is $40,000. The net of tax effect is
discovered, and is reported in the $28,000 [$40,000 – (30% ×
financial statements as an ad $40,000)], so the adjusted
justment to the beginning balance beginning retained earnings is
of retained earnings. The $428,000 ($400,000 + $28,000).
adjustment is reported net of the 5. (a) A change in accounting principle is a
related tax effect. In this case the
change from one generally accepted
netoftax effect is $28,000
principle to another generally accepted of existing facts, or a change from an
principle. A correction of an error is unacceptable principle to a generally
thecorrection of a mathematical mistake, a accepted one. Therefore, a switchfrom the
mistake in the application of an accounting cash basis (unacceptable) to the accrual basis
principle, an oversight or misuse (acceptable) is a correction of an error
reported as a prior period adjustment.
effect ofinventory errors on cost of goods
sold. The effect of the errors on Bren’s
2011 cost of goods sold (CGS) is illus
trated below.
BI
+ P – $26,000 CGS understated $26,000
GAFS
– EI (+ $52,000) CGS understated 52,000
CGS CGS understated $78,000
Beginning inventory is the starting point for
the CGS computation, so BI errors have a
direct effect on CGS. The understatement of
BI ($26,000) causes an understatement of
goods available for sale (GAFS) and thus of
CGS. Ending inventory is subtracted in the
CGS computation, so EI errors have an
inverse effect on CGS. The overstatement of
EI ($52,000) means that too much was
subtracted in the CGS computation, causing
another understatement of CGS. Therefore,
CGS is understated by a total of $78,000.
7. (b) The failure to record the $300,000 of
deferred compensation expense in 2010 is
considered an error. The profession requires that
the correction of an error be treated as a prior
period adjustment. Thus, the requirement is to
determine the retroactive adjustment that should
be made to the beginning balance of the retained
earnings for 2011 (including any income tax
effect). The net adjustment to beginning retained
earnings would be a debit for $230,000
($300,000 less the income tax benefit of
$70,000).
8. (b) The depreciable base used to
compute depreciation expense
under both the straightline and
production methods is equal to the
cost less estimated salvage value of
the asset. Depreciation expense is
overstated and net income is,
therefore, understated when the
estimated salvage value is excluded
from the depreciation computation
under both of these methods.
9. (d) The entry Ritzcar should have
made to accrue sales commissions
earned but unpaid at the end of its
2010 fiscal year is
Commission expense xxx
Commissions payable
xxx
Since Commissions payable is a current
liability, the 2010 ending working capital is
overstated due to Ritzcar’s failure to record
this entry. Since this error was not repeated at
the end of Ritzcar’s 2011 fiscal year, the
income impact of the 2010 error “self
corrected” during 2011, when Ritzcar recorded
both the earned but unpaid 2010 commissions the 2011
plus the 2011 earned commissions. Therefore,
MODULE 9 BASIC TH. & FIN. REP. : B. ERROR CORRECTION 275
statements must be restated with period
specific effects. The restated financial
ending retained earnings would not be statements are
impacted by the error.
Galaxy Corporation
10. (c) A liability is accrued when an RESTATED FINANCIAL
obligation to pay or perform STATEMENTS
services has been incurred. This is 2011 2010
the case even if the liability will not Revenue $135,000 $100,000
be satisfied until a future date. Expenses 86,000 77,000
Net income 49,000 23,000
Therefore, accrued liabilities will be
understated on the December 31, 12/31/11 12/31/10
Total assets $157,000 $105,000
2011 balance sheet because the Total liabilities 50,000 47,000
special insurance costs were not Total owners’ equity 107,000 58,000
recorded. However, there will be no
effect on the December 31, 2011 13. (c) The financial statements of all
balance of retained earnings because periods shouldbe restated and corrections
these costs relate to work in process, made to reflect any periodspecific effects
and work in process does not affect of the error. Answer (a) is incorrect because
net income currently. Please note this is an error, not a change in accounting
that if the special insurance costs principle. Answer (b) is incorrect because
related to goods that were sold, cost although the
of goods sold would have been
understated that would have caused
both net income and retained
earnings to be overstated.
11. (d) The classification of holiday pay
expense for administrative
employees as manufacturing
overhead would result in the
capitalization of some or all of these
costs as a component of ending
inventory, while these costs should
be expensed as incurred. This error
could overstate ending inventory, a
current asset. The overstatement of
ending inventory also understates
the cost of goods sold (Beginning
inventories + Net purchases –
Ending inventories = Cost of goods
sold), and overstates net income
and stockholders’ equity. The
understatement of accrued sales
expenses would not affect current
assets. The misclassification of the
noncurrent note receivable princi
pal as a current asset would have no
impact on stockholders’ equity. The
understatement of depreciation on
manufacturing machinery would
understate the overhead addedto
inventories, a current asset.
12. (d) The entry for the 12/31/10 wage
accrual should have been
Wages expense 12,000
Wages payable 12,000
Failure to accrue wage expense results in an
understatement of wage expense and an
understatement of wages payable by $12,000
in 2010. As a result, net income and retained
earnings are overstated by $12,000 in 2010.
The wages were expensed and paid in 2011.
Therefore, wage expense for 2011 is
overstated, and 2011 net income is
understated by $12,000. This is a
counterbalancing error, and ending retained
earnings in 2011 would be correct. Although
this is a selfcorrecting error, the financial
retained earnings is not sufficient disclosure
asset accounts may be adjusted to reflect for error correction. Answer (d) is incorrect
correction of an error, income statement because even though it is a selfcorrecting
effects must also be disclosed. Answer (d) error, financial statements must be restated
is incorrect because the financial statements with periodspecific effects of the error.
must be restated for all periods presented.
15. (d) The requirement is to identify how
14. (b) The financial statements must be restated anoverstatement of sales in prior year
for all periods presented with periodspecific financial statement should be treated
effects disclosed. Answer (a) is incorrect under IFRS. Answer (d) is correct be
because although beginning inventory may be cause the overstatement is an error
adjusted, prior years’ financial statements which must be accounted for by
must also be restated. Answer (c) is incorrect restating the prior year financial
because correcting the balance of ending statements.
Corrected Financial
Statements
Authoritative
Literature Help
The best way to calculate the new financial statement amounts is to make the required adjusting entries to correct
the account balances as shown below.
Cord Corp.
ADJUSTING JOURNAL ENTRIES
December 31, 2011
(Explanations not required)
Dr. Cr.
(1)
Marketable equity securities $ 30,000
Realized gain on sale of marketable equity securities $ 30,000 [a]
(2)
Unrealized loss on marketable equity securities (other comprehensive income) 13,000
Adjustment to reduce marketable equity securities to market value 13,000 [b]
(3)
Cost of sales 66,000
Inventories 66,000
(4)
Income tax payable 14,400 [c]
Retained earnings 33,600 [c]
(5)
Depreciation 8,000
Accumulated depreciation 8,000 [d]
(6)
Estimated loss from lawsuit 60,000
Estimated liability from lawsuit 60,000
(7)
Deferred pension cost 40,000
Additional pension liability 40,000
(8)
Deferred tax asset 21,900 [i]
Income tax payable 13,200 [ii]
Income tax expense 35,100 [iii]
Supporting Computations for Number 8
Corrected total income tax expense for 2011
Income before income tax, as reported $640,000
Add adjustment increasing income
Realized gain on sale of securities 30,000 [1]
670,000
Deduct adjustments decreasing income
Increase cost of sales for inventory overstatement $66,000
Depreciation on pollution control devices 8,000 74,000
Adjusted taxable income before income tax $596,000
Corrected current portion income tax expense and income taxes payable ($596,000 × 30%) $178,800
Deferred income tax benefits—based on following temporary differences:
Lawsuit expected to be settled in 2012 $60,000 [6]
Unrealized loss on shortterm marketable equity securities 13,000 [2]
Total future deductible amounts $73,000
[i] Deferred tax benefit of future deductible amounts ($73,000 × 30%) 21,900
Corrected total income tax expense $156,900
[ii] Income tax expense as reported (all current, no deferred) $192,000
Corrected income tax payable and income tax expense 178,800
$ 13,200
[iii] Income tax expense, as reported $192,000
Corrected total income tax expense 156,900
$ 35,100
Explanations of Amounts
[a] Gain on sale of marketable equity securities
Selling price $130,000
Cost 100,000
Gain $ 30,000
[b] Adjustment to reduce marketable equity securities to market value
Marketable equity securities, at cost
Balance, 2/2/11 as reported $125,000
Adjustment for recording error 30,000
Adjusted balance, 12/31/11 155,000
Market valuation, 12/31/11 142,000
Adjustment required, 12/31/11 $ 13,000
[c] Prior year adjustment for pollution control devices
Cost of installation, 12/29/10 $ 48,000
Deduct income tax effect ($48,000 × 30%) 14,400
Credit adjustment to retained earnings, 1/1/11 $ 33,600
[d] Depreciation for 2011 on pollution control devices
Cost of the installation on 12/29/10 $ 48,000
Depreciation for 2011 ($48,000 ÷ 6 years) $ 8,000
Cord Corp.
December 31, 2011
Assets
Cash $1,225,000
Marketable equity securities 142,000
Allowance for doubtful accounts (55,000)
Inventories 464,000
Deferred tax asset 21,900
Deferred pension cost 40,000
Accumulated depreciation (288,000)
Total assets $2,677,900
Accounts payable and accrued liabilities $1,685,000
Income tax payable 111,200
Estimated liability from lawsuit 60,000
Pension liability 40,000
Common stock, $20 par 300,000
Retained earnings 419,700
Other comprehensive income (13,000)
Total liabilities and stockholders’ equity $2,677,900
Calculation of corrected retained earnings:
Previous retained earnings (incorrect) 455,000
Less: Net income for 2011 (incorrect) (448,000)
Beginning of year retained earnings (correct) 7,000
Net income (corrected) 379,100
Prior period adjustment for accounting error in expense
pollution control devices in 2010 33,600
Corrected retained earnings 419,700
Cord Corp.
STATEMENT OF INCOME
Net sales $1,700,000
Operating expenses:
Cost of sales (636,000)
Selling and administrative (448,000)
Depreciation (50,000)
Total operating expenses (1,134,000)
Other income/loss:
Gain (loss) on marketable securities 30,000
Estimated loss from lawsuit (60,000)
Income before income tax 536,000
Income tax expense (156,900)
Net income 379,100
Effect of
Error Authoritative
Literature Help
2011 Effects 2012 Effects
(Overstate) (Understate) (OK) (Overstate) (Understate) (OK)
Inventory on balance sheet
Cost of goods sold
Net income
Retained earnings
Research
Authoritative
Literature Help
ASC 250 10 45 23
Concepts
Authoritative
Literature Help
(T) (F)
1. Accounting errors are reported as adjustments to the end of the year retained earnings in the current year’s financial
statements.
2. A selfcorrecting error need not be reported as an error if it has corrected itself in the current year.
3. A change in depreciation method is treated as an error when adjusting the financial statements for the current year.
4. An accounting error is treated as a prior period adjustment.
5. A change in the useful lives of assets in calculating depreciation is treated as an accounting error and
accumulated depreciation is adjusted to reflect this error.
1. False. Accounting errors require an adjustment to the beginning of the year retained earnings in the current year
2. False. A selfcorrecting error would require an adjustment to correct comparative year financial statements. Adjustments to
comparative years should be made to reflect retroactive application of the prior period adjustment to the accounts affected.
3. False. A change in depreciation method is treated as accumulative effect of change in accounting principle.
4. True. Correction of errors involve restatements of prior periods.
5. False. A change in the useful lives of an asset is treated on a prospective basis, and depreciation for the current
year is calculated based on book value divided by the estimated number of years remaining.
Analysis
of Error Authoritative
Literature Help
Retained Other
(O) (U) (O) (U) (O) (U) (O) (U) (O) (U)
1. Cardiff fails to record a sale on
account for $8,000.
2. The inventory was miscounted
at yearend and overstated by
$5,000.
3. Cardiff fails to record
depreciation expense of
$3,500 for the year.
4. The company receives a utility
bill for $400 on December 29,
but fails to record the bill.
5. Availableforsale securities were
not marked to market. Later analy
sis reveals that the securities in
creased in value by $4,000 as of the
end of the current year. Cardiff does
not elect the fair value option for
any of its availableforsale
securities.
Retained Other
(O) (U) (O) (U) (O) (U) (O) (U) (O) (U)
6. Cardiff fails to accrue wages of
$17,000 at the end of the year.
7. Trading securities were not marked to
market. Later analysis reveals that the
securities declined in value by $8,000
as of the end of the current year.
1. Cardiff should have debited Accounts Receivable and credited Sales. Therefore, accounts receivable is understated,
and retained earnings is understated.
2. Cardiff has overstated ending inventory, which understates cost of goods sold. Understating cost of goods sold
results in income being overstated for the period. Net income flows into retained earnings, and thus, retained
earnings is also overstated in the current period.
3. Cardiff should have debited Depreciation Expense and credited Accumulated Depreciation. By not making this entry,
depreciation expense is too low, overstating net income, and overstating retained earnings. Accumulated
depreciation is also too low, which overstates assets.
4. The entry would be to debit Utility Expense and credit Accounts Payable. Failing to make this entry would understate
expenses, which results in overstated net income, overstated retained earnings, and understated liabilities.
5. The unrealized gain on availableforsale securities is not recognized in net income, but is recognized as an
unrealized gain in other comprehensive income. Failing to mark to market when an availableforsale security has
increased in value would result in understating assets and understating other comprehensive income for the
period.
6. The journal entry to accrue wages is to debit Wage Expense and credit Wages Payable. Failure to accrue wages
results in expenses being understated, which in turn, overstates net income and overstates retained earnings for the
period. Failure to accrue wages also results in liabilities being understated.
7. The unrealized gains and losses from trading securities should be included in net income for the period. Failure to mark to
market and recognize the loss would result in assets being overstated, net income being overstated, and retained earnings being
overstated for the period.
Research
Authoritative
Literature Help
ASC 250 10 45 27
280 MODULE 9 BASIC TH. & FIN. REP.: C. ACCOUNTING CHANGES
ACCOUNTING CHANGES
a. Cash basis of accounting
for vacation pay to the
1. On January 1, 2009, Bray Company accrual basis.
purchased for$240,000 a machine with a useful b. Straightline method of
life of ten years and no salvage value. The depreciation for previously
machine was depreciated by the double recorded assets to the
declining balance method and the carrying doubledeclining balance
amount of the machine was $153,600 on method.
December 31, 2010. Bray changed to the c. Presentation of statements of
straightline method on January 1, 2011. Bray individual companies to their
can justify the change. What should be the inclusion in consolidated
depreciation expense on this machine for the statements.
year ended December 31, 2011? d. Completedcontract
a. $15,360 method of accounting
b. $19,200 for longterm
constructiontype
c. $24,000
contracts to the
d. $30,720
percentageof
Items 2 and 3 are based on the following: completion method.
On January 1, 2009, Warren Co. purchased a 6. When a company changes from the straightline

$600,000 machine, with a fiveyear useful life method of depreciation for previously recorded
and no salvage value. The machine was assets to the doubledeclining balance method,
depreciated by an accelerated method for book which of the following should be
and tax purposes. The machine’s carrying used?
amount was $240,000 on December 31, 2010. Cumulative effects of change Retrospective
On January 1, 2011, Warren changed to the in accounting principle application
straightline method for financial reporting a. No No
purposes. Warren can justify the change. b. No Yes
Warren’s income tax rate is 30%. c. Yes Yes
d. Yes No
2. In its 2011 income statement, what
amount shouldWarren report as the Items 7 and 8 are based on the following:
cumulative effect of this change? During 2011, Orca Corp. decided to change
a. $120,000 from the FIFO method of inventory valuation
b. $ 84,000 to the weightedaverage method. Inventory
c. $ 36,000 balances under each method were as follows:
d. $0 FIFO Weightedaverage
January 1, 2011 $71,000 $77,000
December 31, 2011 79,000 83,000
Orca’s income tax rate is 30%.
2009 and 3,500 during 2010.
3. On January 1, 2011, what amount
Holly’s income tax rate is 30%. Holly
should Warren report as deferred should report the accounting change in its 2011
income tax liability as a result of the financial statements as a(n)
change? a. Cumulative effect of a
a. $120,000 change in accounting
b. $ 72,000 principle of $2,000 in
c. $ 36,000 its income statement.
d. $0 b. Entry for current year
depreciation expense on the
4. On January 2, 2011, to better reflect
income statement and
the variable use of its only machine,
treated on a prospective ba
Holly, Inc. elected to change its
sis.
method of depreciation from the
c. Cumulative effect of a
straightline method to the units of
change in accounting
production method. The original cost
of the machine on January 2, 2009, principle of $1,400 in
was $50,000, and its estimated life its income statement.
was ten years. Holly estimates that the d. Adjustment to
machine’s total life is 50,000 machine beginning retained
hours. earnings of $1,400.
Machine hours usage was 8,500 during 5. The effects of a change in accounting
principle should be recorded on a 7. In its 2011 financial statements,
prospective basis when the change is what amount should Orca report as
from the the gain or loss on the cumulative
effect of this accounting change?
a. $2,800
b. $4,000
c. $4,200
d. $0
8. In accordance with the Codification,
Orca should report the effect of this
accounting change as a(n)
a. Prior period adjustment.
b. Component of income from
continuing operations.
c. Retrospective application to
previous year’s financial
statements.
d. Component of income after
extraordinary items.
9. On January 1, 2011, Roem Corp.
changed its inventory method to FIFO
from LIFO for both financial and
income tax reporting purposes. The
change resulted in a $500,000 increase
in the January 1, 2011 inventory,
which is the only change that could be
calculated from the accounting
records. Assume that the income tax
rate for all years is 30%. Retro
spective application would result in
a. An increase in ending
inventory in the 2010 bal
ance sheet.
b. A decrease in ending inventory in the
2011 balance sheet.
c. A decrease in net income in 2010.
d. A gain from cumulative
effect of change on the in
come statement in 2011.
MODULE 9 BASIC TH. & FIN. REP. : C. ACCOUNTING CHANGES 281
$108,000 in 2011.
c. A cumulative effect
10. Which of the following would receive adjustment of $108,000 on
treatment as acumulative effect on an the 2011 income statement.
accounting change on the income statement? d. An increase in
LIFO to FIFO to ending retained
weightedaverage weightedaverage earnings of
a. Yes Yes $180,000 in 2010.
b. Yes No
c. No No
14. The effect of a change in
d. No Yes accounting principle that is
inseparable from the effect of a
11. On August 31, 2011, Harvey Co. change in accounting estimate
decided to change from the FIFO should be reported
periodic inventory system to the a. By restating the financial
weightedaverage periodic inventory statements of all prior
system. Harvey is on a calendar year periods presented.
basis. The cumulative effect of the b. As a correction of an error.
change is determined c. As a component of income
a. As of January 1, 2011. from continuing operations,
b. As of August 31, 2011. in the period of change and
c. During the eight months future periods if the change
ending August 31, 2011, by affects both.
a weightedaverage of the d. As a separate disclosure
purchases. after income from
d. As of the earliest period presented if continuing operations, in
practicable. the period of change and
future periods if the change
12. In 2011, Brighton Co. changed from the affects both.
individual item approach to the aggregate
approach in applying the lower of FIFO cost or
market to inventories. The change should be
reported in Brighton’s financial statements as a
a. Change in estimate on a prospective
basis.
b. Cumulative effect of
change in accounting
principle on the current
year income statement.
c. Retrospective application to the
earliest period presented if
practicable.
d. Prior period adjustment with a
separate disclosure.
13. On January 1, 2011, Poe Construction, Inc.
changed to the percentageofcompletion
method of income recognition for financial
statement reporting but not for income tax re
porting. Poe can justify this change in
accounting principle. As of December 31, 2010,
Poe compiled data showing that income under
the completedcontract method aggregated
$700,000. If the percentageofcompletion
method had been used, the accumulated income
through December 31, 2010, would have been
$880,000. Assuming an income tax rate of 40%
for all years, the cumulative effect of this
accounting change should be reported by Poe as
a. An increase in
constructionin
progress for
$180,000 in the 2010
balance sheet.
b. A decrease in the
beginning balance of
retained earnings for
period presented.
15. Which of the following is considered b. Net income of the current year.
a direct effect of a change in c. Retained earnings of the current year.
accounting principle? d. The carrying value of the
a. Deferred taxes. assets and liabilities at the
b. Profit sharing. beginning of the earliest
c. Royalty payments. period to which it can be
d. None of the above. applied.
16. Indirect effects from a change in 19. On January 1, 2007, Taft Co. purchased a

accounting principle should be patent for
reported $714,000. The patent is being amortized over
a. Retrospectively to the earliest period its remaining legal life of fifteen years expiring
presented. on January 1, 2019. During 2010, Taft
b. As a cumulative change in determined that the economic benefits of the
accounting principle in the patent would not last longer than ten years
current period. from the date of acquisition. What amount
c. In the period in which the should be reported in the balance sheet for the
accounting change oc patent, net of accumulated amortization, at De
curs. cember 31, 2010?
d. As a prior period adjustment. a. $428,400
b. $489,600
17. If it is impracticable to determine the c. $504,000
cumulative effect of an accounting d. $523,600
change to any of the prior periods,
the accounting change should be 20. On January 1, 2007, Flax Co. purchased a
accounted for machine for $528,000 and depreciated it by the
a. As a prior period adjustment. straightline method using an estimated useful
b. On a prospective basis. life of eight years with no salvage value. On
c. As a cumulative effect January 1, 2010, Flax determined that the ma
change on the income state chine had a useful life of six years from the date
ment. of acquisition and will have a salvage value of
d. As an adjustment to $48,000. An accounting change was made in
retained earnings in the 2010 to reflect these additional data. The
first period presented. accumulated depreciation for this machine
should have a balance at December 31, 2010, of
18. If the cumulative effect of applying a. $292,000
an accounting change can be b. $308,000
determined but the periodspecific c. $320,000
effects on all periods cannot be d. $352,000
determined, the cumulative effect of
the change should be applied to 21. How should the effect of a change
a. The end balance of retained in accounting estimate be
earnings of the earliest accounted for?
requiring 2009 financial
statements to be restated.
a. By restating amounts
reported in financial state 25. A company has included in its consolidated
ments of prior periods. financial statements this year a subsidiary
b. By reporting pro forma amounts for acquired several years ago that was
prior periods. appropriately excluded from consolidation last
c. As a prior period adjustment year. This should be reported as
to beginning retained a. An accounting change that
earnings. should be reported pro
d. In the period of change spectively.
and future periods if the b. An accounting change
change affects both. that should be reported
retrospectively.
22. During 2010, Krey Co. increased the c. A correction of an error.
estimated quantity of copper d. Neither an accounting
recoverable from its mine. Krey uses change nor a correction of
the units of production depletion an error.
method. As a result of the change,
which of the following should be 26. Which of the following statements is
reported in Krey’s 2010 financial correct regarding accounting
statements? changes that result in financial
statements that are, in effect, the
Cumulative effect of Pro forma effects of
a change in retroactive application statements of a different reporting
accounting principle of new depletion base entity?
a. Yes Yes a. Cumulativeeffect
b. Yes No adjustments should be
c. No No reported as separate items
d. No Yes on the financial statements
pertaining to the year of
23. Oak Co. offers a threeyear warranty change.
on its products. Oak previously
estimated warranty costs to be 2% of
sales. Due to a technological
advance in production at the begin
ning of 2010, Oak now believes 1%
of sales to be a better estimate of
warranty costs. Warranty costs of
$80,000 and $96,000 were reported
in 2008 and 2009, respectively.
Sales for 2010 were $5,000,000.
What amount should be presented in
Oak’s 2010 financial statements as
warranty expense?
a. $ 50,000
b. $ 88,000
c. $100,000
d. $138,000
24. For 2009, Pac Co. estimated its two
year equipment warranty costs based
on $100 per unit sold in 2009. Experi
ence during 2010 indicated that the
estimate should have been based on
$110 per unit. The effect of this $10
difference from the estimate is
reported
a. In 2010 income from continuing
operations.
b. As an accounting change,
net of tax, below 2010
income from continuing
operations.
c. As an accounting change
requiring 2009 financial
statements to be restated.
d. As a correction of an error
the financial
b. No restatements or statements.
adjustments are required if b. Permitted if the entity encounters new
the changes involve transactions, events, or conditions that
consolidated methods of are substantively different from existing
accounting for subsidiaries. or previous transactions.
c. No restatements or c. Required for material transactions, if
adjustments are required if the entity had previously accounted
the changes involve the cost for similar, though immaterial,
or equity methods of ac transactions under an unacceptable
counting for investments. accounting method.
d. The financial statements d. Required if an alternate accounting
of all prior periods pre policy gives rise to a material change
sented are adjusted in assets, liabilities, or the current year
retrospectively. net income.
27. IFRS requires changes in 29. Under IFRS, a voluntary change in
accounting principles to be reported accounting method may only be
a. On a prospective basis. made by a company if
b. On a retrospective basis. a. A new standard mandates the change
c. By restating the financial statements. in method.
d. By a cumulative b. Management prefers the new method.
adjustment on the c. The new method
income statement. provides reliable and
more relevant
28. Under IFRS, changes in accounting information.
policies are d. There is no
a. Permitted if the change prohibition of the
will result in a more method in the
reliable and more standards.
relevant presentation of
SIMULATIONS
Accounting
Changes
Authoritative
Literature Help
Situation
On January 2, 2011, Quo, Inc. hired Reed to be its controller. During the year, Reed, working
closely with Quo’s president and outside accountants, made changes in accounting policies, corrected
several errors dating from 2010 and before, and instituted new accounting policies.
Quo’s 2011 financial statements will be presented in comparative form with its
2010 financial statements. Items 1 through 10 represent Quo’s transactions.
List A represents possible classifications of these transactions as: a change in accounting
principle, a change in accounting estimate, a correction of an error in previously presented financial
statements, or neither an accounting change nor an accounting error.
List B represents the general accounting treatment for these transactions. These treatments are
• Retrospective application approach—Apply the new accounting principle to all prior periods
presented showing the cumulative effect of the change in the carrying value of assets and
liabilities at the beginning of the first period presented, and adjust financial statements
presented to reflect periodspecific effects of the change.
• Retroactive restatement approach—Restate the 2010 financial statements and adjust 2010
beginning retained earnings if the error or change affects a period prior to 2010 financial
statements.
• Prospective approach—Report 2011 and future financial statements on the new basis, but do
not restate 2010 financial statements.
For each item, select one from List A and one from List B. List B (Select one
approach)
List A (Select one treatment) X. Retrospective application
A. Change in accounting principle. approach.
B. Change in accounting estimate. Y. Retroactive restatement
C. Correction of an error in previously presented financial approach.
statements. Z. Prospective approach.
D. Neither an accounting change nor an accounting error.
Items to be answered cash method to the accrual

method of recognizing
income from these service
contracts.
7. During 2011, Quo
1. Quo manufactures heavy equipment to customer determined that an
specifications on a contract basis. On the basis that it is insurance premium paid and
preferable, accounting for these longterm contracts entirely expensed in 2010
was switched from the completedcontract method to was for the period January
the percentageofcompletion method. 1, 2010, through January 1,
2. As a result of a production breakthrough, Quo 2012.
determined that manufacturing equipment 8. Quo changed its method of
previously depreciated over fifteen years should be depreciating office equipment
depreciated over twenty years. from an accelerated method to
3. The equipment that Quo manufactures is sold with a the straightline method to more
fiveyear warranty. Because of a production closely reflect costs in later
breakthrough, Quo reduced its computation of warranty years.
costs from 3% of sales to 1% of sales.
4. Quo changed from LIFO to FIFO to account for
its finished goods inventory.
5. Quo changed from FIFO to average cost to account for
its rawmaterials and work in process inventories.
6. Quo sells extended service contracts on its
products. Because related services are performed
over several years, in 2011 Quo changed from the
List A List B
Treatment Approach
(A) (B) (C) (D) (X) (Y) (Z)
List A List B
Treatment Approach
(A) (B) (C) (D) (X) (Y) (Z)
9. Quo instituted a pension plan for all employees in 2011 and
adopted the accounting standards related to pensions. Quo had
not previously had a pension plan.
10. During 2011, Quo increased its investment in Worth, Inc. from
a 10% interest, purchased in 2010, to 30%, and acquired a seat
on Worth’s board of directors. As a result of its increased in
vestment, Quo changed its method of accounting for invest
ment in subsidiary from the cost adjusted for fair value method
to the equity method. Quo did not
elect to use the fair value method to
report its 30% investment in Worth.
Calculations
Authoritative
Literature Help
Kent has $500,000 in equipment and machinery that was acquired on January 2, 2009. Kent
has been using the doubledeclining balance method to depreciate the equipment over an
estimated 10year economic life with no salvage. On January 1, 2011, Kent decides to change to
the straightline method with no salvage. Kent has a 40% tax rate.
Calculate the following amounts:
1. Accumulated depreciation as of 12/31/10
2. Depreciation expense for 2011
3. Accumulated depreciation as of 12/31/11
4. Indicate the amount of the accounting change shown net of tax if appropriate
Classification/ Authoritative
Disclosure Literature Help
Clark made the following changes in its accounting policies.
• Clark changed its depreciation method for its production machinery from the doubledeclining
balance method to the straightline method effective January 1, 2011.
• Clark appropriately changed the salvage values used in computing depreciation for its office
equipment.
• Clark appropriately changed the specific subsidiaries constituting the group of companies for
which consolidated financial statements are presented.
For each of the items that Clark changed, identify whether Clark should show the following by
choosing Yes or No in the appropriate columns.
Change item
1. Clark changed its
depreciation method for its
production machinery
from the doubledeclining
balance method to the
straightline method
effective January 1, 2011.
2. Clark appropriately
changed the salvage
values used in computing
depreciation for its office
equipment.
3. Clark appropriately changed
the specific subsidiaries
constituting the group of
companies for which con
solidated financial statements
are presented.
Retrospective
Cumulative effect of Pro forma effects of application to financial
change in principle in retroactive application statements of all prior
net income of the for all prior periods periods presented
period of change presented currently currently
Yes No Yes No Yes No
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Clark Corporation. Clark is considering changing the
depreciation method for its production machinery from the doubledeclining balance method to the
straightline method. Which section of the Professional Standards provides guidance on the nature of
this type of change?
Accounting Authoritative
Treatment Literature Help
Situation
Falk Co. began operations in January, 2010. On January 2, 2011, Falk Co. hired a new
controller. During the year, the controller, working closely with Falk’s president and outside
accountants, made changes in existing accounting policies, instituted new accounting policies, and
corrected several errors dating from prior to 2011.
Falk’s financial statements for the year ended December 31, 2011, will not be presented in
comparative form with its 2010 financial statements.
List A represents possible classifications of these transactions as a change in accounting
principle, a change in accounting estimate, correction of an error in previously presented financial
statements, or neither an accounting change nor an error correction.
List B represents the general accounting treatment required for these transactions. These
treatments are
• Retrospective application approach—Apply the new accounting principle to all prior periods
presented showing the cumulative effect of the change in the carrying value of assets and
liabilities at the beginning of the first period presented, and adjust financial statements presented
to reflect periodspecific effects of the change.
• Retroactive restatement approach—Adjust 2011 beginning retained earnings if the error or
change affects a period prior to 2011.
• Prospective approach—Report 2011 and future financial statements on the new basis, but
do not adjust beginning retained earnings or include the cumulative effect of the change
in the 2011 income statements.
presented financial
List A—Type of change (Select one)
statements.
A. Change in accounting principle. D. Neither an accounting change nor an error
B. Change in accounting estimate. correction.
C. Correction of an error in previously
List B—General accounting treatment (Select one) Y. Retroactive restatement approach.
X. Retroactive application approach. Z. Prospective approach.
For Items 1 and 2, select a classification for each transaction from List A and the general accounting treatment required to
report the change from List B.
1. Falk manufactures customized equipment to customer speci
fications on a contract basis. Falk changed its method of
accounting for these longterm contracts from the completed
contract method to the percentageofcompletion method because
Falk is now able to make reasonable estimates of future
construction costs.
2. Based on improved collection procedures, Falk changed the
percentage of credit sales used to determine the allowance for
uncollectible accounts from 2% to 1%.
List A List B
Type of change Accounting treatment
(A) (B) (C) (D) (X) (Y) (Z)
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Wilson Construction Company. Wilson is considering changing its method
of accounting from the completedcontract method to the percentageofcompletion method. Which section of the
Professional Standards addresses the issue of how to account for the indirect effects of the change?
1. b __ __ 8. c __ __ 15. a __ __ 22. c __ __ 29. c __ __

2. d __ __ 9. a __ __ 16. c __ __ 23. a __ __
3. d __ __ 10. c __ __ 17. b __ __ 24. a __ __
4. b __ __ 11. d __ __ 18. d __ __ 25. b __ __
5. b __ __ 12. c __ __ 19. b __ __ 26. d __ __
6. a __ __ 13. a __ __ 20. a __ __ 27. b __ __ 1st: __/29 = __%
7. d __ __ 14. c __ __ 21. d __ __ 28. a __ __ 2nd: __/29 = __%
5. (b) The requirement is to determine which accounting
C.1. Changes in Accounting Principles (SFAS 154)
change should be reported on a prospective basis. A change
1. (b) A change in depreciation method is a change in depreciation method is a change in principle that is not
in method that is not distinguishable from a distinguishable from a change in estimate, and is accounted
change in estimate, and is accounted for as a for as a change in estimate. The change is reported on a
change in estimate. The change is reported on a prospective basis in the current year and future years. A
prospective basis in the current year and future change from the cash basis to the accrual basis of
years. Book value as of 1/1/11 = $153,600/8 years accounting is a change from nonGAAP to GAAP
remaining = $19,200 depreciation expense in accounted for as the correction of an error. A change in
2011. reporting entity requires retrospective application to the
earliest year presented if practicable. A change in the
2. (d) Zero. A change in depreciation method is a method of accounting for longterm contracts requires
change in method that is not distinguishable retrospective application to the earliest year presented if
from a change in estimate, and is accounted for practicable.
as a change in estimate. The change is reported
on a prospective basis in the current year and 6. (a) The requirement is to determine whether a
future years. A change in depreciation method is change in depreciation method from straightline to
no longer given cumulative effect treatment on doubledeclining balance should be reported as a
the income statement. cumulative effect of a change in accounting principle
and receive retrospective application. A change in
3. (d) Zero. A change in depreciation method is a depreciation method is a change in method that is not
change in method that is not distinguishable from distinguishable from a change in estimate, and is
a change in estimate, and is accounted for as a accounted for as a change in estimate. The change is
change in estimate. The change is reported on a reported on a prospective basis in the current year
prospective basis in the current year and future and future
years. Because a change in depreciation method is
no longer given cumulative effect treatment on the
income statement, there are no deferred income
tax liability effects.
4. (b) A change in depreciation method is a change
in method that is not distinguishable from a
change in estimate, and is accounted for as a
change in estimate. The change is reported on a
prospective basis in the current year and future
years.
years. Therefore, it does not receive cumulative if practicable.
effect treatment or retrospective treatment.
12. (c) A change in inventory method no longer receives
7. (d) A change in inventory method no longer receives cumulative effect treatment on the income statement. The
cumulative effect treatment on the income statement. In accounting change is given retrospective application to the
stead, the accounting change is given retrospective applica earliest period presented, if practicable.
tion to the earliest period presented, if practicable. There
fore, the answer is zero. 13. (a) The requirement is to indicate how a change in
accounting principle from the completedcontract
8. (c) A change in inventory method no longer receives method to the percentageofcompletion method
cumulative effect treatment on the income statement. In should be reported. A change in the method of
stead, the accounting change is given retrospective applica accounting for longterm contracts requires
tion to the earliest period presented, if practicable. retrospective application to the earliest year practi
cable. This results in a $180,000 increase in
9. (a) Retrospective application requires applying income for 2010. The assets would be adjusted for
the new principle to the earliest period presented the earliest period affected, and constructionin
if practicable. Because 2011 beginning inventory progress would increase by $180,000. Net income
is the previous year’s ending inventory, the new for 2010 would increase by $108,000 ($180,000
principle can be applied to the 2010 financial less 40% tax effects), and the deferred tax liability
statements. This would result in an increase in account would increase in 2010 by $72,000.
ending inventory in the balance sheet for 2010, a
decrease in cost of goods sold in 2010, and an 14. (c) The effect of a change in accounting principle
increase in the beginning inventory, which would which is inseparable from the effect of a change in
result in a higher cost of goods sold and a lower accounting estimate should be accounted for as a
net income for 2011. change in accounting estimate. Changes in
estimate should be accounted for in the period of
10. (c) A change in inventory method is given retro change and also in any affected future periods as a
spective application to the earliest period component of income from continuing opera
presented, if practicable. tions. Financial statements are only restated for
11. (d) Retrospective application requires the change changes due to an error. Errors include
to be calculated for the earliest period presented mathematical mistakes, mistakes
12/31/09 book value ($528,000 – $198,000 =
$330,000) is depreciated down to the $48,000
in applying accounting principles, oversights or misuse of salvage value over a remaining useful life of
available facts, and changes from unacceptable accounting three years (six years total – three years already
principles to GAAP. The situation described in this question recorded). Depreciation expense for 2010 is
does not meet the description of an error. $94,000 [($330,000 – $48,000) ÷ 3], increasing
accumulated depreciation to $292,000 ($198,000
15. (a) Deferred taxes is a direct effect from the
+ $94,000).
change in accounting principle, and its effects
should be recorded in the earliest period 21. (d) Changes in accounting estimate are to be ac
presented, if practicable. Profit sharing and counted for in the period of change and in future
royalty payments are indirect effects and should periods if
be reported in the period of the change. the change affects both (i.e., prospectively). Pro forma
16. (c) Indirect effects of a change in accounting amounts are presented for changes in accounting principle
principle should be reported in the period in accounted for using the current (cumulative effect) ap
which the accounting change occurs. Direct
effects are reported retrospectively to the
earliest period presented, if practicable. Answers
(b) and (d) are incorrect since accounting
changes are no longer treated as cumulative
effect changes or prior period adjustments.
17. (b) If it is impracticable to determine the cumulative effect
of an accounting change to any of the prior periods, the
accounting change should be accounted for on a pro
spective basis. Answer (a) is incorrect because accounting
changes are no longer treated as prior period adjustments.
Answer (c) is incorrect because accounting changes are no
longer treated as cumulative effect changes on the income
statement. Answer (d) is incorrect because the change would
not be to retained earnings in the first period presented.
18. (d) If the cumulative effect of applying an
accounting change can be determined, but the
periodspecific effects on all periods cannot be
determined, the cumulative effect of the change
should be applied to the carrying value of the
assets and liabilities at the beginning of the
earliest period to which it can be determined.
C.2. Change in Accounting Estimates
19. (b) This situation is a change in accounting
estimate and should be accounted for currently
and prospectively. From 1/1/07 to 12/31/09,
patent amortization was recorded using a fifteen
year life. Yearly amortization was $47,600
($714,000 ÷ 15), accumulated amortization at
12/31/09 was $142,800 ($47,600 × 3), and the
book value of the patent at 12/31/09 was
$571,200 ($714,000 – $142,800). Beginning in
2010, this book value must be amortized over its
remaining useful life of 7 years (10 years – 3
years). Therefore, 2010 amortization is $81,600
($571,200 ÷ 7) and the 12/31/10 book value is
$489,600 ($571,200 – $81,600).
20. (a) From 1/1/07 to 12/31/09, depreciation was
recorded using an eightyear life. Yearly
depreciation was $66,000 ($528,000 ÷ 8), and
accumulated depreciation at 12/31/09 was
$198,000 (3 × $66,000). In 2010, the estimated
useful life was changed to six years total with a
salvage value of $48,000. Therefore, the
term “restatement” refers only to correction of
proach. Answers (a) and (c) are incorrect because they errors in previously issued financial statements.
apply to retroactivetype changes in principle and error
26. (d) An accounting change that is a change in
correction, respectively.
reporting entity is given retrospective application
22. (c) The effect of a change in accounting estimate to the earliest period presented, if practicable. The
should be accounted for in (a) the period of term “restatement” refers only to correction of
change if the change affects that period only, or errors in previously issued financial statements.
(b) the period of change and future periods if the
C.5. International Financial Reporting Standards
change affects both. The Codification further
states that a change in an estimate should not be (IFRS)
accounted for by restating amounts reported in 27. (b) The requirement is to identify the item that
financial statements of prior periods or by
describes how changes in accounting principles
reporting pro forma amounts for prior periods.
are reported under IFRS. Answer (b) is correct
23. (a) A change in estimated warranty costs due to because IFRS requires changes in accounting
technological advances in production qualifies as a principles to be reported by giving retrospective
change in accounting estimate. Changes in application to the earliest period presented.
estimate are treated prospectively; there is no Answer (a) is incorrect because a change in
retroactive restatement, and the new estimate is accounting estimate is accounted for on a
used in current and future years. Therefore, in prospective basis in the current and future
2010, Oak should use the new estimate of 1% and periods. Answer (c) is incorrect because restate
report warranty expense of $50,000 ($5,000,000 × ment is required for errors in the financial
1%). statements. Answer (d) is incorrect because
cumulative adjustments on the income statement
24. (a) A change in equipment warranty costs based on are not permitted.
additional information obtained through experience
qualifies as a change in accounting estimate. Changes in 28. (a) The requirement is to select the item that describes when
estimate should be accounted for in the period of change as changes in accounting policies are permitted or required.
a component of income from continuing operations and in Answer (a) is correct because changes are permitted if it
future periods if necessary. No restatement is required for a will result in a more reliable and more relevant presentation
change in estimate. of the financial statements.
C.3. Change in Reporting Entity (ASC Topic 250) 29. (c) The requirement is to identify the

circumstances that may justify a voluntary change
25. (b) An accounting change that is a change in in accounting method. Answer (c) is correct
reporting entity is given retrospective application because the new method must provide reliable
to the earliest period presented, if practicable. The and more relevant information.
Accountin
Authoritative
g Literature
Changes
Help List A List B
Treatmen Approac
t h
(A) (B) (C) (X) (Y)
(D) (Z)
1. Quo manufactures heavy equipment to customer specifications on a contract basis. On the
basis that it is preferable, accounting for these longterm contracts was switched from the
completedcontract method to the percentageofcompletion method.
2. As a result of a production breakthrough, Quo determined that manufacturing equipment
previously depreciated over fifteen years should be depreciated over twenty years.
3. The equipment that Quo manufactures is sold with a fiveyear warranty. Because of a
production breakthrough, Quo reduced its computation of warranty costs from 3% of sales
to 1% of sales.
4. Quo changed from LIFO to FIFO to account for its finished goods inventory.
5. Quo changed from FIFO to average cost to account for its raw materials and work in process
inventories.
6. Quo sells extended service contracts on its products. Because related services are
performed over several years, in 2011 Quo changed from the cash method to the
accrual method of recognizing income from these service contracts.
7. During 2011, Quo determined that an insurance premium paid and entirely
expensed in 2010 was for the period January 1, 2010, through January 1, 2012.
8. Quo changed its method of depreciating office equipment from an accelerated
method to the straightline method to more closely reflect costs in later years.
9. Quo instituted a pension plan for all employees in 2011 and adopted the accounting standards
related to pensions. Quo had not previously had a pension plan.
10. During 2011, Quo increased its investment in Worth, Inc. from a 10% interest, purchased in
2010, to 30%, and acquired a seat on Worth’s board of directors. As a result of its increased
investment, Quo changed its method of accounting for investment in subsidiary from the
cost adjusted for fair value method to the equity method.
1. (A, X) This situation represents a change in the method of accounting for longterm
constructiontype contracts and requires retrospective application for all periods
presented.
2. (B, Z) This situation is not a change in accounting principle but is a change in an estimate
and should be handled prospectively.
3. (B, Z) This situation is a change in an estimate. The change in the percentage of warranty costs is not a
change in accounting principle. Changes in estimate are handled prospectively.
4. (A, X) This situation is a change from one acceptable accounting principle to
another and requires retrospective application.
5. (A, X) This situation is a change from one acceptable accounting method to another
and requires the retrospective application approach.
6. (C, Y) The use of the cash method is considered an error since that method is generally not
acceptable. The switch to an acceptable method (accrual) is considered the correction of an
error and requires the retroactive restatement approach.
7. (C, Y) The writeoff of the insurance premium was an error. Since comparative financial
statements are prepared, past years must be corrected using the retroactive restatement
approach even though this error is selfcorrecting after two years.
8. (B, Z) This situation is a change in method which is considered a change in estimate effected
by a change in principle. Per SFAS 154, a change in depreciation method requires
prospective application.
9. (D, Z) Since the company did not previously account for pensions this situation is simply
the adoption of an appropriate accounting principle for pensions. No change in principle
occurs.
10. (D, Y) Quo’s increase in ownership interest (10% to 30%) and its acquisition of a seat on
Worth’s board of directors has given Quo the ability to exercise significant influence in the
operating decisions of Worth. If Quo does not elect to use the fair value option to report its
30% investment in Worth, Quo will use the equity method to account for its investment in
Worth. The cost adjusted for fair value method is no longer applicable due to the change in
Quo’s investment in Worth. However, the change from the cost adjusted for fair value
method to the equity method is not a change in accounting principle. A change in accounting
principle occurs when an accounting principle different from the one used previously for
reporting purposes is adopted. For a change to occur, a choice between two or more
accounting principles must exist. In this case, the change in Quo’s situation allows the equity
method to account for the investment. Quo’s current economic situation is clearly different
and this necessitates the adoption of a different accounting principle. Consequently, this is
not an accounting change. However, the investment account should be retroactively restated
to reflect balances as if the equity method had always been used.
Calculations
Authoritative
Literature Help
1. Accumulated depreciation as of 12/31/10 $180,000
2. Depreciation expense for 2011 $ 40,000
3. Accumulated depreciation as of 12/31/11 $220,000
4. Indicate the amount of the accounting change shown net of tax if appropriate $ 0
1. Before change, Kent used doubledeclining balance and 10year life
2009 1/10 × 2 × $500,000 book value = $100,000 depreciation expense
2010 1/10 × 2 × $400,000 new book value = $ 80,000 depreciation expense
Accumulated depreciation 12/31/09 $180,000
2. To calculate depreciation expense for 2011:
Historical cost $500,000
– Accum. depreciation (180,000)
Book value $320,000
($320,000 – $0 salvage) ÷ 8 years remaining life = $40,000 depreciation expense
3. To calculate accumulated depreciation as of 12/31/11:
2009 $100,000
2010 80,000
2011 40,000
Accum. depr. 12/31/11 $220,000
4. Accounting change net of tax – zero. Accounting standards treat changes in depreciation
method as a change in estimateeffected by a change in method. Therefore, a change in
depreciation is accounted for on a prospective basis.
Disclosure Literature Help
Change item
1. Clark changed its depreciation
method for its production
machinery from the double
declining balance method to the
straightline method effective
January 1, 2011.
2. Clark appropriately changed
the salvage values used in
computing depreciation for
its office equipment.
3. Clark appropriately changed the
specific subsidiaries constituting
the group of companies for which
consolidated financial statements
are presented.
Retrospective
Cumulative effect of Pro forma effects of application to financial
change in principle retroactive application statements of all prior
in net income of the for all prior periods periods presented
period of change presented currently currently
Yes No Yes No Yes No
1. (N, N, N) Clark’s change in depreciation method is a change in accounting estimate

effected by a change in accounting principle. This change would be accounted for on a
prospective basis in the current year and future periods.
2. (N, N, N) Clark’s change in salvage values is a change in accounting estimate. Clark would
not report a cumulative effect, nor pro forma effects, nor would prior period financial
statements be restated.
3. (N, N, Y) Clark’s change in the specific subsidiaries constituting the group of companies for which
consolidated financial statements are presented is a change in reporting entity. The change in reporting
entity requires the change to be retrospectively applied to the financial statements of all prior periods
presented to show financial information for the new reporting entity.
Research
Authoritative
Literature Help
ASC 250 10 45 18
Accounting
Treatment
Authoritative
Literature Help
1. Falk manufactures customized equipment to
customer specifications on a contract basis. Falk
changed its method of accounting for these long
term contracts from the completedcontract method
to the percentageofcompletion method because
Falk is now able to make reasonable estimates of
future construction costs.
2. Based on improved collection procedures, Falk
changed the percentage of credit sales used to
determine the allowance for uncollectible
accounts from 2% to 1%.
List A List B
Type of Change Accounting Treatment
(A) (B) (C) (D) (X) (Y) (Z)
1. (A, X) Changing from using the completedcontract method to the percentageof
completion method is a change in accounting principle. Therefore, retrospective
application to all periods presented is required.
2. (B, Z) The percentage of net credit sales used in determining the amount to be added to the
allowance for uncollectible accounts is an estimate made by management. Changing the
percentage is a change in accounting estimate, which is treated prospectively.
Accounting
Change Authoritative
Literature Help
Posey Corporation
INCOME STATEMENT
Adjusted Adjusted
for the year ending 123111 for the year ending 123110
Sales $130,000 $100,000
Cost of goods sold 87,000 68,000
Gross profit 43,000 32,000
Operating expenses 20,000 17,000
Earnings before taxes 23,000 15,000
Income tax expense (40%) 9,200 6,000
Net income 13,800 9,000
Inventory $14,000 $7,000
Income tax liability 10,000 6,000
To calculate cost of goods sold using FIFO method, you must first calculate purchases using
the average cost method. Using Taccounts for analysis, the amounts are as shown below.
Inventory
(Weightedaverage method)
1110 0
70,000 CGS
Purchases 75,000
123110 5,000
90,000 CGS
Purchases 94,000
123111 9,000
Inventory
(FIFO method)
1110 0
68,000 CGS
Purchases 75,000
123110 7,000
Purchases 94,000 87,000 CGS
123111 14,000
Income tax liability for December 31, 2011, is calculated as
2011 earnings before taxes 23,000 × 40% = $9,200
2010 adjustment to earnings before taxes 2,000 × 40% + 800
Total income tax liability at 123111 $10,000
Research
Authoritative
Literature Help
ASC 250 10 45 8
MODULE 9 BASIC TH. & FIN. REP.: D. FINANCIAL STATEMENTS 295
FINANCIAL STATEMENTS
MULTIPLECHOICE QUESTIONS (1114) 3. What amount should Vane report as income after in
come taxes from continuing operations?
1. In Baer Food Co.’s 2010 singlestep income a. $126,000
statement,the section titled “Revenues” b. $129,500
consisted of the following: c. $140,000
Net sales revenue d. $147,000
Results from discontinued operations:
Loss from discontinued component Z in
cluding loss on disposal of $1,200 $ 16,400
Less tax benefit 4,000
Interest revenue
Gain on sale of equipment
Extraordinary gain
Total revenues
In the revenues section of the 2010 income
statement, Baer Food should have reported
total revenues of
a. $216,300
b. $215,400
c. $203,700
d. $201,900
Vane Co.’s trial balance of income statement
accounts for the year ended December 31,
2011, included the following:
Debit
Sales
Cost of sales $240,000
Administrative expenses 70,000
Loss on sale of equipment 10,000
Sales commissions 50,000
Interest revenue
Freight out 15,000
Loss on early retirement of longterm debt 20,000
Uncollectible accounts expense 15,000
Totals $420,000
Other information
Finished goods inventory:
January 1, 2011 $400,000
December 31, 2011 360,000
Vane’s income tax rate is 30%. In Vane’s
2011 multiplestep income statement,
2. What amount should Vane report as the cost of goods
manufactured?
a. $200,000
b. $215,000
c. $280,000
d. $295,000
Onehalf of the rented premises is occupied
7. In Yew Co.’s 2010 annual report, Yew
by the sales department.
Brock’s total selling expenses for 2010 are described itssocial awareness expenditures
a. $480,000 during the year as follows:
b. $400,000 The Company contributed $250,000 in cash to
c. $370,000 youth and educational programs. The Company
also gave $140,000 to health and human service
d. $360,000
organizations, of which $80,000 was contributed
by employees through payroll deductions. In
5. The following costs were incurred by
addition, consistent with the Company’s
Griff Co., amanufacturer, during 2010: commitment to the environment, the Company
Accounting and legal fees $ 25,000 spent $100,000 to redesign product packaging.
Freightin 175,000 What amount of the above should be
Freightout 160,000
Officers salaries 150,000 included in Yew’s income statement as
Insurance 85,000 charitable contributions expense?
Sales representatives salaries 215,000 a. $310,000
What amount of these costs should be b. $390,000
reported as general and administrative c. $410,000
expenses for 2010? d. $490,000
a. $260,000
8. During 2010 both Raim Co. and Cane
b. $550,000
Co. suffered losses due to the flooding
c. $635,000 of the Mississippi River. Raim is
d. $810,000 located two miles from the river and
6. Which of the following should be included sustains flood losses every two to
in generaland administrative expenses? three years. Cane, which has been
located fifty miles from the river for
Interest Advertising the past twenty years, has never
a. Yes Yes before had flood losses. How should
b. Yes No the flood losses be reported in each
c. No Yes company’s 2010 income statement?
d. No No
Raim Cane
4. Brock Corp. reports operating expenses in As an extraordinary
a. As a component
two catego of income from item
ries: (1) selling, and (2) general and continuing
administrative. The operations
adjusted trial balance at December 31, 2010, b. As a component As a component of
included the of income from income from
following expense and loss accounts: continuing continuing opera
operations tions
Accounting and legal fees $120,000
c. As an As a component of
Advertising 150,000
Freightout 80,000 extraordinary income from
Interest 70,000 item continuing opera
Loss on sale of longterm investment 30,000 tions
Officers’ salaries 225,000 As an extraordinary
Rent for office space 220,000 d. As an item
Sales salaries and commissions 140,000 extraordinary
item
296 MODULE 9 BASIC TH. & FIN. REP.: D. FINANCIAL STATEMENTS
12. Ocean Corp.’s comprehensive
insurance policy allows its assets to
9. Witt Co. incurred the following infrequent be replaced at current value. The
losses during2010: policy has a $50,000 deductible
• $175,000 from a major strike by clause. One of Ocean’s waterfront
employees.
warehouses was destroyed in a
winter storm. Such storms occur
• $150,000 from an earthquake (unusual).
approximately every four years.
• $125,000 from the abandonment of
equipment used in the business. Ocean incurred $20,000 of costs in
dismantling the warehouse and plans
In Witt’s 2010 income statement, the total to replace it. The following data
amount of infrequent losses not considered relate to the warehouse:
extraordinary should be Current carrying amount $ 300,000
a. $275,000 Replacement cost 1,100,000
b. $300,000 What amount of gain should Ocean report as
c. $325,000 a separate component of income before
d. $450,000 extraordinary items?
10. Kent Co. incurred the following infrequent a. $1,030,000
losses during 2010: b. $ 780,000
c. $ 730,000
• A $300,000 loss was incurred on disposal d. $0
of one of four dissimilar factories.
• A major currency devaluation caused a
$120,000 exchange loss on an
amount remitted by a foreign cus
tomer.
• Inventory valued at $190,000 was made
worthless by a competitor’s unexpected
product innovation.
In its 2010 income statement, what amount
should Kent report as losses that are not
considered extraordinary?
a. $610,000
b. $490,000
c. $420,000
d. $310,000
11. Midway Co. had the following
transactions during 2010:
• $1,200,000
pretax loss on
foreign currency
exchange due to a
major unexpected
devaluation by
the foreign
government.
• $500,000 pretax
loss from
discontinued
operations of a
division.
• $800,000 pretax loss on equipment
damaged by a hurricane. This was the first
hurricane ever to strike in Midway’s area.
Midway also received $1,000,000 from its
insurance company to replace a building,
with a carrying value of $300,000, that had
been destroyed by the hurricane.
What amount should Midway report in its
2010 income statement as extraordinary loss
before income taxes?
a. $ 100,000
b. $1,300,000
c. $1,800,000
d. $2,500,000
17. During 2010, Peg Construction Co.
13. Purl Corporation’s income statement for the recognized substantial gains from
year endedDecember 31, 2010, shows the • An increase in value of a foreign
following: customer’s remittance caused by a
Income before income tax and extraordinary item major foreign currency revaluation.
Gain on life insurance coverage—included in the • A courtordered increase in a completed
above $900,000 income amount longterm construction contract’s price
Extraordinary item—loss due to earthquake damage due to design changes.
Purl’s tax rate for 2010 is 40%. How much Should these gains be included in continuing
should be reported as the provision for income operations or reported as an extraordinary
tax in Purl’s 2010 income statement? item in Peg’s 2010 income statement?
a. $200,000
b. $240,000
c. $320,000
d. $360,000
14. Thorpe Co.’s income statement for
the year ended December 31, 2011,
reported net income of $74,100. The
auditor raised questions about the
following amounts that had been
included in net income:
Unrealized loss on decline in market value of
noncurrent investments in stock classified as
availableforsale (net of tax) $(5,400)
Gain on early retirement of bonds payable (net of
$11,000 tax effect)
Adjustment to profits of prior years for errors in
depreciation (net of $3,750 tax effect)
Loss from fire (net of $7,000 tax effect) (14,000)
The loss from the fire was an infrequent but not
unusual occurrence in Thorpe’s line of business.
Thorpe’s December 31, 2011 income statement
should report net income of
a. $65,000
b. $66,100
c. $81,600
d. $87,000
15. On January 1, 2010, Brecon Co.
installed cabinets to display its
merchandise in customers’ stores.
Brecon expects to use these
cabinets for five years. Brecon’s
2010 multistep income statement
should include
a. Onefifth of the cabinet costs in cost of
goods sold.
b. Onefifth of the cabinet
costs in selling, general,
and administrative
expenses.
c. All of the cabinet costs in cost of good
sold.
d. All of the cabinet costs in
selling, general, and ad
ministrative expenses.
16. A material loss should be presented
separately as a component of income
from continuing operations when it is
a. An extraordinary item.
b. A discontinued component of the
business.
c. Unusual in nature and infrequent in
occurrence.
d. Not unusual in nature but infrequent in
occurrence.
Gain from major Gain from increase
currency revaluation in contract’s price
a. Continuing operations Continuing operations
b. Extraordinary item Continuing operations
c. Extraordinary item Extraordinary item
d. Continuing operations Extraordinary item
increase in production costs caused
when a major supplier’s workers went
18. An extraordinary item should be reported on strike. Which of these losses
separately onthe income statement as a should be reported as an
component of income extraordinary item?
Before discontinued operations Antitrust action Production costs
Net of income taxes of a component of a business a. No No
a. Yes Yes b. No Yes
b. Yes No c. Yes No
c. No No d. Yes Yes
d. No Yes
22. In open market transactions, Gold Corp.
19. In 2010, hail damaged several of Toncan Co.’s simultaneouslysold its longterm investment in
vans. Hailstorms had frequently inflicted similar Iron Corp. bonds and purchased its own
damage to Toncan’s vans. Over the years, outstanding bonds. The broker remitted the net
Toncan had saved money by not buying hail cash from the two transactions. Gold’s gain on
insurance and either paying for repairs, or selling the purchase of its own bonds exceeded its loss
damaged vans and then replacing them. In 2010, on the sale of the Iron bonds. Gold should
the damaged vans were sold for less than their report the
carrying amount. How should the hail damage a. Net effect of the two transactions as
cost be reported in Toncan’s 2010 financial an extraordinary gain.
statements? b. Net effect of the two transactions in
a. The actual 2010 hail income before extraordinary items.
damage loss as an c. Effect of its own bond transaction
extraordinary loss, net of gain in income before extraordinary
income taxes. items, and report the Iron bond
b. The actual 2010 hail damage transaction as a loss in income
loss in continuing op before extraordinary items.
erations, with no separate d. Effect of its own bond transaction as
disclosure. an extraordinary gain, and report the
c. The expected average hail Iron bond transaction loss in income
damage loss in continuing before extraordinary items.
operations, with no separate
disclosure.
d. The expected average hail
damage loss in continuing
operations, with separate
disclosure.
20. A transaction that is unusual in nature
and infrequent in occurrence should
be reported separately as a component
of income
a. After cumulative effect of
accounting changes and
before discontinued
operations.
b. After cumulative effect of
accounting changes and after
discontinued operations.
c. Before cumulative effect
of accounting changes
and before discontinued
operations.
d. Before cumulative effect
of accounting changes
and after discontinued
operations.
21. In 2010, Teller Co. incurred losses
arising from its guilty plea in its first
antitrust action, and from a substantial
reported as an
23. Under ASC 220, Comprehensive Income, extraordinary loss.
corrections of errors are reported in d. $500,000 should be reported
a. Other comprehensive income. as revenues from op
b. Other income/(expense). erations of a discontinued
c. Retained earnings. component.
d. Stockholders’ equity. 26. Which of the following criteria is not
24. Service Corp. incurred costs required for a component’s results to
associated with relocating employees be classified as discontinued opera
in a restructuring of its operations. tions?
How should the company account for a. Management must have
these costs? entered into a sales agree
a. Measured at fair value ment.
and recognized over the b. The component is available for
next two years. immediate sale.
b. Measured at fair value and c. The operations and cash
recognized when the li flows of the component will
ability is incurred. be eliminated from the
c. Recognized when the costs are paid. operations of the entity as a
d. Measured at fair value and result of the disposal.
treated as a prior period d. The entity will not have any
adjustment. significant continuing
involvement in the
25. On January 1, 2010, Deer Corp. met operations of the component
the criteria for discontinuance of a after disposal.
business component. For the period
January 1 through October 15, 2010, 27. On November 1, 2010, management
the component had revenues of of Herron Corporation committed to
$500,000 and expenses of $800,000. a plan to dispose of Timms Company,
The assets of the component were sold a major subsidiary. The disposal
on October 15, 2010, at a loss for meets the requirements for
which no tax benefit is available. In its classification as discontinued
income statement for the year ended operations. The carrying value of
December 31, 2010, how should Deer Timms Company was $8,000,000 and
report the component’s operations management estimated the fair value
from January 1 to October 15, 2010? less costs to sell to be $6,500,000. For
a. $500,000 and $800,000 2010, Timms Company had a loss of
should be included with $2,000,000. How much should Herron
revenues and expenses, Corporation present as loss from dis
respectively, as part of continued operations before the effect
continuing operations. of taxes in its income statement for
2010?
b. $300,000 should be reported
as part of the loss on a. $0
operations and disposal of a b. $1,500,000
component. c. $2,000,000
c. $300,000 should be d. $3,500,000
d. None of the above.
33. What is the purpose of reporting
28. On December 1, 2010, Greer Co. committed to a
comprehensive income?
plan to dispose of its Hart business component’s
assets. The disposal meets the requirements to a. To report changes in
be classified as discontinued operations. On that equity due to
transactions with
date, Greer estimated that the loss from the
owners.
disposition of the assets would be $700,000 and
Hart’s 2010 operating losses were $200,000. b. To report a measure of
Disregarding income taxes, what net gain (loss) overall enterprise perfor
should be reported for discontinued operations mance.
in Greer’s 2010 income statement? c. To replace net income with a better
a. $0 measure.
b. $(200,000) d. To combine income from
continuing operations with
c. $(700,000)
income from discontinued
d. $(900,000)
operations and ex
29. A component of Ace, Inc. was traordinary items.
discontinued during 2011. Ace’s
34. During 2010, the “other revenues and
loss on disposal should
a. Exclude the associated employee gains” section of Totman Company’s
Statement of Earnings and
relocation costs.
Comprehensive Income contains
b. Exclude operating losses for the
$5,000 in interest revenue, $15,000
period.
equity in Harpo Co. earnings, and
c. Include associated employee $25,000 gain on sale of availablefor
termination costs. sale securities. Assuming the sale of
d. Exclude associated lease cancellation the securities increased the current
costs. portion of income tax expense by
30. When a component of a business has $10,000, determine the amount of
been discontinued during the year, this Totman’s reclassification adjustment
component’s operating losses of the to other comprehensive income.
current period should be included in
the
a. Income statement as
part of revenues and
expenses.
b. Income statement as part of
the loss on disposal of the
discontinued component.
c. Income statement as part of
the income (loss) from
continuing operations.
d. Retained earnings statement
as a direct decrease in
retained earnings.
31. When a component of a business has
been discontinued during the year, the
loss on disposal should
a. Include operating losses of the current
period.
b. Exclude operating losses during the
period.
c. Be an extraordinary item.
d. Be an operating item.
32. On January 1, 2011, Shine Co. agreed
to sell a business component on
March 1, 2011. The gain on the
disposal should be
a. Presented as an extraordinary gain.
b. Presented as an adjustment to retained
earnings.
c. Netted with the loss from
operations of the component
as a part of discontinued
operations.
as available for sale. The company
a. $ 5,000 does not elect to use the fair value
b. $ 2,500 option for reporting its availablefor
c. $35,000 sale securities. The fair value of the
d. $15,000 securities increases to $2,500 on
December 31, 2009, and to $2,750 on
35. Which of the following is not an December 31, 2010. On December 31,
acceptable option of reporting other 2010, the company sells the securities.
comprehensive income and its Assume no dividends are paid and
components? that the company has a tax rate of
a. In a separate statement of 30%. What is the amount of the
comprehensive income. reclassification adjustment for other
b. In a statement of earnings comprehensive income on Decem
and comprehensive in ber 31, 2010?
come. a. $ 7,500
c. In the footnotes. b. $ (7,500)
d. In a statement of changes in c. $ 5,250
stockholders’ equity. d. $ (5,250)
36. Accumulated other comprehensive 39. A company buys ten shares of

income should be reported on the securities at $1,000 each on January
balance sheet as a component of 15, 2010. The securities are classified
Retained earnings Additional paidin capital as availableforsale. The fair value of
a. No Yes the securities increases to $1,250 per
b. Yes Yes share as of December 31, 2010. The
company does not elect to use the fair
c. Yes No value option for reporting available
d. No No forsale securities. Assume no
dividends are paid and that the
37. Which of the following changes company has a 30% tax rate. What is
during a period is not a component of the amount of the holding gain arising
other comprehensive income? during the period that is classified in
a. Unrealized gains or losses other comprehensive income for the
as a result of a debt se period ending December 31, 2010?
curity being transferred a. 0
from heldtomaturity to b. $1,750
availableforsale. c. $2,500
b. Stock dividends issued to shareholders. d. $7,500
c. Foreign currency translation
adjustments. 40. Searles does not elect the fair value option for
d. Minimum pension liability recording financial assets and liabilities. What
adjustments. amount of comprehensive income should
Searles Corporation report on its statement of
38. A company buys ten shares of income and comprehensive income given the
securities at $2,000 each on December following net of tax figures that represent
31, 2008. The securities are classified changes during a period?
amounts
must be
Pension liability adjustment recognized in OCI $ (3,000) presented
Unrealized gain on availableforsale securities for other
Reclassification adjustment, for securities gain
included in net income
comprehe
Stock warrants outstanding nsive
Net income income
but not
a. $86,500
for
b. $89,000 comprehe
c. $89,500 nsive
d. $90,500 income.
41. If ($2,450) net of tax is the c. Separate EPS amounts must be
reclassification adjustment included presented for comprehensive income
in other comprehensive income in but not for other comprehensive
the year the securities are sold, what income.
is the gain (loss) that is included in d. Separat
income from continuing operations e EPS
before income taxes? Assume a 30% amounts
tax rate. are not
a. $(2,450) required
b. $(3,500) to be
pre
c. $ 2,450
sented
d. $ 3,500
for
42. Which of the following changes during either
a period is not a component of other other
comprehensive income? compre
hensive
a. Pensio
income
n
or
liability
adjust compre
ment hensive
for income.
funded 44. Which of the following options for
status displaying comprehensive income
of plan. is(are) preferred by FASB?
b. Treasury stock, at cost.
c. Foreign currency translation I. A continuation from net
income at the bottom of
adjustment.
the income statement.
d. Reclassifi II. A separate statement that begins with
cation net income. III. In the statement of
adjustme changes in stockholders’ equity.
nt, for
securities a. I.
gain in b. II.
cluded in c. II and III.
net d. I and II.
income.
45. Assume a company does not elect the
43. Which of the following is true? fair value option for reporting financial
a. Separate assets and liabilities. Which of the
EPS following is not classified as other
amounts comprehensive income?
must be a. An
presented adjust
for both ment
other to
compreh pensio
ensive n
income liabilit
and y to
compreh record
ensive the
income. funde
b. Separate d
EPS status
of the
plan. 46. When a full set of generalpurpose financial
b. Subsequent decreases of the fair value statementsare presented, comprehensive
of availableforsale securities that income and its components should
have been previously written down as a. Appear as a part of discontinued
impaired. operations, extraordinary items,
c. Decrease and cumulative effect of a change
s in the in accounting principle.
fair b. Be reported net of related income tax
value of effect, in total and individually.
heldto c. Appear in a supplemental schedule in
maturity the notes to the financial statements.
se d. Be displayed in a financial statement
curities. that has the same prominence as other
d. None of the above. financial statements.
Items 47 through 49 are based on the
following:
The following trial balance of Mint Corp. at
December 31, 2010, has been adjusted except for
income tax expense.
Dr. Cr.
Cash $ 600,000
Accounts receivable, net 3,500,000
Cost in excess of billings on long
term contracts 1,600,000
Billings in excess of costs on long
term contracts $ 700,000
Prepaid taxes 450,000
Property, plant, and equipment, net 1,480,000
Note payable—noncurrent 1,620,000
Common stock 750,000
Additional paidin capital 2,000,000
Retained earnings—unappropriated 900,000
Retained earnings—restricted for
note payable 160,000
Earnings from longterm contracts 6,680,000
Costs and expenses 5,180,000
$12,810,000 $12,810,000
Other financial data for the year ended
December 31, 2010, are
• Mint uses the percentageof
completion method to account for
longterm construction contracts for
financial statement and income tax
purposes. All receivables on these
contracts are considered to be
collectible within twelve months.
• During 2010, estimated tax payments of
$450,000 were charged to prepaid taxes.
Mint has not recorded income tax
expense. There were no temporary or
permanent differences, and Mint’s tax
rate is 30%.
In Mint’s December 31, 2010 balance sheet,
what amount should be reported as
47. Total retained earnings?
a. $1,950,000
b. $2,110,000
c. $2,400,000
d. $2,560,000
48. Total noncurrent liabilities?
a. $1,620,000
b. $1,780,000
c. $2,320,000
d. $2,480,000
49. Total current assets?
a. $5,000,000 50. Mirr, Inc. was incorporated on
b. $5,450,000 January 1, 2010, with proceeds from
c. $5,700,000 the issuance of $750,000 in stock and
d. $6,150,000 bor
55. Dean Co. acquired 100% of Morey Corp.
rowed funds of $110,000. During the first year prior to 2010.During 2010, the individual
of operations, revenues from sales and companies included in their financial statements
consulting amounted to $82,000, and operating the following:
costs and expenses totaled $64,000. On Dean Morey
December 15, Mirr declared a $3,000 cash Officers’ salaries $ 75,000 $50,000
dividend, payable to stockholders on January Officers’ expenses 20,000 10,000
15, 2011. No additional activities affected Loans to officers 125,000 50,000
owners’ equity in 2010. Mirr’s liabilities Intercompany sales 150,000
increased to $120,000 by December 31, 2010. What amount should be reported as related
On Mirr’s December 31, 2010 balance sheet, party disclosures in the notes to Dean’s 2010
total assets should be reported at consolidated financial statements?
a. $885,000 a. $150,000
b. $882,000 b. $155,000
c. $878,000 c. $175,000
d. $875,000 d. $330,000
51. The following changes in Vel Corp.’s account
balances occurred during 2010:
Increase
Assets $89,000
Liabilities 27,000
Capital stock 60,000
Except for a $13,000 dividend payment and the year’s earnings, there were no changes in retained
earnings for 2010. What was Vel’s net income for 2010?
a. $ 4,000
b. $ 9,000
c. $13,000
d. $17,000
52. When preparing a draft of its 2010 balance sheet, Mont, Inc. reported net assets totaling
$875,000. Included in the asset section of the balance sheet were the following:
Treasury stock of Mont, Inc. at cost, which approxi
mates market value on December 31 $24,000
Idle machinery 11,200
Cash surrender value of life insurance on corporate
executives 13,700
Allowance for decline in market value of noncurrent
equity investments 8,400
At what amount should Mont’s net assets be reported in the December 31, 2010 balance sheet?
a. $851,000
b. $850,100
c. $842,600
d. $834,500
53. In analyzing a company’s financial statements, which financial statement would a potential
investor primarily use to assess the company’s liquidity and financial flexibility?
a. Balance sheet.
b. Income statement.
c. Statement of retained earnings.
d. Statement of cash flows.
54. During 2010, Jones Company engaged in the following transactions:
Salary expense to key employees who are also
principal owners $100,000
Sales to affiliated enterprises 250,000
Which of the two transactions would be disclosed as relatedparty transactions in Jones’ 2010 financial
statements?
a. Neither transaction.
b. The $100,000 transaction only.
c. The $250,000 transaction only.
d. Both transactions.
56. Which type of material relatedparty transaction requires disclosure?
a. Only those not reported in the body of the financial statements.
b. Only those that receive accounting recognition.
c. Those that contain possible illegal acts.
d. All those other than compensation arrangements, expense allowances, and
other similar items in the ordinary course of business.
57. Financial statements shall include disclosures of material transactions between related
parties except
a. Nonmonetary exchanges by affiliates.
b. Sales of inventory by a subsidiary to its parent.
c. Expense allowance for executives which exceed normal business
practice.
d. A company’s agreement to act as surety for a loan to its chief executive
officer.
58. Dex Co. has entered into a joint venture with an affiliate to secure access to additional inventory. Under
the joint venture agreement, Dex will purchase the output of the venture at prices negotiated on an
arm’slength basis.
Which of the following is(are) required to be disclosed about the relatedparty transaction?
I. The amount due to the affiliate at the balance sheet date. II. The dollar amount of the
purchases during the year.
a. I only.
b. II only.
c. Both I and II.
59. What is the purpose of information presented in notes to the financial statements?
a. To provide disclosures required by generally accepted accounting
principles.
b. To correct improper presentation in the financial statements.
c. To provide recognition of amounts not included in the totals of the
d. To present management’s responses to auditor comments.
60. Which of the following information should be included in Melay, Inc.’s 2010 summary of
significant accounting policies?
a. Property, plant, and equipment is recorded at cost with depreciation
computed principally by the straightline method.
b. During 2010, the Delay component was sold.
c. Business component 2010 sales are Alay $1M, Be 66. Which of the following describes a
principal market for
lay $2M, and Celay $3M. issued, Colter lost $250,000 of
d. Future common share inventory due to a fire. The inventory
dividends are expected to was a total loss and was uninsured.
approximate 60% of How should Colter present this
earnings. information in its December 31, 2010
financial statements?
61. Which of the following information a. Colter should disclose the
should be disclosed in the summary of loss in a footnote to its
significant accounting policies? 2010 financial statements.
a. Refinancing of debt b. Colter should report an
subsequent to the extraordinary loss in its
balance sheet date. 2010 income statement.
b. Guarantees of indebtedness of others. c. Colter should
c. Criteria for determining report an allowance
which investments are for lost inventory in
treated as cash its 2010 balance
equivalents. sheet.
d. Adequacy of pension plan d. Colter should not report the loss.
assets relative to vested
benefits. 64. Which of the following is a true
statement regarding disclosures for
62. Swift Corp. prepares its financial statements for subsequent events?
its fiscal year ending December 31, 2010. Swift a. Recognize a loss for all
estimates that its product warranty liability is recognized and unrecognized
$28,000 at December 31, 2010. On February 12, subsequent events in the
2011, before the financial statements were current year financial
issued, Swift received information about a statements.
product defect that will require a recall of all b. Recognize a gain or
units sold in 2010. It is expected the product loss for any recognized
recall will cost an additional $40,000 in subsequent event in the
warranty repairs. What should Swift present in current year financial
its December 31, 2010 financial statements? statements.
a. A footnote disclosure explaining the c. Recognize a loss for a recognized
product recall. subsequent event in the financial
b. A footnote disclosure listing statements in the year when the
the estimated amount of subsequent event occurs.
$40,000 in warranty repairs d. Recognize a loss for a recognized
and an explanation of the subsequent event in the current year
recall. financial statements.
c. An estimated warranty liability of
$68,000. 65. The fair value of an asset should be based
d. No disclosure is necessary. upon
a. The replacement cost of an asset.
63. Colter Corp. has a fiscal yearend of b. The price that would be
December 31, 2010. On that date, received to sell the asset at
Colter reported total assets of the measurement date.
$600,000. On March 1, 2011, before c. The original cost of the
the 2010 financial statements were asset plus an adjustment
for obsolescence. establishing fair value of an asset?
d. The price that would be paid to acquire a. The market that has the
the asset. greatest volume and level
of activity for the asset.
b. Any broker or dealer
market that buys or sells the
asset.
c. The most observable
market in which the price
of the asset is minimized.
d. The market in which the amount
received would be maximized.
67. Which of the following is true for
valuing an asset to fair value?
a. The price of the asset
should be adjusted for
transaction costs.
b. The fair value of the asset
should be adjusted for
costs to sell.
c. The fair value price is based
upon an entry price to
purchase the asset.
d. The price should be adjusted
for transportation costs to
transport the asset to its
principal market.
68. Which of the following would meet
the qualifications as market
participants in determining fair value?
a. A liquidation
market in which
sellers are
compelled to sell.
b. A subsidiary of the
reporting unit interested in
purchasing assets similar
to those being valued.
c. An independent entity that is
knowledgeable about the
asset.
d. A broker or dealer that
wishes to establish new
market for the asset.
69. Which of the following is an
assumption used in fair value
measurements?
a. The asset must be inuse.
b. The asset must be considered in
exchange.
c. The most conservative estimate must
be used.
d. The asset is in its highest and best use.
70. The fair value of an asset at initial
recognition is
a. The price paid to acquire the asset.
b. The price paid to acquire the
asset less transaction costs.
c. The price paid to transfer or sell the
asset.
d. The book value of the asset acquired.
71. Which of the following is not a
valuation technique used in fair
value estimates?
a. Income approach.
b. Residual value approach.
c. Market approach.
d. Cost approach.
72. Valuation techniques for fair
value that include the Black
ScholesMerton formula, a
binomial model, or discounted
cash flows are examples of which
valuation technique?
a. Income approach.
b. Market approach.
c. Cost approach.
d. Exit value approach.
73. The market approach valuation technique for
measuring fair value requires which of the
following?
a. Present value of future cash flows.
b. Prices and other relevant
information of transactions
from identical or
comparable assets.
c. The price to replace the service capacity of the a. $ 0
asset. b. $ 20,000
d. The weightedaverage of the present value of c.
$600,000
future cash flows. d.
$ 620,000
information to the
74. A change in valuation techniques financial state
used to measure fair value should be ments.
reported as d. Management’s report to shareholders.
a. A
change 78. Lewis Company was formed on
in January 1, 2009. Selected balances
accoun from the historical cost balance sheet
ting at December 31, 2010, were as
princip follows:
le with Land (purchased in 2009) $120,000
retrosp Investment in nonconvertible bonds (purchased in
ective 2009, and expected to be held to maturity) 60,000
restate Longterm debt 80,000
ment.
The average Consumer Price Index was 100
b. An error
for 2009, and 110 for 2010. In a
correction supplementary constant dollar balance sheet
with (adjusted for changing prices) at December
restatement 31, 2010, these selected account balances
of the should be shown at
financial
Land Investment Longterm debt
statements
a. $120,000 $60,000 $88,000
of previous b. $120,000 $66,000 $88,000
periods. c. $132,000 $60,000 $80,000
c. A change in d. $132,000 $66,000 $80,000
accounting
estimate 79. The following items were among those that
reported on a appeared onRubi Co.’s books at the end of
prospective 2010:
basis. Merchandise inventory $600,000
d. An extraordinary Loans to employees 20,000
item on the current What amount should Rubi classify as
year’s income monetary assets in preparing constant dollar
statement. financial statements?
75. When measuring fair value, which
level has the highest priority for
valuation inputs?
a. Level 1.
b. Level 2.
c. Level 3.
d. Level 4.
76. Which of the following are
observable inputs used for fair value
measurements?
I. Bank prime rate.
II. Default rates on loans.
BI. Financial forecasts.
a. I only.
b. I and II only.
c. I and III only.
d. I, II and III.
77. A company that wishes to disclose
information about the effect of
changing prices should report this
information in
a. The body of the financial statements.
b. The notes to the financial statements.
c. Supplementary
80. In its financial statements, Hila Co. d. A purchasing power loss, if
discloses supplemental information on the the item is a monetary
effects of changing prices. Hila computed the liability.
increase in current cost of inventory as fol
83. The following information pertains to
lows:
each unit of merchandise purchased
Increase in current cost (nominal dollars) for resale by Vend Co.:
Increase in current cost (constant dollars)
March 1, 2010
What amount should Hila disclose as the Purchase price $ 8
inflation component of the increase in Selling price $12
current cost of inventories? Price level index 110
a. $ 3,000 December 31, 2010
b. $12,000 Replacement cost $10
c. $15,000 Selling price $15
Price level index 121
d. $27,000
Under current cost accounting, what is the
81. When computing purchasing power amount of Vend’s holding gain on each unit of
gain or loss on net monetary items, this merchandise?
which of the following accounts is a. $0
classified as nonmonetary? b. $0.80
a. Advances to unconsolidated c. $1.20
subsidiaries. d. $2.00
b. Allowance for uncollectible accounts.
c. Unamortized premium on bonds 84. Kerr Company purchased a machine
payable. for $115,000 on January 1, 2010, the
d. Accumulated depreciation of company’s first day of operations. At
equipment. the end of the year, the current cost
of the machine was $125,000. The
82. During a period of inflation in which a machine has no salvage value, a five
liability account balance remains year life, and is depreciated by the
constant, which of the following occurs? straightline method. For the year
a. A purchasing power gain, if the item is ended December 31, 2010, the
a nonmonetary liability. amount of the current cost
b. A purchasing power gain, if depreciation expense which would
the item is a monetary appear in supplementary current cost
liability. financial statements is
c. A purchasing power loss, if a. $14,000
the item is a nonmonetary b. $23,000
liability. c. $24,000
d. $25,000
purchas
ed less
85. At December 31, 2010, Jannis Corp. owned ending
two assetsas follows: inventor
Equipment Inventory y at
Current cost $100,000 $80,000 current
Recoverable amount $ 95,000 $90,000 cost.
Jannis voluntarily disclosed supplementary 88. Which of the following are examples
information about current cost at December
of concentrations that create
31, 2010. In such a disclosure, at what
vulnerabilities and therefore would
amount would Jannis report total assets?
require disclosure of risks and
a. $175,000
uncertainties?
b. $180,000
c. $185,000 I. Market in which an entity conducts its
d. $190,000 operations.
AI. Available sources of supply of materials used
86. Could current cost financial statements in operations of an entity.
report holdinggains for goods sold during the BI. Volume of business transacted with a certain
period and holding gains on inventory at the contributor.
end of the period? a. I and II.
Goods sold Inventory b. II and III.
a. Yes Yes c. I and III.
b. Yes No d. I, II, and III.
c. No Yes
d. No No 89. Which of the following is required
to be disclosed regarding the risks
87. Manhof Co. prepares supplementary and uncertainties that exist?
reports on income from continuing a. Factors causing an estimate to be
operations on a current cost basis. sensitive.
How should Manhof compute cost of b. The
goods sold on a current cost basis? potential
a. Number impact of
of units estimates
sold times
about
average
values of
current
assets and
cost of
units liabilities
during the when it is
year. reasonabl
b. Number y possible
of units that the
sold estimate
times will
current change in
cost of the near
units at future.
yearend. c. The
c. Number potential
of units impact
sold of
times estimate
current s about
cost of values of
units at
assets
the
beginning and
of the liabilitie
year. s when it
d. Beginni is
ng remotely
inventor possible
y at that the
current estimate
cost will
plus change
cost of in the
goods near
future.
d. A I. Basis of accounting used by an entity to
descri file its income tax return.
ption AI. Cash receipts and disbursements basis of
of the accounting.
operati a. I only.
ons b. II only.
both c. Both I and II.
within d. Neither I nor II.
and
outsid 91. Income tax basis financial statements
e of differ from those prepared under
the GAAP in that income tax basis
home financial statements
countr a. Do not
y. include
90. Which of the following accounting nontaxa
bases may be used to prepare financial ble
statements in conformity with a revenue
comprehensive basis of accounting s and
other than generally accepted nonde
accounting principles? ductible
expense
s in
determi
ning
income.
b.Include
detailed
informati
on about
current
and de
ferred
income
tax
liabilities.
c. Contain
no
disclosure
s about
capital
and
operating
lease
transactio
ns.
d. Recognize certain revenues and
expenses in different reporting
periods.
92. In financial statements prepared on
the income tax basis, how should the
nondeductible portion of expenses
such as meals and entertainment be
reported?
a. Included
in the
expense
category
in the
determina
tion of
income.
b. Include
d in a
separate
category
in the mod
determin ifica
ation of tion
income. s
c. Excluded from the determination of mus
income but included in the t be
determination of retained earnings. the
d. Excluded from the financial sam
statements. e as
thos
93. If a company uses the modified cash e
basis of accounting, the requ
modifications from the pure cash ired
basis should have substantial support. by
In this context substantial support re tax
quires law.
a. T c. The
h modificati
e ons must
fi be the
n same as
a GAAP
n and not
c illogical.
i d. No modifications are allowed.
a
l 94. Which of the following is false?
st a. Prospecti
a ve
t financial
e informati
m on may be
e prepared
n for
ts general or
h limited
a users.
v b. The responsible party is the only
e limited user.
o c. The
n financial
l projectio
y n may
m contain
i assumpti
n ons not
o necessari
r ly
m expected
o to occur.
d d. The
if financ
i ial
c projec
a tion
ti may
o be
n expres
s sed as
fr a
o range
m of
dollar
G s.
A
95. Prospective financial information is
A
P defined as
. a. Any
b. The financial
informati
on about
the past,
present,
or future.
b. Any
financial
informati
on about
the
present or
future.
c. Any
financial
informati
on about
the future
related to
the day
today
operation
s.
d. Any financial information about the
future.
96. To achieve a reasonably objective
basis, financial forecasts and
projections should be prepared
I. In accordance with GAAP.
AI. Using information that is in
accordance with the plans of
the entity.
III. With due professional care.
a. I and III. 103. Which financial statements should be presented for a
b. II and III. trust?
c. I, II, and III. I. Statement of assets and liabilities.
d. I and II. II. Statement of operations.
97. Which of the following disclosures should prospective III. Statement of cash flows.
financial statements include? IV. Statement of changes in net assets.
Summary of significant Summary of a. I only.
accounting policies significant assumptions b. I and II only.
a. Yes Yes c. I, II, and IV.
b. Yes No d. I, III and IV.
c. No Yes
d. No No 104. What is the basis of accounting and at what amount
are assets measured on the financial statements of a trust?
98. Which of the following is the SEC form used by issuer
Basis of accounting Measurement
companies to file as an annual report with the SEC?
a. Cash Cost
a. Form 10Q.
b. Cash Fair value
b. Form 8K. c. Accrual Cost
c. Form 10K. d. Accrual Fair value
d. Form S1.
preceding fiscal
99. Which of the following best describes years.
the content of the SEC Form 10Q? c. The end of the preceding fiscal year.
a. Quarterly audited financial d. The end of the
information and other preceding fiscal
information about the year and the end of
company. the prior two fiscal
b. Annual audited financial years.
information and non
financial information 102. A company is an accelerated filer that
about the company. is required to file Form 10K with the
c. Disclosure of material United States Securities and
events that affect the com Exchange Commission (SEC). What
pany. is the maximum number of days after
d. Quarterly reviewed financial the company’s fiscal yearend that
information and other the company has to file Form 10K
information about the with the SEC?
company. a. 60 days.
b. 75 days.
100. Which of the following is the SEC
c. 90 days.
form used by issuer companies to file
d. 120 days.
as a quarterly report with the SEC?
a. Form 10Q.
b. Form 8K.
c. Form 10K.
d. Form S1.
101. A company is required to file quarterly financial
statements with the United States Securities and
Exchange Commission on Form 10Q. The
company operates in an industry that is not
subject to seasonal fluctuations that could have a
significant impact on its financial condition. In
addition to the most recent quarterend, for
which of the following periods is the company
required to present balance sheets on Form 10
Q?
a. The end of the
corresponding
fiscal quarter of
the preceding
fiscal year.
b. The end of the
preceding fiscal
year and the end of
the corresponding
fiscal quarter of the
105. Galaxy Corporation prepares its financial c. Operating
statements in accordance with IFRS. Galaxy expenses,
intends to refinance a $10,000 note payable due nonoperating
on February 20, 2011. The company expects expenses, and
the note to be refinanced for a period of five extraordinary
years. Under what circumstances can Galaxy items.
report the note payable as a noncurrent liability d. Gross profit, operating profits, and
on its December 31, 2010 statement of financial net profits.
position?
107. Which of the following may not be
a. If Galaxy has the intent and
ability to refinance before disclosed on the income statement
December 31, 2010. for a company that prepares its
financial statements in accordance
b. If Galaxy has executed an
with IFRS?
agreement to refinance
before December 31, 2010. a. Gain or loss.
c. If Galaxy has executed an b. Tax expense.
agreement to refinance c. Gain or loss from extraordinary items.
prior to the issuance of the d. Gain or loss from discontinued
financial statements in operations.
March 2011. 108. Glenda Corporation prepares its financial
d. If Galaxy has the intent and statements in accordance with IFRS. Glenda
ability to refinance before must report finance costs on the statement of
the issuance of the financial cash flows
statements in March 2011. a. In operating activities.
106. Largo Corporation prepares its b. Either in
financial statements in accordance operating
with IFRS. Which of the following activities or
items is required disclosure on the financing activi
income statement? ties.
a. Revenues, cost of c. In financing activities.
goods sold, and d. In investing activities or financing
advertising ex activities.
pense. 109. Larimer Corporation prepares its
b. Finance costs, tax expense, and
financial statements in accordance with
income.
IFRS. Larimer acquired equipment by
issuing 5,000 shares of its
common stock. How should this
transaction be reported on the
statement of cash flows?
a. As an outflow
of cash from
investing
activities and
inflow of cash
from financing
activities.
b. As an inflow of
cash from
financing
activities and an
outflow of cash
from operating
activities.
c. At the bottom
of the statement
of cash flows as
a significant
noncash
transaction.
d. In the notes to
the financial
statements as
a significant
noncash
transaction.
110. For IFRS purposes, cash
advances and loans from
bank overdrafts should
be reported on the
statement of cash flows
as
a. Operating activities.
b. Investing activities.
c. Financing activities.
d. Other significant noncash activities.
111. Which of the
following are
acceptable methods
for reporting
comprehensive
income under IFRS?
I. One comprehensive income statement.
AI. Two statements: an
income statement
and a com
prehensive income
statement.
BI. In the statement of owner’s equity.
a. I only.
b. I and II only.
c. I, II, and III.
d. I and III only.
112. Which of the
following is true
about financial
statement
requirements
under IFRS?
a. Prior year
comparative
financial
statements
are required.
b. Income statements for three years are required.
c. Balance sheets for three years are required.
d. There are
no specific
requireme
nts
regarding
comparati
ve
financial
statements
.
113. Under IFRS,
operating expenses
on the income
statement may be
classified by
Nature Function
a. Yes Yes
b. Yes No
c. No Yes
d. No No
114. Under IFRS, the
statement of cash flows may
bepresented on the
Direct Basis Indirect Basis
a. Yes Yes
b. Yes No
c. No Yes
d. No No
SIMULATIONS
Concepts
Authoritative
Literature Help
Situation
Lim Corporation is preparing its financial statements and has given the project to its new entrylevel accountant, Sam.
Indicate whether each of the following statements made by Sam is True or False.
1. T
h
2. T
h
3. E
4. A

5. A

6. O
7. S
e
8. P
r
Financial Statement
Classification Authoritative
Literature Help
The outline presented below represents the various classifications suggested by the chief accountant for the balance
sheet.
Assets Liabilities Owner’s equity Other
A. Current G. Current J. Preferred stock N. Items excluded from the
B. Investments H. Longterm K. Common stock balance sheet
C. Plant and equipment I. Other liabilities L. Paidin capital excess of par X. Contra valuation account
D. Intangibles M. Retained earnings
E. Deferred charges
F. Other assets
Items 1 through 18 represent accounts of the Craven Corporation. Determine how each account would be classified
fromthe list above. If the account is a contra or valuation account, mark “X” before the letter. For example: “Allowance
for Doubtful Accounts” would be “X–A.” An answer may be selected once, more than once, or not at all.
Items to be answered
(AF) (G, H, I) (J, K, L, M) (N or X)
1. Dividend payable (on Craven’s preferred stock).
2. Plant construction in progress by the company.
3. Factory building (retired from use and held for sale).
4. Land (held for possible future building site).
5. Merchandise inventory (held by Craven
Corporation on consignment).
6. Stock dividend distributable (in common stock to
common stockholders and to be issued at par).
7. Office supplies inventory.

(AF) (G, H, I) (J, K, L, M) (N or X)
8. Sinking fund cash (First National Bank, Trustee).
9. Installment sales accounts receivable (average
collection period eighteen months). All sales are
installment sales.
10. Temporary decline in inventory value.
11. Advances to officers (indefinite repayment date).
12. Estimated warranty costs. The warranty costs are
for a oneyear warranty on parts and labor.
13. Inventory of small tools used in the business.
14. Treasury stock under par value method.
15. Common stock subscribed (Craven Corporation’s stock).
16. Convertible bonds.
17. Securities held as collateral.
18. Bank overdraft (only account with bank).
Balance Sheet
Authoritative
Literature Help
Situation
You have been asked to assist the chief accountant of the Stephen King Corporation in the preparation of a
balance sheet. Presented below is the balance sheet of Stephen King Corporation for the current year, 2011.
Stephen King Corporation
BALANCE SHEET
December 31, 2011
Current assets $ 435,000
Investments 640,000
Property, plant, and equipment 1,720,000
Intangible assets 305,000
$3,100,000
Current liabilities $ 330,000
Longterm liabilities 1,000,000
Stockholders’ equity 1,770,000
$3,100,000
Consider the following information:
1. The current assets section includes: cash $100,000, accounts receivable $170,000 less $10,000 for allowance
for doubtful accounts, inventories $180,000, and unearned revenue $5,000. The cash balance is composed of
$114,000, less a bank overdraft of $14,000. Inventories are stated on the lower of FIFO cost or market.
2. The investments section includes: the cash surrender value of a life insurance contract $40,000; investment in
common stock, shortterm (trading) $80,000 and longterm (availableforsale) $270,000; and bond sinking
fund $250,000. The cost and fair value of investments in common stock are the same.
3. Property, plant, and equipment includes: buildings $1,040,000 less accumulated depreciation $360,000;
equipment $450,000 less accumulated depreciation $180,000; land $500,000; and land held for future use
$270,000.
4. Intangible assets include: a franchise $165,000; goodwill $100,000; and discount on bonds payable $40,000.
5. Current liabilities include: accounts payable $90,000; notes payable—short term $80,000 and longterm
$120,000; and taxes payable $40,000.
6. Longterm liabilities are compose solely of 10% bonds payable due in 2020.
7. Stockholders’ equity has: preferred stock, no par value, authorized 200,000 shares, issued 70,000 shares for
$450,000; and common stock, $1.00 par value, authorized 400,000 shares, issued 100,000 shares at an average
price of $10. In addition, the corporation has retained earnings of $320,000.
8. The company’s management does not elect to use the fair value option for any of its financial assets or liabilities.
Complete the corrected balance sheet. To make it a more realistic exam experience use Excel.
A B C D E
1 Stephen King Corporation
2 Balance Sheet
3 December 31, 2011
4
5 Current assets:
6 Cash
7 Trading securities
8 Accounts receivable (net of $xxx allowance for doubtful accounts)
9 Inventories (lower of FIFO cost or market)
10
11 Total current assets
12
13 Investments:
14 Availableforsale securities
15 Bond sinking fund
16 Land held for future use
17 Cash surrender value of life insurance contract
18
19 Total investments
20
21 Property, plant, and equipment:
22 Land
23 Buildings (net of accumulated depreciation of $xxx)
24 Equipment (net of accumulated depreciation of $xxx)
25
26 Total property, plant, and equipment
27
28 Intangible assets:
29 Franchise
30 Goodwill
31
32 Total intangible assets
33 Total assets
34
35 Current liabilities:
36 Accounts payable
37 Notes payable
38 Taxes payable
39 Bank overdraft
40 Unearned revenue
41
42 Total current liabilities
43
44 Longterm liabilities:
45 Notes payable
46 Bonds payable, 10% due in 2020 (less discount of $xxx)
47
48 Total longterm liabilities
49 Total liabilities
50
51 Stockholders’ equity:
52 Paidin capital
53 Preferred stock, no par, authorized xxx shares, issued xxx shares
54 Common stock, $1.00 par value, authorized xxx shares, issued xxx shares
55 Paidin capital in excess of par value common
56
57 Total paidin capital
58
59 Retained earnings
60
61 Total stockholders’ equity
62 Total liabilities and stockholders’ equity
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Russell Corporation. The CFO of Russell is trying to determine
how to classify items within comprehensive income. Which section of the Professional Standards addresses the
issue of how to classify items in comprehensive income?
Journal
Entries
Authoritative
Literature Help
Situation
Hillside had the following selected account balances as of December 31, 2010.
Accounts receivable $250,000
Prepaid rent 168,000
Supplies 60,000
Inventory 420,000
Equipment (historical cost) 640,000
Salaries payable 15,000
Accumulated depreciation 174,000
The following information was received from Hillside’s accountant. Adjusting entries have not yet been made.
1. It is estimated that $16,000 of accounts will not be collectible. A provision for uncollectible accounts has
never been made by Hillside.
2. Supplies remaining at the end of the year were $37,000.
3. Equipment is depreciated over 20 years with a $60,000 salvage value.
4. Accrued salaries at 12/31/10 were $37,500.
5. The note receivable was signed by the customer on November 1, 2010. It is a 6month note with an interest
rate of 12%, with the principle and interest paid at maturity.
6. Rent was paid on August 1, 2010, for 24 months and recorded in a prepaid rent account.
7. Hillside does not elect to use the fair value option for any of its financial assets or liabilities.
Prepare the adjusting journal entries necessary for each item. If no entry is necessary, write “no entry.”
Calculations
Authoritative
Literature Help
Situation
Hillside had the following selected account balances as of December 31, 2010.
Accounts receivable $250,000
Prepaid rent 168,000
Supplies 60,000
Inventory 420,000
Equipment (historical cost) 640,000
The following information was received from Hillside’s accountant. Adjusting entries have not yet been made.
1. It is estimated that $16,000 of accounts will not be collectible. A provision for uncollectible accounts has
never been made by Hillside.
2. Supplies remaining at the end of the year were $37,000.
3. Equipment is depreciated over 20 years with a $60,000 salvage value.
4. Accrued salaries at 12/31/10 were $37,500.
5. The note receivable was signed by the customer on November 1, 2010. It is a 6month note with an interest rate of
12%, with the principle and interest paid at maturity.
6. Rent was paid on August 1, 2010, for 24 months and recorded in a prepaid rent account.
7. Hillside does not elect to use the fair value option for any of its financial assets or liabilities.
Determine the adjustments necessary for December 31, and indicate the adjusted balances of the selected accounts at
December 31, 2010.
Accounts receivable (net)
Notes receivable
Prepaid rent
Supplies
Inventory
Equipment
Accounts payable
Salaries payable
Disclosures Literature Help
Griffin Co. is in the process of preparing its financial statements for the year ended December 31, 2011.
Items 1 through 6 represent various transactions that occurred during 2011. The following two responses are required
foreach item:
Compute the amount of gain, loss, or adjustment to be reported in Griffin’s 2011 financial statements. Disregard
income taxes. On the CPA exam, a list of numeric answer choices would be provided to select from.
Select from the list below the financial statement category in which the gain, loss, or adjustment should be
presented. A category may be used once, more than once, or not at all.
Financial Statement Categories
A. Income from continuing operations.
B. Extraordinary item.
C. Cumulative effect of change in accounting principle.
D. Prior period adjustment to beginning retained earnings.
E. Separate component of other comprehensive income.
C
o
1. On June 30, 2011, after paying the
semiannual interest due and recording I
amortization of bond discount, Griffin n
redeemed its fifteenyear, 8%
$1,000,000 par bonds at 102. The bonds,
which had a carrying amount of
$940,000 on January 1, 2011, had
originally been issued to yield 10%.
Griffin uses the effective interest
method of amortization, and had paid
interest and recorded amortization on
June 30. Compute the amount of gain or
loss on redemption of the bonds and
select the proper financial statement
category.
2. As of January 1, 2011, Griffin
decided to change the method of
computing depreciation on its sole
piece of equipment from the sum
oftheyears’ digits method to the
straightline method. The
equipment, acquired in January
2008 for $520,000, had an
estimated life of five years and a
salvage value of $20,000.
(A) (B) (C) (D) (E)
A
m
4. In November 2011, Griffin
purchased two marketable
securities, I and II, which it
bought and held principally to
sell in the near term by February _
28, 2012. Relevant data is as _
follows:
Cost
I $125,000
II 235,000
Compute the amount of holding gain
or loss at December 31, 2011, and
select the proper financial statement
category, assuming Griffin classifies _
the securities as trading securities. _
5. During 2011, Griffin received
$1,000,000 from its insurance
company to cover losses suffered
during a hurricane. This was the
first hurricane ever to strike in _
Griffin’s area. The hurricane _
destroyed a warehouse with a
carrying amount of $470,000,
containing equipment with a
carrying amount of $250,000,
and inventory with a carrying
amount of $535,000 and a fair
value of $600,000. Compute the
amount of gain or loss from the
financial statement category.
6. At December 31, 2011, Griffin
prepared the following worksheet
summarizing the translation of its
wholly owned foreign subsidiary’s
financial statements into dollars. Griffin
purchased the foreign subsidiary for
$324,000 on January 2, 2011. On that
date, the carrying amounts of the
subsidiary’s assets and liabilities
equaled their fair values.
currency amounts
Net assets January 2, 2011
(date of purchase) 720,000
Net income, 2011 250,000
Net assets at December 31, 2011 970,000
Net assets at December 31, 2011 970,000
Compute the amount of the foreign currency translation adjustment and
select the proper financial statements category.
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Jane Corporation. Jane has committed itself to a formal plan for sale of a
business component that meets the requirements for presentation as discontinued operations. Which section of the
Professional Standards addresses the issue of how to account for the costs that will be incurred to relocate employees of the
discontinued component?
Classifications
Authoritative
Literature Help
The illustrations below represent accounting transactions that affect the recognition of income for an accounting
period. Their classification is the subject of this objective format matching question.
For each of the ten illustrations below, select the best classification from those listed A–I below. A classification may
be used once, more than once, or not at all.
Classification
A. Change in reporting entity F. Discontinued Operations—Gain or loss from dis
B. Correction of an error continued operations
C. Change in accounting principle G. Not an accounting change
D. Change in estimate H. Part of net income before extraordinary items
E. Extraordinary item I. Discontinued Operations—Gain or loss on disposal
(A) (B) (C) (D) (E) (F) (G) (H)

(I)
1. Newly acquired assets are depreciated using the sum-of-the-
years’ digits method, previously recorded assets are depreciated
using the straight-line method.
2. Accounting for acquisition of a 100% owned subsidiary.
3. Reported as a restatement of all periods presented.
4. Write-down of inventory due to obsolescence.
5. Gains or losses on the disposal of the net assets of a
component are included in this calculation.
6. Changing from the gross profit method for
determining year-end inventory balances to dollar
value LIFO.
7. Accounting for existing construction contracts is
changed from completed contract to percentage-of-
completion.
8. The effects of a change in estimate and a change in
principle are inseparable for the same event.
9. The excess of cash paid over the carrying value to extinguish bonds.
10. Income or loss of the component for the period of disposal included in this
calculation.
Multistep Income
Statement Authoritative
Literature Help
Situation
Presented below is information related to American Horse Company for 2010.
Retained earnings balance, January 1, 2010 $ 980,000
Sales for the year 25,000,000
Cost of goods sold 17,000,000
Interest revenue 70,000
Selling and administrative expenses 4,700,000
Writeoff of goodwill (not tax deductible) 820,000
Income taxes for 2010 905,000
Gain on the sale of investments (normal recurring) 110,000
Loss due to flood damage—extraordinary item (net of tax) 390,000
Loss on the disposition of the wholesale division 615,000
Loss on operations of the wholesale division 200,000
Income tax benefit from discontinued wholesale division 285,000
Dividends declared on common stock 250,000
Dividends declared on preferred stock 70,000
American Horse Company decided to discontinue its entire wholesale operations and to retain its
manufacturing operations. On September 15, American Horse sold the wholesale operations to Rogers
Company. During 2010, there were 300,000 shares of common stock outstanding all year.
Prepare a multistep income statement.
American Horse Company
INCOME STATEMENT
Sales $25,000,000
Net income
Earnings per share
Net income
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Clark Corporation. Clark has incurred a
significant loss that may meet the definition of an extraordinary item. Which section of the
Professional Standards provides guidance on the definition of an extraordinary item?
Financial Statement Authoritative
Classification Literature Help
Select from the list of financial statement categories below the category in which the item should be
presented. A financial statement category may be selected once, more than once, or not at all. Assume
management does not elect to use the fair value option for any financial assets or liabilities.
Financial Statement Categories
A. Income from continuing operations, with no separate disclosure.
B. Income from continuing operations, with separate disclosure (either on the face of statement or
in the notes).
C. Other comprehensive income for the period.
D. Extraordinary items.
E. Separate component of stockholders’ equity.
F. None of the above categories include this item.
I
I
t
1. A
n
2. T
h
3. I
n
4. A

5. A

6. A
7. T

h
8. T
h
Calculate Net Income and Authoritative
Earnings Per Share Literature Help
Situation
Rap Corp. has 100,000 shares of common stock outstanding. In 2010, the company reports income
from continuing operations before taxes of $1,210,000.
Additional transactions not considered in the $1,210,000 are as follows:
1. In 2010, Rap Corp. sold equipment for $40,000. The machine had originally cost $80,000
and had accumulated depreciation of $36,000. The gain or loss is considered ordinary.
2. The company discontinued operations of one of its subsidiaries during the current year at a
loss of $190,000 before taxes. Assume that this transaction meets the criteria for
discontinued operations. The loss of operations of the discontinued subsidiary was $90,000
before taxes; the loss from disposal of the subsidiary was $100,000 before taxes.
3. In 2010, the company reviewed its accounts receivable and determined that $26,000 of
accounts receivable that had been carried for years appeared unlikely to be collected.
4. An internal audit discovered that amortization of intangible assets was understated by
$35,000 (net of tax) in a prior period. The amount was charged against retained earnings.
5. The company sold its only investment in common stock during the year at a gain of
$145,000. The gain is taxed at a total effective rate of 40%. Assume that the transaction
meets the requirements of an extraordinary item.
Complete the table below for the calculation of net income and earnings per share. Assume the
income tax rate is 38% for income from continuing operations.
Rap Corp.
INCOME STATEMENT
Income from continuing operations before income tax
Income tax
Income from continuing operations
Discontinued operations:
Income before extraordinary item
Extraordinary item:
Net income
Per share of common stock:
Income from continuing operations
Discontinued operations, net of tax
Income before extraordinary item
Extraordinary item, net of tax
Net income
1. d __ __ 21. c __ __ 41. d __ __ 61. c __ __ 81. d __ __ 101. c __ __

2. a __ __ 22. c __ __ 42. b __ __ 62. c __ __ 82. b __ __ 102. b __ __
3. a __ __ 23. c __ __ 43. d __ __ 63. a __ __ 83. d __ __ 103. c __ __
4. a __ __ 24. b __ __ 44. d __ __ 64. d __ __ 84. c __ __ 104. d __ __
5. a __ __ 25. b __ __ 45. c __ __ 65. b __ __ 85. a __ __ 105. b __ __
6. d __ __ 26. a __ __ 46. d __ __ 66. a __ __ 86. a __ __ 106. b __ __
7. a __ __ 27. d __ __ 47. b __ __ 67. d __ __ 87. a __ __ 107. c __ __
8. a __ __ 28. d __ __ 48. a __ __ 68. c __ __ 88. d __ __ 108. b __ __
9. b __ __ 29. c __ __ 49. c __ __ 69. d __ __ 89. b __ __ 109. d __ __
10. a __ __ 30. b __ __ 50. a __ __ 70. a __ __ 90. c __ __ 110. a __ __
11. a __ __ 31. a __ __ 51. b __ __ 71. b __ __ 91. d __ __ 111. b __ __
12. c __ __ 32. c __ __ 52. a __ __ 72. a __ __ 92. a __ __ 112. a __ __
13. c __ __ 33. b __ __ 53. a __ __ 73. b __ __ 93. c __ __ 113. a __ __
14. d __ __ 34. d __ __ 54. c __ __ 74. c __ __ 94. b __ __ 114. a __ __
15. b __ __ 35. c __ __ 55. c __ __ 75. a __ __ 95. d __ __
16. d __ __ 36. d __ __ 56. d __ __ 76. b __ __ 96. c __ __
17. a __ __ 37. b __ __ 57. b __ __ 77. c __ __ 97. a __ __
18. b __ __ 38. d __ __ 58. c __ __ 78. c __ __ 98. c __ __
19. b __ __ 39. b __ __ 59. a __ __ 79. b __ __ 99. d __ __ 1st: __/114 = __%
20. d __ __ 40. a __ __ 60. a __ __ 80. a __ __ 100. a __ __ 2nd: __/114 = __%
$54,000) must also be deducted ($180,000 –
D.1. Income and Retained Earnings $54,000 = $126,000).
Statements
1. (d) Baer Food’s 2010 revenues should
include net sales revenue ($187,000),
interest revenue ($10,200), and gain on
sale of equipment ($4,700), for a total
of $201,900. Discontinued operations
(loss of $12,400) and the extraordi
nary gain ($1,500) are both special
items that should be reported as
separate components of income, after
incomefrom continuing operations.
Therefore, these items should not be
included in the revenues section of the
income statement (which is placed
before income from continuing op
erations).
2. (a) To directly compute cost of goods
manufactured (CGM), the formula is
Beginning work in process
+ Direct materials used
+ Direct labor
+ Factory overhead
– Ending work
in processCost
of goods
manufactured
However, none of these elements are given in
this problem, so CGM must be computed
indirectly, using the cost of sales formula
Beginning finished goods $400,000
+ Cost of goods manufactured + CGM
– Ending finished goods –360,000
Cost of sales $240,000
Solving for the missing amount, CGM is
$200,000.
3. (a) All of the revenues, gains, expenses, and
lossesgiven in this problem are components of
income from continuing operations. Income
before income taxes is $180,000, as computed
below.
Revenues ($575,000 + $25,000) $600,000
Expenses and losses ($240,000 + $70,000 + $10,000
+ $50,000 + $15,000 + $15,000 + $20,000)
Income before income taxes $
To compute income from continuing operations
(after taxes), income taxes ($180,000 × 30% =
4. (a) The requirement is to compute the amount of Griff should include the following costs in
expenses to be included in selling expenses for G&A expense:
2010. Advertising ($150,000) and sales salaries Accounting and legal fees $ 25,000
and commissions ($140,000) are clearly selling Officers’ salaries 150,000
expenses, as is the rent for the office space Insurance 85,000
occupied by the sales department ($220,000 × G&A expense $260,000
1/2 = $110,000). Additionally, freightout Freightin ($175,000) is an inventoriable cost
($80,000) is a selling expense because shipping which should be reflected in cost of goods sold
the goods from the point of sale to the customer and ending inventory. Freightout, the cost of
is the final effort in the selling process. The delivering goods to customers ($160,000), is
total selling expense is, therefore, $480,000 included in selling expenses. Sales represen
($150,000 + $140,000 + $110,000 + $80,000). tatives salaries ($215,000) is also a selling
The remaining expenses given are general and expense.
administrative expenses, except for interest and
6. (d) Interest expense is generally considered
the loss on sale of longterm investment, which
are nonoperating items (other expenses and to be anonoperating item and is therefore
losses). included in other expenses and losses.
Operating expenses are usually dividedinto two
5. (a) Operating expenses are usually divided into categories, selling expenses and general and
two categories, selling expenses and general administrative expenses. Since advertising
and administrative (G&A) expenses. Selling expense is directly related to the sale of the
expenses are related to thesale of a company’s company’s products, it is included in selling
products, while G&A expenses are related to expenses. Therefore, neither of the expenses
the company’s general operations. Therefore, given are general and administrative expenses.
inventory loss are not extraordinary
because they are not unusual in nature.
7. (a) Charitable contributions expense
should include all expenses incurred in 11. (a) Extraordinary items are material
2010 by Yew Co. which involve gains or losses which are both
charitable contributions to other unusual in nature and infrequent in
entities. The total charitable occurrence. Foreign currency losses
contributions expense is $310,000, ($1,200,000) and losses due to
consisting of the $250,000 donated to discontinued operations ($500,000)
youth and educational programs and are not considered to be unusual in
the $60,000 ($140,000 – $80,000) nature and thus are not extraordinary.
donated to health and human service Items that may qualify as
organizations. The other $80,000 was extraordinary include some
given to these organizations by the casualties, expropriations,
employees, with the company merely prohibitions under a new law, and
acting as an agent collecting that extinguishment of debt. Midway’s
amount through payroll deductions casualty loss appears to be
and forwarding it on to the extraordinary because the hurricane
organizations. The expenditure for was the first ever to strike in
redesigning product packaging Midway’s area. The net pretax loss
($100,000) would be properly was $100,000 [$800,000 equipment
classified as research and development loss – $700,000 building gain
expense. ($1,000,000 – $300,000)].
12. (c) A gain (loss) must be recognized
8. (a) Extraordinary items are material gains or
when a nonmonetary asset is
losses which are both unusual in nature and
involuntarily converted into
infrequent in occurrence. For Raim Co., which
monetary assets even if the company
sustains flood losses every two to three years, reinvests the monetary assets in
the 2010 flood loss is not infrequent, and should replacement nonmonetary assets.
be recognized as a component of income from The gain or loss is the difference
continuing operations. For Cane Co., the 2010 between the insurance proceeds
flood loss is both unusual and infrequent, so it ($1,100,000 re
should be recognized as an extraordinary item.
9. (b) Extraordinary items are material
items which are both unusual in
nature and infrequent in occurrence.
Theeffect of a strike ($175,000) and a
gain or loss from sale or
abandonment of equipment ($125,000) is not
considered extraordinary. The loss from the
earthquake would be considered unusual and
infrequent. Therefore the $150,000 loss is
extraordinary, and the total amount of
infrequent losses not considered extraordinary
is $300,000 ($175,000 +$125,000).
10. (a) Extraordinary items are material
items which are both unusual in
nature and infrequent in occurrence.
Disposals of plant assets, foreign
currency losses, and inventory losses
are not considered to be unusual in
nature, and thus are not extraordinary.
Items that may qualify as extraordi
nary items include some casualties,
expropriations, and prohibitions under
a new law. In Kent Co.’s 2010 income
statement, losses not considered
extraordinary amount to $610,000. The
factory disposal ($300,000) is
classified as discontinued operations
because the operations carried on there
are dissimilar from operations carried
on at the other factories. The $120,000
foreign currency loss and $190,000
should not be reported in the income
placement cost – $50,000 deductible = statement at all. An unrealized loss on
$1,050,000) and the carrying amount of the noncurrent investments in stock
assets destroyed or used up as a result of the ($5,400) is reported in other
casualty loss. The warehouse (carrying amount comprehensive income, not in net
of $300,000) was destroyed, and cash of income. A correction of an error
$20,000 was used to cover removal costs. ($7,500) is treated as a prior period
Therefore, the gain is $730,000 [$1,050,000 – adjustment. It is reported in the
($300,000 + $20,000)]. It is not an extraordi financial statements as an adjustment
nary item because storms similar to the one that to the beginning balance of retained
destroyed the warehouse occur frequently (every earnings, rather than in the income
four years). statement. Since both of these items
were subtracted in the computation of
13. (c) In this situation, the provision for income reported net income, they must be
tax(income tax expense) will be the amount of added back to compute the correct net
the tax liability to the government determined income of $87,000 ($74,100 + $5,400
without including the extraordinary loss. This + $7,500).
amount is determined by applying the 40% tax
rate to pretax accounting income before 15. (b) In 2010, Brecon Co. would report
extraordinary items adjusted for any permanent one fifth of the cabinet costs as
differences. Accounting income before taxes is depreciation expense in selling,
$900,000, but that amount includes a gain on general, and administrative expenses.
life insurance coverage ($100,000). A gain on Four fifths of the cabinet cost would
life insurance coverage is a permanent remain capitalized as fixed assets at
difference because it is included in accounting the end of 2010. The cabinets are
income but will never be included in taxable considered fixed assets and not a part
income. Therefore, the amount of accounting of cost of goods sold.
income which will be subject to taxes is
16. (d) A material gain or loss that is
$800,000 ($900,000 – $100,000), and the
provision for income taxes is $320,000 unusual in nature or infrequent in
($800,000 × 40%). The tax savings from the occurrence, but not both, should be
extraordinary loss ($300,000 × 40% = presented as a separate component of
$120,000) will not affect the provision for income or loss from continuing
income taxes because the extraordinary item operations. Both discontinued
must be reported together with its tax effect operations and ex
(extraordinary loss of $180,000; net of tax). traordinary items are reported separately after
income from continuing operations.
14. (d) Net income as reported ($74,100)
properly included the gain on early 17. (a) For an item to qualify as an
retirement of bonds payable ($22,000) extraordinary item itmust be both unusual in
and the loss from fire ($14,000). The nature and infrequent in occurrence. The above
fact that the gain and loss were criteria must take into account the environment
reported net of taxes in the income in which the entity operates. An entity with
statement was incorrect, but does not sales in different countries will experience
cause the net income amount to be in foreign currency revaluations on a regular
error. However, the other two items basis, so a currency revaluation would not be
infrequent in occurrence and it is not an ex
component, so it is part of
discontinued operations, not con
traordinary item. Gains from increases in tinuing operations. It is combined with
contract prices are neither infrequent nor the loss from disposal on the income
unusual, so they cannot qualify as extraordinary statement. Discontinued operations is
items. a category distinct from
18. (b) Extraordinary items are reported extraordinary items.
net of incometaxes as a separate 26. (a) Management is not required to
component of income after have entered into a sales agreement. It
discontinuedoperations. is sufficient if management is com
19. (b) Extraordinary items are events and mitted to a disposal plan that is
transactions that are distinguished by reasonable. The other items are all
both their unusual nature and the required for presentation as
infrequency of their occurrence. discontinued operations.
Losses from hail damage are both 27. (d) In discontinued operations,
common and frequent for Toncan. presentation of the income or loss
Estimates of the losses would not be from operations of the component and
presented in the financial statements. the gain or loss on disposal is
No amount is recorded until a loss required. Since the company met the
actually occurs. requirements for “held for sale” status
in 2010, the subsidiary should be
D.2. Unusual or Infrequent Items written down to its fair value less cost
20. (d) A transaction that is unusual in nature and to sell. This would result in a loss of
infrequent in occurrence is considered an $1,500,000 ($8,000,000 carrying
extraordinary item. An extraordinary item is
amount – $6,500,000 fair value).
Therefore, the loss from discontinued
reported after discontinued operations.
operations would be $3,500,000
21. (c) Extraordinary items are events and ($2,000,000 loss from operations +
transactions that are distinguished by $1,500,000 loss on planned disposal).
both their unusual nature and the
infrequency of their occurrence.
Teller Co.’s loss arising from its first
antitrust action meets both of these
criteria (particularly since they
pleaded guilty) and should therefore
be reported as an extraordinary item.
The strike against Teller’s major
supplier, however, should not be
reported as an extraordinary item
because it is usual in nature but may
be expected to recur as a consequence
of customary and continuing business
activities.
22. (c) Extraordinary items are material items which
are both unusual in nature and infrequent in
occurrence.Therefore, the loss on sale of a bond
investment is not extraordinary. Neither item is
treated as extraordinary.
23. (c) Corrections of errors shall continue
to be reported net of tax in retained
earnings as an adjustment of the
beginning balance.
24. (b) Costs of exit activities (including
restructuring charges) should be
measured and recognized at fair
value when they are incurred.
D.3. Discontinued Operations
25. (b) The operating loss of $300,000
($500,000 revenues less $800,000
expenses) relates to a discontinued
displayed.
28. (d) The loss from discontinued
34. (d) Once unrealized items recorded
operations would equal the loss from
operations plus the estimated loss and reported in the current or prior
from disposal of the component. period are recognized as realized and
reported in net income, it is necessary
29. (c) Costs of termination benefits, lease to reverse them out of other
termination, and consolidating facilities comprehensive income. The
or relocating employees related to a reclassification adjustment is to avoid
disposal activity that involves double counting. The reclassification
discontinued operations should be adjustment in this situation is $15,000
included in the results of discontinued ($25,000 gain on AFS securities, net
operations. of $10,000 tax).
30. (b) The requirement is to determine 35. (c) The FASB allows three

how a discontinued component’s presentation formats [answer
operating losses for the current choices (a), (b), and (d)] with a
period should be classified in the preference for the first two
financial statements. The “income alternatives.
(loss) from operations” is combined 36. (d) The accumulated balance of other
with the loss on disposal. comprehensive income should be
31. (a) Gains or losses from the reported as a component of equity,
operation of a discontinued business separate from retained earnings and
component realized for the period are additional paidin capital.
combined with the loss of disposal 37. (b) Comprehensive income is defined
to determine the loss from as the change in equity of a business
discontinued operations. during a period from transactions of
32. (c) Discontinued operations should nonowner sources. Stockholders are
include the gain or loss on disposal owners of the corporation or entity,
plus the results of operations during therefore, transactions between the
the period. entity and shareholder are not a
component of comprehensive income.
D.4. Comprehensive Income
38. (d) Assuming the fair value option is not
33. (b) The purpose of reporting elected, the calculation of holding gains
comprehensive income is to report a recognized in other comprehensive income is
measure of overall enterprise as follows:
performance by displaying all changes Before tax Income tax Net of tax
in equity of an enterprise that result Year ended 12/31/09 $5,000 $1,500 $3,500
from recognized transactions and other Year ended 12/31/10 2,500 750 1,750
economic events of the period other Total gain $7,500 $2,250 $5,250
than transactions with owners in their The reclassification adjustment should be
capacity as owners. An enterprise shown net of tax, so ($5,250) is the adjustment
should continue to display an amount amount. $5,250 had been previously added to
for net income with equal prominence other comprehensive income when the gains
to the comprehensive income amount occurred. The $5,250 needs to be taken out in
order to
as part of other comprehensive
income. Answers (a) and (b) are
avoid counting the gains twice. The incorrect because an adjustment to
securities have been sold so the gains are pension liability to record the funded
now realized and will be part of net income. status of the plan, and subsequent
decreases of the fair value of
39. (b) The gain for the period is 10
availableforsale securities that have
shares times theincrease in fair been previously written down as im
value, which is $250. This gain of paired are included in other
$2,500 must be shown net of tax, so comprehensive income. Answer (d)
the holding gain is $1,750. is incorrect because decreases in the
40. (a) Comprehensive income is computed fair value of heldtomaturity
as follows: securities are not part of other
comprehensive income.
Net income
Other comprehensive income net of tax: 46. (d) Comprehensive income (net income plus
Unrealized gain on securities 15,000
Less: Reclassification adjustment (2,500) 12,500
other comprehensive income) should be
Pension liability adjustment (3,000 displayed in a financial statement that has the
Other comprehensive income same prominence as other financial statements.
Comprehensive income Answer (a) is incorrect because the FASB pre
Notice that stock warrants outstanding are fers that comprehensive income be displayed
not included as part of comprehensive either at the bottom of the income statement,
income. continuing from net income to arrive at a
comprehensive income figure (equals net in
41. (d) If $2,450 (net of tax) is being come plus other comprehensive income), or in a
deducted from other comprehensive separate statement of comprehensive income.
income as a reclassification adjust Answer (b) is incorrect
ment, $2,450 must be the amount of
unrealized gains (net of tax) that have
been recognized in other
comprehensive income. The realized
gains will then be recognized in
income from continuing operations
before tax. The gains before tax
effects are $3,500 ($2,450 ÷ 70%).
42. (b) Comprehensive income disclosures include
the changes during a period of the following
components of other comprehensive income:
unrealized gains and losses on availableforsale
investments and foreign currency items,
including any reclassification adjustments, and
the pension liability adjustment required to
recognize the funded status of the plan. Treasury
stock is deducted from stockholders’ equity and
not a component of other comprehensive
income.
43. (d) Separate EPS calculations are
not required for other
comprehensive income or
44. (d) The FASB prefers that
comprehensive income be shown at
the bottom of the income statement as
a continuation of net income or in a
separate statement beginning with net
income. Presenting comprehensive
income in the statement of changes in
stockholders’ equity is not a method
that is preferred by the FASB.
45. (c) If the fair value option is not
elected, heldtomaturity securities
are reported at amortized cost. Any
decreases or increases in fair value
are reported neither in net income nor
of billings on longterm contracts
because components of other comprehensive ($1,600,000) and prepaid taxes
income may be displayed net of related tax ($450,000). However, income tax
effects or before related tax effects with one expense has not yet been recorded.
amount shown for the aggregate income tax Earnings ($6,680,000) less costs and ex
effect. Answer (c) is incorrect because penses ($5,180,000) result in pretax
comprehensive income can be displayed in the income of $1,500,000. Since the tax rate
two methods preferred by the FASB (mentioned is 30%, tax expense is $450,000 (30% ×
above) or in the statement of changes in $1,500,000). Therefore, an adjustment is
stockholders’ equity.
necessary to debit income tax expense
D.5. Balance Sheets and credit prepaid taxes for
$450,000.Total current assets, after this
47. (b) Total retained earnings includes both adjustment, are $5,700,000.
unappropriated retained earnings and restricted
Cash $ 600,000
retained earnings. Therefore, before closing
Accounts receivable 3,500,000
entries, total retained earnings is $1,060,000 Cost in excess of billings 1,600,000
($900,000 + $160,000). Before computing 2010 $5,700,000
net income, tax expense must be recorded.
Earnings ($6,680,000) less costs and expenses 50. (a) Mirr began operations on 1/1/10 with
($5,180,000) result in pretax income of the following balance sheet elements:
$1,500,000. Since the tax rate is 30%, tax Assets = Liabilities + Owners’ equity
expense is $450,000 (30% × $1,500,000). $860,000 = $110,000 + $750,000
Therefore, an adjustment is necessary to debit During 2010, liabilities increased to $120,000, and
income tax expense and credit prepaid taxes owners’ equity increased to $765,000 [$750,000
for $450,000. After the adjustment, net income beginning balance + $18,000 net income ($82,000
is $1,050,000 ($6,680,000 – $5,180,000 – revenues – $64,000 expenses)
$450,000). After closing entries, total retained – $3,000 dividends declared]. Therefore,
earnings is $2,110,000 ($1,060,000 + 12/31/10 assets must be $885,000.
$1,050,000).
Assets = Liabilities + Owners’ equity
48. (a) The only liabilities included in the Assets = $120,000 + $765,000
Assets = $885,000
trial balance are billings in excess of
costs on longterm contracts 51. (b) The requirement is to determine the net
($700,000) and note payable incomefor 2010 by analyzing changes in the
noncurrent ($1,620,000). Only the note balance sheet. Recall the accounting equation:
is noncurrent. Billings in excess of Assets – Liabilities = Stockholders’ equity. By
costs on longterm contracts is similar inserting the changes given into this formula, we
to unearned revenue and is always find an increase of $62,000 exists in the entire
reported as a current liability. stockholders’ equity section ($89,000 – $27,000 =
49. (c) Current assets listed in the trial $62,000). Stockholders’ equity is composed of
balance are cash ($600,000), accounts capital stock, additional paidin capital and
receivable ($3,500,000), cost in excess retained earnings. Because increases in
business, however, are specifically
excluded from this disclosure
the other two balances are given that total requirement. Therefore, only the
$66,000 ($60,000 + $6,000), the retained $250,000 sale to affiliated enterprises
earnings balance must have decreased by must be disclosed.
$4,000 ($66,000 – $62,000). When dividends
are paid, this reduces retained earnings, while 55. (c) Disclosure of material transactions
Vel Corp. net income increases the balance of between related parties is required
retained earnings. For the equation to balance, except for (1) compensation
the changes in retained earnings account must agreements, expense allowances, and
reduce total stockholders’ equity by $4,000. other similar items in the ordinary
Therefore, if $13,000 in dividends are paid, course of business, and (2)
which reduce retained earnings, and total transactions which are eliminated in
retained earnings are to be reduced by $4,000, the preparation of consolidated or
then net income, which increases retained combined financial statements. The
earnings, must be $9,000. This creates the officers’ salaries and officers’
$4,000 difference needed to make the equation expenses fall into category (1), while
balance ($89,000 – $27,000 = $66,000 – the intercompany sales fall into
$4,000). The following shows the analysis of the category (2). Therefore, only the loans
retained earnings account: to officers ($125,000 + $50,000 =
Retained earnings (beg.) $ xxx $175,000) are reported as relatedparty
Net income (plug) 9,000 disclosures.
Dividends ( 13,000)
Retained earnings (decrease) ($ 4,000) 56. (d) Disclosure of material transactions
between related parties is required
52. (a) Idle machinery ($11,200) and except for (1) compensation
cash surrender value of life insurance agreements, expense allowances, and
($13,700) are both assets. The al other similar items in the ordinary
lowance for decline in market value course of business and (2) transactions
of noncurrent marketable equity
elimi
securities ($8,400) is a contra asset
that is properly included in the asset
section of the balance sheet (as a
deduction). The only item listed
which should not be included in the
asset section of the balance sheet is
the treasury stock ($24,000).
Although the treasury stock account
has a debit balance, it is not an asset;
instead, it is reported as a contra
equity account. Therefore, the
$24,000 must be excluded from the
asset section, reducing the net asset
amount to $851,000 ($875,000 –
$24,000).
53. (a) Although the statement of cash
flows provides information about
liquidity, solvency, and financial
flexibility, a potential investor would
primarily use the balance sheet to
assess liquidity and financial
flexibility. The balance sheet helps
users analyze the company’s ability to
use current assets to pay current
liabilities (liquidity) and the
company’s ability to alter the amounts
and timing of future cash flows to
adapt to unexpected needs or to take
advantage of opportunities
(flexibility).
D.6.a. Disclosures
54. (c) Financial statements must include
disclosures of material transactions
between related parties. Compensation
arrangements in the ordinary course of
ments should be properly presented in
nated in the preparation of consolidated or accordance with GAAP; thus no
combined financial statements. improper presentation should exist. An
swer (c) is incorrect because the totals
57. (b) Disclosure of any material of the financial statements should
relatedpartytransactions is required include all items; thus, no items would
except be excluded. Answer (d) is incorrect
1. Compensation agreements, expense because management’s responses to the
allowances, and similar items in auditor’s comments would be contained
the ordinary course of business. in the management letter, which is a
2. Transactions that are eliminated in separate report typically presented to
the preparation of consolidated or the audit committee or the board of
combined financial statements. directors.
Since sales of inventory between subsidiary and
D.6.b. Accounting Policies
parent are eliminated in preparing consolidated
financial statements, such sales need not be 60. (a) The requirement is to determine
disclosed as a relatedparty transaction. which information should be
Nonmonetary exchanges by affiliates are not included in the summary of
specifically exempted from disclosure, and significant accounting policies.
therefore must be disclosed as relatedparty Disclosure of accounting policies
transactions. Compensation arrangements, should identify and describe the
expense allowances, and similar items in the accounting principles followed by the
ordinary course of business need not be disclosed reporting entity and methods of
as relatedparty transactions. However, in this applying those principles. Answer (a)
case the allowances are in excess of normal is correct because the method of
business practice and therefore must be disclosed. recording and depreciating assets is
Surety and guaranty agreements between related an example of such a required
parties are not specifically exempted from disclosure. Answers (b) and (c) are
disclosure and therefore must be disclosed as incorrect because both represent detail
relatedparty transactions. presented elsewhere in the financial
statements. Answer (d) is incorrect
58. (c) Disclosures of material transactions because it is an estimate of earnings
shall include rather than an accounting policy.
(1) nature of relationship(s), (2) description of
61. (c) Disclosure of accounting policies
transaction(s), including those assigned zero or
nominal amounts, (3) dollar amounts of should identify and describe the
transactions for each income statement period accounting principles followed by
and effect of any change in method of the reporting entity and methods of
establishing terms, and (4) amounts due to/from applying those principles. The
related parties, including terms and manner of criteria for determining which
settlement. investments are treated as cash
equivalents is an example of how the
59. (a) The users of the information are the entity applies accounting principles.
focus of financial reporting. GAAP These disclosures should not dupli
requires disclosures in the notes to cate details presented elsewhere as
facilitate the users’ understanding of the part of the financial statements.
financial statements. Answer (b) is Answers (a), (b), and (d) are not
incorrect because the financial state disclosures of
because they do not meet the
definition of principal market. Answer
accounting policies, and also would be (d) is incorrect because it describes the
presented elsewhere in the financial statements. most advantageous market.
62. (c) This is a recognized subsequent 67. (d) If location is an attribute of the asset, the
event in thefinancial statement price inthe principal market should be adjusted
because Swift records an estimate for for costs to transport the asset to its principal or
warranty liability. Prior to issuing the most advantageous market. Answers (a) and (b)
financial statements, Swift must make are incorrect because prices are not adjusted for
an adjustment for warranty liability transaction costs such as selling costs. Answer
for the product recall. Therefore, (c) is incorrect because fair values are not based
warranty liability should be $68,000 upon entry prices to the market.
on the 2010 balance sheet.
68. (c) Market participants are buyers and
63. (a) This is an unrecognized sellers in theprincipal market or most
subsequent event thatdid not exist as advantageous market for the asset or
of the balance sheet date of December liability. Market participants should be
31, 2010. Therefore, there should be independent, knowledgeable, able to
no adjustment of the 2010 financial transact for the asset, and willing to
statements. However, since the transact (i.e., motivated but not
inventory loss is material in amount compelled to do so). Answer (a) is
and the loss is uninsured, to prevent incorrect because market participants
the financial statements from being should not be compelled to sell.
misleading, Colter should disclose the Answer (b) is incorrect because it is
loss in a footnote to the 2010 financial not an independent, unrelated party.
statements. Answer (d) is incorrect
64. (d) A loss for a recognized subsequent event
shouldbe reported in the current year financial
statements. Therefore, answer (d) is correct.
Answer (a) is incorrect because a loss would not
be recognized in the current year for an
unrecognized subsequent event. However, a
footnote disclosure would be required for the
unrecognized subsequent event if the event is
material and the financial statements would be
misleading if the event were not disclosed. An
swer (b) is incorrect because gains are not
recognized until realized. Answer (c) is
incorrect because recognized subsequent events
result in a loss recognized in the current year
and a corresponding adjustment to record the
liability.
D.6.d. Fair Value Measurements
65. (b) The definition of fair value is the
price thatwould be received to sell an
asset in an orderly transaction between
market participants at the
measurement date. Answer (a) is
incorrect because it is an entry price,
not an exit price. Answer (c) is
incorrect because assets that require to
be revalued to fair value should be
based on an exit value, not an adjusted
historic cost. Answer (d) is incorrect
because the price paid to acquire the
asset is an entry price, not an exit
price.
66. (a) The principal market is the market
in which thereporting entity would sell
the asset or transfer the liability with
the greatest volume and level of
activity for the asset or liability.
Answers (b) and (c) are incorrect
bilities. Answer (a) is incorrect
because the dealer is establishing a new market because it refers to the income
and is not in the principal market that exists for approach. Answer (c) is incorrect
the asset. because it refers to the cost approach.
Answer (d) is incorrect because it is
69. (d) A fair value measurement assumes the not a technique for any of the
highestand best use of the asset that is permissible valuation techniques.
physically possible, legally permissible, and
financially feasible. Answers (a) and (b) are 74. (c) A change in valuation technique
incorrect because to determine the valuation used to measure fair value should be
premise, the asset can be classified as either in reported as a change in accounting
use or inexchange. Answer (c) is incorrect estimate. The change is reported on a
because for valuation purposes, the highest and prospective basis; however, the
best use would maximize the value of the asset. disclosures for change in accounting
estimate are not required for a change
70. (a) The fair value at initial recognition is the in valuation technique. Answers (a),
transaction price that represents the price paid (b), and (d) are incorrect.
to acquire the asset (an entry price). Answer (b)
is incorrect because transaction costs are not 75. (a) The fair value hierarchy prioritizes the
included. Answer (c) is incorrect because it is an inputs tovaluation techniques into three levels:
exit price. Answer (d) is incorrect because it is Level 1, Level 2, and Level 3. The highest
not a fair value measure. priority is given to Level 1 inputs, which are
quoted prices in active markets for identical
71. (b) There are three approaches to assets and liabilities. Answers (b) and (c) are
valuation techniques for fair value: incorrect, because these levels are lower priority
the market approach, the income ap than Level 1. Answer (d) is incorrect because
proach, and the cost approach. There there is no Level 4 input.
is no technique called the residual
value approach. 76. (b) The bank prime rate and the default rates
areboth observable inputs. A financial forecast
72. (a) The income approach uses valuation is developed by an entity and is an unobservable
techniquesto convert future amounts to a single input or Level 3 input. Therefore, answers (a),
present value amount. Therefore, Black (c), and (d) are incorrect.
ScholesMerton, binomial models, or dis
counted cash flow models are examples of the D.6.f. Constant Dollar Accounting
income approach. Answers (b) and (c) are
77. (c) The Codification encourages, but does not
incorrect because these approaches do not use
require, business enterprises to disclose
present value techniques. Answer (d) is
incorrect because there is no exit value supplementary information on the effects of
approach. changing prices. The statementpresents
requirements to be followed by enterprises that
73. (b) The market approach valuation voluntarily elect to disclose this information.
technique usesprices and other Answers (a) and (b) are incorrect because the
relevant information generated by information is not reported in the body of the
market transactions involving financial statements or in the notes to the financial
identical or comparable assets or lia statements. Answer (d) is incorrect because man
constant purchasing power the opening and
closing balances of, and transactions in,
agement’s report to shareholders identifies monetary assets and liabilities. During a period
management’s responsibilities, including of rising prices, monetary liabilities give rise to
responsibilities for the internal control purchasing power gains because they will be
system, and would not include information settled with cash which can be used to purchase
about changing prices. relatively fewer goods or services at a future
78. (c) The requirement is to determine the amounts time.
to be reported for three balance sheet accounts D.6.g. Current Cost Accounting
in a supplementary constant dollar balance
sheet. In a constant dollar balance sheet, 83. (d) Current cost accounting is a method of
nonmonetary items are restated to the current valuingand reporting assets, liabilities,
price level, while monetary items are not revenues, and expenses at their current cost at
restated because they are already stated in the balance sheet date or at the date of their use
or sale. A holding gain is recorded as an
current dollars. The investment in bonds and
increase in an item’s value. At December 31,
the longterm debt are monetary items since
2010, Vend Co. is holding merchandise which
their amounts are fixed by contract in terms of
is currently valued at $10 per unit (replacement
number of dollars. Therefore, these items are
cost), while the original recorded value of the
not restated and are reported at $60,000 and
merchandise was $8 per unit (purchase price).
$80,000, respectively. The land, however, is a
Therefore, the holding gain is $2 per unit.
nonmonetary item and its cost ($120,000) must
be restated to current dollars by using the
TO/FROM ratio (110/100), resulting in an
adjusted amount of $132,000 ($120,000 ×
110/100).
79. (b) The account “loans to employees”
is a monetary asset account since its
payment amount is fixed at some
point in the future. Conversely,
merchandise inventory is considered a
nonmonetary asset account since its
value will change based on relative
price levels in the future. The total
value of monetary assets is the
balance of the loans to employees
account, or $20,000.
80. (a) The increase in current cost (nominal
dollars) of $15,000 is the total increase in
current cost, including any increase caused by
inflation. The effect of changes in the general
price level is not separated from the effect of
changes in specific value. The increase in
current cost (constant dollars) of $12,000 is the
increase in current cost after eliminating any
increase caused by inflation. Therefore, the
inflation component of the increase in current
cost of inventories is $3,000 ($15,000 –
$12,000).
which item is classified as
nonmonetary when computing the
purchasing power gain or loss on net
monetary items. A monetary item is
one that is fixed or determinable
without reference to future prices.
Accumulated depreciation is not a
monetary item. Advances to
unconsolidated subsidiaries,
allowance for doubtful accounts, and
unamortized premium on bonds
payable are all monetary items.
82. (b) A purchasing power gain or loss is the net
gain or loss determined by restating in units of
volume of business transacted with a
84. (c) The requirement is to calculate certain contributor are all examples of
the amount of current cost concentrations that create
depreciation expense which would vulnerabilities that are required to be
appear in supplementary current cost disclosed.
financial statements. Depreciation is
to be measured based on the average 89. (b) The potential impact of estimates about
current cost of the asset during the values of assets and liabilities when it is
period of use. The average current reasonably possible that the estimate will
cost of this machine during 2010 is change in the near future is a required dis
$120,000 [($115,000 + $125,000)  closure regarding significant risks and
2]. Therefore, 2010 depreciation uncertainties. Factors causing an estimate to be
expense is $24,000 ($120,000  5 sensitive is not a required disclosure, only
year useful life). recommended. The potential impact of estimates
about values of assets and liabilities when it is
85. (a) Current cost for inventories and remotely possible that the estimate will change
equipment is measured at the lower of in the near future is not a required disclosure. It
current cost or recoverable amount. For is only a required disclosure if it is reasonably
equipment, recoverable amount possible that the estimates will change in the
($95,000) is lower than current cost; for near future. Only a description of operations
inventory, current cost ($80,000) is outside the home country is a required
lower than recoverable amount. disclosure.
Therefore, the total amount to be
reported for these assets is $175,000 D.8. Other Comprehensive Bases of
($95,000 + $80,000). Accounting
86. (a) Increases or decreases in the 90. (c) Other than generally accepted

current cost of inventory result from accounting principles, the only other
the difference between the measures bases which may be used to prepare
of assets at their entry dates financial statements in conformity
(beginning of year or purchase date) with a comprehensive basis of
and measures of assets at their exit accounting are the cash basis and a
dates (end of year or date of basis of accounting used to file an
use/sale). Based on this definition, income tax return.
holding gains would be reported both
when inventory is sold during the 91. (d) When financial statements are
year (realized gains), and when prepared using an income tax basis,
inventory is held at the end of the two accounting methods can be used:
year (unrealized gains). (1) modified cash basis—hybrid
method of IRS and (2) accrual basis—
87. (a) The current cost of goods sold is IRS. The modified cash basis reflects
computed by multiplying the average the use of accrual basis for
cost of units produced or purchased inventories, cost of goods sold, sales,
during the year times the number of and depreciation, if these are
units sold. significant. The accrual basis uses
D.6.h. Risks and Uncertainites accruals and deferrals with several
exceptions (e.g., prepaid income,
88. (d) The market in which an entity warranty expense). When financial
conducts its operations, the available statements are prepared on an income
sources of supply of materials used in tax basis, the financial statements
operations of an entity, and the should not simply repeat items and
amounts reported in the
include information on the purpose
of the statements, assumptions, and
tax return. Thus, items such as nontaxable significant accounting policies.
municipal interest and the nondeductible
portion of travel and entertainment expense D.11. SEC Reporting Requirements
should be fully reflected in the income statement 98. (c) The requirement is to identify the form used
on the basis used for tax purposes, with footnote tofile as an annual report with the SEC. Answer
disclosure of the differences between the
(c) is correct because Form 10K is the title of
amounts reported in the income statements and
the annual report required to be filed annually by
tax return.
issuer companies. Answer (a) is incorrect
92. (a) In financial statements prepared on because this is the title of the quarterly financial
the income tax basis, the report. Answer (b) is incorrect because Form 8
nondeductible portion of meals and K is the information report that may be filed
entertainment expense should be any time during the year. Answer (d) is incorrect
included with the deductible portion as because a Form S1 is an initial registration
a total amount of travel and form for securities under the Securities Act of
entertainment expense. Additionally, 1933.
the nondeductible portion should be
footnoted. Answer (a) is the best
content of theSEC Form 10Q.
answer among the alternatives given,
Answer (d) is correct because the
although it does not indicate that a
Form 10Q presents reviewed
footnote is required.
quarterly information and other in
93. (c) The requirement is to identify the formation about the company.
statement that best describes Answer (a) is incorrect because the
appropriate modifications in cash information is reviewed, not audited.
basis financial statements. Answer Answer (b) is incorrect because this
(c) is correct because the modifica describes the Form 10K. Answer (c)
tions should be the same as GAAP is incorrect because this describes the
and not illogical. Answer (a) is Form 8K.
incorrect because modified cash basis
financial statements may have
substantial modifications from GAAP.
modifications are not required to be
the same as those required by tax law.
modifications are allowed.
D.9. Prospective Financial Information
94. (b) The responsible party is not the
only limited user. Third parties with
whom the responsible party is ne
gotiating directly are also limited
users. Answer (a) is incorrect because
prospective financial information may
be prepared for general or limited use.
Answer (c) is incorrect because it is
true that assumptions not necessarily
expected to occur may be included in
the financial projection. Answer (d) is
incorrect because the financial
projection may be expressed as a range
of dollars.
95. (d) Prospective financial
information is defined as any
financial information about the
future.
96. (c) Financial forecasts and projections must be
prepared in accordance with GAAP, with the
plans of the entity, and with due professional
care in order to achieve a reasonably objective
basis.
97. (a) Prospective financial statements
Standards
100. (a) The requirement is to identify the (IFRS)
form used tofile as a quarterly report
with the SEC. Answer (a) is correct 105. (b) The requirement is to identify the
because Form 10Q is the title of the circumstancesin which Galaxy may
quarterly report required to be filed present the note as a noncurrent liabil
by issuer companies. ity. Answer (b) is correct because
IFRS requires that Galaxy must have
101. (c) The requirement is to identify the executed an agreement to refinance at
balance sheetrequired in the Form 10Q. the balance sheet date in order to
Answer (c) is correct because the SEC classify the debt as a noncurrent liabil
requires that a Form 10Q contain an ity. Inasmuch as no agreement existed
interim balance sheet as of the end of at the balance sheet date, the note
the most recent fiscal quarter and a payable must be classified as a current
balance sheet as of the end of the liability. Therefore, answers (a), (c),
preceding fiscal year. An interim and (d) are incorrect.
balance sheet for the fiscal quarter of
the preceding year does not need to be
provided unless it is necessary for item requiredto be disclosed on the
understanding the impact of seasonal income statement. The correct answer is
fluctuations. (b) because the income statement may be
prepared by presenting expenses either
102. (b) The requirement is to identify the by nature or by function. The minimum
deadline forfiling a Form 10K for an required disclosures on the income
accelerated filer. Answer (b) is correct statement include income, finance costs,
because the maximum number of days share of profits and losses using the
for an accelerated filer to file a 10K equity method, tax expense, discontinued
with the SEC is 75 days after the operations, profit or loss, noncontrolling
company’s fiscal yearend. However, a interests in profits and losses, and the net
large accelerated filer with $700 profit (loss) attributable to equity holders
million of public float has a deadline of the parent. Therefore, answers (a), (c),
of 60 days, and nonaccelerated filers and (d) are incorrect.
have a deadline of 90 days.
D.12. Financial Statements of Trust item that maynot be disclosed on the
income statement under IFRS. An
103. (c) The requirement is to identify the financial
swer (c) is correct because gain or
statements of a trust. A statement of assets and loss from extraordinary items is not
liabilities, a statement of operations, and a allowed on an income statement
statement of changes in net assets are generally prepared using IFRS. Answers (a),
presented for a trust. (b), and (d) are items that are
104. (d) The requirement is to identify the disclosed on the income statement.
accountingand measurement bases for 108. (b) The requirement is to identify
a trust. The financial statements of a
where the financecosts are presented
trust should be presented on the
in the statement of cash flows. An
accrual basis and the assets are
swer (b) is correct because under
generally measured at their fair
IFRS finance costs (interest expense)
values.
may be reported in either the
D.13. International Financial Reporting operating or financing section of the
statement of cash flows. However,
once it is disclosed in a particular
section, it must be reported on a
consistent basis. Therefore, answers
(a), (c), and (d), are incorrect.
identify how the transac
tion should be reported on
the statement of cash
flows. Answer (d) is
correct because this
transaction did not
involve an exchange of
cash; therefore, it is not
included on the statement
of cash flows. IFRS
requires that significant
noncash transactions be
reported in the notes to
(Note that for US GAAP,
if there are only a few
significant noncash
transactions, they may be
reported at the bottom of
the statement of cash
flows, or they may be re
ported in a separate
schedule in the notes to
the financial statements.)
identify how cash ad
vances and loans from
bank overdrafts should be
reported on the statement
of cash flows. Answer (a)
is correct because IFRS
requires cash advances
and loans from bank
overdrafts to be classified
as operating activities.
111. (b) The requirement is
to identify the
acceptablemethods for
presenting other
Answer (b) is correct
because IFRS provides
that comprehensive
income may be
presented in either one
statement or in two
statements. (US GAAP
allows the presentation
in all three ways.)
identify the true
statementabout IFRS
requirements for financial
statements. Answer (a) is
correct because IFRS
requires the presentation
of prior year financial
statements for
comparative purposes.
113. (a) The requirement is
to identify the manner
inwhich operating
expenses may be
classified on the income
statement under IFRS.
because they may be
classified by nature or
function.
identify how the
statementof cash flows
may be presented. Answer
(a) is correct because the
statement may be
presented on the direct or
the indirect basis.
S
O
T
Concepts
Authoritative
Literature Help
1. The gain or loss from discontinued operations is placed in a separate category under other
income or loss.
2. The gain or loss from infrequent or unusual items is given extraordinary treatment and
disclosed on the income statement after discontinued operations.
3. Exit and disposal activities are classified as discontinued operations.
4. A component of a company can be classified as discontinued in the first period that it meets
the criteria as being held for sale.
5. A correction of an error is included in the cumulative effect of change in accounting
principle on the income statement.
6. Other comprehensive income may be presented at the bottom of the income statement.
7. Separate earnings per share amounts must be presented for both other comprehensive
income and comprehensive income.
8. Prospective financial information includes information on the purpose of the statements,
assumptions, and significant accounting policies.
E
1. (F) Discontinued operations are placed in a separate category after income from
continuing operations and before extraordinary items.
2. (F) An item must be both infrequent and unusual to be treated as an extraordinary item.
3. (F) Exit and disposal activities that are not in connection with a component of the entity that qualifies for
discontinued operations or extraordinary treatment should be reported as unusual or infrequent
income/loss in income from continuing operations before income taxes.
4. (T) A component must be classified as discontinued when it meets the criteria.
5. (F) A correction of an error requires restatement of the financial statements.
6. (T) Flexibility is allowed for presentation.
7. (F) Separate EPS amounts are only required for gains/losses from continuing operations,
discontinued operations, extraordinary items, and cumulative effect of accounting
changes.
8. (T) The notes to prospective financial statements must include those disclosures.
Financial Statement
Classification Authoritative
Literature
Help
1. Dividend payable (on Craven’s preferred

stock).
2. Plant construction in progress by the
company.
3. Factory building (retired from use and held for
sale).
4. Land (held for possible future building site).
5. Merchandise inventory (held by
Craven Corporation on consignment).
6. Stock dividend distributable (in common stock
to common stockholders and to be issued at
par).
7. Office supplies inventory.
(AF) (G, H, I) (J, K, L, M) (N or X)
G
C
F
B
N
A
8. Sinking fund cash (First National Bank,

Trustee).
9. Installment sales accounts

receivable (average collection
period eighteen months). All
sales are installment sales.
10. Temporary decline in inventory value.
11. Advances to officers (indefinite repayment
date).
12. Estimated warranty costs. The warranty costs
are for a oneyear warranty on parts and labor.
13. Inventory of small tools used in the business.
14. Treasury stock under par value method.
15. Common stock subscribed (Craven
Corporation’s stock).
16. Convertible bonds.
17. Securities held as collateral.
18. Bank overdraft (only account with bank).
(AF) (G, H, I) (J, K, L, M) (N or X)
B
A
N
F
G
C
XK
K
H
N
G
1. (G) When a corporation declares a cash or property dividend, the amount to be paid becomes
a liability of the corporation. The dividends payable amount would be classified as a current
liability on the balance sheet. It is important to note that dividends payable represent the
amount distributed to stockholders as a return on their investment. Dividends are not
expenses.
2. (C) When an item of property, plant, or equipment is being constructed by the company that
intends to use it, all of the relevant costs related to the construction should be included in the
asset. The asset would be classified as plant and equipment.
3. (F) A factory building that has been retired from use and held for sale should be classified as
an other asset rather than as property, plant and equipment. The property, plant and
equipment account should include only those tangible assets that are being used in operations.
4. (B) Land that is held for speculative or investment purposes should be classified as an
investment rather than as property, plant, and equipment. The property, plant, and equipment
account should represent only those assets being used in current operations.
5. (N) Consigned inventory is excluded from the balance sheet because it is not owned by
Craven. Consigned inventory represents an arrangement whereby the owner of the goods
transfers physical possession to an agent (Craven). The agent (consignee) will attempt to sell
the goods on the owner’s behalf. The inventory remains an asset of its owner.
6. (K) A stock dividend distributable represents a dividend to be distributed to shareholders in
the form of additional shares of the corporation’s stock. Each shareholder will receive a
proportional share of additional stock. The declaration of a stock dividend does not result in a
liability, as it does not result in any of the corporation’s assets being paid. Thus, a stock
dividend distributable would be classified as an addition in the stockholders’ equity section in
the common stock account.
7. (A) Current assets represent cash or other assets that are expected to be used within the
operating cycle. Office supplies inventory represents an asset that could be expected to be
used within the operating cycle.
8. (B) Generally, a fund is a group of assets set aside for a future nonoperating purpose. A sinking fund
contains assets to be used in the future to retire bonds. These assets are generally invested while waiting
to be used and are noncurrent.
9. (A) An installment sales accounts receivable results when the corporation makes a sale to a
customer and does not receive payment in full on the date of sale. Since this company
normally sells on the installment basis, its operating cycle becomes eighteen months. Its
receivables are current assets because their average life falls within the operating cycle.
10. (N) Temporary decline in inventory value is a loss and appears on the income statement.
11. (F) Advances to officers are considered nontrade receivables. These types of receivables
should be reported separately on the balance sheet as other assets.
12. (G) A warranty is a guarantee made by the seller to the purchaser against defects in the
product’s quality. Estimated warranty expense for a given period can be estimated as a
percentage of sales. The percentage is based on past warranty experience. The estimated
warranty cost represents the warranty expenditures in the future for past sales and is a current
liability.
13. (C) Property, plant, and equipment consists of items used in the normal operations of a
business. The inventory of small tools represents tools used in the business and are not for
sale.
14. (XK) Treasury stock is a corporation’s own stock which has been issued and reacquired
by the corporation. Treasury stock may be accounted for under the cost or par value
method. When the par value method is used, treasury stock would be recorded on the
balance sheet as a reduction or contra to the common stock account.
15. (K) Common stock subscribed represents stock subscriptions that have not been fully paid. The stock is not considered to be
issued until the full price is paid. This account should be classified as an increase in the common stock and it is offset in
stockholders’ equity by a contra account for the balance of the subscription due.
16. (H) A convertible bond is a bond which may be converted to another form of the corporation’s securities during a
specified time frame. A bond is typically classified as a longterm liability on the balance sheet.
17. (N) Corporations do not own securities they hold as collateral. The corporation will retain the securities only in the
event of a default on the receivable the securities are collateralizing. Thus, the securities are excluded from the
balance sheet of Craven and they appear on the balance sheets of their owners.
18. (G) A bank overdraft occurs when a check is written for a greater amount than the balance in the bank account. A
bank overdraft should be classified as a current liability. It should not be offset against other cash account balances
unless the cash account is in the same bank.
Balance Sheet
Authoritative
Literature Help
A B C D E
1 Stephen King Corporation
2 Balance Sheet
3 December 31, 2011
4
5 Current assets:
6 Cash $ 114,000
7 Trading securities 80,000
8 Accounts receivable (net of $10,000 allowance for doubtful accounts) 160,000
9 Inventories (lower of FIFO cost or market) 180,000
10
11 Total current assets 534,000
12
13 Investments:
14 Availableforsale securities 270,000
15 Bond sinking fund 250,000
16 Land held for future use 270,000
17 Cash surrender value of life insurance contract 40,000
18
19 Total investments 830,000
20
21 Property, plant, and equipment:
22 Land 500,000
23 Buildings (net of accumulated depreciation of $360,000) 680,000
24 Equipment (net of accumulated depreciation of $180,000) 270,000
25
26 Total property, plant, and equipment 1,450,000
27
28 Intangible assets:
29 Franchise 165,000
30 Goodwill 100,000
31
32 Total intangible assets 265,000
33 Total assets $3,079,000
34
35 Current liabilities:
36 Accounts payable $90,000
37 Notes payable 80,000
38 Taxes payable 40,000
39 Bank overdraft 14,000
40 Unearned revenue 5,000
41
42 Total current liabilities 229,000
43
44 Longterm liabilities:
A B C D E
45 Notes payable 120,000
46 Bonds payable, 10% due in 2020 (less discount of $40,000) 960,000
47
48 Total longterm liabilities 1,080,000
49 Total liabilities $1,309,000
50
51 Stockholders’ equity:
52 Paidin capital
53 Preferred stock, no par, authorized 200,000 shares, issued 70,000 shares 450,000
54 Common stock, $1.00 par value, authorized 40,000 shares, issued 100,000 shares 100,000
55 Paidin capital in excess of par value common 900,000
56
57 Total paidin capital $1,450,000
58
60
61 Total stockholders’ equity 1,770,000
62 Total liabilities and stockholders’ equity $3,079,000
Research
Authoritative
Literature Help
ASC 220 10 45 13
Journal Entries
Authoritative
Literature Help
1. Bad debt expense 16,000
Allowance for uncollectible account 16,000
2. Supplies expense 23,000
Supplies 23,000
[remaining = 23,000 (60,000 – 37,000)]
3. Depreciation expense 29,000
(640,000 – 60,000) ÷ 20 years = 29,000 per year
4. Salary expense 37,500
5. Interest receivable 1,500
Interest income 1,500
75,000 × 12% × 2/12 = 1,500
6. Rent expense 35,000
Prepaid rent 35,000
168,000 ÷ 24 mo. = 7,000 per month × 5 months = 35,000
Calculations
Authoritative
Literature Help
Accounts receivable (net) 234,000 (1)

Notes receivable 75,000 (2)
Prepaid rent 133,000 (3)
Supplies 37,000 (4)
Inventory 420,000 (5)
Equipment (historical cost) 640,000 (6)
Accounts payable 176,000 (7)
Salaries payable 52,500 (8)
Accumulated depreciation 203,000 (9)
1. $250,000 – $16,000 allowance for uncollectible accounts = $234,000
2. No change. Interest receivable is recorded in a separate account.
3. $168,000 – $35,000 = $133,000
4. Given in the problem.
5. No adjustments were made to inventory.
6. Equipment is at historical cost.
7. No change.
8. $15,000 + $37,500 = $52,500
9. $174,000 + $29,000 = $203,000
Classification/
Disclosures
Authoritative
Literature Help
1. ($73,000, A) The net carrying amount of the bonds redeemed is determined by adjusting the carrying amount of the bondsat
the beginning of the year for any partial year amortization of corresponding premiums or discounts and for any unamortized
issue costs. In this example, Griffin would determine its discount amortization by computing the difference between its bond
interest expense and its bond interest paid as of June 30, 2011.
Bond interest expense Bond interest paid
Carrying amount of bonds Effective Face value of Stated Amortization
× ×
at beginning of period interest rate – bonds interest rate = amount
$940,000 × 10% × 1/2 – $1,000,000 × 8% 1/2 = $7,000
This amount is added to the carrying amount of the bonds at the beginning of the year to determine the net carrying amount:
$940,000 + $7,000 = $947,000. This amount is subtracted from the reacquisition price to determine the loss on redemption:
$1,020,000 ($1,000,000 × 1.02) – $947,000 = $73,000. Gains or losses from early redemption of bonds are treated as gains or
losses in determining net income. Early extinguishment of debt is not generally considered an extraordinary item.
2. ($50,000, A) The accounting change is accounted for on a prospective basis. Therefore, it is necessary to calculate
thebook value of the asset as of the beginning of the year of the change.
SYD
2008 $500,000 × 5/15 = $166,667
2009 $500,000 × 4/15 = $133,333
2010 $500,000 × 3/15 = $100,000
$400,000
On January 1, 2011, the book value is calculated as follows:
– Accumulated depreciation (400,000)
Book value 1/1/11 $120,000
Straightline depreciation for 2011 and future years is calculated as
($120,000 BV – $20,000 salvage value) ÷ 2 years remaining life = $50,000 per year
The depreciation expense would be shown as a part of the calculation of income from continuing operations.
3. ([$125,000], A) Since an accrual was made for Griffin’s contingent liability in 2010, one must first determine the
amount of the liability recorded. If a range of possible losses exists and no amount within the range is more likely
than any other amount, an accrual should be made for the minimum amount of the loss, in this case $250,000. As
Griffin accrued a $250,000 liability and loss in 2010, the 2011 loss would be $125,000 ($250,000 – $375,000). Such
a loss would be classified under income from continuing operations as it is incurred in conjunction with ordinary
operations (amount paid to employee). Such a loss would not be extraordinary as it does not meet the criteria of
being both unusual in nature and infrequent in occurrence.
4. ([$10,000], A) Trading securities are securities that are bought and held principally for the purpose of selling them in
the near term. As Griffin purchased these securities to sell in the near term, any unrealized holding gain or loss would
appear as income from continuing operations on the income statement. The holding gain or loss from marketable
equity securities held in the trading portfolio is computed as of December 31, 2011, by comparing the cost of the
securities at the purchase date with the fair market value at the end of the year.
Cost FV 12/31/11 Gain (loss)
I $125,000 $145,000 $ 20,000
II 235,000 205,000 (30,000)
$(10,000)
5. ([$255,000], B) The amount of gain or loss from the hurricane would be computed by adding the carrying amounts of
theassets destroyed and comparing this amount with the amount of insurance recovery. For Griffin, an extraordinary loss
would result as follows:
Insurance recovery $ 1,000,000
Warehouse 470,000
Equipment 250,000
Inventory 535,000
Total carrying value $ 1,255,000
Extraordinary loss $ (255,000)
As this hurricane is unusual in that it is not related to the normal activities of the entity and infrequent in occurrence in that it is
not expected to occur again in the foreseeable future (this was the first hurricane ever in Griffin’s area), the $255,000 loss
would be classified as an extraordinary loss.
6. ($41,000, E) To compute the translation adjustment for 2011, both net asset figures in dollars must be compared.
The$429,000 represents the translation at the date of purchase plus the translation of net income at a weightedaverage
exchange rate. The $388,000 represents the net assets at the translated rate at the balance sheet date. The $41,000 difference is
the translation adjustment necessary to make the balance sheet balance. This translation adjustment should not be included in
net income, but shall be reported as a separate component of other comprehensive income.
Research
Authoritative
Literature Help
ASC 420 10 25 14
C
l
A
u
L
i
1. N
e
2. A
3. R
4. W
5. G
a
(A) (B) (C) (D) (E) (F) (G) (H) (I)
6. Changing from the gross profit method for determining yearend inventory balances to dollar value LIFO.
7. Accounting for existing construction contracts is changed from completed contract to percentageof
completion.
8. The effects of a change in estimate and a change in principle are inseparable for the same event.
9. The excess of cash paid over the carrying value to extinguish bonds.
10. Income or loss of the component for the period of disposal included in this calculation.
1. (G) The acquisition of assets does not necessitate that the same method of depreciation be used for
the newly acquired assets as for the existing assets. Therefore, no change in accounting principle
has occurred because the previously recorded assets will continue to be depreciated using the
straightline method.
2. (A) Accounting for the acquisition of a 100% owned subsidiary is properly accounted for as a change in
reporting entity.
3. (B) All corrections of errors should be treated as a restatement of the prior period financial statements.
This requires prompt recording of the error in the year in which the error was discovered, and
reporting the effects of the error in the financial statements as an adjustment to the carrying value of
the assets and liabilities as of the beginning of the first period presented with an offsetting adjustment
to the opening balance of retained earnings for that period. Financial statements for each individual
period are adjusted to reflect the correction of the periodspecific effects of the error.
4. (H) For an item to qualify as an extraordinary item it must be both unusual in nature and infrequent
in occurrence. Clearly, the writedown of inventory due to obsolescence does not qualify for
extraordinary treatment; therefore, it should be disclosed separately in the income statement before
extraordinary items.
5. (I) Gains or losses on the disposal of net assets is included in the calculation of gain or loss on
disposal of discontinued operations. Therefore, the total gain or loss on disposal should consist of
the following two calculations: the net asset gain or loss mentioned above and the income or loss
from operations from the measurement date to the disposal date (the phaseout period).
6. (B) The use of the gross profit method to determine yearend inventory balances is not proper
GAAP. Therefore, if a situation such as this existed, it should be treated as a correction of an error.
7. (C) The change from one generally accepted accounting principle to another is considered a change in
accounting principle. Since both the completed contract method and the percentageofcompletion
methods are recognized GAAP, the change from one to the other is properly accounted for as a
change in accounting principle, and accounted for on a retrospective basis.
8. (D) When it is impossible to determine whether a change in accounting principle or a change in estimate has
occurred, the change should be considered as a change in estimate.
9. (H) Gains or losses on extinguishment of debt are no longer treated as extraordinary items.
10. (F) Income or loss from operations is properly included in the calculation of the gain or loss on the
discontinued operations. Therefore, this calculation includes both the income or loss from operations
and the gain or loss on the disposal of net assets. The gain or loss on the disposal should also be
disclosed parenthetically or in the notes to the financial statements.
Multistep Income
Statement Authoritative
Literature Help
American Horse Company
INCOME STATEMENT
Sales $25,000,000
Less cost of goods sold (17,000,000)
Gross profit $ 8,000,000
Less selling and administrative expenses (4,700,000)
Income from operations $ 3,300,000
Other revenue and gains
Interest revenue $ 70,000
Gain on the sale of investments 110,000 $180,000
Other expenses and losses
Writeoff of goodwill (820,000)
Income from continuing operations before income taxes $2,660,000
Income taxes (905,000)
Income from continuing operations $1,755,000
Discontinued operations
Loss on discontinued wholesale division, including loss
on disposal of $200,000 $815,000
Income tax benefit (285,000)
Loss on discontinued operation (net of tax) (530,000)
Income before extraordinary item $1,225,000
Extraordinary loss from flood damage, net of tax (390,000)
Earnings per share
a
Income from continuing operations $5.62
Discontinued operations: (1.77)
b
Income before extraordinary item 3.85
Extraordinary loss (net of tax) (1.30)
c
Net income $2.55

a $1,755,000 – $70,000
= $5.62
300,000 shares
b $1,225,000 – $70,000
= $3.85
300,000 shares
c $835,000 – $70,000
= $2.55
300,000 shares
Research
Authoritative
Literature Help
ASC 225 20 45 2
F
iC
l
L
i
1. A
n
2. T
h
3. I
n
4. A

5. A

6. A

7. T
8. T
(
1. (B) Changes in the market value of (trading type) marketable securities shall be included in the
determination of incomefrom continuing operations of the period in which the change in market value occurs.
2. (E) The accumulated changes in the valuation (unrealized excess of cost over market value) of availableforsale
marketable equity securities shall be reported as accumulated other comprehensive income.
3. (F) Results of operations of a component that has been or will be discontinued should be reported separately as a component
of income, after income from continuing operations but before extraordinary items.
4. (B) A foreign subsidiary must remeasure its financial statements when its functional currency (the currency of the
primary economic environment in which the entity operates) is different from its local currency (the currency
currently used by the entity). The effect of the remeasurement process (gain or loss) should be recognized currently in
income. Aggregate gain or loss for the period should also be disclosed either in the financial statements or in the
notes.
5. (C) When translating a foreign subsidiary’s financial statements from functional currency to reporting currency, a translation
adjustment will result. The translation adjustment is not included in net income but is reported as a component of compre
hensive income and called other comprehensive income.
6. (D) Extraordinary items are events and transactions that are both unusual and infrequent. The earthquake in this
problem occurred in an area previously considered subject to only minor tremors. Therefore, the earthquake would be
considered an extraordinary event. Extraordinary items should be shown separately on the income statement, after
income from continuing operations.
7. (F) The question indicates that it is probable that the company will receive $1,000,000 from a pending lawsuit. Thus,
the $1,000,000 is a gain contingency. Contingencies that may result in gains are not reflected in the accounts, as
doing so might result in the recognition of revenue before its realization. Adequate disclosure of the gain contingency
should be made, but care should be taken to avoid misleading implications as to the likelihood of realization.
8. (B) The cost of research and development services performed by others on behalf of the enterprise are included in
R&D costs. R&D costs are charged to expense when incurred and thus are included in income from continuing
operations of that period. In addition, separate disclosure of the total R&D costs for the period should be made
either in the financial statements or in the notes.
Calculate Net Income
and Earnings Per Share Authoritative
Literature Help
Rap Corp.
INCOME STATEMENT
Income from continuing operations before income tax $1,180,000
Income tax (448,400)
Income from continuing operations $ 731,600
Discontinued operations:
Loss from discontinued operations (including loss from
disposal of $100,000) $(190,000)
Income tax benefit 72,200
Loss from discontinued operations (net of tax) 117,800
Income before extraordinary item $ 613,800
Extraordinary item:
Gain on sale of investment 145,000
Less applicable taxes 58,000 87,000
Per share of common stock:
Income from continuing operations $ 7.32
Discontinued operations, net of tax (1.18)
Income before extraordinary item 6.14
Extraordinary item, net of tax 0.87
Net income ($700,800/100,000) $ 7.01
MODULE 10 INVENTORY 333
INVENTORY
1. The following information applied to Fenn, Inc.
for2011:
Merchandise purchased for resale $400,000
Freightin 10,000
Freightout 5,000
Purchase returns 2,000
Fenn’s 2011 inventoriable cost was
a. $400,000
b. $404,000
c. $408,000
d. $413,000
2. On December 28, 2011, Kerr Manufacturing Co.
purchased goods costing $50,000. The terms
were FOB destination. Some of the costs
incurred in connection with the sale and delivery
of the goods were as follows:
Packaging for shipment $1,000
Shipping 1,500
Special handling charges 2,000
These goods were received on December 31, 2011. In
Kerr’s December 31, 2011 balance sheet, what amount
of cost for these goods should be included in inventory?
a. $54,500
b. $53,500
c. $52,000
d. $50,000
3. On June 1, 2011, Pitt Corp. sold merchandise with a list
price of $5,000 to Burr on account. Pitt allowed trade dis
counts of 30% and 20%. Credit terms were 2/15, n/40 and
the sale was made FOB shipping point. Pitt prepaid $200 of
delivery costs for Burr as an accommodation. On June 12,
2011, Pitt received from Burr a remittance in full payment
amounting to
a. $2,744
b. $2,940
c. $2,944
d. $3,140
4. The following information was taken from Cody
Co.’s accounting records for the year ended
December 31, 2011:
Decrease in raw materials inventory $ 15,000
Increase in finished goods inventory 35,000
Raw material purchased 430,000
Direct labor payroll 200,000
Factory overhead 300,000
Freightout 45,000
There was no work in process inventory at the beginning
or end of the year. Cody’s 2011 cost of goods sold is
a. $895,000
b. $910,000
c. $950,000
d. $955,000
5. The following information pertains to Deal Corp.’s
2011 cost of goods sold:
Inventory, 12/31/10 $ 90,000
2011 purchases 124,000
2011 writeoff of obsolete inventory 34,000
Inventory, 12/31/11 30,000
The inventory written off became obsolete due to an unex
pected and unusual technological advance by a competitor.
In its 2011 income statement, what amount should b. $118,220
Deal report as cost of goods sold? c. $123,360
a. $218,000 d. $128,500
b. $184,000
c. $150,000 9. When allocating costs to inventory produced
d. $124,000 for the period, fixed overhead should be based
upon
6. How should the following costs affect a retailer’s in a. The actual amounts of goods produced
ventory? during the period.
Freightin Interest on inventory loan b. The normal capacity of production facilities.
a. Increase No effect c. The highest production levels in the
b. Increase Increase last three periods.
c. No effect Increase d. The lowest production level in
d. No effect No effect the last three periods.
7. According to the net method, which of the 10. Per the Codification, what is considered the
followingitems should be included in the cost of normal capacity of production facilities?
inventory? a. The average production over the previous five
Freight costs Purchase discounts not taken year period.
a. Yes No b. Actual production for the period.
b. Yes Yes c. Actual production for the period plus loss of
c. No Yes capacity for planned maintenance.
d. No No d. A range that may vary based on
8. The following information pertained to Azur Co. for business and industryspecific
factors.
theyear:
Purchases $102,800 11. How should unallocated fixed overhead
Purchase discounts 10,280 costs be treated?
Freight in 15,420 a. Allocated to finished goods and cost of
Freight out 5,140
Beginning inventory 30,840
goods sold based on ending balances in
Ending inventory 20,560 the accounts.
b. Allocated to raw materials, work in
What amount should Azur report as cost of goods sold process, and finished goods, based on the
for the year? ending balances in the accounts.
a. $102,800
334 MODULE 10 INVENTORY
Inventory
At base At dollar
c. Recognized as Date year cost value LIFO
1/1/10 $90,000 $90,000
an expense in 2010 layer 20,000 30,000
the period in 2011 layer 40,000 80,000
which they are
incurred. What was the price index used
d. Allocated to to compute Bach’s 2011 dollar
value LIFO inventory layer?
work in process,
finished goods, a. 1.09
and cost of b. 1.25
goods sold based c. 1.33
on ending d. 2.00
balances in the 15. Nest Co. recorded the
accounts.
following inventory
12. When manufacturing information during the
inventory, what is the month of January:
accounting treatment for Total Units
abnormal freightin costs? Units Unit cost cost on hand
a. Charge to expense for the Balance on 1/1 2,000 $1 $2,000 2,000
Purchased on 1/8 1,200 3 3,600 3,200
period. Sold on 1/23 1,800 1,400
b. Charge to the finished Purchased on 1/28 800 5 4,000 2,200
goods inventory.
c. Charge to raw materials Nest uses the LIFO method to cost
inventory. inventory. What amount should
d. Allocate to Nest report as inventory on January
raw 31 under each of the following
materials, methods of recording inventory?
work in Perpetual Periodic
process, and a. $2,600 $5,400
finished b. $5,400 $2,600
goods. c. $2,600 $2,600
d. $5,400 $5,400
13. On December 15, 2011,
Flanagan purchased goods
costing $100,000. The
terms were FOB shipping
point. Costs incurred by
Flanagan in connection
with the purchase and
delivery of the goods
were as follows:
Normal freight charges
Handling costs
Insurance on shipment
Abnormal freight charges for express shipping
The goods were received on
December 17, 2011. What is the
amount that Flanagan should charge
to inventory and to current period
expense?
Inventory Current period expense
a. $3,000 $3,700
b. $5,000 $1,700
c. $5,500 $1,200
d. $6,700 $0
14. Bach Co. adopted the dollar
value LIFO inventorymethod as of
January 1, 2011. A single
inventory pool and an internally
computed price index are used to
compute Bach’s LIFO inventory
layers. Information about Bach’s
dollar value inventory follows:
and net realizable value. The net
16. The weightedaverage for the realizable value less normal profit
year inventory cost flowmethod is margin is below the original cost.
applicable to which of the Under the lower of cost or market
following inventory systems? method, the inventory item should
be valued at
Periodic Perpetual
a. Replacement cost.
a. Yes Yes
b. Yes No b. Net realizable value.
c. No Yes c. Net realizable value less
d. No No normal profit margin.
d. Original cost.
17. During January 2011, Metro
Co., which maintains aperpetual 21. Which of the following
inventory system, recorded the statements are correct
following information pertaining when a company
to its inventory: applying the lower of
cost or market method
Units Unit cost Total cost
Balance on 1/1/11 1,000 $1 reports its inventory at
Purchased on 1/7/11 600 3 replacement cost?
Sold on 1/20/11 900 I. The original cost is less than
Purchased on 1/25/11 400 5
replacement cost.
Under the movingaverage AI. The net realizable value is greater
method, what amount should than replacement cost.
Metro report as inventory at a. I only.
January 31, 2011? b. II only.
a. $2,640 c. Both I and II.
b. $3,225 d. Neither I nor II.
c. $3,300
d. $3,900
18. Based on a physical
inventory taken on
December 31, 2011,
Chewy Co. determined its
chocolate inventory on a
FIFO basis at $26,000
with a replacement cost of
$20,000. Chewy
estimated that, after
further processing costs of
$12,000, the chocolate
could be sold as finished
candy bars for $40,000.
Chewy’s normal profit
margin is 10% of sales.
Under the lower of cost or
market rule, what amount
should Chewy report as
chocolate inventory in its
December 31, 2011
balance sheet?
a. $28,000
b. $26,000
c. $24,000
d. $20,000
19. Reporting inventory at
the lower of cost or
market is a departure
from the accounting
principle of
a. Historical cost.
b. Consistency.
c. Conservatism.
d. Full disclosure.
20. The original cost of an inventory
item is below both replacement cost
b. Perpetual Individual item
c. Periodic Total inventory
22. The original cost of an d. Periodic Individual item
inventory item is above the 25. Marsh Company had 150 units
replacement cost and the of product A on hand atJanuary 1,
net realizable value. The
2011, costing $21 each. Purchases
replacement cost is below
of product A during the month of
the net realizable value
January were as follows:
less the normal profit
margin. As a result, under Units Unit cost
the lower of cost or market Jan. 10 200 $22
18 250 23
method, the inventory item 28 100 24
should be reported at the
a. Net realizable value. A physical count on January 31,
b. Net realizable value less 2011, shows 250 units of product A
the normal profit margin. on hand. The cost of the inventory
c. Replacement cost. at January 31, 2011, under the
d. Original cost. LIFO method is
a. $5,850
23. On January 1, 2011, Card b. $5,550
Corp. signed a threeyear c. $5,350
noncancelable purchase d. $5,250
contract, which allows
Card to purchase up to 26. During January 2011,
500,000 units of a Metro Co., which
computer part annually maintains a perpetual
from Hart Supply Co. at inventory system,
$.10 per unit and recorded the following
guarantees a minimum information pertaining to
annual purchase of its inventory:
100,000 units. During Unit Total Units
2011, the part Units cost cost on hand
unexpectedly became Balance on 1/1/11 1,000 $1 $1,000 1,000
Purchased on 1/7/11 600 3 1,800 1,600
obsolete. Card had Sold on 1/20/11 900 700
250,000 units of this Purchased on 1/25/11 400 5 2,000 1,100
inventory at December 31,
2011, and believes these
parts can be sold as scrap
for $.02 per unit. What
amount of probable loss
from the purchase
commitment should Card
report in its 2011 income
statement?
a. $24,000
b. $20,000
c. $16,000
d. $ 8,000
24. Thread Co. is selecting its inventory
system in preparation for its first
year of operations. Thread intends to
use either the periodic weighted
average method or the perpetual
movingaverage method, and to
apply the lower of cost or market
rule either to individual items or to
the total inventory. Inventory prices
are expected to generally increase
throughout 2011, although a few
individual prices will decrease.
What inventory system should
Thread select if it wants to maximize
the inventory carrying amount at De
cember 31, 2011?
Inventory method Cost or market application
a. Perpetual Total inventory
c. Decrease Decrease
Under the LIFO method, what d. Decrease Increase
amount should Metro report as
29. Generally, which inventory
inventory at January 31, 2011?
costing method approximates
a. $1,300
most closely the current cost for
b. $2,700
each of the following?
c. $3,900
d. $4,100 Cost of goods sold Ending inventory
a. LIFO FIFO
27. Drew Co. uses the average cost b. LIFO LIFO
inventory method for internal c. FIFO FIFO
reporting purposes and LIFO for d. FIFO LIFO
financial statement and income tax
30. During periods of rising prices,
reporting. At December 31, 2011,
the inventory was $375,000 using a perpetual inventorysystem would
average cost and $320,000 using result in the same dollar amount of
LIFO. The unadjusted credit balance ending inventory as a periodic
in the LIFO Reserve account on inventory system under which of
December 31, 2011, was $35,000. the following inventory cost flow
What adjusting entry should Drew methods?
record to adjust from average cost to FIFO LIFO
LIFO at December 31, 2011? a. Yes No
Debit b. Yes Yes
a. Cost of goods sold $55,000 c. No Yes
Inventory d. No No
b. Cost of goods sold $55,000 31. On January 1, 2010, Poe
LIFO reserve
Company adopted the dollarvalue
c. Cost of goods sold $20,000
Inventory LIFO inventory method. Poe’s
d. Cost of goods sold $20,000 entire inventory constitutes a
LIFO reserve single pool. Inventory data for
2010 and 2011 are as follows:
28. A company decided to change Inventory Inventory Relevant
its inventory valuationmethod from at current at base price
Date year cost year cost index
FIFO to LIFO in a period of rising 1/1/10 $150,000 $150,000 1.00
prices. What was the result of the 12/31/10 220,000 200,000 1.10
change on ending inventory and net 12/31/11 276,000 230,000 1.20
income in the year of the change? Poe’s LIFO inventory value at
Ending inventory Net income
December 31, 2011, is
a. Increase a. $230,000
b. Increase b. $236,000
cost, and, in
the
c. $241,000 denominator,
d. $246,000 the ending in
ventory at base
32. Brock Co. adopted the year cost.
dollarvalue LIFO c. In the
inventory method as of numerator, the
January 1, 2010. A single ending inventory
inventory pool and an at base year cost,
internally computed price and, the
index are used to denominator, the
compute Brock’s LIFO ending inventory
inventory layers. at current year
Information about cost.
Brock’s dollarvalue d. In the
inventory follows: denominator,
Inventory the average of
At base At current the ending in
Date year cost year cost
1/1/10 $40,000 $40,000 ventory at base
2010 layer 5,000 14,000 year cost and at
12/31/10 45,000 54,000 current year
2011 layer 15,000 26,000
12/31/11 $60,000 $80,000
cost.
What was Brock’s dollarvalue 35. Jones Wholesalers stocks

LIFO inventory at December 31, a changing variety of
2011? products. Which
a. $80,000 inventory costing method
b. $74,000 will be most likely to give
c. $66,000 Jones the lowest ending
inventory when its
d. $60,000
product lines are subject
33. Estimates of pricelevel to specific price
changes for specific increases?
inventories are required for a. Specific identification.
which of the following b. Weightedaverage.
inventory methods? c. Dollarvalue LIFO.
a. Conventional retail. d. FIFO periodic.
b. Dollarvalue LIFO. 36. Dart Company’s
c. Weightedaverage cost. accounting records
d. Average cost retail. indicated the following
34. When the double information:
extension approach to the Inventory, 1/1/11 $ 500,000
dollarvalue LIFO Purchases during 2011 2,500,000
Sales during 2011 3,200,000
inventory method is used,
the inventory layer added A physical inventory taken on
in the current year is December 31, 2011, resulted in an
multiplied by an index ending inventory of $575,000.
number. Which of the Dart’s gross profit on sales has
following correctly states remained constant at 25% in recent
how components are used years. Dart suspects some
in the calculation of this inventory may have been taken by
index number? a new employee. At December 31,
a. In the 2011, what is the estimated cost of
numerator, the missing inventory?
average of the a. $ 25,000
ending inven
tory at base year
cost and at
current year
cost.
b. In the
numerator, the
ending
inventory at
current year
a. $1,500,000
b. $100,000 b. $1,590,000
c. $175,000 c. $1,620,000
d. $225,000 d. $1,710,000
37. On July 1, 2011, Casa 39. Kew Co.’s accounts payable
Development Co. balance at December 31,2011, was
purchased a tract of land $2,200,000 before considering the
for $1,200,000. Casa following data:
incurred additional cost
of $300,000 during the • Goods shipped to Kew FOB
remainder of 2011 in shipping point on De
cember 22, 2011, were
preparing the land for
lost in transit. The invoice
sale. The tract was cost of $40,000 was not
subdivided into recorded by Kew. On
residential lots as January 7, 2012, Kew
follows: filed a $40,000 claim
Lot class Number of lots Sales price per lot against the common
A 100 carrier.
B 100 • On December 27, 2011, a
C 200 vendor authorized Kew to
Using the relative sales value return, for full credit, goods
method, what amount of costs shipped and billed at $70,000
should be allocated to the Class A on December 3, 2011. The
lots? returned goods were shipped
by Kew on December 28,
a. $300,000
2011. A $70,000 credit memo
b. $375,000 was received and recorded by
c. $600,000 Kew on January 5, 2012.
d. $720,000 • Goods shipped to Kew FOB
destination on Decem
38. Herc Co.’s inventory at
ber 20, 2011, were received on
December 31, 2011, January 6, 2012. The invoice
was$1,500,000 based on a cost was $50,000.
physical count priced at cost,
and before any necessary What amount should Kew report
adjustment for the following: as accounts payable in its
December 31, 2011 balance
• Merchandise costing sheet?
$90,000, shipped FOB a. $2,170,000
shipping point from a
b. $2,180,000
vendor on December 30,
c. $2,230,000
2011, was received and
recorded on January 5,
d. $2,280,000
2012. 40. Lewis Company’s usual
• Goods in the shipping area sales terms are net sixty
were excluded from in days, FOB shipping point.
ventory although Sales, net of returns and
shipment was not made allowances, totaled
until January 4, 2012.
$2,300,000 for the year
The goods, billed to the
customer FOB shipping ended December 31, 2011,
point on December 30, before yearend
2011, had a cost of adjustments. Additional
$120,000. data are as follows:
What amount should Herc report as
inventory in its December 31,
2011 balance sheet?
Holden reported the sale
of ten freezers and
• On December 27, 2011, Lewis remitted $8,500. The
authorized a customer to remittance was net of the
return, for full credit, goods agreed 15% commission.
shipped and billed at What amount should
$50,000 on December 15, Grimm recognize as
2011. The returned goods consignment sales reve
were received by Lewis on nue for 2011?
January 4, 2012, and a
a. $ 7,700
$50,000 credit memo was
issued and recorded on the b. $ 8,500
same date. c. $ 9,800
• Goods with an invoice d. $10,000
amount of $80,000 were
billed and recorded on 43. The following items were
January 3, 2012. The included in Opal Co.’s
goods were shipped on inventory account at
December 30, 2011. December 31, 2011:
• Goods with an invoice Merchandise out on consignment, at sales price, includ
amount of $100,000 were ing 40% markup on selling price $40,000
billed and recorded on Goods purchased, in transit, shipped FOB shipping point 36,000
December 30, 2011. The Goods held on consignment by Opal 27,000
goods were shipped on By what amount should Opal’s
January 3, 2012. inventory account at December 31,
Lewis’ adjusted net sales for 2011 2011, be reduced?
should be a. $103,000
a. $2,330,000 b. $ 67,000
b. $2,280,000 c. $ 51,000
c. $2,250,000 d. $ 43,000
d. $2,230,000 44. On December 1, 2011, Alt
41. On January 1, 2011, Dell, Department Store received
Inc. contracted with the 505 sweaters on consignment
city of Little to provide from Todd. Todd’s cost
custom built desks for the for the sweaters was $80
city schools. The contract each, and they were
made Dell the city’s sole priced to sell at $100.
supplier and required Dell Alt’s commission on
to supply no less than consigned goods is 10%.
4,000 desks and no more At December 31, 2011,
than 5,500 desks per year five sweaters remained.
for two years. In turn, In its December 31,
Little agreed to pay a fixed 2011 balance sheet, what
price of $110 per desk. amount should Alt report
During 2011, Dell pro as payable for consigned
duced 5,000 desks for goods?
Little. At December 31,
2011, 500 of these desks
were segregated from the
regular inventory and were
accepted and awaiting
pickup by Little. Little
paid Dell $450,000 during
2011. What amount should
Dell recognize as contract
revenue in 2011?
a. $450,000
b. $495,000
c. $550,000
d. $605,000
42. On October 20, 2011,
Grimm Co. consigned
forty freezers to Holden
Co. for sale at $1,000 each
and paid $800 in
transportation costs. On
December 30, 2011,
inventory amounts were
a. $49,000 essentially unchanged.
b. $45,400 Which of the following
c. $45,000 statements explains the
d. $40,400 increased inventory
turnover ratio?
45. Southgate Co. paid the intransit a. Cost of goods sold
insurance premium for consignment decreased.
goods shipped to Hendon Co., the b. Accounts receivable
consignee. In addition, Southgate turnover increased.
advanced part of the commissions c. Total asset turnover
that will be due when Hendon sells increased.
the goods. Should Southgate include d. Gross profit percentage
the intransit insurance premium and decreased.
the advanced commissions in
inventory costs? 50. Selected data
Insurance premium pertaining
Advanced commissions to Lore Co.
a. Yes for the calendar year
b. No 2011 is as follows:
c. Yes Net cash sales $ 3,000
d. No Cost of goods sold 18,000
Inventory at beginning of year 6,000
46. Jel Co., a consignee, paid Purchases 24,000
the freight costs for goods Accounts receivable at beginning of year 20,000
shipped from Dale Co., a Accounts receivable at end of year 22,000
consignor. These freight Lore would use which of the
costs are to be deducted following to determine the
from Jel’s payment to average days’ sales in
Dale when the con inventory?
signment goods are sold.
Until Jel sells the goods,
the freight costs should be
included in Jel’s
a. Cost of goods sold.
b. Freightout costs.
c. Selling expenses.
d. Accounts receivable.
47. Heath Co.’s current ratio
is 4:1. Which of the
following transactions
would normally increase
its current ratio?
a. Purchasing inventory on
account.
b. Selling inventory on
account.
c. Collecting an account
receivable.
d. Purchasing machinery for
cash.
48. During 2011, Rand Co. purchased
$960,000 of inventory. The cost of
goods sold for 2011 was $900,000,
and the ending inventory at
December 31, 2011, was $180,000.
What was the inventory turnover for
2011?
a. 6.4
b. 6.0
c. 5.3
d. 5.0
49. In a comparison of 2011
to 2010, Neir Co.’s
inventory turnover ratio
increased substantially
although sales and
Numerator Denominator
a. 365 Average inventory
b. 365 Inventory turnover
c. Average inventory Sales divided by 365
d. Sales divided by 365 Inventory turnover d. $0

Items 55 and 56 are based on the
51. Cord Builders, Inc. has
following data pertainingto Pell
consistently used the percentageof
Co.’s construction jobs, which
completion method of accounting for
commenced during 2011:
constructiontype contracts. During
2010 Cord started work on a
$9,000,000 fixedprice construction
contract that was completed in 2012.
Cord’s accounting records disclosed
the following:
Cumulative contract costs incurred $3,900,000
Estimated total cost at completion 7,800,000
Project 1 Project 2
Contract price $420,000 $300,000
Costs incurred during 2011 240,000 280,000
Estimated costs to complete 120,000 40,000
Billed to customers during 2011 150,000 270,000
Received from customers during 2011 90,000 250,000
completion method of
How much income would Cord recognizing income.
have recognized on this During 2011, Hansen
contract for the year ended started work on a
December 31, 2011? $3,000,000 fixedprice
a. $100,000 construction contract.
b. $300,000 The accounting records
c. $600,000 disclosed the following
d. $700,000 data for the year ended
December 31, 2011:
52. State Co. recognizes
Costs incurred $ 930,000
construction revenue and Estimated cost to complete 2,170,000
expenses using the Progress billings 1,100,000
percentageofcompletion Collections 700,000
method. During 2010, a
How much loss should Hansen have
single longterm project
was begun, which recognized in 2011?
continued through 2011. a. $230,000
Information on the project b. $100,000
follows: c. $ 30,000
2010
Accounts receivable from
construction contract $100,000
Construction expenses 105,000
Construction in progress 122,000
Partial billings on contract 100,000
Profit recognized from the long
term construction contract in 2011
should be
a. $ 50,000
b. $108,000
c. $128,000
d. $228,000
53. Lake Construction
Company has
consistently used the
percentageof
completion method of
recognizing income.
During 2010, Lake
entered into a fixedprice
contract to construct an
office building for
$10,000,000.
Information relating to
the contract is as
follows:
Percentage of completion
Estimated total cost at completion $7,500,000
Income recognized (cumulative) 500,000
Contract costs incurred during 2011
were
a. $3,200,000
b. $3,300,000
c. $3,500,000
d. $4,800,000
54. Hansen Construction,
Inc. has consistently
used the percentageof
55. If Pell used the Progress Income
completed contract billings to date previously recognized
method, what amount a. Yes No
of gross profit (loss) b. No Yes
would Pell report in its c. No No
2011 income statement? d. Yes Yes
a. $ (20,000) 59. The calculation of the
b. $ 0
income recognized in the
c. $ 340,000
third year of a fiveyear
d. $ 420,000
construction contract
56. If Pell used the accounted for using the
percentageofcompletion percentageofcompletion
method, what amount of method includes the ratio of
gross profit (loss) would a. Total costs incurred to date
Pell report in its 2011 to total estimated costs.
income statement? b. Total costs incurred to date
a. $(20,000) to total billings to date.
b. $ 20,000 c. Cost incurred in year three
c. $ 22,500 to total estimated costs.
d. $ 40,000 d. Costs incurred in year three
to total billings to date.
used in calculating the 60. When should an
income recognized in anticipated loss on a
the fourth and final year longterm contract be
of a contract accounted recognized under the
for by the percentageof percentageofcompletion
completion method? method and the
Actual total costs completedcontract
Income previously recognized
a. Yes method, respectively?
b. Yes Percentageofcompletion Completedcontract
c. No a. Over life of project Contract complete
d. No b. Immediately Contract complete
c. Over life of project Immediately
58. A company used the d. Immediately Immediately
percentageofcompletion methodof
accounting for a fiveyear 61. In accounting for a long
construction contract. Which of the term construction contractusing
following items will the company the percentageofcompletion
use to calculate the income method, the progress billings on
recognized in the third year? contracts account is a
a. FIFO is allowed.
a. Contra current asset b. Interest costs may be
account. capitalized if there is a
b. Contra noncurrent asset lengthy production period
account. to prepare goods for sale.
c. Noncurrent liability c. The weightedaverage
account. method is acceptable.
d. Revenue account. d. Inventories
are always
62. Brady Corporation values its
valued at net
inventory at the lower ofcost or net realizable
realizable value as required by value.
IFRS. Brady has the following
information regarding its inventory: 68. Which of the following
Historical cost methods of accounting
Estimated selling price for inventory is not
Estimated costs to complete and sell allowed under IFRS?
Replacement cost a. LIFO.
What is the amount for inventory b. Specific identification.
that Brady should report on the c. FIFO.
balance sheet under the lower of d. Weightedaverage.
cost or net realizable value method?
a. $1,000
b. $ 900
c. $ 850
d. $ 750
63. A company determined the
following values for its inventory
as of the end of its fiscal year:
Historical cost
Current replacement cost
Net realizable value
Net realizable value less a normal profit margin
Fair value
Under IFRS, what amount should the company report as inventory on its
balance sheet?
a. $70,000
b. $85,000
c. $90,000
d. $95,000
64. Under IFRS, which of the following inventory items are not valued at the lower
of cost or net realizable value?
a. Manufactured inventory items.
b. Retail inventory items.
c. Biological inventory items.
d. Industrial inventory items.
65. Under IFRS, the specific identification method of accounting for
inventory is required for
a. All inventory items.
b. Inventory items which are interchangeable.
c. Inventory items that are not interchangeable and goods that
are produced and segregated for specific projects.
d. Biological (agricultural) inventories.
66. The information provided below is for an item in Harris Corporation’s
inventory at year end. Harris presents its financial statements in
accordance with IFRS:
Estimated selling price 1,300
Estimated completion and selling costs 150
Replacement cost 1,100
What should be the value of this inventory item in the company’s financial
statements?
a. $1,100
b. $1,150
c. $1,200
d. $1,300
67. Which of the following is not true about accounting for inventory
under IFRS?
SIMULATIONS
Concepts
Authoritative
Literature Help
Indicate whether each of the following is included in the cost of inventory.
Included Not included
1. Merchandise purchased for resale
2. Freightout
3. Direct materials
4. Sales returns
5. Packaging for shipment to customer
6. Factory overhead
7. Interest on inventory loan
8. Purchase discounts not taken
9. Freightin
10. Direct labor
Journal Entries
Authoritative
Literature Help
Blaedon uses the periodic inventory method for inventories. Prepare the journal entries for each of the following
transactions. Blaedon uses the gross method for recording inventory transactions.
1. On January 5, 2011, purchased $17,000 of garden tillers on account from Bestbuilt Tillers, terms 2/10, n/30,
FOB destination. Freight charges were $200.
2. On January 10, 2011, returned garden tillers worth $2,000 to Bestbuilt Tillers due to defects.
3. On January 14, 2011, paid for the remaining tillers purchased in 1.
4. On January 28, 2011, purchased $30,000 of lawn mowers from Lawn Giant, terms 3/10, n/30, FOB shipping point.
The freight charges were $820.
5. On February 6, 2011, paid for the lawn mowers purchased in part 4. from Lawn Giant.
Calculations
Authoritative
Literature Help
Situation
A client, Blaedon Co., sells lawn mowers and garden tillers. The garden tillers are purchased from Bestbuilt Tillers and
sold to customers without modification. The lawn mowers, however, are purchased from several contractors. Blaedon then
makes ongoing design refinements to the mowers before selling them to customers.
The lawn mowers cost $200. Blaedon then makes the design refinements at a cost of $85 per lawn mower. Blaedon stores
the lawn mowers in its own warehouse and sells them directly to retailers at a list price of $500. Blaedon uses the FIFO inven
tory method. Approximately twothirds of new lawn mower sales involve tradeins. For each used lawn mower traded in and
returned to Blaedon, retailers receive a $40 allowance regardless of whether the tradein was associated with a sale of a 2011 or
2012 model. Blaedon’s net realizable value on a used lawn mower averages $25.
At December 31, 2011, Blaedon’s inventory of new lawn mowers includes both 2011 and 2012 models. When the 2012
model was introduced in September 2011, the list price of the remaining 2011 model lawn mowers was reduced below cost.
Blaedon is experiencing rising costs.
Blaedon has contacted your firm for advice on how to report the carrying value of inventory, the impact of the decline
in value on the 2011 models, and the effects of using the FIFO method on their December 31, 2011 financial statements.
Assume that Blaedon had the following information regarding the garden tiller inventory:
Purchases $210,000
Purchase discounts 38,000
Freightin 12,100
Freightout 18,000
Beginning inventory 42,900
Ending inventory 34,250
Calculate the following items:
1. Goods available for sale
2. Costs of goods sold
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of the inventories of Litton Corporation. Research the Professional Standards
for the section that provides guidance on the items that should be included in the cost of inventory. Enter your response in the
answer fields below.
Calculation of
Gross Profit
Authoritative
Literature Help
Situation
London, Inc. began operation of its construction division on October 1, 2010, and entered into contracts for two separate
projects. The Beta project contract price was $600,000 and provided for penalties of $10,000 per week for late completion.
Although during 2011 the Beta project had been on schedule for timely completion, it was completed four weeks late in
August 2012. The Gamma project’s original contract price was $800,000. Change orders during 2012 added $40,000 to the
original contract price.
The following data pertains to the separate longterm construction projects in progress:
Beta Gamma
As of September 30, 2011:
Costs incurred to date $360,000 $410,000
Billings 315,000 440,000
Cash collections 275,000 365,000
Costs incurred to date 450,000 720,000
Estimated costs to complete 180,000
Billings 560,000 710,000
Additional information
• London accounts for its longterm construction contracts using the percentageofcompletion method for financial
reporting purposes and the completedcontract method for income tax purposes.
• Enacted income tax rates are 25% for 2011 and 30% for future years.
• London’s income before income taxes from all divisions, before considering revenues from longterm construction
projects, was $300,000 for the year ended September 30, 2011. There were no other temporary or permanent
differences.
Prepare a schedule showing London’s gross profit (loss) recognized for the years ended September 30, 2011, and 2012,
under the percentageofcompletion method.
London Inc.
SCHEDULE OF GROSS PROFIT (LOSS)
Beta Gamma
For the Year Ended September 30, 2011:
Estimated gross profit (loss):
Contract price
Less total costs
Estimated gross profit (loss)
Percent complete:
Costs incurred to date
Total costs
Percent complete
Gross profit (loss) recognized
For the Year Ended September 30, 2012:
Estimated gross profit (loss):
Contract price
Less total costs
Estimated gross profit (loss)
Percent complete:
Costs incurred to date
Total costs
Percent complete
Less gross profit (loss) recognized in prior year
Financial Statement Authoritative
Disclosures Literature Help
Situation
London, Inc. began operation of its construction division on October 1, 2010, and entered into contracts for two separate
projects. The Beta project contract price was $600,000 and provided for penalties of $10,000 per week for late completion.
Although during 2011 the Beta project had been on schedule for timely completion, it was completed four weeks late in
August 2012. The Gamma project’s original contract price was $800,000. Change orders during 2012 added $40,000 to the
original contract price.
The following data pertains to the separate longterm construction projects in progress:
Beta Gamma
Costs incurred to date $360,000 $410,000
Billings 315,000 440,000
Costs incurred to date 450,000 720,000
Estimated costs to complete 180,000
Billings 560,000 710,000
• London accounts for its longterm construction contracts using the percentageofcompletion method for financial
reporting purposes and the completedcontract method for income tax purposes.
• Enacted income tax rates are 25% for 2011 and 30% for future years.
• London’s income before income taxes from all divisions, before considering revenues from longterm construction
projects, was $300,000 for the year ended September 30, 2011. There were no other temporary or permanent
differences.
Prepare the following schedule showing London’s balances in the following accounts at September 30, 2011, under
the percentageofcompletion method:
• Accounts receivable
• Costs and estimated earnings in excess of billings
• Billings in excess of costs and estimated earnings
London Inc.
SCHEDULE OF SELECTED BALANCE SHEET ACCOUNTS
September 30, 2011
Accounts receivable
Costs and estimated earnings in excess of billings:
Construction in progress
Less: Billings
Costs and estimated earnings in excess of billings
Billings in excess of costs and estimated earnings
Estimated loss on contract
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Cole Construction Company. Cole constructs buildings under longterm
contracts using the completed contract basis of accounting. Cole has determined that a loss is anticipated on its contract
with Hale corporation. Which section of the Professional Standards provides guidance on how this situation should affect
Cole’s financial statements? Enter your response in the answer fields below.
Inventory Concepts
Authoritative
Literature Help
Items 1 through 13 represent True or False statements concerning inventory accounting methods. Indicate whether
eachstatement is true or false by clicking on the appropriate response.
1. T
2. T
h
3. I
n
4. A

5. U
n
6. T
h
7. T
h
8. U
n
9. A
10. D
u
11. I
n
12. T
h
13. U
n
Cost Flow Concepts
Authoritative
Literature Help
Below are statements describing inventory and cost flow methods. Identify which method matches each description by
clicking on the correct term and placing it in the space provided. You may use a term once, more than once, or not at all.
Terms
Specific identification
Weightedaverage
Simple average
Movingaverage
Firstin, firstout
Lastin, firstout
Dollarvalue LIFO
Gross profit
Method
1. During a period of rising prices, this method results in a higher net income.
2. This method most closely matches the physical flow of inventory.
3. Method that uses historical sales margins to estimate ending inventory.
4. Method that is appropriate when there is a relatively small number of significant dollar value items
in inventory.
5. Average cost must be calculated each time additional inventory is purchased.
6. Method that averages the cost of all items on hand and purchased during the period.
7. This method results in the lowest ending inventory in a period of rising prices.
8. Method that uses a price index to measure changes in inventory.
9. If used for tax purposes, this method must also be used for financial reporting purposes.
10. The cost of goods sold balance is the same whether a perpetual or periodic inventory system is used.
Schedule of Ending Authoritative
Inventory Literature Help
Situation
York Co. sells one product, which it purchases from various suppliers. York’s trial balance at December 31, 2011,
included the following accounts:
Sales (33,000 units @ $16) $528,000
Sales discounts 7,500
Purchases 368,900
Purchase discounts 18,000
Freightin 5,000
Freightout 11,000
York Co.’s inventory purchases during 2011 were as follows:
Units Cost per unit Total cost
Beginning inventory, January 1 8,000 $8.20 $ 65,600
Purchases, quarter ended March 31 12,000 8.25 99,000
Purchases, quarter ended June 30 15,000 7.90 118,500
Purchases, quarter ended September 30 13,000 7.50 97,500
Purchases, quarter ended December 31 7,000 7.70 53,900
55,000 $434,500
York’s accounting policy is to report inventory in its financial statements at the lower of cost or market, applied to total
inventory. Cost is determined under the lastin, firstout (LIFO) method.
York has determined that, at December 31, 2011, the replacement cost of its inventory was $8 per unit and the net
realizable value was $8.80 per unit. York’s normal profit margin is $1.05 per unit.
From this information, complete the following schedules.
York Co.
SUPPORTING SCHEDULE OF ENDING INVENTORY
December 31, 2011
Inventory at cost (LIFO):
Cost
Units per unit Total cost
Beginning inventory, January 1
Purchases, quarter ended March 31
Purchases, quarter ended June 30
Totals
York Co.
SCHEDULE OF COST OF GOODS SOLD
Beginning inventory
Add: Purchases
Less: Purchase discounts
Add: Freightin
Goods available for sale
Less: Ending inventory
Cost of goods sold
Research
Authoritative
Literature Help
Assume that you are assigned to the audit of Heath Corporation. Heath is considering changing its method of
costing inventory. Which section of the Professional Standards provides guidance on the appropriate methods for
determining inventory cost? Enter your response in the answer fields below.
1. c __ __ 15. b __ __ 29. a __ __ 43. d __ __ 57. a __ __

2. d __ __ 16. b __ __ 30. a __ __ 44. c __ __ 58. b __ __
3. c __ __ 17. b __ __ 31. c __ __ 45. c __ __ 59. a __ __
4. b __ __ 18. c __ __ 32. c __ __ 46. d __ __ 60. d __ __
5. c __ __ 19. a __ __ 33. b __ __ 47. b __ __ 61. a __ __
6. a __ __ 20. d __ __ 34. b __ __ 48. b __ __ 62. c __ __
7. a __ __ 21. b __ __ 35. c __ __ 49. d __ __ 63. c __ __
8. b __ __ 22. b __ __ 36. a __ __ 50. b __ __ 64. c __ __
9. b __ __ 23. c __ __ 37. c __ __ 51. a __ __ 65. c __ __
10. d __ __ 24. a __ __ 38. d __ __ 52. a __ __ 66. b __ __
11. c __ __ 25. c __ __ 39. a __ __ 53. b __ __ 67. d __ __
12. a __ __ 26. b __ __ 40. d __ __ 54. b __ __ 68. a __ __
13. c __ __ 27. d __ __ 41. c __ __ 55. a __ __ 1st: __/68 = __%
14. d __ __ 28. c __ __ 42. d __ __ 56. b __ __ 2nd: __/68 = __%
A. Determining Inventory and Cost of Goods Sold Purchase price less returns ($400,000 – $2,000) $398,000

Freightin 10,000
1. (c) Inventoriable costs include all costs necessary $408,000
toprepare goods for sale. For a merchandising concern Note that freightout is a selling expense, not an
these costs include the purchase price of the goods, inventoriable cost, as the diagram below indicates.
freightin, insurance, warehousing, and any costs
necessary to get the goods to the point of sale (except Customer
interest on any loans obtained to purchase the goods). In
this problem, inventoriable costs total $408,000. Inventoriable costs Point Selling expense
of sale (1) Raw materials purchased $430,000
Decrease in RM inventory 15,000
2. (d) When the shipping terms are FOB destination, Raw materials used $445,000
the seller bears all costs of transporting the goods (2) Beginning WIP $ --
to the buyer. Therefore, the seller is responsible RM used (from above) 445,000
Direct labor 200,000
for the payment of packaging costs ($1,000),
Factory overhead 300,000
shipping costs ($1,500), and the special handling Cost to account for 945,000
charges ($2,000). The only amount to be included Ending WIP --
as the buyer’s cost of the inventory purchased is Cost of goods manuf. $945,000
the purchase price ($50,000). (3) Cost of goods manuf. $945,000
Less: increase in FG inv. 35,000
3. (c) Purchases are always recorded net of trade discounts. Cost of goods sold $910,000
When more than one trade discount is applied to a list price,
it is called a chain discount. Chain discounts are applied in The decrease in RM inventory is added when computing RM
steps; each discount applies to the previously discounted used because RM were used in excess of those purchased.
price. The cost, net of trade discounts, is $2,800 [$5,000 – The increase in FG inventory is deducted when computing
(30% × $5,000) = $3,500; and $3,500 – (20% × $3,500) = cost of goods sold because it represents the portion of goods
$2,800]. Payment was made within the discount period, so manufactured which were not sold. The freightout is
the net purchase price is $2,744 [$2,800 – (2% × $2,800)]. irrelevant for this question because freightout is a selling
The remittance from Burr would also include re expense and therefore does not affect cost of goods sold.
imbursement of the $200 of delivery costs. Since the terms
were FOB shipping point, Burr is responsible for paying 5. (c) To compute cost of goods sold, the solutions
this amount, and must reimburse Pitt, who prepaid the approach is to set up a Taccount for inventory
freight. Thus, the total remittance is $2,944 ($2,744 + Inventory
$200). 12/31/10 90,000
Purchases 124,000 34,000 Writeoff
4. (b) Three computations must be performed: raw ? Cost of goods sold
materials used, cost of goods manufactured, and 12/31/11 30,000
cost of goods sold. Purchases increase inventory, while the writeoff and cost
of goods sold decrease inventory. Cost of goods sold can
be computed as $150,000 using the Taccount. An
alternate solutions approach is to use the CGS
computation
BI $ 90,000
+ Purchases 124,000
CGAS 214,000
– EI (30,000)
$34,000 recognized as inventory loss*
$184,000
$150,000 recognized as CGS
* Theoretically correct treatment.
6. (a) The cost of inventory should include all expenditures
(direct and indirect) incurred to bring an item to its ex
isting condition and location. Freightin charges are thus
appropriately included in inventory costs. Interest cost
shall not be capitalized for assets that are in use or ready for
their intended use in the earnings activities of the
enterprise. Thus,
prepare goods for sale. For a merchandising concern, these
include the purchase price of the goods, freightin,
interest on an inventory loan should not be included in insurance, warehousing, and any costs necessary to get the
inventory (it should be expensed as incurred). goods to the point of sale. Abnormal freight and handling
should be charged to expense of the period. Therefore, the
7. (a) The cost of inventory should include all normal costs for inventory are $5,500 ($3,000 + $2,000 +
expenditures (direct and indirect) incurred to $500) and the abnormal freight of $1,200 is charged to
bring an item to its existing condition and current expense of the period.
location. Freight charges are thus appropriately
included in inventory costs. Under the net
purchase method, purchase discounts not taken
are recorded in a Purchase Discounts Lost
account. When this method is used, purchase
discounts lost are considered a financial (i.e.,
“other”) expense, and are thus excluded from the
cost of inventory.
8. (b) Azur should report cost of goods sold calculated
as
Cost of goods sold (CGS) = Beg. Inventory + Net
purchases* + Freight in – Ending Inventory
CGS = $ 30,840 + $92,520** + $15,420 – $20,560
CGS = $118,220
Freight out is a selling expense and does not enter the
calculation of cost of goods sold.
* Net purchase = Purchases – Purchase returns and
allowances – Purchase discounts
* ($102,800 – $10,280)
9. (b) Fixed overhead is allocated based on the
normal capacity of the production facilities.
Normal capacity is the production expected to be
achieved over a number of periods or seasons
under normal circumstances, taking into account
the loss of capacity resulting from planned
maintenance. Answer (a) is incorrect, because the
actual amount of production may only be used if
it approximates normal capacity. Answers (c)
and (d) are incorrect because the accounting
standards do not specify a formula to calculate
normal capacity.
10. (d) Normal capacity refers to a range in
production levels that will vary based on
business and industryspecific factors. Normal
capacity is the production expected to be
achieved over a number of periods or seasons
under normal circumstances, taking into account
the loss of capacity resulting from planned
maintenance. Answer (a) is incorrect because the
Codification does not specify a formula for
calculating normal capacity. Answers (b) and (c)
are incorrect because actual production may
only be used if it approximates normal capacity.
11. (c) Unallocated fixed overhead costs are
recognized as an expense in the period in which
they are incurred. Therefore, answers (a), (b),
and (d) are incorrect.
12. (a) Any abnormal costs for freight, handling
costs, and wasted material are required to be
treated as current period charges, and not a part
of inventory cost. Therefore, answers (b), (c),
and (d) are incorrect.
13. (c) Inventoriable costs include all costs necessary to
until the next purchase. After the 1/7/11 purchase, Metro
B. Inventory Valuation and CostFlow Methods owns 1,600 units (1,000 + 600) at a total cost of $2,800
($1,000 + $1,800). Therefore, the movingaverage unit
14. (d) Ending inventory at dollar value LIFO cost at that time is $1.75 ($2,800 ÷ 1,600 units). After the
iscalculated as the base year inventory times the 1/20/11 sale of 900 units (at a unit of cost of $1.75), Metro
index. Therefore, the index used can be owns 700 units at a unit cost of $1.75 (700 × $1.75 =
calculated as 2.00 = ($80,000 EI at dollar value $1,225). The 1/25/11 purchase of 400 units at a total cost
LIFO/$40,000 base year cost). of $2,000 increases inventory to its 1/31/11 balance of
$3,225 ($1,225 + $2,000). The new unit cost (not required)
15. (b) The inventory valuations are calculated as fol
is $2.93 ($3,225 ÷ 1,100).
lows:
Valuations of ending inventory under LIFO perpetual B.5. Lower of Cost or Market
1,400 units at $1.00 = $1,400 18. (c) The lower of cost or market (LCM) is used
800 units at $5.00 = 4,000 forfinancial reporting of inventories. The market value of
Total $5,400
inventory is defined as the replacement cost (RC), as long
Value of ending inventory under LIFO periodic as it is less than the ceiling (net realizable value, or NRV)
2,000 units at $1.00 = $2,000 and more than the floor (NRV less a normal profit, or NRV
200 units at $3.00 = 600 – NP). In this case, the amounts are
Total $2,600 Ceiling: NRV = $40,000 est. sell. price
B.2. WeightedAverage – $12,000 disp. cost = $28,000
Floor: NRV – NP = $28,000 – (10% × $40,000) $24,000
RC: $20,000
16. (b) The requirement is to determine whether
theweightedaverage inventory method is applicable to a Since RC falls below the floor, the floor (NRV – NP) is
periodic and/or a perpetual inventory system. The the designated market value. Once market value is
weightedaverage method computes a weightedaverage designated, LCM can be determined by simply
unit cost of inventory for the entire period and is used with determining the lower of cost ($26,000) or market
periodic records. The movingaverage method requires that ($24,000). Therefore, inventory is reported at $24,000.
a new unit of cost be computed each time new goods are
19. (a) SFAC 5 establishes five different attributes
purchased and is used with perpetual records.
onwhich assets can be measured. The attribute used
B.4. MovingAverage should be determined by the nature of the item and the
relevance and reliability of the attribute measured. The
17. (b) The movingaverage method requires that a five attributes are historical cost, current cost, current
newunit cost be computed each time goods are purchased. market value, net realiz
The new unit cost is used to cost all sales of inventory
original cost (meaning statement I is
not correct), and RC must be less than
able value, and present value. NRV (meaning statement II is
Historical cost is defined as the correct) and greater than NRV – NP.
amount of cash, or its equivalent, paid
to acquire an asset. Reporting 22. (b) Inventory is priced at market
inventory at lower of cost or market is when market valueis less than cost.
a departure from the historical cost Market value is defined as current
principle as the inventory could replacement cost, subject to a
potentially be carried at the market ceiling of net realizable value (NRV)
value if lower. Although, reporting and a floor of net realizable value
inventory at lower of cost or market minus a normal profit margin.
does not create a departure from
Original Cost
conservatism as this method carries at
inventory the lowest or most Net Realizable Value
conservative value. The use of LCM (NRV)
does not violate the principle of
consistency either, as it would be NRV – Normal Profit
reported on this basis continually.
Finally the use of LCM would not Replacement Cost
violate the principle of full disclosure
In this situation, replacement cost
as its use would be discussed in the
lies outside of (below) the floor and
footnotes.
ceiling limitations. Therefore, NRV
20. (d) Inventory is to be valued at less a normal profit margin (the
the lower of cost ormarket. Under floor), will be used as the market to
this method, market is replacement determine LCM. Since original
cost provided that replacement cost cost is greater than market, market
is lower than net realizable value will be used to price the inventory
(ceiling) and higher than net for the period.
realizable value less the normal
profit margin (floor). The question
does not specify whether
replacement cost is above or below
net realizable value, but since the
original cost is below both of these
values, that information is
irrelevant.
NRV/RC
OC
NRV -
NP
Either NRV or RC will be
designated as the market value of
the inventory, and since the original
cost is below both of these values,
the inventory will be valued at its
original cost. Answer (c) is incorrect
because NRV – NP represents the
market floor. Answers (a) and (b)
are incorrect because they are both
above the original cost.
21. (b) Lower of cost or market
(LCM) is used for financial reporting
of inventories. The market value of
inventory is defined as the
replacement cost (RC) as long as it is
less than the ceiling (net realizable
value, or NRV) and more than the
floor (NRV less a normal profit, or
NRV – NP). Therefore, if inventory is
reported at RC, RC must be less than
FirstOut (LIFO)
B.6. Losses on Purchase
Commitments 25. (c) The requirement is to
determine the cost of the
23. (c) The requirement is to 1/31/11 inventory, using the
determine the amount ofprobable loss LIFO method. LIFO stands
from the purchase commitment that for lastin, firstout; this
Card should report in its 2011 income means that the cost of the
statement. When there is a decline in units purchased most
market value below the contract price recently are included in cost
at the balance sheet date and the of goods sold. Therefore,
contract is noncancelable, an the 1/31/11 inventory
unrealized loss should be recorded in consists of the 250 units that
the period of decline and reported in were purchased at the
the income statement. In this case, earliest date(s). Thus, the
Card has a contract to purchase a 1/31/11 inventory would
minimum of 100,000 units both in consist of the 150 units on
2012 and 2013 at $.10 per unit. The hand at 1/1/11 (150 × $21 =
$20,000 loss (200,000 × $.10) on $3,150) plus an additional
these obsolete units should be 100 units purchased at the
reduced by the amount Card believes earliest purchase date in
is realizable from the sale of these January (January 10; 100 ×
units. Therefore, the loss on $22 = $2,200). The total
purchase commitment is $16,000 value of the inventory at
[$20,000 – (200,000 × 1/31/11 would be $5,350
.02)]. Additionally, Card Corp. would ($3,150 + $2,200).
need to record a loss of $20,000 ($.08 26. (b) LIFO stands for lastin,
× 250,000) from inventory firstout; this means that it is
obsolescence. assumed that any units sold
24. (a) To maximize its inventory are the units most recently
purchased. In a perpetual
carrying amount atDecember 31,
system, LIFO is applied at
2011, Thread should use the
the time of each sale rather
perpetual movingaverage method
than once a year as in a
with the lower of cost or market rule
periodic system. Using
applied to the total inventory. First,
LIFO, the 900 units sold on
when using the perpetual moving
1/20/11 would consist of the
average method, the cost of sales
600 units purchased on
throughout the year are determined
1/7/11 and 300 of the 1,000
using the average cost of purchases
units in the 1/1/11 balance.
up to the time of the sale. On the
This would leave in
other hand, under the periodic
inventory 700 units from the
weightedaverage method, the cost
1/1/11 balance. After the
of each item is the weightedaverage
1/25/11 purchase, inventory
of all units purchased during the
included those 700 units
year. During a period of rising
plus the 400 units purchased
prices, the perpetual movingaverage
on 1/25/11. Therefore,
method results in a lower cost of
ending inventory is $2,700
goods sold and a higher ending
[(700 × $1) + (400 × $5)].
inventory because the cost of items
sold throughout the year is the 27. (d) When a company uses
average of the earlier, lower prices. LIFO for external report
Second, the application of the lower ing purposes and another
of cost or market rule to the total inventory method for
inventory will result in a higher internal pur
ending inventory because market poses, a LIFO Reserve account is
values lower than cost are offset used to reduce inventory from the
against market values higher than internal valuation to the LIFO
cost. valuation. LIFO Reserve is a contra
B.7. & B.8. FirstIn, FirstOut account to inventory, and is adjusted
up or
(FIFO), and LastIn,
is used, the first/last purchase
determination is made only at the end
down at yearend with a of the year, based upon the actual
corresponding increase or decrease to chronological order of all purchases.
Cost of Goods Sold. In this case, the When a perpetual method is used,
LIFO Reserve accountmust be however, the first/last purchase
adjusted from a balance of $35,000 to determination is made continuously
a balance of $55,000 ($375,000 – throughout the year. When inventory
$320,000). Therefore, LIFO Reserve levels get low under the perpetual
is credited for $20,000 ($55,000 – method, early purchase costs will
$35,000) with a corresponding debit often be assigned to goods sold, a
to Cost of Goods Sold. situation that is much less likely to
occur in a periodic system. Therefore,
28. (c) In a change to LIFO, no in times of either rising or falling
recognition is given to any prices, LIFO ending inventory is
cumulative effect associated usually different under a periodic
with the change because it is system than under a perpetual system.
usually not determinable.
Thus, the effect on ending in
B.9. DollarValue LIFO
ventory and net income is the 31. (c) When using dollarvalue
result solely of current year LIFO, the ending inventory at
effects. In a period of rising current year cost must first be
prices, LIFO will result in a converted to base year cost. This
lower ending inventory amount is given at 12/31/11
amount than FIFO because ($230,000), but it could be computed
theearlier lower costs are as follows: $276,000 ÷ 1.20 =
assumed to remain in ending $230,000. The next step is to
inventory. LIFO will also determine the incremental LIFO
result in a lower net income layers at base year cost. The 1/1/10
because the more recent
(base year) layer is $150,000, the
2010 layer is $50,000 ($200,000 –
higher costs are assigned to
$150,000), and the 2011 layer is
cost of goods sold.
$30,000 ($230,000 – $200,000).
29. (a) The inventory costing method Finally, the LIFO layers are restated
which most closely approximates the using the price index in effect at the
current cost for cost of goods sold is time each layer was added.
LIFO, while the method which more Ending inventory
Base cost at DV LIFO cost
accurately reflects ending inventory is 1/1/10 layer $150,000 × 1.00 = $150,000
FIFO. Under LIFO, the most recent 2010 layer 50,000 × 1.10 = 55,000
purchases are assumed to be the first 2011 layer 30,000 × 1.20 = 36,000
goods sold; thus, cost of goods sold $230,000 $241,000
contains relatively current costs. On
the other hand, since FIFO assumes
that the goods from beginning
inventory and the earliest purchases
are sold first, the ending inventory is
made up of more recent purchases
and thus represents a more current
value.
30. (a) Under the FIFO method, the first
goods purchased are considered to be
the first goods used or sold. Ending
inventory is thus made up of the latest
(most recent) purchases. Whenever
the FIFO method is used, the ending
inventory is the same whether a
perpetual or periodic system is used.
This is true even during periods of
rising or falling prices because the
inventory flow is always in
chronological order. Under the LIFO
method, the latest (most recent) pur
chases are considered to be the first
goods used or sold. Ending inventory
is thus made up of the first (oldest)
purchases. When a periodic method
32. (c) When using dollarvalue use of ending inventory at
LIFO, the ending inventory at current year cost and
current year cost must first be ending inventory at base
converted to base year cost. The year cost in calculating the
12/31/11 inventory at base year cost dollarvalue LIFO index.
is given as $60,000. Since the The index number used to
12/31/10 inventory at base year cost convert the current year’s
was $45,000 ($40,000 base layer and inventory layer is
$5,000 2010 layer), a new layer of calculated as follows:
$15,000 was added in 2011 ($60,000 Ending inventory
– $45,000). This layer must be at current year cost
Index =
restated using the 2011 price index. Ending inventory
The 2011 price index is computed at base year cost
using the doubleextension technique, This index indicates the relationship
as illustrated below. between current and base year prices
EI at yearend prices as a percentage, and when multiplied
= $80,000 by the new layer (which is the
EI at base year prices $60,000
increase in inventory in base year
Therefore, the 12/31/11 inventory dollars), it will convert the layer to
using dollarvalue LIFO is $66,000 current dollars.
as computed below.
Base cost 35. (c) During periods of rising
Base layer $40,000 prices, the inventorycosting methods
2010 layer 5,000 which will give Jones the lowest
2011 layer 15,000 × 1.33 ending inventory balance are LIFO
methods, because inventory items that
33. (b) The requirement is to were purchased at the earliest date
determine which inventory (when prices were lower) will remain
method requires estimates in inventory and the most recently
of price level changes for purchased and more expensive items
specific inventories. In will be expensed through cost of
accordance with the dollar goods sold. Any FIFO method will
value LIFO method, the produce a higher ending inventory
ending inventory is first balance during inflation since the
converted to the base year items purchased earliest (at lower
cost so that the incremental prices) will be expensed through
layers can be determined. CGS, while the more expensive items
The incremental layers are remain in inventory. Answers (a) and
then restated using the price (b) are incorrect because neither will
index which was in effect at give Jones a lower ending inventory
the time each of the layers balance than dollarvalue LIFO,
were added to the particularly as Jones’ inventory
inventory. Thus, the changes (because dollarvalue LIFO
specific layers of the allows the LIFO “layers” to be made
ending inventory are up of similar, not necessarily
adjusted to the current price identical, items).
level. Therefore, answer (b)
B.10. Gross Profit
is correct. Answers (a), (c),
and (d) are incorrect 36. (a) The gross profit method can
because these methods do be used to estimatethe cost of
not specifically adjust for missing inventory. The first step is to
price level changes. compute the cost of goods available
34. (b) The requirement is to for sale.
$120,000).
Beginning inventory 39. (a) Before adjustment, the

Purchases balance in the Accounts
Cost of goods available for sale Payable account is
The second step is to estimate cost of $2,200,000. The $40,000 of
goods sold based on the gross profit goods lost in transit from a
percentage. vendor were shipped FOB
Sales shipping point. This means
Estimated gross profit ($3,200,000 × 25%) the buyer owns the goods
Cost of goods sold ($3,200,000 × 75%) while they were in transit;
Note that a shortcut is to realize that therefore, Kew should
if gross profit is 25% of sales, cost of record the purchase and ac
goods sold must be 75% of sales. The counts payable in 2011.
third step is to compute estimated Kew, not the vendor, is
ending inventory. ultimately responsible for
Cost of goods available for sale the lost goods (note that
Estimated cost of goods sold Kew, not the vendor, is
Estimated ending inventory suing the common carrier).
The $70,000 return that was
Since the actual count of ending
recorded on 1/5/12 should
inventory at December 31 was
only $575,000, the estimated have been recorded in 2011
shortage in inventory is $25,000 when the return was
($600,000 – $575,000). authorized (December 27,
2011). Therefore, Kew
B.14. Cost Apportionment by should reduce 12/31/11
Relative Sales Value Accounts Payable by
$70,000. The $50,000 of
37. (c) The total cost of acquiring the goods received on 1/6/12
land and preparingit for sale were properly recorded in
($1,200,000 + $300,000 = 2012, since the terms were
$1,500,000) should be allocated to FOB destination (the buyer
the residential lots based on their does not own the goods
relative sales value, as computed until they are physically
below. received). Therefore, no
Lot # of Sales adjustment is necessary for
class lots price this amount. Kew should
A 100 × $24,000 report 12/31/11 Accounts
B 100 × 16,000
C 200 × 10,000 Payable at $2,170,000
($2,200,000 + $40,000 –
Fraction allocated $70,000).
Total cost to Class A
× 40. (d) Net sales is $2,300,000,
$1,500,000 ($2,400/$6,000)
subject to three possible
C. Items to Include in Inventory adjustments. The goods
returned ($50,000) should
38. (d) Before adjustment, the be recorded as a return in
inventory based on a 2011, when Lewis
physical count was authorized the return.
$1,500,000. The $90,000 of
merchandise shipped FOB
shipping point by a vendor
on 12/30/11 should also be
included in Herc’s 12/31/11
inventory because Herc, the
buyer, owns the goods
while in transit under these
terms. The goods in the
shipping area (cost,
$120,000) are also owned
by Herc because they were
not shipped until 2012 and
Herc still retains the risks
of ownership until that
point. Therefore, 12/31/11
inventory is $1,710,000
($1,500,000 + $90,000 +
$10,000 (10 × $1,000).
Since this return was not recorded Note that the trans
until 2012, 2011 sales must be portation costs ($800) do
adjusted downward. The goods not affect sales either; one
shipped on 12/30/11 ($80,000) were fourth (10/40) is reflected
recorded as a sale in 2012 Since the in cost of goods sold and
terms were FOB shipping point, the threefourths (30/40) is
sale must be recorded in 2011 when included in ending
the goods were shipped; therefore, inventory.
2011 sales must be adjusted upward.
The goods shipped on 1/3/12 43. (d) No adjustment is necessary for the
($100,000) should not be recorded as goods in transit ($36,000). The goods
a sale until 2012. Since the sale was were shipped FOB shipping point,
recorded in 2011, 2011 sales must be which means the buyer (Opal) owns
adjusted downward. Therefore, the goods while in transit. Therefore,
adjusted net sales for 2011 should be Opal properly included these goods in
$2,230,000 ($2,300,000 – $50,000 + 12/31/11 inventory. The
$80,000 – $100,000). merchandise out on consignment is
41. (c) Generally, goods are owned by the consignor (Opal) and
considered sold when legaltitle to the should be included in Opal’s
goods passes to the buyer. In certain inventory at cost [$40,000 – (40% ×
situations, however, the transfer of $40,000) = $24,000]. Therefore,
title criteria does not reflect the inventory must be reduced by
underlying economics of the $16,000 for this item ($40,000 –
situation. In this situation, although $24,000). The goods held on con
transfer of legal title may not have signment ($27,000) are owned by
occurred for the 500 segregated the consignor, not Opal; therefore,
desks, the economic substance of the inventory must be reduced $27,000
transaction is that the seller no for this item. The total reduction in
longer retains the risks of ownership. inventory is $43,000 ($16,000 +
Therefore, all 5,000 desks (including $27,000).
the 500 segregated and accepted
desks) are considered sold in 2011, 44. (c) Alt sold 500 of the consigned
and revenue of $550,000 is sweaters (505 – 5) at $100 each,
recognized (5,000 × $110). Note that resulting in total sales of $50,000
the amount of cash collected (500 × $100). Alt must report a
($450,000) does not affect the payable to Todd for this amount, less
amount of revenue recognized in this Alt’s commission [$50,000 – (10% ×
case. $50,000) = $45,000]. Alt does not
owe Todd anything for the unsold
D. Consignments sweaters until they are sold.
42. (d) A consignor recognizes 45. (c) Inventoriable costs include all
sales revenue from con costs necessary to prepare goods for
signments when the sale. These costs include the purchase
consignee sells the price or manufacturing cost of the
consigned goods to the goods, freight, and any other costs
ultimate customer. Sales necessary to get the goods to the point
commissions earned by the of sale. The intransit insurance
consignee ($10,000 × 15% premium would therefore be included
= $1,500) are reported as a in inventory costs. Commissions paid
selling expense by the to the consignee are selling expenses
consignor and are not in the period the consigned goods are
netted against sales sold that are not required to ready the
revenue. Therefore, sales goods for sale. These costs, therefore,
revenue is reported at the are not included in inventory.
total selling price of
inventory, divided by two. Since
beginning inventory is not given, it
46. (d) In a consignment, the must be computed using the cost of
manufacturer or wholesaleris goods sold relationship
referred to as the consignor and the Cost of goods sold $ 900,000
dealer or retailer is referred to as the + Ending inventory 180,000
consignee. In such an arrangement, Cost of goods available for sale $1,080,000
– Purchases – 960,000
title to the goods remains with the
Beginning inventory $ 120,000
consignor until they are sold to a
third party. Jel’s payment of
reimbursable freight costs results in
an account receivable from Dale,
which Jel will subtract from the sale
proceeds it remits to Dale. An
swers (a), (b), and (c) are incorrect
because the consignee, Jel, generally
does not bear any costs associated
with the sale of consigned goods.
E. Ratios
47. (b) The formula to compute
the current ratio is
Current assets
Current ratio =
Current liabilities
The following entries would be
recorded when inventory is sold on
account:
Accounts receivable Sales price
Sales of merchandise
Cost of goods sold Cost of
Inventory merchandise
Since the selling price (increase to
AR) is normally higher than the
cost of the merchandise sold
(decrease to merchandise
inventory) the sale would normally
cause a net increase in current
assets, and therefore, a net increase
in the current ratio. When the
existing current ratio is greater than
one, increases of equal amounts to
the numerator (inventory, a
component of current assets) and
denominator (accounts payable, a
component of current liabilities)
will reduce the ratio. When an
account receivable is collected, cash
(a current asset) is increased by the
same amount that accounts
receivable (another current asset) is
decreased. Thus, the transaction has
no impact on the current ratio.
When machinery (a noncurrent
asset) is purchased for cash (a
current asset), there is a decrease in
the current ratio.
48. (b) The formula for inventory
turnover is
Cost of goods
sold
Average
inventory
Average inventory is equal to
beginning inventory plus ending
method is generally computed as
Thus, if cost of goods sold increases follows:
while inventory remains unchanged,
then the inventory turnover ratio will
increase.
In addition, we must examine the
effects of the increase in cost of
goods sold on the gross profit
percentage when sales remain
constant. Assuming the same facts as
above, and sales of $200, we get the
following results:
Sales 200 200
– Cost of goods sales – 100 – 150
Gross profit 100 50
Thus, as cost of goods sold
increases, the gross profit and the
gross profit percentage will
decrease.
Answer (a) is incorrect because a
decrease in cost of goods sold will
cause the inventory ratio to increase.
Answers (b) and (c) are incorrect
because they are not related to
inventory turnover.
50. (b) Average days’ sales in
inventory measures thenumber of
days inventory is held before sale;
it reflects on efficiency of
inventory policies. It is computed
using the following formula:
365
Inventory
turnover
F. LongTerm Construction
Contracts
51. (a) The total expected income
on the contract at12/31/11 is
$900,000 ($9,000,000 –
$8,100,000). The formula for
recognizing profit under the
percentageofcompletion method
is
Cost to date Expected
Total expected costs × profit
$6,300,000
$8,100,000 × $900,000
This result is the total profit on the
contract in 2010 and 2011. The 2010
profit recognized must be subtracted
from $700,000 to determine the 2011
profit. At 12/31/10, the total expected
income on the contract was
$1,200,000 ($9,000,000 –
$7,800,000). The income recognized
in 2010 was $600,000, as computed
below.
$3,900,000
$7,800,000
$1,200,000 =
×
$600,000
Therefore, 2011 income is
$700,000 less $600,000, or
$100,000.
52. (a) Profit to be recognized
using the percentageofcompletion
Cost to date × Expected – Profit recognized
Total expected cost profit in previous periods
Therefore, average inventory is Not enough information is given in
$150,000 [($120,000 + $180,000) ÷ this problem to perform this
2], and inventory turnover is 6.0 computation, so 2011 profit must be
times ($900,000 ÷ 150,000). computed indirectly. Since only
construction expenses and profit are
49. (d) The solutions approach is to debited to the constructionin
create a numericalexample that progress (CIP account), 2010 profit
conforms to the facts given in the must have been $17,000 ($122,000
question. The inventory turnover CIP less $105,000 const. exp.).
ratio is calculated as follows: Cumulative profit recognized by the
Cost of goods end of 2011 must be $67,000
sold [$364,000 CIP less $297,000
Average cumulative const. exp. ($105,000 +
inventory $192,000)]. Therefore, 2011 profit
was $50,000 ($67,000 − $17,000).
If we assume that cost of goods sold
has increased from 100 to 150 and
average inventory has remained
unchanged at 50 then the following
ratios result:
Cost of goods sold 100
= 2
Average inventory 50
CIP
2010 Exp. 105,000
2010 Profit ? 2010 Profit = $17,000
2010 End. bal 122,000
2011 Exp. 192,000
2011 Profit ? 2011 Profit = $50,000
2011 End. bal. 364,000
Costs to date × Estimated profit = Gross profit to date
Total estimated costs
53. (b) Based on the
information given, it must Pell would recognize gross profit of
be assumed that costs $40,000 on project 1
incurred are used to $240,000
measure the extent of $240,000 + $120,000 × [$420,000 – ($240,000 + $120,000)] =$40,000
progress toward project
Note that prior years’ gross profit
completion. At 12/31/10,
need not be subtracted from $40,000
the project was 20%
because the project commenced
complete and total
during 2011. Under both the
estimated costs were
percentageofcompletion method and
$7,500,000. Therefore, costs
the completedcontract method, an
incurred as of 12/31/10
expected loss must be recognized in
were 20% of $7,500,000, or
$1,500,000. At 12/31/11, full in the period in which the
the project was 60% expected loss is discovered. Project 2
complete and total has an expected loss of ($20,000)
estimated costs were [$300,000 – ($280,000 + $40,000)]
$8,000,000. Therefore, costs which must be recognized in full in
incurred as of 12/31/11 are 2011. The net gross profit recognized
60% of $8,000,000 or on the two projects is $20,000
$4,800,000. The costs ($40,000 profit less ($20,000) loss.
incurred during 2011 were 57. (a) In the final year of a contract
$4,800,000 less $1,500,000, accounted for bythe percentageof
or $3,300,000. completion method, the percentage of
54. (b) The requirement is to completion is 100%, since costs to
determine the amount of date equal total costs. Therefore, the
formula to calculate income to be
loss to recognize in 2011 on
recognized in the final year is simply
a longterm, fixedprice con Inc
struction contract. Under om
e
both the percentageof pre
completion method and the vio
usl
completedcontract method, y
an expected loss on a
contract must be recognized
in full in the period in which
the expected loss is
discovered. Therefore,
Hanson must recognize a
loss of $100,000 in 2011.
Expected contract revenue
Expected contract costs ($930,000 + $2,170,000)
Expected loss
55. (a) The expected income on

project 1 [$420,000 –
($240,000 + $120,000) = $60,000] is
not recognized until the project is
completed under the completed
contract method. However, under the
completed contract method, an
expected loss on a contract must be
recognized in full in the period
inwhich it is discovered. Project 2
has an expected loss of ($20,000)
[$300,000 − ($280,000 + $40,000)]
which must be recognized
immediately in 2011.
56. (b) Construction companies that
use the percentageofcompletion
method in accounting for longterm
construction contracts usually
recognize gross profit according to
the costtocost method.
liabilities as current. On the
particular year. The formula to balance sheet, the
calculate current income is as Construction in Progress
follows: (CIP) account is netted with
the contra account, progress
Cost to date × Expected
Total expected cost profit
billings. If CIP exceeds
billings, the excess is
Progress billings do not impact the reported as a current asset
amount of income recognized. [answer (a)]. If billings
exceed CIP, the excess is
59. (a) The requirement is to reported as a current
determine the ratio to beused to liability. Answers (b) and
calculate income in the third year (c) are incorrect because the
using the percentageof accounts related to
completion method. Income may construction contracts are
be recognized on a costtocost classified as current.
basis when the percentageof Answer (d) is incorrect
completion method is used. because progress billings is
not used as a basis for
Cost to date × Expected
Total expected cost profit
recognizing revenues.
Answers (b) and (d) are incorrect G. International Financial

because billings to date are not used Reporting Standards (IFRS)
as a basis for recognizing revenues.
Answer (c) is incorrect as the costto
cost calculation requires a cumulative calculate the amount that
calculation so changes in expected should be presented for inventory.
costs and expected income can be Answer (c) is correct be
adjusted for; thus, costs incurred in cause the lower of cost or net realizable
year three would be an incorrect basis value method requires
for recognition of income. net realizable value to be calculated as
the estimated selling
60. (d) An anticipated loss on a longterm price less estimated costs of completion
contract should be recognized and estimated costs to
immediately under both the sell. Therefore, the NRV is $850
percentageofcompletion and the ($900 – $50). The lower of
completedcontract methods. cost or net realizable value is
determined by comparing the
cost of $1,000 to the NRV of $850,
determine the proper clas and using the lower
sification for the progress
amount. Inventory should be reported
billings on contracts account
at $850.
under the percentageof
completion method. In the 63. (c) The requirement is to
construction industry, determine the amount that
operating cycles for should be reported as inventory.
construction contracts Answer (c) is correct be
generally exceed one year. cause under IFRS inventory is
Therefore, the predominant reported at the lower of cost or
practice is to classify all net realizable value. Therefore, the
contractrelated assets and amount is $90,000, which
(Contract price –
Actual costs)
r
e is the lower of $100,000 cost or
$90,000 net realizable value.
Actual
income 64. (c) The requirement is to
identify the inventory items
that are not valued at the lower of cost or net realizable value
Therefore both actual total costs under IFRS. Answer (c) is correct
and income because biological inven
previouslyrecognized are used in tory items are valued at fair value
calculating income. less the cost to sell at the
58. (b) Under the percentageof point of harvest.
completion method ofaccounting for
longterm contracts, the costtocost
formula is used to compute the
amount of income to be recognized in
a
65. (c)
Th
e
re
qu
ire
m
en
t
is
to
id
en
tif
y
w
he
n
th
e
sp
ec
ifi
c
id
en
tif
ic
ati
on
m
et
ho
d
is
re
qu
ire
d
un
de
r
IF
R
S.
A
ns
w
er
(c)
is
co
rre
ct
be
ca
us
e
th
e
sp
ec
ifi
c
id
en
tif
ic
ati
on
m
et
ho
d
is
re
qu
ire
d
fo
r
in
ve
nt
or
y
ite
m
s
th
at
ar
e
no
t
int
er
ch
an
ge
ab
le
an
d
go
od
s
th
at
ar
e
pr
od
uc
ed
an
d
se
gr
eg
at
ed
fo
r
sp
ec
ifi
c
pr
oj
ec
ts.
66. (b
)
T
he
re
qu
ir
e
m
en
t
is
to
de
te
r
m
in
e
th
e
va
lu
e
of
th
e
in
ve
nt
or
y
ite
m
un
de
r
IF
R
S.
A
ns
w
er
(b
)
is
co
rr
ec
t
be
ca
us
e
un
de
r
IF
R
S,
in
ve
nt
or
y
is
pr
es
en
te
d
at
th
e
lo
w
er
of
co
st
($
1,
20
0)
or
ne
t
re
ali
za
bl
e
va
lu
e
($
1,
30
0
se
lli
ng
pr
ic
e
–
$1
50
es
ti
m
at
ed
co
m
pl
eti
on
an
d
se
lli
ng
co
st
s).
T
he
re
fo
re,
th
e
ite
m
sh
ou
ld
be
va
lu
ed
at
$1
,0
50
.
67. (d)
The
requ
ire
men
t is
to
iden
tify
the
stat
eme
nt
that
is
not
corr
ect
abo
ut
acc
ount
ing
for
inve
ntor
ies
und
er
IFR
S.
An
swe
r (d)
is
corr
ect
bec
ause
inve
ntor
ies
are
not
alw
ays
valu
ed
at
net
reali
zabl
e
valu
e.
The
y
are
valu
ed
at
the
low
er
of
cost
or
net
reali
zabl
e
valu
e.
68. (a)
The
req
uire
me
nt
is
to
ide
ntif
y
the
met
hod
of
ac
cou
ntin
g
that
is
not
allo
wed
und
er
IFR
S.
Ans
wer
(a)
is
cor
rect
bec
aus
e
the
LIF
O
met
hod
is
not
allo
wed
und
er
IFR
S.
All
of
the
oth
er
met
hod
s
are
allo
wed
.
Concepts
Authoritative
Literature Help
Included Not included
1. Merchandise purchased for resale
2. Freightout
3. Direct materials
4. Sales returns
5. Packaging for shipment to customer
6. Factory overhead
7. Interest on inventory loan
8. Purchase discounts not taken
9. Freightin
10. Direct labor
1. Merchandise purchased for resale is a part of inventory.
2. Freightout is part of selling expense.
3. Direct materials are part of work in process, which is an inventory account
for manufacturers.
4. Sales returns are a contra account to sales, and are not part of inventory.
5. Packaging for shipment to customer is part of selling expenses.
6. Factory overhead is part of work in process, which is an inventory account
for manufacturing firms.
7. Interest on inventory loan is an operating expense. Interest cost should not be
capitalized for assets that are in use or ready for their intended use in the
earnings activities of the enterprise.
8. Purchase discounts lost are considered a financing expense and are
excluded from the cost of inventory.
9. Freightin is part of getting the goods in place to sell and should be
included in inventory.
10. Direct labor is part of work in process, and is an inventory account for
manufacturing firms.
Journal Entries
Authoritative
Literature Help
1. On January 5, 2011, purchased $17,000 of garden tillers on
account from Bestbuilt Tillers, terms 2/10, n/30, FOB
destination. Freight charges were $200.
Purchases 17,000
2. On January 10, 2011, returned garden tillers worth $2,000 to Bestbuilt
Tillers due to defects.
3. On January 14, 2011, paid for the remaining tillers purchased in 1.
Purchase discounts 300*
Cash 14,700
*
15,000 × .02 = 300

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The following items, Copyright © by the American Institute of Certified Public Accountants, Inc.

Basic Theory and Financial Reporting TREP 9 241

Individual Taxation ITAX 35 862

(A) (B) (C) (D) (E) (F) (G) (H)

a. Supervise members of the 54. Which of the following is most likely

50. Which of the following is least 55. An auditor who discovers that a

110. Quality control for a

(I) (D) (N)

Ratio 20X8 20X7

(H) (I) (J) (K) (L) (M)

1. a __ __ 21. b __ __ 41. c __ __ 61. c __ __ 81. b __ __ 101. c __ __

33. (a) The requirement is to identify the 36. (d) The requirement is to identify an

34. (a) The requirement is to identify the 37. (d) The requirement is to identify the

50. (a) The requirement is to identify 54. (b) The requirement is to identify the

51. (a) The requirement is to identify the 55. (d) The requirement is to identify the

accounting system. Answer (b) is incorrect 82. (c) The requirement is to determine why an

Factor Increased audit riskDecreased audit risk Fraud risk factor

Audit procedures (A) (B) (C) (D)

cash. Which of the following controls would be most 93. With properly designed internal control, the

From From From

For Receipts and

Prepares Approves & Compares Invoice

1. a __ __ 35. d __ __ 69. c __ __ 103. c __ __ 137. d __ __

161. (d) The requirement is to determine how a 166. (d) The requirement is to determine the

(A) (B) (C) (D) (E) (F) (G) (H)

Bank accounts Disbursement date Receipt date

84. An auditor usually examines

120. Recorded entries in which of 124. Which of the following matters

1. TWD may not have legal

1. b __ __ 31. c __ __ 61. a __ __ 91. b __ __ 121. c __ __ 151. d __ __

roborative use of the findings. Answer (b) is 137. (c) The requirement is to

(A) (B) (C) (D) (E) (F) (G) (H)

Ratio Spreadsheet Formula Calculation

1. c __ __ 35. a __ __ 69. b __ __ 103. a __ __ 137. d __ __

98. (a) The requirement is to 101. (a) The requirement is to

1. d __ __ 10. c __ __ 19. a __ __ 28. b __ __ 37. b __ __ 46. b __ __

19. What is the primary objective of 22. Which of the following statements is

c. Increase Increase Decrease d. Unrelated to the expected rate of errors in the re­

41. Which of the following

54. Use of the ratio estimation 55. An auditor is performing

2. Enter the exact

1. d __ __ 13. d __ __ 25. b __ __ 37. a __ __ 49. a __ __

46. (c) The requirement is to 48. (b) The requirement is to

47. (d) The requirement is to 49. (a) The requirement is to

1. (A) Thirty items. Calculated by dividing the population book value

1. b __ __ 7. b __ __ 13. d __ __ 19. c __ __ 25. c __ __ 31. c __ __

42. A retail store received cash and 45. Zeta Co. reported sales revenue

59. On January 2, 2010, Blake Co. sold a used 63. It is proper to recognize

Service Revenue Acct . Receivable

[3] To convert 2010 purchases to accrual

266 MODULE 9 BASIC TH. & FIN. REP. : A. BASIC CONCEPTS

On January 1, 2009, Warren Co. purchased a 6. When a company changes from the straight­line

16. Indirect effects from a change in 19. On January 1, 2007, Taft Co. purchased a

Items to be answered cash method to the accrual

1. b __ __ 8. c __ __ 15. a __ __ 22. c __ __ 29. c __ __

C.3. Change in Reporting Entity (ASC Topic 250) 29. (c) The requirement is to identify the

1. (N, N, N) Clark’s change in depreciation method is a change in accounting estimate

36. Accumulated other comprehensive 39. A company buys ten shares of

Assets Liabilities Owner’s equity Other

(A) (B) (C) (D) (E) (F) (G) (H)

1. d __ __ 21. c __ __ 41. d __ __ 61. c __ __ 81. d __ __ 101. c __ __

30. (b) The requirement is to determine 35. (c) The FASB allows three

86. (a) Increases or decreases in the 90. (c) Other than generally accepted

1. a 21. b 41. c 61. c 81. b 101. c

1. a 35. d 69. c 103. c 137. d

1. b 31. c 61. a 91. b 121. c 151. d

1. c 35. a 69. b 103. a 137. d

1. d 10. c 19. a 28. b 37. b 46. b

c. Increase Increase Decrease d. Unrelated to the expected rate of errors in the re

1. d 13. d 25. b 37. a 49. a

1. b 7. b 13. d 19. c 25. c 31. c

On January 1, 2009, Warren Co. purchased a 6. When a company changes from the straightline

1. b 8. c 15. a 22. c 29. c

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What was Brock’s dollarvalue 35. Jones Wholesalers stocks

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