Exam PRACTICE

1. Auditors consider financial statement assertions to identify appropriate audit procedures. For items a through f, match each assertion with the statement that most closely approximates its meaning. Each statement may be used only once. Assertion Statement a. Completeness b. Cutoff c. Existence and occurrence d. Presentation and disclosure e. Rights and obligations f. Valuation 1. There is such an asset. 2. The company legally owns the assets. 3. All assets have been recorded. 4. Transactions are recorded in the correct accounting period. 5. Assets are recorded at proper amounts. 6. Assets are properly classified.

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 is used twice. Audit Procedures Type of Audit Procedure g. Prepare a flowchart of internal control over sales. h. Calculate the ratio of bad debt expense to credit sales. i. Determine whether disbursements are properly approved. j. Confirm accounts receivable. k. Compare current financial information with comparable prior periods.

7. Analytical procedures 8. Tests of controls 9. Risk assessment procedures (other than analytical procedures) 10. Test of details of account balances, transactions, or disclosures

2. State whether each of the following statements is correct or incorrect concerning audit risk and its componentsinherent risk, control risk, and detection risk.

a. The risk of material misstatement is composed of the three components of audit risk. b. Inherent risk is the possibility of material misstatement before considering the client's internal control. c. Less control risk means an increase in the risk of material misstatement. d. Detection risk does not exist when no audit is performed. e. Rather than restrict detection risk through the performance of more substantive procedures, auditors assess it. f. Absent any other changes, an increase in the risk of material misstatement results in an increase in audit risk. g. Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially or immaterially misstated. h. Both inherent risk and control risk exists independently of the audit of financial statements.

3. Michael Green, CPA, is considering audit risk at the financial statement level in planning the audit of the National Federal Bank (NFB) Company's financial statements for the year ended December 31, 20X1. Audit risk at the financial statement level is influenced by the risks of material misstatements (including fraud risks), which may be indicated by a combination of factors related to management, the environment, and the entity. For each of the following factors, indicate whether they increase or decrease the risk of material misstatement and (2) whether they create a risk of fraud.

Factor Effect on Risks of Material Misstatement (Increase or Decrease) Create a Risk of Fraud? (Yes or No) a. NFB is a continuing audit client. b. The banking industry has been significantly impacted by the downturn in the economy in recent years. c. NFB operates in a growing, prosperous area and has remained profitable over the years. d. Government regulation and overview of the banking industry is extensive and effective. e. NFB's board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer. f. Interest rates have been very volatile recently. g. Management at the bank's branch offices has authority for directing and controlling NFB's operations and is compensated based on branch profitability. h. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the board's audit committee. i. The accounting department has experienced little turnover in personnel, during the five years, Green has audited NFB. j. During 20X1, NFB increased the efficiency of its accounting operations by installing a new, sophisticated computer system. k. NFB's formula has consistently underestimated the allowance for loan losses in current years. l. Management has been receptive to Green's suggestions relating to accounting adjustments. 4. 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 (NE) on the risk of material misstatement. Information Effect on Risk of Material Misstatement a. Because municipalities have received increased federal and state funding for environmental purposes, TWD returned to profitability for the first year following three years with losses. b. TWD's Board of Directors is controlled by Mead, the majority stockholder, who also acts as the chief executive officer. c. The internal auditor reports to the controller and the controller reports to Mead. d. The accounting department has experienced a high rate of turnover of key personnel. e. TWD's bank has a loan officer who meets regularly with TWD's CEO and controller to monitor TWD's financial performance. f. TWD's employees are paid biweekly. g. TWD has such a strong financial presence in its industry to allow it often to dictate the terms or conditions of transactions with its suppliers. h. During 20X1, TWD changed its method of preparing its financial statements from the cash basis to generally accepted accounting principles. i. During 20X1, TWD sold one-half of its controlling interest in United Equipment Leasing (UEL) Co. TWD retained significant influence over UEL. j. During 20X1, litigation was filed against TWD from action 10 years ago that alleged that TWD discharged pollutants into state waterways were dropped by the state. Loss contingency disclosures that TWD included in prior year's financial statements are being removed from the 20X1 financial statements. k. During December 20X1, TWD signed a contract to lease disposal equipment from an entity owned by Mead's parents. This related-party transaction is not disclosed in TWD's notes to the 20X1 financial statements. l. 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 a below-market price. TWD intends to service this new site in 20X2. m. During December 20X1, TWD increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost. n. Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 20X1 disclosed a new operating 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 clean-up inspection in 20X2. o. An initial public offering of TWD's stock is planned for late 20X2. 5. Assume the following general flow of documents in an accounting system. Reply to the following questions:

a. The auditors are concerned about source documents that reflect valid transactions that have not been recorded in the journals. Which procedure would be most effective? (1)Trace from source documents to journals. (2)Vouch from journals to source documents. (3) Either (1) or (2). b. The auditors are concerned about transactions that have been recorded in the journals (and subsequently in the ledgers) that are not validthat is, a transaction is recorded, but it did not actually occur (e.g., a fraudulent overstatement of sales). Which procedure would be most effective? (1) Trace from source documents to journals. (2) Vouch from journals to source documents. (3) Either (1) or (2). c. The auditors are concerned about transactions that have been recorded for improper amounts. Which procedure would be most effective? (1) Trace from source documents to journals. (2) Vouch from journals to source documents. (3) Either (1) or (2). d. Tracing from source documents to journals most directly tests: (1) Completeness (understatements). (2) Existence (overstatements). e. Vouching from journals (or ledgers) to source documents most directly tests: (1) Completeness (understatements). (2) Existence (overstatements).

6. Select the term that most closely applies for each definition (or portion of a definition) in the first column. Each term may be used only once or not at all. Definition (or Portion) Term a. Representations by management that are communicated, explicitly or implicitly, in the financial statements. b. A description of the nature, timing, and extent of the audit procedures to be performed. c. An estimate of the time required to perform each step in the audit. d. The purpose of this document is to avoid misunderstandings between the auditors and the client. e. The risk of material misstatement of an assertion about an account without considering internal control. f. At the overall engagement level, this is the risk that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. g. An identified risk that requires special audit consideration. h. A risk that threatens management's ability to achieve the organization's objectives. 1. Audit plan 2. Assertions 3. Audit risk 4. Representation letter 5. Business risk 6. Control risk 7. Engagement letter 8. Inherent risk 9. Significant risk 10. Survival risk 11. Time budget