Study Unit 13: questions

Question 1

The auditor who interviews the plant manager is most likely to rely upon this interview as primary support for an audit conclusion on

Answer 1

The necessity to record a provision for deferred maintenance costs.

The auditor typically does not use the responses to inquiries as primary support for an audit conclusion. However, the determination by management that a liability exists should convince the auditor that an entry should be made.

Question 2

An analysis of which of the following accounts would best aid in verifying that all fixed assets have been capitalized?

Answer 2

Repairs and maintenance.

To determine whether all transactions affecting fixed assets for the period are correctly reflected in the balance of the account, the auditor should (1) perform analytical procedures, (2) reconcile subsidiary and general ledgers, and (3) analyze repairs and maintenance. The auditor should vouch significant debits from the repairs and maintenance expense account to determine whether any should have been capitalized.

Question 3

The auditor may conclude that depreciation charges are insufficient by noting

Answer 3

Excessive recurring losses on assets retired.

Excessive recurring losses on assets retired indicate excess carrying amounts at the dates of disposition. The implication is that the method of cost allocation has not been sufficient. The effect of understating depreciation in prior periods would have been to overstate income in those periods and understate income in the period of retirement.

Question 4

In performing a search for unrecorded retirements of fixed assets, an auditor most likely would

Answer 4

Inspect the property ledger and the insurance and tax records, and then tour the client’s facilities.

Question 5

An auditor determines that a client has properly capitalized a leased asset (and corresponding lease liability) as representing, in substance, an installment purchase. As part of the auditor’s procedures, (s)he should

Answer 5

Evaluate the propriety of the interest rate used in discounting the future lease payments.

Under U.S. GAAP, a capital lease is recorded by the lessee as an asset and a liability at the present value of the minimum lease payments. Thus, the interest rate used in the discounting process is an important consideration in determining whether the asset is fairly presented in the balance sheet. The interest rate is the lessee’s incremental borrowing rate, unless the lessor’s implicit rate in the lease is known and is less than the lessee’s incremental rate.

Question 6

In verifying the amount of goodwill recorded by a client in the current period, the most convincing evidence an auditor can obtain is by comparing the recorded amounts of assets acquired and liabilities assumed with the

Answer 6

Fair values as evidenced by independent appraisals.

Question 7

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 possibility of a(n)

Answer 7

Lien on the plant equipment.

When liens are placed on equipment or property, the lienholder often requires that the assets be insured and that the lienholder be named as the beneficiary. Hence, the policy is likely to be held by the lienholder even though the client is required to pay the premiums.

Question 8

In testing for unrecorded retirements of equipment, an auditor most likely would

Answer 8

Select items of equipment from the accounting records and then locate them during the plant tour.

Question 9

When the risk of material misstatement is assessed as low for assertions related to payroll, substantive tests of payroll balances most likely would be limited to applying analytical procedures and

Answer 9

Recalculating payroll accruals.

When controls are judged to be effective, the auditor’s procedures are typically limited to analytical procedures and testing for completeness and cutoff of the year-end accruals.

Question 10

An auditor usually obtains evidence of a company’s equity transactions by reviewing its

Answer 10

Minutes of board of directors meetings.

Equity transactions are typically few in number and large in amount. They require authorization by the board of directors. Thus, an auditor reviews the minutes of the board meetings to identify transactions.

Question 11

During an audit of a company’s equity accounts, the auditor determines whether restrictions have been imposed on retained earnings resulting from loans, agreements, or state law. This audit procedure most likely is intended to verify relevant assertion about

A.Existence or occurrence.

B.Classification and understandability.

C.Valuation and allocation.

D.Completeness.

Answer 11

Classification and understandability.

The presentation and disclosure assertions include assertions about classification and understandability. Financial information should be properly presented and disclosed, and disclosures should be clear (AU-C 315 and AS No. 15). Hence, when restrictions have been placed on retained earnings, the auditor should determine that they are properly disclosed in the notes to the financial statements.

Question 12

When a company has a material amount of treasury stock certificates on hand, a year-end count of the certificates by the auditor is

Answer 12

Always part of the audit plan.

All capital transactions should be verified. Thus, the auditor should count the certificates of treasury stock on hand at year end at the same time the other securities are counted. This procedure provides direct evidence that the treasury stock exists and is in the possession of the entity. Any treasury stock certificates not on hand are confirmed with the holders.

Question 13

The auditor is concerned with establishing that dividends are paid to client corporation shareholders who hold stock as of the

Answer 13

Record date.

Persons who hold stock in the corporation as of the record date are entitled to payment of the dividend. The auditor should test the dividend payment list to gather evidence that dividends were paid to the appropriate shareholders. The integrity of the dividend payment process is enhanced when an independent agent (usually a financial institution) is used to pay dividends.

Question 14

A bond trust indenture is the contractual agreement between the bondholders and the bond issuer. It contains the date of issue and the date of maturity of the bond issue. It also contains:

Answer 14

(1) the amount of the bonds,
(2) interest rates,
(3) payment dates,
(4) descriptions of collateral,
(5) provisions for conversion or retirement,
(6) trustee duties,
(7) sinking-fund requirements, and
(8) restrictions on the borrower.

Question 15

During its fiscal year, a company issued, at a discount, a substantial amount of first-mortgage bonds. When performing audit work in connection with the bond issue, the independent auditor should

Answer 15

Review the minutes for authorization.

Bonds issued during the year under audit should be traced to the minutes of the shareholders’ or board of directors’ meetings to check for proper authorization. The amount sold should be no greater than the amount authorized in the minutes.

Question 16

The auditor can best verify a client’s bond sinking-fund transactions and year-end balance by

Answer 16

Confirmation with the bond trustee.

The bond trustee is an outside, independent agent responsible for maintaining subsidiary ledgers and paying dividends. (S)he also often keeps the sinking-fund accounts. Consequently, the auditor should verify bond sinking-fund transactions with this trustee.

Question 17

An audit of noncurrent debt:

Answer 17

(1) determines that all noncurrent debt has been recorded and constitutes bona fide liabilities;
(2) verifies that federal and state laws relevant to financial reporting have been complied with;
(3) determines that premium, discount, interest payable, and interest expense are accurately recorded;
(4) monitors compliance with debt contracts; and
(5) reviews proper presentation and disclosure in the financial statements. The auditor therefore should determine that the client has obtained the opinion of a lawyer on the legality of the bond issue.

Question 18

In a private placement of bonds, one not involving the use of an independent trustee, the auditor is most concerned with?

Answer 18

In a private placement of bonds, one not involving the use of an independent trustee, the auditor is most concerned that the cash received from the issue is accurately recorded. The auditor also is concerned that the cash is adequately safeguarded by the CFO’s department. Failure to employ a trustee substantially increases the risks of material misstatement for all aspects of bond issues.

Question 19

During an audit of an issuer of bonds, the auditor should obtain written confirmation regarding debenture transactions from the

Answer 19

Trustee.

Debentures are bonds backed by the general credit of the issuer and not secured by specific assets. A bond issuer normally employs the services of an independent financial institution as trustee. The bond trustee is responsible for executing bond transactions, e.g., distributing or paying interest, and protecting the interests of bondholders. Accordingly, the auditor should confirm transactions with the trustee.

Question 20

Treetop Corporation acquired a building and arranged mortgage financing during the year. 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.

Answer 20

Deed.

A deed provides evidence of ownership rights and obligations relative to mortgaged property. However, it typically does not contain information about costs of mortgages.

Question 21

A charge in the subsequent period to a notes receivable account from the cash disbursements journal should alert the auditor to the possibility that a

Answer 21

Contingent liability has become a real liability and has been settled.

The entry may represent the establishment of a receivable from a party for whom the client has guaranteed a debt. The payment of the debt upon default of the party is recognized by a debit to notes receivable and a credit to cash.

Question 22

An auditor’s plan to audit noncurrent debt most likely includes steps that require

Answer 22

Correlating interest expense recorded for the period with outstanding debt.

By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to noncurrent debt, unrecorded interest-bearing obligations may be outstanding.

Question 23

Several years ago, Conway, Inc., secured a conventional real estate mortgage loan. Which of the following audit procedures would be least likely to be performed by an auditor auditing the mortgage balance?

A.Recompute mortgage interest expense.

B.Review the mortgage amortization schedule.

C.Examine the current year’s canceled checks.

D.Inspect public records of lien balances.

Answer 23

Inspect public records of lien balances.

Public real estate records do not disclose current balances. They disclose only the original amounts of mortgages. Other evidence is normally available, such as receipts for payments to the mortgagee and confirmations from payees.

Question 24

In performing a count of negotiable securities, an auditor records the details of the count on a security count worksheet. What other information is usually included on this worksheet?

Answer 24

An acknowledgment by a client representative that the securities were returned intact.

A securities count worksheet should include a record of all the significant information from the securities, such as names, amounts, and interest rates. Also, to ensure a clear chain of custody, it should contain an acknowledgment by a client representative that the securities were returned intact when the count was complete.

Question 25

In a manufacturing company, which one of the following audit procedures provides the least assurance of the existence of the general ledger balance of investment in stocks and bonds at the audit date?

Answer 25

Examination of paid checks issued in payment of securities purchased.

Paid checks issued in payment for securities do not provide assurance that the investments are in existence and still owned by the client at the balance sheet date.

Question 26

An auditor usually determines whether dividend income from publicly-held investments is reasonable by computing the amounts that should have been received by referring to

Answer 26

Records produced by investment services.

Standard investment advisory services publish dividend records for all listed stocks. They show amounts and payment dates for dividend declarations and permit the auditor to independently recompute the client’s reported dividend income.

Question 27

When a client engages in transactions involving derivatives, the auditor should

Answer 27

Determine whether the applicable reporting framework specifies the means of measuring fair value.

Derivatives are measured at fair value. Thus, the auditor should (1) determine whether the applicable reporting framework specifies the method for measuring fair value and (2) evaluate whether the measurement is consistent with the method. Fair value estimates may be obtained from a third-party source (e.g., a broker-dealer). The auditor should understand the method used by the source to make the estimate and consider the significance of the work of the management’s specialist. If the entity has used a valuation model, the auditor applies AU-C 540,Auditing Accounting Estimates, including Fair Value Accounting Estimates, and Related Disclosures.

Question 28

An auditor usually tests the reasonableness of dividend income from investments in publicly held companies by computing the amounts that should have been received by referring to

Answer 28

Dividend record books produced by investment advisory services.

Investment advisory services, such as Dun & Bradstreet, publish dividend amounts and payment dates for publicly traded entities. The auditor can obtain this information to test whether the client has properly recorded investment income.

Question 29

Which of the following pairs of accounts would an auditor most likely analyze on the same working paper?

A.Accrued interest receivable and accrued interest payable.

B.Interest income and interest expense.

C.Notes payable and notes receivable.

D.Notes receivable and interest income.

Answer 29

Notes receivable and interest income.

Answer (D) is correct.
The auditor analyzes information and presents the analysis for related accounts on the same working paper. Notes receivable and interest on them are such related accounts.

Question 30

An audit of the completeness assertion addresses whether balances and transactions related to derivatives and hedging activities that should be recorded are recorded. A substantive procedure for the completeness assertion about derivatives and hedging:

Answer 30

A substantive procedure for the completeness assertion about derivatives and hedging activities is a request to the counterparty to a derivative for information about it, for example, whether an agreement exists to repurchase securities sold or whether side agreements have been made.

Question 31

The auditor should insist that a representative of the client be present during the physical examination of securities to

Answer 31

Acknowledge the receipt of securities returned.

A client representative should be present when the auditor examines the securities to acknowledge that all the securities have been returned intact. The auditor should receive a written receipt at the completion of the count to protect the auditor from claims by management that the auditor is responsible for any shortage that may have developed

Question 32

In establishing the existence and ownership of an investment held by a corporation in the form of publicly traded stock, an auditor should inspect the securities or

Answer 32

confirme the number of shares owned that are held by an independent custodian.

Question 33

An auditor’s inquiries of management disclosed that the entity recently invested in a series of energy derivatives to hedge against the risks associated with fluctuating oil prices. Under these circumstances, the auditor should

Answer 33

Evaluate management’s conclusion about the recognition of an impairment loss.

The auditor (1) evaluates management’s conclusion about recognition of an impairment loss for a decline in fair value below cost or carrying amount and (2) obtains support for the amount of the recorded adjustment, including compliance with the reporting framework.

Question 34

An auditor is testing the reasonableness of dividend income from investments in issuers. The auditor most likely would compute the amount that should have been received and recorded by the client by

Answer 34

Electronically accessing the details of dividend records on the Internet.

Answer (A) is correct.
Standard investment advisory services publish dividend records for all listed stocks. They show amounts and payment dates for dividend declarations and permit the auditor to independently recompute the client’s reported dividend income.

Question 35

If the auditor discovers that the net carrying amount of a client’s trading securities is overstated because of a loss in fair value, the auditor should insist that the

Answer 35

Loss in fair value be recognized in the financial statements of the client.
Under U.S. GAAP, trading securities are accounted for at fair value. The unrealized holding loss should be recognized in earnings (a debit), and the net carrying amount of the securities should be reduced (a credit).