Chapter 5: Reading Notes and MC answers

Reading Notes:

1. The various auditing standards that provide guidance on the audit opinion formulation process

Auditors in the United States follow auditing guidance issued by: (AICPA vs. PCAOB vs.
IAASB: SAS vs. AS or AU vs. ISA)

2. The auditing standards

Audit to be performed by individuals having adequate technical training and proficiency as an

auditor

Auditors to be independent:

1. In fact, i.e., in reality in terms of mental attitude and

2. In appearance, i.e., in how the auditor is perceived by users

Audit to be conducted with professional care expected of a prudent auditor

3. The audit opinion formulation process

4. The importance to the audit opinion formulation process

Recording and processing transactions that affect a group of related accounts

Begin when a transaction occurs and ends when it is recorded in financial statements

Break the audit into manageable sections of related accounts

5. The assertions that are inherent to financial statements and explain their importance to the audit opinion
formulation process

Assertions made by management

Existence
Completeness
Rights and obligations
Valuation
Presentation and disclosure
Related evidence is obtained for accounts and disclosure in financial statements

6. The purpose and types of audit procedures used to obtain audit evidence

Audit evidence: Information used by auditor in arriving at conclusions on which the opinion is based
Audit procedures: Procedures designed to obtain audit evidence to support audit opinion(s)
Risk assessment procedures
Provide information for assessing the risks of material misstatement in the financial
statements
Do not provide sufficient evidence upon which to base an audit opinion
Used for purposes of planning the audit

7. The importance of audit documentation and provide examples

• Assisting engagement team in:

• Planning and performing audit
• Supervising and reviewing audit work
• Retaining a record of matters of continuing significance to future audits
• Enabling internal or external inspections of completed audits
• Assisting auditors in understanding work performed in prior year
Example:
• Audit programs
• Analyses prepared by client or auditor
• Memorandums
• Summaries of significant findings or issues
• Letters of confirmation and representation
• Checklists
• Correspondence concerning significant findings or issues

8. Audit activities in Phase I of the audit opinion formulation process

Preconditions for accepting auditing engagements

Use of an acceptable financial reporting framework

Agreement of management to acknowledge and understand its responsibilities

9. Audit activities in Phase II of the audit opinion formulation process

Identifying relevant risks and determining audit procedures required to address them
Continuing clients - Update information from previous year’s audit
New clients - the risk assessment process is more time consuming
 10. Audit activities in Phase III of the audit opinion formulation process

Auditor tests controls

Determine whether controls are operating effectively at year-end or throughout the year
Auditor obtains more persuasive audit evidence
As the reliance auditor places on effectiveness of a control increases

11. Audit activities in Phase IV of the audit opinion formulation process

Substantive procedures include:

Substantive analytical procedures
Tests of details of account balances
Considerations in determining appropriate substantive procedures:
Source of potential misstatement
Extent and type of potential misstatement

12. Audit activities in Phase V of the audit opinion formulation process

Completing various review and communication activities

Making a decision about what types of opinions should be issued
Deciding on the appropriate opinion to be issued
It can be based on financial statements and internal control
It can be issued in one report or in two separate reports

13. The concepts related to the auditor’s assessment of internal control design effectiveness, implementation,
and operating effectiveness

Factors considered in deciding whether to categorize a deficiency as significant or not

Risk that is being mitigated and whether other controls operate effectively
Materiality of related account balances
Nature of deficiency
Volume of transactions affected
Subjectivity of account balance that is subject to control
Rate at which control fails to operate

14. The frameworks for professional decision making and ethical decision making to issues involving
conducting an audit

Implications for substantive procedures in financial statement audit:

Auditor will do limited testing of inventory quantities at year end
Auditor will assess year-end inventory for potential obsolescence
Auditor will continue to examine all adjusting entries at the end of the year

MC answers 5:

5-27 LO 1 Which of the following statements is correct regarding the setting of auditing standards in the U.S.?
a. The AICPA is responsible for the setting auditing standards for audits of nonpublic entities.
b. The PCAOB is responsible for setting auditing standards for audits of public companies.
c. The AICPA is responsible for setting auditing standards for audits of both public and nonpublic entities.
d. The SEC sets auditing standards for auditors of public and nonpublic entities.
e. Both (a) and (b) are correct.
5-28 LO 1 The following describes a situation in which an auditor has to determine the most appropriate standards
to follow. The audited company is headquartered in Paris but has substantial operations within the United States
(60% of all operations) and has securities registered with the SEC and is traded on the NYSE. The company uses
International Financial Reporting Standards (IFRS) for its accounting framework. What would be the most
appropriate set of auditing standards to follow?
a. PCAOB.
b. Either PCAOB or AICPA.
c. Either IAASB or AICPA.
d. Only the AICPA standards would be appropriate.

5-29 LO 2 Which of the following is not required as part of the fieldwork standards?
a. An audit should be properly planned and supervised.
b. Auditors should develop an understanding of the client’s controls as an important prerequisite to developing
specific audit tests.
c. Auditors should obtain sufficient appropriate audit evidence by performing audit procedures to provide a
reasonable basis for the audit opinion being provided.
d. All of the above are required by the fieldwork standards.

5-30 LO 2 Which of the following is included as part of the AICPA’s principles governing an audit?
a. Auditors need to obtain a high level of assurance that the financial statements are free of all misstatements.
b. An audit has inherent limitations such that auditor cannot provide absolute assurance about whether the
financial statements are free of misstatement.
c. Auditors need to maintain professional skepticism only on audits where there is a high risk of material
misstatement.
d. All of the above are included as part of the AICPA’s principles governing an audit.

5-31 LO 3 Which of the following statements is true about the audit opinion formulation process presented in this
chapter?
a. The audit opinion formulation process is significantly different for the financial statement only audit and the
integrated audit.
b. The audit opinion formulation process is based on the premise that management has responsibility to prepare the
financial statements and maintain internal control over financial reporting.
c. The audit opinion formulation process is comprised of seven phases.
d. All of the above are true statements regarding the audit opinion formulation process.

5-32 LO 3 Which of the following activities is not part of the activities within the audit opinion formulation process?
a. The auditor develops a common understanding of the audit engagement with the client.
b. The auditor determines the appropriate nonaudit consulting services to provide to the client.
c. The auditor identifies and assesses risks of material misstatements and then responds to those identified risks.
d. The auditor determines the appropriate audit opinion(s) to issue.

5-33 LO 4 Which of the following is a reason that the auditor uses an accounting cycle approach when performing
an audit?
a. The accounting cycle approach allows the auditor to focus exclusively on either the balance sheet or income
statement.
b. COSO internal control components are based on the accounting cycles.
c. The accounting cycles provide a convenient way to break the audit up into manageable pieces.
d. The auditor needs to be able to provide an opinion related to each accounting cycle.

5-34 LO 4 Which of the following accounts would not be included in the Acquisition and Payment for Long-Lived
Assets Cycle?
a. Revenue.
b. Depreciation expense.
c. Gain on disposal.
d. Equipment.
5-35 LO 5 Which of the following is not one of the management assertions?
a. Completeness.
b. Existence.
c. Rights and obligations.
d. Valuation.
e. They are all management assertions.

5-36 LO 5 Which management assertion addresses whether the components of the financial statements are properly
classified, described, and disclosed?
a. Completeness.
b. Existence.
c. Rights and obligations.
d. Presentation and disclosure.
e. None of the above address whether the components of the financial statements are properly classified, described,
and disclosed.

5-37 LO 6 Assume that an auditor is physically examining a client’s equipment. What type of audit procedure is the
auditor performing?
a. Inspection of documentation.
b. Inspection of assets.
c. External confirmation.
d. Observation.

5-38 LO 6 Which of the following is a true statement regarding audit evidence and audit procedures?
a. The auditor has a responsibility to design and perform audit procedures to obtain sufficient appropriate
audit evidence.
b. Inquiry is a type of audit procedure that typically does not require corroborating evidence.
c. The audit procedures that are performed during an audit are summarized in a document referred to as an audit
engagement letter.
d. Reperformance involves checking the mathematical accuracy of a document or record, such as an inventory count
sheet.

5-39 LO 7 Which of the following items should be included in audit documentation?

a. Procedures performed.
b. Audit evidence examined.
c. Conclusions reached with respect to relevant financial statement assertions.
d. All of the above should be included.

5-40 LO 7 Which of the following statements is a false statement regarding audit documentation?
a. An audit program is an example of audit documentation.
b. The only purpose of audit documentation is to provide evidence that the audit was planned and performed
in accordance with auditing standards.
c. Audit documentation helps facilitate internal and external inspections of completed audits.
d. All of the above statements are true.

5-41 LO 8 Which of the following statements is a true statement regarding client acceptance?
a. Auditors in the U.S. are required to communicate with the predecessor auditor before accepting a new
client.
b. Audit firms are required to provide audits for any organization that requests one.
c. Communication with a predecessor audit must be written.
d. International auditing standards require auditors to communicate with the predecessor auditor before accepting a
new client.

5-42 LO 8 Which of the following documents contains the agreed-upon terms of the audit engagement?
a. Audit program.
b. Audit plan.
c. Audit engagement letter.
d. Audit documentation.

5-43 LO 9 Which of the following statements is correct regarding the design of controls related to credit limits?
a. The effectiveness of the control design is contingent on the credit manager’s process for establishing and
reviewing credit limits.
b. Because the process of establishing credit limits is fairly time consuming, the control should be designed so that
the marketing manager has the ability to approve sales on an ad hoc basis while waiting for the credit approval.
c. The control should be designed so that the sales manager has final approval regarding credit limits.
d. All are correct statements regarding the design of controls related to credit limits.

5-44 LO 9 Which of the following tests of controls would not typically be used in assessing control design
effectiveness?
a. Inquiry.
b. Observation.
c. Inspection of documentation.
d. Reperformance.

5-45 LO 10 The auditor is testing the operating effectiveness of controls in the revenue cycle and notes the
following: (a) the organization does not regularly follow its credit policies; rather it often overrides the credit policy
when divisional management needs to meet its performance goals; and (b) the sales manager has the ability to
override the credit policy for important customers. Which of the following statements would be correct regarding an
integrated audit of sales and receivables?
a. Based on the test of controls, the auditor would likely assess control risk as high.
b. The auditor would be able to perform less rigorous substantive procedures.
c. The auditor likely concluded that the controls were not effectively designed.
d. All of the above are correct statements.

5-46 LO 10 Assume the auditor concludes the controls related to accounts receivable are operating effectively based
on inquiry and other appropriate tests. Which of the following is a correct inference regarding the auditor’s
conclusion?
a. The auditor will not need to perform direct tests on the valuation of accounts receivable.
b. The auditor could not have concluded that the internal controls over credit were effective unless the
auditor determined that the credit limits are updated for changed conditions.
c. The auditor does not need to confirm accounts receivable because the risk of a material misstatement of
receivables is mitigated by the controls.
d. The auditor does not need to perform any more direct tests of the account balances if the auditor has tested the IT
general controls.

5-47 LO 11 In performing substantive procedures, which of the following statements provides appropriate guidance
to the auditor?
a. The auditor can perform both substantive analytical procedures and substantive tests of details.
b. The auditor should perform substantive procedures for all assertions of all financial statement accounts.
c. The auditor should perform more (or more rigorous) substantive procedures when control risk is low than when
control risk is high.
d. All of the above statements provide appropriate guidance.

5-48 LO 11 In which of the following scenarios is the auditor likely to obtain more (or more rigorous) substantive
evidence?
a. When subjectivity related to the assertion is low.
b. When controls are determined to be operating effectively.
c. When the account is immaterial.
d. When the design of controls is determined to be ineffective.

5-49 LO 12 Which of the following procedures is least likely to be performed during Phase V of the audit opinion
formulation process?
a. Assessment of misstatements detected during the performance of substantive procedures and tests of controls.
b. Performance of preliminary analytical review procedures.
c. Performance of an engagement quality review.
d. Determination of the appropriate audit opinion(s) to issue.

5-50 LO 12 Which of the following statements is correct regarding the auditor’s report on a public company’s
internal control over financial reporting?
a. A company cannot have a material weakness in internal controls if the auditor does a quality audit and does not
find a material misstatement.
b. The auditor must explicitly reference the criteria for evaluating internal control, using the COSO framework, for
example.
c. The audit is performed in conjunction with the auditing standards promulgated by the AICPA Auditing
Standards Board.
d. The audit must report on whether management used the appropriate tools in its assessment of internal control over
financial reporting.

5-51 LO 13 The auditor discovers that there is a key control deficiency over sales contracts and that some contracts
near the end of the year are not properly reviewed by management. Which of the following would be the best way
for the auditor to respond to the control deficiency identified?
a. Expand the testing over the control with a larger sample from the last quarter of the year.
b. Wait to assess whether the deficiency is a material weakness or significant deficiency based on the actual
number of errors or misstatements found in the related account balances.
c. Expand the sample size for substantive testing and review of contracts during the latter part of the year to
determine if revenue is appropriately identified.
d. All of the above.

5-52 LO 13 Assume the auditor has assessed the design of controls and determines that the company has an
ineffective control design related to pricing and dating of sales. This assessment is due to an inadequate segregation
of duties. Based on this information, which of the following actions should the auditor take?
a. Resign from the audit because the entity is not auditable.
b. Do not test controls over sales pricing and dating of sales transactions.
c. Expand the direct tests of related account balances by selecting recorded sales and tracing back to shipping
documents and authorized price lists.
d. Answers (b) and (c) above.