39) An engagement letter establishes a clear understanding of the terms of the engagement
between the client and the auditor.
40) Because auditors are responsible for having appropriate competence and capabilities to
perform an audit, auditors are not normally permitted to consult with outside specialists during
an audit engagement.
41) If a prospective client has been audited in the past, the successor auditor will typically rely
solely on the representations about the client by the predecessor auditor.
42) A major consideration in audit staffing is the need for continuity from year to year.
43) When a successor auditor requests information from a company’s previous auditor, and there
are legal problems or disputes between the client and the predecessor auditor, the predecessor
auditor’s response to the new auditor may be limited to stating that no information will be
provided.
44) Staff assigned to an audit engagement must be knowledgeable about the client’s industry.
8.3 Learning Objective 8-3
1) In order to obtain an understanding of the client’s business, the audit firm will consider
A) inherent and control risk of the client.
B) audit risk to the CPA firm.
C) the client’s business risk and the risk of material misstatements in the financial statements.
D) the CPA firm’s potential ongoing revenue from the audit client.
2) Most auditors assess the risk of material misstatement as high for related parties and related-
party transactions because
A) of the unique classification of related-party transactions required on the balance sheet.
B) of the lack of independence between the parties.
C) of the unique classification of related-party transactions required on the income statement.
D) it is required by generally accepted accounting principles.
3) A tour of the client’s facilities provides the auditor an opportunity to
A) meet key personnel.
B) observe operations.
C) assess physical safeguards over assets.
D) all of the above
4) The auditor determines that Matthews Company occupies the 3rd floor of an office tower for
which it pays no rent. The most likely explanation is
A) they got lucky the landlord hasn’t noticed the lack of payments.
B) the landlord has weak internal controls over billings.
C) a related party transaction in which a major shareholder owns the office tower.
D) Matthews Company is engaging in fraudulent activities.
5) An official record of meetings of the board of directors and stockholders is included in the
corporate
A) bylaws.
B) charter.
C) minutes.
D) license.
6) A related party transaction may be indicated when another company
A) subsidizes certain operating expenses of the company.
B) purchases its securities at their fair value.
C) loans to company at market rates.
D) has had a distributor relationship with the company for 10 years.
7) Which of the following is an accurate statement regarding a public company’s code of ethics?
A) A code of ethics is required under The Foreign Corrupt Practices Act.
B) A code of ethics is required only for mid-level managers and below.
C) The SEC requires companies to disclose amendments and waivers to the code of ethics for the
CEO, CFO and principal accounting officer.
D) The PCAOB requires companies to review their code of ethics every five years.
8) An auditor should examine minutes of the board of directors’ meetings
A) through the date of the financial statements.
B) through the date of the audit report.
C) only at the beginning of the audit.
D) on a test basis.
9) Which of the following would most likely not be classified as a related-party transaction?
A) an advance of one week’s salary to an employee
B) sales of merchandise between affiliated companies
C) loans or credit sales to the principal owner of the client company
D) exchanges of equipment between two companies owned by the same person
10) Which of the following best describes the corporate minutes of an entity?
A) official record of the meetings of the board of directors and the stockholders
B) unofficial record of the meeting of the board of directors
C) official record of management meeting with investors and creditors of the company
D) unofficial record of the board of directors meetings
11) Related party
A) transactions must be disclosed in the footnotes even if the amounts are immaterial.
B) disclosures include the nature of the related party relationship and a description of the
transaction.
C) transactions are considered arm’s-length transactions.
D) disclosures are required only for public companies.
12) Auditors should understand client objectives related to
A) reliability of financial reporting.
B) effectiveness and efficiency of operations.
C) compliance with laws and regulations.
D) all of the above.
13) When analyzing a client’s performance measurement system,
A) ratio analysis and benchmarking against key competitors are utilized.
B) only income statement numbers are used.
C) inherent risk of financial statement misstatements may be decreased if the performance
measurement system encourages aggressive accounting.
D) the auditor is likely to decrease the extent of testing if the client has set unreasonable
objectives.
14) Define the term “related party” and discuss why an auditor should identify the client’s related
parties early in the audit.
15) What documents do auditors routinely obtain to aid in their understanding of a client’s
governance system? Briefly discuss each of these documents.
16) What are three factors that have increased the importance of obtaining an understanding of a
client’s business and industry? How can an auditor obtain this understanding?
17) There are three primary reasons for obtaining a thorough understanding of the client’s
industry and external environment. What are these reasons?
18) Auditors should obtain copies of the client’s code of ethics and minutes of the meetings of
the board of directors to aid in their understanding of the company’s management and
governance structure.
19) Many risks are common to all clients in certain industries.
20) Transactions with related parties must be disclosed in the financial statements if they are
deemed to be material.
21) All known related parties must be identified and included in the auditor’s permanent files
related to the client.
22) Because of the lack of independence between related parties, the Sarbanes-Oxley Act
prohibits all related party transactions.
23) Management’s philosophy and operating style influence the risk of material misstatements in
the financial statements.
24) The auditor should read the corporate minutes to obtain authorizations and other information
that is relevant to performing the audit.
25) Material transactions between the client and the client’s related parties must be disclosed in
the auditor’s report.
26) A tour of the client’s facilities can help the auditor assess physical safeguards over assets and
interpret accounting data related to assets such as factory equipment.
27) Operations are approaches followed by the entity to achieve organizational objectives.
8.4 Learning Objective 8-4
1) Which of the following is a correct statement regarding analytical procedures?
A) A major strength in using industry ratios for auditing is the difference between the nature of
the client’s financial information and that of the firms making up the industry totals.
B) Common-size financial statements display all items as a percentage change from a base year.
C) In identifying areas of specific risk, the auditor is likely to focus on the liquidity activity
ratios.
D) In order to look for a misstatement in the allowance for bad debts, the auditor should divide
gross sales by sales returns and allowances.
2) Which of the following would not be classified as an analytical procedure?
A) benchmarking the company’s profitability ratios against others in the industry
B) preparing common size financial statements
C) calculating income statement account balances as a percent of sales when the level of sales
has changed from the prior year
D) reconciling fixed asset dispositions with the fixed asset ledger
3) When performing planning analytical procedures for a client the auditor detected that the
gross profit percentage had declined by 50% from the previous year to the year currently under
audit. The auditor should
A) investigate the possibility the client may have made an error in their cost of goods sold
computation.
B) assist management in developing greater cost efficiencies in their product line.
C) prepare a going concern opinion for the client.
D) advise the client to have extensive disclosure to alleviate investor concerns.
4) Which is a liquidity activity ratio?
A) profit margin
B) inventory turnover
C) return on assets
D) times interest earned
5) When using financial ratios, the most important comparisons are to those of previous years for
the company and to industry averages or similar companies for the same year.
6) Auditors perform preliminary analytical procedures to better understand the client’s business
and to assess client business risk.
7) In order to be meaningful, a company’s ratios should be compared to their prior year’s ratios,
not industry benchmarks.
8) Preliminary analytical procedures can help the auditor assess client business risk.
8.5 Learning Objective 8-5
1) Auditing standards define ________ as the magnitude of misstatements that individually, or
when aggregated with other misstatements, could reasonably be expected to influence the
economic decisions of users made on the basis of the financial statements.
A) fraud
B) inherent risk
C) materiality
D) significant
2) Which of the following is part of planning?
A) Set materiality for the financial statements as a whole.
B) Estimate total misstatement in the segment.
C) Estimate the combined misstatement.
D) Compare the combined estimated with preliminary judgment.
3) When dealing with materiality,
A) if the client refuses to correct a material misstatement, the auditor is required to adjust the
financial statements.
B) management is responsible for determining whether financial statements are materially
misstated.
C) materiality must be determined as as percentage of sales.
D) the auditor must bring any material misstatements to the client’s attention.
4) ________ materiality is materiality for segments of the audit.
A) Segment
B) Individual
C) Financial statement
D) Performance
5) Materiality does not depend on the decisions of users who rely on the statements to make the
decisions.
6) The first step in applying materiality is to determine performance materiality.
8.6 Learning Objective 8-6
1) Audit standards require the auditor to consider materiality early in the audit. Which
statement(s) regarding preliminary materiality are true?
I. Preliminary materiality may change during the engagement.
II. Preliminary materiality is the maximum amount by which the auditor believes the financials
could be misstated and still not affect the decisions of reasonable users.
A) I only
B) II only
C) both I and II
D) neither I nor II
2) Why do auditors establish a preliminary judgment about materiality?
A) to determine the appropriate level of staff to assign to the audit
B) so the client can know what records to make available to the auditor
C) to help plan the appropriate evidence to accumulate
D) to finalize the control risk assessment
3) If an auditor establishes a relatively high level for materiality, then the auditor will
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.
4) Which of the following is a reason that the auditors may change the preliminary judgment
about materiality?
A) The auditors decide that the preliminary judgment was too large.
B) The auditors decide that the preliminary judgment was too small.
C) Client circumstance may have changed due to qualitative events.
D) all of the above
5) Which of the following is the primary basis used to decide materiality for a profit-oriented
entity?
A) net sales
B) net assets
C) net income before tax
D) all of the above
6) Auditing standards ________ that the basis used to determine the preliminary judgment about
materiality be documented in the audit files.
A) permit
B) do not allow
C) require
D) strongly encourage
7) Amounts involving fraud are usually considered ________ important than unintentional errors
of equal dollar amounts.
A) less
B) no less
C) no more
D) more
8) Qualitative factors can affect an auditor’s assessment of materiality. Which of the following
statements is true?
I. Misstatements that are otherwise immaterial may be material if they affect earnings trends.
II. Misstatements that are otherwise minor may be material if there are possible consequences
arising from contractual obligations.
A) I only
B) II only
C) I and II
D) neither I nor II