Deck 6: Client Acceptance and Planning the Audit

Question 1

What are the three main factors that influence the organizational structure of all public accounting firms?

Answer 1

1. The need for independence from clients. Independence permits auditors to remain unbiased in drawing conclusions about their clients' financial statements.
2. The importance of a structure to encourage competence. The ability of the structure to encourage competence permits auditors to conduct audits and perform other services efficiently and effectively.
3. The increased litigation risk faced by auditors. Firms continue to experience increases in litigation-related costs from lawsuits. Some organizational structures afford a degree of protection to individual firm members.

Question 2

Why might the decisions about materiality and risks be different for the internal auditor than for the external auditor when conducting an audit of a system?

A) The auditors are applying different skills during the conduct of the audit.
B) External auditors have different expectations with respect to quality control.
C) Internal auditors focus only on the potential for dollar errors internally.
D) External users may have different needs than management.

Answer 2

D

Question 3

The audit plan includes the nature, timing and extent of audit procedures for the purposes of risk assessment, including those that are linked to the individual audit assertions, as well as any other audit procedures that are considered necessary. At what point in the audit process is the audit plan finalized?

A) When the auditor has finished documenting internal controls.
B) When the client risk profile has been completed.
C) When risk assessments are complete.
D) When inherent risk information has been gathered.

Answer 3

C

Question 4

The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

A) custom-designed operational or strategic information systems
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically controlled equipment used in the manufacturing process

Question 5

Simon owns a clothing store, Simonello. Simonello recently purchased a material amount of fabric from Simonique Inc., a textile company also owned by Simon. With regards to this transaction, the auditors should

A) request a confirmation from Simonique that the transaction took place.
B) inspect the textile received in the warehouse to ensure that the amount sent equals the amount ordered.
C) qualify the audit report, as this puts management's integrity into question.
D) verify that the business relationship is disclosed in the financial statements.

Question 6

An important reason for adequately planning the audit engagement is to

A) help decide whether the engagement should be accepted.
B) enable the auditor to obtain sufficient appropriate audit evidence.
C) properly design the contents of the engagement letter.
D) keep audit risk as low as possible.

Question 7

An important reason for auditors to obtain good knowledge of a client's industry is that

A) payroll processing functions could differ from client to client.
B) control risks will vary from zero to 100% and can be better assessed in context.
C) detection risk must be set in accordance with the needs of the industry as well as of the individual client.
D) organizations like city governments have unique accounting requirements that could be complex.

Question 8

An effective audit is one that

A) reduces the audit risk to the targeted level.
B) ensures that there are no errors contained in the financial statements.
C) does not contain errors of a dollar amount higher than 5% of the net income of the company.
D) is completed on time and within budget.

Question 9

A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued is the

A) inherent risk.
B) audit risk.
C) statistical risk.
D) financial risk.

Question 10

The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

A) electronic data interchange systems for purchase orders, sales invoices, and payments
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically controlled equipment used in the manufacturing process

Question 11

Jibbery Company has numerous transactions with related parties. For example, it has borrowed money from shareholders, purchases raw materials from a subsidiary company, and sells finished goods to its parent company. Which of the following describes one of the impacts of these transactions on risk assessment ?

A) inherent risk would be set as low
B) inherent risk would be set as high
C) control risk would be set as low
D) audit risk would be decreased

Question 12

How is lack of understanding of a client's knowledge and industry linked to the auditor's business risk?

A) sales and collection processes need to be carefully documented so that the auditor can assess the value of accounts receivable
B) failure to fully understand the nature of the client's transactions could result in litigation should the client fail
C) the auditor may not be adequately trained to understand the nature of the client's business and thus may conduct a poor quality audit
D) there may not be sufficient expertise assigned to the audit engagement, resulting in a lack of understanding of complex issues

Question 13

Risks associated with specific industries may affect the auditor's assessment of client business risk and acceptable audit risk, and even influence client acceptance decisions. Which of the following businesses would be the most risky for the auditor to accept as a new client?

A) a small manufacturer of metal and plastic parts that has steady profits and has been in business for 15 years
B) a client who is developing a computer game that is expected to be ready in three years and has no other products
C) a retail company in the clothing industry that has mid-range pricing and appeals to a large population sector
D) a firm consisting of a partnership of ten lawyers that operates out of three different cities in one province

Question 14

A thorough understanding of the client's business and industry and knowledge about the company's operations are essential for doing an adequate audit. Why do auditors need greater knowledge about major customers and suppliers and related risks?

A) Information technology connects these organizations, so they affect each other.
B) Information technology provides rapid information about organizations.
C) There is increased importance of human capital and other intangible assets.
D) Joint ventures and strategic alliances affect client business risks.

Question 15

It is important for the auditor to obtain a good understanding of the client's industry to develop a client risk profile. If the auditor is looking at a client in the fashion clothing industry, a risk specific to the industry would be

A) the high risk of poor governance and management oversight.
B) the high risk of defective products.
C) the high risk of obsolescence of their inventory.
D) the volatility in the stock market with regards to common stock.

Question 16

The Canadian Auditing Standards state that the auditor must develop an audit plan. List and explain the components that must be included in the auditor's plan.

Question 17

The existence of advanced automated systems affects the audit process. Which of the following characteristics is an indicator of the presence of an advanced automated information system?

A) use of data communications (such as the Internet) to transfer transaction data
B) use of packaged software to process sales both locally and across Canada
C) use of customer relationship management systems to manage sales information
D) numerically-controlled equipment used in the manufacturing process

Question 18

When the auditor has properly planned and performed the audit to reduce risk to an acceptably low level that is consistent with the objective of the audit, this means that the auditor has conducted enough work to

A) reduce inherent risks to an acceptable level.
B) increase detection risk to a satisfactory level.
C) detect errors in internal controls so that control risk can be set higher.
D) detect material misstatements to the targeted level of assurance.

Question 19

One of the purposes of developing a client risk profile is to assist the auditor in

A) developing the pertinent audit procedures for tests of internal controls.
B) assessing the client's business risk.
C) locating related parties that need to be disclosed.
D) deciding whether fraud or illegal acts have taken place.

Question 20

During the audit engagement, the primary auditor may rely on other individuals, such as specialists, other auditors, and internal auditors (secondary auditors). The primary way to defend the auditor against negligence should such other individuals conduct poor quality work is whether the

A) other individuals were professionals with recognized credentials.
B) primary auditor conducted sufficient quality control work with respect to the secondary auditor(s).
C) secondary auditor had ever been sued before.
D) appropriate level of materiality had been used during the conduct of the engagement.

Question 21

What is the purpose of developing a client risk profile? List the steps involved in developing a client risk profile.

Question 22

The auditor will obtain a copy of the client's articles of incorporation (if applicable) and retain a copy in the permanent file. Important information in the articles of incorporation includes

A) the interest rates currently being paid for bonds that have been issued.
B) voting rights of each class of shares issued by the company.
C) which shares have been redeemed by the company in the current year.
D) the interest rates that are being received on long-term notes invested.

Question 23

Your client, Macilbink Ltd., manufactures calendars, books, and magazines. The printing presses that they use are only three years old, yet new technology has been developed that would result in cuts in ink and electricity costs by over 20%, while simplifying the setup process, making smaller production runs more feasible. Macilbink Ltd. is facing lowered demand for its products and will need to change direction or innovate to stay in business. The effect of the new printing technology has resulted in which of the following risk assessment changes by Macilbink Ltd.'s auditors?

A) decreased control risk
B) increased control risk
C) decreased client business risk
D) increased client business risk

Question 24

If the client has set unreasonable objectives or if the performance measurement system encourages aggressive accounting, the auditor will

A) increase inherent risk of financial statement misstatements.
B) lower inherent risk of financial statement misstatements.
C) increase control risk of financial statement misstatements.
D) lower control risk of financial statement misstatements.

Question 25

Vanovo Ltd. has purchased several companies in the retail sector. Recently, Vanovo purchased both a coffee and donut chain (that also owned bakeries) and a submarine sandwich chain. Unfortunately, the planned synergies between these two retail chains did not arise. What effect would this have on the financial statements of Vanovo Ltd., the parent company?

A) The financial statements will be incorrectly calculated and should be checked.
B) The fixed assets and goodwill recorded at acquisition could be impaired.
C) Risk of material misstatement for payroll expenses will increase.
D) Costs of goods sold will likely be overstated for both of the new chains.

Question 26

In addition to direct impacts on the financial statements, the auditor also needs to consider indirect effects. An assessment of client objectives and strategies can reveal issues that could lower income or cause contingent liabilities. Which of the following could cause lost sales, increases in warranty expenses, and product liability claims?

A) poor product quality
B) excessive advertising
C) ineffective projections
D) inaccurate budgets

Question 27

When reading the corporate minutes, the auditor extracted the approved annual salary for the President, the Chief Executive Officer, and other senior executives. What audit step would the auditor likely conduct with this information?

A) trace the payroll amount to each individual officer's payroll record
B) check that the payroll has been recorded into the correct bank account
C) verify that payroll cheques have two signatures for all large amounts
D) ensure that all overtime is approved and adequately documented

Question 28

Which of the following would you expect to find in a corporation's bylaws?

A) The kinds and amounts of capital stock authorized.
B) The date of incorporation.
C) The rules and procedures adopted by the shareholders of the corporation.
D) The types of business activities that the corporation is authorized to conduct.

Question 29

If management and salespeople are compensated on the basis of achieving high sales targets, there is increased incentive to record sales before they have been earned. In such a situation, the auditor will increase the extent of testing for which of the following transaction-related audit objectives for sales?

A) cutoff and classification
B) classification and occurrence
C) occurrence and cutoff
D) completeness and cutoff

Question 30

An effective board of directors helps ensure that the company takes only appropriate risks. The audit committee can

A) reduce the likelihood of fraud and financial statement errors through oversight of the entity-level controls.
B) reduce the likelihood of financial statement errors by helping management of the company with complex financial reporting issues.
C) reduce the likelihood of financial statement errors by helping management in the preparation of the financial statements and related notes.
D) reduce the likelihood of overly aggressive accounting through oversight of financial reporting.

Question 31

Michum Inc. has related parties with a company owned by the CEO's brother that comprise about $500 000. There are also related party transactions with the owner (about $250) and with two of the officers ($750 and $1000) respectively. Which related parties should be identified and included in audit documentation?

A) those with material transactions only
B) those that had transactions in the current year only
C) all related parties
D) only those that could lead to a conflict of interest

Question 32

Which of the following is an important purpose of an organizational code of ethics and the associated processes to ensure adherence?

A) to ensure that there are no fraudulent or illegal transactions at the company
B) to train employees in acceptable conduct at the organization
C) to prevent unethical employees from acting in unacceptable ways
D) to provide a powerful signal of acceptable organizational conduct

Question 33

Brandon is working on the audit of Michum Inc. In accordance with CAS 550 (related parties), Brandon had obtained a management confirmation of all related-party transactions. When auditing the purchasing cycle of Michum, Brandon found that the company had purchased over $500 000 of merchandise from Elite Crust Inc., a company that is owned by the CEO's brother. The $500 000 purchase is a material amount and it was not included in the confirmation provided by Michum. Brandon should

A) inform the audit committee.
B) qualify the audit report.
C) discuss this issue with the management of Michum.
D) reduce materiality to increase the likelihood of discovering other undisclosed related party transactions.

Question 34

When reading the corporate minutes, the auditor obtained information regarding loans that were authorized for borrowing. What audit step would the auditor likely conduct with this information?

A) trace the authorized amounts to the bank statements
B) verify that notes payable have been recorded
C) calculate interest payable as of the end of the year
D) contact a credit rating agency to determine the rating of the lender

Question 35

A client's performance measurement system includes key performance indicators that management uses to

A) measure its profitability.
B) compare its performance with prior periods.
C) prepare the financial statements.
D) measure progress toward its objectives.

Question 36

Knowledge of the client's industry and external environment can be obtained in different ways. Discuss some of the ways that this knowledge can be obtained.

Question 37

Your preliminary discussion with European Real Estate Management (EREM) Corporation indicated that the company was owned by three Swedish individuals who sold limited liability partnerships of shopping malls, office buildings, and large residential apartment buildings to European investors. Often, a single shopping mall was broken up into several limited liability partnerships to make the ownership pieces small enough to sell easily.
In some cases these partnership units were sold to European companies, who diversified and bought units in several buildings. Other units were purchased by individuals. If a property looked particularly promising, the owners of EREM occasionally purchased units or advised their wives and family members to purchase units.
Required:
Explain why it is important for the auditor to identify related party transactions. Why are related party transactions a high-risk area for the EREM audit?

Question 38

The official record of the meetings of the board of directors and shareholders is contained in the corporate

A) bylaws.
B) charter.
C) minutes.
D) license.

Question 39

A code of ethics is an important document for organizational conduct. In response to the Sarbanes-Oxley Act in the United States, the SEC requires which of the following actions for organizations that have not adopted a code of ethics?

A) explanation of why it has not done so
B) disclosure of actions undertaken to prevent and detect fraud
C) disclosure of all related parties in management and discussion documents
D) a cost-benefit analysis for immediate implementation of one

Question 40

Black Rock Limited is a marble and tile outlet that has a large outdoor area as well as an indoor showroom for a variety of stone, tile, and marble. It is July and your firm has just been appointed as the auditor for the September year-end audit. The previous auditing firm had conducted review engagements. The company's bank has asked for audited financial statements for the current year end.
Required:

A) What is the purpose of obtaining knowledge of the client's industry and business environment? Identify at least three procedures that you could undertake in this area.
B) What is the purpose of obtaining knowledge of the client's business? Identify at least three procedures that you could undertake in this area.

Question 41

A) One step in the planning phase of an audit is to obtain information about the client's legal obligations. Identify the types of legal documents and records that auditors examine to obtain this information.
B) Discuss the audit-relevant information contained in each of these three types of documents that an auditor should be aware of early in the audit.

Question 42

It is important that the policies, procedures, and key decisions of senior management, the board of directors, and the audit committee be considered when developing a client risk profile because

A) they have a pervasive effect on the company.
B) they influence the most important decisions for the company.
C) it is required by accounting and auditing standards.
D) they have the effect of increasing client business risks.

Question 43

During the course of an audit engagement an auditor prepares and accumulates audit working papers. The primary purpose of the audit working papers is to

A) aid the auditor in adequately planning the work.
B) provide a point of reference for future audit engagements.
C) support the underlying concepts included in the preparation of the basic financial statements.
D) support the auditor's report.

Question 44

Which of the following is a factor that relates to "attitudes or rationalization" to commit fraudulent financial reporting?

A) significant accounting estimates involving subjective judgments
B) excessive pressure for management to meet debt repayment requirements
C) management's practice of making overly aggressive forecasts
D) high turnover of accounting, internal audit, and information technology staff

Question 45

Fraud risk factors are examples of factors that increase the risk of fraud. Which of the following is an example of a management "opportunities" risk factor?

A) The company has lost a major account and income is falling.
B) Two major competitors have gone bankrupt as margins decline in the industry.
C) The Chief Executive Officer owns forty percent of the outstanding share capital.
D) New accounting standards provide three different methods for valuing financial instruments.

Question 46

Fraud risk factors are examples of factors that increase the risk of fraud. Which of the following is an example of a management "incentives or pressures" risk factor?

A) Customer demand for a new product line was significantly less than expected.
B) Management and the auditors disagree on how to value a large contract in progress.
C) There is only one board member who understands financial statements and she has suffered a heart attack.
D) There has been significant turnover in the accounting department in the last year.

Question 47

There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of comparing the gross margin with prior years and looking for large fluctuations?

A) to understand the client's industry and business
B) to assess going concern
C) to identify possible misstatements
D) to reduce detailed tests

Question 48

Anna performed a trend analysis of accounts receivable (AR) balances and computed the days to collect AR ratio. When she compared the results of her analysis with industry averages, she found the results were unusually low compared to the industry norm. Anna can conclude that

A) the accounts receivable balance is wrong.
B) the accounts receivable has an increased risk of misstatement.
C) the integrity of the company's management is questionable.
D) she will not be able to rely on internal controls for accounts receivable for audit purposes.

Question 49

Frontenac Construction, your audit client, is a construction company. In the initial planning phase of the audit, you identified that it has many contracts with severe non-performance clauses if any of the current constructions are not completed on the dates set in the contracts over the next three years. As the auditor, you would set the inherent risk for sales and penalties as

A) high.
B) moderate.
C) low.
D) unknown: this cannot be determined until more procedures are performed.

Question 50

Three conditions for fraud are referred to as the "fraud triangle." One of the sides of this triangle is incentives or pressures. The other two sides are

A) opportunities and a desire to meet debt repayment obligations.
B) opportunities and attitudes or rationalizations.
C) attitudes or rationalizations and the need to maintain stock prices.
D) the need to maintain stock prices and the need to meet debt repayment obligations.

Question 51

In order to assess if a company is a going concern, the auditor can calculate which of the following ratios during the audit planning and compare with previous years and successful companies in the industry?

A) debt to equity ratio
B) accounts receivable turnover ratio
C) percent of interest expense to sales
D) inventory turnover ratio

Question 52

White Top Telephones is the largest telephone distributor in the province, distributing wired and cordless phones as well as cell phones. Management always seems to be in a rush and is difficult to approach. Unfortunately, this attitude has permeated down to all of the staff. Everyone seems to be hurrying about, doing what needs to be done. Sometimes it seems as if they don't even have time for their customers. Yet, everything seems to get done. The company's website has a lengthy privacy policy statement indicating that customers are number one and that all data is kept secure.
Required:
Explain the importance of the control environment and corporate governance structure. During what phases of the risk assessment and planning process would the control environment and corporate governance structure be documented and assessed?

Question 53

The Sarbanes-Oxley Act requires management to certify that it has informed the auditor and audit committee of any

A) related party transactions.
B) significant deficiencies in business practices.
C) significant deficiencies in internal controls.
D) specific business or industry risk.

Question 54

Which of the following is a factor that relates to "incentives or pressures" to commit fraudulent financial reporting?

A) significant accounting estimates involving subjective judgments
B) excessive pressure for management to meet debt covenant requirements
C) management's practice of making overly achievable forecasts
D) high turnover of accounting, internal audit, and information technology staff

Question 55

There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of comparing prepaid expenses and related expense accounts with those of prior years?

A) to understand the client's industry and business
B) to assess going concern
C) to identify possible misstatements
D) to reduce tests of controls

Question 56

Mario, the owner of Clayton's ice cream, is giving Steve, the manager of the audit, a private tour of the production facilities. By doing the tour, Steve will

A) be better able to identify control risks.
B) understand the client's business and operations better.
C) be able to gather audit evidence on operational efficiencies.
D) Steve should not be taking a tour alone with the owner as this could compromise his independence.

Question 57

During discussion and inquiry with management, the auditor determined that the company has started a new line of business that requires a substantial investment in manufacturing equipment. The company has also implemented wireless scanning for its warehouse and inventory. Which of the following techniques will the auditor likely use to corroborate these statements?

A) further inquiry of the accounting personnel
B) inspection of recent sales invoices for types of sales
C) use of analytical procedures, comparing last year to this year
D) observation during the plant tour

Question 58

Organizations with a good control environment are able to document their positive "tone at the top" with a clear code of ethics. How would the auditor include the presence of such a code of ethics in the risk assessment process?

A) increase inherent risks associated with violations of laws and regulations
B) lower inherent risks associated with violations of laws and regulations
C) increase control risks associated with violations of laws and regulations
D) lower control risks associated with violations of laws and regulations

Question 59

Juniper Berry is a private company in the Niagara region that operates in the fruit and vegetable industry. In its main St. Catharines plant, it receives picked berries and sorts and packages them. It also makes some related products such as jams, cookies, and pies. Your firm has recently been hired as the auditor of Juniper Berry. The partner in charge of the audit has asked you to write a memo explaining why it is important to gain understanding of the business operations and processes of Juniper Berry and also to list some suggested procedures to be performed in the process of understanding the business operations and processes.
To assist you with your memo, the partner provided you with some notes she took at a recent meeting with the management of Juniper Berry:
- Juniper Berry (JB) sells and manufactures a wide range of products, including fresh and frozen berries, jam, cookies, and pies. Fresh and frozen berries make up most of JB's revenues.
- JB sells mostly to grocery stores directly. However, its frozen berries are packaged with the Mondo Grocers logo as they have an exclusive contract to sell all of their frozen berry production to Mondo.
- In 2011, JB installed a new scale system to weigh berries when they are delivered from various farms. The amount to be paid to the farmer is then calculated and recorded immediately. The system automatically records the inventory and issues an electronic payment for the amount calculated by the scale. JB is proud to be technologically advanced, as it has allowed the company to cut some jobs and be more cost efficient.
- Given that most of the packaging and processing of berries into derived products is automated, capital assets represent a significant portion of the balance sheet and also required JB to obtain a large bank loan in 2011 when the plant upgrade took place.

Question 60

There are many types of analytical procedures that the auditor can conduct during the planning stage of the financial statement audit. What is the purpose of calculating key ratios for the client's business and comparing them with industry averages?

A) to understand the client's industry and business
B) to assess going concern
C) to indicate possible misstatements
D) to reduce detailed tests