Question 1

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:

Accepted Answer

Choice "B" is correct. Generally accepted accounting principles specify that, in order to qualify for hedge treatment, the entity must demonstrate and disclose a number of transaction features including risk exposure. The auditor would therefore need to examine the contracts to evaluate the character of the hedge and the degree to which losses should be recognized in the determination of income, as well as the character of any disclosures. Choice "A" is incorrect. Generally accepted accounting principles require this derivative to be valued at fair value. While the auditor does need to test management's assertions about fair value, analytical procedures are not the most likely way to do this. More likely, the auditor would obtain quoted market prices from financial publications, the exchanges, the National Association of Securities Dealers Automated Quotations System (NASDAQ), or pricing services. If quoted market prices were not available, estimates based on valuation models would be used. Choice "C" is incorrect. The auditor would not generally confirm marketability with a commodity specialist, but rather would test the valuation of such securities by reference to quoted market prices, by using pricing services, or based on a valuation model. Choice "D" is incorrect. There is no requirement that investments in derivatives be communicated to those charged with governance.

Question 2

While observing a client's annual physical inventory, an auditor recorded test counts for several items and noticed that certain test counts were higher than the recorded quantities in the client's perpetual records. This situation could be the result of the client's failure to record:

Accepted Answer

Choice "D" is correct. Failure to record sales returns would result in actual inventory quantities being greater than those recorded in the perpetual inventory records. Choice "A" is incorrect. Failure to record purchase discounts would result in a difference in recorded costs, rather than recorded quantities. Choice "B" is incorrect. Failure to record purchase returns would result in actual inventory quantities being less than those recorded in the perpetual inventory records. Choice "C" is incorrect. Failure to record sales would result in actual inventory quantities being less than those recorded in the perpetual inventory records.

Question 3

In performing tests concerning the granting of stock options, an auditor should:

Accepted Answer

Choice "D" is correct. In auditing the granting of stock options, the auditor would normally trace the transactions to approval by the board of directors. Choice "A" is incorrect. The Secretary of State would not be able to confirm the granting of stock options. Choice "B" is incorrect. Verifying the existence of option holders provides little evidence to support management's financial statement assertions. Choice "C" is incorrect. Converted stock options may be distributed from authorized common shares rather than treasury stock.

Question 4

An auditor analyzes repairs and maintenance accounts primarily to obtain evidence in support of the audit assertion that all:

Accepted Answer

Choice "D" is correct. Analysis of repairs and maintenance expense provides assurance with regard to management's assertion that expenditures for property and equipment have been capitalized and have not been charged to expense. Choice "A" is incorrect. Analysis of repairs and maintenance accounts provides limited evidence about the appropriate cutoff of transactions for the period. Choice "B" is incorrect. Analysis of repairs and maintenance accounts does not provide evidence about the appropriate cutoff of expenditures for property and equipment. Choice "C" is incorrect. Analysis of capitalized expenditures might help identify noncapitalizable expenditures, which were capitalized erroneously.

Question 5

When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud most likely would be reduced if the:

Accepted Answer

Choice "A" is correct. When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud would be reduced if the trust company deals only with the person reconciling the accounts, and not with the employees responsible for maintaining investment records. Choice "B" is incorrect. The securities should be in the entity's name, and not the trust company's. Choice "C" is incorrect. If interest and dividend checks are mailed directly (custody of the asset) to the employee authorized to sell the securities (authorization), incompatible duties would result which may result in fraud being concealed. Choice "D" is incorrect. Limiting access to the assets would reduce the possibility of theft, but would not reduce the possibility of concealing fraud.

Question 6

Which of the following procedures would an auditor most likely perform to obtain assurance that slowmoving and obsolete items included in inventories are properly identified?

Accepted Answer

Choice "C" is correct. Examining an analysis of inventory turnover helps identify slow-moving, excess, defective, and obsolete items included in inventories. In order for inventory to be properly valued, these items may need to be written down. Choice "A" is incorrect. Testing shipping and receiving cutoff provides evidence regarding completeness of inventory and rights and obligations related to inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items. Choice "B" is incorrect. Confirming inventories at locations outside the entity's premises provides evidence regarding existence and completeness of inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items. Choice "D" is incorrect. Tracing inventory observation test counts to perpetual listings provides evidence regarding the completeness of inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items.

Question 7

An auditor scans a client's investment records for the period just before and just after the year-end to determine that any transfers between categories of investments have been properly recorded. The primary purpose of this procedure is to obtain evidence about management's financial statement assertions of:

Accepted Answer

Choice "D" is correct. Investments may be classified as trading, available-for-sale, or held-to-maturity. The classification of each investment into one of these three categories determines how it will be shown on the balance sheet (understandability and classification) and whether it will be valued at market or at amortized cost (valuation and accuracy). Choices "A", "B", and "C" are incorrect. Reviewing transfers of investments between categories will not provide evidence regarding rights and obligations or existence. Rights and obligations and existence would be concerned with whether the securities actually exist and are owned by the client.

Question 8

Which of the following questions would an auditor least likely include on an internal control questionnaire concerning the initiation and execution of equipment transactions?

Accepted Answer

Choice "D" is correct. Questions relating to access controls for assets would not normally be a part of a questionnaire related to controls over the initiation and execution of equipment purchases. Choice "A" is incorrect. Questions about controls related to the authorization of major repairs would likely be included on a questionnaire related to controls over the initiation and execution of equipment purchases. Choice "B" is incorrect. Questions about the existence of prenumbered purchase orders would likely be included on the internal control questionnaire since prenumbering functions as an important control supporting the completeness assertion. Choice "C" is incorrect. Questions about controls related to competitive bids would likely be included on a questionnaire related to controls over the initiation and execution of equipment purchases.

Question 9

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

Accepted Answer

Choice "D" is correct. In auditing investments in securities and derivatives, the auditor must assess the reasonableness and appropriateness of assumptions, market variables, and valuation models. In order to do this, the auditor must consider whether the substance of transactions or events differs materially from their form. Remember that generally accepted accounting principles require transactions and events to be reported in accordance with their economic substance, even if this differs from their form. Choice "B" is incorrect. While the auditor might confirm settled and unsettled transactions with the broker, whether a security is held for trading purposes is based on management intent and would not be confirmed with the broker. Choice "C" is incorrect. There is no requirement that the auditor notify those charged with governance about the risks involved in derivative transactions. Choice "D" is incorrect. There is no requirement that the auditor add an explanatory paragraph to the auditor's report describing the risks associated with each derivative.

Question 10

In auditing long-term bonds payable, an auditor most likely would:

Accepted Answer

Choice "C" is correct. Comparing interest expense with the bond payable amount for reasonableness provides evidence that all interest expense was included and that the outstanding balance of the bonds payable is reasonable, as well as providing limited evidence concerning the amortization of bond discounts or premiums. Choice "A" is incorrect. The auditor would recalculate bond premiums and discounts, rather than use an analytical procedure. Choice "B" is incorrect. The auditor would normally examine documentation of the bond instruments rather than of assets purchased to determine the existence of any liens on the assets. Choice "D" is incorrect. The auditor would confirm the outstanding bonds payable balance, not the existence of individual bondholders.

Question 11

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:

Accepted Answer

Choice "C" is correct. Investment income from dividends is generally recalculated by comparing recorded income with dividend record books produced by investment advisory services such as "Moody's Dividend Record." These books state the dividend that was declared and paid by the investee. Choice "A" is incorrect. Stock ledgers maintained by independent registrars indicate how many shares of stock are issued and outstanding, and identify the shareholders of record, but they do not contain information concerning dividends. Choice "B" is incorrect. Dividend records on file with the SEC would probably include appropriate information, but it is more efficient to use a single source (such as "Moody's") than it is to obtain and review SEC records for each investee. Choice "D" is incorrect. Annual audited financial statements of the investee companies give the total dividends paid, but there may not be enough information to determine exactly how much went to each type of stock and hence to each stockholder. In addition, it is more efficient to use a single source (such as "Moody's") than it is to obtain and review the financial statements of each investee.

Question 12

In auditing accounts receivable, the negative form of confirmation request most likely would be used when:

Accepted Answer

Choice "B" is correct. Negative confirmations are used when the combined assessed level of inherent and control risk is low, a large number of small balances is involved, and the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. Choice "A" is incorrect. Blank positive confirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information. Choice "C" is incorrect. If a small number of accounts are involved and a large number of errors are anticipated, positive confirmations should be used. Choice "D" is incorrect. Confirmations are used exclusively as a substantive test, and are not used in the assessment of control risk.

Question 13

Which of the following auditing procedures most likely would provide assurance about a manufacturing entity's inventory valuation?

Accepted Answer

Choice "A" is correct. Testing the entity's computation of standard overhead rates generally provides assurance about a client's inventory valuation. Choice "B" is incorrect. Obtaining confirmation of inventories pledged under loan agreements provides assurance about the appropriate presentation, description, and disclosure of such matters in the financial statements. Choice "C" is incorrect. Reviewing shipping and receiving cutoff procedures for inventories provides assurance about completeness and existence of inventory. Choice "D" is incorrect. Tracing test counts to the entity's inventory listing provides assurance about the completeness of the client's listing.

Question 14

Which of the following best describes the auditor's responsibility with respect to fair values?

Accepted Answer

Choice "C" is correct. The auditor's overall responsibility is to obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP. Choice "A" is incorrect. While it is true that the auditor should determine whether management has the intent and ability to carry out courses of action that may affect fair values, this is just one part of evaluating fair value measurements and not the best description of the auditor's overall responsibility. Choice "B" is incorrect. While it is true that the auditor should assess the risk of material misstatement of fair value measurements, this is done to determine the nature, timing, and extent of audit procedures. It is not the best representation of the auditor's overall responsibility. Choice "D" is incorrect. Management (and not the auditor) should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.

Question 15

In establishing the existence and ownership of a long-term investment in the form of publicly-traded stock, an auditor should inspect the securities or:

Accepted Answer

Choice "C" is correct. The auditor would confirm the number of shares held by an independent custodian to establish the existence and ownership of a long-term investment in publicly traded securities. Choice "A" is incorrect. The investee company may not have timely information regarding the ownership of its stock. Choice "B" is incorrect. Inspection of the audited financial statements of the investee company does not provide evidence about ownership of the securities. Choice "D" is incorrect. Determination that the investment is carried at the proper market value provides assurance about valuation and about appropriate presentation and disclosure in the financial statements.

Question 16

When a company's stock record books are maintained by an outside registrar or transfer agent, the auditor should obtain confirmation from the registrar or transfer agent concerning the:

Accepted Answer

Choice "C" is correct. If a client uses a stock transfer agent, confirmations should be used to provide evidence of shares authorized, issued, and outstanding, as well as to provide evidence of the individual transactions. Choice "A" is incorrect. It is the auditor's responsibility to identify, examine, and evaluate the disclosure of related party transactions. The stock transfer agent would not necessarily know which parties are related to the client. Choice "B" is incorrect. The auditor should recalculate, or should review management's calculations of, stock subscriptions receivable. Confirmation from the stock transfer agent would not be necessary to review this information. Choice "D" is incorrect. Proper authorization of stock rights and warrants would best be verified by reviewing the minutes of Board of Director meetings. Confirmation from the stock transfer agent would not be necessary to review this information.

Question 17

Which of the following statements is correct concerning the use of negative confirmation requests?

Accepted Answer

Choice "A" is correct. Although returned negative confirmations may provide evidence about the financial statement assertions, unreturned negative confirmation requests do not provide explicit evidence that the intended third parties received the confirmation requests and verified that the information contained in them is correct. Choice "B" is incorrect. Negative confirmation requests may be used when the combined assessed level of inherent and control risk is low, which would generally imply that a somewhat higher level of detection risk could be accepted. Choice "C" is incorrect. Alternative procedures are necessary only for unreturned positive confirmation requests. Unreturned negative confirmation requests generally imply that the respondent agrees with the stated balance. Choice "D" is incorrect. Accounts receivable confirmations in general provide little assurance when understatements of account balances are suspected, since recipients have a vested interest in not reporting such understatements.

Question 18

When an auditor does not receive replies to positive requests for year-end accounts receivable confirmations, the auditor most likely would:

Accepted Answer

Choice "C" is correct. When using positive confirmation requests, the auditor should generally follow up with a second and sometimes third request to those parties from whom replies have not been received. In addition, asking the client to contact its customers may encourage further responses. Choice "A" is incorrect. Confirmations are designed to provide evidence of existence, so nonresponses would require alternative procedures focused on existence as well. Verification that the account was subsequently written off tests the valuation assertion, but does not provide evidence of existence. Choice "B" is incorrect. The auditor sets detection risk based on the assessed levels of inherent risk and control risk, and would only increase the acceptable level of detection risk in response to a decrease in inherent or control risk. Failure to receive confirmations would not cause the auditor to make such a change. Choice "D" is incorrect. Inherent risk assessments would not be affected by confirmation response rates, which are not subject to client control.

Question 19

When using confirmations to provide evidence about the completeness assertion for accounts payable, the appropriate population most likely would be:

Accepted Answer

Choice "A" is correct. When testing the completeness assertion for accounts payable, the appropriate population would be a list of vendors with whom the entity has previously done business. Choice "B" is incorrect. Confirming amounts recorded would test the existence assertion, rather than completeness. Choice "C" is incorrect. Checks drawn in the subsequent period represent only a subset of the client's vendor listing. (It would not include liabilities that have not yet been paid). In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected in the client's financial statements. Choice "D" is incorrect. The invoices filed in the entity's open invoice file would provide only a subset of the client's vendor listing. (It would not include liabilities for which the invoice had not yet been received.) In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected in the client's financial statements.

Question 20

Which of the following internal controls most likely would be used to maintain accurate inventory records?

Accepted Answer

Choice "D" is correct. In order to maintain accurate perpetual inventory records, periodic inventory counts should be used to adjust perpetual records. Choice "A" is incorrect. By comparing perpetual inventory records to current costs, the company ensures that the inventory is appropriately valued at the lower of cost or market, but the accuracy of the perpetual inventory is not assured. Choice "B" is incorrect. While a just-in-time inventory system will usually reduce the amount of inventory on hand, it does not necessarily improve the accuracy of inventory records. Choice "C" is incorrect. The matching of requisitions, receiving reports, and purchase orders is a control to ensure that purchases of inventory are properly authorized, but it does not necessarily improve the accuracy of inventory records.

Exam 1: CPA Auditing and Attestation Exam