Exam 2 Free Response Pools - problems only(1)

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Acc 531 Exam 2 – Free Response Questions Pool 1) What are some typical types of evidence that may be collected in testing an entity’s internal controls? 2) While performing an audit on the internal controls over financial reporting for AirWaves Corporation, your audit team finds what it considers to be a significant deficiency. AirWaves is a large, private company. What steps would you take to communicate this finding? 3) Trumpeter Corporation is a small publicly traded company that specializes in the restoration and sale of fine musical instruments. The audit committee is made up of a CEO from a technology company, a college accounting professor, and a local marketing executive. All are sufficiently independent from management. Members of the audit committee meet three times a year. Each time they meet, a different member, who chooses the topics to discuss, leads the meeting. The audit committee then sends the minutes of its meetings to the entity’s CFO. Solely from this information, what are your conclusions about this audit committee’s role within the control environment? 4) You are an experienced audit senior. The new staff accountant on your audit team does not understand what a control deficiency is. Give him a definition of “control deficiency.” Include examples of two types of control deficiencies. 5) CBA Associates is auditing a large publicly traded company. The audit of internal controls over financial reporting has been properly planned and the auditors have already identified controls to test using a top-down, risk-based approach. What is the next step? Give three examples of procedures that may be completed in the next step in the audit. 1

6) Discuss the differences between a control deficiency, a significant deficiency, a material weakness, and the two dimensions of the control deficiency - likelihood and magnitude. 7) When determining the sample size of accounts receivable to test the internal control, what are three factors that are important for you to consider? 8) Your manager, Sally, believes that nonstatistical sampling is the best method to use on the audit of YaYa Corporation. You, however, believe that statistical sampling is by far the better method. In addition, you have a great deal of training in the proper use of sampling techniques. Prepare an argument to convince Sally why statistical sampling should be used. 9) Indicate which of the following audit procedures, used as tests of controls, do not involve audit sampling. 1. Observing and evaluating segregation of duties. 2. Testing of whether sales invoices are supported by authorized customer orders and shipping documents. 3. Reviewing entity's procedures for accounting for the numerical sequence of shipping documents. 4. Examining sales orders for proper credit approval. 5. Recomputing the information on copies of sales invoices. 6. Comparing the average days outstanding in accounts receivable with industry averages. 2

10) For a particular audit, the sample size for testing controls over the revenue cycle is relatively large. What can you infer about the desired confidence level, the tolerable deviation rate, and the expected population deviation rate? Answer: There is a direct relationship between the confidence level and sample size. Therefore, one can infer from a large sample size that the auditor would like a higher confidence level. On the other hand, the sample size is inversely related to the tolerable deviation rate. Therefore, the tolerable deviation rate must have been relatively low. The expected population deviation rate and sample size are directly related, so there must be a larger expected population deviation rate. 11) Summarize the concept behind monetary-unit sampling (MUS). How does MUS use attribute-sampling theory? 12) Your uncle Bob, a CPA, has recently started auditing and he wants your advice on some tests of sales transactions he is conducting. Bob selected a haphazard sample of 15 sales with a total book value of $75,000. In his sample, he found a total of $500 in net overstatement errors. The total sales balance per book is $10,000,000. Overall materiality for the engagement is $300,000. Tolerable misstatement for sales is $70,000. If the sample results indicate that Bob's best estimate of total misstatement in sales is $35,000, can Bob safely conclude that no additional work is needed in this area? Include in your answer a clear discussion of how sample results are compared to tolerable misstatement. 13) You have been placed in charge of determining the sample size for an audit of accounts receivable. Your superior would like a confidence level of 99%. How does this affect your determination of sample size? What can you infer about the level of risk of incorrect acceptance that your superior is willing to accept? Answer: A lot of work will be required to achieve a 99% confidence level. This work is reflected in a relatively large sample size. Because confidence levels and the risk of incorrect acceptance are complements, the superior is willing to accept a 1% risk of incorrect 3

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acceptance. 14) Match each factor of sample size to (1) its relationship to sample size (A-Direct or B-Inverse) and (2) the appropriate effect on the sample size if the factor increases (C-Increase or D- Decrease). 1. Tolerable misstatement 2. Population size 3. Desired confidence level 4. Expected misstatement Answer: 1. B, D 2. A, C 3. A, C 4. A, C 15) What is one advantage and one disadvantage of classical variables sampling? 16) Identify whether the following tests are tests of controls, substantive analytical procedures, tests of details of transactions, or tests of details of account balances. 1. Select a sample of customer receivables and send positive confirmations to each customer. 2. Examine monthly bank reconciliations for the internal auditors' initials indicating internal verification and review of the reconciliation. 3. Select a sample of entries in the sales journal and trace each to the shipping documents. 4. Compute receivable turnover and compare with previous years. 5. For a sample of new customers, determine whether credit approval was properly administered and documented. 6. Compare the dates on a sample of sales invoices with the dates of shipment and the dates the transactions were recorded in the sales journal. 4

17) Identify four of the seven primary functions in the revenue cycle and describe each function. 18) What inherent risk factors should an auditor consider when auditing the revenue process of a computer manufacturer? 19) For each of the following independent situations, indicate the type of report on ICFR you would issue. Justify your report choice. a. Hansen, Incorporated, has restated previously issued financial statements to reflect the correction of a misstatement. b. Shu & Han Engineering does not have effective oversight of the entity’s external financial reporting. c. Kim Semiconductor has an ineffective audit committee. d. The internal audit function at Smith Components, a very large manufacturing company, was ineffective. The entity’s auditor has determined that the internal audit function needed to be effective in order for the entity to have an effective monitoring component. e. The auditors of Benron identified significant financial statement fraud by the entity’s chief financial officer. f. Conroy Trucking Company has an ineffective control environment. g. Edwards & Eddins, CPAs, communicated significant deficiencies to Waste Disposal’s management and the audit committee for the last two years. At the end of the current year, these significant deficiencies remain uncorrected. 20) For each of the following independent situations relating to the audit of ICFR, indicate the reason for and the type of audit report you would issue. 5

a. During the audit of Wood Pharmaceuticals, you are surprised to find several control deficiencies in the entity’s internal control. You determine that there is a reasonable possibility that any one of them could result in a misstatement that is significant. Although the odds are extremely low that the deficiencies, singly or taken together, will result in a material misstatement of the entity’s financial statements, the large number of problems causes you concern. Management’s written assessment concludes that the entity’s ICFR was effective as of the report date. b. You agreed to perform an audit for Rodriguez & Company, after the entity’s year-end. Due to time constraints, your audit firm could not complete a full audit of ICFR. However, the evidence you did collect suggests that the entity has exceptionally strong ICFR. You seriously doubt that a material weakness would have been found if time had permitted a more thorough audit. Management’s written assessment concludes that the entity’s ICFR was effective as of the report date. c. George & Diana Company’s internal audit function identified a material weakness in the entity’s ICFR. The entity corrected this weakness about four months prior to the end of the annual reporting period. Management reassessed controls in the area and found them effective. After reevaluating and retesting the relevant controls, you believe the controls to have been effective for a sufficient period of time to provide adequate evidence that they were designed and operating effectively as of the end of the entity’s reporting period. Management’s written assessment concludes that the entity’s internal control was effective as of the report date. d. Reynolds’ Distilleries identified what you agree is a material weakness and made an adverse assessment in its report on ICFR. The entity had not corrected the material weakness as of the end of the reporting period. e. Cindy & David Company’s management identified a material weakness in the entity’s ICFR during its assessment process. The entity corrected this weakness about a month prior to the end of the annual reporting period. Management reassessed controls in the area and believes they were effective as of the end of the reporting period. After reevaluating and retesting the relevant controls, you agree that the new controls are well designed, but since the controls over this particular area are applied only once at the end of each month (i.e., the controls have only operated two times since being corrected), you do not believe you have sufficient audit evidence to assess their operating effectiveness. Management’s written assessment concludes that the entity’s internal control was effective as of the report date. 6

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f. During the audit of ICFR for Big Al & Larry Industries, you discover several control deficiencies. You determine that there is more than a reasonable possibility that any one of them could result in a financial statement misstatement. Although you do not believe that any of the deficiencies taken individually will result in a material misstatement, you believe there is a moderately low likelihood that, taken together, the deficiencies could produce a material misstatement. Management’s written assessment concludes that the entity’s internal control was effective as of the report date. 7

21) Calgari Clothing Company manufactures high-quality silk ties that are marketed under a number of trademarked names. Joe and Vandervelte LLP has been the company’s auditors for five years. Lisa Austen, the senior-in-charge of the audit, has reviewed Calgari’s controls over purchasing and inventory, and she determined that a number of controls can be relied upon to reduce control risk. Austen has decided to test two control procedures over purchases and inventory: (1) purchase orders are agreed to receiving reports and vendor’s invoices for product, quantity, and price; and (2) inventory is transferred to raw material stores using an approved, prenumbered receiving report. Austen decided to use a nonstatistical sampling approach based on the following judgments for each control procedure and has judgmentally decided to use a sample size of 75 purchase orders for control 1 and 30 receiving reports for control 2. Parameters Control Procedure 1 2 Desired confidence 95% 90% Tolerable deviation rate 7% 9% Expected population deviation rate 2% 2.5% After completing the examination of the sample items, Austen noted one deviation for each control procedure. What conclusion should Austen reach about each control procedure? 8

22) During the year, Strang Corporation began to encounter cash-flow difficulties, and a cursory review by management revealed receivable collection problems. Strang’s management engaged Stanley, CPA, to perform a special investigation. Stanley studied the billing and collection process and noted the following:  The accounting department employs one bookkeeper, who receives and opens all incoming mail. This bookkeeper is also responsible for depositing receipts, filing remittance advices on a daily basis, recording receipts in the cash receipts journal, and posting receipts in the individual customer accounts and the general ledger accounts. There are no cash sales. The bookkeeper prepares and controls the mailing of monthly statements to customers.  The concentration of functions and the receivable collection problems caused Stanley to suspect that a systematic theft of customers’ payments through a delayed posting of remittances (lapping of accounts receivable) is present. Stanley was surprised to find that no customers complained about receiving erroneous monthly statements. Identify the procedures Stanley should perform to determine whether lapping exists. Do not discuss deficiencies in the internal control system. 23) The XYZ Company billing department has decided to assign one employee to each of its customers. This employee will be responsible for granting credit to the entity and then handling the billing. XYZ believes this will result in better customer service, because the entity will only have to deal with one person and that one person will be very familiar with the credit terms. As an auditor, would you agree with XYZ's decision? 9

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