CPA REVIEW

3
Auditing &
Attestation
by
Vincent W. Lambers, MBA, CPA and
Richard Delgaudio, MBA, CPA.

3
Auditing
and
Attestation

byVincentW.Lambers,MBA,CPA
RichardDelGaudio,MBA,CPA
RonaldLaPlante,CPA,CMA,CIA

Publishedby

Copyright 2012 by LearnForce Partners, LLC

All rights reserved. No part of this publication
may be reproduced in any form without the
written permission of the publisher.

Good Luck! You have selected a CPA course designed for success. You have all the materials needed for a program
that will p repare you for taking the Auditing section of the CPA ex amination. These materials are u p-to-date and
designed to facilitate effecti ve study. Our instructors are thoroughly familiar with the material and the CPA
examination.
We have endeavored to produce an error-free set of materials. However, we are aware that sometimes errors creep in
when we least ex pect it. Sh ould you notice any errors, omissions, or have any suggestions, please discuss email
Lambers CPA Review at support@lambers.com.

______________________________________________________________________
Chapter Subjects of Volume 3AUDITING and ATTESTATION
Chapter One
INTRODUCTION, GENERAL AND FIELD STANDARDS
Chapter Two
THE THIRD STANDARD OF FIELD WORKEVIDENCE
Chapter Three
STANDARDS OF REPORTING
Chapter Four
ATTESTATION STANDARDS, GOVERNMENT AUDITING STANDARDS, QUALITY CONTROL
STANDARDS
Chapter Five
REVIEWS, COMPILATIONS, SPECIAL REPORTS AND OTHER REPORTS
Chapter Six
THE AUDIT SAMPLING PROCESS
Chapter Seven
AUDITING WITH TECHNOLOGY
Chapter Eight
PROFESSIONAL RESPONSIBILITIES
Chapter Nine
AUDITING UPDATES AND INTERNATIONAL STANDARDS
Material from Uniform CPA Examination Questions and Unofficial Answers, copyright 1977
through 2012 by the Am erican Institute of Cer tified Public Accountants, Inc., is reprinted (or
adapted) with permission.

____________________________________________________________________________________________
ACKNOWLEDGMENTS
It would be impossible to write a C PA examination book of an y kind without the a ssistance of the Am erican
Institute of Certified Public Accountants, and their various operating divisions, in granting permission to use various
materials. We respectfully acknowledge and thank those persons in the American Institute who promptly answered
our inquiries.
Those areas of the book for which we received permission to use copyrighted material from the American Institute are:

CPA Examination Questions, Problems and Solutions

Opinions of the Financial Accounting Standards Board and Predecessor Bodies
Adaptations, Quotations, Case Examples and Tables from "An Auditor's Approach to Statistical Sampling"
Statements on Auditing Standards issued by AICPA
Statements on Standards for Accounting Review Services issued by AICPA
Statements on Standards for Attestation Engagements issued by AICPA
Richard DelGaudio, CPA
January 2012

Chapter One
Introduction, General and Field Standards
INTRODUCTION
OBJECTIVE OF THE ORDINARY EXAMINATION OF FINANCIAL STATEMENTS
To express an opinion on reliability and fairness of management prepared financial statements by means of the
auditor's report.

STANDARD SHORT-FORM AUDITOR'S REPORTUNQUALIFIED

(Note: Audit reports are covered in detail in Chapter 3. Discussion here is for quick reference purposes only.)
The form of the standard report on financial statements covering a single year is as follows:
Independent Auditor's Report
Board of Directors
X Corporation
We have audited the accompanying balance sheet of X Company as of December 31, 20XX, and the
related statements of income, retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a reasonable
basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of X Company as of (at) December 31, 20XX, and the results of its operations and its
cash flows for the year then ended in conformity with accounting principles generally accepted in the
United States of America.
(Date of completion of audit)
(Firm Name and Signature)

(Italics added for emphasis)

Briefly, the auditors standard report may be modified and take one of the following forms:
Qualified ReportUsually issued when the auditor takes exception to a material item or items in the financial
statements because of departures from GAAP. A qualified opinion may also be issued when the auditor's
examination is restricted with respect to an item in the financial statements. This type of report communicates to the
reader of the financial statements that management's financial reports are fairly presented "except for" a departure
from GAAP, which is material enough to mention but not pervasive enough to render the financial statements
misleading when taken as a whole.
Adverse ReportIssued when the auditor feels that the departures from GAAP are serious enough to render the
statements misleading. In this case, the CPA was able to apply auditing procedures, but discovered material and
pervasive departures from GAAP that the client refused to correct. Thus, the dividing line between "except for"
(qualified) opinion and an adverse opinion is one of materiality and pervasiveness of the departure from GAAP.

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Disclaimer ReportIssued when the auditor's examination was incomplete (scope restricted because of nature of
examination or other audit restrictions) to the point where he was unable to express an opinion on the financial
statements or where the uncertainties have a pervasive and material effect on the financial statements. Thus, a
disclaimer can result from inadequate auditing procedures or material uncertainties.
A complete discussion of the auditor's reporting function is in Chapter 3.

DISTINCTION BETWEEN RESPONSIBILITIES OF AUDITOR AND MANAGEMENT

1.
2.
3.
4.

Fairness of the representations contained in financial statements is part of management's responsibility.

Management is responsible for development of adequate controls, safeguarding of assets, sound accounting
policies that will produce proper statements (i.e., internal control).
Auditor's responsibility is confined to the expression of an opinion, and the adequacy of auditing procedures.
Purpose of the ordinary examination is not primarily the detection of fraud. Auditor is aware that fraud may
exist and as such may affect the financial statements. The auditor must assess the risk that fraud may have
affected the financial statements, and as such, the auditor would appropriately modify the audit procedures.

SAS NO. 102: DEFINING PROFESSIONAL REQUIREMENTS IN

STATEMENTS ON AUDITING STANDARDS
Requirements of SAS No. 102
The statement defines categories of professional requirements which are identified by specific terms, to describe the
extent of responsibility they impose on auditors, as follows:
a. Unconditional requirements: The auditor is required to comply with an unconditional requirement in all cases
in which the circumstances exist to which the unconditional requirement applies. An unconditional
requirement is indicated by the words "must" or "is required. "
b. Presumptively mandatory requirements: The auditor is required to comply with a presumptively mandatory
requirement in all cases in which the circumstances exist to which the presumptively mandatory requirement
applies. A procedure or action within a SAS that uses the word "should" would be categorized under the
presumptive mandatory requirements. However, in rare circumstances, the auditor may depart from a
presumptively mandatory requirement provided the auditor documents his or her justification for the departure
and how the alternative procedures performed in the circumstances were sufficient to achieve the objectives of
the presumptively mandatory requirement.
c. Explanatory material and other references is descriptive and not imperative. The auditor is required to
understand the procedures and actions. Whether the auditor carries out the procedures or actions is based on his
or her professional judgment based on the engagement objective. Procedure, action or explanatory material that
includes terms such as "may, might, could."
d. Use of the term "should consider": If a SAS provides that a procedure or action is one that the auditor "should
consider," the consideration of the procedure or action is presumptively required, but carrying out the
procedure or action is not.

GENERALLY ACCEPTED AUDITING STANDARDS

Auditing "standards" differ from auditing "procedures" in that procedures relate to acts to be performed, whereas
standards deal with measures of the quality of the performance of those acts and the objectives to be attained by the
use of the procedures undertaken. The generally accepted auditing standards, which are interdependent and
interrelated, are represented by the general standards, field standards, and reporting standards from the time the
Auditing Standards Board of the AICPA will issue interpretations of the standards in publications known as
Statements on Auditing Standards (SAS's).

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General Standards
1.
2.
3.

The audit must be performed by a person or persons having adequate technical training and proficiency as an
auditor.
In all matters relating to the assignment an independence in mental attitude is to be maintained by the auditor
or auditors.
Due professional care is to be exercised in the performance of the examination and the preparation of the
report.

Standards of Field Work

1.
2.
3.

The auditor must adequately plan the work and must properly supervise any assistants.
The auditor must obtain a sufficient understanding of the entity and its environment, including its internal
control, to assess the risk of material misstatement of the financial statements whether due to error or fraud,
and to design the nature, timing, and extent of further audit procedures.
The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a
reasonable basis for an opinion regarding the financial statements under audit.

Standards of Reporting
1.
2.
3.
4.

The report shall state whether the financial statements are presented in accordance with generally accepted
principles of accounting.
The report shall identify those circumstances in which such principles have not been consistently observed in
the current period in relation to the preceding period.
Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise
stated in the report.
The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or
an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed,
the reasons therefor should be stated. In all cases where an auditor's name is associated with financial
statements the report should contain a clear-cut indication of the character of the auditor's examination, if any,
and the degree of responsibility he is taking.

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OVERVIEW OF THE AUDIT PROCESS

A.

Decision Criteria
1. Independence
Rule 101 Code
of Conduct
GAAS
2. Competency
Rule 201 Code
of Conduct
General Standards
3. Predecessor Auditor

Decision to
Accept Client

B.
Document Engagement Understanding
(Engagement Letter)

C.

Plan Audit
1. Understand the entity
and its environment:
a. Management
b. Industry
c. Regulation
d. Economy
e. Outside pressure
2.
3.
4.

D.

Decision on Audit Risk

a. Potential for Errors
b. Potential for Illegal Acts
c. Potential for Fraud

Perform Analytical Review

Initial Understanding of Internal Control
Audit Program
1) Preliminary based upon
1-3 and planned level of reliance on
Internal Controls
2) Detail nature, timing and extent
of Tests

Consider Internal Controls

Outcomes
Planned level
of Reliance
needs to
be modified

Confirms
Planned
level of
reliance

Update Planned
Audit Program
Developed in
C4 above

Go with
original plan
as developed
in C4 above

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E.

Assess the Risk of Material Misstatement Due to Errors or Fraud

F.

Identify Specific Risks

G.

Modify Planned Audit Program to Address Specific Risks

H.

Perform
Substantive
Audit Tests

Extraordinary Results
1. Errors
2. Fraud
3. Illegal Acts

Nothing
extraordinary
encountered

Update Programs
after discussions
with client

I.

Obtain
Representation
Letter

J.

Propose Necessary
Adjusting Entries
Rejected
By client

Accepted
By client

Modify
opinion
appropriately

Issue
unqualified
opinion

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DECISION TO ACCEPT A CLIENT

The decision to accept an engagement is made by reference to the General Standards of G.A.A.S. and by
consultation with the predecessor auditor, if applicable.

GENERAL STANDARDS
The general standards are concerned with the professional training and conduct of the auditor. Specifically, there are
three general standards:
1. The audit must be performed by a person or persons having adequate technical training and proficiency as an
auditor.
2. In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor
or auditors.
(Since the auditor is attesting to the fairness of the financial statements, it is important that he have no bias
towards the client. If the CPA is not independent of his client he must disclaim an opinion.)
3. Due professional care is to be exercised in the performance of the examination and the preparation of the
report.

COMMUNICATIONS BETWEEN PREDECESSOR AND SUCCESSOR AUDITORS

(SAS NO. 84)
The purpose of the communication between predecessor and successor auditors when a change of auditors is in
process is to help the successor auditor in deciding to accept the client. The term "predecessor auditor" refers to an
auditor who has resigned or who has been notified that his services have been terminated. The term "successor
auditor" refers to an auditor who has accepted an engagement or an auditor who has been invited to make a
proposal for an engagement. This statement applies whenever an independent auditor has been retained, or is to be
retained, to make an examination of financial statements in accordance with generally accepted auditing standards.
The initiative in communicating rests with the successor auditor. The communication may be either written or
oral. Both the predecessor and successor auditors should hold in confidence information obtained from each other.
This obligation applies whether or not the successor accepts the engagement.

Communications Before Successor Accepts Engagement

Inquiry of the predecessor auditor is a necessary procedure because the predecessor may be able to provide the
successor with information that will assist him in determining whether to accept the engagement. The successor
should bear in mind that, among other things, the predecessor and the client may have disagreed about
accounting principles, auditing procedures, or similarly significant matters.

Request for Permission of Client to Authorize Disclosure

The successor auditor should explain to his prospective client the need to make an inquiry of the predecessor and
should request permission to do so. Except as permitted by the Rules of Conduct, an auditor is precluded from
disclosing confidential information obtained in the course of an audit engagement unless the client consents. The
successor auditor should ask the prospective client to authorize the predecessor to respond fully to the
successor's inquiries. If a prospective client refuses to permit the predecessor to respond or limits the response, the
successor auditor should inquire as to the reasons and consider the implications of that refusal in deciding
whether to accept the engagement.
The successor auditor should make specific and reasonable inquiries of the predecessor regarding matters that the
successor believes will assist him in determining whether to accept the engagement. His inquiries should include
specific questions regarding, among other things, facts that might bear on the integrity of management, on
disagreements with management as to accounting principles, auditing procedures, or other similarly
significant matters, and on the predecessor's understanding as to the reasons for the change of auditors.

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The predecessor should respond promptly and fully, on the basis of facts known to him, to the successor's
reasonable inquiries. However, should he decide, due to unusual circumstances such as impending litigation,
not to respond fully to the inquiries, he should indicate that his response is limited. If the successor auditor
receives a limited response, he should consider its implications in deciding whether to accept the engagement.

Other Communications
When one auditor succeeds another, the successor auditor must obtain sufficient competent evidential matter to
afford a reasonable basis for expressing his opinion on the financial statements he has been engaged to examine as
well as on the consistency of the application of accounting principles in the current year as compared with the
preceding year. This may be done by applying appropriate auditing procedures to the account balances at the
beginning of the period under examination and in some cases to transactions in prior periods. The successor auditor's
examination may be facilitated by (a) making specific inquiries of the predecessor regarding matters that the
successor believes may affect the conduct of his examination, such as audit areas that have required an inordinate
amount of time or audit problems that arose from the condition of the accounting system and records, and (b)
reviewing the predecessor auditor's working papers. In reporting on his examination, however, the successor
auditor should not make reference to the report or work of the predecessor auditor as the basis, in part, for
his own opinion.
The successor auditor should request the client to authorize the predecessor to allow a review of the
predecessor's working papers. It is customary in such circumstances for the predecessor auditor to make himself
available to the successor auditor for consultation and to make available for review certain of his working papers.
The predecessor and successor auditors should agree on those working papers that are to be made available
for review and those that may be copied. Ordinarily, the predecessor should permit the successor to review
working papers relating to matters of continuing accounting significance, such as the working paper analysis of
balance sheet accounts, both current and noncurrent, and those relating to contingencies. Valid business reasons,
however, may lead the predecessor auditor to decide not to allow a review of his working papers. When more than
one successor auditor is considering acceptance of an engagement, the predecessor auditor should not be
expected to make himself or his working papers available until the successor has accepted the engagement.

Financial Statements Reported On by Predecessor

If, during his examination, the successor auditor becomes aware of information that leads him to believe that
financial statements reported on by the predecessor auditor may require revision, he should request his client to
arrange a meeting among the three parties to discuss this information and attempt to resolve the matter. If the client
refuses or if the successor is not satisfied with the result, the successor auditor may be well advised to consult with
his attorney in determining an appropriate course of further action.

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SAMPLE ENGAGEMENT LETTER

BETTER & BEST CPAs
Lambers CPA Review
This letter will confirm our understanding of the terms and objectives of our engagement and the nature and limitations of the
services we will provide.

We will audit the statement of financial condition of Lambers CPA Review as of December 31, 2010, and the related
statements of Income, Retained Earnings and Cash Flows for the year then ended for the purpose of expressing an opinion
on them. The financial statements are the responsibility of the management of Lambers CPA Review. Encompassed in that
responsibility is the creation and maintenance of proper accounting records, the selection of appropriate accounting
principles, the safeguarding of assets, and compliance with relevant laws and regulations. Our responsibility is to express an
opinion on the financial statements based on our audit, and is limited to the period covered by our audit. If circumstances
preclude us from issuing an unqualified opinion, we will discuss the reasons with you in advance. A report will not be issued
for this engagement if we are unable to finish the audit.

We will conduct our audit in accordance with auditing standards generally accepted in the United States. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures
included in the financial statements. Accordingly, the areas and number of transactions selected for testing will involve
judgment. It also includes assessing the accounting principles used and significant estimates made by Lambers CPA Review,
as well as evaluating the overall financial statement presentation.

Our audit is designed to provide reasonable assurance of detecting misstatements that, in our judgment, could have a
material effect on the financial statements taken as a whole. Consequently, our audit will not necessarily detect all
misstatements that might exist due to error, fraudulent financial reporting, or misappropriation of assets. Lambers CPA
Review is responsible for establishing and maintaining a sound system of internal control, which is the best means of
preventing or detecting errors, fraudulent financial reporting, and misappropriation of assets. We will inform you of all
matters of fraud and material errors, and all illegal acts, unless they are clearly inconsequential, that come to our attention.

Management is responsible for adjusting the financial statements to correct material misstatements and for affirming to the
auditor in a representation letter that the effects of any uncorrected misstatements aggregated by the auditor during the
current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate to the
financial statements taken as a whole.

Our report on the financial statements is presently expected to read as follows:

[Standard Audit Report] Refer to page 3-1 for text

If you intend to publish or otherwise reproduce the financial statements and make reference to our firm, you agree to provide
us with printers' proofs or masters for our review and approval before printing. You also agree to provide us with a copy of
the final reproduced material for our approval before it is distributed.

Our fees will be billed as work progresses and are based on the amount of time required plus out-of-pocket expenses.
Invoices are payable upon presentation. Our initial fee estimate assumes no unexpected circumstances will be encountered.
We will notify you immediately of any circumstances we encounter that could significantly affect our initial estimate of total
fees, which will range from $50,000 to $75,000.
If this letter correctly expresses your understanding, please sign the enclosed copy where indicated and return it to us.
We appreciate the opportunity to serve you and trust that our association will be a long and pleasant one.
Sincerely,
John Better CPA
[Engagement Partner's Signature]
Accepted and agreed to:
Vincent Lambers
[Client Representative's Signature]
President
[Title]
November 20, 2009
[Date]

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PLANNING THE ENGAGEMENT

The First Standard of Field Work
The work is to be adequately planned, and assistants, if any, are to be properly supervised.

SAS No. 108: Planning and Supervision

General
The first standard of fieldwork deals with planning and supervision in an audit.
The auditor must adequately plan the work and must properly supervise any assistants.
Planning
I. Appointment of the auditor:
A. It is preferable to appoint the auditor early in the process to enable the auditor to plan the audit prior to the
balance sheet date.
B. Although early appointment of the auditor is preferable, an auditor may accept an engagement near or after
the close of the fiscal year.
1) Before accepting an engagement, the auditor should determine whether circumstances are likely to
permit an adequate audit and expression of an unqualified opinion and, whether a qualified opinion or
disclaimer of opinion may be needed.
C. If there is a change in auditors, the auditor must follow SAS No. 84, Communications Between Predecessor
and Successor Auditors, as amended.
II. Establishing an understanding with the client:
A. The auditor should establish an understanding with the client regarding the services to be performed for
each engagement.
1) The understanding should be communicated in the form of a written communication, such as an
engagement letter.
2) The understanding should include:
a) The objectives of the engagement to express an opinion on the financial statements.
b) Management's responsibilities for:
the financial statements and selection and application of the accounting principles.
establishing and maintaining effective internal control over financial reporting.
designing and implementing programs and controls to prevent and detect fraud.
identifying and ensuring that the entity complies with the laws and regulations applicable to its
activities.
making all financial records and related information available to the auditor
adjusting the financial statements to correct material misstatements and for affirming to the
auditor in the management representation letter that the effects of any uncorrected
misstatements aggregated by the auditor during the current engagement and pertaining to the
latest period presented are immaterial, both individually and in the aggregate, to the financial
statements taken as a whole.
c) Management agrees to provide the auditor with a representation letter at the conclusion of the
engagement.
d) Auditor's responsibility and audit expectations:
To conduct the audit in accordance with GAAS to obtain reasonable, rather than absolute,
assurance as to whether the financial statements are free of material misstatement, whether
caused by error or fraud.
A material misstatement may remain undetected.
An audit is not designed to detect error or that is immaterial to the financial statements.
If the auditor is unable to complete the audit or unable to form or has not formed an opinion, he
or she may decline to express an opinion or decline to issue a report as a result of the
engagement.

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e)

Definition of an audit:
An audit includes obtaining an understanding of the entity and its environment, including its
internal control, sufficient to access the risk of material misstatement of the financial statements
and to design the nature, timing and extent of further audit procedures.
An audit is not designed to provide assurance on internal control or to identify significant
deficiencies.
The auditor is responsible for ensuring that those charged with are aware of any significant
deficiencies that come to his or her attention.

3) Other matters that may be communicated (not required) include:

a) The overall audit strategy
b) Involvement of specialists or internal auditors
c) Involvement of a predecessor auditor
d) Fees and billing
e) Any limitation of or other arrangements regarding the liability of the auditor or the client, such as
indemnification to the auditor
f) Conditions under which access to audit documentation may be granted to others
g) Additional services to be provided relating to regulatory requirements
h) Other services to be provided in connection with the engagement, such as nonattest services.
III. Preliminary engagement activities:
A. The auditor should perform certain other preliminary engagement activities to ensure that the auditor:
1) Maintains the necessary independence and ability to perform the engagement.
2) That there are no issues with management integrity that may affect the auditor's willingness to continue
with the engagement, and,
3) That there is no misunderstanding with the client as to the terms of the engagement.
B. The auditor should perform the following activities at the beginning of the current audit engagement.
1) Perform procedures regarding continuance of the client relationship and the specific audit engagement.
2) Evaluate the auditor's compliance with ethical requirements including independence.
Note: The consideration of client continuance and ethical requirements (including independence), occurs
throughout the audit as changes in conditions and circumstances occur. However, the auditor's initial
procedures on both client continuance and evaluation of the auditor's ethical requirements should be
performed prior to performing other significant activities for the current audit engagement.
IV. Establish an overall audit strategy:
A. The auditor should establish an overall audit strategy for the audit that includes the following actions.
1) Determine the characteristics of the engagement that define the scope of the audit, such as:
Basis of reporting (GAAP, OCBOA)
Industry-specific reporting requirements, and
Locations of the entity.
2) Determine the resources that will be needed to perform the audit such as:
The personnel to assign for specific audit areas, such as the use of experienced team members for
high-risk areas or the involvement of experts on complex matters.
Personnel to assign to specific audit areas, such as the number to assign to inventory observations,
extent of other auditors' work, audit budget to allocate sufficient time to high-risk areas
When personnel are assigned, such as at an interim period or at key cutoff dates.
How to manage, direct and supervise the audit
3) Determine the reporting objectives of the engagement to plan the timing of the audit and the nature of
the communications required such as deadlines, key dates for communications, etc.

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4) Consider the important factors that will determine the focus of the audit team's efforts such as:
Materiality levels
Identification of areas of high risks of material misstatement
Identification of material account balances
Evaluation of whether the auditor may plan to obtain evidence regarding the operating effectiveness
of internal control, and
Identification of recent significant entity-specific, industry, financial reporting, or other relevant
developments.
5) The auditor should also consider the results of preliminary engagement activities and experience
gained on other engagements performed for the entity.
6) Once the audit strategy is established, the auditor should start the development of a more detailed audit
plan to deal with the matters identified in the audit strategy.
V. Audit plan:
A. The auditor must develop an audit plan (a.k.a. audit program) in which the auditor documents the audit
procedures to be used that, when performed, are expected to reduce audit risk to an acceptable low level.
B. The audit plan is more detailed than the audit strategy and includes the nature, timing, and extent of audit
procedures to be performed to reduce audit risk to an acceptably low level.
C. The audit plan should include:
1) A description of the nature, timing, and extent of planned risk assessment procedures sufficient to
assess the risks of material misstatement.
2) A description of other audit procedures to be carried out for the engagement in order to comply with
GAAS, such as seeking direct communication with the entity's lawyers.
VI. Determine the extent of involvement of professionals with specialized skills,
including IT professionals:
A. The auditor should consider whether specialized skills are needed to perform the audit and whether the
auditor should seek the assistance of a professional possessing such skills.
B. If a professional is needed, the auditor should consider whether the professional will function as a member
of the team requiring supervision.
C. The use of IT professionals may be a significant aspect of many audit engagements. Factors to consider in
determining whether an IT professional is needed include:
1) Complexity of the entity's systems and IT controls
2) Significance of changes made to existing systems or implementation of new systems
3) Extent to which data is shared among systems
4) Extent of the entity's participation in electronic commerce
5) Entity's use of emerging technologies
6) Significance of audit evidence that is available only in electronic form.
D. Audit procedures assigned to an IT professional include inquiry of the entity's IT personnel as to how data
and transactions are initiated, authorized, recorded, processed and reported, and how IT controls are
designed, inspecting systems documentation, observing the operation of IT controls, and planning and
performing tests of IT controls.
VII. Communicating with those charged with governance and management:
A. The auditor may discuss elements of planning with those charged with governance and the entity' s
management.
B. Typically discussions with those in charge with governance include the overall audit strategy and timing of
the audit, including any limitations or any additional requirements.
C. Discussions with management often occur to facilitate the conduct and management of the audit
engagement.
VIII. Additional considerations in initial audit engagements:
A. If the auditor is performing an initial audit, the auditor should perform the following activities before
starting the initial audit:
1) Perform procedures regarding the acceptance of the client relationship and the specific audit
engagement.
2) Communicate with the previous auditor, where there has been a change in auditors.

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3) Perform additional procedures including:

Arrange to review the previous auditor's audit documentation
Any major issues discussed with management in connection with the initial selection as auditors
The planned audit procedures regarding opening balances
The assignment of personnel
Other procedures required by the firm's quality control system.
Supervision
Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit
and determining whether those objectives were accomplished. The extent of supervision depends on various factors
that include:
a. The complexity of the subject matter
b. Qualifications of persons performing the work
c. Knowledge of the client's business and industry.
1. The auditor with the final responsibility for the audit should communicate with members of the audit team
regarding the susceptibility of the entity's financial statements to material misstatement due to error or fraud.
a. The discussion should emphasize the need to maintain a questioning mind and to exercise professional
skepticism in gathering and evaluating evidence throughout the audit.
b. Assistants should be informed of their responsibilities and the objectives of the audit procedures they are to
perform.
c. The auditor should direct assistants to bring to his or her attention accounting and auditing issues raised
during the audit that the assistant believes are of significance to the financial statements or auditor's report.
2. The work performed by each assistant should be reviewed to determine whether it was adequately performed and
documented and to evaluate the results.
3. Each assistant has a professional responsibility to bring to the attention of appropriate individuals in the firm
disagreements or concerns with respect to accounting and auditing issues that the assistant believes are of
significance to the financial statements or auditor's report.

SAS No. 109 Understanding the Entity and its Environment

and Assessing the Risks of Material Misstatement
The Second Standard of Field Work
General Standards
1.

The auditor must obtain a sufficient understanding of the entity and its environment, including its internal
control, to assess the risk of material misstatement of the financial statements whether due to error or fraud,
and to design the nature, timing, and extent of further audit procedures.

Obtaining an understanding of an entity and its environment, and then assessing the risk of material
misstatement is an essential part of performing an audit in accordance with GAAS.
That understanding establishes the framework from which the auditor plans the audit and includes:
Establishing materiality for planning purposes and evaluating whether that judgment remains appropriate as the
audit progresses.
Considering the appropriateness of the selection and application of accounting principles and the adequacy of
financial statement disclosures.
Identifying areas where special audit consideration may be necessary such as with related-party transactions,
going-concern, dealing with complex transactions, and evaluating the overall business purpose of transactions.
Developing expectations in performing analytical procedures.
Designing and performing additional audit procedures to reduce audit risk to a lower level.
Evaluating the sufficiency and appropriateness of audit evidence obtained.

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Obtaining an understanding of the entity and its environment involves three steps:
1. Apply risk assessment procedures in order to gather information about the entity and its environment,
including its internal control
2. Understand the entity and its environment, including its internal control
3. Assess the risks of material misstatement
Each of these three steps is discussed below.
Apply risk assessment procedures in order to gather information about the entity and its environment,
including its internal control
In the first step, the auditor should perform certain risk assessment procedures to gather information to facilitate an
understanding of the entity and its environment, including its internal control:
1. Inquiries of management and others within the entity
2. Perform analytical procedures
3. Observation and inspection
4. Have discussions among audit team members
In addition, the auditor might perform other procedures where the information obtained may be helpful in
identifying risks of material misstatement. One example is for the auditor to make inquiries of others outside the
entity such as the entity's external legal counsel or valuation experts that the entity has used.
1. Inquiries:
a. The auditor may communicate with management as well as others within the entity, such as production and
internal audit personnel, and other employees with different levels of authority.
b. In determining those individuals within an entity to whom inquiries may be directed, or the extent of those
inquiries, the auditor should consider what may be obtained that help the auditor in identifying risk of
misstatement.
Examples include:
Subject of inquiry
Those individuals charged with
governance

Benefits of inquiry
May help the auditor understand the environment in which the financial
statements are prepared.

Internal audit personnel

May relate their activities concerning the design and effectiveness of the
entity's internal control and whether management has satisfactorily responded
to any findings from these activities.

Employees involved in initiating,

authorizing, processing, or
recording complex or unusual
transactions
In-house legal counsel

May help the auditor in evaluating the appropriateness of the selection and
application of certain accounting policies.

Marketing, sales, or production

personnel

May relate to changes in the entity's marketing strategies, sales trends,

production strategies, or contractual arrangements with its customers.

May relate to such matters as litigation, compliance with laws and regulations,
knowledge of or suspected fraud affecting the entity, warranties, post-sales
obligations, arrangements (such as joint ventures) with business partners, and
the meaning of certain contract terms.

2. Perform analytical procedures:

a. SAS No. 56, Analytical Procedures, requires an auditor to apply analytical procedures in planning the audit
as an aid in understanding entity and its environment and to identify areas that may represent specific risks
relevant to the audit.
b. In performing analytical procedures as risk assessment procedures, the auditor should develop expectations
about plausible relationships that are reasonably expected to exist in the financial statements.

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c.

The auditor would then compare those expectations with recorded amounts or ratios developed from
recorded amounts. If the procedure yields unusual or unexpected relationships, the auditor should consider
those results in identifying risks of material misstatement.

3. Observation and inspection:

a. Observation and inspection may support inquiries of management and others, and also provide information
about the entity and its environment.
b. Such procedures typically include the following:
Observation of entity activities and operations
Inspection of documents (such as business plans and strategies), records, and internal control manuals
Reading reports prepared by management, (such as quarterly management reports and interim financial
statements), those charged with governance (such as board minutes), and internal audit
Visits to the entity's premises and plant facilities
Tracing transactions through the information system
4. Discussions among audit team members
a. Key members of the audit team (including the auditor with final responsibility) should discuss the
susceptibility of the entity's financial statements to material misstatement in a so-called "brain-storming
session."
1) The session can be held concurrently with the brain-storming session that is required by SAS No. 99.
2) When the entire engagement is performed by a single auditor, the auditor should consider and
document the susceptibility of the entity's financial statements to material misstatements.
b.

An auditor may determine that specialists should be assigned to the audit team and, if so, should be present
at the brain-storming session.
Example: An auditor may believe that a professional possessing IT or other specialized skills is needed on
the team and should be included in the brain-storming session.

c. The objectives of the brain-storming meeting is for members of the team to:
1) Gain a better understanding of the potential for material misstatements in the financial statements
resulting from fraud or error.
2) Understand how the results of the procedures that they perform may affect other aspects of the audit,
including the decisions about the nature, timing, and extent of further audit procedures.
3) Specific discussion points include:
Susceptibility of the financial statements to material misstatement due to fraud (as required by SAS
No. 99).
Areas of significant audit risk
Areas susceptible to management override of controls
Unusual accounting procedures used by the client
Important control systems
Materiality at the financial statement level and at the account level
How materiality will be used to determine the extent of testing.
Application of GAAP to the entity's facts and circumstances in light of the entitys accounting
policies.
That the members should exercise a degree of professional skepticism throughout the engagement,
to be alert for information or other conditions that indicate that a material misstatement due to a
fraud or error may have occurred, and to be rigorous in following up on such indications.
Note: There may be a need for multiple sessions to facilitate the ongoing exchange of information between
audit team members. The overall purpose of the sessions is for audit team members to continue to
communicate and share information obtained throughout the audit that may affect the assessment of the
risks of material misstatement.
5. Other procedures
a. In identifying the risks of material misstatement, the auditor should consider the results of the assessment of
the risk of material misstatement due to fraud performed during planning as required by SAS No. 99.

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Understand the entity and its environment, including its internal control
In the second step, the auditor understands the entity and its environment consisting of an understanding of the
following:
1. Industry, regulatory, and other external factors
2. Nature of the entity
3. Objectives and strategies and the related business risks that may result in a material misstatement of the
financial statements
4. Measurement and review of the entity's financial performance
5. Internal control, which includes the selection and application of accounting policies
1. Industry, regulatory and other external factors:
a. The auditor should obtain an understanding of relevant industry, regulatory and other external factors that
include:
1) Industry conditions:
The market and competition, including demand, capacity, and price competition
Cyclical or seasonal activity
Product technology relating to the entity's products
Supply availability and cost
2) Regulatory environment:
Accounting principles and industry-specific practices
Regulatory framework, if applicable
Legislation and regulation that significantly affect the entity's operations
Income and other tax considerations
Government policies currently affecting the conduct of the entity's business including monetary and fiscal
policies, financial incentives, and tariffs and trade restrictions
Environmental requirements affecting the industry and the entity's business
3) Other external factors currently affecting the entity's business:
General level of economic activity, such as recession and growth
Interest rates and availability of financing
Inflation and currency revaluation
2. Nature of the entity:
a. The auditor should obtain an understanding of the nature of the entity to better understand the classes of
transactions, account balances, and disclosures to be expected in the financial statements. The auditor should
understand the entity's:
1) Operations
2) Ownership
3) Governance
4) Types of investments the entity has made or plans to make
5) Financing sources and structure
6) Complex transactions that may give rise to risk of material misstatement such as the allocation of goodwill to
subsidiaries, investments in joint ventures, and use of special-purpose entities.
7) Related party transactions
3. Objectives and strategies and the related business risks:
a. The auditor should obtain an understanding of the entity's objectives and strategies and the related business
risks that may result in a material misstatement of the financial statements.
1) Examples of objectives and strategies (e.g., how the entity addresses industry, regulatory, and other external
factors) and the related business risk following:

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Objectives and Strategies

Example of related business risk

Industry developments

An entity does not have the personnel or

expertise to. deal with changes in the industrv

New products or services have been developed

There might be greater product liability from

the additional products.

There has been an expansion of business

The demand from the expansion might not be

accurately estimated or be able to be absorbed
within the entitv

New accounting requirements

There might be higher costs to implement the

changes or there is improper implementation

Regulatory requirements

There might be increased legal exposure

Current and prospective financing requirements

There could be a loss of financing due to the

entity's inability to meet requirements

Use of information technology

There could be a risk that systems and

processes are not compatible

b. Business risks result from significant conditions, events, circumstances, actions, or inactions that could
adversely affect the entity's ability to achieve its objectives and execute its strategies.
1) Most business risks eventually have an effect on the financial statements but not all business risks give rise
to the risks of material misstatement.
2) A business risk is broader than the risk of material misstatement, although business risk includes the risk of
material misstatement.
3) A business risk may also have a longer-term consequence that the auditor may need to consider when
assessing the appropriateness of the going concern assumption.
Example: A business risk of a decline in the industry in which the entity operates may affect the entity's
ability to continue as a going concern.

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Examples of conditions and events that may indicate risks of material misstatement as found in Appendix C
of SAS No. 109 are summarized below.
Operations in regions that are economically unstable
Operations exposed to volatile markets, such as futures trading
High degree of complex regulation
Going concern and liquidity issues, including loss of significant
customers
Marginally achieving explicitly stated strategic objectives
Constraints on the availability of capital and credit
Changes in the industry in which the entity operates
Changes in the supply chain
Developing or offering new products or services, or moving into new lines of business
Expanding into new locations
Changes in the entity, such as large acquisitions, reorganizations, or unusual events
Entities or divisions likely to be sold
Complex alliances and joint ventures
Use of off-balance-sheet entities and other complex transactions
Significant related party transactions
Lack of personnel with appropriate accounting and financial reporting skills
Changes in key personnel including key executives
Weaknesses in internal control, particularly those not addressed by management
Inconsistencies between the entity's IT strategy and its business strategies.
Changes in the IT environment Installation of significant new IT systems related to financial reporting Inquiries
into the entity's operations or financial results by regulatory or government bodies
Past misstatements, history of errors, or a significant amount of adjustments at period end.
Significant amount of or nonsystematic transactions, including intercompany transactions and large revenue
transactions at year end.
Transactions that are recorded based on management's intent, for example, debt refinancing, assets to be sold,
and classification of marketable securities
Application of new accounting pronouncements
Complex processes related to accounting measurements
Events or transactions that result in significant measurement uncertainty, including accounting estimates
Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees, and
environmental remediation.

4. Measurement and review of the entity's financial performance

a. The auditor should obtain an understanding of the entity's financial status to assist the auditor in considering
whether financial pressures increase the risk of material misstatement.
b. Information may be internally or externally generated as follows:
1) Internally generated information may include key performance financial and nonfinancial indicators,
including:
Budgets
Variance analysis
Subsidiary information
Divisional, departmental, or other level performance reports
Entity's performance comparison with that of competitors
2) External information may include:
Analysts' reports
Credit rating agency reports

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Note: Internal measures may be used to highlight unexpected results including trends that require management's
inquiry of others in order to determine their cause and take corrective action. Further, performance measures may
indicate that there is a risk of misstatement of financial information such as an entity that has unusually rapid growth
or profitability when compared with the industry growth. When the unusual growth is combined with other factors,
such as a performance-based bonus or compensation, there may be potential risk of management bias in preparing
financial statements.
I.

Understanding the Entitys Internal Control

A. Internal control is a processeffected by an entity's board of directors, management, and other personnel
designed to provide reasonable assurance regarding the achievement of objectives in the following
categories: (a) reliability of financial reporting, (b) effectiveness and efficiency of operations, and (c)
compliance with applicable laws and regulations.
B. Internal control consists of the following five interrelated components.
1. Control environment sets the tone of an organization, influencing the control consciousness of its
people. It is the foundation for all other components of internal control, providing discipline and
structure.
2. Risk assessment is the entity's identification and analysis of relevant risks to achievement of its
objectives, forming a basis for determining how the risks should be managed.
3. Control activities are the policies and procedures that help ensure that management directives are
carried out.
4. Information and communication are the identification, capture, and exchange of information in a
form and time frame that enable people to carry out their responsibilities.
5. Monitoring is a process that assesses the quality of internal control performance over time.
C. There is a direct relationship between objectives, which are what an entity seeks to achieve, and
components, which represent what is needed to achieve the objectives.
D. Internal control is related to the entire entity although not all controls and objectives are relevant to an audit
of the entity's financial statements.

II. Objectives of Internal Control

A. Three objectives:
1. Financial Reporting Objectivescontrols that are relevant to an audit pertain to an entity's objective of
preparing financial statements for external purposes that are fairly presented in conformity with
generally accepted accounting principles or a comprehensive basis of accounting other than GAAP.
2. Operational Objectivescontrols that relate to the effectiveness and efficiency of operations.
3. Compliance Objectivescontrols that relate to entity's compliance with applicable laws and
regulations.
B. During a financial statement audit the auditor is generally more concerned with financial statement controls
as opposed to operational and compliance controls. However, there may be circumstances where the
auditor would be concerned with operational and compliance controls because they have a bearing on the
audit process. For example, controls pertaining to nonfinancial data the auditor uses in analytical
procedures, such as production statistics, or pertaining to detecting noncompliance with laws or regulations
having a direct and material effect on the financial statements, such as compliance with income tax laws.
III. Limitations of an Entity's Internal Control
A. Management's responsibilitycontrols are influenced and designed by management and as such will
only be as effective as management desires.
B. Reasonable assurancethe cost of internal control should not exceed the benefits to be derived by the
structure (cost-benefit relationship).

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C. Inherent limitationsall control structures have the following inherent limitations:

1. Controls can be circumvented by collusion of employees.
2. Management can override any system of controls.
3. No system can prevent errors arising from fatigue, lack of knowledge or human error.
4. Because of the inherent limitations, control risk can never by reduced to zero in an audit. There is
always some control risk, even in the "perfect" system.
D. The control concepts apply equally to all types of information processing (manual and EDP).
IV. Consideration of Internal Control in Planning an AuditAuditor's Responsibility
A. In all audits, the auditor should obtain an understanding of each of the five components of internal
control sufficient to plan the audit by performing procedures to understand the design of controls relevant
to an audit of financial statements, and whether they have been implemented.
B. In planning the audit, knowledge obtained in (A) above would be used to:
1. Identify the types of potential misstatements that occur (errors, frauds, illegal acts).
2. Consider factors that affect the risk of material misstatements.
3. Make a preliminary evaluation of control risk and decide upon an initial audit approach.
C. The nature, timing, and extent of procedures the auditor chooses to obtain an understanding will vary
depending on the size and complexity of the entity, previous experience with the entity, the nature of
controls, and the extent of client documentation.
1.

The auditor normally employs the following procedures to gain an understanding

Inquiry
Observation
Examination
Reperformance

D. Placed in Operation vs. Operating Effectiveness

1. Placed in operation is concerned whether an entity is using a particular control.
2. Operating effectiveness is concerned with how the control was applied, its consistency of use, and by
whom it was applied.
3. The auditor is not required to obtain knowledge about operating effectiveness as part of
understanding internal control. However, if the auditor plans to assess control risk at less than
the maximum, operating effectiveness must be tested.
E. Understanding Control Components
1. Control Environment
The auditor should obtain sufficient knowledge of the control environment to understand
management's and the board of directors' attitude, awareness, and actions concerning the control
environment considering both the substance of controls and the collective effect.
The auditor is more concerned with the substance of the controls rather than their form because
controls may be established but not acted upon.
The control environment sets the tone of an organization, influencing the control consciousness of
its people. It is the foundation for all other components of internal control, providing discipline
and structure. Control environment factors include the following:
a. Integrity and ethical values.
b. Commitment to competence.
c. Board of directors or audit committee participation.
d. Management's philosophy and operating style.
e. Organizational structure.
f. Assignment of authority and responsibility.
g. Human resource policies and practices.

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2.

Risk Assessment
An entity's risk assessment for financial reporting purposes is its identification, analysis, and
management of risks relevant to the preparation of financial statements that are fairly presented in
conformity with generally accepted accounting principles. For example, risk assessment may
address how the entity considers the possibility of unrecorded transactions or identifies and
analyzes significant estimates recorded in the financial statements. Risks relevant to reliable
financial reporting also relate to specific events or transactions.
Risks relevant to financial reporting include external and internal events and circumstances that
may occur and adversely affect an entity's ability to record, process, summarize, and report
financial data consistent with the assertions of management in the financial statements. Risks can
arise or change due to circumstances such as:
a. Changes in operating environment.
b. New personnel.
c. New or revamped information systems.
d. Rapid growth.
e. New technology.
f. New lines, products, or activities.
g. Corporate restructurings.
h. Foreign operations.
i. Accounting pronouncements.
The auditor should obtain sufficient knowledge of the entity's risk assessment process to
understand how management considers risks relevant to financial reporting objectives
and decides about actions to address those risks.
An entity's risk assessment differs from the auditor's consideration of audit risk in a
financial statement audit. The purpose of an entity's risk assessment is to identify,
analyze, and manage risks that affect all the entity objectives. In a financial statement
audit, the auditor assesses inherent and control risks to evaluate the likelihood that
material misstatements could occur in the financial statements.

3.

Control Activities
Control activities are the policies and procedures that help ensure that management directives are
carried out. They help ensure that necessary actions are taken to address risks to achievement of the
entity's objectives. Control activities have various objectives and are applied at various organizational
and functional levels. Generally, control activities that may be relevant to an audit may be categorized
as policies and procedures that pertain to the following:

Performance reviewsactual performance vs. budgets, forecasts, etc.

Information processingcontrols to check the accuracy, completeness and authorization of
transactions.
Physical controlsphysical security, authorization for access to computer programs and data
files, periodic counting and comparison of physical amount to control records.
Segregation of dutiesassignment of different people the responsibility of authorizing,
recording transactions and maintaining custody of assets.
Typical control activities include:
Capable personnel.
Segregation of functional responsibilities of authorization, custody, and record keeping.
Segregation of duties in the accounting function.
Periodic reconciliations.
Limit access to records, assets, and computer equipment and programs.
Prenumbered documents.
Specific written authorization procedures.
Independent checks on performance.
Controls over the execution of transactions.
Accounting entries need adequate documentation.
Input, process and output controls over computer processing.

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4.

The auditor should obtain an understanding of those control activities relevant to planning the
audit. However, audit planning does not require an understanding of all control activities
related to the financial statements. Generally, as an auditor obtains an understanding of other
control components knowledge of control activities is obtained. The auditor should consider the
knowledge about the presence or absence of control activities obtained from the understanding of
other components in determining whether it is necessary to devote additional attention to obtaining
an understanding of the control activities to plan the audit.

Information and Communication

The information system relevant to financial reporting objectives, which includes the accounting
system, consists of the methods and records established to record, process, summarize, and report
entity transactions (as well as events and conditions) and to maintain accountability for the related
assets, liabilities, and equity. The quality of system-generated information affects management's ability
to make appropriate decisions in controlling the entity's activities and to prepare reliable financial
reports.
The auditor should obtain sufficient knowledge of the information system relevant to financial
reporting to understand:
The classes of transactions in the entity's operations that are significant to the financial statements.
How those transactions are initiated.
The accounting records, supporting information, and specific accounts in the financial statements
involved in the processing and reporting of transactions.
The accounting processing involved from the initiation of a transaction to its inclusion in the
financial statements, including electronic means (such as computers and electronic data
interchange) used to transmit, process, maintain, and access information.
The financial reporting process used to prepare the entity's financial statements, including
significant accounting estimates and disclosures.

5.

Monitoring
An important management responsibility is to establish and maintain internal control. Management
monitors controls to consider whether they are operating as intended and that they are modified as
appropriate for changes in conditions.
Monitoring is a process that assesses the quality of internal control performance over time. It involves
assessing the design and operation of controls on a timely basis and taking necessary corrective
actions. This process is accomplished through ongoing activities, separate evaluations, or by various
combinations of the two. In many entities, internal auditors or personnel performing similar functions
contribute to the monitoring of an entity's activities. Monitoring activities may include using
information from communications from external parties such as customer complaints and regulator
comments that may indicate problems or highlight areas in need of improvement.
The auditor should obtain sufficient knowledge of the major types of activities the entity uses to
monitor internal control over financial reporting, including how those activities are used to initiate
corrective action (e.g., Internal Auditors).

V. Auditor's ResponsibilityDocumentation of Understanding of Controls

A. An independent auditor must document his/her understanding of the internal control components.
Reasons:
1. Show compliance with GAAS in workpapers.
2.

Serve as a point of reference for current and future audits and engagements.

B. Methods of Documentation
1. Form and extent is a matter of professional judgment based upon size and complexity of the client and
size of CPA firm (more people working on audit would probably mean more extensive
documentation).

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2.

Common forms of documentation

a. Internal Control Questionnaire (ICQ)a series of questions designed to elicit a "yes" or "no"
answer. A "yes" answer is considered a positive attribute of the system. Conversely, a "no"
answer is a weakness or deficiency in the system.
b. Narrative (written)memoranda describing system
c. Flow Charta symbolic representation of the auditor's understanding of the system.
d. Checklists.
e. It is common for most CPA firms to use a combination of "a" through "d" rather than rely on
one documentation style only.

VI. Auditor's ResponsibilityAssessing Control Risk

A. Control Riskthe risk that the client's internal control policy and procedures are not effective in
preventing or detecting material misstatements in the financial statements.
B. Control RiskAssessment outcome possibilities
1. Control Risk at the maximum
Decision based upon the conclusion that testing the effectiveness of controls would not be cost
effective.
Must identify specific risks of material misstatement that may exist in the system and the specific
audit responses undertaken by the auditor.
2.

Control Risk at less than the maximum

a. Based upon his/her initial understanding of the internal control components, the auditor may
conclude that control risk may be less than the maximum, and it will be cost effective to test the
effectiveness of controls.
b.

The auditor in this situation must evaluate the cost/benefit of extending his/her understanding
of internal controls to make a final decision concerning control risk.

c.

The cost/benefit decision is based upon the audit time involved in extending the auditor's
understanding of internal controls, including tests of control, versus the time that may be saved
with the possible reduction of substantive audit tests.

Tests of Controlsaudit tests designed to determine whether specific control procedures

that the auditor plans to rely on are actually in place and operating effectively in the
entity under audit.

Substantive Testsaudit tests designed to substantiate one or more financial statement

assertions.

Should the auditor decide not to extend his/her understanding of internal controls
because of cost/benefit considerations, control risk would then be assessed at the
maximum for all financial statement assertions.

d.

Should the auditor conclude that his/her understanding should be extended the following
procedures would be completed:
Extend the understanding of control activities in order to determine what control activities are
prescribed by the client, by whom are those activities (procedures) performed, and whether
those procedures are likely to be effective in reducing control risk.
Document the understanding of control activities.
Perform tests of controls.
Assess control risk based upon the auditor's extended understanding and the results of
tests of controls.

e.

If the auditor concludes that control risk is less than the maximum and the auditor plans to design
substantive tests based upon that fact, the basis for assessing control risk at less than the maximum
must be documented in the workpapers.

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FLOWCHART OF AUDITOR'S CONSIDERATION OF INTERNAL CONTROL

Obtain understanding
of Internal Controls
sufficient to plan
the Audit
Document understanding
in Workpapers

Determine if controls have

been implemented
Assess Control Risk
based upon initial
understanding

Control Risk
may be less than
Maximum

Control
Risk at
Maximum
Document conclusion
in W/P's
reasons need to
be stated

Is it cost
effective to
extend auditor's
understanding

Design substantive
tests

No

Yes

Extend Auditor's
understanding to focus on
control activities
Document understanding
Test Controls
Assess Control Risks
Control Risk
at maximum
Design substantive
tests

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Control Risk less than

maximum
Document calls for conclusion
Design substantive tests

SUMMARY OF AUDITOR'S
WORKPAPER DOCUMENTATION
INTERNAL CONTROL

Understanding
Required

Documentation
Requirement

Yes, to extent necessary to

plan audit and determine
nature, timing and extent
of audit tests

Yes, type and extent

auditor's judgment

Yes
Only if have bearing
on audit process

Yes
Only if understanding
obtained

Item(s)
1.

Internal Control
Components

2.

Objectives of Internal
Control
Financial Reporting
Operational
Compliance

3.

Design of Controls

Yes

Yes

4.

Whether Controls
have been implemented

Yes

Yes

5.

Operating Effectiveness
of Controls

Only if control risk is to be

assessed at less than
maximum.
Must use Test of Controls.

Yes, if tested**

6.

Assessment of
Control Risk

Yes

Yes

7.

Reportable Conditions

Yes

Yes, if noted

8.

Material Weaknesses

Yes

Yes, if noted

** Must document tests used and their results.

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VII. Transaction Cycles and Internal Control Components

A. In order to audit an entity, the auditor must become familiar with the major types of transactions engaged in
by the entity and the processing of those transactions.
1. The auditor is concerned with
What those transactions are.
How those transactions are initiated.
The authorization procedures surrounding those transactions.
The accounting records generated from those transactions.
The manner in which those transactions are processed.
How those transactions are reflected on the financial statements.
2.

The needed information is obtained by gaining sufficient understanding of the "Information and
Processing" and "Control Activities" components of internal control.
Auditors usually take a "transaction cycle" approach when understanding the above internal
control components.
Transaction Cycle refers to the policies and the sequence of procedures for processing a
particular type of transaction.

B. A transaction cycle can be represented by the following:

Control Objective
Begin
Transaction Authorization (All transactions must be authorized)
Transaction Execution
Flow of
transactions

(Only authorized transactions must be

executed)

Source Document
(All transactions must be recorded)
Accounting
System

Book of Original Entry

General Ledger

(All transactions must be summarized)

Trial Balance
Financial Statement
End
C. Specific transaction cycles are
1. Sales and Accounts Receivable.
2. Cash Receipts.
3. Purchasing and Accounts Payable.
4. Cash Disbursements.
5. Payroll.

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(All transactions must be properly valued,

classified and reported in the proper
accounting period)

The CPA Candidate must have a detailed understanding of the control activities involved in the various
transaction cycles. Following is a summary of the typical control activities that should be present in an ideal
system of internal control for a medium-sized manufacturing company. Questions on the CPA exam,
whether objective type or essay, focus on control activities of a medium-sized manufacturing company.
D. TYPICAL ORGANIZATIONAL CHART FOR A MEDIUM-SIZED MANUFACTURING COMPANY

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SALES AND ACCOUNTS RECEIVABLE

Control Activity

Responsibility of:

How Performed or
Communicated

Credit limits are clearly defined.

Senior management

Written document

Credit limits are clearly communicated.

Senior management

Written document

Credit manager

Credit reports

Senior management

Reviewed

Senior management

Organization chart

Credit limits and changes in credit limits are

communicated to persons responsible for
approving sales orders on a timely basis.

Senior management

Written document

The company has clearly defined policies

and procedures for acceptance and approval
of sales orders.

Senior management

Written document

Prenumbered sales orders are used and

accounted for.

N/A

N/A

Prenumbered shipping documents are used

to record shipments.

N/A

N/A

Shipping document information is verified

prior to shipment.

Shipping personnel

Review

Senior management

Organization chart

Billing clerk

Review

N/A

N/A

Credit manager

Signed

The credit of prospective customers is

investigated before it is extended to them.
Credit limits are periodically reviewed.
The people who perform the credit function
are independent of -Sales.
Billing.
Collection.
Accounting.

The people who perform the shipping

function are independent of -Sales.
Billing.
Collection.
Accounting.
All shipping documents are accounted for.
Prenumbered credit memos are used to
document sales returns.
All credit memos are approved and
accounted for.

1-27

How Performed or
Communicated

Control Activity

Responsibility of:

Credit memos are matched with receiving

reports for returned goods.

Accounts Receivable
Clerk

Reviewed

Cash sales are controlled by cash registers

or prenumbered cash receipts forms.

N/A

N/A

Someone other than the cashier has custody

to the cash register tape compartment.

N/A

N/A

Someone other than the cashier takes periodic

readings of the cash register and balances
the cash on hand.

Management

Written document

Information necessary to prepare invoices

(e.g., prices, discount policies) is clearly
communicated to billing personnel on a
timely basis.

Management

Price lists

Prenumbered invoices are prepared promptly

after goods are shipped.

Billing Clerk

--------

Quantities on the invoices are compared to

shipping documents.

Billing Clerk

Review

Senior management

Organization chart

Invoices are posted to the subsidiary ledger

on a timely basis.

Billing clerk

Prepares Sales
Journal

Invoices are posted to the sales and accounts

receivable subsidiary ledgers or journals
on a timely basis.

Accounts Receivable
Clerk

Updates Records

Personnel independent of
sales and collection

Written documentation

Accounts Receivable Clerk

-----

Collection Clerk

Documented

Senior management

Documented

The people who perform the billing function

are independent of -Sales.
Credit.
Collection.
Accounting for receivables

The sales and accounts receivable balances

shown in the general ledger are reconciled
to the sales and accounts receivable
subsidiary ledgers on a regular basis.
Monthly statements are mailed to customers.
Exceptions to monthly statements are
investigated and resolved.
Past due accounts are periodically reviewed
for collectibility.

1-28

CASH RECEIPTS

Responsibility of:
The entity maintains records of payments
on accounts by customer.

How Performed or
Communicated

Accounts Receivable
Clerk

Subsidiary ledgers

Mail Room

Cash receipts listing

Cash receipts are deposited intact.

Cash Receipts Clerk

-----

People who handle cash receipts are

adequately bonded.

Senior management

-----

Cash receipts are posted to the cash receipts

journal on a timely basis.

Cash Receipts Clerk

Journal

Cash receipts are posted to the accounts

receivable subsidiary ledger on a timely basis.

Accounts Receivable
Clerk

From cash receipts

listing

The people who enter cash receipts to the

accounting system are independent of the
physical handling of collections.

Senior management

Organization chart

Timely bank reconciliations are prepared or

reviewed by someone independent of the cash
receipts function.

Senior management

Written document

Someone other than the person responsible

for maintaining accounts receivable opens the
mail and lists the cash receipts.

PURCHASING AND ACCOUNTS PAYABLE

Responsibility of:

How Performed or
Communicated

All purchases over a predetermined amount are

approved by management.

Senior management

Sign purchase order

Non-routine purchases (for example, services,

fixed assets, or investments) are approved by
management.

Senior management

Sign

A purchase order system is used, prenumbered

purchase orders are accounted for, and physical
access to purchase orders is controlled.

Management

-----

Purchasing agent

Review

Open purchase orders are periodically

reviewed.

1-29

Responsibility of:

How Performed or
Communicated

Senior management

Organization chart

The purchasing function is independent of -Receiving.

Invoice processing.
Cash disbursements.
Blind copy of purchase order is forwarded to
receiving personnel (no quantities or price
indicated).

Purchasing agent

-----

All goods are inspected and counted when

received.

Receiving Clerk

-----

Prenumbered receiving reports, or a log, are

used to record the receipt of goods.

Receiving Clerk

-----

The receiving reports or log indicate the date

the items were received.

Receiving Clerk

-----

The receiving function is independent of -Purchasing.

Invoice processing.
Cash disbursements.

Senior management

Organization chart

Invoices from vendors are matched with

applicable receiving reports and purchase
orders.

Accounts Payable Clerk

Review

Invoices are reviewed for proper quantity and

prices, and mathematical accuracy.

Accounts Payable Clerk

Recompute
Sign

Invoices from vendors are posted to the

Purchases Journal on a timely basis.

Accounts Payable Clerk

-----

The invoice processing function is independent

of -Purchasing.
Receiving.
Cash disbursements.

Senior management

1-30

Organization chart

CASH DISBURSEMENT
Responsibility of:

How Documented or
Communicated

Senior management

Policy manual

Accounts Payable Clerk

File Invoices by
Due Date

Supporting documentation such as invoices and

receiving reports are reviewed before the
checks are signed.

Treasurer

Review
Sign

Supporting documents are canceled to avoid

duplicate payment.

Treasurer

Cancel documents

Checks are mailed by signer.

Treasurer

Policy manual

All disbursements except those from petty

cash are made by check.
All vendor invoices are paid on a timely
basis to take advantage of discounts.

Cash disbursements are posted to the cash

disbursements journal on a timely basis.

Cash disbursements clerk

Timely bank reconciliations are prepared or

reviewed by the owner or manager or someone
independent of the cash receipts or
disbursements function.

Senior management

----Review
and
Sign

PAYROLL
Responsibility of:

How Performed or
Communicated

Wages and salaries are approved by

management.

Senior management

Written document

Salaries of senior management are based on

written authorization of the board of directors.

Board of Directors

Written document

Maintenance of personnel files is under the

control of the personnel department.

Senior management

Written document

Employee/Personnel Dept.

Signs documents

Access to personnel files is limited to those

who are independent of the payroll or cash
functions.

Personnel department

Written document

Wage and salary rates and payroll deductions

are reported promptly to employees who
perform the payroll processing function.

Personnel department

Written document

Proper authorization is obtained for all payroll

deductions.

1-31

Responsibility of:

How Performed or
Communicated

Payroll department

Complete forms

Periodic governmental reports are filed on a

timely basis.
Adequate time records are maintained for
employees paid by the hour.
Time records for hourly employees are
approved by a supervisor.

Time Clock
Department manager

----Signs time card

Payroll is calculated using authorized pay

rates, payroll deductions, and time records.

Payroll accounting
department

-----

Payroll registers are reviewed for accuracy.

Check signer

Reviews, Signs

Payroll cost distributions are reconciled to

gross pay.

Payroll accounting
department

Written document

Net pay is distributed by persons who are

independent of personnel, payroll preparation,
time-keeping, and check preparation functions.

Treasurer

-----

The responsibility for custody and follow-up of

unclaimed wages is assigned to someone who is
independent of personnel, payroll processing,
and cash disbursement functions.

Treasurer

-----

1-32

Diagrammed View of Transaction Cycles

Purchase
Requisition
Purchase
Order
Sales
Order

Sales
Invoice

Receiving
Report

Vendor
Invoice

Time
Cards

Voucher
Package

Check

Time
Tickets

Bill of
Lading

Check

SALES
JOURNAL
BY INVOICE
NO.
SUBSIDIARY
LEDGER
BY
CUSTOMER
Accounts Receivable
SALES

Deposit
Slip

Remittance
Listing

CASH
RECEIPTS
JOURNAL BY
DATE
SUBSIDIARY
LEDGER BY
CUSTOMER

PURCHASES
JOURNAL OR
VOUCHER
REGISTER

CASH
Accounts Receivable

Purchases
Accounts
Payable

CASH
DISBURSEMENTS
JOURNAL

PAYROLL
JOURNAL
BY
PAYROLL
EMPLOYEE
EARNINGS
CARDS BY
EMPLOYEE

Accounts
Payable
CASH

Payroll Exp.
CASH

General Ledger

Trial Balance
Financial
Statements

Balance
Sheet

Income
Statement

Cash
Flows

1-33

Source
Documents

BOOKS
OF
ORIGINAL
ENTRY

Affected
Accounts

VIII. Application of Internal Control Concepts to Small and Mid-sized Entities

A. The way internal control components apply will vary based upon an entity's size and complexity.
B. Internal Control components consideration in small and mid-sized entities
1. Control Environment
May be implemented differently than larger companies.
For example, small entities may not have a written code of conduct but, instead, develop a
culture that emphasizes the importance of integrity and ethical behavior through oral
communication and management example.
2.

Risk Assessment
Basic concepts of risk assessment should be present in every entity, but formalized risk assessment
procedures may be lacking.
Management may learn about risks through direct personal involvement with employees and
outside parties.

3.

Control Activities
Extensive control activities, especially those involving segregation of duties, may be absent in
smaller entities.
Management may compensate for lack of control activities by exercising oversight responsibility
in those areas where control activities are lacking.

4.

Information and Communication

Communication may be less formal but easier to achieve in a smaller organization due primarily to
the entity's size and fewer levels of employees.
Also greater visibility of and availability of management in a smaller organization usually
contributes to adequate information and communication goals.

5.

Monitoring
Ongoing management activities in small and mid-sized entities are likely to contribute to the
achievement of adequate monitoring procedures.
Management's close involvement in operations will often identify significant variance from
expectations and inaccuracies in financial data.

IX. Effect of Information Technology Auditors Consideration of Internal Control

A. Definition of Information Technology
Information technology (IT) encompasses automated means of originating, processing, storing, and
communicating information, and includes recording devices, communication systems, computer systems,
and other electronic devices.
B. The auditor is primarily interested in the entitys use of IT to initiate, record, process, and report
transactions or other financial data.
C. IT can affect internal control, evidential matter, and the auditors understanding of internal control and the
assessment of control risk.
D. Auditors Considerations of IT
1. The auditor may determine that assessing control risk below maximum for certain assertions may be
effective and more efficient than performing only substantive tests.
2. Alternatively, the auditor may determine that it is not practical or possible to restrict detection risk to an
acceptable level by performing only substantive tests for one or more financial statement assertions. In
such circumstances, the auditor should obtain evidential matter about the effectiveness of both the
design and operation of controls to reduce the assessed level of control risk. Such evidential matter
may be obtained from several sources including:

1-34

o
o
o

Testing the controls planned and performed concurrent with or subsequent to obtaining the
understanding.
Performing procedures that were not specifically planned as tests of controls but that provide
evidential matter about the effectiveness of the design and operation of the controls.
For certain assertions, the auditor may desire to further reduce the assessed level of control risk.
In such cases, the auditor considers whether evidential matter sufficient to support a further
reduction is likely to be available and whether performing additional tests of controls to obtain
such evidential matter would be efficient.

3. The auditor may assess control risk at the maximum level because he or she believes controls are
unlikely to pertain to an assertion, or are unlikely to be effective, or because evaluating the
effectiveness of controls would be inefficient.
o

However, the auditor needs to be satisfied that performing only substantive tests would be
effective in restricting detection risk to an acceptable level. When evidence of an entitys
initiation, recording, or processing of financial data exists only in electronic form, the ability of
the auditor to obtain the desired assurance only from substantive tests would significantly
diminish.
The auditor uses the understanding of internal control and the assessed level of control risk to
determine the nature, timing and extent of substantive tests to be performed.

SAS No. 112 Communicating Internal Control Matters

Identified in an Audit
1. An auditor must evaluate identified control deficiencies and determine whether those deficiencies, individually or
in the aggregate, are significant deficiencies or material weaknesses.
a. A control deficiency exists when the design or operation of a control does not allow management or employees,
in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely
basis.
A deficiency in design exists when a control necessary to ineet the control objective is missing or an
existing control is not properly designed so that even if the control operates as designed, the control
objective is not always met.
A deficiency in operation in exists when a properly designed control does not operate as designed or when
the person performing the control does not possess the necessary authority or qualifications to perform the
control effectively.
b. A significant deficiency is a control, or combination of control deficiencies that adversely affects the entity's
ability to initiate, authorize, record, process, or report financial data reliably in accordance with GAAP such that
there is more than a remote likelihood6 that a misstatement of the entity's financial statements that is more than
inconsequential will not be prevented or detected.
The term more than consequential describes the magnitude of potential misstatement that could occur as a
result of a significant deficiency and services as a threshold for evaluating whether a control deficiency or a
combination of deficiencies is a significant deficiency.
A misstatement is inconsequential if a reasonable person would conclude, after considering the possibility
of further undetected misstatements, that the misstatement, either individually or in the aggregate, would
clearly be immaterial to the financial statements.
Note: The auditor should consider both qualitative and quantitative factors in determining whether a
potential misstatement is inconsequential.
c. A material weakness is a significant deficiency, or combination of control deficiencies, that results in more than
a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.

1-35

d. In evaluating whether control deficiencies are significant deficiencies or material weaknesses, the auditor
should consider the likelihood and magnitude of misstatement. Factors that may affect the likelihood that a
control, or combination of controls, could fail to prevent or detect a misstatement.
The nature of the financial statement accounts, disclosures, and assertions involved such as suspense
accounts and related party transactions that involve greater risk.
The susceptibility of the related assets or liabilities to loss or fraud.
The subjectivity and complexity of the amount involved, and the extent of judgment needed to determine
that amount.
The cause and frequency of any known or detected exceptions related to the operating effectiveness of a
control.
The interaction or relationship of the control with other controls.
The interaction of the control deficiency with other control deficiencies.
The possible future consequences of the deficiency.
e. Factors that affect the magnitude of a misstatement that could result from a deficiency or deficiencies in
controls include the following:
The financial statement amounts or total of transactions exposed to the deficiency
The volume of activity in the account balance or class of transactions exposed to the deficiency in the
current period or expected in future periods.
f. In determining whether a control deficiency is a significant deficiency or material weakness, the auditor should
evaluate the possible mitigating effects of effective compensating controls (controls that limit the severity of a
control deficiency or material deficiency) that have been tested and evaluated as part of the financial statement
audit.
g. Multiple control deficiencies that affect the same financial statement account balance or disclosure increase the
likelihood of misstatement. In combination, such deficiencies may constitute a significant deficiency or material
weakness, even though such deficiencies are individually insignificant. The auditor should evaluate individual
control deficiencies that affect the same account balance, disclosure, relevant assertion, or component of
internal control, to determine whether they collectively result in a significant deficiency or material weakness.
Note: In determining whether a control deficiency or combination of deficiencies is a significant deficiency or
material weakness, the auditor should consider possible mitigating effects of compensating controls that have
been tested and evaluated as part of the audit. A compensating control is one that limits the severity of a control
deficiency and prevents it from rising to the level of a significant deficiency or material weaknesses.
Compensating controls mitigate the effects of a control deficiency, but do not eliminate control deficiency
altogether.
Example: An owner-managed entity does not segregate duties within the accounts payable function. As a
compensating control, the owner reviews the supporting documentation for all checks that exceed $1,000.
Conclusion: The company has a control deficiency in internal control due to a lack of segregation of duties.
The auditor could evaluate the effect of the compensating control (the owner's review) and determine whether it
operates effectively for the purpose of mitigating the effects of the control deficiency in the accounts payable
function.
h. Examples of significant deficiencies: The following deficiencies are ordinarily categorized as at least being
significant deficiencies in internal control.
Controls over the selection and application of accounting principles that are in conformity with GAAP.
Having sufficient expertise in selecting and applying accounting principles is an aspect of such controls.
Antifraud programs and controls
Controls over nonroutine and nonsystematic transactions.
Controls over the period-end financial reporting process, including controls over procedures used to enter
transaction totals into the general ledger (initiate, authorize, record, and process journal entries into the
general ledger), and record recurring and nonrecurring adjustments to the financial statements.

1-36

i. Examples of likely material weaknesses: Each of the following deficiencies is at least individually considered to
be a significant deficiency and is a strong indicator of a material weakness in internal control.
Ineffective oversight of the entity's financial reporting and internal control by those charged with
governance.
Restatement of previously issued financial statements to reflect the correction of a material misstatement.
Note: A correction includes a misstatement due to error or fraud, but does not include restatements to
reflect a change in accounting principle to comply with a new accounting principle or a voluntary change
from one GAAP to another GAAP.
Identification by the auditor of a material misstatement in the financial statements for the period under
audit that was not initially identified by the New Auditing SAS No. 102-114 entity's internal control,
including misstatements involving estimation and judgment for which the auditor identifies likely material
adjustments and corrections of the recorded amounts. This is a strong indicator of a material weakness even
if management subsequently corrects the misstatement.
An ineffective internal audit function or risk assessment function at an entity for which such functions are
important to the monitoring or risk assessment component of internal control, such as for a very large or
highly complex entities.
For complex entities in highly regulated industries, an ineffective regulatory compliance function only to
the extent that such lack of compliance could have a material effect on the reliability of financial reporting.
Identification of fraud of any magnitude on the part of senior management.
Note: An auditor's goal is to obtain reasonable assurance that the financial statements are free from material
misstatement due to error or fraud. However, for purposes of evaluating and communicating deficiencies in
internal control, the auditor should evaluate fraud of any magnitude, including fraud resulting in immaterial
misstatements, on the part of senior management, of which he or she is aware.
2. Communicating a deficiency or material weakness: An auditor is required to communicate significant deficiencies
and material weaknesses identified in the audit, in writing, to management and those charged with governance.
a. The communication is best to be made by the report release date7, but no later than 60 days following the
report release date.
b. Significant deficiencies and material weaknesses that were communicated in previous audits and have not yet
been remediated should also be communicated.
c. The body charged with governance may take different forms that include the board of directors, a committee of
the board of directors, management (particularly in smaller entities) a management committee, partners, or
some combination of these parties.
d. Communication is required even if the auditor knows that management or those in charge with governance are
fully aware of the significant deficiency or material weakness.
Note: The auditor may decide to communicate certain identified significant deficiencies and material
weaknesses during the audit as an interim Such early communications are not required to be in writing provided
the communication is ultimately in writing no later than 60 days following the report release date.
e. The auditor is permitted, but not required, to communicate either orally or in writing, other matters that the
auditor:
Believes to be of potential benefit to the entity, such as recommendations for operational or administrative
efficiency, or for improving internal control,
Has been requested to communicate, such as control deficiencies that are not significant nor material
weaknesses.
f. The written communication of significant deficiencies and material weaknesses should:
State that the purpose of the audit was to express an opinion on the financial statements, but not to express
an opinion on the effectiveness of the entity's internal control over financial reporting.
State that the auditor is not expressing an opinion on the effectiveness of internal control.
Include the definition of the terms significant deficiency and, where relevant, material weakness.
Identify the matters that are considered to be significant deficiencies and, if applicable, those that are
considered to be material weaknesses.
State that the communication is intended solely for the information and use of management, those charged
with governance, and others within the organization and is not intended to be or should not be used by
anyone other than these specified parties. If an entity is required to furnish a communication to a
governmental authority, specific reference to such governmental authorities may be made.

1-37

CONSIDERATION OF FRAUD IN A FINANCIAL STATEMENT AUDIT

(SAS NO. 99)
I.

Description and Characteristics of Fraud

A. The primary factor that distinguishes fraud from error is whether the underlying action that results in the
misstatement of the financial statements is intentional (fraud) or unintentional (error).
B. Two types of misstatements are relevant to the auditors consideration of fraudmisstatements arising
from fraudulent financial reporting and misstatements arising from misappropriation of assets.
1. Fraudulent financial reporting may be accomplished by the following:
Manipulation, falsification, or alteration of accounting records or supporting
documents from which financial statements are prepared.
Misrepresentation in or intentional omission from the financial statements of events,
transactions, or other significant information.
Intentional misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure.
2. Misstatements arising from misappropriation of assets involve the theft of an entitys assets.
Misappropriation of assets can be accomplished in various ways, including embezzling receipts,
stealing assets, or causing an entity to pay for goods or services that have not been received.
C. Three conditions generally are present when fraud occurs:
1. Management or other employees have an incentive or are under pressure, which provides a reason
to commit fraud.
2. Circumstances exist that provide an opportunity for a fraud to be perpetrated.
3. Those involved are able to rationalize a fraudulent act as being consistent with their personal code
of ethics.
D. Management and employees engaged in fraud will take steps to conceal the fraud from the auditors and
others within and outside the organization. Fraud may be concealed by withholding evidence or
misrepresenting information in response to inquiries or by falsifying documentation.
E. Fraud may also be concealed through collusion among management employees, or third parties.
F. Management has a unique ability to perpetrate fraud because it frequently is in a position to directly or
indirectly manipulate accounting records and present fraudulent financial information.
G. The presence of certain conditions may suggest to the auditor the possibility that fraud may exist.
1. An important contract may be missing
2. A subsidiary ledger may not be satisfactorily reconciled to its control account, or
3. The results of an analytical procedure performed during the audit may not be consistent with
expectations.

II.

Discussion Among Engagement Personnel Regarding the Risks of Material Misstatement

Due to Fraud
A. In planning the audit, members of the audit team should discuss the potential for material misstatement
due to fraud.
B. The discussion should include:
1. A sharing of the insights of the more experienced audit team members, including the auditor
(usually partner) with final responsibility for the audit, based on their knowledge of the entitys
business and the industry in which it operates.
2. Emphasizing the importance of maintaining the proper state of mind throughout the audit
regarding the potential for material misstatement due to fraud (professional skepticism).

III.

Obtaining the Information Needed to Identify the Risks of Material Misstatement Due to Fraud
The auditor should perform the following procedures to obtain information that is used to identify the risks of
material misstatement due to fraud:
A. Make inquiries of management and others within the entity to obtain their views about the risks of fraud
and how they are addressed.

1-38

Whether management has knowledge of any fraud that has been perpetrated or any alleged or
suspected fraud
Whether management is aware of allegations of fraud, for example, because of communications from
employees, former employees, analysts, short sellers, or other investors
Management's understanding about the risks of fraud in the entity, including any specific fraud risks
the entity has identified or account balances or classes of transactions for which a risk of fraud may be
likely to exist
Programs and controls the entity has established to mitigate specific fraud risks the entity has
identified, or that otherwise help to prevent, deter, and detect fraud, and how management monitors
those programs and controls
For an entity with multiple locations, (a) the nature and extent of monitoring of operating locations or
business segments, and (b) whether there are particular operating locations or business segments for
which a risk of fraud may be more likely to exist
Whether and how management communicates to employees its views on business practices and
ethical behavior
B. Consider any unusual or unexpected relationships that have been identified in performing analytical
procedures in planning the audit.
C. Perform analytical procedures specifically designed to determine fraud risk in the revenue/receivable
cycle.
D. Consider whether one or more fraud risk factors exist.
1. Risk factors relating to misstatements arising from fraudulent financial reporting.
Incentives/Pressures:
a. Financial stability or profitability is threatened by economic, industry, or entity operating
conditions, such as (or as indicated by):
High degree of competition or market saturation, accompanied by declining margins
High vulnerability to rapid changes, such as changes in technology, product
obsolescence, or interest rates
Significant declines in customer demand and increasing business failures in either the
industry or overall economy
Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover
imminent
Recurring negative cash flows from operations or an inability to generate cash flows from
operations while reporting earnings and earnings growth
Rapid growth or unusual profitability, especially compared to that of other companies in
the same industry
New accounting, statutory, or regulatory requirements
b. Excessive pressure exists for management to meet the requirements or expectations of third
parties due to the following:
Profitability or trend level expectations of investment analysts, institutional investors,
significant creditors, or other external parties (particularly expectations that are unduly
aggressive or unrealistic), including expectations created by management in, for example,
overly optimistic press releases or annual report messages.
Need to obtain additional debt or equity financing to stay competitive including financing
of major research and development or capital expenditures
Marginal ability to meet debt repayment or other debt covenant requirements
Perceived or real adverse effects of reporting poor financial results on significant pending
transactions, such as business combinations or contract awards
c. Management or the board of directors' personal net worth is threatened by the entity's
financial performance arising from the following:
Heavy concentrations of their personal net worth in the entity
Significant portions of their compensation (for example, bonuses, stock options, and
earn-out arrangements) being contingent upon achieving aggressive targets for stock
price, operating results, financial position, or cash flow
Personal guarantees of debts of the entity that are significant to their personal net worth
d. There is excessive pressure on management or operating personnel to meet financial targets
set up by the board of directors or management, including sales or profitability incentive
goals.

1-39

Opportunities:
a. The nature of the industry or the entity's operations provides opportunities to engage in
fraudulent financial reporting that can arise from the following:
Significant related-party transactions not in the ordinary course of business or with
related entities not audited or audited by another firm
Assets, liabilities, revenues, or expenses based on significant estimates that involve
subjective judgments or uncertainties that are difficult to corroborate
Significant, unusual, or highly complex transactions, especially those close to year end
that pose difficult "substance over form" questions
Significant operations located or conducted across international borders in jurisdictions
where differing business environments and cultures exist
Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions
for which there appears to be no clear business justification
b. There is ineffective monitoring of management as a result of the following:
Domination of management by a single person or small group (in a non-owner managed
business) without compensating controls
Ineffective board of directors or audit committee oversight over the financial reporting
process and internal control
c. There is a complex or unstable organizational structure as evidenced by the following:
Difficulty in determining the organization or individuals that have controlling interest in
the entity
Overly complex organizational structure involving unusual legal entities or managerial
lines of authority
High turnover of senior management, counsel, or board members
d. Internal control components are deficient as a result of the following:
Inadequate monitoring. of controls, including automated controls and controls over
interim financial reporting (where external reporting is required)
High turnover rates or employment of ineffective accounting, internal audit, or
information technology staff
Ineffective accounting and information systems including situations involving reportable
conditions
Attitudes/Rationalizations:
a. Ineffective communication and support of the entity's values or ethical standards by
management or the communication of inappropriate values or ethical standards
b. Non-financial management's excessive participation in or preoccupation with the selection of
accounting principles or the determination of significant estimates
2.

Risk factors relating to misappropriation of assets.

Incentives/Pressures:
a. Personal financial obligations may create pressure on management or employees with access
to cash or other assets susceptible to theft to misappropriate those assets.
b. Adverse relationships between the entity and employees with access to cash or other assets
susceptible to theft may motivate those employees to misappropriate those assets. For
example, adverse relationships may be created by the following:
Known or anticipated future employee layoffs
Promotions, compensation, expectations or other rewards inconsistent with expectations.
Opportunities:
a. Certain characteristics or circumstances may increase the susceptibility of assets to
misappropriation. For example, opportunities to misappropriate assets increase when there are
the following:
Large amounts of cash on hand or processed
Inventory items that are small in size, of high value, or in high demand
Easily convertible assets, such as bearer bonds, diamonds, or computer chips
Fixed assets that are small in size, marketable, or lacking observable identification of
ownership

1-40

b.

Inadequate internal control over assets may increase the susceptibility of misappropriation of
those assets. For example, misappropriation of assets may occur because there is the
following:
.
Inadequate segregation of duties or independent checks
Inadequate management oversight of employees responsible for assets, for example,
inadequate supervision or monitoring of remote locations
Inadequate job applicant screening of employees with access to assets Inadequate record
keeping with respect to assets
Inadequate system of authorization and approval of transactions (for example, in
purchasing)
Inadequate physical safeguards over cash, investments, inventory, or fixed assets
Lack of timely and appropriate documentation of transactions, for example, credits for
merchandise returns
Lack of mandatory vacations for employees performing key control functions
Inadequate management understanding of information technology, which enables
information technology employees to perpetrate a misappropriation
Inadequate access controls over automated records

Attitudes/Rationalizations:
Risk factors reflective of employee attitudes/rationalizations, that allow them to justify
misappropriations of assets, are generally not susceptible to observation by the auditor.
Nevertheless, the auditor who becomes aware of the existence of such information should consider
it in identifying the risks of material misstatement arising from misappropriation of assets. For
example, auditors may become aware of the following attitudes or behavior of employees who
have access to assets susceptible to misappropriation:
Disregard for the need for monitoring or reducing risks related to misappropriations of
assets
Disregard for internal control over misappropriation of assets by overriding existing
controls or by failing to correct known internal control deficiencies
Behavior indicating displeasure or dissatisfaction with the company or its treatment of the
employee
Changes in behavior or lifestyle that may indicate assets have been misappropriated
IV. Identifying Risks That May Result in a Material Misstatement Due to Fraud
A. The auditor should use the information obtained from the procedures described in III. to determine
material misstatement due to fraud. The identification process involves the application of professional
judgment and includes consideration of a number of factors, including:
1. The type of risk that may exist, that is, whether it involves fraudulent financial reporting or
misappropriation of assets.
2. The significance of the risk, that is, whether it is of a magnitude that could result in a possible
material misstatement of the financial statements.
3. The likelihood of the risk, that is, the likelihood that it will result in a material misstatement in the
financial statements.
4. The pervasiveness of the risk, that is, whether the potential risk is pervasive to the financial
statements as a whole or specifically related to a particular assertion, account, or class of transactions.
V.

Responding to the Results of the Assessment

A. The auditors responds to risks of material misstatement due to fraud in the following three ways:
1. A response to identified risks that has an overall effect on how the audit is conductedthat is, a
response involving more general considerations apart from the specific procedures otherwise planned.
2. A response to identified risks involving the nature, timing, and extent of the auditing procedures to be
performed.
3. A response involving the performance of certain procedures to further address the risk of material
misstatement due to fraud involving management override of controls, given the unpredictible ways
in which such override could occur.

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VI. Evaluating Audit Test Results

A. Conditions may be identified during fieldwork that change or support a judgment regarding the assessment
of the risks, such as the following:
1. Discrepancies in the accounting records, including:
Transactions that are not recorded in a complete or timely manner or are improperly recorded as
to amount, accounting period, classification, or entity policy
Unsupported or unauthorized balances or transactions
Last-minute adjustments that significantly affect financial results Evidence of employees' access
to systems and records inconsistent with that necessary to perform their authorized duties
2. Conflicting or missing evidential matter, including:
Missing documents
Unavailability of other than photocopied or electronically transmitted documents when
documents in original form are expected to exist Significant unexplained items on reconciliations
Inconsistent, vague, or implausible responses from management or employees arising from
inquiries or analytical procedures
Unusual discrepancies between the entity's records and confirmation replies
Missing inventory or physical assets of significant magnitude Unavailable or missing electronic
evidence, inconsistent with the entity's record retention practices or policies
Inability to produce evidence of key systems development and program change testing and
implementation activities for current-year system changes and deployments
3. Problematic or unusual relationships between the auditor and client, including:
Denial of access to records, facilities, certain employees, customers, vendors, or others from
whom audit evidence might be sought
Undue time pressures imposed by management to resolve complex or contentious issues
Complaints by management about the conduct of the audit or management intimidation of audit
team members, particularly in connection with the auditor's critical assessment of audit evidence
or in the resolution of potential disagreements with management
Unusual delays by the entity in providing requested information
Tips or complaints to the auditor about alleged fraud
Unwillingness to facilitate auditor access to key electronic files for testing through the use of
computer-assisted audit techniques
Denial of access to key IT operations staff and facilities, including security, operations, and
systems development personnel
B. Responding to misstatements that may be the result of fraud:
1. If the auditor believes that the misstatement is or may be the result of fraud, and either has determined
that the effect could be material to the financial statements or has been unable to evaluate whether the
effect is material, the auditor should:
a. Consider the implications for other aspects of the audit.
b. Discuss the matter and the approach for further investigation with an appropriate level of
management that is at least one level above those involved, and with senior management and the
audit committee.
c. Attempt to obtain additional evidential matter to determine whether material fraud has occurred
or is likely to have occurred, and, if so, its effect on the financial statements and the auditor's
report thereon.
d. Consider the need for and timing of discussions with the audit committee or board of directors.
e. If appropriate, suggest that the client consult with legal counsel.
2. The auditors consideration of the risks of material misstatement and the results of audit tests may
indicate such a significant risk of material misstatement due to fraud that the auditor should consider
withdrawing from the engagement and communicating the reasons for withdrawal to the audit
committee or others with equivalent authority and responsibility.
VII. Communicating About Possible Fraud to Management, the Audit Committee, and Others
A. Whenever the auditor has determined that there is evidence that fraud may exist, that matter should be
brought to the attention of an appropriate level of management. This is appropriate even if the matter
might be considered inconsequential, such as a minor defalcation by an employee at a low level in the
entity's organization. Fraud involving senior management and fraud (whether caused by senior

1-42

management or other employees) that causes a material misstatement of the financial statements should be
reported directly to the audit committee. In addition, the auditor should reach an understanding with the
audit committee regarding the nature and extent of communications about misappropriations perpetrated
by lower-level employees.
B. If the auditor, as a result of the assessment of the risks of material misstatement, has identified risks of
material misstatement due to fraud that have continuing control implications (whether or not transactions
or adjustments that could be the result of fraud have been detected), the auditor should consider whether
these risks represent reportable conditions relating to the entity's internal control that should be
communicated to senior management and the audit committee.
C. The disclosure of possible fraud to parties other than the client's senior management and its audit
committee ordinarily is not part of the auditor's responsibility and ordinarily would be precluded by the
auditor's ethical or legal obligations of confidentiality unless the matter is reflected in the auditor's report.
The auditor should recognize, however, that in the following circumstances a duty to disclose to parties
outside the entity may exist:
1. To comply with certain legal and regulatory requirements
2. To a successor auditor when the successor makes inquiries in accordance with SAS No. 84,
Communications Between Predecessor and Successor Auditors
3. In response to a subpoena
4. To a funding agency or other specified agency in accordance with requirements for the audits of
entities that receive governmental financial assistance
VIII. Documenting the Auditors Consideration of Fraud
A. The auditor should document the following:
1. The discussion among engagement personnel in planning the audit regarding the susceptibility of the
entity's financial statements to material misstatement due to fraud, including how and when the
discussion occurred, the audit team members who participated, and the subject matter discussed
2. The procedures performed to obtain information necessary to identify and assess the risks of material
misstatement due to fraud
3. Specific risks of material misstatement due to fraud that were identified, and a description of the
auditor's response to those risks
4. If the auditor concludes that the performance of some or all of the additional procedures to further
address the risk of management override of controls was unnecessary in a particular circumstance, the
reasons supporting the auditor's conclusion
5. Other conditions that caused the auditor to believe that additional auditing procedures or other
responses were required and any further responses the auditor concluded were appropriate, to address
such risks or other conditions
6. The nature of the communications about fraud made to management, the audit committee, and others

ILLEGAL ACTS BY CLIENTS (SAS NO. 54)

I.

Definition of Illegal Acts

A. Refers to violations of laws or governmental regulations.
B. May be entered into on behalf of the entity being audited by management or employees.

II.

Relation of Illegal Acts to the Financial Statements

A. Two types of illegal acts:
1. Acts having a direct material effect on the financial statements. Examples include: tax laws affecting
accrual of taxes, government regulations affecting the profit to be earned on government contracts.
a) The auditor is more apt to discover this type of illegal act since they are usually related to the
audit of specific amounts on the financial statements.
2. Acts having an indirect effect on the financial statements. Examples include laws relating to
occupational safety and health, environmental protection, etc.
a) The auditor may not become aware of these acts unless he is informed by the client of the
existence of the illegal act or of a governmental investigation.

1-43

B.

Specific audit procedures may bring possible illegal acts to the auditor's attention. These include:
1. Reading minutes
2. Inquiry of client's legal counsel
3. Inquiries of management and employees

C.

Specific information gathered during the audit that may be indicative of an illegal act:

Unauthorized transactions, improperly recorded transactions, or transactions not recorded in a

complete or timely manner in order to maintain accountability for assets

Investigation by a governmental agency, an enforcement proceeding, or payment of unusual fines or

penalties

Violations of laws or regulations cited in reports of examinations by regulatory agencies that have
been made available to the auditor

Large payments for unspecified services to consultants, affiliates, or employees

Sales commissions or agents' fees that appear excessive in relation to those normally paid by the
client or to the services actually received

Unusually large payments in cash, purchases of bank cashiers' checks in large amounts payable to
bearer, transfers to numbered bank accounts, or similar transactions

Unexplained payments made to government officials or employees

Failure to file tax returns or pay government duties or similar fees that are common to the entity's
industry or the nature of its business.

D.

Communications concerning illegal acts

After it has been determined that an illegal act has occurred, the auditor should report the circumstances to
personnel within the client's organization at a high enough level of authority so that appropriate action can
be taken by the client with respect to:
a. Consideration of remedial actions.
b. Adjustments or disclosures that may be necessary in the financial statements.
c. Disclosures that may be required in other documents (such as a proxy statement).
In some circumstances, the only persons in the organization of a sufficiently high level of authority to take
necessary action may be the audit committee or the board of directors. The auditor should also consider the
implications of an illegal act in relation to the intended degree of reliance to be placed on internal
accounting control and the representations of management.

III.

Effects On the Auditor's Report

The auditor may not be able to determine the amounts associated with certain events, taken alone or with
similar events, of which he becomes aware, or whether an act is, in fact, illegal because of inability to obtain
sufficient competent evidential matter. In those circumstances, the auditor should consider the need to qualify
his opinion or disclaim an opinion because of the scope limitation.
If the auditor concludes that the effect of an event, taken alone or with similar events, is material in amount and
that the event has not been properly accounted for or disclosed in the financial statements, he should qualify his
opinion or express an adverse opinion because of the departure from generally accepted accounting principles.
The auditor may conclude that an illegal act's effects on the financial statements are not susceptible of
reasonable estimation. When such an uncertainty exists, the auditor should consider the need to modify his
report.
If the client informs the auditor that it will refuse to accept an auditor's report that has been modified for the
reasons cited above, the auditor should withdraw from the current engagement, indicating the reasons for his
withdrawal in writing to the board of directors. In such circumstances, the auditor may wish to consult with his
legal counsel.

1-44

THE AUDITOR'S CONSIDERATION OF THE INTERNAL AUDIT

FUNCTION IN AN AUDIT OF FINANCIAL
STATEMENTS (SAS NO. 65)
The work of internal auditors cannot be substituted for the work of the independent auditor; however, the
independent auditor should consider the procedures, if any, performed by internal auditors in determining the nature,
timing, and extent of his own auditing procedures.
Internal auditors often perform a number of services for management, including, but not limited to, studying and
evaluating internal accounting control, reviewing operating practices to promote increased efficiency and economy,
and making special inquiries at management's direction.
The independent auditor should acquire an understanding of the internal audit function as it relates to the expression
of an opinion on the financial statements.

Requirements
A.

As part of obtaining an understanding of the internal control structure, the auditor should obtain an
understanding of the internal audit function sufficient to identify those internal audit activities that are relevant
to planning the audit.
1. Relevant activities are those that provide evidence about the design and effectiveness of policies and
procedures that pertain to the entity's ability to record, process, summarize, and report financial data. (An
example of internal audit activities that are not relevant is procedures to test the efficiency of
management decision-making processes.)
2. The extent of procedures necessary to obtain the understanding varies based on the circumstances.

B.

If, after obtaining an understanding of the internal audit function, the auditor concludes that the internal
auditors' activities are not relevant to the financial statement audit, the auditor does not have to give further
consideration to the function.
1. Even if some internal audit activities are relevant to the audit, the auditor is still permitted to conclude
that it would not be an efficient audit approach to consider the work of the internal auditors further.
2. Additional consideration of how the internal auditors' work might affect the nature, timing and extent of
audit procedures may be an efficient approach, for example, if the internal auditors have already
performed procedures that the auditor would have to reperform.

C.

If the auditor decides further consideration is efficient, the auditor should assess the competence and
objectivity of the internal audit function in light of the intended effect of the internal auditors' work on the
audit. The auditor should perform procedures to evaluate the quality and effectiveness of the internal auditors'
work that significantly affects the nature, timing and extent of the auditor's procedures.

D.

In addition, the auditor may request direct assistance from the internal auditors in performing the audit. When
direct assistance is provided, the auditor should
1. consider the internal auditors' competence and objectivity and
2. supervise, review, evaluate, and test their work.

Reviewing the Competence and Objectivity of Internal Auditors

When considering the competence of internal auditors, the independent auditor should inquire about the
qualifications of the internal audit staff, including, for example, consideration of the client's practices for hiring,
training, and supervising the internal audit staff.
When considering the objectivity of internal auditors, the independent auditor should consider the
organizational level to which internal auditors report the results of their work and the organizational level to
which they report administratively. This frequently is an indication of the extent of their ability to act
independently of the individuals responsible for the functions being audited. One method for judging internal
auditors' objectivity is to review the recommendations made in their reports.

1-45

Evaluating the Work of Internal Auditors

In evaluating the work of internal auditors, the independent auditor should examine, on a test basis,
documentary evidence of the work performed by internal auditors and should consider such factors as whether
the scope of the work is appropriate, audit programs are adequate, working papers adequately document work
performed, conclusions reached are appropriate in the circumstances, and any reports prepared are consistent with
the results of the work performed. The independent auditor should also perform tests of some of the work of
internal auditors. The extent of these tests will vary depending on the circumstances, including the type of
transactions and their materiality. These tests may be accomplished by either (a) examining some of the transactions
or balances that internal auditors examined, or (b) examining similar transactions or balances but not those actually
examined by internal auditors. The independent auditor should compare the results of his tests with the results of the
internal auditors' work in reaching conclusions on that work.

Arrangements With Internal Auditors

When the work of internal auditors is expected to be significant to the independent auditor's study and evaluation of
internal accounting control, the independent auditor should, at the outset of the engagement, inform internal auditors
of the reports and working papers he will need. He should also consult with internal auditors concerning work they
are performing, since work not yet completed may also have a bearing on his examination. Also, work done by
internal auditors will frequently be more useful to the independent auditor if plans for the work are discussed in
advance.

Using Internal Auditors to Provide Direct Assistance to the Independent Auditor

The independent auditor may make use of internal auditors to provide direct assistance in performing an
examination in accordance with generally accepted auditing standards. Internal auditors may assist in performing
substantive tests or tests of compliance. When the independent auditor makes such use of internal auditors, he
should consider their competence and objectivity and supervise and test their work to the extent appropriate in the
circumstances.

Judgments on Audit Matters

When the independent auditor considers the work of internal auditors in determining the nature, timing, and extent
of his own audit procedures, or when internal auditors provide direct assistance in the performance of his work,
judgments as to the effectiveness of internal accounting control, sufficiency of tests performed, materiality of
transactions, and other matters affecting his report on the financial statements, must be those of the independent
auditor.

1-46

Chapter One - Questions

Introduction, General and Field Standards
1. Tests of controls are performed in order to determine
whether or not
a. Controls are functioning as designed.
b. Necessary controls are absent.
c. Incompatible functions exist.
d. Material dollar errors exist.

6. Operating control over the check signature plate

normally should be the responsibility of the
a. Secretary.
b. Chief accountant.
c. Vice president of finance.
d. Treasurer.

2. For good internal accounting control, which of the

following functions should not be the responsibility of
the treasurer's department?
a. Data processing.
b. Handling of cash.
c. Custody of securities.
d. Establishing credit policies.

7. Internal control over cash receipts is weakened when

an employee who receives customer mail receipts also
a. Prepares initial cash receipts records.
b. Records credits to individual accounts receivable.
c. Prepares bank deposit slips for all mail receipts.
d. Maintains a petty cash fund.
8. Which of the following best describes proper internal
control over payroll?
a. The preparation of the payroll must be under the
control of the personnel department.
b. The confidentiality of employee payroll data
should be carefully protected to prevent fraud.
c. The duties of hiring, payroll computation, and
payment to employees should be segregated.
d. The payment of cash to employees should be
replaced with payment by checks.

3. During an audit an internal auditor may provide

direct assistance to an independent CPA in

a.
b.
c.
d.

Obtaining an
understanding of
the internal
control structure
No
Yes
Yes
Yes

Performing
tests of
controls
No
No
Yes
Yes

Performing
substantive
tests
No
No
No
Yes

9. Transaction authorization within an organization may

be either specific or general. An example of specific
transaction authorization is the
a. Establishment of requirements to be met in
determining a customer's credit limits.
b. Setting of automatic reorder points for material or
merchandise.
c. Approval of a detailed construction budget for a
warehouse.
d. Establishment of sales prices for products to be
sold to any customer.

4. Which of the following statements regarding auditor

documentation of the client's system of internal control
is correct?
a. Documentation must include flow charts.
b. Documentation must include procedural writeups.
c. No documentation is necessary although it is
desirable.
d. No one particular form of documentation is
necessary, and the extent of documentation may
vary.

10. Effective internal control over purchases generally

can be achieved in a well-planned organizational
structure with a separate purchasing department that has
a. The ability to prepare payment vouchers based on
the information on a vendor's invoice.
b. The responsibility of reviewing purchase orders
issued by user departments.
c. The authority to make purchases of requisitioned
materials and services.
d. A direct reporting responsibility to the controller
of the organization.

5. It would be appropriate for the payroll accounting

department to be responsible for which of the following
functions?
a. Approval of employee time records.
b. Maintenance of records of employment,
discharges, and pay increases.
c. Preparation of periodic governmental reports as to
employees' earnings and withholding taxes.
d. Distribution of pay checks to employees.

1Q-1

11. An example of an internal control weakness is to

assign to a department supervisor the responsibility for
a. Reviewing and approving time reports for
subordinate employees.
b. Initiating requests for salary adjustments for
subordinate employees.
c. Authorizing payroll checks for terminated
employees.
d. Distributing payroll checks to subordinate
employees.

16. Which of the following is a primary function of the

purchasing department?
a. Authorizing the acquisition of goods.
b. Ensuring the acquisition of goods of a specified
quality.
c. Verifying the propriety of goods acquired.
d. Reducing expenditures for goods acquired.
17. An auditor uses the knowledge provided by the
understanding of internal control and the final assessed
level of control risk primarily to determine the nature,
timing, and extent of the
a. Attribute tests.
b. Compliance tests.
c. Tests of controls.
d. Substantive tests.

12. The independent auditor should acquire an

understanding of a client's internal audit function to
determine whether the work of internal auditors will be
a factor in determining the nature, timing, and extent of
the independent auditor's procedures. The work
performed by internal auditors might be such a factor
when the internal auditor's work includes
a. Verification of the mathematical accuracy of
invoices.
b. Review of administrative practices to improve
efficiency and achieve management objectives.
c. Study and evaluation of internal accounting
control.
d. Preparation of internal financial reports for
management purposes.

18. Which of the following controls would be most

effective in assuring that recorded purchases are free of
material errors?
a. The receiving department compares the quantity
ordered on purchase orders with the quantity
received on receiving reports.
b. Vendors' invoices are compared with purchase
orders by an employee who is independent of the
receiving department.
c. Receiving reports require the signature of the
individual who authorized the purchase.
d. Purchase orders, receiving reports, and vendors'
invoices are independently matched in preparing
vouchers.

13. It is important for the CPA to consider the

competence of the audit clients' employees because their
competence bears directly and importantly upon the
a. Cost/benefit relationship of the system of internal
control.
b. Achievement of the objectives of the system of
internal control.
c. Comparison of recorded accountability with
assets.
d. Timing of the tests to be performed.

19. The auditor may observe the distribution of

paychecks to ascertain whether
a. Payrate authorization is properly separated from
the operating function.
b. Deductions from gross pay are calculated correctly
and are properly authorized.
c. Employees of record actually exist and are
employed by the client.
d. Paychecks agree with the payroll register and the
time cards.

14. Which of the following would be least likely to be

included in an auditor's tests of controls?
a. Inspection.
b. Observation.
c. Inquiry.
d. Confirmation.

20. A flowchart is most frequently used by an auditor in

connection with the
a. Preparation of generalized computer audit
programs.
b. Documentation of the client's internal control
procedures.
c. Use of statistical sampling in performing an audit.
d. Performance of analytical review procedures of
account balances.

15. Tests of controls are concerned primarily with each

of the following questions except
a. How were the procedures performed?
b. Why were the procedures performed?
c. Were the necessary procedures performed?
d. By whom were the procedures performed?

1Q-2

21. An auditor's purpose for performing tests of controls

is to provide reasonable assurance that
a. The controls on which the auditor plans to rely are
being applied as perceived during the preliminary
evaluation.
b. The risk that the auditor may unknowingly fail to
modify the opinion on the financial statements is
minimized.
c. Transactions are executed in accordance with
management's authorization and access to assets is
limited by a segregation of functions.
d. Transactions are recorded as necessary to permit
the preparation of the financial statements in
conformity with generally accepted accounting
principles.

26. An effective system of control procedures over the

payroll function would include
a. Verification of agreement of job time tickets with
employee clock card hours by a payroll
department employee.
b. Reconciliation of totals on job time tickets with
job reports by employees responsible for those
specific jobs.
c. Custody of rate authorization records by the
supervisor of the payroll department.
d. Preparation of payroll transaction journal entries
by an employee who reports to the supervisor of
the personnel department.
27. Which of the following procedures in the cash
disbursements cycle should not be performed by the
accounts payable department?
a. Comparing the vendor's invoice with the receiving
report.
b. Canceling supporting documentation after
payment.
c. Verifying the mathematical accuracy of the
vendor's invoice.
d. Signing the voucher for payment by an authorized
person.

22. An auditor would consider internal control over a

client's payroll procedures to be ineffective if the
payroll department supervisor is responsible for
a. Hiring subordinate payroll department employees.
b. Having custody over unclaimed paychecks.
c. Updating employee earnings records.
d. Applying pay rates to time tickets.
23. Which of the following departments should have the
responsibility for authorizing payroll rate changes?
a. Personnel.
b. Payroll.
c. Treasurer.
d. Timekeeping.

28. Which of the following is not a reason an auditor

should obtain an understanding of the components of an
entity's internal control in planning an audit?
a. Identify the types of potential misstatements that
can occur.
b. Design substantive tests.
c. Consider the operating effectiveness of the internal
control structure.
d. Consider factors that affect the risk of material
misstatements.

24. When considering the objectivity of internal

auditors, an independent auditor should
a. Evaluate the quality control program in effect for
the internal auditors.
b. Examine documentary evidence of the work
performed by the internal auditors.
c. Test a sample of the transactions and balances that
the internal auditors examined.
d. Determine the organizational level to which the
internal auditors report.

29. Which of the following is not a component of an

entity's internal control?
a. Control risk.
b. Control procedures.
c. Information and communication.
d. The control environment.

25. Internal control procedures are strengthened when

the quantity of merchandise ordered is omitted from the
copy of the purchase order sent to the
a. Department that initiated the requisition.
b. Receiving department.
c. Purchasing agent.
d. Accounts payable department.

30. When goods are received, the receiving clerk should

match the goods with the
a. Purchase order and the requisition form.
b. Vendor's invoice and the receiving report.
c. Vendor's shipping document and the purchase
order.
d. Receiving report and the vendor's shipping
document.

1Q-3

31. The mailing of disbursement checks and remittance

advices should be controlled by the employee who
a. Signed the checks last.
b. Approved the vouchers for payment.
c. Matched the receiving reports, purchase orders,
and vendors' invoices.
d. Verified the mathematical accuracy of the
vouchers and remittance advices.

35. An internal control narrative indicates that an

approved voucher is required to support every check
request for payment of merchandise. Which of the
following procedures provides the greatest assurance
that this control is operating effectively?
a. Select and examine vouchers and ascertain that the
related canceled checks are dated no later than the
vouchers.
b. Select and examine vouchers and ascertain that the
related canceled checks are dated no earlier than
the vouchers.
c. Select and examine canceled checks and ascertain
that the related vouchers are dated no earlier than
the checks.
d. Select and examine canceled checks and ascertain
that the related vouchers are dated no later than the
checks.

32. An auditor uses the knowledge provided by the

understanding of internal control and the assessed level
of control risk primarily to
a. Determine whether procedures and records
concerning the safeguarding of assets are reliable.
b. Ascertain whether the opportunities to allow any
person to both perpetrate and conceal irregularities
are minimized.
c. Modify the initial assessments of inherent risk and
preliminary judgments about materiality levels.
d. Determine the nature, timing, and extent of
substantive tests for financial statement assertions.

36. For effective internal control purposes, the vouchers

payable department generally should
a. Stamp, perforate, or otherwise cancel supporting
documentation after payment is mailed.
b. Ascertain that each requisition is approved as to
price, quantity, and quality by an authorized
employee.
c. Obliterate the quantity ordered on the receiving
department copy of the purchase order.
d. Establish the agreement of the vendor's invoice
with the receiving report and purchase order.

33. An auditor's flowchart of a client's accounting

system is a diagrammatic representation that depicts the
auditor's
a. Program for tests of controls.
b. Understanding of the system.
c. Understanding of the types of irregularities that
are probable, given the present system.
d. Documentation of the study and evaluation of the
system.

37. A weakness in internal control over recording

retirements of equipment may cause an auditor to
a. Trace additions to the "other assets" account to
search for equipment that is still on hand but no
longer being used.
b. Select certain items of equipment from the
accounting records and locate them in the plant.
c. Inspect certain items of equipment in the plant and
trace those items to the accounting records.
d. Review the subsidiary ledger to ascertain whether
depreciation was taken on each item of equipment
during the year.

34. After obtaining an understanding of an entity's

internal control and assessing control risk, an auditor
may next
a. Perform tests of controls to verify management's
assertions that are embodied in the financial
statements.
b. Consider whether evidential matter is available to
support a further reduction in the assessed level of
control risk.
c. Apply analytical procedures as substantive tests to
validate the assessed level of control risk.
d. Evaluate whether the internal control structure
policies and procedures detected material
misstatements in the financial statements.

38. Which of the following components of an entity's

internal control includes the development of personnel
manuals documenting employee promotion and training
policies?
a. Control procedures.
b. Control environment.
c. Accounting system.
d. Quality control system.

1Q-4

39. After obtaining an understanding of an entity's

internal control structure, an auditor may assess control
risk at the maximum level for some assertions because
the auditor
a. Believes the internal control policies and
procedures are unlikely to be effective.
b. Determines that the pertinent internal control
structure elements are not well documented.
c. Performs tests of controls to restrict detection risk
to an acceptable level.
d. Identifies internal control policies and procedures
that are likely to prevent material misstatements.

c.
d.

The cost of an entitys internal control structure

should not exceed the benefits expected to be
derived.
Adequate safeguards over access to assets and
records should permit an entity to maintain proper
accountability.

44. Proper authorization procedures in the revenue

cycle usually provide for the approval of bad debt writeoffs by an employee in which of the following
departments?
a. Treasurer.
b. Sales.
c. Billing.
d. Accounts receivable.

40. Which of the following control activities is not

usually performed in the vouchers payable department?
a. Determining the mathematical accuracy of the
vendor's invoice.
b. Having an authorized person approve the voucher.
c. Controlling the mailing of the check and
remittance advice.
d. Matching the receiving report with the purchase
order.

45. An auditor assesses control risk because it

a. Indicates where inherent risk may be the greatest.
b. Affects the level of detection risk the auditor may
accept.
c. Determines whether sampling risk is sufficiently
low.
d. Includes the aspects of nonsampling risk that are
controllable.

41. The primary objective of procedures performed to

obtain an understanding of internal control is to provide
an auditor with
a. Evidential matter to use in reducing detection risk.
b. Knowledge necessary to plan the audit.
c. A basis from which to modify tests of controls.
d. Information necessary to prepare flowcharts.

46. When considering the objectivity of internal

auditors, an independent auditor should
a. Test a sample of the transactions and balances that
the internal auditors examined.
b. Determine the organizational level to which the
internal auditors report.
c. Evaluate the quality control program in effect for
the internal auditors.
d. Examine documentary evidence of the work
performed by the internal auditors.

42. When assessing an internal auditor's objectivity, an

independent auditor should
a. Evaluate the adequacy of the internal auditor's
audit programs.
b. Inquire about the internal auditor's educational
background and professional certification.
c. Consider the organizational level to which the
internal auditor reports.
d. Review the internal auditor's working papers.

47. In an audit of financial statements in accordance

with generally accepted auditing standards, an auditor is
required to
a. Identify specific internal control procedures
relevant to management's financial statement
assertions.
b. Perform tests of controls to evaluate the
effectiveness of the entity's accounting system.
c. Determine whether procedures are suitably
designed to prevent or detect material
misstatements.
d. Document the auditor's understanding of the
entity's internal control.

43. When considering internal control, an auditor

should be aware of the concept of reasonable assurance,
which recognizes that
a. Procedures requiring segregation of duties may be
circumvented by employee collusion and
management override.
b. Establishing and maintaining the internal control
structure is an important responsibility of
management.

1Q-5

48. The acceptable level of detection risk is inversely

related to the
a. Assurance provided by substantive tests.
b. Risk of misapplying auditing procedures.
c. Preliminary judgment about materiality levels.
d. Risk of failing to discover material misstatements.

54. What is the general character of the three generally

accepted auditing standards classified as general
standards?
a. Criteria for competence, independence, and
professional care of individuals performing the
audit.
b. Criteria for the content of the financial statements
and related footnote disclosures.
c. Criteria for the content of the auditor's report on
financial statements and related footnote
disclosures.
d. The requirements for the planning of the audit and
supervision of assistants, if any.

49. When an auditor becomes aware of a possible client

illegal act, the auditor should obtain an understanding of
the nature of the act to
a. Increase the assessed level of control risk.
b. Recommend remedial actions to the audit
committee.
c. Evaluate the effect on the financial statements.
d. Determine the reliability of management's
representations.

55. The accuracy of information included in footnotes

that accompany the audited financial statements of a
company whose shares are traded on a stock exchange
is the primary responsibility of
a. The stock exchange officials.
b. The independent auditor.
c. The company's management.
d. The Securities and Exchange Commission.

50. As the acceptable level of detection risk decreases,

the assurance directly provided from
a. Substantive tests should increase.
b. Substantive tests should decrease.
c. Tests of controls should increase.
d. Tests of controls should decrease.

56. A CPA is most likely to refer to one or more of the

three general auditing standards in determining
a. The nature of the CPA's report qualification.
b. The scope of the CPA's auditing procedures.
c. Requirements for the review of internal control.
d. Whether the CPA should undertake an audit
engagement.

51. Mailing disbursement checks and remittance advices

should be controlled by the employee who
a. Approves the vouchers for payment.
b. Matches the receiving reports, purchase orders,
and vendors' invoices.
c. Maintains possession of the mechanical checksigning device.
d. Signs the checks last.

57. Which of the following criteria is unique to the

auditor's attest function?
a. General competence.
b. Familiarity with the particular industry of which
his client is a part.
c. Due professional care.
d. Independence.

52. Immediately upon receipt of cash, a responsible

employee should
a. Record the amount in the cash receipts journal.
b. Prepare a remittance listing.
c. Update the subsidiary accounts receivable records.
d. Prepare a deposit slip in triplicate.

58. The auditor's report may be addressed to the

company whose financial statements are being
examined or to that company's
a. Chief operating officer.
b. President.
c. Board of Directors.
d. Chief financial officer.

53. What is the meaning of the generally accepted

auditing standard which requires that the auditor be
independent?
a. The auditor must be without bias with respect to
the client under audit.
b. The auditor must adopt a critical attitude during
the audit.
c. The auditor's sole obligation is to third parties.
d. The auditor may have a direct ownership interest
in his client's business if it is not material.

1Q-6

59. When a CPA is approached to perform an audit for

the first time, the CPA should make inquiries of the
predecessor auditor. This is a necessary procedure
because the predecessor may be able to provide the
successor with information that will assist the successor
in determining
a. Whether the predecessor's work should be utilized.
b. Whether the company follows the policy of
rotating its auditors.
c. Whether in the predecessor's opinion internal
control of the company has been satisfactory.
d. Whether the engagement should be accepted.

63. Which of the following procedures would an auditor

most likely perform in planning a financial statement
audit?
a. Reviewing investment transactions of the audit
period to determine whether related parties were
created.
b. Performing analytical procedures to identify areas
that may represent specific risks.
c. Reading the minutes of stockholder and director
meetings to discover whether any unusual
transactions have occurred.
d. Obtaining a written representation letter from the
client to emphasize management's responsibilities.

60. Preliminary arrangements agreed to by the auditor

and the client should be reduced to writing by the
auditor. The best place to set forth these arrangements
is in
a. A memorandum to be placed in the permanent
section of the auditing working papers.
b. An engagement letter.
c. A client representation letter.
d. A confirmation letter attached to the constructive
services letter.

64. Before accepting an audit engagement, a successor

auditor should make specific inquiries of the
predecessor auditor regarding
a. Disagreements the predecessor had with the client
concerning auditing procedures and accounting
principles.
b. The predecessor's evaluation of matters of
continuing accounting significance.
c. The degree of cooperation the predecessor
received concerning the inquiry of the client's
lawyer.
d. The predecessor's assessments of inherent risk and
judgments about materiality.

61. The element of the audit planning process most

likely to be agreed upon with the client before
implementation of the audit strategy is the
determination of the
a. Methods of statistical sampling to be used in
confirming accounts receivable.
b. Pending legal matters to be included in the inquiry
of the client's attorney.
c. Evidence to be gathered to provide a sufficient
basis for the auditor's opinion.
d. Schedules and analyses to be prepared by the
client's staff.

65. To exercise due professional care an auditor should

a. Attain the proper balance of professional
experience and formal education.
b. Design the audit to detect all instances of illegal
acts.
c. Critically review the judgment exercised by those
assisting in the audit.
d. Examine all available corroborating evidence
supporting management's assertions.

62. Which of the following standards requires a critical

review of the work done and the judgment exercised by
those assisting in an audit at every level of supervision?
a. Proficiency.
b. Audit risk.
c. Inspection.
d. Due care.

66. When an auditor becomes aware of a possible

illegal act by a client, the auditor should obtain an
understanding of the nature of the act to
a. Evaluate the effect on the financial statements.
b. Determine the reliability of managements
representations.
c. Consider whether other similar acts may have
occurred.
d. Recommend remedial actions to the audit
committee.

1Q-7

67. The ultimate purpose of assessing control risk is to

contribute to the auditors evaluation of the risk that
a. Specified controls requiring segregation of duties
may be circumvented by collusion.
b. Entity policies may be overridden by senior
management.
c. Tests of controls may fail to identify procedures
relevant to assertions.
d. Material misstatements may exist in the financial
statements.

b.
c.
d.

Establish the agreement of the vendors invoice

with the receiving report and purchase order.
Stamp, perforate, or otherwise cancel supporting
documentation after payment is mailed.
Ascertain that each requisition is approved as to
price, quantity, and quality by an authorized
employee.

72. When the shipping department returns

nonconforming goods to a vendor, the purchasing
department should send to the accounting department
the
a. Unpaid voucher.
b. Debit memo.
c. Vendor invoice.
d. Credit memo.

68. An auditors primary consideration regarding an

entitys internal control policies and procedures is
whether the policies and procedures
a. Affect the financial statement assertions.
b. Prevent management override.
c. Relate to the control environment.
d. Reflect managements philosophy and operating
style.

73. An entitys internal control requires for every check

request that there be an approved voucher, supported by
a prenumbered purchase order and a prenumbered
receiving report. To determine whether checks are being
issued for unauthorized expenditures, an auditor most
likely would select items for testing from the population
of all
a. Purchase orders.
b. Canceled checks.
c. Receiving reports.
d. Approved vouchers.

69. Which of the following controls most likely would

help ensure that all credit sales transactions of an entity
are recorded?
a. The billing department supervisor sends copies of
approved sales orders to the credit department for
comparison to authorized credit limits and current
customer account balances.
b. The accounting department supervisor independently reconciles the accounts receivable subsidiary
ledger to the accounts receivable control account
monthly.
c. The accounting department supervisor controls the
mailing of monthly statements to customers and
investigates any differences reported by
customers.
d. The billing department supervisor matches
prenumbered shipping documents with entries in
the sales journal.

74. When there are numerous property and equipment

transactions during the year, an auditor who plans to
assess control risk at a low level usually performs.
a. Analytical procedures for property and equipment
balances at the end of the year.
b. Tests of controls and extensive tests of property
and equipment balances at the end of the year.
c. Analytical procedures for current year property
and equipment transactions.
d. Tests of controls and limited tests of current year
property and equipment transactions.

70. An entity with a large volume of customer

remittances by mail could most likely reduce the risk of
employee misappropriation of cash by using
a. Employee fidelity bonds.
b. Independently prepared mailroom prelists.
c. Daily check summaries.
d. A bank lockbox system.

75. In obtaining an understanding of a manufacturing

entitys internal control concerning inventory balances,
an auditor most likely would
a. Review the entitys descriptions of inventory
policies and procedures.
b. Perform test counts of inventory during the
entitys physical count.
c. Analyze inventory turnover statistics to identify
slow-moving and obsolete items.
d. Analyze monthly production reports to identify
variances and unusual transactions.

71. For effective internal control, the accounts payable

department generally should
a. Obliterate the quantity ordered on the receiving
department copy of the purchase order.

1Q-8

76. Which of the following procedures most likely

would be considered a weakness in an entitys internal
controls over payroll?
a. A voucher for the amount of the payroll is
prepared in the general accounting department
based on the payroll departments payroll
summary.
b. Payroll checks are prepared by the payroll
department and signed by the treasurer.
c. The employee who distributes payroll checks
returns unclaimed payroll checks to the payroll
department.
d. The personnel department sends employees
termination notices to the payroll department.

80. The audit work performed by each assistant should

be reviewed to determine whether it was adequately
performed and to evaluate whether the
a. Auditor's system of quality control has been
maintained at a high level.
b. Results are consistent with the conclusions to be
presented in the auditor's report.
c. Audit procedures performed are approved in the
professional standards.
d. Audit has been performed by persons having
adequate technical training and proficiency as
auditors.
81. An auditor obtains knowledge about a new client's
business and its industry to
a. Make constructive suggestions concerning
improvements to the client's internal control
structure.
b. Develop an attitude of professional skepticism
concerning management's financial statement
assertions.
c. Evaluate whether the aggregation of known
misstatements causes the financial statements
taken as a whole to be materially misstated.
d. Understand the events and transactions that may
have an effect on the client's financial statements.

77. Which of the following controls would an entity

most likely use in safeguarding against the loss of
marketable securities?
a. An independent trust company that has no direct
contact with the employees who have record
keeping responsibilities has possession of the
securities.
b. The internal auditor verifies the marketable
securities in the entitys safe each year on the
balance sheet date.
c. The independent auditor traces all purchases and
sales of marketable securities through the
subsidiary ledgers to the general ledger.
d. A designated member of the board of directors
controls the securities in a bank safe-deposit box.

82. Jones, CPA, is auditing the financial statements of

XYZ Retailing, Inc. What assurance does Jones provide
that direct effect illegal acts that are material to XYZ's
financial statements, and illegal acts that have a
material, but indirect effect on the financial statements
will be detected?

78. Before accepting an audit engagement, a successor

auditor should make specific inquiries of the
predecessor auditor regarding the predecessor's
a. Opinion of any subsequent events occurring since
the predecessor's audit report was issued.
b. Understanding as to the reasons for the change of
auditors.
c. Awareness of the consistency in the application of
GAAP between periods.
d. Evaluation of all matters of continuing accounting
significance.

a.
b.
c.
d.

Direct effect
illegal acts
Reasonable
Reasonable
Limited
Limited

Indirect effect
illegal acts
None
Reasonable
None
Reasonable

83. An auditor concludes that a client has committed an

illegal act that has not been properly accounted for or
disclosed. The auditor should withdraw from the
engagement if the
a. Auditor is precluded from obtaining sufficient
competent evidence about the illegal act.
b. Illegal act has an effect on the financial statements
that is both material and direct.
c. Auditor cannot reasonably estimate the effect of
the illegal act on the financial statements.
d. Client refuses to accept the auditor's report as
modified for the illegal act.

79. Which of the following factors most likely would

cause an auditor not to accept a new audit engagement?
a. An inadequate understanding of the entity's
internal control structure.
b. The close proximity to the end of the entity's fiscal
year.
c. Concluding that the entity's management probably
lacks integrity.
d. An inability to perform preliminary analytical
procedures before assessing control risk.
1Q-9

84. Because of the risk of material misstatement, an

audit of financial statements in accordance with
generally accepted auditing standards should be planned
and performed with an attitude of
a. Objective judgment.
b. Independent integrity.
c. Professional skepticism.
d. Impartial conservatism.

89. Which of the following most likely would not be

considered an inherent limitation of the potential
effectiveness of an entity's internal control?
a. Incompatible duties.
b. Management override.
c. Mistakes in judgment.
d. Collusion among employees.

85. An auditor's flowchart of a client's accounting

system is a diagrammatic representation that depicts the
auditor's
a. Assessment of control risk.
b. Identification of weaknesses in the system.
c. Assessment of the control environment's
effectiveness.
d. Understanding of the system.

90. After obtaining an understanding of internal control

and assessing control risk, an auditor decided not to
perform additional tests of controls. The auditor most
likely concluded that the
a. Additional evidence to support a further reduction
in control risk was not cost beneficial to obtain.
b. Assessed level of inherent risk exceeded the
assessed level of control risk.
c. Internal control structure was properly designed
and justifiably may be relied on.
d. Evidence obtainable through tests of controls
would not support an increased level of control
risk.

86. Management's attitude toward aggressive financial

reporting and its emphasis on meeting projected profit
goals most likely would significantly influence an
entity's control environment when
a. The audit committee is active in overseeing the
entity's financial reporting policies.
b. External policies established by parties outside the
entity affect its accounting practices.
c. Management is dominated by one individual who
is also a shareholder.
d. Internal auditors have direct access to the board of
directors and entity management.
87. An auditor should obtain sufficient knowledge of
an entity's accounting system to understand the
a. Safeguards used to limit access to computer
facilities.
b. Process used to prepare significant accounting
estimates.
c. Procedures used to assure proper authorization of
transactions.
d. Policies used to detect the concealment of
irregularities.
88. When obtaining an understanding of an entity's
internal control procedures, an auditor should
concentrate on the substance of the procedures rather
than their form because
a. The procedures may be operating effectively but
may not be documented.
b. Management may establish appropriate procedures
but not enforce compliance with them.
c. The procedures may be so inappropriate that no
reliance is contemplated by the auditor.
d. Management may implement procedures whose
costs exceed their benefits.

1Q-10

91. Which of the following audit procedures would an

auditor most likely perform to test controls relating to
management's assertion concerning the completeness of
sales transactions?
a. Verify that extensions and footings on the entity's
sales invoices and monthly customer statements
have been recomputed.
b. Inspect the entity's reports of prenumbered
shipping documents that have not been recorded in
the sales journal.
c. Compare the invoiced prices on prenumbered sales
invoices to the entity's authorized price list.
d. Inquire about the entity's credit granting policies
and the consistent application of credit checks.
92. Which of the following internal control procedures
most likely would assure that all billed sales are
correctly posted to the accounts receivable ledger?
a. Daily sales summaries are compared to daily
postings to the accounts receivable ledger.
b. Each sales invoice is supported by a prenumbered
shipping document.
c. The accounts receivable ledger is reconciled daily
to the control account in the general ledger.
d. Each shipment on credit is supported by a
prenumbered sales invoice.

93. An auditor most likely would assess control risk at

the maximum if the payroll department supervisor is
responsible for
a. Examining authorization forms for new
employees.
b. Comparing payroll registers with original batch
transmittal data.
c. Authorizing payroll rate changes for all
employees.
d. Hiring all subordinate payroll department
employees.

98. Which of the following procedures would an auditor

most likely include in the initial planning of a financial
statement audit?
a. Obtaining a written representation letter from the
client's management.
b. Examining documents to detect illegal acts having
a material effect on the financial statements.
c. Considering whether the client's accounting
estimates are reasonable in the circumstances.
d. Determining the extent of involvement of the
client's internal auditors.

94. In a properly designed internal control system, the

same employee most likely would match vendors'
invoices with receiving reports and also
a. Post the detailed accounts payable records.
b. Recompute the calculations on vendors' invoices.
c. Reconcile the accounts payable ledger.
d. Cancel vendors' invoices after payment.

99. Which of the following factors most likely would

influence an auditor's determination of the auditability
of an entity's financial statements?
a. The complexity of the accounting system.
b. The existence of related party transactions.
c. The adequacy of the accounting records.
d. The operating effectiveness of control procedures.

95. Which of the following internal control activities

most likely would prevent direct labor hours from being
charged to manufacturing overhead?
a. Periodic independent counts of work in process for
comparison to recorded amounts.
b. Comparison of daily journal entries with approved
production orders.
c. Use of time tickets to record actual labor worked
on production orders.
d. Reconciliation of work-in-process inventory with
periodic cost budgets.

100. Hill, CPA, has been retained to audit the financial

statements of Monday Co. Monday's predecessor
auditor was Post, CPA, who has been notified by
Monday that Post's services have been terminated.
Under these circumstances, which party should initiate
the communications between Hill and Post?
a. Hill, the successor auditor.
b. Post, the predecessor auditor.
c. Monday's controller or CFO.
d. The chairman of Monday's board of directors.

96. Which of the following internal control procedures

most likely would be used to maintain accurate
inventory records?
a. Perpetual inventory records are periodically
compared with the current cost of individual
inventory items.
b. A just-in-time inventory ordering system keeps
inventory levels to a desired minimum.
c. Requisitions, receiving reports, and purchase
orders are independently matched before payment
is approved.
d. Periodic inventory counts are used to adjust the
perpetual inventory records.
97. An auditor tests an entity's policy of obtaining credit
approval before shipping goods to customers in support
of management's financial statement assertion of
a. Valuation or allocation.
b. Completeness.
c. Existence or occurrence.
d. Rights and obligations.

1Q-11

101. The senior auditor responsible for coordinating the

field work usually schedules a pre-audit conference
with the audit team primarily to
a. Give guidance to the staff regarding both technical
and personnel aspects of the audit.
b. Discuss staff suggestions concerning the
establishment and maintenance of time budgets.
c. Establish the need for using the work of specialists
and internal auditors.
d. Provide an opportunity to document staff
disagreements regarding technical issues.
102. To obtain an understanding of a continuing client's
business in planning an audit, an auditor most likely
would
a. Perform tests of details of transactions and
balances.
b. Review prior-year working papers and the
permanent file for the client.
c. Read specialized industry journals.
d. Reevaluate
the
client's
internal
control
environment.

103. In planning an audit of a new client, an auditor

most likely would consider the methods used to process
accounting information because such methods
a. Influence the design of internal control.
b. Affect the auditor's preliminary judgment about
materiality levels.
c. Assist in evaluating the planned audit objectives.
d. Determine the auditor's acceptable level of audit
risk.
104. Which of the following statements is not correct
about materiality?
a. The concept of materiality recognizes that some
matters are important for fair presentation of
financial statements in conformity with GAAP,
while other matters are not important.
b. An auditor considers materiality for planning
purposes in terms of the largest aggregate level of
misstatements that could be material to any one of
the financial statements.
c. Materiality judgments are made in light of
surrounding circumstances and necessarily involve
both quantitative and qualitative judgments.
d. An auditor's consideration of materiality is
influenced by the auditor's perception of the needs
of a reasonable person who will rely on the
financial statements.
105. Which of the following circumstances most likely
would cause an auditor to consider whether material
misstatements exist in an entity's financial statements?
a. Management places little emphasis on meeting
earnings projections.
b. The board of directors makes all major financing
decisions.
c. Reportable conditions previously communicated to
management are not corrected.
d. Transactions selected for testing are not supported
by proper documentation.
106. When assessing the internal auditors' competence,
the independent CPA should obtain information about
the
a. Organizational level to which the internal auditors
report.
b. Educational
background
and
professional
certification of the internal auditors.
c. Policies prohibiting the internal auditors from
auditing areas where relatives are employed.
d. Internal auditors' access to records and information
that is considered sensitive.

1Q-12

107. Proper segregation of duties reduces the

opportunities to allow persons to be in positions to both
a. Journalize entries and prepare financial statements.
b. Record cash receipts and cash disbursements.
c. Establish internal controls and authorize
transactions.
d. Perpetuate and conceal errors and irregularities.
108. In an audit of financial statements, an auditor's
primary consideration regarding an internal control
policy or procedure is whether the policy or procedure
a. Reflects management's philosophy and operating
style.
b. Affects
management's
financial
statement
assertions.
c. Provides adequate safeguards over access to
assets.
d. Enhances
management's
decision-making
processes.
109. Which of the following are considered control
environment factors?

a.
b.
c.
d.

Detection
risk
Yes
Yes
No
No

Personnel
policies and
practices
Yes
No
Yes
No

110. The ultimate purpose of assessing control risk is to

contribute to the auditor's evaluation of the risk that
a. Tests of controls may fail to identify procedures
relevant to assertions.
b. Material misstatements may exist in the financial
statements.
c. Specified controls requiring segregation of duties
may be circumvented by collusion.
d. Entity policies may be overridden by senior
management.
111. To obtain evidential matter about control risk, an
auditor selects tests from a variety of techniques
including
a. Inquiry.
b. Analytical procedures.
c. Calculation.
d. Confirmation.

112. Which of the following is a step in an auditor's

decision to assess control risk at below the maximum?
a. Apply analytical procedures to both financial data
and nonfinancial information to detect conditions
that may indicate weak controls.
b. Perform tests of details of transactions and account
balances to identify potential errors and
irregularities.
c. Identify specific internal control policies and
procedures that are likely to detect or prevent
material misstatements.
d. Document that the additional audit effort to
perform tests of controls exceeds the potential
reduction in substantive testing.
113. The likelihood of assessing control risk too high is
the risk that the sample selected to test controls
a. Does not support the auditor's planned assessed
level of control risk when the true operating
effectiveness of the control structure justifies such
an assessment.
b. Contains misstatements that could be material to
the financial statements when aggregated with
misstatements in other account balances or
transactions classes.
c. Contains proportionately fewer monetary errors or
deviations from prescribed internal control
structure policies or procedures than exist in the
balance or class as a whole.
d. Does not support the tolerable error for some or all
of management's assertions.
114. Upon receipt of customers' checks in the mailroom,
a responsible employee should prepare a remittance
listing that is forwarded to the cashier. A copy of the
listing should be sent to the
a. Internal auditor to investigate the listing for
unusual transactions.
b. Treasurer to compare the listing with the monthly
bank statement.
c. Accounts receivable bookkeeper to update the
subsidiary accounts receivable records.
d. Entity's bank to compare the listing with the
cashier's deposit slip.
115. Proper authorization of write-offs of uncollectible
accounts should be approved in which of the following
departments?
a. Accounts receivable.
b. Credit.
c. Accounts payable.
d. Treasurer.

1Q-13

116. Which of the following procedures most likely

would not be an internal control procedure designed to
reduce the risk of errors in the billing process?
a. Comparing control totals for shipping documents
with corresponding totals for sales invoices.
b. Using computer programmed controls on the
pricing and mathematical accuracy of sales
invoices.
c. Matching shipping documents with approved sales
orders before invoice preparation.
d. Reconciling the control totals for sales invoices
with the accounts receivable subsidiary ledger.
117. In assessing control risk for purchases, an auditor
vouches a sample of entries in the voucher register to
the supporting documents. Which assertion would this
test of controls most likely support?
a. Completeness.
b. Existence or occurrence.
c. Valuation or allocation.
d. Rights and obligations.
118. Which of the following internal control procedures
is not usually performed in the vouchers payable
department?
a. Matching the vendor's invoice with the related
receiving report.
b. Approving vouchers for payment by having an
authorized employee sign the vouchers.
c. Indicating the asset and expense accounts to be
debited.
d. Accounting for unused prenumbered purchase
orders and receiving reports.
119. Which of the following questions would an auditor
least likely include on an internal control questionnaire
concerning the initiation and execution of equipment
transactions?
a. Are requests for major repairs approved at a
higher level than the department initiating the
request?
b. Are prenumbered purchase orders used for
equipment and periodically accounted for?
c. Are requests for purchases of equipment reviewed
for consideration of soliciting competitive bids?
d. Are procedures in place to monitor and properly
restrict access to equipment?

120. The objective of tests of details of transactions

performed as tests of controls is to
a. Monitor the design and use of entity documents
such as prenumbered shipping forms.
b. Determine whether internal control structure
policies and procedures have been placed in
operation.
c. Detect material misstatements in the account
balances of the financial statements.
d. Evaluate whether internal control structure
procedures operated effectively.
121. Which of the following tests of controls most
likely would help assure an auditor that goods shipped
are properly billed?
a. Scan the sales journal for sequential and unusual
entries.
b. Examine shipping documents for matching sales
invoices.
c. Compare the accounts receivable ledger to daily
sales summaries.
d. Inspect unused sales invoices for consecutive
prenumbering.
122. In assessing the competence and objectivity of an
entity's internal auditor, an independent auditor least
likely would consider information obtained from
a. Discussions with management personnel.
b. External quality reviews of the internal auditor's
activities.
c. Previous experience with the internal auditor.
d. The results of analytical procedures.
123. The element of the audit planning process most
likely to be agreed upon with the client before
implementation of the audit strategy is the
determination of the
a. Evidence to be gathered to provide a sufficient
basis for the auditor's opinion.
b. Procedures to be undertaken to discover litigation,
claims, and assessments.
c. Pending legal matters to be included in the inquiry
of the client's attorney.
d. Timing of inventory observation procedures to be
performed.
124. A successor auditor most likely would make
specific inquiries of the predecessor auditor regarding
a. Specialized accounting principles of the client's
industry.
b. The competency of the client's internal audit staff.
c. The uncertainty inherent in applying sampling
procedures.
d. Disagreements with management as to auditing
procedures.

1Q-14

125. Which of the following statements would least

likely appear in an auditor's engagement letter?
a. Fees for our services are based on our regular per
diem rates, plus travel and other out-of-pocket
expenses.
b. During the course of our audit we may observe
opportunities for economy in, or improved
controls over, your operations.
c. Our engagement is subject to the risk that material
errors or irregularities, including fraud and
defalcations, if they exist, will not be detected.
d. After performing our preliminary analytical
procedures we will discuss with you the other
procedures we consider necessary to complete the
engagement.
126. Which of the following procedures would an
auditor most likely perform in planning a financial
statement audit?
a. Inquiring of the client's legal counsel concerning
pending litigation.
b. Comparing the financial statements to anticipated
results.
c. Examining computer generated exception reports
to verify the effectiveness of internal controls.
d. Searching for unauthorized transactions that may
aid in detecting unrecorded liabilities.
127. The in-charge auditor most likely would have a
supervisory responsibility to explain to the staff
assistants
a. That immaterial irregularities are not to be
reported to the client's audit committee.
b. How the results of various auditing procedures
performed by the assistants should be evaluated.
c. What benefits may be attained by the assistants'
adherence to established time budgets.
d. Why certain documents are being transferred from
the current file to the permanent file.
128. Which of the following would an auditor most
likely use in determining the auditor's preliminary
judgment about materiality?
a. The anticipated sample size of the planned
substantive tests.
b. The entity's annualized interim financial
statements.
c. The results of the internal control questionnaire.
d. The contents of the management representation
letter.

129. As the acceptable level of detection risk decreases,

an auditor may
a. Reduce substantive testing by relying on the
assessments of inherent risk and control risk.
b. Postpone the planned timing of substantive tests
from interim dates to the year end.
c. Eliminate the assessed level of inherent risk from
consideration as a planning factor.
d. Lower the assessed level of control risk from the
maximum level to below the maximum.
130. Which of the following characteristics most likely
would heighten an auditor's concern about the risk of
intentional manipulation of financial statements?
a. Turnover of senior accounting personnel is low.
b. Insiders recently purchased additional shares of
the entity's stock.
c. Management places substantial emphasis on
meeting earnings projections.
d. The rate of change in the entity's industry is slow.
131. The third general standard states that due care is to
be exercised in the performance of an audit. This
standard is ordinarily interpreted to require
a. Thorough review of the existing safeguards over
access to assets and records.
b. Limited review of the indications of employee
fraud and illegal acts.
c. Objective review of the adequacy of the technical
training and proficiency of firm personnel.
d. Critical review of the judgment exercised at every
level of supervision.
132. The primary objective of procedures performed to
obtain an understanding of the internal control structure
is to provide an auditor with
a. Knowledge necessary for audit planning.
b. Evidential matter to use in assessing inherent risk.
c. A basis for modifying tests of controls.
d. An evaluation of the consistency of application of
management's policies.
133. The overall attitude and awareness of an entity's
board of directors concerning the importance of the
internal control structure usually is reflected in its
a. Computer-based controls.
b. System of segregation of duties.
c. Control environment.
d. Safeguards over access to assets.

1Q-15

134. When considering the internal control structure, an

auditor should be aware of the concept of reasonable
assurance, which recognizes that
a. Internal control policies and procedures may be
ineffective due to mistakes in judgment and
personal carelessness.
b. Adequate safeguards over access to assets and
records should permit an entity to maintain proper
accountability.
c. Establishing and maintaining the internal control
structure is an important responsibility of
management.
d. The cost of an entity's internal control structure
should not exceed the benefits expected to be
derived.
135. Control risk should be assessed in terms of
a. Specific control procedures.
b. Types of potential irregularities.
c. Financial statement assertions.
d. Control environment factors.
136. Sound internal control procedures dictate that
immediately upon receiving checks from customers by
mail, a responsible employee should
a. Add the checks to the daily cash summary.
b. Verify that each check is supported by a
prenumbered sales invoice.
c. Prepare a duplicate listing of checks received.
d. Record the checks in the cash receipts journal.
137. An auditor generally tests the segregation of duties
related to inventory by
a. Personal inquiry and observation.
b. Test counts and cutoff procedures.
c. Analytical procedures and invoice recomputation.
d. Document inspection and reconciliation.
138. After obtaining an understanding of the internal
control structure and assessing control risk, an auditor
decided to perform tests of controls. The auditor most
likely decided that
a. It would be efficient to perform tests of controls
that would result in a reduction in planned
substantive tests.
b. Additional evidence to support a further reduction
in control risk is not available.
c. An increase in the assessed level of control risk is
justified for certain financial statement assertions.
d. There were many internal control structure
weaknesses that could allow errors to enter the
accounting system.

139. To provide assurance that each vendor invoice is

submitted and paid only once, an auditor most likely
would examine a sample of paid vouchers and
determine whether each voucher is
a. Supported by a vendor's invoice.
b. Stamped "paid" by the check signer.
c. Prenumbered and accounted for.
d. Approved for authorized purchases.

144. Management philosophy and operating style most

likely would have a significant influence on an entity's
control environment when
a. The internal auditor reports directly to management.
b. Management is dominated by one individual.
c. Accurate management job descriptions delineate
specific duties.
d. The audit committee actively oversees the financial
reporting process.

140. An internal auditor's work would most likely affect

the nature, timing, and extent of an independent CPAs
auditing procedures when the internal auditor's work
relates to assertions about the
a. Existence of contingencies.
b. Valuation of intangible assets.
c. Existence of fixed asset additions.
d. Valuation of related party transactions.

145. Which of the following is a management control

method that most likely could improve management's
ability to supervise company activities effectively?
a. Monitoring compliance with internal control
requirements imposed by regulatory bodies.
b. Limiting direct access to assets by physical
segregation and protective devices.
c. Establishing budgets and forecasts to identify
variances from expectations.
d. Supporting employees with the resources necessary
to discharge their responsibilities.

141. In assessing the objectivity of internal auditors, an

independent auditor should
a. Evaluate the quality control program in effect for the
internal auditors.
b. Examine documentary evidence of the work
performed by the internal auditors.
c. Test a sample of the transactions and balances that
the internal auditors examined.
d. Determine the organizational level to which the
internal auditors report.

142. In planning an audit, the auditor's knowledge about

the design of relevant internal control policies and
procedures should be used to
a. Identify the types of potential misstatements that
could occur.
b. Assess the operational efficiency of the internal
control structure.
c. Determine whether controls have been circumvented
by collusion.
d. Document the assessed level of control risk.

143. Which of the following auditor concerns most

likely could be so serious that the auditor concludes that
a financial statement audit cannot be conducted?
a. The entity has no formal written code of conduct.
b. The integrity of the entity's management is suspect.
c. Procedures requiring segregation of duties are
subject to management override.
d. Management fails to modify prescribed controls for
changes in conditions.

1Q-16

146. In an audit of financial statements in accordance

with generally accepted auditing standards, an auditor is
required to
a. Document the auditor's understanding of the entity's
internal control structure.
b. Search for significant deficiencies in the operation
of the internal control structure.
c. Perform tests of controls to evaluate the
effectiveness of the entity's accounting system.
d. Determine whether control procedures are suitably
designed to prevent or detect material
misstatements.
147. Which of the following internal controls most
likely would reduce the risk of diversion of customer
receipts by an entity's employees?
a. A bank lockbox system.
b. Prenumbered remittance advices.
c. Monthly bank reconciliations.
d. Daily deposit of cash receipts.
148. In obtaining an understanding of an entity's
internal control structure policies and procedures that
are relevant to audit planning, an auditor is required to
obtain knowledge about the
a. Design of the policies and procedures pertaining to
the internal control structure elements.
b. Effectiveness of the policies and procedures that
have been placed in operation.
c. Consistency with which the policies and procedures
are currently being applied.
d. Control procedures related to each principal
transaction class and account balance.

149. Which of the following is a control procedure that

most likely could help prevent employee payroll fraud?
a. The personnel department promptly sends employee
termination notices to the payroll supervisor.
b. Employees who distribute payroll checks forward
unclaimed payroll checks to the absent employees'
supervisors.
c. Salary rates resulting from new hires are approved
by the payroll supervisor.
d. Total hours used for determination of gross pay are
calculated by the payroll supervisor.
150. Which of the following controls would a company
most likely use to safeguard marketable securities when
an independent trust agent is not employed?
a. The investment committee of the board of directors
periodically reviews the investment decisions
delegated to the treasurer.
b. Two company officials have joint control of
marketable securities, which are kept in a bank safedeposit box.
c. The internal auditor and the controller independently
trace all purchases and sales of marketable securities
from the subsidiary ledgers to the general ledger.
d. The chairman of the board verifies the marketable
securities, which are kept in a bank safe-deposit
box, each year on the balance sheet date.
151. In assessing control risk, an auditor ordinarily
selects from a variety of' techniques, including
a. Inquiry and analytical procedures.
b. Reperformance and observation.
c. Comparison and confirmation.
d. Inspection and verification.
152. Which of the following statements is correct
concerning an auditor's assessment of control risk?
a. Assessing control risk may be performed
concurrently during an audit with obtaining an
understanding of the entity's internal control
structure.
b. Evidence about the operation of control procedures
in prior audits may not be considered during the
current year's assessment of control risk.
c. The basis for an auditor's conclusions about the
assessed level of control risk need not be
documented unless control risk is assessed at the
maximum level.
d. The lower the assessed level of control risk, the less
assurance the evidence must provide that the control
procedures are operating effectively.

1Q-17

153. An auditor assesses control risk because it

a. Is relevant to the auditor's understanding of the
control environment.
b. Provides assurance that the auditor's materiality
levels are appropriate.
c. Indicates to the auditor where inherent risk may be
the greatest.
d. Affects the level of detection risk that the auditor
may accept.
154. Assessing control risk at below the maximum level
most likely would involve
a. Performing more extensive substantive tests with
larger sample sizes than originally planned.
b. Reducing inherent risk for most of the assertions
relevant to significant account balances.
c. Changing the timing of substantive tests by omitting
interim-date testing and performing the tests at year
end.
d. Identifying specific internal control structure
policies and procedures relevant to specific
assertions.
155. After assessing control risk at below the maximum
level, an auditor desires to seek a further reduction in
the assessed level of control risk. At this time, the
auditor would consider whether
a. It would be efficient to obtain an understanding of
the entity's accounting system.
b. The entity's internal control structure policies and
procedures have been placed in operation.
c. The entity's internal control structure policies and
procedures pertain to any financial statement
assertions.
d. Additional evidential matter sufficient to support a
further reduction is likely to be available.
156. When assessing control risk below the maximum
level, an auditor is required to document the auditor's

a.
b.
c.
d.

Understanding of
the entity's control
environment
Yes
No
Yes
No

Basis for
concluding that
control risk is below
the maximum level
No
Yes
Yes
No

157. When there are numerous property and equipment

transactions during the year, an auditor who plans to
assess control risk at a low level usually performs
a. Tests of controls and extensive tests of property and
equipment balances at the end of the year.
b. Analytical procedures for current year property and
equipment transactions.
c. Tests of controls and limited tests of current year
property and equipment transactions.
d. Analytical procedures for property and equipment
balances at the end of the year.

161. In determining the effectiveness of an entity's

policies and procedures relating to the existence or
occurrence assertion for payroll transactions, an auditor
most likely would inquire about and
a. Observe the segregation of duties concerning
personnel responsibilities and payroll disbursement.
b. Inspect evidence of accounting for prenumbered
payroll checks.
c. Recompute the payroll deductions for employee
fringe benefits.
d. Verify the preparation of the monthly payroll
account bank reconciliation.

158. An auditor suspects that a client's cashier is

misappropriating cash receipts for personal use by
lapping customer checks received in the mail. In
attempting to uncover this embezzlement scheme, the
auditor most likely would compare the
a. Dates checks are deposited per bank statements with
the dates remittance credits are recorded.
b. Daily cash summaries with the sums of the cash
receipts journal entries.
c. Individual bank deposit slips with the details of the
monthly bank statements.
d. Dates uncollectible accounts are authorized to be
written off with the dates the write-offs are actually
recorded.

162. In obtaining an understanding of a manufacturing

entity's internal control structure concerning inventory
balances, an auditor most likely would
a. Analyze the liquidity and turnover ratios of the
inventory.
b. Perform analytical procedures designed to identify
cost variances.
c. Review the entity's descriptions of inventory
policies and procedures.
d. Perform test counts of inventory during the entity's
physical count.

159. In testing controls over cash disbursements, an

auditor most likely would determine that the person
who signs checks also
a. Reviews the monthly bank reconciliation.
b. Returns the checks to accounts payable.
c. Is denied access to the supporting documents.
d. Is responsible for mailing the checks.
160. For effective internal control, the accounts payable
department generally should
a. Stamp, perforate, or otherwise cancel supporting
documentation after payment is mailed.
b. Ascertain that each requisition is approved as to
price, quantity, and quality by an authorized
employee.
c. Obliterate the quantity ordered on the receiving
department copy of the purchase order.
d. Establish the agreement of the vendor's invoice with
the receiving report and purchase order.

1Q-18

163. The work of internal auditors may affect the

independent auditor's
I. Procedures performed in obtaining an understanding
of the internal control structure.
II. Procedures performed in assessing the risk of
material misstatement.
III. Substantive procedures performed in gathering
direct evidence.
a.
b.
c.
d.

I and II only.
I and III only.
II and III only.
I, II, and III.

164. During the initial planning phase of an audit, a

CPA most likely would
a. Identify specific internal control activities that are
likely to prevent fraud.
b. Evaluate the reasonableness of the client's
accounting estimates.
c. Discuss the timing of the audit procedures with the
client's management.
d. Inquire of the client's attorney as to whether any
unrecorded claims are probable of assertion.

165. In creating lead schedules for an audit engagement,

a CPA often uses automated workpaper software. What
client information is needed to begin this process?
a. Interim financial information such as third quarter
sales, net income, and inventory and receivables
balances.
b. Specialized journal information such as the invoice
and purchase order numbers of the last few sales and
purchases of the year.
c. General ledger information such as account
numbers, prior-year account balances, and currentyear unadjusted information.
d. Adjusting entry information such as deferrals and
accruals, and reclassification journal entries.
166. To reduce the risks associated with accepting email responses to requests for confirmation of accounts
receivable, an auditor most likely would
a. Request the senders to mail the original forms to the
auditor.
b. Examine subsequent cash receipts for the accounts
in question.
c. Consider the e-mail responses to the confirmations
to be exceptions.
d. Mail second requests to the e-mail respondents.

CPA Exam Tip:

Within a multiple choice testlet you can
change your answers to any of the questions
prior to completing the testlet. Once you
complete the testlet you cannot go back and
change the answers.

1Q-19

Chapter One - Problems

Introduction, General and Field Standards
NUMBER 1
The flowchart on the following page depicts the activities relating to the purchasing, receiving, and accounts
payable departments of Model Company, Inc.
Required:
Based only on the flowchart, describe the internal control procedures (strengths) that most likely would provide
reasonable assurance that specific internal control objectives for the financial statement assertions regarding
purchases and accounts payable will be achieved. Do not describe weaknesses in the internal control structure.

NUMBER 2
An auditor's working papers include the narrative description below of the cash receipts and billing portions of the
internal control structure of Rural Building Supplies, Inc. Rural is a single-store retailer that sells a variety of tools,
garden supplies, lumber, small appliances, and electrical fixtures to the public, although about half of Rural's sales
are to construction contractors on account. Rural employs 12 salaried sales associates, a credit manager, three fulltime clerical workers, and several part-time cash register clerks and assistant bookkeepers. The full-time clerical
workers perform such tasks as cash receipts, billing, and accounting and are adequately bonded. They are referred to
in the narrative as "accounts receivable supervisor," "cashier," and "bookkeeper."
NARRATIVE
Retail customers pay for merchandise by cash or credit card at cash registers when merchandise is purchased. A
contractor may purchase merchandise on account if approved by the credit manager based only on the manager's
familiarity with the contractor's reputation. After credit is approved, the sales associate files a prenumbered charge
form with the accounts receivable (A/R) supervisor to set up the receivable.
The A/R supervisor independently verifies the pricing and other details on the charge form by reference to a
management-authorized price list, corrects any errors, prepares the invoice, and supervises a part-time employee
who mails the invoice to the contractor. The A/R supervisor electronically posts the details of the invoice in the A/R
subsidiary ledger; simultaneously, the transaction's details are transmitted to the bookkeeper. The A/R supervisor
also prepares a monthly computer-generated A/R subsidiary ledger without a reconciliation with the A/R control
account and a monthly report of overdue accounts.
The cash receipts functions are performed by the cashier who also supervises the cash register clerks. The cashier
opens the mail, compares each check with the enclosed remittance advice, stamps each check "for deposit only," and
lists checks for deposit. The cashier then gives the remittance advices to the bookkeeper for recording. The cashier
deposits the checks daily separate from the daily deposit of cash register receipts. The cashier retains the verified
deposit slips to assist in reconciling the monthly bank statements, but forwards to the bookkeeper a copy of the daily
cash register summary. The cashier does not have access to the journals or ledgers.
The bookkeeper receives the details of transactions from the A/R supervisor and the cashier for journalizing and
posting to the general ledger. After recording the remittance advices received from the cashier, the bookkeeper
electronically transmits the remittance information to the A/R supervisor for subsidiary ledger updating. The
bookkeeper sends monthly statements to contractors with unpaid balances upon receipt of the monthly report of
overdue balances from the A/R supervisor. The bookkeeper authorizes the A/R supervisor to write off accounts as

1Q-20

NUMBER 1 (cont.)

1Q-21

NUMBER 2 (cont.)
uncollectible when six months have passed since the initial overdue notice was sent. At this time, the credit manager
is notified by the bookkeeper not to grant additional credit to that contractor.
Required:
Based only on the information in the narrative, describe the internal control weaknesses in Rural's internal control
structure concerning the cash receipts and billing functions. Organize the weaknesses by employee job function:
Credit manager, A/R supervisor, Cashier, and Bookkeeper. Do not describe how to correct the weaknesses.

NUMBER 3
A partially-completed charge sales systems flowchart follows on the next page. The flowchart depicts the charge
sales activities of the Bottom Manufacturing Corporation.
A customer's purchase order is received and a six-part sales order is prepared, therefrom. The six copies are initially
distributed as follows:
Copy No. 1: Billing copy--to billing department.
Copy No. 2: Shipping copy--to shipping department.
Copy No. 3: Credit copy--to credit department.
Copy No. 4: Stock request copy--to credit department.
Copy No. 5: Customer copy--to customer.
Copy No. 6: Sales order copy--file in sales order department.
When each copy of the sales order reaches the applicable department or destination, it calls for specific internal
control procedures and related documents. Some of the procedures and related documents are indicated on the
flowchart. Other procedures and documents are labeled letters a to r.
Required: List the procedures or the internal documents that are labeled letters c to r in the flowchart of Bottom
Manufacturing Corporation's charge sales system.
Organize your answer as follows (note that an explanation of the letters a and b which appear in the flowchart are
entered as examples): (See Flowchart Symbols, Chapter 7.)
Procedures or Internal Document
Prepare six-part sales order.
File by order number.

Flowchart Symbol Letter

a.
b.

1Q-22

NUMBER 3 (cont.)

1Q-23

NUMBER 4
Dodd, CPA, audited Adams Company's financial statements for the year ended December 31, 1989. On November
1, 1990, Adams notified Dodd that it was changing auditors and that Dodd's services were being terminated. On
November 5, 1990, Adams invited Hall, CPA, to make a proposal for an engagement to audit its financial
statements for the year ended December 31, 1990.
Required:
a. What procedures concerning Dodd should Hall perform before accepting the engagement?
b. What additional procedures should Hall consider performing during the planning phase of this audit (after
acceptance of the engagement) that would not be performed during the audit of a continuing client?

NUMBER 5
An auditor is required to obtain a sufficient understanding of each of the elements of an entity's internal control
structure. This is necessary to plan the audit of the entity's financial statements and to assess control risk.
Required:
a. For what purposes should an auditor's understanding of the internal control structure elements be used in
planning an audit?
b. What is required for an auditor to assess control risk at below the maximum level?
c. What should an auditor consider when seeking a further reduction in the planned assessed level of control
risk?
d. What are an auditor's documentation requirements concerning an entity's internal control structure and the
assessed level of control risk?

NUMBER 6
The following illustrates a MANUAL SYSTEM FOR EXECUTING PURCHASES AND CASH
DISBURSEMENTS TRANSACTIONS.
Required:
Indicate what each of the letters (A) through (L) represent. Do not discuss adequacies or inadequacies in the system
of internal control.
(Number 6 continued on next page.)

1Q-24

NUMBER 6 (cont.)

1Q-25

NUMBER 7
Number 7 consists of 13 items. Select the best answer for each item. Answer all items.
Required:
The flowchart on the next page depicts part of a client's revenue cycle. Some of the flowchart symbols are labeled to
indicate control procedures and records. For each symbol numbered 61 through 73, select one response from the
answer lists below. Each response in the lists may be selected once or not at all.
Answer Lists
Operations and control procedures
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.
M.
N.
O.

Enter shipping data

Verify agreement of sales order and shipping document
Write off accounts receivable
To warehouse and shipping department
Authorize account receivable write-off
Prepare aged trial balance
To sales department
Release goods for shipment
To accounts receivable department
Enter price data
Determine that customer exists
Match customer purchase order with sales order
Perform customer credit check
Prepare sales journal
Prepare sales invoice

Documents, journals, ledgers, and files

P.
Q.
R.
S.
T.
U.
V.
W.
X.
Y.
Z.

Shipping document
General ledger master file
General journal
Master price file
Sales journal
Sales invoice
Cash receipts journal
Uncollectible accounts file
Shipping file
Aged trial balance
Open order file

1Q-26

NUMBER 7 (cont.)

1Q-27

NUMBER 8
Number 8 consists of 15 items pertaining to an auditors risk analysis of an entity. Select the best answer for each
item.
Bond, CPA, is considering audit risk at the financial statement level in planning the audit of Toxic Waste Disposal
(TWD) Companys financial statements for the year ended December 31, 1993. TWD is a privately-owned entity
that contracts with municipal governments to remove environmental wastes. Audit risk at the financial statement
level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related
to management, the industry, and the entity.
Required:
Based only on the information below, indicate whether each of the following factors (Items 106 through 120)
would most likely increase audit risk (I), decrease audit risk (D), or have no effect on audit risk (N).
Items to be Answered:
Company Profile
106. This was the first year TWD operated at a profit since 1989 because the municipalities received increased
federal and state funding for environmental purposes.
107. TWDs Board of Directors is controlled by Mead, the majority stockholder, who also acts as the chief
executive officer.
108. The internal auditor reports to the controller and the controller reports to Mead.
109. The accounting department has experienced a high rate of turnover of key personnel.
110. TWDs bank has a loan officer who meets regularly with TWDs CEO and controller to monitor TWDs
financial performance.
111. TWDs employees are paid biweekly.
112. Bond has audited TWD for five years.
Recent Developments
113. During 1993, TWD changed its method of preparing its financial statements from the cash basis to generally
accepted accounting principles.
114. During 1993, TWD sold one half of its controlling interest in United Equipment Leasing (UEL) Co. TWD
retained significant interest in UEL.
115. During 1993, litigation filed against TWD in 1988 alleging that TWD discharged pollutants into state
waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years
financial statements are being removed for the 1993 financial statements.
116. During December 1993, TWD signed a contract to lease disposal equipment from an entity owned by Meads
parents. This related party transaction is not disclosed in TWDs notes to its 1993 financial statements.
117. During December 1993, TWD completed a barter transaction with a municipality. TWD removed waste from
a municipally-owned site and acquired title to another contaminated site at below market price. TWD intends
to service this new site in 1994.

1Q-28

118. During December 1993, TWD increased its casualty insurance coverage on several pieces of sophisticated
machinery from historical cost to replacement cost.
119. Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 1993 disclosed a
new policy. TWD guaranteed to several municipalities that it would refund the federal and state funding paid
to TWD if any municipality fails federal or state site clean-up inspection in 1994.
120. An initial public offering of TWDs stock is planned for late 1994.

NUMBER 9
Number 9 consists of 15 items. Select the best answer for each item.
Field, CPA, is auditing the financial statements of Miller Mailorder, Inc. (MMI) for the year ended January 31,
1995. Field has compiled a list of possible errors and fraud that may result in the misstatement of MMIs financial
statements, and a corresponding list of internal control activities that, if properly designed and implemented, could
assist MMI in preventing or detecting the errors and fraud.
Required:
For each possible error and fraud numbered 106 through 120, select one internal control activity from the answer
list that, if properly designed and implemented, most likely could assist MMI in preventing or detecting the errors
and fraud. Each response in the list of internal control activities may be selected once, more than once, or not at all.
Possible Errors and Fraud
106. Invoices for goods sold are posted to incorrect customer accounts.
107. Goods ordered by customers are shipped, but are not billed to anyone.
108. Invoices are sent for shipped goods, but are not recorded in the sales journal.
109. Invoices are sent for shipped goods and are recorded in the sales journal, but are not posted to any customer
account.
110. Credit sales are made to individuals with unsatisfactory credit ratings.
111. Goods are removed from inventory for unauthorized orders.
112. Goods shipped to customers do not agree with goods ordered by customers.
113. Invoices are sent to allies in a fraudulent scheme and sales are recorded for fictitious transactions.
114. Customers checks are received for less than the customers full account balances, but the customers full
account balances are credited.
115. Customers checks are misappropriated before being forwarded to the cashier for deposit.
116. Customers checks are credited to incorrect customer accounts.
117. Different customer accounts are each credited for the same cash receipt.

1Q-29

118. Customers checks are properly credited to customer accounts and are properly deposited, but errors are made
in recording receipts in the cash receipts journal.
119. Customers checks are misappropriated after being forwarded to the cashier for deposit.
120. Invalid transactions granting credit for sales returns are recorded.
Internal Control Activities
A. Shipping clerks compare goods received from the warehouse with the details on the shipping documents.
B.

Approved sales orders are required for goods to be released from the warehouse.

C.

Monthly statements are mailed to all customers with outstanding balances.

D.

Shipping clerks compare goods received from the warehouse with approved sales orders.

E.

Customer orders are compared with the inventory master file to determine whether items ordered are in stock.

F.

Daily sales summaries are compared with control totals of invoices.

G.

Shipping documents are compared with sales invoices when goods are shipped.

H.

Sales invoices are compared with the master price file.

I.

Customer orders are compared with an approved customer list.

J.

Sales orders are prepared for each customer order.

K.

Control amounts posted to the accounts receivable ledger are compared with control totals of invoices.

L.

Sales invoices are compared with shipping documents and approved customer orders before invoices are
mailed.

M.

Prenumbered credit memos are used for granting credit for goods returned.

N.

Goods returned for credit are approved by the supervisor of the sales department.

O.

Remittance advices are separated from the checks in the mailroom and forwarded to the accounting
department.

P.

Total amounts posted to the accounts receivable ledger from remittance advices are compared with the
validated bank deposit slip.

Q.

The cashier examines each check for proper endorsement.

R.

Validated deposit slips are compared with the cashiers daily cash summaries.

S.

An employee, other than the bookkeeper, periodically prepares a bank reconciliation.

T.

Sales returns are approved by the same employee who issues receiving reports evidencing actual return of
goods.

1Q-30

NUMBER 10
Green, CPA, is considering audit risk at the financial statement level in planning the audit of National Federal Bank
(NFB) Companys financial statements for the year ended December 31, 1990. Audit risk at the financial statement
level is influenced by the risk of material misstatements, which may be indicated by a combination of factors related
to management, the industry, and the entity. In assessing such factors Green has gathered the following information
concerning NFBs environment.
Company profile:
NFB is a federally-insured bank that has been consistently more profitable than the industry average by marketing
mortgages on properties in a prosperous rural area, which has experienced considerable growth in recent years.
NFB packages its mortgages and sells them to large mortgage investment trusts. Despite recent volatility of interest
rates, NFB has been able to continue selling its mortgages as a source of new lendable funds.
NFB's board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive
officer. Management at the banks branch offices has authority for directing and controlling NFB's operations and
is compensated based on branch profitability. The internal auditor reports directly to Harris, a minority shareholder,
who also acts as chairman of the boards audit committee.
The accounting department has experienced little turnover in personnel during the five years Green has audited
NFB. NFB's formula consistently underestimates the allowance for loan losses, but its controller has always been
receptive to Greens suggestions to increase the allowance during each engagement.
Recent developments:
During 1990, NFB opened a branch office in a suburban town thirty miles from its principal place of business.
Although this branch is not yet profitable due to competition from several well-established regional banks,
management believes that the branch will be profitable by 1992.
Also, during 1990, NFB increased the efficiency of its accounting operations by installing a new, sophisticated
computer system.
Required:
Based only on the information above, describe the factors that most likely would have an effect on the risk of
material misstatements. Indicate whether each factor increases or decreases the risk. Use the format illustrated
below.
Environmental factor
Branch management has authority for
directing and controlling operations.

Effect on risk of
material misstatements
Increase

NUMBER 11
Butler, CPA, has been engaged to audit the financial statement of Young Computer Outlets, Inc., a new client.
Young is a privately-owned chain of retail stores that sells a variety of computer software and video products.
Young uses an in-house payroll department at its corporate headquarters to compute payroll data, and to prepare and
distribute payroll checks to its 300 salaried employees.
Butler is preparing an internal control questionnaire to assist in obtaining an understanding of Youngs internal
control and in assessing control risk.

1Q-31

Required:
Prepare a Payroll segment of Butlers internal control questionnaire that would assist in obtaining an
understanding of Youngs internal control and in assessing control risk.
Do not prepare questions relating to cash payrolls, EDP applications, payments based on hourly rates, piece-work,
commissions, employee benefits (pensions, health care, vacations, etc.), or payroll tax accruals other than
withholdings.
Use the format in the following example:
Yes

Question
Are paychecks prenumbered and accounted for?

No

NUMBER 12
Kent, CPA, is the engagement partner on the financial statement audit of Super Computer Services Co. (SCS) for
the year ended April 30, 1998. On May 6, 1998, Smith, the senior auditor assigned to the engagement, had the
following conversation with Kent concerning the planning phase of the audit:
Kent:

Do you have all the audit programs updated yet for the SCS engagement?

Smith: Mostly, I still have work to do on the fraud risk assessment.

Kent:

Why? Our "errors and irregularities" program from last year is still OK. It's passed peer review several
times. Besides, we don't have specific duties regarding fraud. If we find it, we'll deal with it then.

Smith: I don't think so. That new CEO, Mint, has almost no salary, mostly bonuses and stock options. Doesn't that
concern you?
Kent:

No. Mint's employment contract was approved by the Board of Directors just three months ago. It was
passed unanimously.

Smith: I guess so, but Mint told those stock analysts that SCS's earnings would increase 30% next year. Can Mint
deliver numbers like that?
Kent:

Who knows? We're auditing the '98 financial statements, not '99. Mint will probably amend that forecast
every month between now and next May.

Smith: Sure, but all this may change our other audit programs.
Kent:

No, it won't. The programs are fine as is. If you find fraud in any of your tests, just let me know. Maybe
we'll have to extend the tests. Or maybe we'll just report it to the audit committee.

Smith: What would they do? Green is the audit committee's chair, and remember, Green hired Mint. They've been
best friends for years. Besides, Mint is calling all the shots now. Brown, the old CEO, is still on the Board,
but Brown's never around. Brown's even been skipping the Board meetings. Nobody in management or on
the Board would stand up to Mint.
Kent:

That's nothing new. Brown was like that years ago. Brown caused frequent disputes with Jones, CPA, the
predecessor auditor. Three years ago, Jones told Brown how ineffective the internal audit department was
then. Next thing you know, Jones is out and I'm in. Why bother? I'm just as happy that those understaffed
internal auditors don't get in our way. Just remember, the bottom line is . . . are the financial statements

1Q-32

fairly presented? And they always have been. We don't provide any assurance about fraud. That's
management's job.
Smith: But what about the lack of segregation of duties in the cash disbursements department? That clerk could
write a check for anything.
Kent:

That's a reportable condition every year and probably will be again this year. But we're talking costeffectiveness here, not fraud. We just have to do lots of testing on cash disbursements and report it again.

Smith: What about the big layoffs coming up next month? It's more than a rumor. Even the employees know it's
going to happen, and they're real uptight about it.
Kent:

I know, it's the worst kept secret at SCS, but we don't have to consider that now. Even if it happens, it will
only improve next year's financial results. Brown should have let these people go years ago. Let's face it,
how else can Mint even come close to the 30% earnings increase next year?

Required:
Begin the answer to each requirement (i.e., A, B, and C) on the top of a new page.
a. Describe the fraud risk factors that are indicated in the dialogue above.
b. Describe Kent's misconceptions regarding the consideration of fraud in the audit of SCS's financial statements
that are contained in the dialogue above and explain why each is a misconception.
c. Describe an auditor's working paper documentation requirements regarding the assessment of the risk of
material misstatement due to fraud.

NUMBER 13
A number of procedures are performed by the auditor in the assessment of control risk.
Procedures:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

The auditor tests the effectiveness of the controls.

The auditor prepares flowcharts, narratives, questionnaires, or other material.
The auditor considers the factors affecting the risk of material misstatement.
The auditor documents the reasons for assessing control risk at the maximum.
The auditor designs substantive tests.
The auditor collects evidence on the operating effectiveness of the procedures.
The auditor records the basis for determining that the controls are working as designed.
The auditor considers whether the evidence supports a lower assessed level of control risk.
The auditor applies limited substantive tests to determine whether a control is operational.
The auditor identifies the types of potential misstatement.

Required:
Match the statement that most closely relates to the procedures that an auditor may perform in this process. A
statement may be used more than once or not at all.
Statements:
A. Describes a reason for the auditor to obtain an understanding of internal control.
B. Describes what is required for an auditor to assess control risk below the maximum.
C. Describes the documentation requirements for the understanding of internal control and assessment of control
risk.
D. Describes a procedure that would not be performed.

1Q-33

NUMBER 14
AUDITING SIMULATION
During the course of an audit of an entitys financial statement, the auditor may become aware of matters related to
internal control that may be of interest to the audit committee of the Board of Directors or others of equivalent
authority.
Deficiencies in internal control design
Inadequate overall internal control design
Absence of appropriate segregation of duties consistent with appropriate control objectives
Absence of appropriate reviews and approvals of transactions, accounting entries, or systems output
Inadequate procedures for appropriately assessing and applying accounting principles
Inadequate provisions for the safeguarding of assets
Absence of other control techniques considered appropriate for the type and level of transaction activity
Evidence that a system fails to provide complete and accurate output that is consistent with objectives and
current needs because of design flaws

Failures in the operation of internal control

Evidence of failure of identified controls in preventing or detecting misstatements of accounting
information
Evidence that a system fails to provide complete and accurate output consistent with the entitys control
objectives because of the misapplication of control procedures
Evidence of failure to safeguard assets from loss, damage or misappropriation
Evidence of intentional override of the internal control structure by those in authority to the detriment of
the overall objectives of the system
Evidence of failure to perform tasks that are part of the internal control structure, such as reconciliations
not prepared or not timely prepared
Evidence of willful wrongdoing by employees or management
Evidence of manipulation, falsification, or alteration of accounting records or supporting documents
Evidence of intentional misapplication of accounting principles
Evidence of misrepresentation by client personnel to the auditor

Required: Compose an internal control letter for the ABC Corporation for the year ended December 31, 20XX.
Select at least three internal control deficiencies and/or failures that you would communicate to the client.

1Q-34

Chapter One - Solutions to Questions

Introduction, General and Field Standards
1. (a) Tests of controls are designed to determine whether the control procedures prescribed by the client are
actually functioning. An example of a test of controls would be to examine purchase orders for proper authorization.
2. (a) Data processing is a recording function and thus should be under the direction of the controller. Answers (b),
(c) and (d) are functions of the treasurer's department since they are "custodial" in nature.
3. (d) In performing an audit, the CPA may request direct assistance from internal auditors. For example, internal
auditors may assist the independent CPA in obtaining an understanding of the internal control structure or in
performing tests of controls or substantive tests.
4. (d) The auditor is required to assess the internal control structure as part of the audit process. The documentation
provides evidence that the auditor has complied with the second standard of field work. The extent and type of
documentation is left to the auditor's judgment.
5. (c) This department has access to the records necessary to prepare payroll tax reports.
6. (d) Treasurer is responsible for cash disbursements.
7. (b) There is a control weakness because the employee has both custody of an asset (cash) and the accounting
record (accounts receivable subsidiary ledgers).
8. (c) The authorization of transactions, record keeping, and custodial functions should be segregated.
9. (c) Special authorization refers to a certain item. General authorization refers to classes of items.
10. (c) Purchasing agent has authority to purchase, not authority to initiate purchases.
11. (d) Department supervisor authorizes payroll and should not be responsible for distribution (custodial
functioncustody of checks).
12. (c) The work of internal auditors is a part of, but not a substitute for, the independent auditor's evaluation of
internal control. Answer (a) is work not necessarily performed by internal auditors. Answers (b) and (d) do not
directly affect internal accounting control.
13. (b) One of the basic elements of an adequate system of internal control is competent personnel with clear lines
of authority and responsibility.
14. (d) Inquiry is the first step in determining the client's control system. The system is then tested by applying the
procedures detailed in answers (a) and (b). Answer (d) is used to verify balances, not test controls.
15. (b) The question deals with the primary questions asked in testing controls. The auditor is least concerned with
why. He performs the procedures because he is concerned with control which centers primarily on how, where and
who, as opposed to why (this is answered in the understanding of the system).
16. (b) The purchasing department's function is solely to purchase previously authorized goods and services at the
desired quality and best price. They have no function in authorization for purchase receiving or payment.

1S-1

17. (d) Substantive tests are audit tests performed to substantiate the fairness of presentation of each account on the
financial statements. The nature, timing, and extent of substantive tests is determined by the creditor's assessment of
control risk. Answers (a), (b) and (c) are synonymous terms, and these tests are used to determine whether internal
control procedures are actually in place in the client's operation.
18. (d) In order to prevent material errors in recording purchases, an employee who is independent of the purchasing
or receiving function should compare the quantity purchased with the quantity received and the quantity billed by
the vendor. This is the function of the accounts payable clerk.
19. (c) Answers (a), (b) and (d) are incorrect because the auditor can ascertain that these controls are in place by
other means through records available within the company. However, in order to determine whether a given
employee actually exists, the auditor must observe the actual distribution of checks and would usually include the
employee providing some form of personal identification.
20. (b) The auditor may document his understanding of the client's internal control through the use of a narrative,
internal control questionnaire or flowchart or any other appropriate means. Therefore, answer (b) is the correct
answer.
21. (a) The purpose of tests of controls is to provide reasonable assurance that internal controls are being applied as
determined by the auditor during the review of the internal control structure.
22. (b) The payroll accounting department has a recording responsibility and as such it should not have custody of
unclaimed payroll checks (custody of an asset). If the payroll accounting department had custody of payroll checks,
its employees could add a fictitious employee to the payroll and subsequently obtain the check.
23. (a) In an organizational structure, the personnel department is delegated the authorization power over pay rates.
24. (d) In order to evaluate the objectivity of internal auditors, it is necessary for the independent CPA to determine
the organizational level to which the internal auditor reports. If, for example, the internal auditor reports to the
controller, it would be impossible for the internal auditor to be objective.
25. (b) The receiving department copy of the purchase order should be "blind" (i.e., quantities omitted). This
ensures that the receiving department personnel count the incoming merchandise. Thus the company will end up
paying only for what was received, which may not be what was billed by the vendor.
26. (a) Control procedures over the payroll function include the reconciliation of job time tickets to employee clock
card hours. Answer (b) is incorrect because the reconciliation should be done by the payroll department, not the
individual employee responsible for those jobs.
27. (b) The supporting documentation should be canceled by the check signer (usually the treasurer) and not the
accounts payable department.
28. (c) An auditor should obtain an understanding of the internal control structure to plan the audit and to determine
the nature, timing, and extent of substantive tests to be performed. The auditor's understanding will help identify
types of potential misstatements that can occur [answer (a)] and factors that affect the risk of material misstatements
[answer (d)]. These answers affect the nature, timing, and extent of tests. Answer (c) deals with the effect of the
internal control structure on the client's operations, not its effect on the nature, timing and extent of the auditor's
tests.
29. (a) An entity's internal control structure consists of three elements: the control environment, the accounting
system, and control procedures.

1S-2

30. (c) When goods are received, they should be examined for quantity to determine agreement with the amount
ordered (purchase order) and the amount the vendor claims to have shipped (vendor's shipping document). The
receiving clerk prepares a receiving report which indicates the quantity received. Agreement of quantity on
receiving report with quantity on vendor's invoice is usually determined before payment, not at time of receipt of the
goods.
31. (a) Before checks are prepared, employees approve the vouchers for payment, match documents and verify
mathematical accuracy. Checks are prepared and then signed by an individual with proper authority who also
controls the mailing of the checks. Keeping the control of mailing with the employee who signed the checks, instead
of sending them back to an employee who performed an earlier procedure in the disbursements process, prevents
alterations of check amounts and payees.
32. (d) The second standard of field work states that, "The auditor should obtain a sufficient understanding of the
internal control structure to plan the audit and to determine the nature, timing and extent of tests to be performed."
These tests are the substantive tests for financial statement assertions. The auditor does not use the knowledge
provided by the understanding of the internal control structure and the assessed level of control risk to determine the
reliability of procedures to safeguard assets [answer (a)] and opportunities to perpetrate and conceal irregularities
[answer (b)]; instead, the safeguarding of assets and minimization of irregularities affect the understanding of the
control structure and assessment of control risk. Answer (c) is unrelated to internal control structure. Inherent risk,
which is the susceptibility of a balance or transaction to an error, and materiality judgments are not directly affected
by the control structure.
33. (b) There are three common methods the auditor uses to document his understanding of the internal control
structure (control environment, accounting system, control procedures) in the audit workpapersnarrative,
flowchart, and internal control questionnaire. Answer (a) refers to an audit program, which takes the form of a series
of procedures, not a flowchart. Answer (c) is part of what the auditor does in obtaining an understanding of the
accounting system but is not something that would typically be presented diagrammatically in a flowchart. Also, a
flowchart is not used to document the auditor's evaluation of an accounting system [answer (d)].
34. (b) After the auditor assesses control risk, he may desire a further reduction in the assessed level of control risk
for some assertions. He would then decide if it is likely that additional evidential matter could be obtained to
support a lower assessed level of control risk for these assertions. If yes, and it is likely to be efficient to obtain such
evidential matter, the auditor would then perform additional tests of controls. Next, whether the auditor performed
additional tests of controls or not, the auditor would document the basis for conclusions about the assessed level of
control risk and design substantive tests. Answer (a) incorrectly refers to tests of controls, instead of substantive
tests, as tests of financial statement assertions. Analytical procedures, used as substantive tests [answer (c)], would
not typically be performed immediately after assessing control risk, but rather after designing substantive tests.
Answer (d) might be part of tests of controls or obtaining an understanding of the control structure, neither of which
occurs immediately after assessing control risk.
35. (d) The auditor wants to determine if checks are only written after a voucher, which would be dated no later
than the check, has been approved. This is a test of validity which involves going back in a system. Answers (a) and
(b) are testing completeness by going forward in the system from vouchers to checks. Answer (c) is looking for
vouchers approved after the check is written, which is a departure from the control procedure.
36. (d) The vouchers payable department approves vendors' invoices for payment. Before approval, the invoice
should be compared with supporting documents. The other answers are desirable internal control procedures, but
they are typically performed by other departmentscash disbursements [answer (a)] and purchasing [answers (b)
and (c)].
37. (b) A weakness in controls over recording equipment retirements increases the risk that equipment which is
removed from the plant is not removed from the accounting records. When the auditor selects items in the
accounting records and tries to locate them in the plant, he may discover retired equipment that is still in the
accounting records. Answer (a) is testing the correctness of the "other assets" account, which should include
equipment that is on hand but not in use. Answer (c) is a test to determine that equipment on hand, not retired

1S-3

equipment, is included in the accounting records. Answer (d) tests accuracy and completeness of depreciation
expense.
38. (b) The entity's internal control structure consists of the control procedures, the control environment and the
accounting system. The control environment consists of management's and the board of directors' philosophy,
operating style, attitude to work controls, the entity's organizational structure, and personnel policies and
procedures. The accounting system consists of the methods and records used to identify, assemble, classify, and
record transactions. The control procedures are the policies and procedures established to provide reasonable
assurance that specific control objectives are met and include segregation of duties, authorization methods and
independent checks on performance. The organization's personnel manuals would be part of the control
environment.
39. (a) Control risk is the risk that the client's internal control structure will not be effective in preventing, detecting,
and correcting errors and irregularities in the normal course of business. Thus, if the auditor assesses control risk at
the maximum, the auditor has determined that risk of errors and irregularities being present in account balances is
very likely.
40. (c) The check signer is responsible for the mailing of the check and remittance advice. The check would not be
returned to the vouchers payable department for mailing because it could be altered as to payee and/or amount.
Answers (a), (b) and (d) are valid procedures that are performed by the vouchers payable department.
41. (b) The second standard of field work states, "The auditor should obtain a sufficient understanding of the
Internal Control Structure to plan the audit and to determine the nature, timing, and extent of tests to be performed."
42. (c) Objectivity refers to the potential bias of the internal auditor. Objectivity is enhanced by having the internal
auditor report to a level of management sufficiently removed from the accounting function (preferably the board of
directors). Answers (a), (b), and (d) relate to the competency of internal auditors rather than their objectivity.
43. (c) Because of the inherent limitations of any internal control structure it may be impossible to provide absolute
assurance that the objectives of internal control are satisfied. Reasonable assurance, which recognizes that the cost
of an entitys internal control structure should not exceed the benefits that are expected to be derived, may be
enough. Answer (a) is an example of an inherent limitation of an entitys internal control structure.
44. (a) Authorization for write-off of bad debts rests with the credit manager. The credit manager, organizationally,
reports to the treasurer.
45. (b) Detection risk is the risk that the auditor's procedures are not sufficiently extensive to discover an error or an
irregularity should one exist in an account. Detection risk is minimized by selecting a large sample size. Control risk
is the risk that the client's internal controls are not sufficient to prevent, detect, and correct errors and irregularities
in the normal course of business. Thus, when control risk is high, the auditor would choose a large sample size in
order to minimize detection risk.
46. (b) Objectivity refers to the potential biasness of the internal auditor. Objectivity is enhanced by having the
internal auditor report to a level of management sufficiently removed from the accounting function (preferably the
board of directors). Answers (a), (c) and (d) relate to the quality of the internal auditor's work rather than the
objectivity of the internal auditors.
47. (d) If the auditor does not plan to reduce the audit sample size based upon an assessment of control risk (the
auditor, for example, may consider control risk to be at the maximum), all the auditor is required to do is to
document the client's internal control structure. Answers (a), (b) and (c) imply that the auditor is planning to reduce
the audit sample size based upon an assessment of control risk which is below the maximum.
48. (a) Detection risk is the risk that the auditor's procedures will not detect an error in an account when in fact one
exists. As the auditor's assurance that there are no errors in an account balance by applying substantive procedures
is increased, the auditor's detection risk by definition may decrease.

1S-4

49. (c) Illegal acts have financial statement implications in that the client may be faced with fines or penalties as a
result of the illegal acts. Such contingencies should be recognized in the financial statements. Thus, the auditor must
obtain an understanding of the illegal acts in order to consider its potential financial statement effect.
50. (a) When detection risk decreases, the auditor will accept a smaller chance of not detecting an error; therefore,
the auditor would test more transactions. That is, the auditor would increase the scope of substantive testing.
51. (d) Once the checks have been signed, they should not be returned to any employee involved in the
disbursement cycle of the entity. Answers (a), (b) and (c) represent tasks performed by individuals in the
disbursement cycle. Therefore, these individuals should not be responsible for mailing the disbursement checks.
52. (b) The initial task in the cash receipts cycle is to establish immediate control over incoming cash receipts. This
control is achieved by listing incoming cash receipts. The task is performed by the employee responsible for
opening the mail.
53. (a) Since the auditor is working in an "attest" function, he can have no interest in the client operations or else his
objective judgment would be biased.
54. (a) The general standards concern the auditor as an individual and describe his audit competence, need for
independence, and require due professional care.
55. (c) The auditor is responsible for his report only; management is responsible for the statements and disclosures.
56. (d) General standards refer to the training and proficiency of the auditor.
57. (d) Without independence the auditor cannot objectively issue an opinion.
58. (c) The independent auditor's report should be addressed to the client, the board of directors, or the stockholders,
depending on the circumstances.
59. (d) This is a major consideration for the successor CPA to determine whether to accept the engagement. "The
successor auditor should make specific and reasonable inquiries of the predecessor regarding matters that the
successor believes will assist him in determining whether to accept the engagement."
60. (b) Engagement letters are used each time the CPA is associated with the financial statements. Their purpose is
to clarify the nature of the engagement and have management agree to this (evidenced by signing the engagement
letter).
61. (d) Answers (a), (b) and (c) involve judgment by the auditor only and as such the decision process only involves
the auditor. Answer (d), however, would necessarily have to involve the client since the client will be preparing the
schedules.
62. (d) The third general standard of GAAS states in part that "due professional care" is to be exercised in the
conduct of the audit. The implicit meaning of this standard is that each level of personnel within a CPA firm be
adequately supervised. The purpose of the review is to critically review the work done and the judgment exercised
by all staff levels.
63. (b) Generally accepted audit standards require that in a financial statement audit, the CPA is required to perform
analytical procedures in the planning stage and final review stage of the audit.
64. (a) Before accepting an audit engagement, a successor auditor should make inquiries of the predecessor auditor
in order to assist the successor auditor in deciding whether to accept the client. Answer (a) is correct because
disagreements concerning audit procedures could affect the scope of the audit and the final expression of an
opinion.

1S-5

65. (c) The third general standard is: Due professional care is to be exercised in the performance of the audit and the
preparation of the report. Exercise of due care requires critical review at every level of supervision of the work done
and the judgment exercised by those assisting in the audit. Answer (a) relates to the first general standard. Answers
(b) and (d) incorrectly include the word all. Auditors are not expected to examine all the evidence and detect all
illegal acts.
66. (a) The objective of an audit of financial statements is the expression of an opinion on the fairness with which
they present financial position, results of operations, and cash flows in conformity with generally accepted
accounting principles. When the auditor becomes aware of information concerning a possible illegal act, the auditor
should obtain sufficient information to evaluate the effect on the financial statements. Answers (b) and (c) are
implications for other aspects of the audit. The audit committee should be informed, but it is not the auditors
responsibility to recommend remedial actions, as indicated in answer (d).
67. (d) Control risk is defined as the risk that a material misstatement that could occur in an assertion will not be
prevented or detected on a timely basis by an entitys internal control structure policies or procedures. The auditor
assesses control risk as part of his overall evaluation of the risk that material misstatements may exist in the
financial statements.
68. (a) Internal control structure policies and procedures relevant to an audit are those that pertain to an entitys
ability to record, process, summarize, and report financial data consistent with management's assertions. The
auditors primary concern is the affect those policies and procedures have on the financial statement assertions.
Management override, answer (b), is an inherent limitation of internal control structures. Answer (c) is one element
of the internal control structure. Answer (d) is a factor comprising the control environment element of the internal
control structure.
69. (d) A sale typically occurs and should be recorded when goods are shipped. Matching prenumbered shipping
documents with sales journal entries is a good control to ensure that all sales are recorded. All the shipping
documents should be accounted for as either resulting in a journal entry or having been voided.
70. (d) When a bank lockbox system is used, customers send their remittances directly to the bank, thus eliminating
the possibility of employees misappropriating those cash receipts. Answers (b) and (c) do provide some control but
involve employees. Answer (a) provides protection if a theft of cash occurs, rather than preventing the
misappropriation.
71. (b) To avoid paying incorrect or duplicate amounts to vendors, the accounts payable department should compare
the quantities and prices on the vendors invoice to the quantities noted on the receiving report and to what was
requested on the purchase order. Answers (a), (c) and (d) are good controls, but do not involve the accounts payable
department. The control in answer (a) involves the receiving department. The control in answer (c) is performed by
the treasurer or cash disbursements clerk. The control in answer (d) involves the requisitioning and purchasing
departments.
72. (b) The accounting department is responsible for recording amounts due to vendors. If goods are returned to a
vendor, a debit memo should be prepared indicating that the buyer is debiting the vendors payable account. The
purchasing department may prepare the debit memo, but the accounting department needs the debit memo to record
the reduction in the account payable account.
73. (b) The objective is to determine whether checks have been issued for unauthorized expenditures that are not
supported with an approved voucher, a purchase order, and a receiving report. The direction of testing would be
from the cash disbursement back through to the beginning of the transaction. If any of the necessary documents is
missing, the expenditure may not have been authorized. Testing from the other documents forward will not reveal
unauthorized transactions because those documents provide the authorization for expenditures.

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74. (d) An auditor assesses control risk to determine the acceptable detection risk and extent of substantive tests to
perform. When an auditor plans to assess control risk at a low level, he must identify specific policies and
procedures that are likely to prevent or detect material misstatements, and he must perform tests of controls to
evaluate the effectiveness of such policies and procedures. If, based on the tests of controls, the control risk is
assessed at a low level, the auditor may limit the extent of substantive testing. Answers (a) and (c) do not include
references to tests of controls, which would be required. Answer (b) includes extensive substantive tests, which is
incorrect.
75. (a) An auditor is required to obtain an understanding of a clients internal control structure. Reviewing policies
and procedures manuals that describe a client system such as inventory and the related controls is a standard audit
step in obtaining that understanding. The procedures presented in answers (b), (c), and (d) are designed to test dollar
amounts in the financial statements, not to understand the internal control structure.
76. (c) Documents should not flow back through a system. If checks are returned to a record keeping department,
such as the payroll department as in this case, they may be misallocated or may represent unauthorized or invalid
payments, such as payments to fictitious or terminated employees in this case. The other choices are examples of
internal control strengths.
77. (a) A basic control procedure is to separate custody of assets from the record keeping for those assets. Using an
independent trust company to hold securities is a very common procedure. Answer (d), which assigns custody of the
securities to one individual in the organization, is not very practical for marketable securities, nor is it a common
control procedure. Answer (b) provides assurance at one point in time only; however, losses could occur during the
year. Answer (c) does not go beyond ledger accounts, providing no safeguard against theft of the physical securities.
78. (b) Inquiry of the predecessor auditor before accepting an audit engagement is a necessary procedure because
the predecessor auditor may be able to provide the successor auditor with information that will assist him or her in
determining whether to accept the engagement. The inquiries should include specific questions regarding the
predecessor's understanding as to the reason for the change of auditors. Answers (a), (c) and (d) are unrelated to the
question of client acceptance and would have no significance for the predecessor auditor unless they led the
successor to believe that financial statements reported on by the predecessor may require revision.
79. (c) CPA firms should have quality control systems that include policies and procedures for deciding whether to
accept or continue a client in order to minimize the likelihood of association with a client whose management lacks
integrity. Accordingly, if a new client's management probably lacks integrity, an auditor would likely not accept the
new audit engagement. Answer (b) may be a factor affecting client acceptance but, although early appointment is
preferable, an auditor may accept an engagement near or after the close of the fiscal year. The situations presented
in answers (a) and (d) would typically not arise until after the new engagement was accepted.
80. (b) The first standard of field work requires supervision of assistants, if any. Supervision involves directing the
efforts of assistants who are involved in accomplishing the objectives of the audit and determining whether those
objectives were accomplished. An element of supervision is reviewing the work performed by each assistant to
determine whether it was adequately performed and to evaluate whether the results are consistent with the
conclusions to be presented in the auditor's report. Answer (a) refers to quality control standards that are CPA-firm
based and distinct from the responsibility of individuals to adequately supervise each assistant on a particular
engagement. Answer (c) refers to audit procedures, which would be approved as part of the planning process, not
as part of the review process. Answer (d) relates to the first general standard which requires that the audit be
performed by person(s) with adequate training and proficiency, rather that to the review of assistant's work, which is
the supervision requirement of the first field work standard.
81. (d) An auditor obtains knowledge about a new client's business and its industry as part of audit planning. The
auditor should obtain a level of knowledge of the entity's business that will enable him or her to plan and perform
the audit in accordance with generally accepted auditing standards. That level of knowledge should enable him or
her to obtain an understanding of the events, transactions, and practices that may have a significant effect on the
financial statements. Knowledge of a client's business and industry can help an auditor provide constructive
suggestions, answer (a), and evaluate misstatements, answer (c), but the reason to obtain such knowledge is to plan

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the audit engagement. All audits should be planned and performed with an attitude of professional skepticism,
answer (b). This skepticism is not developed by obtaining knowledge about a client's business and industry.
82. (a) The auditor's responsibility in regard to illegal acts having a direct and material affect on the financial
statements is the same as that for errors and irregularities; that is, to design the audit to provide reasonable assurance
of detecting such illegal acts. An audit provides no assurance that illegal acts that have an indirect effect on the
financial statements will be detected because the auditor, who is proficient in accounting and auditing, does not
have sufficient basis for recognizing all possible violations of laws and regulations and may not become aware of
these illegal acts unless informed by the client.
83. (d) If the auditor concludes that an illegal act has a material effect on the financial statements, and the act has
not been properly accounted for or disclosed, the auditor should express a qualified or adverse opinion. If the client
refuses to accept the auditor's report, the auditor should withdraw from the engagement and indicate the reasons for
withdrawal in writing to the audit committee or board of directors. Answer (a) would cause the auditor to disclaim
an opinion on the financial statements, which would not result in withdrawing from the engagement unless the client
refused to accept the disclaimer. Answer (b) would not result in withdrawal if the client properly accounts for the
illegal act. Answer (c) would not result in withdrawal if the client properly discloses the contingency and/or the
auditor includes the uncertainty in the auditor's report.
84. (c) An audit of financial statements in accordance with generally accepted auditing standards should be planned
and performed with an attitude of professional skepticism, which means that the auditor neither assumes that
management is dishonest nor assumes unquestioned honesty. The auditor attributes of objectivity, independence,
integrity, impartiality, and conservatism presented in answers (a), (b) and (d) are desirable, but not specifically
required in planning and performing an audit.
85. (d) The auditor must document the understanding of a client's internal control structure. Such documentation
may include flowcharts, questionnaires, decision tables, or memorandum. Flowcharts, which are diagrams that
show a sequence of operations or processes, would not typically be used to describe or depict other work done by
the auditor in meeting the second standard of field work regarding internal control structure. Thus, although the
auditor would perform the activities listed in answers (a), (b) and (c), he or she would probably use means other
than flowcharts to document the work that was done.
86. (c) The control environment represents the collective effort of various factors on enhancing or mitigating the
effectiveness of specific control procedures and policies. Management's philosophy and operating style is a factor
that has a significant influence on the control environment, particularly when management is dominated by one or a
few individuals. Characteristics of management philosophy and style include management's approach to taking and
monitoring business risks; management's attitudes and actions toward financial reporting; and management's
emphasis on meeting budget, profit, and other financial and operating goals.
Audit committees, answer (a),
external influences, answer (b), and an internal audit function, answer (d), are also control environment factors.
However, domination of management by one individual who is also a shareholder is a control environment factor
that could have significantly more influence on the effectiveness of control procedures and policies - especially in a
negative way.
87. (b) The auditor should obtain sufficient knowledge of the accounting system to understand the classes of
transactions in the entity's operations that are significant to the financial statements; how those transactions are
initiated; the accounting records, supporting documents, and specific accounts involved in processing and reporting
transactions; the accounting processes involved from the initiation of a transaction to its inclusion in the financial
statements, including how the computer is used; and the financial reporting process used to prepare financial
statements, including significant estimates and disclosures. The process to prepare significant estimates is thus part
of the accounting system, which consists of the methods and records established to identify, assemble, analyze,
classify, record, and report an entity's transactions and to maintain accountability for the related assets and
liabilities. Answers (a), (c) and (d) are examples of control procedures and do not fall under the accounting system
definition.

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88. (b) The auditor should concentrate on the substance of management's policies, procedures, and related actions
rather than their form because management may establish appropriate policies and procedures but not act on them.
Answer (a) is incorrect because the lack of documentation is a form issue whereas operating effectiveness relates to
substance, which is what interests the auditor. Answer (c) is incorrect because if the auditor does not plan to rely,
the difference between form and substance is irrelevant. Answer (d) is not related to the question in that it deals
with management's cost/benefit evaluation of implementing controls, not substance v. form.
89. (a) Segregating incompatible duties is a typical control procedure. Thus, the existence of incompatible duties is
a weakness in control procedures, not an inherent limitation of the internal control structure. Even if control
policies and procedures are placed in operation, the potential effectiveness of an entity's internal control structure is
subject to inherent limitations. Mistakes in the application of policies and procedures may arise from such causes as
mistakes in judgment, which is answer (c), as well as personal carelessness, fatigue, and distraction. Also, policies
and procedures that require segregation of duties can be circumvented by management override or collusion among
internal or external parties, which are answers (b) and (d).
90. (a) After obtaining an understanding of the internal control structure and assessing control risk, the auditor may
desire a further reduction in the assessed level of control risk for certain assertions. In such cases, the auditor
considers whether additional evidential matter sufficient to support a further reduction is likely to be available, and
whether it would be cost efficient to perform tests of controls to obtain that evidential matter. If the auditor decides
not to perform additional tests it is likely that the auditor concluded that additional evidence to support a further
reduction in control risk was not likely to be available or was not cost beneficial to obtain, which is the answer in
this case. Answer (b) is incorrect because inherent risk has no direct bearing on the assessment of control risk.
Answer (c) is incorrect because the design of the internal control structure has to be tested for effectiveness in order
to rely on the controls. The word "increase" makes answer (d) incorrect.
91. (b) If the auditor is concerned with completeness, he or she would test the client's controls that are designed to
determine that all sales that occur are recorded. These controls could include the entity accounting for all
prenumbered shipping documents, which provide the basis for recording sales, to determine that none have been
omitted. Answer (a) deals with mathematical accuracy, not completeness. Answers (c) and (d) deal with
authorization of prices and credit, not with completeness.
92. (a) If an entity wants to be sure that all billed sales are correctly posted to the accounts receivable subsidiary
ledger, an internal control procedure that compares invoices or billings to the subsidiary ledger entries should be
designed. Thus, comparing daily summaries of billed sales to daily postings to the receivables ledger will provide
the necessary assurance. Answers (b) and (d), which compare invoices and shipments, do not include any
comparisons with postings to the accounts receivable ledger. Answer (c), which compares general and subsidiary
ledgers, does not include comparisons to billings or invoices.
93. (c) Authorization and recording are incompatible functions that should be assigned to different individuals. In
this case, authorization of payroll changes, which is typically the responsibility of the human resources department,
should be segregated from recording payroll, which is the responsibility of the payroll department. If the payroll
department supervisor is responsible for these two functions, the entity's internal control structure may be
inadequate to prevent or detect material misstatements in the payroll area. Thus, the auditor would assess control
risk at the maximum. Answers (a) and (b) are activities that the payroll department supervisor may want to perform
to verify the accuracy of the payroll and are compatible with the payroll department's responsibility. Answer (d) is
compatible with payroll department activities. Although it might be preferable for the human resources or
personnel department to be responsible for the formal hiring of employees, departments such as payroll must get
involved in the hiring process when it involves their department employees.
94. (b) The accounts payable, or vouchers payable, department has the responsibility to prepare vouchers for
payment. As part of that process, an employee in that department should check vendors' invoices for mathematical
accuracy by recomputing calculations and extensions, and should match the vendors' invoices with receiving reports
and purchase orders for quantities, prices, and terms. Answers (a) and (c) are posting and reconciling activities that
should be performed by accounting department employees who are not involved in preparing vouchers for payment.
Answer (d) is incorrect because an employee in the treasurer's department should cancel invoices after they are paid.

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95. (c) Time tickets should be designed to keep track of hours worked, by whom, and on what production orders.
After approval by a production supervisor, time tickets provide the information on number of hours worked directly
on specific production orders. If time tickets are properly used to record actual hours worked on orders, approval
and/or review of these cards should prevent direct labor hours from being incorrectly charged to manufacturing
overhead. Answer (a) is incorrect because counts of work in process will not provide breakdowns between direct
and indirect costs and therefore would not prevent direct labor hours from being incorrectly charged to overhead.
Answer (b) is incorrect because errors may be made on the production orders. In order to prevent and/or detect
errors regarding direct labor hours, the production orders would have to be compared to time tickets. Answer (d) is
incorrect because work-in-process inventory is a total which combines direct labor and manufacturing overhead.
Even if this total is correct, direct labor could have been incorrectly charged to manufacturing overhead.
96. (d) Accurate inventory records would reflect actual quantities in existence. If a company periodically counts
inventory and adjusts the perpetual inventory records accordingly, those inventory records are likely to be accurate.
Answer (a) is incorrect because current cost may not be the basis used to value inventory; a company may be using
last-in-first-out, standard costs, lower of cost or market, etc. Answer (b) addresses management's concern about
excessive inventory levels, not the accuracy of inventory records. Answer (c) is a procedure that relates to the
accuracy of amounts paid to vendors.
97. (a) The valuation or allocation assertion concerns collectibility of receivables. That is, accounts receivable
should be valued at estimated net realizable value, after deducting an allowance for uncollectible accounts. If an
entity has credit approval policies, the gross and net amounts presented for receivables on the balance sheet are
more likely to be fairly stated. The completeness assertion in answer (b) is concerned with whether or not all sales
that have occurred are recorded, not whether or not those sales will generate collectible receivables. The existence
or occurrence assertion in answer (c) is concerned with whether or not recorded sales and receivables are valid and
not fictitious, rather than the amount collectible. The rights and obligations assertion in answer (d) is concerned
with whether or not the entity owns the receivable, not the amount collectible.
98. (d) AU 311 states that the procedures that an auditor may consider in planning the audit usually involve a review
of his records relating to the entity and discussion with other firm personnel and personnel of the entity. An example
of those procedures is to determine the extent of involvement, if any, of consultants, specialists, and internal
auditors. Choice (a) is incorrect because a written representation letter is required, but is not a part of the planning
process (it is obtained the last day of field work). Choice (b) is incorrect because an auditor must consider illegal
acts that might have a material effect on the financial statements, but that is not part of the planning process. Choice
(c) is incorrect because determining the reasonableness of accounting estimates is accomplished by gathering
evidence that support the estimations in the field work phase and not in the planning stage.
99. (c) AU 319 states that the auditor's understanding of the internal control structure may sometimes raise doubts
about the auditability of an entity's financial statements. Concerns about the integrity of the entity's management
may be so serious as to cause the auditor to conclude that the risk of management misrepresentations in the financial
statements is such that an audit cannot be conducted. Concerns about the nature and extent of an entity's records
may cause the auditor to conclude that it is unlikely that sufficient competent evidential matter will be available to
support an opinion on the financial statements. Choice (a) is incorrect because the complexity of the accounting
system would not influence the auditor negatively. Choice (b) is incorrect because related party transactions would
be closely scrutinized by the auditor but would not influence the auditor negatively. Choice (d) is incorrect because
the operating effectiveness of the control procedure would influence the level of risk the auditor is willing to assume
but not the auditability of the financial statements.
100. (a) AU 315 states that the initiative in communicating rests with the successor auditor. The communication
may be either written or oral. Both the predecessor and successor auditors should hold in confidence information
obtained from each other. This obligation applies whether or not the successor accepts the engagement. Before
contacting the predecessor, the successor auditor must have the permission from the client to do so.

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101. (a) AU 311 states that a pre-engagement audit conference is a meeting between the senior auditor and the other
members of the audit team to discuss the time and review the general plan of the audit. Specific personnel are
assigned to specific areas at that time and each member of the team is evaluated to determine that each member is
independent of the client. A list of related parties is distributed to enable staff members to recognize related party
transactions when they encounter them. Choices (b) and (c) could be part of the discussion, but they are not the
primary reasons for the meeting. Furthermore, the initial time budget is the responsibility of the partner and the
senior in charge and the decision to rely on specialists and internal auditors is not made by the audit staff. Choice
(d) is incorrect because disagreements regarding technical issues are discussed and resolved after field work has
started.
102. (b) AU 311 states that knowledge of an entity's business is ordinarily obtained through experience with the
entity or its industry and inquiry of personnel of the entity. Working papers from prior years may contain useful
information about the nature of the business, organizational structure, operating characteristics, and transactions that
may require special consideration. Other sources may be audit guides, industry publications, financial statements of
other entities in the industry, textbooks, periodicals, and individuals knowledgeable about the industry. Choice (a) is
incorrect because tests of transactions and balances will not provide the auditor with an overall understanding of the
client's business. Choice (c) might be correct for a new client, but the question states that this is a continuing client.
The firm has obtained an understanding of the client's business in prior years and documented that understanding in
the working papers. Choice (d) is incorrect because evaluating the internal control environment will not provide the
auditor with an overall understanding of the client' s business.
103. (a) AU 311 states that the auditor should consider the methods the entity uses to process accounting
information because such methods influence the design of the internal control structure. The extent to which
computer processing is used in accounting applications, as well as the complexity of that processing, may also
influence the nature, timing, and extent of audit procedures. Choices (b), (c), and (d) are incorrect because
materiality, audit objectives, and acceptable level of audit risk are not based on the methods used to process
accounting information.
104. (b) AU 312 states that, in planning the audit, the auditor should use judgment as to the appropriately low level
of audit risk and the preliminary judgment about materiality levels in a manner that can be expected to provide,
within the inherent limitations of the auditing process, sufficient evidential matter to obtain reasonable assurance
about whether the financial statements are free of material misstatement. Materiality levels include an overall level
for each statement; however, because the statements are interrelated, and for reasons of efficiency, the auditor
ordinarily considers materiality for planning purposes in terms of the smallest aggregate level of misstatements that
could be considered material to any one of the financial statements. For example, if misstatements aggregating
approximately $100,000 would have a material effect on income but such misstatements would have to aggregate
approximately to $200,000 to materially affect financial position, it would not be appropriate to design auditing
procedures that would be expected to detect misstatements of approximately $200,000. The lower amount is
normally used. Choice (a) is incorrect because the concept of materiality recognizes that some matters are important,
while other matters are not, for fair presentation of financial statements in conformity with GAAP. Choices (c) and
(d) are incorrect because the auditor's consideration of materiality is a matter of professional judgment and is
influenced by a perception of the needs of a reasonable person who will rely on the financial statements. Materiality
is "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding
circumstances, makes it probable that the judgment of a reasonable person relying on the information would have
been changed or influenced by the omission."
105. (d) AU 316 states that if a condition or circumstance differs adversely from the auditor's expectation, the
auditor needs to consider the reason for such a difference. For example:
Analytical procedures disclose significant differences from expectations.
Significant unreconciled differences between reconciliations of a control account and subsidiary records.
Confirmation requests disclose significant differences or yield fewer responses than expected.
Transactions selected for testing are not supported by proper documentation.
Supporting records or files that should be readily available are not promptly produced when requested.
Audit tests detect errors that apparently were known to client personnel, but were not voluntarily disclosed.

1S-11

When such conditions exist, the planned scope of audit procedures should be reconsidered. As the differences from
expectations increase, the auditor should consider whether the assessment of the risk of material misstatement of the
financial statements made in the planning stage of the engagement is still appropriate. Choices (a) and (b) are
encouraging factors that management is not willing to circumvent the rules just to meet earnings projections and
that the board of directors makes all financial decisions. Choice (c) is incorrect because uncorrected conditions do
not necessarily mean that material misstatements exist.
106. (b) AU 322 states that when assessing the internal auditors' competence, the auditor should obtain or update
information from prior years about such factors as:
Educational level and professional experience of internal auditors.
Professional certification and continuing education.
Audit policies, programs, and procedures.
Practices regarding assignment of internal auditors.
Supervision and review of internal auditors' activities.
Quality of working-paper documentation, reports, and recommendations.
Evaluation of internal auditors' performance.
Choices (a), (c), and (d) are not among the factors listed above.
107. (d) AU 319 states that control procedures are those policies and procedures, in addition to the control
environment and accounting system, that management has established to provide reasonable assurance that specific
entity objectives will be achieved. Control procedures have various objectives and are applied at various
organizational and data processing levels. They may also be integrated into specific components of the control
environment and the accounting system. Generally, they may be categorized as procedures that pertain to:
Proper authorization of transactions and activities.
Segregation of duties that reduce the opportunities to both perpetrate and conceal irregularities, assigning
different people the responsibilities of authorizing transactions, recording transactions, and maintaining custody
of assets.
Design and use of adequate documents and records to help ensure the proper recording of transactions and
events, such as monitoring the use of prenumbered shipping documents.
108. (b) AU 319 states that, for purposes of an audit of financial statements, an entity's internal control structure
consists of the three following elements:
1) The control environment

2) The accounting system

3) Control procedures

Dividing the internal control structure into three elements facilitates discussion of its nature and how the auditor
considers it in an audit. The auditor's primary consideration, however, is whether an internal control structure policy
or procedure affects financial statement assertions rather than its classification into any particular category. Choice
(a) is incorrect because managements philosophy and style are considered part of the environment but not as a
primary concern. Choice (c) is incorrect because safeguarding against access to assets is a control procedure. Not all
control procedures, however, are related to access to assets. Choice (d) is incorrect because, although managements
decision making process is important, it does not primarily relate to an audit.
109. (c) AU 319 states that detection risk is the risk that an error or irregularity won't be detected by the audit. It is
unrelated to the client's control environmental factors. The control environment represents the collective effect of
various factors on establishing, enhancing, and mitigating the effectiveness of specific policies and procedures such
as:
Management's philosophy and operating style.
The entity's organizational structure.
The functioning of the board of directors and its committees, particularly the audit committee.
Methods of assigning authority and responsibility.
Management's control methods for monitoring and following up on performance, including internal auditing.
Personnel policies and practices.
Various external influences that affect an entity's operations and practices.

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110. (b) AU 319 states that the ultimate purpose of assessing control risk is to contribute to the auditor's evaluation
of the risk that material misstatements exist in the financial statements. The process of assessing control risk
(together with assessing inherent risk) provides evidential matter about the risk that such misstatements may exist in
the financial statements. The auditor uses this evidential matter as part of the reasonable basis for an opinion.
Choice (a) is incorrect because failure to identify procedures relevant to assertions is not the ultimate purpose of
assessing risk. Choices (c) and (d) are incorrect because collusion or management that override policies are inherent
risks that the auditor cannot totally eliminate and therefore cannot be the ultimate purpose of assessing control.
111. (a) AU 319 states that when the auditor assesses control risk at below the maximum level, he should obtain
sufficient evidential matter to support that assessed level. The type of evidential matter, its source, its timeliness,
and the existence of other evidential matter related to the conclusion to which it leads, all bear on the degree of
assurance evidential matter provides. These characteristics influence the nature, timing, and extent of the tests of
controls that the auditor applies to obtain evidential matter about control risk. The auditor selects such tests from a
variety of techniques such as inquiry, observation, inspection, and reperformance of a policy or procedure that
pertains to an assertion. No one specific test of controls is always necessary, applicable, or equally effective in every
circumstance. Choices (b), (c), and (d) are incorrect because they are direct tests of financial statement balances
(substantive tests), and not tests of controls which provide evidence about control risk.
112. (c) AU 319 states that the auditor may make a preliminary assessment of control risk at less than a high level
only when the auditor:

is able to identify policies and procedures of the accounting and internal control systems relevant to specific
assertions which are likely to prevent or detect material misstatements in the financial statements; and
plans to perform tests of control to support the assessment.

Choice (a) is incorrect because analytical procedures or tests of reasonableness test amounts of financial data.
Choice (b) is incorrect because tests of details are performed as a substantive test to determine material mistakes in
the financial statements. Choice (d) is incorrect because, if the audit effort of performing tests of controls exceeds
the potential reduction in substantive testing, tests of controls will not be performed because doing so would reduce
audit efficiency.
113. (a) AU 350 states that the risk of incorrect rejection and the risk of assessing control risk too high relate to the
efficiency of the audit. If the auditor's evaluation of a sample leads him to unnecessarily assess control risk too high
for an assertion, he would ordinarily increase the scope of substantive tests to compensate for the perceived
ineffectiveness of the internal control structure policy or procedure. Although the audit may be less efficient in these
circumstances, the audit is, nevertheless, effective. Choice (b) is incorrect because tests of controls are not designed
to directly detect misstatements. Tests of controls directed toward the operating effectiveness of an internal control
policy and procedure are concerned with how the policy is applied, and how consistent and by whom it was applied.
Choice (d) is incorrect because tolerable errors are related to substantive tests of details.
114. (c) A copy of the remittance listing is sent to the accounts receivable clerk and posted to the subsidiary records.
Accounting for assets is a function that should be separated from the custody of those assets. The accounts
receivable bookkeeper maintains records of the balance owed by each customer, while the cashier has custody of the
cash. The cashier does not have an opportunity to cover a shortage of cash by using checks received on account
because the AR ledger would indicate a different balance than that owed. There is no need to send copies to the
internal auditor, the treasurer, or the bank, because the goal is to establish accountability for the asset.
115. (d) The treasurer has responsibility for custody of assets; therefore, authorizing the write-off of a receivable (an
asset) is the responsibility of the treasurer. Choice (a) is incorrect because A/R is an accounting function that should
be separated from the custody of the asset. Choice (b) is incorrect because the credit department authorized credit to
customers and they should not be in the position of writing-off what they authorized. Choice (c) is incorrect because
the accounts payable department has nothing to do with receivables.

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116. (d) The reconciliation provides evidence that sales which have been invoiced are recorded in the accounts
receivable subsidiary ledger but does not reduce the risk of errors in billing. Choice (a) is incorrect because it
reduces the risk of errors in the billing process by providing evidence that all items shipped were included in the
sales invoices. Choice (b) is incorrect because it reduces the risk of errors in the billing process by controlling the
mathematical accuracy of the computations on the sales invoices. Choice (c) is incorrect because matching shipping
documents with sales orders reduces the risk of errors in the billing process by providing evidence that approved
sales orders were shipped before being invoiced.
117. (b) AU 326 states that assertions about existence or occurrence deal with whether assets or liabilities of the
entity exist at a given date and whether recorded transactions have occurred during a given period. For example,
management asserts that finished goods inventories in the balance sheet are available for sale, or management
asserts that sales in the income statement represent the exchange of goods or services with customers for cash or
other consideration. Choice (a) is incorrect because tracing supports completeness. Choices (c) and (d) are incorrect
because valuation and rights would not be tested from the voucher register to the supporting documents.
118. (d) The unused forms should be accounted for by the department in which the forms are prepared - purchase
orders in the purchasing department and receiving reports in the receiving department. Choice (a) is incorrect
because the reconciliation of vouchers payable with the receiving report is done before the authorization of payment
of the invoice. Choice (b) is incorrect because vouchers payable should approve vouchers for payment by having an
authorized employee sign the voucher. Choice (c) is incorrect because vouchers payable should indicate on the
voucher the accounts to be debited when the voucher is authorized for payment.
119. (d) An internal control questionnaire concerning the initiation and execution of equipment transactions would
not be concerned with equipment that is owned and in place because it is not part of the current transactions. Choice
(a) is incorrect because requests for major repairs should be authorized at a higher level to control the use of the
assets. Choice (b) is incorrect because prenumbered purchase orders should be used for the purchases. Choice (c) is
incorrect because requests for purchases of equipment should be reviewed for consideration of soliciting bids.
120. (d) AU 319 states that the substantive tests that the auditor performs consist of tests of details of transactions
and balances and analytical procedures. In assessing control risk, the auditor also may use tests of details of
transactions as tests of controls. The objective of tests of details of transactions performed as substantive tests is to
detect material misstatements in the financial statements. The objective of tests of details of transactions performed
as tests of controls is to evaluate whether an internal control structure policy or procedure operated effectively.
Although these objectives are different, both may be accomplished concurrently through performance of a test of
details on the same transaction. The auditor should recognize, however, that careful consideration should be given
to the design and evaluation of such tests to ensure that both objectives will be accomplished. Choices (a), (b), and
(c) are incorrect because tests of details would not be used to monitor the design of the documents, nor the internal
control policy, nor to detect material misstatements.
121. (b) The auditor is looking for evidence to prove that goods shipped are properly billed. To accomplish the
completeness of the billing process for all goods shipped, it is necessary to sample from a population that includes
all goods shipped by examining a sample of shipping documents and tracing them to matching sales invoices.
122. (d) AU 322 states that in assessing competence and objectivity, the auditor usually considers information
obtained from previous experience with the internal audit function, from discussions with management personnel,
and from a recent external quality review, if performed, of the internal audit function's activities. The auditor may
also use professional internal auditing standards as criteria in making the assessment. If the auditor determines that
the internal auditors are sufficiently competent and objective, the auditor should then consider how the internal
auditors' work may affect the audit. The other choices are all considered by the auditor as per above and therefore
incorrect.
123. (d) The client is responsible for counting inventory and the auditor is responsible for observing the client's
count. Since the timing of the observation depends on the timing of the count, there must be agreement between the
auditor and client regarding the inventory observation procedures before the auditor finalizes an audit strategy for
inventory. Answers (a), (b) and (c) are evidence-gathering issues that are decided by the auditor without specific

1S-14

regard to timing and other client concerns. Independently of the client, the auditor determines the extent of evidence
needed in the audit, the nature of procedures to follow in the audit, and the scope of issues to be addressed in a legal
letter.
124. (d) A successor auditor is required to make inquiries of the predecessor auditor regarding matters that the
successor believes will assist him in determining whether he should accept a new audit engagement. The inquiries,
which focus on the integrity of management and the reasons for the change in auditors, should include specific
questions regarding disagreements with management as to accounting principles, auditing procedures, or other
similarly significant matters. Answers (a) and (b) are issues which may surface when the successor communicates
with the predecessor auditor, but are not directly related to the client acceptance decision. Answer (c) is unrelated to
the successor/predecessor interaction.
125. (d) An engagement letter sets forth the terms of the engagement and the level of responsibility the auditor is
assuming in the engagement. Typical points covered include the type of service to be performed, dates covered,
professional standards to be followed, description of procedures to be employed, limited responsibility for detection
of fraud, report on control deficiencies, other work to be performed, client assistance, and fees. The engagement
letter does not typically include statements regarding future discussions about audit procedures after analytical
procedures are performed. Answers (a), (b) and (c) are examples of points that are usually included in an
engagement letter.
126. (b) As part of planning, an auditor is required to use analytical procedures to enhance the auditor's
understanding of the client's business and to identify areas that may represent specific risks relevant to the audit.
Analytical procedures involve comparisons of financial statement amounts to expectations developed by the auditor.
Anticipated results, such as budgets and forecasts, is one source for developing such expectations. Other sources
include prior period information, current period relationships within the financial statements, industry information,
and relevant nonfinancial information. Answers (a) and (d) are procedures that are typically performed at the end of
the audit, not during the planning stage. Answer (c) is a test of controls, not a planning procedure.
127. (b) Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of
the audit and determining whether those objectives were accomplished. The in-charge auditor, as part of his
supervisory responsibility, should review the work of each assistant to determine whether it was adequately
performed and to evaluate whether the results are consistent with the conclusions to be presented in the auditor's
report. This review and evaluative process should be explained to staff assistants by the in-charge auditor. Answers
(a), (c) and (d) are issues that the in-charge may discuss with assistants but they are related more to staff
development than to the in-charge's supervisory responsibility.
128. (b) In planning the audit, the auditor should consider his preliminary judgment about materiality levels. In
some situations, this is done before the financial statements under audit have been prepared. In such a situation, the
auditor's preliminary judgment about materiality might be based on the entity's annualized interim statements, or
financial statements of one or more prior annual periods. Answers (a), (c) and (d) are incorrect because the auditor's
preliminary judgment about materiality levels is considered in planning the audit, before sample sizes and
substantive test are planned, and before internal control questionnaires and management representation letters are
prepared.
129. (b) Detection risk is the risk that the auditor will not detect a material misstatement that exists in an assertion.
As the acceptable level of detection risk decreases, the assurance provided from substantive tests should increase.
Since applying substantive tests as of an interim date rather than as of the year-end potentially increases the risk that
misstatements that may exist will not be detected, if the auditor wants to decrease detection risk, he may decide to
perform substantive tests at year-end rather than at an interim date. Answer (a) is incorrect because substantive tests
should be increased when allowable detection risk decreases. Answer (c) is incorrect because inherent risk cannot
be ignored. Answer (d) is incorrect because control risk cannot be lowered without additional testing of controls.

1S-15

130. (c) Material misstatements, including intentional manipulation of financial statements, are more likely to occur
when management places undue emphasis on meeting earnings projections, especially if compensation is affected
by meeting earnings targets. Another management characteristic that increases the risk of intentional manipulation is
high turnover of senior accounting personnel, not the low turnover indicated in answer (a). Similarly, a rapid rate of
change in an entity's industry would heighten an auditor's concern rather than a slow rate of change, as presented in
answer (d). The auditor may be more concerned if insiders are selling stock, rather than purchasing stock, as
presented in answer (b).
131. (d) The third general standard requires the independent auditor to perform his work with due care. Exercise of
due care requires critical review at every level of supervision of the work done and the judgment exercised by those
assisting in the audit. Answer (a) is incorrect because it is related to the second standard of field work, not the third
general standard, and because the auditor may not thoroughly review all controls in all engagements. Answer (b) is
incorrect because the auditor would thoroughly review indications of fraud and illegal acts, rather than limit his
review. Answer (c) is incorrect because it is related to the first general standard, not the third, and because the
adequacy of training and proficiency is not something the auditor objectively reviews.
132. (a) The second standard of field work requires the auditor to obtain an understanding of the internal control
structure to plan the audit. The primary objective, therefore, of performing procedures to obtain that understanding
is to provide the auditor with the knowledge necessary for audit planning. Answer (b) deals with inherent risk,
which is assessed independent of the internal control structure. Answer (c) refers to tests of controls, modification of
which would be based on information obtained after initially designing those tests. Evaluating consistent application
of management policies, answer (d), may be of interest to the auditor but it is not the primary objective of
performing procedures to understand the internal control structure.
133. (c) An entity's internal control structure consists of three elements: the control environment, the accounting
system, and control procedures. The control environment reflects the overall attitude, awareness, and actions of the
board of directors, management, owners, and others concerning the importance of control and its emphasis in the
entity. Answers (a), (b) and (d) are examples of control procedures.
134. (d) Because of the inherent limitations of any internal control structure, it may be impossible to provide
absolute assurance that the objectives of internal control are satisfied. Reasonable assurance, which recognizes that
the cost of an entity's internal control structure should not exceed the benefits that are expected to be derived, may
be enough. Answers (a) and (c) are correct statements about the internal control structure, but they are unrelated to
the concept of reasonable assurance. Answer (b), which is also unrelated to the concept of reasonable assurance, is
incorrect because adequate safeguards over access to assets and records would not be enough to maintain proper
accountability; additional controls would be necessary.
135. (c) Assessing control risk is the process of evaluating the effectiveness of an entity's internal control structure
in preventing or detecting material misstatements in financial statement assertions. Thus, control risk should be
assessed in terms of those financial statement assertions. Answers (a) and (d) refer to control procedures and control
environment factors, which, as elements of the internal control structure, provide input for assessing control risk.
Answer (b) is incorrect because control risk assessment is concerned not only with potential irregularities, which are
intentional misstatements, but also with unintentional errors.
136. (c) The initial task in the cash receipts cycle is to establish immediate control over incoming cash receipts. This
control is achieved by having the employee who is responsible for opening the mail prepare listings of checks
received. Answers (a) and (d) are procedures that should be performed later in the processing of cash receipts as
checks are deposited and recorded. Answer (b) is not a control procedure that is typically found in the cash receipts
cycle.
137. (a) Some internal control procedures, such as the segregation of duties, may not generate an audit trail of
documents that the auditor can inspect. The auditor can test this type of control procedure by making inquiries of
client personnel and observing who performs what duties. Answers (b) and (c) are procedures that relate more to
substantive tests of financial statement amounts, rather than to tests of controls. Answer (d) is incorrect because

1S-16

segregation of duties related to inventory is a control that is not evidenced by documents that the auditor can
inspect.
138. (a) If the controls appear to be effective, the auditor would test the controls and if they were found to be
effective the auditor would assess control risk below the maximum and reduce the extent of substantive testing.
These tests of controls should only be performed when it is efficient to do so. It would be efficient if less time and
effort would be spent testing controls than could be saved in substantive tests due to the lower control risk
assessment. Answer (b) is incorrect because if the auditor does not expect to find evidence to support a reduction in
his control risk assessment, he will not perform additional tests of controls. Answers (c) and (d) are incorrect
because tests of controls are performed when control risk assessments are decreasing and there are internal control
strengths, not when control risk is increasing and there are weaknesses in controls.
139. (b) In order to avoid duplicate payments, an entity's check signer should cancel the documents supporting the
payment and stamp the voucher as "paid." If the auditor wants assurance that vouchers are not paid more than once,
the auditor would select a sample of paid vouchers and determine if they have been stamped "paid." Answers (a)
and (d) are incorrect because the auditor would determine if each voucher is supported by a vendor's invoice and is
approved for authorized purchases if the auditor wanted assurance that the payment was for a valid authorized
purchase, not to determine that vouchers have been paid only once. Answer (c) is incorrect because the auditor
would determine that vouchers are prenumbered and accounted for if the auditor wanted assurance that no vouchers
were lost or omitted.
140. (c) In making judgments about the extent of the effect of an internal auditor's work on the CPA's auditing
procedures, the CPA should consider the materiality of financial statement amounts, the risk of material
misstatement, and the degree of subjectivity involved in the evaluation of the audit evidence gathered in support of
the assertions. Work done by internal auditors related to assertions about fixed asset additions, because such
assertions involve a low degree of subjectivity and may have a lower risk of material misstatement, will likely affect
the CPA's auditing procedures. Answers (a), (b) and (d) deal with contingencies, valuation, and related-party
transactions, which are examples of assertions that might have high risk or involve a high degree of subjectivity.
141. (d) If the independent auditor decides that it would be efficient to consider how the internal auditors' work
might affect the audit, the independent auditor should assess the competence and objectivity of the internal audit
function. When assessing objectivity, the auditor should determine the organizational status of the internal auditor,
including the level to which the internal auditor reports. Answers (a), (b) and (c) are procedures that the independent
auditor would perform to assess the internal auditors' competence, not objectivity.
142. (a) The auditor should obtain an understanding of a client's internal control structure, including knowledge
about the design of relevant policies, procedures and records and whether they have been placed in operation by the
entity. In planning the audit, such knowledge should be used to identify types of material misstatements, consider
factors that affect the risk of material misstatements, and design substantive tests. Answer (b), which refers to
operational efficiency, is a management concern rather than a planning objective of the auditor. Answer (c) is
incorrect because the potential for collusion is an inherent limitation of an entity's internal control structure.
Accordingly, based only on the auditor's knowledge of the design of control policies and procedures, the auditor
cannot determine if controls have been circumvented by collusion. Answer (d) is incorrect because the auditor, after
obtaining knowledge about the design of control policies and procedures, must also evaluate the internal control
structure before documenting the assessed level of control risk in the workpapers.
143. (b) The auditor's understanding of an entity and its internal control structure may raise doubts about the
auditability of that entity's financial statements. For example, concerns may arise about the integrity of the entity's
management. These concerns may be so serious as to cause the auditor to conclude that the risk of management
misrepresentations in the financial statements is such that an audit cannot be conducted. Answers (a) and (d) may be
concerns for the auditor, but since codes of conduct are not required business practice and changes in controls are
often dictated by cost-benefit considerations, these concerns are not so serious as to render financial statements
unauditable. Answer (c) is incorrect because management override of controls is an inherent limitation of any
internal control structure.

1S-17

144. (b) Management philosophy and operating style, which is one of the various factors that have an effect on the
control environment, encompass a broad range of characteristics. Such characteristics may include management's
approach to taking and monitoring risks, management's attitudes and actions toward financial reporting, and
management's emphasis on meeting financial and operating goals. These characteristics have a significant influence
on the control environment, particularly when management is dominated by one or a few individuals. Answer (a),
which refers to the internal audit function, answer (c) which refers to a method of assigning authority and
responsibility, and answer (d), which refers to audit committees, are incorrect because they are not part of
management philosophy and operating style, but rather are part of other control environment factors.
145. (c) Management control methods is a control environment factor that affects management's ability to
effectively supervise overall company activities. These methods include establishing systems that set forth
management's plans and the results of actual performance, establishing methods that identify variances from budgets
and forecasts, and using methods to investigate variances. Answer (a) refers to external influences, which is a
separate control environment factor that includes monitoring and compliance requirements imposed by regulatory
bodies. Answer (b) is a control procedure, rather than a part of management controls or the control environment.
Answer (d) refers to personnel policies and practices, which is a separate control environment factor that includes
giving employees the necessary resources to discharge their responsibilities.
146. (a) The auditor is required to document the auditor's understanding of the entity's internal control structure. The
form and extent of documentation may be influenced by the size and complexity of the entity, but in all audits this
understanding must be documented. Answer (b) is incorrect because searching for deficiencies in the internal
control structure is not required when performing a financial statement audit in accordance with GAAS. Answer (c)
is incorrect because the auditor only performs tests of controls when the auditor plans to assess control risk below
the maximum. Answer (d) is incorrect because if the auditor assesses control risk at the maximum, he or she does
not have to determine whether control procedures are suitably designed.
147. (a) When a bank lockbox system is used, customers, in effect, send their remittances directly to the bank, thus
eliminating the possibility of employees misappropriating those cash receipts. The other answers are internal control
procedures that involve employees. Answer (b) is incorrect because in addition to using prenumbered remittance
advices, an employee would have to account for their sequence to determine if any have been returned, but the
accompanying cash not properly recorded. Answer (c) is incorrect because a reconciliation of cash per bank and
cash per books will not detect cash receipts that have not been properly recorded and not deposited in the bank.
Answer (d) is incorrect because depositing cash receipts daily will not, by itself, reduce the risk of misappropriated
cash receipts.
148. (a) The auditor should obtain an understanding of each of the internal control structure elements to plan the
audit. The understanding should include knowledge about the design of relevant policies, procedures, and records
and whether they have been placed in operation by the entity. Answer (b) is incorrect because the auditor, although
he or she may be concerned with effectiveness of policies and procedures when control risk is assessed below the
maximum, is not required to obtain knowledge about operating effectiveness as part of the understanding of the
internal control structure. Answer (c) is incorrect because consistency in applying policies or procedures is related
to operating effectiveness. Answer (d) is incorrect because audit planning does not require an understanding of the
control procedures related to each account balance, transaction class, and disclosure component in the financial
statements.
149. (a) Payroll fraud could involve fictitious employees and/or fictitious salary rates. In order to prevent these
frauds, new hires, terminations of employees, and salary rates should be approved by the personnel department,
which in turn should keep the payroll department and employee supervisors informed on a timely basis. Answer (b)
is incorrect because an unclaimed payroll check, which may have been written for a fictitious or recently terminated
employee, should be returned to the treasurer. Answer (c) is incorrect because the personnel department is
responsible for approving salary rates, whereas the payroll supervisor is responsible for accounting for the payroll.
Answer (d) is incorrect because employee supervisors calculate the total hours used by the payroll department in
determining gross pay.

1S-18

150. (b) Keeping marketable securities in a bank safe-deposit box and assigning joint control to two officials should
reduce the likelihood of those securities being misappropriated. These physical security and access controls are
likely to be used to safeguard marketable securities when an independent trust agent is not employed. Answers (a),
(c) and (d) are incorrect because the listed controls will not physically safeguard and prevent the misuse of
marketable securities. Reviewing investment decisions will not determine if securities have been misappropriated.
Comparing subsidiary and general ledgers will not necessarily prevent securities from being stolen, nor detect
transactions that have not entered the accounting system. Annual physical verification by the chairman of the board
is not a timely control and has limited effectiveness.
151. (b) In assessing control risk, the auditor may perform tests of controls directed toward the effectiveness of the
design or operation of an internal control structure policy or procedure. These tests include inquiries, inspection of
documents and reports, observation, and reperformance of the application of the policy or procedure by the auditor.
Answers (a), (c) and (d) are incorrect because analytical procedures, comparison and confirmation, and verification
are examples of substantive tests, not tests of controls used to assess control risk.
152. (a) The objective of procedures performed to understand the internal control structure is to provide the auditor
with knowledge necessary for audit planning. The objective of tests of controls is to provide the auditor with
evidence to use in assessing control risk. Because procedures performed to achieve one of these objectives may also
pertain to the other objective, understanding the internal control structure and assessing control risk may be
performed concurrently in an audit. Answer (b) is incorrect because findings from prior audits are considered in the
current year's control risk assessment. Answer (c) is incorrect because when the auditor assesses control risk at the
maximum, the auditor should document his or her conclusion that control risk is at the maximum, but need not
document the basis for that conclusion. Answer (d) is incorrect because the auditor needs additional evidence for
lower levels of assessed control risk.
153. (d) Using the audit risk model (audit risk = inherent risk x control risk x detection risk), acceptable detection
risk can be calculated as a function of allowable audit risk, inherent risk, and control risk. In order to determine his
or her acceptable level of detection risk, the auditor must therefore assess control risk. Answer (a) is incorrect
because the auditor obtains an understanding of the internal control structure before assessing control risk. Answer
(b) is incorrect because materiality levels are based on factors other than assessed control risk. Answer (c) is
incorrect because inherent risk assessment is independent from control risk assessment.
154. (d) Assessing control risk at below the maximum involves identifying specific internal control structure
policies and procedures relevant to specific assertions that are likely to prevent or detect material misstatements in
those assertions, and performing tests of controls to evaluate the effectiveness of such policies and procedures.
Answers (a) and (c) are incorrect because if control risk is assessed below the maximum the auditor would perform
fewer substantive tests, perhaps at an earlier or interim date, since less assurance is needed from substantive tests.
Answer (d) is incorrect because inherent risk is independent from control risk.
155. (d) After obtaining the understanding of the internal control structure and assessing control risk, the auditor
may desire to seek a further reduction in the assessed level of control risk for certain assertions. In such cases, the
auditor considers whether additional evidential matter sufficient to support a further reduction is likely to be
available, and whether it would be efficient to perform tests of controls to obtain that evidential matter. Answers (a)
and (b) are incorrect because the auditor obtains an understanding of the accounting system and considers whether
policies and procedures have been placed in operation as part of the auditor's understanding of the internal control
structure. Answer (c) is incorrect because the auditor identifies internal control structure policies and procedures
relevant to financial statement assertions as part of the auditor's assessment of control risk at below the maximum.
156. (c) The auditor is required to document the auditor's understanding of the entity's internal control structure,
which includes the control environment, regardless of the assessed level of control risk. If the auditor assesses
control risk at the maximum level, the auditor should document his or her conclusion that control risk is at the
maximum level but need not document the basis for that conclusion. If the auditor assesses control risk below the
maximum, the auditor should document his or her conclusion and the basis for that conclusion.

1S-19

157. (c) An auditor assesses control risk to determine acceptable detection risk and the nature, extent and timing of
substantive tests to perform. When an auditor plans to assess control risk at a low level, the auditor must identify
specific policies and procedures that are likely to prevent or detect material misstatements, and he or she must
perform tests of controls to evaluate the effectiveness of such policies and procedures. If, based on tests of controls,
the control risk is assessed at a low level, the auditor may limit the extent of substantive testing. Answer (a) includes
extensive substantive tests, which would not be done when control risk is assessed at a low level. Answers (b) and
(d) refer only to analytical procedures, which are substantive tests, and do not include tests of controls, which are
necessary in order to assess control risk at a low level.
158. (a) Lapping can occur when cash/check that is received from a customer is misappropriated and a subsequent
cash receipt is credited to that customer's account. If the auditor suspects lapping of cash receipts, the auditor should
compare the dates checks are listed on bank statements to the dates customer credits are recorded in customer
receivable accounts. This would help find credits given to customers on dates that differ from the date the deposit
was made. Answers (b) and (c) will not detect lapping because they deal with totals, rather than specific customer
accounts. If the total on a cash summary equals the total recorded in the cash receipts journal, or if the total for a
given deposit is the same on a bank deposit slip as on the bank statement, postings to individual customer accounts
may still be incorrect. Answer (d) has nothing to do with dates cash/checks are received.
159. (d) The individual who signs checks should also mail the checks to reduce the likelihood of others accessing
and misusing checks. Answer (a) is incorrect because the individual with custody of an asset, such as access to
blank checks, should not be responsible for reconciling or comparing assets and records. Answer (b) is incorrect
because if checks are returned to accounts payable, amounts or payees can be altered or the checks otherwise
misappropriated. Answer (c) is incorrect because the person who signs the checks should review the supporting
documents for agreement with the checks and then cancel those documents to avoid reuse.
160. (d) In order to avoid paying incorrect or duplicate amounts to vendors, the accounts payable department should
clerically check the quantities, prices and mathematical calculations on the vendor's invoice and compare the
invoice to the receiving report and purchase order. Answer (a) is a control procedure that should be performed by
the treasurer or cash disbursements clerk. Answer (b) is a control procedure that involves the requisitioning and
purchasing departments. Answer (c) is a control procedure that involves the purchasing and receiving departments.
161. (a) Assertions about existence or occurrence deal with whether assets or liabilities of the entity exist at a given
date and whether recorded transactions occurred during a given period. Segregating payroll-related duties such as
authorizing new hires and wage rates, as is done by a personnel department, and disbursing payroll checks, as is
done by the treasurer, reduces the likelihood that fictitious payroll transactions that did not occur will get recorded.
The auditor, therefore, inquires about and observes the segregation of payroll-related duties. Answer (b), which is
concerned with omitted checks, relates to the completeness assertion. Answer (c), which is concerned with
appropriate amounts, relates to the valuation assertion. Answer (d) relates more to completeness and valuation than
to existence or occurrence.
162. (c) An auditor is required to obtain an understanding of the internal control structure. In obtaining that
understanding, the auditor makes inquiries of management, inspects documents and records, and observes entity
activities and operations. Reviewing descriptions of inventory policies and procedures, such as might be found in
policies and procedures manuals, would be an example of a procedure performed by the auditor to obtain an
understanding of the inventory internal control structure. Answers (a), (b) and (d) are substantive tests that are
designed to tests dollar amounts in the financial statements, not to understand the internal control structure.
163. (d) The internal auditors' work may affect the nature, timing, and extent of the audit, including procedures the
auditor performs when obtaining an understanding of the entity's internal control structure, procedures the auditor
performs when assessing risk, and substantive procedures the auditor performs. Answers (a), (b) and (c) are
incorrect because the work of internal auditors affects all three of the procedures listed.
164. (c) The planning phase of the audit involves making preliminary judgements about materiality, audit risk and
timing of procedures. Answers (a), (b) and (d) are procedures that would be completed during the evidence
gathering phase rather than the planning phase.

1S-20

165. (c) Lead schedules are audit workpapers that contain unadjusted general ledger amounts for all accounts. In
order to prepare these schedules, the names, account numbers, and unadjusted general ledger amounts must be
determined. A typical lead schedule would appear as follows:
Client Name
Account Name and Number
Audit Date
Prior
Year
Balance

Current
Year
Balance

XXXX

YYY

Adjustments
Dr
Cr
ZZZ

Audited
Balance
YYYZZZ

166. (a) The problem with e-mail responses to audit confirmation requests is that the origin of the e-mail is not
secure. That means that someone other than the recipient of the confirmation request may respond. By requesting a
"hard copy" of the confirmation, the auditor may place greater reliance on the communication.

1S-21

Chapter One - Solutions to Problems

Introduction, General and Field Standards
NUMBER 1
The internal control procedures that most likely would provide reasonable assurance that specific control objectives
for the financial statement assertions regarding purchases and accounts payable will be achieved are
1. Proper authorization of requisitions by department head is required before purchase orders are prepared.
2. Purchasing department assures that requisitions are within budget limits before purchase orders are prepared.
3. The adequacy of each vendor's past record as a supplier is verified.
4. Secure facilities limit access to the goods during the receiving activity.
5. Receiving department makes a blind count of the goods received, independently of any other department.
6. The requisitioning department head independently verifies the quantity and quality of the goods received.
7. Requisitions, purchase orders, and receiving reports are matched with vendor invoices as to quantity and price.
8. Accounts payable department recomputes the mathematical accuracy of each invoice.
9. The voucher register is independently reconciled to the control accounts monthly.
10. All supporting documentation is required for payment and is made available to the treasurer.
11. The purchasing, receiving, and accounts payable functions are segregated.

NUMBER 2
Credit Manager
1.
2.
3.
4.
5.

The credit manager approves credit for purchases on account from customers based on familiarity.
Bad credit can be extended to these customers increasing risk for the company.
A copy of the customer order form is not maintained by the credit manager.
A copy of the order form is not sent to shipping to generate a packing slip.
The credit manager does not prepare a monthly report about the collectibility of all past due accounts.

Accounts Receivable Supervisor

1.
2.
3.
4.
5.
6.
7.

The accounts receivable supervisor should not be authorizing price changes because they are incompatible
duties.
Sales and A/R should not be recorded until confirmation has been received that the goods have been shipped.
The A/R supervisor should not reconcile the A/R ledger with the control account.
The A/R supervisor should not receive the sales order form and record A/R.
The A/R supervisor does not account for the numerical sequence of customer sales orders.
The subsidiary A/R ledger is not reconciled to the general ledger.
Access to assets is not limited and controlled.

Cashier
1.
2.
3.
4.
5.
6.
7.

The cashier should not supervise the cash register clerks.

The cashier should not be responsible for opening the mail.
Someone else in the mailroom should receive and prepare the check control listing.
One copy of the listing should be sent to the cashier.
The remittance advice and a copy of the control listing should be sent to the A/R supervisor.
Remittance advice should not be sent to the bookkeeper.
The cashier should not reconcile the bank account.

1S-22

Bookkeeper
1.
2.
3.
4.
5.
6.
7.

The bookkeeper should not receive A/R details from the accounts receivable supervisor.
The bookkeeper does not need remittance advice from the cashier to journalize and post to the general ledger.
The cashier provides a copy of the daily cash register summary for that purpose.
The bookkeeper should not mail monthly statements to customers.
An employee who does not handle cash receipts should mail monthly statements to customers.
The credit manager, not the bookkeeper, should authorize the write-off of uncollectible accounts.
The credit manager, not the bookkeeper, should decide whether to grant more credit to customers.

NUMBER 3
Flowchart
Symbol Letter
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.

Internal Control Procedure or Internal Document

Approve customer credit and terms.
Release merchandise to shipping department.
File by sales order number.
File pending receipt of merchandise.
Prepare bill of lading.
Copy of bill of lading to customer.
Ship merchandise to customer.
File by sales order number.
Customer purchase order and sales order.
File pending notice of shipment.
Prepare three-part sales invoice.
Copy of invoice to customer.
Post to (or enter in) sales journal.
Account for numerical sequence.
Post to customer accounts.
File by (payment due) date.

NUMBER 4
a.

The procedures Hall should perform before accepting the engagement include the following:
1. Hall should explain to Adams the need to make an inquiry of Dodd and should request permission to do so.
2. Hall should ask Adams to authorize Dodd to respond fully to Hall's inquiries.
3. If Adams refuses to permit Dodd to respond or limits Dodd's response, Hall should inquire as to the
reasons and consider the implications in deciding whether to accept the engagement.
4. Hall should make specific and reasonable inquiries of Dodd regarding matters Hall believes will assist in
determining whether to accept the engagement, including specific questions regarding:
Facts that might bear on the integrity of management;
Disagreements with management as to accounting principles, auditing procedures, or other similarly
significant matters;
Dodd's understanding as to the reasons for the change of auditors.
5. If Hall receives a limited response, Hall should consider its implications in deciding whether to accept the
engagement.

1S-23

b.

The additional procedures Hall should consider performing during the planning phase of this audit that would
not be performed during the audit of a continuing client may include the following:
1. Hall may apply appropriate auditing procedures to the account balances at the beginning of the audit period
and, possibly, to transactions in prior periods.
2. Hall may make specific inquiries of Dodd regarding matters Hall believes may affect the conduct of the
audit, such as
Audit areas that have required an inordinate amount of time;
Audit problems that arose from the condition of the accounting system and records.
3. Hall may request Adams to authorize Dodd to allow a review of Dodd's working papers.
4. Hall should document compliance with firm policy regarding acceptance of a new client.
5. Hall should start obtaining the documentation needed to create a permanent working paper file.

NUMBER 5
a.

In planning an audit, an auditor's understanding of the internal control structure elements should be used to
identify the types of potential misstatements that could occur, to consider the factors affecting the risk of
material misstatement, and to influence the design of substantive tests.

b.

An auditor obtains an understanding of the design of relevant internal control structure policies and procedures
and whether they have been placed in operation. Assessing control risk at below the maximum level further
involves identifying specific policies and procedures relevant to specific assertions that are likely to prevent or
detect material misstatements in those assertions. It also involves performing tests of controls to evaluate the
operating design and effectiveness of such policies and procedures.

c.

When seeking a further reduction in the assessed level of control risk, an auditor should consider whether
additional evidential matter sufficient to support a further reduction is likely to be available, and whether it
would be efficient to perform tests of controls to obtain that evidential matter.

d.

An auditor should document the understanding of an entity's internal control structure elements obtained to
plan the audit. The auditor also should document the basis for the auditor's conclusion about the assessed level
of control risk. If control risk is assessed at the maximum level, the auditor should document that conclusion,
but is not required to document the basis for that conclusion. However, if the assessed level of control risk is
below the maximum level, the auditor should document the basis for the conclusion that the effectiveness of
the design and operation of internal control structure policies and procedures supports that assessed level.

NUMBER 6
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.

Prepare purchase order

To vendor
Prepare receiving report
From purchasing
From receiving
Purchase order no. 5
Receiving report no. 1
Prepare and approve voucher
Unpaid voucher file, filed by due date
Treasurer
Sign checks and cancel voucher package documents
Canceled voucher package

1S-24

NUMBER 7
61.
62.
63.
64.
65.
66.
67.
68.
69.
70.
71.
72.
73.

M
Z
L
B
H
S
O
U
I
Q
N
T
Y

NUMBER 8
106.
107.
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
118.
119.
120.

D
I
I
I
D
N
D
I
I
D
I
I
N
I
I

Decrease
Increase
Increase
Increase
Decrease
No effect
Decrease
Increase
Increase
Decrease
Increase
Increase
No effect
Increase
Increase

NUMBER 9
106.
107.
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
118.
119.
120.

C.
G.
F.
K.
I.
B.
D.
L.
P.
C.
C.
P.
S.
P.
N.

1S-25

NUMBER 10
The factors most likely to have an effect on the risk of material misstatements and their resulting effect include the
following:
Environmental factor
Government regulation over the banking industry is extensive.

Effect on risk of
material misstatements
Decrease

NFB operates profitably in a growing prosperous area.

Decrease

Overall demand for the industrys product is high.

Decrease

Interest rates have been volatile recently.

Increase

The availability of funds for additional mortgages is promising.

Decrease

The principal shareholder is also the chief executive officer and controls
the board of directors.

Increase

Branch management is compensated based on branch profitability.

Increase

The internal auditor reports directly to the chairman of the boards

audit committee, a minority shareholder.

Decrease

The accounting department has experienced little turnover in personnel

recently.

Decrease

NFB is a continuing audit client.

Decrease

Management fails to establish proper procedures to provide reasonable

assurance of reliable accounting estimates.

Increase

Management has been receptive to Greens suggestions relating to accounting

adjustments.

Decrease

NFB recently opened a new branch office that is not yet profitable.

Increase

NFB recently installed a new sophisticated computer system.

Increase

1S-26

NUMBER 11
Young Computer Outlets, Inc.
Payroll
Internal Control Questionnaire
Question

Yes

No

Yes

No

1. Are payroll changes (hires, separations, salary changes, overtime,

bonuses, promotions, etc.) properly authorized and approved?
2. Are discretionary payroll deductions and withholdings authorized in
writing by employees?
Question
3. Are the employees who perform each of the following payroll functions
independent of the other five functions?

personnel and approval of payroll changes

preparation of payroll data
approval of payroll
signing of paychecks
distribution of paychecks
reconciliation of payroll account

4. Are changes in standard data on which payroll is based (hires,

separations, salary changes, promotions, deduction and withholding changes,
etc.) promptly input to the system to process the payroll?
5. Is gross pay determined by using authorized salary rates and time and
attendance records?
6. Is there a suitable chart of accounts and/or established guidelines for
determining salary account distribution and for recording payroll
withholding liabilities?
7. Are clerical operations in payroll preparation verified?
8. Is payroll preparation and recording reviewed by supervisors or internal
audit personnel?
9. Are payrolls approved by a responsible official before payroll checks are
issued?
10. Are payrolls disbursed through an imprest account?
11. Is the payroll bank account reconciled monthly to the general ledger?
12. Are payroll bank reconciliations properly approved and differences promptly
followed up?
13. Is the custody and follow-up of unclaimed salary checks assigned to a
responsible official?

1S-27

14. Are differences reported by employees followed up on a timely basis by

persons not involved in payroll preparation?
15. Are there procedures (e.g., tickler files) to assure proper and timely payment
of withholdings to appropriate bodies and to file required information returns?
16. Are employee compensation records reconciled to control accounts?
17. Is access to personnel and payroll records, checks, forms, signature plates,
etc. limited?

NUMBER 12
a.

b.

There are many fraud risk factors that are indicated in the dialogue. Among the fraud risk factors are the
following:

A significant portion of Mint's compensation is represented by bonuses and stock options. Although
this arrangement has been approved by SCS's Board of Directors, this may be a motivation for Mint,
the new CEO, to engage in fraudulent financial reporting.

Mint's statement to the stock analysts that SCS's earning would increase 30% next year may be both an
unduly aggressive and unrealistic forecast. That forecast may tempt Mint to intentionally misstate
certain ending balances this year that would increase the profitability of the next year.

SCS's Audit committee may not be sufficiently objective because Green, the chair of the audit
committee, hired Mint, the new CEO, and they have been best friends for years.

One individual, Mint, appears to dominate management without any compensating controls. Mint
seems to be making all the important decisions without any apparent input from other members of
management or resistance from the Board of Directors.

There were frequent disputes between Brown, the prior CEO, who like Mint apparently dominated
management and the Board of Directors, and Jones, the predecessor auditor. This fact may indicate
that an environment exists in which management will be reluctant to make any changes that Kent
suggests.

Management seems to be satisfied with an understaffed and ineffective internal audit department. This
situation displays an inappropriate attitude regarding the internal control environment.

Management has failed to properly monitor and correct a significant deficiency in its internal control
the lack of segregation of duties in cash disbursements. This disregard for the control environment is
also a risk factor.

Information about anticipated future layoffs has spread among the employees. This information may
cause an increase in the risk of material misstatement arising from the misappropriation of assets by
dissatisfied employees.

Kent has many misconceptions regarding the consideration of fraud in the audit of SCS's financial statements
that are contained in the dialogue. Among Kent's misconceptions are the following:

Kent states that an auditor does not have specific duties regarding fraud. In fact, an auditor has a
responsibility to specifically assess the risk of material misstatement due to fraud and to consider that
assessment in designing the audit procedures to be performed.

1S-28

c.

Kent is not concerned about Mint's employment contract. Kent should be concerned about a CEO's
contract that is based primarily on bonuses and stock options because such an arrangement may
indicate a motivation for management to engage in fraudulent financial reporting.

Kent does not think that Mint's forecast for 1999 has an effect on the financial statement audit for
1998. However, Kent should consider the possibility that Mint may intentionally misstate the 1998
ending balances to increase the reported profit in 1999.

Kent believes that the audit programs are fine as is. Actually, Kent should modify the audit programs
because of the many risk factors that are present in the SCS audit.

Kent is not concerned that the internal audit department is ineffective and understaffed. In fact, Kent
should be concerned that SCS has permitted this situation to continue because it represents a risk
factor relating to misstatements arising from fraudulent financial reporting and/or the misappropriation
of assets.

Kent states that an auditor provides no assurances about fraud because that's management's job. In fact,
an auditor has a responsibility to plan and perform an audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement, whether caused by error or fraud.

Kent is not concerned that the prior year's reportable condition has not been corrected. However, Kent
should be concerned that the lack of segregation of duties in the cash disbursements department
represents a risk factor relating to misstatements arising from the misappropriation of assets.

Kent does not believe that the rumors about big layoffs in the next month have an effect on audit
planning. In planning the audit, Kent should consider this risk factor because it may cause an increase
in the risk of material misstatement arising from the misappropriation of assets by dissatisfied
employees.

In planning a financial statement audit, the auditor should document in the working papers evidence of the
performance of the assessment of the risk of material misstatement due to fraud. Where risk factors are
identified, the documentation should include those risk factors identified and the auditor's response to those
risk factors, individually or in combination. In addition, during the performance of the audit, the auditor may
identify fraud risk factors or other conditions that cause the auditor to believe that an additional response is
required. The auditor should document such risk factors or other conditions, and any further response that an
auditor concludes is appropriate.

NUMBER 13
1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

1S-29

NUMBER 14
AUDITING SIMULATION
ABC Corporation
123 Main Street
New York, NY
Board of Directors:
In planning and performing our audit of the financial statements of the ABC Corporation for the year ended
December 31, 20XX, we considered its internal control in order to determine our auditing procedures for the
purpose of expressing our opinion on the financial statements and not to provide assurance on the internal control
structure. However, we noted certain matters involving internal control and its operation that we consider to be
reportable conditions under standards established by the American Institute of Certified Public Accountants.
Reportable conditions involve matters coming to our attention relating to significant deficiencies in the design or
operation of internal control that, in our judgment, could adversely affect the organizations ability to record,
process, summarize, and report financial data consistent with the assertions of management in the financial
statements.
During the prior audit, internal control deficiencies were suggested and agreement made that these deficiencies
would be corrected. Our review disclosed that several important items were either not implemented or are not
functioning properly.
We have noted a lack of appropriate reviews and approval of transactions in several important areas. Such reviews
were not made, or review and approval actions not documented.
Two instances were noted where important assets were not properly safeguarded from loss, damage or
misappropriation. In one instance, insurance was found to be inadequate and in the other, assets were not
inventoried periodically as required and asset responsibility was not documented.
Details of these items are included in Exhibit A.
This report is intended solely for the information and use of the board of directors, the audit committee, and
management.

Signature
Date

CPA Exam Tip:

On written communications there is a spelling button
available above the text entry section. You can use this to
help check your spelling, which is one of the items that will
be graded.

1S-30

Chapter Two
The Third Standard of Field WorkEvidence
The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a
reasonable basis for an opinion regarding the financial statements under audit.

EVIDENTIAL MATTER (SAS No. 31 As Amended)

Most of the independent auditor's work in forming an opinion on financial statements consists of obtaining and
evaluating evidential matter concerning management assertions in the form of financial statements. The measure of
the validity of such evidence for audit purposes lies in the judgment of the auditor.
1.

NATURE OF ASSERTIONS
Assertions are representations by management that are embodied in financial statement components. They can
be either explicit or implicit and can be classified according to the following broad categories:
a.
Existence or occurrencedeal with whether assets or liabilities of the entity exist at a given date and
whether recorded transactions have occurred during a given period (i.e., all transactions are valid).
b.
Completenessdeal with whether all transactions and accounts that should be presented in the financial
statements are so included (i.e., no omitted transactions).
c.
Rights and obligationsdeal with whether assets are the rights of the entity (i.e., ownership) and
liabilities are the obligations of the entity at a given date.
d.
Valuation or allocationdeal with whether asset, liability, revenue, and expense components have been
included in the financial statements at appropriate amounts (proper dollar values and proper time period).
e.
Presentation and disclosuredeal with whether particular components of the financial statements are
properly classified, described, and disclosed.

2. USE OF ASSERTIONS IN DEVELOPING AUDIT OBJECTIVES AND DESIGNING SUBSTANTIVE

TESTS
In obtaining evidential matter in support of financial statement assertions, the auditor develops specific audit
objectives in the light of those assertions. In developing the audit objectives of a particular engagement, the
auditor should consider the specific circumstances of the entity, including the nature of its economic activity
and the accounting practices unique to its industry.
There is not necessarily a one-to-one relationship between audit objectives and procedures. Some auditing
procedures may relate to more than one objective. On the other hand, a combination of auditing procedures may
be needed to achieve a single objective.
In selecting particular substantive tests to achieve the audit objectives that have been developed, an auditor
considers, among other things, the extent of reliance, if any, to be placed on internal accounting control, the
relative risk of errors or irregularities that would be material to financial statements, and the expected
effectiveness and efficiency of such tests.
The nature, timing, and extent of the procedures to be applied on a particular engagement are a matter of
professional judgment to be determined by the auditor, based on the specific circumstances.
In entities where significant information is transmitted, processed, or accessed electronically, the auditor may
determine that it is not practical or possible to reduce detection risk to an acceptable level by performing only
substantive tests for one or more financial statement assertions. For example, the potential for improper
initiation or alteration of information to occur and not be detected may be greater if information is produced,
maintained, or accessed only in electronic form. In such circumstances, the auditor should perform tests of
controls to gather evidential matter to use in assessing control risk, or consider the effect on his or her report.

2-1

3. DEFINITION OF AUDIT EVIDENCE:

a. Audit evidence consists of all information used by the auditor in arriving at the conclusions on which the
audit opinion is based and includes the information contained in the accounting records underlying the
financial statements and other information, including evidence obtained from:
Procedures performed during the audit
Other sources, such as previous audits and a firm's quality control procedures for client acceptance and
continuance.
b.

Auditors are not expected to examine all information that exists.

4. DEFINITION OF ACCOUNTING RECORDS:

a. Accounting records include the records of initial entries and support records, including checks and records
of electronic funds transfers, invoices, contracts, general and other ledgers, journal entries, and other
adjustments to the financial statements that are not reflected in formal journal entries, and records such as
worksheets and spreadsheets supporting cost allocations, computations, reconciliations, and disclosures.
5. The auditor should obtain audit evidence by testing the accounting records through analysis and review,
reperforming procedures, reconciling related types and applications of the same information.
a.

Management is responsible for the preparation of financial statements based on the accounting records of
the entity. Because accounting records alone do not provide sufficient appropriate audit evidence on which
to base an audit opinion, the auditor should obtain other audit evidence that includes, but is not limited to:

Minutes to meetings
Confirmations from third parties
Industry analysts' reports
Comparable data about competitors (benchmarking)
Controls manuals
Information obtained by the auditor from such audit procedures as inquiry, observation, and
inspection.

6. When assessing risks and designing further audit procedures, the auditor should consider the sufficiency and
appropriateness of audit evidence to be obtained.
Sufficiency is the measure of the quantity of audit evidence.
Appropriateness (reliability) is the measure of the quality of the audit evidence, which is its relevance and
reliability in providing support for, or detecting misstatements in, the classes of transactions, account balances,
and disclosures and related assertions.
a.

The sufficiency and appropriateness of audit evidence are interrelated.

The greater the risk of misstatement, the more audit evidence is required.
The higher the quality of evidence, the less audit evidence may be required.

b.

Obtaining more audit evidence may not compensate for low quality.

7. APPROPRIATENESS OF AUDIT EVIDENCE

a.

The appropriateness of audit evidence is influenced by its source and nature and is dependent on the
individual circumstances under which it was obtained.

While recognizing that exceptions may exist, the following are generalizations about the appropriateness of audit
evidence:

2-2

RELIABILITY OF AUDIT EVIDENCE

8.

Most reliable audit evidence

Obtained from knowledgeable independent sources
outside the entity

Least reliable audit evidence

Obtained from less knowledgeable sources outside
the entity

Generated internally when the related controls are

effective.

Generated internally when the related controls are

not effective.

Obtained directly by the auditor, such as through

observation of the application of a control.

Obtained indirectly or by inference, such as inquiry

about the application of a control.

Obtained in documentary form, such as paper,

electronic, or other medium such as contemporaneously
written record of a meeting.

Obtained through subsequent oral representation of

the matters discussed.

Obtained by original documents

Obtained by photocopies or facsimiles.

When information produced by the entity is used by the auditor to perform additional audit procedures, the
auditor should obtain audit evidence about the accuracy and completeness of the information.
a.

9.

Obtaining such evidence may be done concurrently with the actual audit procedure and by using several
approaches including testing controls over the production and maintenance of the information or by using
computer-assisted audit techniques (CAATs) to recalculate the information.

An auditor typically obtains audit evidence that is from different sources or of a different nature from items of
evidence considered individually.
a.

Obtaining audit evidence from different sources or of a different nature may indicate that an individual
item is not reliable.
Example: An auditor corroborates information received one source independent of the entity that increases
the assurance received from a management representation.

b.

When audit evidence from two sources is inconsistent, the auditor should determine whether additional
audit procedures are needed to resolve the inconsistency.

10. The difficulty in obtaining audit evidence or its cost, is not in itself a valid basis for omitting an audit procedure
for which there is not an appropriate alternative.
11. Use of management assertions:
a. Management makes assertions (implicitly and explicitly) regarding the recognition, measurement,
presentation, and disclosure of information in the financial statements and related disclosures. Such
assertions used by the auditor fall into the following categories:
b.

Assertions about classes of transactions and events for the period under audit:
Occurrence: Transactions and events have been recorded have occurred and pertain to the entity.
Completeness: All transactions and events that should have been recorded have been recorded.
Accuracy: Amounts and other data relating to recorded transactions and events have been recorded
appropriately.
Cutoff: Transactions and events have been recorded in the correct accounting period.
Classification: Transactions and events have been recorded in the property amounts.

2-3

c. Assertions about account balances at the period end:

Existence: Assets, liabilities, and equity interests exist.
Rights and obligations: The entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
Completeness: All assets, liabilities, and equity interests that should have been recorded have been
recorded.
Valuation and allocation: Assets, liabilities, and equity interests are included in the financial
statements at appropriate amounts and any resulting valuation or allocation adjustments are
appropriately recorded.
d.

Assertions about presentation and disclosure:

Occurrence and rights and obligations: Disclosed events and transactions have occurred and pertain to
the entity.
Completeness: All disclosures that should have been included in the financial statements have been
included.
Classification and understandability: Financial information is appropriately presented and described
and disclosures are clearly expressed.
Accuracy and valuation: Financial and other information are disclosed fairly and at appropriate
amounts.

e.

An auditor should use relevant assertions for classes of transactions, account balances, and presentation
and disclosures in sufficient detail as a basis for assessing risks of material misstatements and for the
design and performance of additional audit procedures.

f.

The auditor should use relevant assertions in assessing risks by considering the different types of potential
misstatements that may occur, and then designing further audit procedures that are responsive to the
assessed risks.
Relevant assertions are those that have a meaningful bearing on whether the account is fairly stated.
Examples: The valuation assertion may not be relevant to the cash account unless currency translation is
involved.
Valuation may not be relevant to the gross amount of accounts receivable but may be related to the
allowance account.

g.

The auditor should determine the relevance of each financial statement assertion. To identify relevant
assertions, the auditor should determine the source of likely potential misstatements within each significant
class of transactions, account balances, and presentation and disclosure. In determining whether a
particular assertion is relevant to a significant account balance or disclosure, the auditor should evaluate
the:
Nature of the assertion,
Volume of transactions or data related to the assertion, and,
Nature and complexity of the systems, including the use of information technology, by which the
entity processes and controls supporting the assertion.

12. Audit procedures to obtain audit evidence:

a.

The auditor should obtain audit evidence to draw reasonable conclusions on which to base the audit
opinion by performing audit procedures to:
Risk assessment procedures: Obtain an understanding of the entity and its environment, including its
internal control, to assess the risks of material misstatement at the financial statement and relevant
assertion levels.
Tests of controls: When necessary, or when the auditor has determined to do so, test the operating
effectiveness of controls in preventing or detecting material misstatements at the relevant assertion
level.

2-4

 Substantive procedures: Detect material misstatements at the relevant assertion level including tests of
details of classes of transactions, account balances, and disclosures, and substantive analytical
procedures.
13. Risk assessment procedures:
a.

The auditor must perform risk assessment procedures to provide a satisfactory basis for the assessment of
risks at the financial statement and relevant assertion levels.

b.

Risk assessment procedures by themselves do not provide sufficient appropriate audit evidence on which to
base the audit opinion and must be supplemented by further audit procedures in the form of tests of
controls, when relevant or necessary, and substantive procedures.

14. Tests of controls:

a.

Tests of controls are necessary in two circumstances.

When the auditor's risk assessment includes an expectation of the operating effectiveness of controls,
the auditor should test those controls to support the risk assessment.
When the substantive procedures alone do not provide sufficient appropriate audit evidence, the
auditor should perform tests of controls to obtain audit evidence about their operating effectiveness.

15. Substantive procedures:

a.

Regardless of the assessed risk of material misstatement, the auditor should design and perform substantive
procedures for all relevant assertions related to each material class of transactions, account balance, and
disclosure to obtain sufficient appropriate audit evidence.
Note: As described in SAS No. 110, Performing Audit Procedures in Response to Assessed Risks and
Evaluating the Audit Evidence Obtained, the auditor should plan and perform substantive procedures to be
responsive to the related planned level of detection risk, which includes the results of tests of controls, if
any. The auditor's risk assessment is judgmental, however, and may not be sufficiently precise to identify
all risks of material misstatement. Further, there are inherent limitations in internal control, including the
risk of management override, the possibility of human error, and the effect of systems changes.

16. Types of audit procedures:

a.

The auditor should use one or more types of audit procedures, which in combination may be risk
assessment procedures, tests of controls, or substantive procedures.

b.

A combination of two or more audit procedures may be necessary to obtain sufficient appropriate audit
evidence when performing tests of controls or substantive procedures at the relevant assertion level.

c.

Audit evidence obtained from previous audits may provide audit evidence where the auditor should
perform audit procedures to establish its continuing relevance.

d.

The nature and timing of the audit procedures may be affected by the fact that some of the accounting data
and other information may be available only in electronic form and only at certain points or periods in
time.
Examples:
Use of electronic messages in lieu of paper source documents, such as purchase orders, bills of lading,
invoices, and checks
Electronic commerce between and entity and its suppliers and customers through connected computers
over a public network, such as the Internet.
Image processing system where documents are scanned and converted into electronic images to
facilitate storage and reference, and source documents are not retained after conversion.

2-5

Note: Certain information may be retrievable after a specified period of time if files are changed and if
backup files do not exist. An entity's data retention policies may require the auditor to request retention of
some information for the auditor's review or to perform audit procedures at a time when the information is
available.
e.

When information is in electronic form, the auditor may carry out through CAATs certain of the audit
procedures identified in the following sections:
Inspection of records or documents
Inspection of tangible assets
Observation
Inquiry
Confirmation
Recalculation
Reperformance
Analytical procedures

f.

Inquiry:
1) Inquiry normally involves:
Considering the knowledge, objectivity, experience, responsibility, and qualifications of the individual
being questioned
Asking clear, concise, and relevant questions
Using open or closed questions appropriately
Listening actively and effectively
Considering the reactions and responses and asking follow-up questions
Evaluating the response.
2) In some cases, the auditor should obtain replies to inquiries in the form of written representations from
management.
3) Inquiry alone typically does not provide sufficient appropriate audit evidence to detect a material
misstatement. The auditor should perform audit procedures in addition to the use of inquiry to obtain
sufficient appropriate audit evidence.
4) Understanding management's past history of carrying out its stated intentions with respect to assets or
liabilities, management's stated reasons for choosing a particular course of action, and management's ability
to pursue a specific course of action may provide relevant information about management' s intent.

g. Analytical procedures:
1) An analytical procedure might be scanning, which is the auditor's use of professional judgment to
review accounting data to identify significant or unusual items and then to test those items.
Scanning includes searching for large or unusual items in the accounting records (such as nonstandard
journal entries), as well as in transaction data for indications of misstatements that have occurred.

2-6

EXAMPLES OF AUDIT
TESTS AND THEIR CLASSIFICATION
Purpose of Test
Substantive Test

Tests of Controls

Analytical
Procedures

Yes
Example A

No, only used as

Substantive Tests

Inquiry and
Observation

Yes
Example H

Yes
Examples B, C, I

Tests of Transactions

Yes
Example D

Yes
Examples E, F

Tests of Balances
(Details)

Yes
Examples G, H

No, only used as

Substantive Tests

Type of
Test

Examples:
A.

Comparison of this year's expenses with last year's expenses.

B.

Observation by auditor that cash is deposited daily by a specific clerk.

C.

Inquiry by auditor about who deposits cash and how often.

D.

Examination of invoices to support additions (specific transactions) to fixed assets account during year.

E.

Examine sales invoices to see if initials of credit manager are there to indicate a credit file and credit
approval (Inspection Test).

F.

Vouch from sales invoices to credit files to see if customer has a credit file and has been approved for
credit (Reperformance Test).

G.

Confirmation of year-end balances in accounts receivable.

H.

Observation of the existence of a building.

I.

Extended walk-through of an application.

2-7

SEQUENCE OF IDENTIFYING SPECIFIC AUDIT PROCEDURES

GENERALIZED AUDIT APPROACH
(NOTE: The letters A, B, C, D refer to specific sections of this chapter which follow.)

Management's Financial Statement

Assertions

Result in the auditor identifying

Specific audit objectives

Result in the auditor

selecting specific

Audit Procedures
(tests)

Document in the form of

Audit Programs

2-8

A. MANAGEMENT ASSERTIONS IN FINANCIAL STATEMENTS

a) Existence or occurrence
b) Completeness
c) Rights and obligations
d) Valuation or allocation (cut off)
e) Presentation (classification) and disclosure

B. SPECIFIC AUDIT OBJECTIVES

a)

A misrepresentation of any management assertions could cause the financial statements to be materially
misstated (the auditor must exercise judgment in determining what is a material misstatement).
b) To determine what type of evidence to obtain, the auditor develops specific audit objectives for each
account balance based upon the overall financial statement assertions.
For example:

If the auditor is gathering evidence on the assertion of the existence of inventory, the
auditor's objective would be to gather evidence that the inventory included on the balance
sheet physically existed as of the audit date.

c)

Once the auditor has determined the specific audit objectives for each account balance, based on the
financial statement assertions, appropriate audit procedures are selected to gather evidence.
d) Following are audit objectives for various account balances:

Cash
1.

2.
3.

ExistenceVerification of cash balances.

a. On hand
b. In banks
c. In transit
ClassificationRestricted or committed funds must be segregated from other cash and disclosed.
AllocationCash receipts and disbursements must be recorded in the proper accounting period.

Accounts Receivable
1.
2.

3.
4.
5.

ExistenceVerify that the balances represent amounts owed by others.

Classification:
a. Trade
b. Officers and employees
c. Other
d. Current or noncurrent
ValueThe allowance for doubtful accounts must be adequate so that A/R is stated at net realizable value.
DisclosurePledged, discounted, assigned or sold receivables must be disclosed.
AllocationSales and sales transactions that result in accounts receivable, and cash receipts that affect A/R
must be recorded in the proper accounting period.

Notes Receivable
1.
2.

3.
4.
5.

ExistenceVerify that the balances represent amounts owed by others including accrued interest.
Classification:
a. Trade
b. Officers and employees
c. Other (nontrade)
d. Current or noncurrent
e. Due from affiliates
ValueAre the notes collectible?
DisclosurePledged, discounted, assigned or sold notes should be disclosed.
AllocationAre the transactions affecting notes recorded in the proper accounting period including accrued
interest?

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Inventories
1.
2.
3.
4.
5.

ExistenceVerify physical existence of products, material, work-in-process, supplies, in transit and

consignments.
ValueThat the inventory has been priced according to GAAP consistently applied.
Inventory tabulations are accurate by verification of footings, extensions and summaries. Obsolete, slowmoving and nonsalable items are reduced to NRV. ClassificationThat inventories are classified by type such
as finished goods, work-in-process, raw material and manufacturing supplies.
DisclosureThe method of valuation such as FIFO, LIFO, average, etc., is required to be disclosed (APB 22).
Inventories pledged should be disclosed.
AllocationVerify that sales and purchases have been recorded in the correct accounting period.

Fixed Assets
1.
2.
3.
4.

ExistenceVerify the physical existence of fixed assets as carryovers from prior years or additions of the
current year.
ValuationVerify that the cost of retired and abandoned assets along with related depreciation has been
removed from the accounts. Verify that current depreciation charges are adequate under the company's
depreciation policy consistently applied.
ClassificationThat carrying value and classification are according to GAAP.
DisclosureDepreciation accounting policies are disclosed and all significant liens or encumbrances on fixed
assets.

Investments
1.
2.
3.

4.

ExistenceEstablish the physical existence of stocks, bonds, notes, mortgages, venture agreements and
insurance policies by physical inspection or confirmation.
ValueVerify that the underlying assets will support the carrying value and whether a permanent decline in
value has occurred.
Classification and Method of AccountingVerify according to GAAP as:
a. Current
b. Noncurrent
c. Cost
d. Equity method
e. Consolidation
f. Intercompany eliminations
IncomeVerify that income from investments has been reported according to GAAP.
a. Interest
b. Dividends
c. Equity method pickup
d. Consolidated NI
e. Gains or losses
DisclosureSignificant accounting policies, affiliation with related entities and significant transactions.
Disclose encumbrances and liens.

Prepayments, Deferred Charges and Intangibles

1.

2.
3.
4.

Existence:
a. PrepaymentsVerify that such items represent benefits assignable to future periods according to GAAP.
b. Deferred ChargesDiffer from prepayments in that they are assignable over longer periods (bond
discount). Verify as in (a). R&D as defined in FASB No. 2 should be expensed.
c. IntangiblesVerify that carrying value is assignable to future periods as a benefit. Must be amortized over
a maximum of 40 years.
ClassificationProperly classified:
a. Current (prepayments)
b. Noncurrent
ValuationAmortization policies are according to GAAP and reasonable.
DisclosureSignificant accounting policies have been disclosed.

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Liabilities
1.

ExistenceVerify that recorded liabilities exist and that there are no unrecorded liabilities:
a. Accounts payable
f. Leases
b. Notes payable
g. Contingencies (adjustment type)
c. Bonds
h. Lawsuits
d. Product warranties
i. Income taxes
e. Pensions
j. Contracts

2.

ValuationVerify that the carrying value of liabilities is according to GAAP and is reasonable. Problem
areaswarranties, pensions, contingencies, lawsuits, income taxes, contracts.

3.

ClassificationVerify according to current and noncurrent.

4.

DisclosureVerify that disclosure is according to GAAP. Principal areas of disclosure, liabilities and others
are:
a. Foreign currency translation
h. Contracts
b. Business combinations
i. Early extinguishment of debt
c. Contracts
j. Accounting changes
d. Leases and lease commitments
k. Nonmonetary translations
e. Deferred income taxes
l. Stock options
f. Pension plans
m. Restrictive covenants
g. Contingencies

5.

AllocationVerify that liabilities have been recorded in the right period according to GAAP.

6.

Completeness Verify that the entity has complied with all applicable laws, rules and regulations which could
materially result in liabilities, direct or indirect.

Stockholders' Equity
1.

2.
3.

ClassificationVerify that the amounts included are properly classified according to GAAP:
a. Capital stock
1) Common and preferred
b. Capital contributed by source
1) Paid-in surplus
c. Retained earnings
1) Appropriated and unappropriated
ValuationThat the amounts included in S.E. since inception of the company and during the audit period are
according to GAAP.
DisclosureVerify that disclosure has been made of dividend restrictions, stock subscription rights, stock
options, stock repurchase plans, preferred dividends in arrears, liquidation preferences and restrictive
covenants.

Revenues, Costs and Expenses

1.
2.
3.
4.
5.

AllocationVerify that such items are in the proper accounting period.

Verify that costs, expenses have been matched with revenue.
Nonoperating income or loss has been identified and properly classified.
The income presents on a consistent basis the results of operations.
DisclosureAccounting policies affecting net income have been disclosed.

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SPECIAL NOTE ON THE COMPLETENESS ASSERTION:

The audit of financial statements in accordance with GAAS must also verify that the financial statements are
complete. That is, all transactions that should be recorded in the financial statements are in fact recorded (no
transactions are omitted). Procedures to verify this question include all the specific procedures to verify the other
financial statement assertions plus the use of analytical procedures.
Below is a summary of specific audit procedures that address the completeness assertion:
a.

Sales-and-purchases cutoff procedures that include tracing shipping and receiving documents processed after
the audit period to accounting records for the proper period.*

b.

Analytical procedures in which the auditor investigates relationships among data that indicate a financial
statement account or balance may be understated. For example, the auditor may obtain evidence that all
interest-bearing debt is recorded by examining the relationship between recorded interest expense and the
average balance of interest-bearing debt outstanding for the period. Disproportionate relationships based on the
auditor's knowledge of interest rates should be investigated. Other examples include: a comparison of
investment income to average investments for the period to test whether income earned on investments is
recorded; the relationship of average pay times number of employees to payroll expense to substantiate that
salaries are recorded; and the relationship of membership fee revenue to the number of members of an
organization.

c.

Confirmations of balances or transactions designed to identify unrecorded amounts, such as accounts payable
confirmations that request the creditor to specify the amount of the client's obligation.

d.

Tests of bank reconciliations, including examination of checks clearing the bank after the audit period to
identify cash disbursements processed but not recorded or inappropriately recorded in the subsequent period.

e.

Reading the minutes of the meetings (of the) board of directors and stockholders and tracing transactions
authorized in the minutes to amounts recorded in the accounting records.

f.

Overall reconciliations using financial and nonfinancial data, such as "proofs" of cash and sales.

Cutoff tests are specific audit tests that are performed to ensure that transactions have been recorded in the
proper accounting period (Financial Statement assertions of valuation and allocation and completeness).

Specific procedures to conduct:

1.

Sales Cutoff test:

Select a sampling of shipping documents (i.e. Bills of Lading) for a period of time before and after the audit
date (for example, 3 days prior to and after the audit date). For the shipping documents selected, obtain the
matching customer invoices. Determine that the date on the invoice corresponds to the date on the shipping
document. For example, an item shipped before year end should be billed to the customer before year end.

2.

Purchase Cutoff test:

Select a sample of receiving reports for a period of time before year end and after year end. For the receiving
documents selected, determine that purchases and accounts payable are recorded in the same period as the item
was received by examining entries in the purchases journal and inspecting vendor invoices.

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Testing for under- and over- statement

To test for understatement of account balances, begin with source documents and trace to recordings in the
accounting records.
Example:
To test for unrecorded sales, select a sample of shipping documents. Determine for each shipping document
selected that:
1) a customer invoice was prepared
2) an entry was recorded in the sales journal, and
3) the customer's subsidiary accounts receivable balance was up to date.

To test for overstatement, select a sample of items that have been recorded in the accounting records and
determine that source documents exist for the transaction.
Example:
To test for overstated sales, select a sample of items recorded in the sales journal. Determine that:
1) A customer invoice exists for the item.
2) That evidence of shipment exists (i.e. Bill of Lading).
3) That a customer purchase order exists.

C. AUDIT PROCEDURES
SAS No. 103 AUDIT DOCUMENTATION
Issued: December 2005
Effective date: This Statement is effective for audits of financial statements for periods ending on or before
December 15, 2006. Early application is permitted.
Objective:
The objective of SAS No. 103 is to establish new expanded standards and guidance on audit documentation.
General:
Audit documentation consists of the record of audit procedures performed, relevant audit evidence obtained, and
conclusions reached by the auditor, otherwise found in working (work) papers. Such documentation may be
recorded in paper or electronic or other media format
Audit documentation requirements are included in various auditing standards as well as other standards such as
government auditing standards, laws, and regulations applicable to the engagement. If an auditor transfers or copies
paper documentation to another media, he or she should apply procedures to generate a copy that is faithful in form
and content to the original paper document. There also may be legal, regulatory, or other reasons to retain the
original paper document.
1.

An auditor must prepare audit documentation in connection with each engagement sufficient to provide a clear
understanding of the work performed, the audit evidence obtained, its source, and the conclusions reached.

2.

Auditor documentation should be in sufficient detail to enable an experienced auditor, with no previous
connection to the audit, to understand:
a.

The nature, timing and extent of the audit procedures performed to comply with the and applicable legal
and regulatory requirements,

b.

The results of the audit procedures performed and the audit evidence obtained,

c.

The conclusions reached on significant matters, and

2-13

d.

That the accounting records agree or reconcile with the audited financial statements or other audited
information.
Note: The SAS defines an experienced auditor to mean an individual (internal or external to the firm) who
possesses the competencies that would have enabled him or her to perform the audit. Such competencies
include a) an understanding of audit processes, b) the and related legal and regulatory requirements, c) the
business environment in which the entity operates, and d) auditing and financial reporting issues related to
the entity's industry.

3.

Oral explanations on their own do not represent sufficient support for an auditor's work performed or
conclusions reached but it may be used to help clarify or explain information contained in the audit
documentation.

4.

The SAS expands the documentation requirements of SAS No. 96, Audit Documentation, to require an auditor
to document discussions of significant findings or issues with management and others, on a timely basis,
including when and with whom the discussions took place.

5. An auditor is not required to retain in audit documentation superseded drafts of working papers or financial
statements, notes that reflect incomplete or preliminary thinking, previous copies, and duplicate documents.
6.

7.

An auditor must:
a.

Document information identified that contradicts or is inconsistent with the auditor's final conclusions, and
how the auditor addressed the contradiction or inconsistency in forming the conclusion.

b.

Document who performed the audit work and the date such work was done, and who reviewed the specific
audit documentation and the date of such review.

c.

Document the identifying characteristics of the specific items tested.

An auditor must assemble the final audit file on a timely basis, but within 60 days following the report release
date (referred to as the documentation completion date).
a.

At any time prior to the documentation completion date (60 days), the auditor may make changes to the
audit documentation for certain reasons including:

8.

Completion of documentation and assembly of audit evidence

Perform routine file-assembling procedures
Sign off on file completion checklists
Add information received after the date of the auditor's report, such as receipt of an original
confirmation that was previously faxed.

b.

The report release date should be recorded in the audit documentation.

c.

After the documentation completion date, the auditor must not delete or discard audit documentation prior
to the end of the specified retention period. Any additions after the documentation completion date should
be documented.

The auditor's report shall not be dated earlier than the date on which the auditor obtained sufficient appropriate
audit evidence to support opinion on the financial statements.
a. Sufficient appropriate audit evidence includes evidence that the audit documentation has been reviewed
and that the entity's financial statements, including disclosures, have been prepared and management
has taken responsibility for them.
b.

Delays in releasing the report may require the auditor to perform additional procedures for subsequent
events.

c.

In circumstances where the auditor concludes that procedures were omitted from the audit or
information was not known to him or her at the report date, the auditor should make changes to reflect
either the performance of the new audit procedure or the new conclusion reached, including:

2-14

1) When and by whom such changes were made and reviewed,

2) The specific reasons for the changes, and
3) The effect, if any, of the changes on the auditor's conclusions.
9.

Audit documentation is the property of the auditor subject to the following rules:
a.

At the auditor's discretion, the auditor may make available to the entity copies of the audit documentation,
provided such disclosure does not undermine the independence or the validity of the audit process.

b.

The auditor should adopt reasonable procedures to retain audit documentation for a sufficient period of
time with a minimum workpaper retention period of five years from the report release date, or longer if
required by statutes, regulations, or the firm's internal quality control policies.

c.

An auditor should adopt reasonable procedures to maintain the confidentiality of client information and
should apply appropriate and reasonable controls for audit documentation to:
1) Clearly determine when and by whom audit documentation was created, changed, or reviewed,
2) Protect the integrity of the information at all stages of the audit, particularly when information is shared
among audit team members or transmitted electronically,
3) Prevent unauthorized changes to the documentation, and
4) Allow access to the documentation by audit team members and other authorized parties.

D. AUDIT PROGRAMSGENERAL AUDIT PROCEDURES

1.

2.

Audit programs are required to be prepared in all audits conducted in accordance with GAAS. The purpose
of audit programs is two-fold:
a) To show evidence in the workpapers that the audit was adequately planned, and
b) To serve as a step-by-step guide for the audit of a particular account.
The following audit programs are typical procedures that are normally performed during an audit:

Planning
1.
2.
3.
4.

Obtain a client engagement letter or document understanding in workpapers.

Obtain from client any special reporting requirements regarding loan or debenture agreement or S.E.C.
requirements.
Review client's internal control structure.
Prepare a budget.

Cash
1.
2.
3.
4.
5.

6.
7.
8.

Review internal control before year end.

Confirm all accounts with bank with which company transacted business during year as of ________ .
Arrange to receive cutoff bank statements, and canceled checks and bank advices for the period up to 2 weeks
after year end.
Verify the propriety of the bank reconciliation and all reconciled items. Trace any unreturned O/S check
amounts to supporting documents.
For bank cutoff statement:
a. Verify the deposits in transit into the bank reconciliation.
b. Make sure that all the checks dated at year end or prior are listed as O/S on the bank reconciliation.
c. Review source documents for items not clearing in the bank's cutoff statement (i.e., purchase order, invoice
or bank deposit receipt).
Perform interbank transfer test to determine if transfers between corporate accounts have been properly
recorded.
Count petty cash, reconcile with vouchers to balance sheet date. (NOTE: This should be done during inventory
observation.)
If cash disbursement test reveals that internal control over cash is weak, do a proof of cash for an interim
month. Month chosen ________

2-15

a.

For that month, test foot books of original entry (i.e., cash receipts and cash disbursements) and trace to
general ledger; and reconcile to bank deposits and withdrawals.
b. Clear all outstanding items.
9. Note for financial statement presentation of any cash restrictions (i.e., 90-day notice accounts, certificate of
deposit, etc.).
10. Conclude as to audit objectives.

Accounts Receivable
1.
2.

3.
4.
5.
6.

Review internal control before year end.

Obtain A/R aging, as of date of interim work or year end as applicable.
a. Select A/R balances for positive confirmation, and confirm a representative sample of total dollar value
and number of accounts.
b. Agree the aged listing to the G/L control account.
Send second requests two weeks after original request.
Obtain explanations for all differences.
For nonreplies, perform alternate verification procedures. Trace all entries on customer A/R card to subsequent
cash receipts, proof of delivery, or authorized credit issuance.
Summarize confirmation results, and conclude as to adequacy.

If interim audit work was performed, do step 7; otherwise omit.

7.

Obtain year-end A/R aging:

a. Reconcile the interim to year-end balance by tracing to sales register, C/R register, and any adjustments,
and summarize on a work paper.
b. Foot the aged T/B.
c. Agree total to G/L.
d. Compare the individual customer balances for interim versus year end and investigate unusual differences.
e. Review for any large credit balances; consider reclassifying as accounts payable.
8. Obtain an analysis of allowance for bad debts.
a. One showing beginning balance, expense additions, deductions (write-offs) and ending balance.
b. A second schedule showing composition of ending balance (i.e., those accounts deemed uncollectible).
c. Determine reasonableness of allowance for bad debts by reference to aged A/R T/B and discussions with
credit department.
9. Review sales cutoff before and after year-end tracing from sales register to shipping documents, and relating
the test to documents (bills of lading) obtained at the year-end inventory.
10. Review credit memos for authenticity and proper approval.
11. Conclude on propriety of A/R, bad debt expense, and allowance for uncollectible accounts.

Inventory
1.
2.
3.

Review internal control prior to year end.

Send confirmations to any locations outside the factory where the client's inventory is held.
Physical inventory observation:
a. Prior to inventory date, determine that proper instructions have been issued to client personnel. Review
procedures with company controller.
b. If tags are used, obtain tag control of those issued and those used.
c. Tour premises and determine that inventory is not moving and that no shipping or receiving is going on.
d. Determine that slow-moving obsolete inventory and customer inventory are prominently marked and are
not being counted. Make a note of these items to insure that they have not been included in the priced
inventory listing.
e. Determine that the tags are being filled out in accordance with instructions.
f. Make test counts, recording a few from all areas and all classes (RM, W/P and FG) of inventory for
subsequent tie-in to priced inventory.
g. Obtain shipping and receiving cutoff documents.

2-16

h.
i.

Obtain carbon copy of all tags prior to end of physical inventory and check into tag listing.
If perpetual system is in use, select a sample from perpetual records and trace to inventory count to the
floor and count some items on the floor and trace to the perpetual records.
j. If inventory tags are not used (i.e., if the inventory is listed on count sheets), test that all items are being
counted by reference to audit procedures in (i). In addition, count the number of inventory sheets and note
the last item on each sheet in order that we may test to see if we received a complete priced inventory.
4. Inventory Valuation
a. Obtain a complete listing of the priced inventory.
b. Quantities:
1. Trace all test counts obtained at the time of the physical to final inventory.
2. Trace listing of obsolete items to priced inventory in order to verify their exclusion.
c. Prices:
1. Raw Materials
a) Select a representative sample and trace to the vendor invoice or cost card to determine that the
correct prices were used.
2. W.I.P. and Finished Goods
a) Select a sample and trace to cost records.
b) Do an overhead cost calculation to determine if overhead application is correct.
c) Select a sample and test if cost buildup procedure for material, labor and overhead is adequate to
yield reasonable pricing.
5. Inventory Summarization
a. Test extensions of final inventory.
b. Foot the summarization, and agree the total to the G/L control total.
c. Compare list with prior years and investigate any large differences and compare for obsolete items or item
written off in prior year and included this year.
6. Cutoff
a. Review cutoff with reference to shipping and receiving documents from the physical and incorporate the
work with that done in A/R and A/P.
7. Lower of Cost or Market Test
a. For a reasonable sample, compare inventory value with recent sales invoices. Examine gross profits by
product line if possible.
8. Slow Moving or Obsolete Inventory
a. Review purchase records and/or perpetual records and compare inventory lists and any available activity
reports for slow moving or obsolete inventory. Evaluate what reserve should be applied, if any.
9. If applicable, review perpetual cards for large fluctuations of quantity and investigate.
10. Conclude on inventory valuation and cutoff.

Prepaids and Other Assets

1.
2.

3.

4.

Review internal control prior to year end.

Prepaid insurance
a. Obtain schedule from client.
b. Test calculation of prepaid and expense amounts
c. Review major insurance policies.
d. Review audits regarding W/C and product liability.
e. Vouch premium payment to invoice.
f. Review adequacy of insurance coverage.
g. Confirm any policies with cash value.
Other prepaid and deferred charges
a. Obtain schedule from client.
b. Review schedule for propriety by checking calculations to supporting documents.
c. Review amortization rates of intangibles if appropriate.
Conclusion.

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Fixed Assets
1.
2.
3.
4.
5.
6.

7.
8.
9.

Review internal control prior to year end.

Obtain a summary schedule of fixed assets and related accumulated depreciation; check beginning balances to
permanent file.
Obtain detailed schedule of additions and disposals and trace to schedule in item 2.
a. For significant purchases review invoice. Scope _____________________
b. Inspect major asset additions.
Review analysis of repair accounts and reclassify material amounts if necessary.
Test depreciation calculation and reconcile expense to addition to accumulated depreciation accounts and
expense accounts.
Obtain schedule of sales or disposals.
a. Review supporting documents and determine proper gain or loss or adjustment to basis of like asset
acquired.
b. Vouch proceeds to documents.
c. Check that the proper amounts of cost and accumulated depreciation have been removed from books.
Obtain necessary items to compute investment credit.
Note any liens on fixed assets for footnote disclosure.
Conclusion.

Notes Payable and Long-Term Debt

1.
2.
3.
4.
5.
6.
7.

Review internal control prior to year end.

Obtain a schedule of notes payable with interest paid, accrued, and expensed and prepaid, and classify as to
current and noncurrent.
Confirm balances, collateral, and interest rates with payee. Determine if in default and obtain default letters if
needed.
Vouch changes for period.
Obtain copy of agreement for permanent file and note if provisions are being adhered to.
Check interest calculations and reconcile to ledger.
Conclusion.

Accounts Payable
1.
2.
3.
4.
5.
6.

7.

Review internal control prior to year end.

Obtain list of accounts payable and trace to source invoices for proper recording and reconcile with general
ledger. Scope _______________________________
Obtain vendor statements and reconcile to list (for significant vendors).
a. Consider confirmation of significant balances, including zero balances.
b. Reconcile returned confirms, if used.
Review debit balances (material amounts) and consider reclassification and confirmation.
Review old or disputed items and document.
Search for unrecorded liabilitiessubsequent events.
a. Review minutes for liabilities.
b. For several days immediately after balance sheet date: Scope: _____________
1. Examine recorded vouchers and cash disbursements for proper period recording.
2. Examine unentered vouchers and invoices and unmatched receiving reports for possible adjustment.
3. Cross reference to inventory section cutoff work.
Conclude.

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Other Liabilities and Accrued Expenses

1.
2.

3.
4.
5.
6.

Review internal control prior to year end.

Obtain schedules from client for:
a. Withheld taxes.
b. Accrued payroll, commissions, payroll taxes.
c. Other accrued expenses.
Review source documents to determine propriety of accrual and test amounts.
Compare to prior year accruals and document differences.
Ascertain no material unrecorded accruals by reference to subsequent payments.
Conclude.

Tax Provisions
1.
2.
3.
4.
5.
6.
7.

Obtain an analysis of federal and state provisions and expense accounts and reconcile to ledger.
Vouch payments made during period.
Examine revenue agent reports received during period and review any adjustments booked.
Obtain or prepare a reconciliation of income per books, per taxes.
Check provisions for period considering Schedule M items, investment credit, N.O.L.C., etc.
Review for proper allocation of timing differences, etc.
Conclusion.

Capital Stock
1.
2.

3.
4.

Obtain schedule of each class from articles of incorporation, and from minutes determine amount issued and
reconcile to ledger.
Confirmation with:
a. Transfer agent as to total shares authorized and issued, shares in name of client, and holders of 10% or
more, unbilled fees, etc.
b. Registrar, same as in (a).
c. Compare (a) and (b) to pertinent schedules in permanent file.
Review and vouch to source documents any changes during period.
Obtain pertinent data on:
a. Any options granted or exercised.
b. Warrants granted or exercised.
c. Rights.
d. Conversion features of debenture issues.
e. Treasury stock.
1. Obtain schedule regarding number of shares, cost, etc.
2. Review period transactions for proper accounting treatment.

Paid-in Surplus
1.

Obtain schedule and reconcile to ledger and #1 above.

Retained Earnings
1.
2.
3.

Schedule.
Verify dividends paid or declared and if applicable dividend status on preferred cumulative stock.
Vouch period's activity.

2-19

SPECIAL AUDIT PROCEDURES AND PROBLEMS

RELATED PARTY TRANSACTIONS (SAS No. 45)
There are specific procedures with respect to related party transactions that should be considered by the auditor
when performing an examination of financial statements in accordance with generally accepted auditing standards.

Related Party Defined

The term "related parties" means the reporting entity, its affiliates, principal owners, management and members
of their immediate families, entities for which investments are accounted for by the equity method, and any other
party with which the reporting entity may deal when one party has the ability to significantly influence the
management or operating policies of the other, to the extent that one of the transacting parties might be prevented
from fully pursuing its own separate interests. Related parties also exist when another entity has the ability to
significantly influence the management or operating policies of the transacting parties, or when another entity has
an ownership interest in one of the transacting parties and the ability to significantly influence the other, to the
extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

Examples of Related Party Transactions

Examples of related party transactions include transactions between a parent company and its subsidiaries,
transactions between or among subsidiaries of a common parent, and transactions in which the reporting entity
participates with other affiliated businesses, with management or with principal stockholders (or other ownership
interests). Transactions between or among the foregoing parties are considered to be related party transactions even
though they may not be given accounting recognition. For example, an entity may provide services to a related party
without charge.
Sometimes two or more entities are under common ownership or management control, but they do not transact
business between or among themselves. Mere existence of common control, however, may result in operating
results or financial position significantly different from those that would have been obtained if the entities were
autonomous. For example, two or more entities in the same line of business may be commonly controlled by a party
with the ability to increase or decrease the volume of business done by each. Consequently, the nature of the
common control should be disclosed.
An entity may be economically dependent on one or more parties with which it transacts a significant volume of
business, such as a sole or major customer, supplier, franchisor, franchisee, distributor, general agent, borrower, or
lender. Such parties should not be considered related parties solely by virtue of economic dependency unless one of
them clearly exercises significant management or ownership influence over the other. Disclosure of economic
dependency may, however, be necessary for a fair presentation of financial position, results of operations, or cash
flows in conformity with generally accepted accounting principles.

Accounting Considerations
Except for the disclosure requirements of the Securities and Exchange Commission's Regulation S-X and the
accounting treatment prescribed by certain Opinions of the Accounting Principles Board when related parties are
involved, established accounting principles ordinarily do not require transactions with related parties to be
accounted for on a basis different from that which would be appropriate if the parties were not related. Until such
time as applicable accounting principles are established by appropriate authoritative bodies, the auditor should view
related party transactions within the framework of existing pronouncements, placing primary emphasis on the
adequacy of disclosure of the existence of such transactions and their significance in the financial statements of the
reporting entity.
Generally, financial statements should recognize the economic substance of transactions rather than merely their
legal form. Accounting Principles Board Statement No. 4, paragraph 35, states: "Although financial accounting is

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concerned with both the legal and economic effects of transactions and other events and many of its conventions are
based on legal rules, the economic substance of transactions and other events are usually emphasized when
economic substance differs from legal form."
Examples of transactions that raise questions as to their substance and that may be indicative of the existence of
related parties are the following:
1. Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below current
market rates.
2. Selling real estate at a price that differs significantly from its appraised value.
3. Exchanging property for similar property in a nonmonetary transaction.
4. Making loans with no scheduled terms as to when or how the funds will be repaid.

Audit Procedures
During an examination made in accordance with generally accepted auditing standards, an auditor should be aware
of the possible existence of material related party transactions that could affect the financial statements. The
auditor should obtain an understanding of management responsibilities and the relationship of each component to
the total entity, evaluate internal accounting controls over management activities, and consider the business purpose
served by the various components of the entity. Normally, the business structure and style of operating are based on
the abilities of management, tax and legal considerations, product diversification, and geographical location.
Experience has shown, however, that business structure and operating style are occasionally deliberately designed
to obscure related party transactions.
In the absence of evidence to the contrary, transactions with related parties should not be assumed to be outside the
ordinary course of business. The auditor should, however, be aware of the possibility that transactions with related
parties may have been motivated solely, or in large measure, by conditions similar to the following:
1. Lack of sufficient working capital or credit to continue the business.
2. An urgent desire for a continued favorable earnings record in the hope of supporting the price of the company's
stock.
3. An overly optimistic earnings forecast.
4. Dependence on a single or relatively few products, customers, or transactions, for the ongoing success of the
venture.
5. A declining industry characterized by a large number of business failures.
6. Excess capacity.
7. Significant litigation, especially litigation between stockholders and management.
8. Significant obsolescence dangers because the company is in a high-technology industry.

Determining the Existence of Related Parties

The auditor should place emphasis on auditing material transactions with parties he knows are related to the
reporting entity. Certain relationships, such as parent-subsidiary or investor-investee, may be clearly evident.
Determining the existence of others requires the application of specific audit procedures which may include the
following:
1. Evaluate the company's procedures for identifying and properly accounting for related party transactions.
2. Inquire of appropriate management personnel as to the names of all related parties and whether there were any
transactions with these parties during the period.
3. Review filings by the reporting entity with the Securities and Exchange Commission and other regulatory
agencies for the names of related parties and for other businesses in which officers and directors occupy
directorship or management positions.

USING THE WORK OF A SPECIALIST (SAS No. 73)

A specialist is a person (or firm) possessing special skill or knowledge in a particular field other than accounting or
auditing, such as actuaries, appraisers, attorneys, engineers, and geologists.

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Decision to Use the Work of a Specialist

During his examination an auditor may encounter matters potentially material to the fair presentation of financial
statements in conformity with generally accepted accounting principles that require special knowledge and that in
his judgment require using the work of a specialist.
Examples of the types of matters that the auditor may decide require him to consider using the work of a specialist
include, but are not limited to the following:
1. Valuation (e.g., works of art, special drugs, and restricted securities).
2. Determination of physical characteristics relating to quantity on hand or condition (e.g., mineral reserves, or
materials stored in piles above ground).
3. Determination of amounts derived by using specialized techniques or methods (e.g., certain actuarial
determinations).
4. Interpretation of technical requirements, regulations, or agreements (e.g., the potential significance of contracts
or other legal documents, or legal title to property).
In performing an examination of financial statements in accordance with generally accepted auditing standards, the
auditor may use the work of a specialist as an audit procedure to obtain competent evidential matter. The
circumstances surrounding the use of a specialist differ. Although the familiarity of individual auditors with the
work performed by certain types of specialists may differ, the auditing procedures necessary to comply with
generally accepted auditing standards need not vary as a result of the extent of the auditor's knowledge.

Selecting a Specialist
The auditor should satisfy himself concerning the professional qualifications and reputation of the specialist by
inquiry or other procedures, as appropriate. The auditor should consider the following:
1. The professional certification, license, or other recognition of the competence of the specialist in his field, as
appropriate.
2. The reputation and standing of the specialist in the views of his peers and others familiar with his capability or
performance.
3. The relationship, if any, of the specialist to the client.
Ordinarily, the auditor should attempt to obtain a specialist who is unrelated to the client. However, when the
circumstances so warrant, work of a specialist having a relationship to the client may be acceptable. Work of a
specialist unrelated to the client will usually provide the auditor with greater assurance of reliability because of the
absence of a relationship that might impair objectivity.
An understanding should exist among the auditor, the client, and the specialist as to the nature of the work to be
performed by the specialist. Preferably, the understanding should be documented and should cover the following:
1. The objectives and scope of the specialist's work.
2. The specialist's representations as to his relationship, if any, to the client.
3. The methods or assumptions to be used.
4. A comparison of the methods or assumptions to be used with those used in the preceding period.
5. The specialist's understanding of the auditor's corroborative use of the specialist's findings in relation to the
representations in the financial statements.
6. The form and content of the specialist's report that would enable the auditor to make the evaluation.

Using the Findings of the Specialist

Although the appropriateness and reasonableness of methods or assumptions used and their application are the
responsibility of the specialist, the auditor should obtain an understanding of the methods or assumptions used by
the specialist to determine whether the findings are suitable for corroborating the representations in the financial
statements. The auditor should consider whether the specialist's findings support the related representations in the
financial statements and make appropriate tests of accounting data provided by the client to the specialist.
Ordinarily, the auditor would use the work of the specialist unless his procedures lead him to believe that the
findings are unreasonable in the circumstances. If the specialist is related to the client, the auditor should
consider performing additional procedures with respect to some or all of the related specialist's assumptions,

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methods, or findings to determine that the findings are not unreasonable or engage an outside specialist for that
purpose.

Effect of the Specialist's Work On the Auditor's Report

If the auditor determines that the specialist's findings support the related representations in the financial statements,
he may reasonably conclude that he has obtained sufficient competent evidential matter. If there is a material
difference between the specialist's findings and the representations in the financial statements, or if the auditor
believes that the determinations made by the specialist are unreasonable, he should apply additional procedures. If,
after applying any additional procedures that might be appropriate, he is unable to resolve the matter, the auditor
should obtain the opinion of another specialist, unless it appears to the auditor that the matter cannot be resolved. A
matter that has not been resolved will ordinarily cause the auditor to conclude that he should qualify his opinion or
disclaim an opinion, because the inability to obtain sufficient competent evidential matter as to an assertion of
material significance in the financial statements constitutes a scope limitation.
The auditor may conclude, after performing additional procedures, including possibly obtaining the opinion of
another specialist, that the representations in the financial statements are not in conformity with generally accepted
accounting principles. In that event, he should express a qualified or adverse opinion.

Reference to the Specialist in the Auditor's Report

When expressing an unqualified opinion, the auditor should not refer to the work or findings of the specialist. Such
a reference in an unqualified opinion might be misunderstood to be a qualification of the auditor's opinion or a
division of responsibility, neither of which is intended. Further, there may be an inference that the auditor making
such reference performed a more thorough audit than an auditor not making such reference.
If the auditor decides to modify his opinion as a result of the report or findings of the specialist, reference to and
identification of the specialist may be made in the auditor's report if the auditor believes such reference will
facilitate an understanding of the reason for the modification.

INQUIRY OF A CLIENT'S LAWYER CONCERNING LITIGATION, CLAIMS, AND

ASSESSMENTS (SAS No. 12)
In General
In forming an opinion on financial statements, evidential matter relating to litigation, claims and assessments is a
significant audit concern of the auditor. Such evidential matter usually lies outside the financial records, and
because of its nature it is difficult for the auditor to determine its existence, and, beyond that, the effect on the
financial statements. Management and legal counsel of the entity are usually the primary source of representation
and assurances as to the adequacy of financial presentation and disclosure of such matters. Refusal of legal counsel
to furnish requested information where counsel has given substantive attention to the matter is a limitation on the
scope of the examination and precludes an unqualified opinion.

Audit Objectives
For litigation, claims, and assessments, the independent auditor should obtain evidential matter as to:
1. The existence of a condition, situations, or set of circumstances indicating an uncertainty as to the possible loss
to an entity arising from litigation, claims and assessments.
2. The period in which the underlying cause for legal action occurred.
3. The degree of probability of an unfavorable outcome.
4. The amount or range of potential loss.

Audit Procedures
1.
2.

Inquire of management as to the policies and procedures adopted for identifying, evaluating, and accounting for
litigation, claims, and assessments.
Obtain from management a representation letter containing a description and evaluation of litigation, claims,
and assessments that existed at the date of the balance sheet being reported on, and during the period from the
balance sheet date to the date the information is furnished, with an identification of those matters referred to

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3.
4.

5.
6.
7.
8.

legal counsel. Obtain assurances from management, ordinarily in writing, that they have disclosed all such
matters required to be disclosed by FASB #5, Accounting for Contingencies.
Examine documents in the client's possession concerning litigation, claims, and assessments, including
correspondence and invoices from lawyers.
Obtain assurance from management, ordinarily in writing, that it has disclosed all unasserted claims that the
lawyer has advised them are probable of assertion and must be disclosed in accordance with FASB #5. Also,
the auditor, with the client's permission, should inform the lawyer that the client has given the auditor this
assurance.
Read minutes of meetings of stockholders, directors, and appropriate committees held during and subsequent to
the period being examined.
Read contracts, loan agreements, leases, and correspondence from taxing or other governmental agencies, and
similar documents.
Obtain information concerning guarantees from bank confirmation forms.
Inspect other documents for possible guarantees by the client.

Client's Lawyer Inquiries

A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the
information furnished by management concerning litigation, claims, and assessments. Evidential matter obtained
from the client's inside general counsel or legal department may provide the auditor with the necessary
corroboration, but evidential matter from inside counsel is not a substitute for information that outside counsel may
refuse to furnish to the auditor.
A letter of audit inquiry should include:
1. Identification of the company, including subsidiaries, and the date of the examination.
2. A list or request for a list from counsel that describes and evaluates pending or threatened litigation, claims, and
assessments with respect to which the lawyer has been engaged and to which he has devoted substantive
attention on behalf of the company.
3. A list prepared by management that describes and evaluates unasserted claims and assessments that
management considers to be probable of assertion, and that, if asserted, would have at least a reasonable
possibility of an unfavorable outcome, with respect to which the lawyer has devoted substantive attention on
behalf of the company.
4. As to each matter, a request that the lawyer either furnish the following information or comment on those
matters as to which his views may differ from those stated by management, as appropriate:
a. A description of the nature of the matter, the progress of the case to date, and the action the company
intends to take (for example, to contest the matter vigorously or to seek an out-of-court settlement).
b. An evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the
amount or range of potential loss.
c. With respect to a list prepared by management, an identification of the omission of any pending or
threatened litigation, claims, and assessments, or a statement that the list of such matters is complete.
5. A statement that, in the case of an unasserted possible claim or assessment that may call for financial statement
disclosure, the lawyer, as a matter of professional responsibility to the client, should advise and consult with the
client concerning the question of disclosure and the requirements of FASB #5. The lawyer should confirm this
understanding in the reply.
6. The lawyer should identify the nature of and reasons for any limitation on his response. Matters that are not
material should be excluded from inquiry.
In special circumstances, the auditor may obtain a response concerning matters covered by the audit inquiry letter in
a conference, which offers an opportunity for a more detailed discussion and explanation than a written reply. The
auditor should appropriately document conclusions reached concerning the need for accounting for or
disclosure of litigation, claims, and assessments.
A lawyer may be required by his Code of Professional Responsibility to resign his engagement if his advice
concerning these matters is disregarded by the client. When the auditor is aware that a client has changed lawyers or
that a lawyer engaged by the client has resigned, the auditor should inquire as to the reasons.

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Limitations On the Scope of a Lawyer's Response

A lawyer may appropriately limit his response if he has not given substantive attention to the matter. Also, a
lawyer's response may be limited to matters that are considered individually or collectively material to the financial
statements, provided the lawyer and auditor have reached an understanding on the limits of materiality for this
purpose. Such limitations are not limitations on the scope of the auditor's examination.
A lawyer's refusal to furnish the information requested in an inquiry letter, either in writing or orally where the
lawyer has devoted substantive attention, would be a limitation on the scope of the auditor's examination
sufficient to preclude an unqualified opinion.
A lawyer's response to such an inquiry and the procedures set forth previously provide the auditor with sufficient
evidential matter to satisfy himself concerning the accounting for and reporting of pending and threatened litigation,
claims and assessments. The auditor obtains sufficient evidential matter to satisfy himself concerning reporting for
those unasserted claims and assessments required to be disclosed in financial statements from the foregoing
procedures and the lawyer's specific acknowledgment of his responsibility to his client in respect to disclosure
obligations. This approach with respect to unasserted claims and assessments is necessitated by the public interest
in protecting the confidentiality of lawyer-client communications.

Other Limitations On a Lawyer's Response

A lawyer may be unable to respond concerning the likelihood of an unfavorable outcome of litigation, claims, and
assessments or the amount or range of potential loss, because of inherent uncertainties. Factors influencing the
likelihood of an unfavorable outcome may sometimes not be within a lawyer's competence to judge; historical
experience of the entity in similar litigation or the experience of other entities may not be relevant or available; and
the amount of the possible loss frequently may vary widely at different stages of litigation. Consequently, a lawyer
may not be able to form a conclusion with respect to such matters. In such circumstances, the auditor ordinarily
will conclude that the financial statements are affected by an uncertainty concerning the outcome of a future
event which is not susceptible of reasonable estimation (a condition for accrual under FASB #5 is that the
amount of loss can be reasonably estimated). If the effect of the matter on the financial statements could be material,
the auditor ordinarily will conclude that he is unable to express an unqualified opinion.

CLIENT REPRESENTATIONS (SAS No. 85)

There is a requirement that the independent auditor obtain certain written representations from management as
a part of an examination made in accordance with generally accepted auditing standards and provides guidance
concerning the representations to be obtained.

Reliance on Management Representations

Representations from management are part of the evidential matter the independent auditor obtains, but they are not
a substitute for the application of those auditing procedures necessary to afford a reasonable basis for his opinion on
the financial statements. Written representations from management ordinarily confirm oral representations given to
the auditor.
The auditor obtains written representations from management relating to its knowledge or intent when he believes
they are necessary to complement his other auditing procedures.

Obtaining Written Representations

The specified written representations obtained by the auditor will depend on the circumstances of the engagement
and the nature and basis of presentation of the financial statements. They ordinarily include the following matters, if
applicable:
1. Management's acknowledgment of its responsibility for the fair presentation in the financial statements of
financial position, results of operations, and cash flows in conformity with generally accepted accounting
principles or other comprehensive basis of accounting.
2. Availability of all financial records and related data.
3. Management is responsible for adjusting the financial statements to correct material misstatements and that
any unrecorded misstatements aggregated by the auditor are immaterial to the financial statements of the

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4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.

current period. A summary of the unrecorded misstatements should be included in or attached to the
representation letter.
Completeness and availability of all minutes of meetings of stockholders, directors, and committees of
directors.
Absence of errors in the financial statements and unrecorded transactions.
Information concerning fraud involving management or employees that could have a material effect on the
financial statements.
Information concerning related party transactions and related amounts receivable or payable.
Noncompliance with aspects of contractual agreements that may affect the financial statements.
Information concerning subsequent events.
Irregularities involving management or employees.
Communications from regulatory agencies concerning noncompliance with, or deficiencies in, financial
reporting practices.
Plans or intentions that may affect the carrying value or classification of assets or liabilities.
Disclosure of compensating balance or other arrangements involving restrictions on cash balances, and
disclosure of line-of-credit or similar arrangements.
Reduction of excess or obsolete inventories to net realizable value.
Losses from sales commitments.
Satisfactory title to assets, liens on assets, and assets pledged as collateral.
Agreements to repurchase assets previously sold.
Losses from purchase commitments for inventory quantities in excess of requirements or at prices in excess of
market.
Violations or possible violations of laws or regulations whose effects should be considered for disclosure in
the financial statements or as a basis for recording a loss contingency.
Other liabilities and gain or loss contingencies that are required to be accrued or disclosed by Statement of
Financial Accounting Standards No. 5.
Unasserted claims or assessments that the client's lawyer has advised are probable of assertion and must be
disclosed in accordance with FASB No. 5.
Capital stock repurchase options or agreements or capital stock reserved for options, warrants, conversions, or
other requirements.

Managements Consideration of Unrecorded Misstatements

The representation letter obtained by the auditor must include, in addition to the items noted in the previous section,
the following:
1. An acknowledgement by management that it has considered the financial statement misstatements
aggregated by the auditor during the current engagement, and has concluded that any unrecorded
misstatements are immaterial, both individually and in the aggregate, to the financial statements as a whole.
2. Example:
We believe that the effects of the unrecorded financial statement misstatements summarized in the
attached schedule are immaterial, both individually and in the aggregate, to the financial statements.

Scope Limitations
Management's refusal to furnish a written representation that the auditor believes is essential constitutes a
limitation on the scope of the auditor's examination sufficient to preclude an unqualified opinion. Further, the
auditor should consider the effects of management's refusal on his ability to rely on other of their representations.
Representation letters should be prepared on the client's stationery and signed by appropriate officers and
employees. In most cases the CPA will draft the representation letter, but the officer or employee must accept the
statements in the letter as his own representations.
It is important that the representation letter be signed by one or more officers or responsible employees who are
knowledgeable about the particular area or activity reported upon. For example (and depending on the
circumstances), the company secretary might prepare the representation concerning minutes of the board of
directors, the controller might affirm the fair presentation of the financial statements and recording of liabilities, and
the purchasing agent might report on the purchase commitments.

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All client representations should be obtained as of the audit completion date. If the representation letter refers to
events occurring in the subsequent period, it is appropriate that the letter be signed, dated, and delivered to the
auditor on the last day of field work.
Client representation letters are evidential matter supporting the auditor's opinion. Accordingly, they should be
prepared for each succeeding examination of financial statements. If the auditor's report is updated, he should obtain
from the client an additional representation as to events occurring subsequent to the date of his previous report.

AUDITING ACCOUNTING ESTIMATES (SAS No. 57)

An accounting estimate is the approximation of a financial statement element, item, or account. Accounting
estimates are often included in historical financial statements because:
1.
2.

The measurement of some amounts or the valuation of some accounts is uncertain, pending the outcome of
future events.
Relevant data concerning events that have already occurred cannot be accumulated on a timely, cost-effective
basis.

Management is responsible for making the accounting estimates used in the financial statements. The auditor is
responsible for evaluating the reasonableness of accounting estimates. Thus, the auditor should approach the audit
of accounting estimates with an attitude of professional skepticism, and be aware of the fact that estimates are the
result of both subjective and objective factors.

Developing Accounting Estimates

Management is responsible for establishing a process for preparing accounting estimates. Although the process may
not be documented or formally applied, it normally consists of:
1. Identifying situations for which accounting estimates are required.
2. Identifying the relevant factors that may affect the accounting estimate.
3. Accumulating relevant, sufficient, and reliable data on which to base the estimate.
4. Developing assumptions that represent management's judgment of the most likely circumstances and events
with respect to the relevant factors.
5. Determining the estimated amount based on the assumptions and other relevant factors.
6. Determining that the accounting estimate is presented in conformity with applicable accounting principles and
that disclosure is adequate.

Internal Control Structure Related to Accounting Estimates

An entity's internal control structure may reduce the likelihood of material misstatements of accounting estimates.
Specific relevant aspects of that structure include the following:
1. Management communication of the need for proper accounting estimates
2. Accumulation of relevant, sufficient, and reliable data on which to base an accounting estimate
3. Preparation of the accounting estimate by qualified personnel
4. Adequate review and approval of the accounting estimates by appropriate levels of authority, including
a. Review of sources of relevant factors
b. Review of development of assumptions
c. Review of reasonableness of assumptions and resulting estimates
d. Consideration of the need to use the work of specialists
e. Consideration of changes in previously established methods to arrive at accounting estimates
5. Comparison of prior accounting estimates with subsequent results to assess the reliability of the process used to
develop estimates
6. Consideration by management of whether the resulting accounting estimate is consistent with the operational
plans of the entity.

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Evaluating Accounting Estimates

The auditor's objective when evaluating accounting estimates is to obtain sufficient competent evidential matter to
provide reasonable assurance that:
1. All accounting estimates that could be material to the financial statements have been developed.
2. Those accounting estimates are reasonable in the circumstances.

Evaluating Reasonableness
1.

In evaluating the reasonableness of an estimate, the auditor normally concentrates on key factors and
assumptions that are:
a. Significant to the accounting estimate.
b. Sensitive to variations.
c. Deviations from historical patterns.
d. Subjective and susceptible to misstatement and bias.
The auditor normally should consider the historical experience of the entity in making past estimates as well as
the auditor's experience in the industry. However, changes in facts, circumstances, or entity's procedures may
cause factors different from those considered in the past to become significant to the accounting estimate.

2.

In evaluating reasonableness, the auditor should obtain an understanding of how management developed the
estimate. Based on that understanding, the auditor should use one or a combination of the following
approaches:
a. Review and test the process used by management to develop the estimate.
b. Develop an independent expectation of the estimate to corroborate the reasonableness of management's
estimate.
c. Review subsequent events or transactions occurring prior to completion of fieldwork.

3.

Review and test management's process. In many situations, the auditor assesses the reasonableness of an
accounting estimate by performing procedures to test the process used by management to make the estimate.
The following are procedures the auditor may consider performing when using this approach:
a. Identify whether there are controls over the preparation of accounting estimates and supporting data that
may be useful in the evaluation.
b. Identify the sources of data and factors that management used in forming the assumptions, and consider
whether such data and factors are relevant, reliable, and sufficient for the purpose based on information
gathered in other audit tests.
c. Consider whether there are additional key factors or alternative assumptions about the factors.
d. Evaluate whether the assumptions are consistent with each other, the supporting data, relevant historical
data, and industry data.
e. Analyze historical data used in developing the assumptions to assess whether the data is comparable and
consistent with data of the period under audit, and consider whether such data is sufficiently reliable for the
purpose.
f. Consider whether changes in the business or industry may cause other factors to become significant to the
assumptions.
g. Review available documentation of the assumptions used in developing the accounting estimates and
inquire about any other plans, goals, and objectives of the entity, as well as consider their relationship to
the assumptions.
h. Consider using the work of a specialist regarding certain assumptions.
i. Test the calculations used by management to translate the assumptions and key factors into the accounting
estimate.

4.

Develop an expectation. Based on the auditor's understanding of the facts and circumstances, he may
independently develop an expectation as to the estimate by using other key factors or alternative assumptions
about those factors.

5.

Review subsequent events or transactions. Events or transactions sometimes occur subsequent to the date of
the balance sheet, but prior to the completion of fieldwork, that are important in identifying and evaluating the

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reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In
such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or
unnecessary as the event or transaction can be used by the auditor in evaluating their reasonableness.

SAS No. 114 The Auditors Communication with

Those Charged with Governance
Requirements:
1.

The auditor must communicate with those charged with governance matters related to the financial statement
audit that are, in the auditor's professional judgment, significant and relevant to the responsibilities of those
charged with governance in overseeing the financial reporting process.

2.

Those charged with governance include:

Board of directors
Partners, members, proprietors, or a committee of management, trustees or equivalent persons
Owner-manager such as in the case of a smaller entity
Audit committee or subgroup

3.

Matters to be communicated include:

4.

5.

a.

The auditor's responsibilities under generally accepted auditing standards,

b.

An overview of the planned scope and timing of the audit, and,

c.

Significant findings from the audit including:

The auditor's views about qualitative aspects of the entity's significant accounting practices, including
accounting policies, accounting estimates, and financial statement disclosures.
Significant difficulties, if any, encountered during the audit
Uncorrected misstatements, other than those the auditor believes are trivial
Disagreements with management, if any.
Other findings or issues, if any, arising from the audit that are significant and relevant to those charged
with governance regarding their oversight of the financial reporting process.

d.

Additional items to communicate: Unless all of those charged with govemance are involved in managing
the entity, the auditor should also communicate:
Material, corrected misstatements that were brought to the attention of management as a result of audit
procedures
Representations the auditor is requesting from management as presented in the management
representation letter
Management's consultations with other accountants
Significant issues, if any, arising from the audit that were discussed, or the subject of correspondence,
with management.

Form of communications:
a.

Significant findings from the audit must be communicated in writing.

b.

All other communications may be oral or in writing.

Timing of communications
a.

The auditor should communicate with those charged with governance on a sufficiently timely basis to
enable those charged with governance time to take appropriate action.

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Chapter Two - Questions

The Third Standard of Field WorkEvidence
1. Which of the following is not a typical analytical
review procedure?
a. Study of relationships of financial information with
relevant nonfinancial information.
b. Comparison of financial information with similar
information regarding the industry in which the
entity operates.
c. Comparison of recorded amounts of major
disbursements with appropriate invoices.
d. Comparison of recorded amounts of major
disbursements with budgeted amounts.

5. A CPA auditing an electric utility wishes to determine

whether all customers are being billed. The CPA's best
direction of test is from the
a. Meter department records to the billing (sales)
register.
b. Billing (sales) register to the meter department
records.
c. Accounts receivable ledger to the billing (sales)
register.
d. Billing (sales) register to the accounts receivable
ledger.

2. Auditors may use positive and/or negative forms of

confirmation requests for accounts receivable. An
auditor most likely will use
a. The positive form to confirm all balances
regardless of size.
b. A combination of the two forms, with the positive
form used for large balances and the negative form
for the small balances.
c. A combination of the two forms, with the positive
form used for trade receivables and the negative
form for other receivables.
d. The positive form when controls related to
receivables are satisfactory, and the negative form
when controls related to receivables are
unsatisfactory.

6. Which of the following audit procedures is most

effective in testing credit sales for understatement?
a. Age accounts receivable.
b. Confirm accounts receivable.
c. Trace sample of initial sales slips through
summaries to recorded general ledger sales.
d. Trace sample of recorded sales, from general ledger
to initial sales slip.
7. One reason why the independent auditor makes an
analytic review of the client's operations is to identify
a. Weaknesses of a material nature in the system of
internal control.
b. Noncompliance with prescribed control procedures.
c. Improper separation of accounting and other
financial duties.
d. Unusual transactions.

3. Of the following which is the least persuasive type of

audit evidence?
a. Documents mailed by outsiders to the auditor.
b. Correspondence between auditor and vendors.
c. Copies of sales invoices inspected by the auditor.
d. Computations made by the auditor.

8. The auditor obtains corroborating evidential matter for

accounts receivable by using positive or negative
confirmation requests. Under which of the following
circumstances might the negative form of the accounts
receivable confirmation be useful?
a. A substantial number of accounts are in dispute.
b. Internal control over accounts receivable is
ineffective.
c. Client records include a large number of relatively
small balances.
d. The auditor believes that recipients of the requests
are unlikely to give them consideration.

4. Analytical review procedures are

a. Substantive tests designed to evaluate a system of
internal control.
b. Compliance tests designed to evaluate the validity
of management's representation letter.
c. Substantive tests designed to evaluate the
reasonableness of financial information.
d. Compliance tests designed to evaluate the
reasonableness of financial information.

2Q-1

9. An auditor is testing sales transactions. One step is to

trace a sample of debit entries from the accounts
receivable subsidiary ledger back to the supporting sales
invoices. What would the auditor intend to establish by
this step?
a. All sales have been recorded.
b. Debit entries in the accounts receivable subsidiary
ledger are properly supported by sales invoices.
c. All sales invoices have been properly posted to
customer accounts.
d. Sales invoices represent bona fide sales.

14. Which one of the following procedures would not be

appropriate for an auditor in discharging his
responsibilities concerning the client's physical
inventories?
a. Confirmation of goods in the hands of public
warehouses.
b. Supervising the taking of the annual physical
inventory.
c. Carrying out physical inventory procedures at an
interim date.
d. Obtaining written representation from the client as
to the existence, quality, and dollar amount of the
inventory.

10. Approximately 95% of returned positive accountreceivable confirmations indicated that the customer
owed a smaller balance than the amount confirmed. This
might be explained by the fact that
a. The cash-receipts journal was held open after year
end.
b. There is a large number of unrecorded liabilities.
c. The sales journal was closed prior to year end.
d. The sales journal was held open after year end.

15. As part of an audit, a CPA must request a

representation letter from his client. Which one of the
following is not a valid purpose of such a letter?
a. To provide audit evidence.
b. To emphasize to the client his responsibility for the
correctness of the financial statements.
c. To satisfy himself by means of other auditing
procedures when certain customary auditing
procedures are not performed.
d. To provide possible protection to the CPA against a
charge of knowledge in cases where fraud is
subsequently discovered to have existed in the
accounts.

11. An auditor should examine minutes of board of

directors' meetings
a. Through the date of his report.
b. Through the date of the financial statements.
c. On a test basis.
d. Only at the beginning of the audit.

16. To best ascertain that a company has properly

included merchandise that it owns in its ending
inventory, the auditor should review and test the
a. Terms of the open purchase orders.
b. Purchase cut-off procedures.
c. Contractual commitments made by the purchasing
department.
d. Purchase invoices received on or around year end.

12. The return of a positive account-receivable

confirmation without an exception attests to the
a. Collectibility of the receivable balance.
b. Accuracy of the receivable balance.
c. Accuracy of the aging of accounts receivable.
d. Accuracy of the allowance for bad debts.
13. During his examination of a January 19, 19X3, cutoff bank statement, an auditor noticed that the majority
of checks listed as outstanding at December 31, 19X2,
had not cleared the bank. This would indicate
a. A high probability of lapping.
b. A high probability of kiting.
c. That the cash-disbursements journal had been held
open past December 31, 19X2.
d. That the cash-disbursements journal had been
closed prior to December 31, 19X2.

17. Which of the following audit procedures would be

least likely to lead the auditor to find unrecorded fixed
asset disposals?
a. Examination of insurance policies.
b. Review of repairs and maintenance expense.
c. Review of property tax files.
d. Scanning of invoices for fixed asset additions.

2Q-2

18. The physical count of inventory of a retailer was

higher than shown by the perpetual records. Which of
the following could explain the difference?
a. Inventory items had been counted but the tags
placed on the items had not been taken off the
items and added to the inventory accumulation
sheets.
b. Credit memos for several items returned by
customers had not been prepared.
c. No journal entry had been made on the retailer's
books for several items returned to its suppliers.
d. An item purchased "FOB shipping point" had not
arrived at the date of the inventory count and had
not been reflected in the perpetual records.

22. In designing written audit programs, an auditor

should establish specific audit objectives that relate
primarily to the
a. Timing of audit procedures.
b. Cost-benefit of gathering evidence.
c. Selected audit techniques.
d. Financial statement assertions.
23. Which of the following presumptions does not relate
to the competence of audit evidence?
a. The more effective the internal control structure,
the more assurance it provides about the accounting
data and financial statements.
b. An auditor's opinion, to be economically useful, is
formed within reasonable time and based on
evidence obtained at a reasonable cost.
c. Evidence obtained from independent sources
outside the entity is more reliable than evidence
secured solely within the entity.
d. The independent auditor's direct personal
knowledge, obtained through observation and
inspection, is more persuasive than information
obtained indirectly

19. In order to efficiently establish the correctness of the

accounts payable cutoff, an auditor will be most likely to
a. Coordinate cutoff tests with physical inventory
observation.
b. Compare cutoff reports with purchase orders.
c. Compare vendors' invoices with vendors'
statements.
d. Coordinate mailing of confirmations with cutoff
tests.

24. For all audits of financial statements made in

accordance with generally accepted auditing standards,
the use of analytical procedures is required to some
extent

20. As a result of analytical review procedures, the

independent auditor determines that the gross profit
percentage has declined from 30% in the preceding year
to 20% in the current year. The auditor should
a. Express an opinion which is qualified due to
inability of the client company to continue as a
going concern.
b. Evaluate management's performance in causing this
decline.
c. Require footnote disclosure.
d. Consider the possibility of an error in the financial
statements.

a.
b.
c.
d.

In the
planning
stage
Yes
No
No
Yes

As a
substantive
test
No
Yes
Yes
No

In the
review
stage
Yes
No
Yes
No

25. Which of the following procedures is least likely to

be performed before the balance sheet date?
a. Testing of internal control over cash.
b. Confirmation of receivables
c. Search for unrecorded liabilities.
d. Observation of inventory.

21. The third standard of field work states that sufficient

competent evidential matter is to be obtained through
inspection, observation, inquiries, and confirmations to
afford a reasonable basis for an opinion regarding the
financial statements under audit. The substantive
evidential matter required by this standard may be
obtained, in part, through
a. Flowcharting the internal control structure.
b. Proper planning of the audit engagement.
c. Analytical procedures.
d. Auditor working papers.

2Q-3

26. Which of the following procedures would an auditor

ordinarily perform during the review of subsequent
events?
a. Review the cut-off bank statements for the period
after the year-end.
b. Inquire of the client's legal counsel concerning
litigation.
c. Investigate reportable conditions previously
communicated to the client.
d. Analyze related party transactions to discover
possible irregularities.

30. To help plan the nature, timing, and extent of

substantive auditing procedures, preliminary analytical
procedures should focus on
a. Enhancing the auditor's understanding of the
client's business and events that have occurred
since the last audit date.
b. Developing plausible relationships that corroborate
anticipated results with a measurable amount of
precision.
c. Applying ratio analysis to externally generated data
such as published industry statistics or price
indices.
d. Comparing recorded financial information to the
results of other tests of transactions and balances.

27. Six months after issuing an unqualified opinion on

audited financial statements, an auditor discovered that
the engagement personnel failed to confirm several of
the client's material accounts receivable balances. The
auditor should first
a. Request the permission of the client to undertake
the confirmation of accounts receivable.
b. Perform alternative procedures to provide a
satisfactory basis for the unqualified opinion.
c. Assess the importance of the omitted procedures to
the auditor's ability to support the previously
expressed opinion.
d. Inquire whether there are persons currently relying,
or likely to rely, on the unqualified opinion.

31. Cooper, CPA, is auditing the financial statements of

a small rural municipality. The receivable balances
represent residents' delinquent real estate taxes. The
internal control structure at the municipality is weak. To
determine the existence of the accounts receivable
balances at the balance sheet date, Cooper would most
likely
a. Send positive confirmation requests.
b. Send negative confirmation requests.
c. Examine evidence of subsequent cash receipts.
d. Inspect the internal records such as copies of the
tax invoices that were mailed to the residents.

28. Which of the following circumstances is most likely

to cause an auditor to consider whether a material
misstatement exists?
a. Transactions selected for testing are not supported
by proper documentation.
b. The turnover of senior accounting personnel is
exceptionally low.
c. Management places little emphasis on meeting
earnings projections.
d. Operating and financing decisions are dominated
by several persons.

32. An auditor would most likely verify the interest

earned on bond investments by
a. Vouching the receipt and deposit of interest checks.
b. Confirming the bond interest rate with the issuer of
the bonds.
c. Recomputing the interest earned on the basis of
face amount, interest rate, and period held.
d. Testing the internal controls over cash receipts.

29. The primary objective of analytical procedures used

in the final review stage of an audit is to
a. Obtain evidence from details tested to corroborate
particular assertions.
b. Identify areas that represent specific risks relevant
to the audit.
c. Assist the auditor in assessing the validity of the
conclusions reached.
d. Satisfy doubts when questions arise about a client's
ability to continue in existence.

33. Which of the following most likely would be

detected by an auditor's review of a client's sales cut-off?
a. Unrecorded sales for the year.
b. Lapping of year-end accounts receivable.
c. Excessive sales discounts.
d. Unauthorized goods returned for credit.

2Q-4

34. Auditors should request that an audit client send a

letter of inquiry to those attorneys who have been
consulted concerning litigation, claims, or assessments.
The primary reason for this request is to provide
a. Information concerning the progress of cases to
date.
b. Corroborative evidential matter.
c. An estimate of the dollar amount of the probable
loss.
d. An expert opinion as to whether a loss is possible,
probable, or remote.

c.
d.

The auditor's opinion was qualified because of a

departure from generally accepted accounting
principles.
The results of the subsequent period's tests of
controls make the omitted procedure less important.

39. Each of the following might, by itself, form a valid

basis for an auditor to decide to omit a test except for the
a. Difficulty and expense involved in testing a
particular item.
b. Degree of reliance on the relevant internal controls.
c. Relative risk involved.
d. Relationship between the cost of obtaining
evidence and its usefulness.

35. A written client representation letter most likely

would be an auditor's best source of corroborative
information of a client's plans to
a. Terminate an employee pension plan.
b. Make a public offering of its common stock.
c. Settle an outstanding lawsuit for an amount less
than the accrued loss contingency.
d. Discontinue a line of business.

40. Soon after Boyd's audit report was issued, Boyd

learned of certain related party transactions that
occurred during the year under audit. These
transactions were not disclosed in the notes to the
financial statements. Boyd should
a. Plan to audit the transactions during the next
engagement.
b. Recall all copies of the audited financial
statements.
c. Determine whether the lack of disclosure would
affect the auditor's report.
d. Ask the client to disclose the transactions in
subsequent interim statements.

36. In an audit of contingent liabilities, which of the

following procedures would be least effective?
a. Reviewing a bank confirmation letter.
b. Examining customer confirmation replies.
c. Examining invoices for professional services.
d. Reading the minutes of the board of directors.
37. An auditor searching for related party transactions
should obtain an understanding of each subsidiary's
relationship to the total entity because:
a. This may permit the audit of intercompany account
balances to be performed as of concurrent dates.
b. Intercompany transactions may have been
consummated on terms equivalent to arm's-length
transactions.
c. This may reveal whether particular transactions
would have taken place if the parties had not been
related.
d. The business structure may be deliberately
designed to obscure related party transactions.

41. When using the work of a specialist, an auditor

may refer to and identify the specialist in the auditor's
report if the
a. Auditor wishes to indicate a division of
responsibility.
b. Specialist's work provides the auditor greater
assurance of reliability.
c. Auditor expresses an adverse opinion as a result
of the specialist's findings.
d. Specialist is not independent of the client.
42. Negative confirmation of accounts receivable is less
effective than positive confirmation of accounts
receivable because
a. A majority of recipients usually lack the
willingness to respond objectively.
b. Some recipients may report incorrect balances
that require extensive follow-up.
c. The auditor can not infer that all nonrespondents
have verified their account information.
d. Negative confirmations do not produce evidential
matter that is statistically quantifiable.

38. An auditor concludes that the omission of a

substantive procedure considered necessary at the time
of the examination may impair the auditor's present
ability to support the previously expressed opinion. The
auditor need not apply the omitted procedure if
a. The risk of adverse publicity or litigation is low.
b. The results of other procedures that were applied
tend to compensate for the procedure omitted.

2Q-5

43. An auditor's program to examine long-term debt

should include steps that require
a. Examining bond trust indentures.
b. Inspecting the accounts payable subsidiary
ledger.
c. Investigating credits to the bond interest income
account.
d. Verifying the existence of the bondholders.

48. Tracing bills of lading to sales invoices provides

evidence that
a. Shipments to customers were invoiced.
b. Shipments to customers were recorded as sales.
c. Recorded sales were shipped.
d. Invoiced sales were shipped.

44. Which of the following documentation is required

for an audit in accordance with generally accepted
auditing standards?
a. An internal control questionnaire.
b. A client engagement letter.
c. A planning memorandum or checklist.
d. A client representation letter.

49. Analytical procedures used in planning an audit

should focus on identifying
a. Material weaknesses in the internal control
structure.
b. The predictability of financial data from individual
transactions.
c. The various assertions that are embodied in the
financial statements.
d. Areas that may represent specific risks relevant to
the audit.

45. If specific information comes to an auditor's attention

that implies the existence of possible illegal acts that
could have a material, but indirect effect on the financial
statements, the auditor should next
a. Apply audit procedures specifically directed to
ascertaining whether an illegal act has occurred.
b. Seek the advice of an informed expert qualified to
practice law as to possible contingent liabilities.
c. Report the matter to an appropriate level of
management at least one level above those
involved.
d. Discuss the evidence with the client's audit
committee, or others with equivalent authority and
responsibility.

50. Which of the following audit procedures is best for

identifying unrecorded trade accounts payable?
a. Examining unusual relationships between monthly
accounts payable balances and recorded cash
payments.
b. Reconciling vendors' statements to the file of
receiving reports to identify items received just
prior to the balance sheet date.
c. Reviewing cash disbursements recorded subsequent
to the balance sheet date to determine whether the
related payables apply to the prior period.
d. Investigating payables recorded just prior to and
just subsequent to the balance sheet date to
determine whether they are supported by receiving
reports.

46. To determine whether accounts payable are

complete, an auditor performs a test to verify that all
merchandise received is recorded. The population of
documents for this test consists of all
a. Vendor's invoices.
b. Purchase orders.
c. Receiving reports.
d. Canceled checks.

51. The negative request form of accounts receivable

confirmation is useful particularly when the

47. Which of the following internal control procedures

most likely addresses the completeness assertion for
inventory?
a. Work in process account is periodically reconciled
with subsidiary records.
b. Employees responsible for custody of finished
goods do not perform the receiving function.
c. Receiving reports are prenumbered and periodically
reconciled.
d. There is a separation of duties between payroll
department and inventory accounting personnel.

a.
b.
c.
d.

2Q-6

Assessed level
of control
risk relating to
receivables is
Low
Low
High
High

Number of
small
balances is
Many
Few
Few
Many

Consideration
by the
recipient is
Likely
Unlikely
Likely
Likely

52. A basic premise underlying the application of

analytical procedures is that
a. The study of financial ratios is an acceptable
alternative to the investigation of unusual
fluctuations.
b. Statistical tests of financial information may lead to
the discovery of material errors in the financial
statements.
c. Plausible relationships among data may reasonably
be expected to exist and continue in the absence of
known conditions to the contrary.
d. These procedures cannot replace tests of balances
and transactions.

56. In testing the existence assertion for an asset, an

auditor ordinarily works from the
a. Financial statements to the potentially unrecorded
items.
b. Potentially unrecorded items to the financial
statements.
c. Accounting records to the supporting evidence.
d. Supporting evidence to the accounting records.
57. In an audit of inventories, an auditor would least
likely verify that
a. All inventory owned by the client is on hand at the
time of the count.
b. The client has used proper inventory pricing.
c. The financial statement presentation of inventories
is appropriate.
d. Damaged goods and obsolete items have been
properly accounted for.

53. An auditor's purpose in reviewing the renewal of a

note payable shortly after the balance sheet date most
likely is to obtain evidence concerning management's
assertions about
a. Existence or occurrence.
b. Presentation and disclosure.
c. Completeness.
d. Valuation or allocation.

58. The scope of an audit is not restricted when an

attorney's response to an auditor as a result of a client's
letter of audit inquiry limits the response to
a. Matters to which the attorney has given substantive
attention in the form of legal representation.
b. An evaluation of the likelihood of an unfavorable
outcome of the matters disclosed by the entity.
c. The attorney's opinion of the entity's historical
experience in recent similar litigation.
d. The probable outcome of asserted claims and
pending or threatened litigation.

54. An auditor's purpose in reviewing credit ratings of

customers with delinquent accounts receivable most
likely is to obtain evidence concerning management's
assertions about
a. Presentation and disclosure.
b. Existence or occurrence.
c. Rights and obligations.
d. Valuation or allocation.

59. Two assertions for which confirmation of accounts

receivable balances provides primary evidence are
a. Completeness and valuation.
b. Valuation and rights and obligations.
c. Rights and obligations and existence.
d. Existence and completeness.

55. Which of the following statements concerning

evidential matter is correct?
a. Competent evidence supporting management's
assertions should be convincing rather than merely
persuasive.
b. An effective internal control structure contributes
little to the reliability of the evidence created within
the entity.
c. The cost of obtaining evidence is not an important
consideration to an auditor in deciding what
evidence should be obtained.
d. A client's accounting data cannot be considered
sufficient audit evidence to support the financial
statements.

60. Cutoff tests designed to detect credit sales made

before the end of the year that have been recorded in the
subsequent year provide assurance about management's
assertion of
a. Presentation.
b. Completeness.
c. Rights.
d. Existence.

2Q-7

61. An auditor's analytical procedures most likely would

be facilitated if the entity
a. Corrects material weaknesses in internal control
before the beginning of the audit.
b. Develops its data from sources solely within the
entity.
c. Segregates obsolete inventory before the physical
inventory count.
d. Uses a standard cost system that produces variance
reports.

c.
d.

Existence or occurrence.
Rights and obligations

66. Which of the following types of audit evidence is the

least persuasive?
a. Prenumbered purchase order forms.
b. Bank statements obtained from the client.
c. Test counts of inventory performed by the auditor.
d. Correspondence from the clients attorney about
litigation.

62. If the objective of a test of details is to detect

overstatements of sales, the auditor should trace
transactions from the
a. Cash receipts journal to the sales journal.
b. Sales journal to the cash receipts journal.
c. Source documents to the accounting records.
d. Accounting records to the source documents.

67. Which of the following combinations of procedures

would an auditor most likely perform to obtain evidence
about fixed asset additions?
a. Inspecting documents and physically examining
assets.
b. Recomputing calculations and obtaining written
management representations.
c. Observing operating activities and comparing
balances to prior period balances.
d. Confirming
ownership
and
corroborating
transactions through inquiries of client personnel.

63. Which of the following procedures most likely

would justify the use of the negative form of accounts
receivable confirmation?
a. A small number of accounts may be in dispute and
the accounts receivable balance arises from sales to
a few major customers.
b. A small number of accounts may be in dispute and
the accounts receivable balance arises from sales to
many customers with small balances.
c. A substantial number of accounts may be in dispute
and the accounts receivable balance arises from
sales to a few major customers.
d. A substantial number of accounts may be in dispute
and the accounts receivable balance arises from
sales to many customers with small balances.

68. An auditor most likely would inspect loan

agreements under which an entitys inventories are
pledged to support managements financial statement
assertion of
a. Existence or occurrence.
b. Completeness.
c. Presentation and disclosure.
d. Valuation or allocation.
69. An auditor most likely would analyze inventory
turnover rates to obtain evidence concerning
managements assertions about
a. Existence or occurrence.
b. Rights and obligations.
c. Presentation and disclosure.
d. Valuation or allocation.

64. The audit working paper that reflects the major

components of an amount reported in the financial
statements is the
a. Interbank transfer schedule.
b. Carryforward schedule.
c. Supporting schedule.
d. Lead schedule.

70. Which of the following procedures would an auditor

most likely perform to verify managements assertion of
completeness?
a. Compare a sample of shipping documents to related
sales invoices.
b. Observe the clients distribution of payroll checks.
c. Confirm a sample of recorded receivables by direct
communication with the debtors.
d. Review standard bank confirmations for indications
of kiting.

65. An auditor concluded that no excessive costs for idle

plant were charged to inventory. This conclusion most
likely related to the auditor's objective to obtain evidence
about the financial statement assertions regarding
inventory, including presentation and disclosure and
a. Valuation and allocation.
b. Completeness.

2Q-8

71. An auditors decision either to apply analytical

procedures as substantive tests or to perform tests of
transactions and account balances usually is determined
by the
a. Availability of data aggregated at a high level.
b. Relative effectiveness and efficiency of the tests.
c. Timing of tests performed after the balance sheet
date.
d. Auditors familiarity with industry trends.

76. Which of the following most likely would indicate

the existence of related parties?
a. Writing down obsolete inventory just before year
end.
b. Failing to correct previously identified internal
control structure deficiencies.
c. Depending on a single product for the success of
the entity.
d. Borrowing money at an interest rate significantly
below the market rate.

72. Analytical procedures used in the overall review

stage of an audit generally include
a. Considering unusual or unexpected account
balances that were not previously identified.
b. Performing tests of transactions to corroborate
managements financial statement assertions.
c. Gathering evidence concerning account balances
that have not changed from the prior year.
d. Retesting control procedures that appeared to be
ineffective during the assessment of control risk.

77. Which of the following procedures would an auditor

most likely perform to obtain evidence about the
occurrence of subsequent events?
a. Recomputing a sample of large-dollar transactions
occurring after year end for arithmetic accuracy.
b. Investigating changes in stockholders' equity
occurring after year end.
c. Inquiring of the entity's legal counsel concerning
litigation, claims, and assessments arising after year
end.
d. Confirming bank accounts established after year
end.

73. In using the work of a specialist, an understanding

should exist among the auditor, the client, and the
specialist as to the nature of the specialists work. The
documentation of this understanding should cover
a. A statement that the specialist assumes no
responsibility to update the specialists report for
future events or circumstances.
b. The conditions under which a division of
responsibility may be necessary.
c. The specialists understanding of the auditors
corroborative use of the specialists findings.
d. The auditors disclaimer as to whether the
specialists findings corroborate the representations
in the financial statements.

78. Which of the following matters is an auditor required

to communicate to an entity's audit committee?
I.

II.

a.
b.
c.
d.

74. To which of the following matters would materiality

limits not apply when obtaining written client
representations?
a. Losses from sales commitments.
b. Unasserted claims and assessments.
c. Irregularities involving management.
d. Noncompliance with contractual agreements.

Disagreements with management about

matters significant to the entity's financial
statements that have been satisfactorily
resolved.
Initial selection of significant accounting
policies in emerging areas that lack
authoritative guidance.
I only.
II only.
Both I and II.
Neither I nor II.

79. Auditors try to identify predictable relationships

when using analytical procedures. Relationships
involving transactions from which of the following
accounts most likely would yield the highest level of
evidence?
a. Accounts receivable.
b. Interest expense.
c. Accounts payable.
d. Travel and entertainment expense.

75. Which of the following factors most likely would

affect an auditors judgment about the quantity, type, and
content of the auditors working papers?
a. The assessed level of control risk.
b. The likelihood of a review by a concurring
(second) partner.
c. The number of personnel assigned to the audit.
d. The content of the management representation
letter.
2Q-9

80. An auditor selected items for test counts while

observing a client's physical inventory. The auditor then
traced the test counts to the client's inventory listing.
This procedure most likely obtained evidence concerning
management's assertion of
a. Rights and obligations.
b. Completeness.
c. Existence or occurrence.
d. Valuation.

c.
d.

Inspect items of equipment observed during the

plant tour and then trace them to the equipment
subsidiary ledger.
Scan the general journal for unusual equipment
additions and excessive debits to repairs and
maintenance expense.

85. An auditor most likely would extend substantive tests

of payroll when
a. Payroll is extensively audited by the state
government.
b. Payroll expense is substantially higher than in the
prior year.
c. Overpayments are discovered in performing tests of
details.
d. Employees complain to management about too
much overtime.

81. In testing plant and equipment balances, an auditor

examines new additions listed on an analysis of plant and
equipment. This procedure most likely obtains evidence
concerning management's assertion of
a. Completeness.
b. Existence or occurrence.
c. Presentation and disclosure.
d. Valuation or allocation.

86. A client has a large and active investment portfolio

that is kept in a bank safe deposit box. If the auditor is
unable to count the securities at the balance sheet date,
the auditor most likely will
a. Request the bank to confirm to the auditor the
contents of the safe deposit box at the balance sheet
date.
b. Examine supporting evidence for transactions
occurring during the year.
c. Count the securities at a subsequent date and
confirm with the bank whether securities were
added or removed since the balance sheet date.
d. Request the client to have the bank seal the safe
deposit box until the auditor can count the
securities at a subsequent date.

82. In evaluating an entity's accounting estimates, one of

an auditor's objectives is to determine whether the
estimates are
a. Not subject to bias.
b. Consistent with industry guidelines.
c. Based on objective assumptions.
d. Reasonable in the circumstances.
83. Which of the following audit procedures is best for
identifying unrecorded trade accounts payable?
a. Reviewing cash disbursements recorded subsequent
to the balance sheet date to determine whether the
related payables apply to the prior period.
b. Investigating payables recorded just prior to and
just subsequent to the balance sheet date to
determine whether they are supported by receiving
reports.
c. Examining unusual relationships between monthly
accounts payable balances and recorded cash
payments.
d. Reconciling vendors' statements to the file of
receiving reports to identify items received just
prior to the balance sheet date.

87. Which of the following is required documentation in

an audit in accordance with generally accepted auditing
standards?
a. A flowchart or narrative of the accounting system
describing the recording and classification of
transactions for financial reporting.
b. An audit program setting forth in detail the
procedures
necessary
to
accomplish the
engagement's objectives.
c. A planning memorandum establishing the timing of
the audit procedures and coordinating the
assistance of entity personnel.
d. An internal control questionnaire identifying
policies and procedures that assure specific
objectives will be achieved.

84. In testing for unrecorded retirements of equipment,

an auditor most likely would
a. Select items of equipment from the accounting
records and then locate them during the plant tour.
b. Compare depreciation journal entries with similar
prior-year entries in search of fully depreciated
equipment.

2Q-10

88. In using the work of a specialist, an auditor referred

to the specialist's findings in the auditor's report. This
would be an appropriate reporting practice if the
a. Client is not familiar with the professional
certification, personal reputation, or particular
competence of the specialist.
b. Auditor, as a result of the specialist's findings, adds
an explanatory paragraph emphasizing a matter
regarding the financial statements.
c. Client understands the auditor's corroborative use
of the specialist's findings in relation to the
representations in the financial statements.
d. Auditor, as a result of the specialist's findings,
decides to indicate a division of responsibility with
the specialist.

91. Which of the following auditing procedures most

likely would assist an auditor in identifying related party
transactions?
a. Retesting ineffective internal control procedures
previously reported to the audit committee.
b. Sending second requests for unanswered positive
confirmations of accounts receivable.
c. Reviewing accounting records for nonrecurring
transactions recognized near the balance sheet date.
d. Inspecting communications with law firms for
evidence of unreported contingent liabilities.
92. Before applying principal substantive tests to the
details of accounts at an interim date prior to the balance
sheet date, an auditor should
a. Assess control risk at below the maximum for the
assertions embodied in the accounts selected for
interim testing.
b. Determine that the accounts selected for interim
testing are not material to the financial statements
taken as a whole.
c. Consider whether the amounts of the year-end
balances selected for interim testing are reasonably
predictable.
d. Obtain written representations from management
that all financial records and related data will be
made available.

89. Zero Corp. suffered a loss that would have a

material effect on its financial statements on an
uncollectible trade account receivable due to a
customer's bankruptcy. This occurred suddenly due to a
natural disaster ten days after Zero's balance sheet date,
but one month before the issuance of the financial
statements and the auditor's report. Under these
circumstances,
The
financial
statements
should be
adjusted
a. Yes
b. Yes
c. No
d. No

The event
requires financial
statement
disclosure, but
no adjustment
No
No
Yes
Yes

The auditor's
report should
be modified
for a lack of
consistency
No
Yes
Yes
No

93. After field work audit procedures are completed, a

partner of the CPA firm who has not been involved in
the audit performs a second or wrap-up working paper
review. This second review usually focuses on
a. The fair presentation of the financial statements in
conformity with GAAP.
b. Irregularities involving the client's management and
its employees.
c. The materiality of the adjusting entries proposed by
the audit staff.
d. The communication of internal control weaknesses
to the client's audit committee.

90. Which of the following statements ordinarily is

included among the written client representations
obtained by the auditor?
a. Compensating balances and other arrangements
involving restrictions on cash balances have been
disclosed.
b. Management acknowledges responsibility for
illegal actions committed by employees.
c. Sufficient evidential matter has been made
available to permit the issuance of an unqualified
opinion.
d. Management acknowledges that there are no
material weaknesses in the internal control.

94. On the basis of audit evidence gathered and

evaluated, an auditor decides to increase the assessed
level of control risk from that originally planned. To
achieve an overall audit risk level that is substantially the
same as the planned audit risk level, the auditor would
a. Decrease substantive testing.
b. Decrease detection risk.
c. Increase inherent risk.
d. Increase materiality levels.

2Q-11

95. During the annual audit of Ajax Corp., a publicly

held company, Jones, CPA, a continuing auditor,
determined that illegal political contributions had been
made during each of the past seven years, including the
year under audit. Jones notified the board of directors
about the illegal contributions, but they refused to take
any action because the amounts involved were
immaterial to the financial statements.

c.
d.

The auditor can make constructive suggestions to

management.
The audit evidence gathered supports the auditor's
conclusions.

99. The permanent file of an auditor's working papers

generally would not include
a. Bond indenture agreements.
b. Lease agreements.
c. Working trial balance.
d. Flowchart of the internal control structure.

Jones should reconsider the intended degree of reliance

to be placed on the
a. Letter of audit inquiry to the client's attorney.
b. Prior years' audit programs.
c. Management representation letter.
d. Preliminary judgment about materiality levels.

100. Which of the following presumptions is correct

about the reliability of evidential matter?
a. Information obtained indirectly from outside
sources is the most reliable evidential matter.
b. To be reliable, evidential matter should be
convincing rather than persuasive.
c. Reliability of evidential matter refers to the amount
of corroborative evidence obtained.
d. An effective internal control structure provides
more assurance about the reliability of evidential
matter.

96. An entity's income statements were misstated due to

the recording of journal entries that involved debits and
credits to an unusual combination of expense and
revenue accounts. The auditor most likely could have
detected this irregularity by
a. Tracing a sample of journal entries to the general
ledger.
b. Evaluating the effectiveness of the internal control
structure policies and procedures.
c. Investigating
the
reconciliations
between
controlling accounts and subsidiary records.
d. Performing analytical procedures designed to
disclose differences from expectations.

101. Which of the following auditing procedures most

likely would provide assurance about a manufacturing
entity's inventory valuation?
a. Testing the entity's computation of standard
overhead rates.
b. Obtaining confirmation of inventories pledged
under loan agreements.
c. Reviewing shipping and receiving cutoff
procedures for inventories.
d. Tracing test counts to the entity's inventory listing.

97. Which of the following documentation is not

required for an audit in accordance with generally
accepted auditing standards?
a. A written audit program setting forth the
procedures necessary to accomplish the audit's
objectives.
b. An indication that the accounting records agree or
reconcile with the financial statements.
c. A client engagement letter that summarizes the
timing and details of the auditor's planned field
work.
d. The basis for the auditor's conclusions when the
assessed level of control risk is below the
maximum level.

102. 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
a. Correspond with the investee company to verify the
number of shares owned.
b. Inspect the audited financial statements of the
investee company.
c. Confirm the number of shares owned that are held
by an independent custodian.
d. Determine that the investment is carried at the
lower of cost or market.

98. Audit programs should be designed so that

a. Most of the required procedures can be performed
as interim work.
b. Inherent risk is assessed at a sufficiently low level.

2Q-12

103. An auditor's purpose in reviewing credit ratings of

customers with delinquent accounts receivable most
likely is to obtain evidence concerning management's
assertions about
a. Valuation or allocation.
b. Presentation and disclosure.
c. Existence or occurrence.
d. Rights and obligations.

108. In auditing payroll, an auditor most likely would

a. Verify that checks representing unclaimed wages
are mailed.
b. Trace individual employee deductions to entity
journal entries.
c. Observe entity employees during a payroll
distribution.
d. Compare payroll costs with entity standards or
budgets.

104. Determining that proper amounts of depreciation

are expensed provides assurance about management's
assertions of valuation or allocation and
a. Presentation and disclosure.
b. Completeness.
c. Rights and obligations.
d. Existence or occurrence.

109. In auditing long-term bonds payable, an auditor

most likely would
a. Perform analytical procedures on the bond
premium and discount accounts.
b. Examine documentation of assets purchased with
bond proceeds for liens.
c. Compare interest expense with the bond payable
amount for reasonableness.
d. Confirm the existence of individual bond-holders at
year end.

105. In auditing accounts receivable the negative form of

confirmation request most likely would be used when
a. Recipients are likely to return positive confirmation
requests without verifying the accuracy of the
information.
b. The combined assessed level of inherent and
control risk relative to accounts receivable is low.
c. A small number of accounts receivable are
involved but a relatively large number of errors are
expected.
d. The auditor performs a dual purpose test that
assesses control risk and obtains substantive
evidence.

110. In performing tests concerning the granting of stock

options, an auditor should
a. Confirm the transaction with the Secretary of State
in the state of incorporation.
b. Verify the existence of option holders in the entity's
payroll records or stock ledgers.
c. Determine that sufficient treasury stock is available
to cover any new stock issued.
d. Trace the authorization for the transaction to a vote
of the board of directors.

106. When using confirmations to provide evidence

about the completeness assertion for accounts payable,
the appropriate population most likely would be
a. Vendors with whom the entity has previously done
business.
b. Amounts recorded in the accounts payable
subsidiary ledger.
c. Payees of checks drawn in the month after the year
end.
d. Invoices filed in the entity's open invoice file.

111. An auditor analyzes repairs and maintenance

accounts primarily to obtain evidence in support of the
audit assertion that all
a. Noncapitalizable expenditures for repairs and
maintenance have been recorded in the proper
period.
b. Expenditures for property and equipment have been
recorded in the proper period.
c. Noncapitalizable expenditures for repairs and
maintenance have been properly charged to
expense.
d. Expenditures for property and equipment have not
been charged to expense.

107. In evaluating the reasonableness of an accounting

estimate, an auditor most likely would concentrate on
key factors and assumptions that are
a. Consistent with prior periods.
b. Similar to industry guidelines.
c. Objective and not susceptible to bias.
d. Deviations from historical patterns.

2Q-13

112. Before applying substantive tests to the details of

asset accounts at an interim date, an auditor should
assess
a. Control risk at below the maximum level.
b. Inherent risk at the maximum level.
c. The difficulty in controlling the incremental audit
risk.
d. Materiality for the accounts tested as insignificant.

116. After determining that a related party transaction

has, in fact, occurred, an auditor should
a. Add a separate paragraph to the auditor's standard
report to explain the transaction.
b. Perform analytical procedures to verify whether
similar transactions occurred, but were not
recorded.
c. Obtain an understanding of the business purpose of
the transaction.
d. Substantiate that the transaction was consummated
on terms equivalent to an arm's-length transaction.

113. "There are no violations or possible violations of

laws or regulations whose effects should be considered
for disclosure in the financial statements or as a basis for
recording a loss contingency." The foregoing passage
most likely is from a(an)
a. Client engagement letter.
b. Report on compliance with laws and regulations.
c. Management representation letter.
d. Attestation report on an internal control structure.

117. An auditor ordinarily uses a working trial balance

resembling the financial statements without footnotes,
but containing columns for
a. Cash flow increases and decreases.
b. Audit objectives and assertions.
c. Reclassifications and adjustments.
d. Reconciliations and tickmarks.

114. Which of the following statements is correct about

the auditor's use of the work of a specialist?
a. The specialist should not have an understanding of
the auditor's corroborative use of the specialist's
findings.
b. The auditor is required to perform substantive
procedures to verify the specialist's assumptions
and findings.
c. The client should not have an understanding of the
nature of the work to be performed by the
specialist.
d. The auditor should obtain an understanding of the
methods and assumptions used by the specialist.

118. Which of the following factors would least likely

affect the quantity and content of an auditor's working
papers?
a. The condition of the client's records.
b. The assessed level of control risk.
c. The nature of the auditor's report.
d. The content of the representation letter.
119. Which of the following matters is an auditor
required to communicate to an entity's audit committee?
a. The basis for assessing control risk below the
maximum.
b. The process used by management in formulating
sensitive accounting estimates.
c. The auditor's preliminary judgments about
materiality levels.
d. The justification for performing substantive
procedures at interim dates.

115. The primary reason an auditor requests letters of

inquiry be sent to a client's attorneys is to provide the
auditor with
a. The probable outcome of asserted claims and
pending or threatened litigation.
b. Corroboration of the information furnished by
management about litigation, claims, and
assessments.
c. The attorneys' opinions of the client's historical
experiences in recent similar litigation.
d. A description and evaluation of litigation, claims,
and assessments that existed at the balance sheet
date.

120. Which of the following relatively small

misstatements most likely could have a material effect
on an entity's financial statements?
a. An illegal payment to a foreign official that was
not recorded.
b. A piece of obsolete office equipment that was not
retired.
c. A petty cash fund disbursement that was not
properly authorized.
d. An uncollectible account receivable that was not
written off.

2Q-14

121. An auditor should design the written audit program

so that
a. All material transactions will be selected for
substantive testing.
b. Substantive tests prior to the balance sheet date will
be minimized.
c. The audit procedures selected will achieve specific
audit objectives.
d. Each account balance will be tested under either
tests of controls or tests of transactions.

126. Which of the following types of audit evidence is

the most persuasive?
a. Prenumbered client purchase order forms.
b. Client work sheets supporting cost allocations.
c. Bank statements obtained from the client.
d. Client representation letter.
127. An auditor most likely would inspect loan
agreements under which an entity's inventories are
pledged to support management's financial statement
assertion of
a. Presentation and disclosure.
b. Valuation or allocation.
c. Existence or occurrence.
d. Completeness.

122. The audit program usually cannot be finalized until

the
a. Consideration of the entity's internal control
structure has been completed.
b. Engagement letter has been signed by the auditor
and the client.
c. Reportable conditions have been communicated to
the audit committee of the board of directors.
d. Search for unrecorded liabilities has been
performed and documented.

128. In auditing intangible assets, an auditor most likely

would review or recompute amortization and determine
whether the amortization period is reasonable in support
of management's financial statement assertion of
a. Valuation or allocation.
b. Existence or occurrence.
c. Completeness.
d. Rights and obligations.

123. An auditor would least likely initiate a discussion

with a client's audit committee concerning
a. The methods used to account for significant
unusual transactions.
b. The maximum dollar amount of misstatements that
could exist without causing the financial statements
to be materially misstated.
c. Indications of fraud and illegal acts committed by a
corporate officer that were discovered by the
auditor.
d. Disagreements with management as to accounting
principles that were resolved during the current
year's audit.

129. Cutoff tests designed to detect purchases made

before the end of the year that have been recorded in the
subsequent year most likely would provide assurance
about management's assertion of
a. Valuation or allocation.
b. Existence or occurrence.
c. Completeness.
d. Presentation and disclosure.

124. Tracing shipping documents to prenumbered sales

invoices provides evidence that
a. No duplicate shipments or billings occurred.
b. Shipments to customers were properly invoiced.
c. All goods ordered by customers were shipped.
d. All prenumbered sales invoices were accounted for.

130. An auditor most likely would make inquiries of

production and sales personnel concerning possible
obsolete or slow-moving inventory to support
management's financial statement assertion of
a. Valuation or allocation.
b. Rights and obligations.
c. Existence or occurrence.
d. Presentation and disclosure.

125. An auditor vouched data for a sample of employees

in a payroll register to approved clock card data to
provide assurance that
a. Payments to employees are computed at authorized
rates.
b. Employees work the number of hours for which
they are paid.
c. Segregation of duties exist between the preparation
and distribution of the payroll.
d. Internal controls relating to unclaimed payroll
checks are operating effectively.

2Q-15

131. In confirming with an outside agent, such as a

financial institution, that the agent is holding investment
securities in the client's name, an auditor most likely
gathers evidence in support of management's financial
statement assertions of existence or occurrence and
a. Valuation or allocation.
b. Rights and obligations.
c. Completeness.
d. Presentation and disclosure.

135. Which of the following would not be considered an

analytical procedure?
a. Estimating payroll expense by multiplying the
number of employees by the average hourly wage
rate and the total hours worked.
b. Projecting an error rate by comparing the results of
a statistical sample with the actual population
characteristics.
c. Computing accounts receivable turnover by
dividing credit sales by the average net receivables.
d. Developing the expected current-year sales based
on the sales trend of the prior five years.

132. Which of the following statements is correct

concerning the use of negative confirmation requests?
a. Unreturned negative confirmation requests rarely
provide significant explicit evidence.
b. Negative confirmation requests are effective when
detection risk is low.
c. Unreturned negative confirmation requests indicate
that alternative procedures are necessary.
d. Negative confirmation requests are effective when
understatements of account balances are suspected.

136. 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
a. Purchase discounts.
b. Purchase returns.
c. Sales.
d. Sales returns.

133. When an auditor does not receive replies to positive

requests for year-end accounts receivable confirmations,
the auditor most likely would
a. Inspect the allowance account to verify whether the
accounts were subsequently written off.
b. Increase the assessed level of detection risk for the
valuation and completeness assertions.
c. Ask the client to contact the customers to request
that the confirmations be returned.
d. Increase the assessed level of inherent risk for the
revenue cycle.

137. To gain assurance that all inventory items in a

client's inventory listing schedule are valid, an auditor
most likely would trace
a. Inventory tags noted during the auditor's
observation to items listed in the inventory listing
schedule.
b. Inventory tags noted during the auditor's
observation to items listed in receiving reports and
vendors invoices.
c. Items listed in the inventory listing schedule to
inventory tags and the auditor's recorded count
sheets.
d. Items listed in receiving reports and vendors'
invoices to the inventory listing schedule.

134. Analytical procedures used in the overall review

stage of an audit generally include
a. Gathering evidence concerning account balances
that have not changed from the prior year.
b. Retesting control procedures that appeared to be
ineffective during the assessment of control risk.
c. Considering unusual or unexpected account
balances that were not previously identified.
d. Performing tests of transactions to corroborate
management's financial statement assertions.

138. When control risk is assessed as low for assertions

related to payroll, substantive tests of payroll balances
most likely would be limited to applying analytical
procedures and
a. Observing the distribution of paychecks.
b. Footing and crossfooting the payroll register.
c. Inspecting payroll tax returns.
d. Recalculating payroll accruals.

2Q-16

139. In performing a search for unrecorded retirements

of fixed assets, an auditor most likely would
a. Inspect the property ledger and the insurance and
tax records, and then tour the client's facilities.
b. Tour the client's facilities, and then inspect the
property ledger and the insurance and tax records.
c. Analyze the repair and maintenance account, and
then tour the client's facilities.
d. Tour the client's facilities, and then analyze the
repair and maintenance account.

a.
b.
c.
d.

140. Which of the following procedures would an

auditor most likely perform in auditing the statement of
cash flows?
a. Compare the amounts included in the statement of
cash flows to similar amounts in the prior year's
statement of cash flows.
b. Reconcile the cutoff bank statements to verify the
accuracy of the year-end bank balances.
c. Vouch all bank transfers for the last week of the
year and first week of the subsequent year.
d. Reconcile the amounts included in the statement of
cash flows to the other financial statements'
balances and amounts.

Becomes aware of conditions causing substantial

doubt about the entity's ability to continue as a
going concern.
Desires to disclose the specialist's findings, which
imply that a more thorough audit was performed.
Is able to corroborate another specialist's earlier
findings that were consistent with management's
representations.
Discovers significant deficiencies in the design of
the entity's internal control structure that
management does not correct.

144. The refusal of a client's attorney to provide

information requested in an inquiry letter generally is
considered
a. Grounds for an adverse opinion.
b. A limitation on the scope of the audit.
c. Reason to withdraw from the engagement.
d. Equivalent to a reportable condition.
145. Which of the following procedures would an
auditor most likely perform in obtaining evidence about
subsequent events?
a. Determine that changes in employee pay rates after
year end were properly authorized.
b. Recompute depreciation charges for plant assets
sold after year end.
c. Inquire about payroll checks that were recorded
before year end but cashed after year end.
d. Investigate changes in long-term debt occurring
after year end.

141. In determining whether transactions have been

recorded, the direction of the audit testing should be
from the
a. General ledger balances.
b. Adjusted trial balance.
c. Original source documents.
d. General journal entries.

146. To which of the following matters would

materiality limits not apply in obtaining written
management representations?
a. The availability of minutes of stockholders' and
directors' meetings.
b. Losses from purchase commitments at prices in
excess of market value.
c. The disclosure of compensating balance
arrangements involving related parties.
d. Reductions of obsolete inventory to net realizable
value.

142. Which of the following statements is correct

concerning an auditor's use of the work of a specialist?
a. The work of a specialist who is related to the client
may be acceptable under certain circumstances.
b. If an auditor believes that the determinations made
by a specialist are unreasonable, only a qualified
opinion may be issued.
c. If there is a material difference between a
specialist's findings and the assertions in the
financial statements, only an adverse opinion may
be issued.
d. An auditor may not use a specialist in the
determination of physical characteristics relating to
inventories.

147. The date of the management representation letter

should coincide with the date of the
a. Balance sheet.
b. Latest interim financial information.
c. Auditor's report.
d. Latest related party transaction.

143. In using the work of a specialist, an auditor may

refer to the specialist in the auditor's report if, as a result
of the specialist's findings, the auditor
2Q-17

148. When auditing related party transactions, an auditor

places primary emphasis on
a. Ascertaining the rights and obligations of the
related parties.
b. Confirming the existence of the related parties.
c. Verifying the valuation of the related party
transactions.
d. Evaluating the disclosure of the related party
transactions.

153. What type of analytical procedure would an auditor

most likely use in developing relationships among
balance sheet accounts when reviewing the financial
statements of a nonpublic entity?
a. Trend analysis.
b. Regression analysis.
c. Ratio analysis.
d. Risk analysis.
154. An auditor is considering whether the omission of a
substantive procedure considered necessary at the time
of an audit may impair the auditor's present ability to
support the previously expressed opinion. The auditor
need not apply the omitted procedure if the
a. Financial statements and auditor's report were not
distributed beyond management and the board of
directors.
b. Auditor's previously expressed opinion was
qualified because of a departure from GAAP.
c. Results of other procedures that were applied tend
to compensate for the procedure omitted.
d. Omission is due to unreasonable delays by client
personnel in providing data on a timely basis.

149. Which of the following procedures would an

auditor ordinarily perform first in evaluating
management's accounting estimates for reasonableness?
a. Develop independent expectations of management's
estimates.
b. Consider the appropriateness of the key factors or
assumptions used in preparing the estimates.
c. Test the calculations used by management in
developing the estimates.
d. Obtain an understanding of how management
developed its estimates.
150. Which of the following pairs of accounts would an
auditor most likely analyze on the same working paper?
a. Notes receivable and interest income.
b. Accrued interest receivable and accrued interest
payable.
c. Notes payable and notes receivable.
d. Interest income and interest expense.

155. Which of the following statements is correct

concerning an auditor's required communication with an
entity's audit committee?
a. This communication is required to occur before the
auditor's report on the financial statements is
issued.
b. This communication should include management
changes in the application of significant accounting
policies.
c. Any significant matter communicated to the audit
committee also should be communicated to
management.
d. Significant audit adjustments proposed by the
auditor and recorded by management need not be
communicated to the audit committee.

151. An auditor's working papers serve mainly to

a. Provide the principal support for the auditor's
report.
b. Satisfy the auditor's responsibilities concerning the
Code of Professional Conduct.
c. Monitor the effectiveness of the CPA firm's quality
control procedures.
d. Document the level of independence maintained by
the auditor.

156. An auditor may achieve audit objectives related to

particular assertions by
a. Performing analytical procedures.
b. Adhering to a system of quality control.
c. Preparing auditor working papers.
d. Increasing the level of detection risk.

152. Which of the following procedures would an

auditor least likely perform before the balance sheet
date?
a. Confirmation of accounts payable.
b. Observation of merchandise inventory.
c. Assessment of control risk.
d. Identification of related parties.

2Q-18

157. The confirmation of customers' accounts receivable

rarely provides reliable evidence about the completeness
assertion because
a. Many customers merely sign and return the
confirmation without verifying its details.
b. Recipients usually respond only if they disagree with
the information on the request.
c. Customers may not be inclined to report
understatement errors in their accounts.
d. Auditors typically select many accounts with low
recorded balances to be confirmed.

162. An auditor most likely would limit substantive audit

tests of sales transactions when control risk is assessed as
low for the existence or occurrence assertion concerning
sales transactions and the auditor has already gathered
evidence supporting
a. Opening and closing inventory balances.
b. Cash receipts and accounts receivable.
c. Shipping and receiving activities.
d. Cutoffs of sales and purchases.
163. Which of the following procedures would an
auditor most likely perform in searching for unrecorded
liabilities?
a. Trace a sample of accounts payable entries recorded
just before year end to the unmatched receiving
report file.
b. Compare a sample of purchase orders issued just
after year end with the year-end accounts payable
trial balance.
c. Vouch a sample of cash disbursements recorded just
after year end to receiving reports and vendor
invoices.
d. Scan the cash disbursements entries recorded just
before year end for indications of unusual
transactions.

158. Which of the following sets of information does an

auditor usually confirm on one form?
a. Accounts payable and purchase commitments.
b. Cash in bank and collateral for loans.
c. Inventory on consignment and contingent liabilities.
d. Accounts receivable and accrued interest receivable.
159. An auditor's analytical procedures most likely
would be facilitated if the entity
a. Segregates obsolete inventory before the physical
inventory count.
b. Uses a standard cost system that produces variance
reports.
c. Corrects material weaknesses in internal control
before the beginning of the audit.
d. Develops its data from sources solely within the
entity.

164. An auditor traced a sample of purchase orders and

the related receiving reports to the purchases journal and
the cash disbursements journal. The purpose of this
substantive audit procedure most likely was to
a. Identify unusually large purchases that should be
investigated further.
b. Verify that cash disbursements were for goods
actually received.
c. Determine that purchases were properly recorded.
d. Test whether payments were for goods actually
ordered.

160. To measure how effectively an entity employs its

resources, an auditor calculates inventory turnover by
dividing average inventory into
a. Net sales.
b. Cost of goods sold.
c. Operating income.
d. Gross sales.

165. Which of the following explanations most likely

would satisfy an auditor who questions management
about significant debits to the accumulated depreciation
accounts?
a. The estimated remaining useful lives of plant assets
were revised upward.
b. Plant assets were retired during the year.
c. The prior year's depreciation expense was
erroneously understated.
d. Overhead allocations were revised at year end.

161. The usefulness of the standard bank confirmation

request may be limited because the bank employee who
completes the form may
a. Not believe that the bank is obligated to verify
confidential information to a third party.
b. Sign and return the form without inspecting the
accuracy of the client's bank reconciliation.
c. Not have access to the client's cutoff bank statement.
d. Be unaware of all the financial relationships that the
bank has with the client.

2Q-19

166. Which of the following circumstances most likely

would cause an auditor to suspect an employee payroll
fraud scheme?
a. There are significant unexplained variances between
standard and actual labor cost.
b. Payroll checks are disbursed by the same employee
each payday.
c. Employee time cards are approved by individual
departmental supervisors.
d. A separate payroll bank account is maintained on an
imprest basis.

170. Which of the following procedures would an

auditor most likely perform to obtain evidence about the
occurrence of subsequent events?
a. Confirming a sample of material accounts receivable
established after year end.
b. Comparing the financial statements being reported on
with those of the prior period.
c. Investigating personnel changes in the accounting
department occurring after year end.
d. Inquiring as to whether any unusual adjustments
were made after year end.

167. The objective of tests of details of transactions

performed as substantive tests is to
a. Comply with generally accepted auditing standards.
b. Attain assurance about the reliability of the
accounting system.
c. Detect material misstatements in the financial
statements.
d. Evaluate whether management's policies and
procedures operated effectively.

171. Which of the following matters would an auditor

most likely include in a management representation
letter?
a. Communications with the audit committee
concerning weaknesses in the internal control
structure.
b. The completeness and availability of minutes of
stockholders' and directors' meetings.
c. Plans to acquire or merge with other entities in the
subsequent year.
d. Management's acknowledgment of its responsibility
for the detection of employee fraud.

168. Which of the following statements is correct

concerning an auditor's use of the work of a specialist?
a. The auditor need not obtain an understanding of the
methods and assumptions used by the specialist.
b. The auditor may not use the work of a specialist in
matters material to the fair presentation of the
financial statements.
c. The reasonableness of the specialist's assumptions
and their applications are strictly the auditor's
responsibility.
d. The work of a specialist who has a contractual
relationship with the client may be acceptable under
certain circumstances.

172. Which of the following auditing procedures most

likely would assist an auditor in identifying related party
transactions?
a. Inspecting correspondence with lawyers for evidence
of unreported contingent liabilities.
b. Vouching accounting records for recurring
transactions recorded just after the balance sheet
date.
c. Reviewing confirmations of loans receivable and
payable for indications of guarantees.
d. Performing analytical procedures for indications of
possible financial difficulties.

169. Which of the following is an audit procedure that an

auditor most likely would perform concerning litigation,
claims, and assessments?
a. Request the client's lawyer to evaluate whether the
client's pending litigation, claims, and assessments
indicate a going concern problem.
b. Examine the legal documents in the client's lawyer's
possession concerning litigation, claims, and
assessments to which the lawyer has devoted
substantive attention.
c. Discuss with management its policies and procedures
adopted for evaluating and accounting for litigation,
claims, and assessments.
d. Confirm directly with the client's lawyer that all
litigation, claims, and assessments have been
recorded or disclosed in the financial statements.

173. The permanent (continuing) file of an auditor's

working papers most likely would include copies of the
a. Lead schedules.
b. Attorney's letters.
c. Bank statements.
d. Debt agreements.

2Q-20

174. Which of the following statements is correct about

an auditor's required communication with an entity's
audit committee?
a. Any matters communicated to the entity's audit
committee also are required to be communicated to
the entity's management.
b. The auditor is required to inform the entity's audit
committee about significant errors discovered by the
auditor and subsequently corrected by management.
c. Disagreements with management about the
application of accounting principles are required to
be communicated in writing to the entity's audit
committee.
d. Weaknesses in the internal control structure
previously reported to the entity's audit committee
are required to be communicated to the audit
committee after each subsequent audit until the
weaknesses are corrected.

CPA Exam Tip:

At the bottom of the screen of a multiple
choice testlet the question numbers that
comprise the testlet are displayed. You can
click on these numbers to access any question
within the testlet. A box will surround the
number of the question that is being displayed
on the screen.

175. Which of the following events occurring after the

issuance of an auditor's report most likely would cause
the auditor to make further inquiries about the previously
issued financial statements?
a. An uninsured natural disaster occurs that may affect
the entity's ability to continue as a going concern.
b. A contingency is resolved that had been disclosed in
the audited financial statements.
c. New information is discovered concerning
undisclosed lease transactions of the audited period.
d. A subsidiary is sold that accounts for 25% of the
entity's consolidated net income.

2Q-21

Chapter Two Problems

The Third Standard of Field WorkEvidence
NUMBER 1
Green, CPA, is auditing the financial statements of Taylor Corporation for the year ended December 31, 1989.
Green plans to complete the field work and sign the auditor's report about May 10, 1990. Green is concerned about
events and transactions occurring after December 31, 1989, that may affect the 1989 financial statements.
Required:
a. What are the general types of subsequent events that require Green's consideration and evaluation?
b. What are the auditing procedures Green should consider performing to gather evidence concerning subsequent
events?

NUMBER 2
Kent, CPA, is engaged in the audit of Davidson Corp.'s financial statements for the year ended December 31, 1989.
Kent is about to commence auditing Davidson's employee pension expense, but Kent's preliminary inquiries
concerning Davidson's defined benefit pension plan lead Kent to believe that some of the actuarial computations
and assumptions are so complex that they are beyond the competence ordinarily required of an auditor. Kent is
considering engaging Park, an actuary, to assist with this portion of the audit.
Required:
a. What are the factors Kent should consider in the process of selecting Park?
b. What are the matters that should be understood among Kent, Park, and Davidson's management as to the
nature of the work to be performed by Park?
c. May Kent refer to Park in the auditor's report if Kent decides to issue an unqualified opinion? Why?
d. May Kent refer to Park in the auditor's report if Kent decides to issue other than an unqualified opinion as a
result of Park's findings? Why?

NUMBER 3
Larkin, CPA, has been engaged to audit the financial statements of Vernon Distributors, Inc., a continuing audit
client, for the year ended September 30, 1991. After obtaining an understanding of Vernon's internal control
structure, Larkin assessed control risk at the maximum level for all financial statement assertions concerning
investments. Larkin determined that Vernon is unable to exercise significant influence over any investee and none
are related parties.
Larkin obtained from Vernon detailed analyses of its investments in domestic securities showing:

The classification between current and noncurrent portfolios;

A description of each security, including the interest rate and maturity date of bonds and par value and
dividend rate on stocks;
A notation of the location of each security, either in the Treasurer's safe or held by an independent custodian;
The number of shares of stock or face amount of bonds held at the beginning and end of the year;
The beginning and ending balances at cost and at market, and the unamortized premium or discount on bonds;
Additions to and sales from the portfolios for the year, including date, number of shares, face amount of
bonds, cost, proceeds, and realized gain or loss;
Valuation allowances at the beginning and end of the year and changes therein;
Accrued investment income for each investment at the beginning and end of the year, and income earned and
collected during the year.

2Q-22

Larkin then prepared the following partial audit program of substantive auditing procedures:
1.
2.
3.
4.
5.
6.
7.
8.

Foot and crossfoot the analyses.

Trace the ending totals to the general ledger and financial statements.
Trace the beginning balances to the prior year's working papers.
Obtain positive confirmation as of the balance sheet date of the investments held by any independent
custodian.
Determine that income from investments has been properly recorded as accrued or collected by reference to
published sources, by computation, and by tracing to recorded amounts.
For investments in nonpublic entities, compare carrying value to information in the most recently available
audited financial statements.
Determine that all transfers between the current and noncurrent portfolios have been properly authorized and
recorded.
Determine that any other-than-temporary decline in the price of an investment has been properly recorded.

Required:
a. Identify the primary financial statement assertion relative to investments that would be addressed by each of
the procedures #4 through #8 and describe the primary audit objective of performing that procedure. Use the
format illustrated below.
Primary Assertion

b.

Objective

Describe three additional substantive auditing procedures Larkin should consider in auditing Vernon's
investments.

2Q-23

NUMBER 4
The purpose of all auditing procedures is to gather sufficient competent evidence for an auditor to form an opinion
regarding the financial statements taken as a whole.
Required:
a. In addition to the example below, identify and describe five means or techniques of gathering audit evidence
used to evaluate a client's inventory balance.
Technique
Observation

b.

Description
An auditor watches the performance of some
function, such as a client's annual inventory
count.

Identify the five general assertions regarding a client's inventory balance and describe one different
substantive auditing procedure for each assertion. Use the format illustrated below.
Assertion

Substantive Auditing Procedure

NUMBER 5
Kane, CPA, is auditing Star Wholesaling Company's financial statements and is about to perform substantive audit
procedures on Star's trade accounts payable balances. After obtaining an understanding of Star's internal control
structure for accounts payable, Kane assessed control risk at near the maximum. Kane requested and received from
Star a schedule of the trade accounts payable prepared using the trade accounts payable subsidiary ledger (voucher
register).
Required:
Describe the substantive audit procedures Kane should apply to Star's trade accounts payable balances. Do not
include procedures that would be applied only in the audit of related party payables, amounts withheld from
employees, and accrued expenses such as pensions and interest.

NUMBER 6
Cook, CPA, has been engaged to audit the financial statements of General Department Stores, Inc., a continuing
audit client, which is a chain of medium-sized retail stores. General's fiscal year will end on June 30, 1993, and
General's management has asked Cook to issue the auditor's report by August 1, 1993. Cook will not have sufficient
time to perform all of the necessary field work in July 1993, but will have time to perform most of the field work as
of an interim date, April 30, 1993.
For the accounts to be tested at the interim date, Cook will also perform substantive tests covering the transactions
of the final two months of the year. This will be necessary to extend Cook's conclusions to the balance sheet date.
Required:
a. Describe the factors Cook should consider before applying principal substantive tests to General's balance
sheet accounts at April 30, 1993.
b. For accounts tested at April 30, 1993, describe how Cook should design the substantive tests covering the
balances as of June 30, 1993, and the transactions of the final two months of the year.

2Q-24

NUMBER 7
Question Number 7 consists of 9 items. Select the best answer for each item. Answer all items.
To support financial statement assertions, an auditor develops specific audit objectives. The auditor then designs
substantive tests to satisfy or accomplish each objective.
Required:
Items 1 through 9 represent audit objectives for the investments, accounts receivable, and property and equipment
accounts. To the right of each set of audit objectives is a listing of possible audit procedures for that account. For
each audit objective, select the audit procedure that would primarily respond to the objective. Select only one
procedure for each audit objective. A procedure may be selected only once, or not at all.
Items to be Answered:
Audit Procedures for Investments

Audit Objectives for Investments

1.

Investments are properly described and

classified in the financial statements.

A.

Trace opening balances in the subsidiary

ledger to prior years audit working papers.

2.

Recorded investments represent investments

actually owned at the balance sheet date.

B.

Determine that employees who are

authorized to sell investments do not have
access to cash.

C.

Examine supporting documents for a sample

of investment transactions to verify that
prenumbered documents are used.

D.

Determine that any impairments in the price

of investments have been properly recorded.

E.

Verify that transfers from the current to the

noncurrent investment portfolio have been
properly recorded.

F.

Obtain positive confirmations as of the

balance sheet date of investments held by
independent custodians.

G.

Trace investment transactions to minutes of

the Board of Directors meetings to determine
that transactions were properly authorized.

2Q-25

NUMBER 7 (cont.)
Audit Procedures for Accounts Receivable

Audit Objectives for Accounts Receivable

3.

Accounts receivable represent all amounts

owed to the entity at the balance sheet date.

4.

The entity has legal right to all accounts

receivable at the balance sheet date.

5.

Accounts receivable are stated at net

realizable value.

6.

Accounts receivable are properly described

and presented in the financial statements.

A.

Analyze the relationship of accounts

receivable and sales and compare it with
relationships for preceding periods.

B.

Perform sales cut-off tests to obtain

assurance that sales transactions and
corresponding entries for inventories and
cost of goods sold are recorded in the same
and proper period.

C.

Review the aged trial balance for significant

past due accounts.

D.

Obtain an understanding of the business

purpose of transactions that resulted in
accounts receivable balances.

E.

Review loan agreements for indications of

whether accounts receivable have been
factored or pledged.

F.

Review the accounts receivable trial balance

for amounts due from officers and
employees.

G.

Analyze unusual relationships between

monthly accounts receivable balances and
monthly accounts payable balances.

Audit Objectives for Property & Equipment

7.

The entity has legal right to property and

equipment acquired during the year.

8.

Recorded property and equipment represent

assets that actually exist at the balance sheet
date.

9.

Audit Procedures for Property & Equipment

A.

Trace opening balances in the summary

schedules to the prior years audit working
papers.

B.

Review the provision for depreciation

expense and determine that depreciable lives
and methods used in the current year are
consistent with those used in the prior year.

C.

Determine that the responsibility for

maintaining the property and equipment
records is segregated from the responsibility
for custody of property and equipment.

D.

Examine deeds
certificates.

E.

Perform cut-off tests to verify that property

and equipment additions are recorded in the
proper period.

F.

Determine that property and equipment is

adequately insured.

G.

Physically examine all major property and

equipment additions.

Net property and equipment are properly

valued at the balance sheet date.

2Q-26

and

title

insurance

NUMBER 8
Number 8 consists of 6 items. Select the best answers for each item. Answer all items. Your grade will be based on
the total number of correct answers.
Required:
Items 99 through 104 represent the items that an auditor ordinarily would find on a client-prepared bank
reconciliation. The accompanying List of Auditing Procedures represents substantive auditing procedures. For
each item, select one or more procedures, as indicated, that the auditor most likely would perform to gather evidence
in support of that item. The procedures on the List may be selected once, more than once, or not at all.
Assume:

The client prepared the bank reconciliation on 10/2/94.

The bank reconciliation is mathematically accurate.

The auditor received a cutoff bank statement dated 10/7/94 directly from the bank on 10/11/94.

The 9/30/94 deposit in transit, outstanding checks #1281, #1285, #1289, and #1292, and the correction of the
error regarding check #1282 appeared on the cutoff bank statement.

The auditor assessed control risk concerning the financial statement assertions related to cash at the maximum.
General Company
Bank Reconciliation
1st National Bank of U.S. Bank Account
September 30, 1994
$28,375

99. Select 2 Procedures - Balance per bank

100. Select 5 Procedures - Deposits in transit
9/29/94
9/30/94

$4,500
1,525

101. Select 5 Procedures - Outstanding checks

# 988
8/31/94
#1281
9/26/94
#1285
9/27/94
#1289
9/29/94
#1292
9/30/94

2,200
675
850
2,500
7,225

102. Select 1 Procedure - Customer note collected by bank

103. Select 2 Procedures - Error: Check #1282, written on 9/26/94
for $270 was erroneously charged by bank
as $720; bank was notified on 10/2/94

6,025
34,400

(13,450)
20,950
(3,000)

450
$18,400

104. Select 1 Procedure - Balance per books

2Q-27

List of Auditing Procedures

A. Trace to cash receipts journal.
B. Trace to cash disbursements journal.
C. Compare to 9/30/94 general ledger.
D. Confirm directly with bank.
E. Inspect bank credit memo.
F. Inspect bank debit memo.
G. Ascertain reason for unusual delay.
H. Inspect supporting documents for reconciling item not appearing on cutoff statement.
I.

Trace items on the bank reconciliation to cut-off statement.

J.

Trace items on the cutoff statement to bank reconciliation.

NUMBER 9
Analytical procedures are an important part of the audit process and consist of evaluations of financial information
made by the study of plausible relationships among both financial and non-financial data. Analytical procedures are
used to assist in planning other auditing procedures, as substantive tests in obtaining evidential matter, and as an
overall review of the financial information.
Required:
a. Describe the objectives and the characteristics of analytical procedures used in planning an audit.
b.

Describe the factors that influence an auditor's decision to select analytical procedures as substantive tests,
including the factors that affect their effectiveness and efficiency.

c.

Describe an auditor's objectives in applying analytical procedures in the overall review stage of an audit and
which analytical procedures generally would be included in the overall review stage.

2Q-28

NUMBER 10
Required:
Items 1 through 12 represent possible errors and irregularities that an auditor suspects are present. The
accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to
gather evidence concerning possible errors and irregularities. For each item, select one or two procedures, as
indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on
the list may be selected once, more than once, or not at all.
Possible Errors and Irregularities
1.

The auditor suspects that a kiting scheme exists because an accounting department employee who can issue
and record checks seems to be leading an unusually luxurious lifestyle. (Select only 1 procedure)

2.

The auditor suspects that the controller wrote several checks and recorded the cash disbursements just before
the year end but did not mail the checks until after the first week of the subsequent year. (Select only 1
procedure)

3.

The entity borrowed funds from a financial institution. Although the transaction was properly recorded, the
auditor suspects that the loan created a lien on the entitys real estate that is not disclosed in its financial
statements. (Select only 1 procedure)

4.

The auditor discovered an unusually large receivable from one of the entitys new customers. The auditor
suspects that the receivable may be fictitious because the auditor has never heard of the customer and because
the auditors initial attempt to confirm the receivable has been ignored by the customer. (Select only 2
procedures)

5.

The auditor suspects that fictitious employees have been placed on the payroll by the entitys payroll
supervisor, who has access to payroll records and to the paychecks. (Select only 1 procedure)

6.

The auditor suspects that selected employees of the entity received unauthorized raises from the entitys
payroll supervisor, who has access to payroll records. (Select only 1 procedure)

7.

The entitys cash receipts of the first few days of the subsequent year were properly deposited in its general
operating account after the year end. However, the auditor suspects that the entity recorded the cash receipts
in its books during the last week of the year under audit. (Select only 1 procedure)

8.

The auditor suspects that vouchers were prepared and processed by an accounting department employee for
merchandise that was neither ordered nor received by the entity. (Select only 1 procedure)

9.

The details of invoices for equipment repairs were not clearly identified or explained to the accounting
department employees. The auditor suspects that the bookkeeper incorrectly recorded the repairs as fixed
assets. (Select only 1 procedure)

10. The auditor suspects that a lapping scheme exists because an accounting department employee who has access
to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days.
(Select only 2 procedures)
11. The auditor suspects that the entity is inappropriately increasing the cash reported on its balance sheet by
drawing a check on one account and not recording it as an outstanding check on that account, and
simultaneously recording it as a deposit in a second account. (Select only 1 procedure)
12. The auditor suspects that the entitys controller has overstated sales and accounts receivable by recording
fictitious sales to regular customers in the entitys books. (Select only 2 procedures)

2Q-29

List of Auditing Procedures

A.

Compare the details of the cash receipts journal entries with the details of the corresponding daily deposit
slips.

B.

Scan the debits to the fixed asset accounts and vouch selected amounts to vendors invoices and managements
authorization.

C.

Perform analytical procedures that compare documented authorized pay rates to the entitys budget and
forecast.

D.

Obtain the cutoff bank statement and compare the cleared checks to the year-end bank reconciliation.

E.

Prepare a bank transfer schedule.

F.

Inspect the entitys deeds to its real estate.

G.

Make inquiries of the entitys attorney concerning the details of real estate transactions.

H.

Confirm the terms of borrowing arrangements with the lender.

I.

Examine selected equipment repair orders and supporting documentation to determine the propriety of the
charges.

J.

Send requests to confirm the entitys accounts receivable on a surprise basis at an interim date.

K.

Send a second request for confirmation of the receivable to the customer and make inquiries of a reputable
credit agency concerning the customers creditworthiness.

L.

Examine the entitys shipping documents to verify that the merchandise that produced the receivable was
actually sent to the customer.

M.

Inspect the entitys correspondence files for indications of customer disputes or for evidence that certain
shipments were on consignment.

N.

Perform edit checks of data on the payroll transaction tapes.

O.

Inspect payroll check endorsements for similar handwriting.

P.

Observe payroll check distribution on a surprise basis.

Q.

Vouch data in the payroll register to documented authorized pay rates in the human resources departments
files.

R.

Reconcile the payroll checking account and determine if there were unusual time lags between the issuance
and payment of payroll checks.

S.

Inspect the file of prenumbered vouchers for consecutive numbering and proper approval by an appropriate
employee.

T.

Determine that the details of selected prenumbered vouchers match the related vendors invoices.

U.

Examine the supporting purchase orders and receiving reports for selected paid vouchers.

2Q-30

NUMBER 11
Most of an auditors work in forming an opinion on financial statements consists of obtaining and evaluating
evidential matter concerning the financial statement assertions.
Required:
a. What is the definition of financial statement assertion?
Do not list the assertions.
b.

What is the relationship between audit objectives and financial statement assertions?

c.

What should an auditor consider in developing the audit objectives of a particular engagement?

d.

What is the relationship between audit objectives and audit procedures?

e.

What are an auditors primary considerations when selecting particular substantive tests to achieve audit
objectives?

NUMBER 12
Miller, CPA, is engaged to audit the financial statements of Superior Wholesaling for the year ended December 31,
1996. Miller obtained and documented an understanding of superiors internal control relating to accounts
receivable and assessed control risk relating to accounts receivable at the maximum level. Miller requested and
obtained from Superior an aged accounts receivable schedule listing the total amount owed by each customer as of
December 31, 1996, and sent positive confirmation requests to a sample of the customers. Subsequently, Miller
tested the accuracy of the aged accounts receivable schedule. Miller has asked Adler, the staff assistant assigned to
the engagement, to follow up on the eight returned confirmations that follow. Assume that each confirmation is
material if the potential misstatement is projected to the population.
Required:
a. Describe the procedure(s), if any, that Adler should perform to resolve each of the eight confirmations that
were returned. Assume that Superior will record any necessary adjusting entries and that Adler will verify that
they are appropriate.
b.

Assume that Miller sent second requests for accounts receivable balances initially selected for confirmation for
which no responses were received. Describe the alternative substantive procedures that Miller should consider
applying to the accounts receivable selected for confirmation for which no responses were received to Millers
second requests. Assume that these accounts receivable in the aggregate, when projected as misstatements to
the population, would affect Millers decision about whether the financial statements are materially misstated.

c.

In addition to performing the confirmation procedures and alternative procedures described in requirements (a)
and (b) and the procedures described in the first paragraph above, what additional substantive procedures
should Miller consider performing to complete the audit of Superiors accounts receivable and related
allowances? Assume that all accounts receivable are trade receivables.

2Q-31

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

January 15, 1997

Atom Co.
362 Main Street
Anytown, USA

January 15, 1997

Baker Co.
18 Lakeview Drive
Central City, USA

Confirm #11

Confirm #28

Dear C. L. Adams:

Dear S. Brown:

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $15,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $25,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

Yes, we ordered $15,000 worth of

merchandise from Superior in November.
However, we mailed Superior a check for
$15,000 on 12/18/96.

Sure we ordered $25,000 of merchandise on

Oct. 10, 1996, but Superior was out-of-stock
until recently. They back-ordered the goods
and we finally received them on Jan. 6, 1997.

Name C.L. Adams Position Acctg. Mgr.

Date 1/22/97

Name S. Brown Position A/P Supervisor

Date Jan. 18, 1997

Note to files: Blake indicates that the check

was received and deposited on 12/28/96, but
posted to the wrong customers account.
C. Miller

2Q-32

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

January 15, 1997

Delta Outlet Stores, Inc.
Confirm #41
Sunshine Mall
River City, USA

January 15, 1997

Clark Retailing
35 Lincoln Avenue
Jackson, USA

Confirm #34

Dear J. P. Cummings:

Dear R. Dunn:

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $32,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $45,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

We received $24,000 of goods on

consignment from Superior on 12/10/96, but
theyre not sold yet!

No way! Superior promised these goods in

10 days on Dec. 2nd. When we didnt receive
them, I canceled the order on Dec. 12th.
General Wholesaling shipped us similar
goods overnight!

Name J. Cummings
Date 1/19/97

Position President

Name R. Dunn Position General Manager

Date Jan. 18th

2Q-33

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

January 15, 1997

Eagle Distributors
2700 Ocean Shore Blvd. Confirm #58
Ocean City, USA

Franklin Co.
17 United Street
Industry City, USA

Dear T. Engle:

Dear S. Brown:

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $59,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $65,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

I use an accounts payable voucher system

by individual invoice. I cant verify $59,000,
but Superior is one of my regular suppliers. I
am sure I probably owe them something.

Name

Name T. Engle Position Acctg. Mgr

1-20-97

January 15, 1997

Position

Confirm #67

Date

Note to files: This confirmation was returned

by the postal service as return to sender -no such addressee at this location.
C. Miller

Date

2Q-34

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

Superior Wholesaling, Inc.

123 Commercial Blvd.
Anytown, USA

January 15, 1997

Grove Retailing
3838 Curtis Blvd.
Union Center, USA

January 15, 1997

Hall Enterprises, Inc.
55 Green Street
Grant City, USA

Confirm #71

Confirm #86

Dear H. Gates:

Dear K. Hines:

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $75,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Our auditor, Miller, CPA, is currently auditing our

financial statements. To facilitate this audit, please
confirm the balance due us as of December 31, 1996,
which is shown on our records as $80,000. Indicate
in the space below whether this is in agreement with
your records. If there are exceptions, please provide
any information that will assist the auditor in
reconciling the difference.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Please mail your reply directly to Miller, CPA. A

stamped, self-addressed envelope is enclosed for
your convenience.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

Sincerely,
J. Blake
J. Blake, Controller
Superior Wholesaling, Inc.

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

To Miller, CPA:
The amount shown above is correct as of December
31, 1996, except as follows:

Our records show that a check for $75,000

was mailed on 12/27/96.

Mailed that check for full amount on

1-3-97: merchandise was only received on
12-23-96.

Name H. Gates Position Controller

Date 1/22/97

Name K. Hines Position Accountant

Date 1-18-97

2Q-35

NUMBER 13
Cook, CPA, is auditing the financial statements of DollarMart, a local retailer of clothes, appliances, sporting goods,
and electronics. During prior years audits of DollarMart, Cook noticed that management was less concerned about
the timely recording of expenses and liabilities than revenues and assets. As a result, very little of DollarMarts
internal control resources were expended in assuring an accurate and timely recording of accounts payable. Cook
also believes that DollarMarts management may be motivated to delay recording its liabilities at year end, so Cook
is approaching the search for unrecorded liabilities with caution.
Required:
a.

What substantive auditing procedures would Cook most likely consider performing in searching for
DollarMarts unrecorded liabilities?

b.

How would the nature, timing, and extent of Cooks substantive auditing procedures most likely be affected by
DollarMarts deficient control environment?

NUMBER 14
Smith, CPA, is the supervising partner of the financial statement audit of Digit Sales Co., a publicly-held entity that
files reports with the SEC. Hall, the senior auditor assigned to the engagement, had the following conversation with
Smith at the end of the field work:
Smith: Dont you think that Digits board of directors would be surprised with those huge inventory adjustments
that we had Digit book last week?
Hall:

I guess so, but what about that new assistant controller, Green? What incompetence!

Smith: Well, I suppose Green has a bit to learn about GAAP, but I was really upset when Dodd, the controller,
contacted that other CPA firm about the contingent liability I wanted booked.
Hall:

Which one was that?

Smith: You know, the employment discrimination suit filed by the union.
Hall:

Oh, now I remember. Digits going to lose that one big time.

Smith: Right! You know it. I know it. The lawyer knows it. Even Dodd knows it. But it wasnt booked until the
other CPAs agreed with me.
Hall:

Well, the important thing is that they did book it. I was more upset about their two-week delay in having
the financial statements completed on time.

Smith: I know it cost us a lot of time, but Dodd was never late on that before. Maybe I should change the dates on
next years engagement letter rather than complain to the board.
Hall:

How about that large receivable?

Smith: What a joke! Dodd wouldnt write that overdue account off and Digit doesnt even sell that model
anymore. At least Green was on our side.

2Q-36

Hall:

They never did collect a penny on that account.

Smith: I heard that the customer finally filed for bankruptcy last month.
Hall:

At least Dodd finally booked the write-off after that poorly-timed vacation.

Smith: I suppose so, but I still cant believe that Dodd took two weeks off near the end of our field work.
Hall:

Actually, that was great. With Dodd gone, Green booked that inventory adjustment without much of a
battle.

Smith: Sure, but we couldnt finish the field work until Dodd signed the rep letter and booked that receivable
write-off. The report was late and it caused me grief with our managing partner.
Hall:

But thats not fair. It wasnt our fault. The bottom line is they got a clean opinion and this job is history.

Smith: Not really. We havent communicated with the audit committee yet.
Hall:

What do we have to tell them? They got an unqualified opinion . . . and remember, there were only a few
reportable conditions. Im out of here.

Required:
a.

From the discussion above, what specific matters is Smith required to communicate to Digits audit
committee? Do not include matters that are not required to be communicated under GAAS.

b.

What other matters (omitted from the discussion above) is Smith required to communicate to Digits audit
committee under GAAS?

NUMBER 15
The following Accounts ReceivableConfirmation Statistics working paper (indexed B-3) was prepared by an
audit assistant during the calendar year 1991 audit of Lewis County Water Co., Inc., a continuing audit client. The
engagement supervisor is reviewing the working papers.

2Q-37

Lewis County Water Co., Inc.

ACCOUNTS RECEIVABLECONFIRMATION STATISTICS
12/31/91
Index

Accounts
Number
Confirmation Requests
Positives
Negatives
Total sent
Accounts selected/client asked us not to confirm
Total selected for testing
Total accounts receivable at 12/31/91, confirm date

B-3

Dollars

Percent

Amount

54
140
194
6
200

2.7%
7.0%
9.7%
0.3%
10.0%

260,000
20,000
280,000

2,000

100.0%

$2,000,000*

Percent
13.0%
10.0%
23.0%

100.0%

RESULTS
Replies received through 2/25/92
Positives -- no exception
Negatives -- did not reply or replied no exception
Total confirmed without exception

44 C
120 C
164

2.2%
6.0%
8.2%

180,000
16,000
196,000

9.0%
.8%
9.8%

Differences reported and resolved, no adjustment

Positives
Negatives
Total

6
12
18

.3%
.6%
.9%

30,000
2,000
32,000

1.5%
.1%
1.6%

.1%
.4%
.5%

10,000
2,000
12,000

.5%
.1%
.6%

Differences found to be potential adjustments

Positives
Negatives
Total -- .6% adjustment, immaterial

2 CX
8 CX
10

Accounts selected/client asked us not to confirm

.3%

Tickmark Legend

Agreed to accounts receivable subsidiary ledger

Agreed to general ledger and lead schedule

Includes one related party transaction
C Confirmed without exception, W/P B-4
CX Confirmed with exception, W/P B-5
Overall conclusion -- The potential adjustment of $12,000 or .6% is below materiality threshold; therefore, the
accounts receivable balance is fairly stated.
Required: Describe the deficiencies in the working paper that the engagement supervisor should discover.
Assume that the accounts were selected for confirmation on the basis of a sample that was properly planned and
documented on working paper B-2.

2Q-38

NUMBER 16
Temple, CPA, is auditing the financial statements of Ford Lumber Yards, Inc., a privately held corporation with 300
employees and five shareholders, three of whom are active in management. Ford has been in business for many
years but has never had its financial statements audited. Temple suspects that the substance of some of Ford's
business transactions differs from their form because of the pervasiveness of related party relationships and
transactions in the local building supplies industry.
Required:
The audit procedures Temple should apply to identify Ford's related party relationships and transactions include
some of the following procedures. For each of the following procedures, indicate (Y) for "Yes" if the procedure is
one that Temple would likely apply and (N) for "No" if the procedure is one that Temple would not likely apply.
1.

Evaluate the company's procedures for identifying and properly reporting related party relationships and
transactions.

2.

Request from management the names of all related parties and inquire whether there were any related party
transactions.

3.

Review confirmations of accounts receivable, particularly for the small balances.

4.

Review tax returns and filings with other regulatory agencies for the names of related parties.

5.

Review cash receipts for a few days prior to and after year-end, particularly for significant amounts of currency.

6.

Review the stock certificate book to identify the shareholders.

7.

Review the minutes of board of directors' meetings.

8.

Review conflict-of-interest statements obtained by the company from its management.

9.

Review the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders.

10. Request from the client's competitors the names of known related parties.
11. Review all investment transactions to determine whether the investment created related party relationships.
12. Review accounting records for large, unusual, or nonrecurring transactions or balances, paying particular
attention to transactions recognized at or near the end of the reporting period.
13. Review invoices from law firms that have performed services for the company for indications of the existence
of related party relationships or transactions.
14. Review accounting records for consistently recurring transactions that, in the aggregate, are considered
immaterial.

2Q-39

NUMBER 17
The purpose of all auditing procedures is to gather sufficient competent evidence for an auditor to form an opinion
regarding the financial statements taken as a whole.
Required:
Seven procedures for gathering audit evidence to evaluate a client's inventory balance are listed below. Match the
description that follows with the appropriate procedure. Not all descriptions are used.
Procedure:
1.
Observation
2.

Analysis

3.

Comparison

4.

Inquiry

5.

Confirmation

6.

Inspection

7.

Calculation

Description:
A.

An auditor combines amounts in meaningful ways to allow the application of audit judgment, such as the
determination of whether a proper inventory cutoff was performed.

B.

An auditor examines documents relating to transactions and balances, such as shipping and receiving records
to establish ownership of inventory.

C.

An auditor reads the footnote disclosures for adequacy of disclosure.

D.

An auditor obtains acknowledgements in writing from third parties of transactions or balances, such as
inventory in public warehouses or on consignment.

E.

An auditor recomputes certain amounts, such as the multiplication of quantity times price to determine
inventory amounts.

F.

An auditor questions client personnel about events and conditions, such as obsolete inventory.

G.

An auditor relates two or more amounts, such as inventory cost in perpetual inventory records to costs as
shown on vendor invoices as part of the evaluation of whether inventory is priced at the lower of cost or
market.

H.

An auditor watches the performance of some function, such as a client's annual inventory count.

2Q-40

Chapter Two -- Solutions to Questions

The Third Standard of Field Work -- Evidence
1. (c) Analytical review procedures are designed to discover unusual relationships. Answers (a), (b) and (d) are
examples of analytical review procedures.
2. (b) Positive confirmation requests ask for a reply whether or not the balance is correct. A negative request asks
for a reply only if the balance is incorrect. With a large number of accounts, positive requests are used with large
balances and negative requests are used for small balances.
3. (c) The competency (reliability) of evidence depends upon the degree of control exercised over the evidence by
the client. The client does not have any control in answers (a), (b) and (d). The client does have control over sales
invoices and, thus, it is the least competent.
4. (c) Analytical review procedures are substantive tests. Answer (a) is incorrect because substantive tests do not
evaluate a system of internal control, the auditor does. Answers (b) and (d) are incorrect because analytical review
procedures are not compliance tests.
5. (a) Trace from source documents to records to ensure all items have been billed.
6. (c) Source document to accounting records.
7. (d) Comparison, trend and ratios are analytical tools used by the auditor to detect unusual transactions.
8. (c) In this case, no one account has a material effect on the balance; thus, negative confirms are in order.
9. (b) The client is not inflating sales or accounts receivable by making fictitious entries.
10. (d) Shipments made after year end were included in customers' year end accounts receivable balances.
Consequently, customers' accounts payable balances at year end were smaller than confirmed.
11. (a) The review of corporate minutes is a standard part of work done in the subsequent period.
12. (b) Verification from an independent third party as to the validity of an account balance.
13. (c) Normally, the auditor would expect most checks to clear during the period from year end to the date of his
cut-off bank statement.
14. (b) It is not the auditor's responsibility to supervise the inventory taking, but rather to observe the physical
inventory.
15. (c) Client representations in any form (written or oral) must be supported by other audit evidence.
16. (b) Purchase cutoff procedures are designed to determine that items actually received in inventory have been
included in the proper period.
17. (b) The question deals with fixed asset disposals. The auditor examines repairs and maintenance accounts to find
unrecorded fixed asset additions.
18. (b) The physical inventory was higher than the perpetual record which indicates that inventory was not booked
as received or that returns to suppliers were not recorded. Answer (b) meets the criteria for the answer.

2S-1

19. (a) Cutoff tests are used to determine whether items have been recorded in the proper period. By coordinating
cutoff tests with the physical inventory, auditors can determine if the items are physically present.
20. (d) Analytical review procedures are designed to detect unusual fluctuations in financial statement account
balances. They are not conclusive evidence in the same respect as confirmation or documentation. The results of
these analytical procedures should be investigated, however, if unusual relationships are revealed.
21. (c) Substantive audit procedures include test of balances and analytical procedures. The objectives of analytical
procedures is to gather evidence concerning the completeness of the items included in the financial statements, and
to indicate unusual fluctuations in account balances that may require more detailed substantive audit procedures.
22. (d) In planning an audit, an auditor is required to prepare written audit programs. These programs should set
forth in reasonable detail the audit procedures that the auditor believes are necessary to accomplish the objectives of
the audit. Those objectives are to determine whether or not the financial statements are fairly presented in
accordance with GAAP. That is, whether or not the financial statement assertions embodied in the financial
statement components are fairly stated, in all material respects. The timing and cost-benefit issues presented in
answers (a) and (b) have a bearing on audit procedures and audit programs but are not related to establishing audit
objectives. Answer (c) is incorrect because audit techniques are selected to meet auditor objectives, not to establish
those objectives.
23. (b) There should be a rational relationship between the cost of obtaining evidence and the usefulness of the
information obtained. However, when considering competency of evidence, time and cost are not relevant. The
three presumptions made about the competency of evidence are presented in answers (a), (c) and (d). (a) The more
effective the internal control structure, the more assurance it provides about the reliability of accounting data and
financial statements. (c) When evidential matter can be obtained from independent sources outside the entity, it is
more competent than evidential matter secured solely within the entity. (d) The independent auditor's direct
personal knowledge, obtained through examination, observation, computation, and inspection, is more persuasive
than information obtained indirectly.
24. (a) Analytical procedures are required by GAAS in the planning and review stages of an audit. Analytical
procedures are substantive audit tests, but as a substantive test they are used to plan the audit and in the final review.
25. (c) The auditor is concerned with unrecorded liabilities as of the balance sheet date (completeness assertion),
thus audit procedures performed to identify unrecorded liabilities before the balance sheet date would be
meaningless. Accounts receivable may be confirmed prior to the balance sheet date if the auditor concludes internal
controls surrounding accounts receivable are effective [answer (b)]. Inventory counts may be observed prior to year
if the client maintains perpetual inventory records and the controls surrounding those records are effective [answer
(d)].
26. (b) GAAS requires that the auditor must obtain an attorney's letter date as of the last day of field work (audit
report date). Information received from the client's attorney may be the basis for an adjustment of the financial
statement as of year end or the basis for financial statement disclosures of events occurring during the subsequent
period.
27. (c) Before undertaking any audit procedures, the auditor would determine whether omitted procedures constitute
the ability to issue an opinion. If the omitted procedures were deemed to be necessary to support the opinion issued,
the auditor would attempt to perform such procedures.
28. (a) If transactions are not supported by proper documentation, it may indicate that the transactions are fictitious.
IF so, the financial statements would be materially misstated.

2S-2

29. (c) The objective of analytical procedures used in the overall review stage of the audit is to assist the auditor in
assessing the conclusions reached and in the evaluation of the overall financial statement presentation. Answer (a)
refers to substantive tests of details, not analytical procedures. Answer (b) is an objective of analytical procedures
used in planning the audit. Answer (d) involves the auditor obtaining information about management's plans and
assessing the likelihood that such plans can be implemented; these are not analytical procedures.
30. (a) The purpose of applying analytical procedures in planning the audit is to assist in planning the nature,
timing, and extent of auditing procedures that will be used to obtain evidential matter for specific account balances
or classes of transactions. To accomplish this, the analytical procedures used in planning the audit should focus on
enhancing the auditor's understanding of the client's business and the transactions and events that have occurred
since the last audit date, and identifying areas that may represent specific risks relevant to the audit. Answer (b)
refers to analytical procedures used as substantive tests.
31. (a) Confirmation of receivables is a generally accepted auditing procedure. The use of positive confirmation
requests is preferable when individual account balances are relatively large or when there is reason to believe that
there may be a substantial number of accounts in dispute or with inaccuracies or irregularities. The negative form is
useful when internal control surrounding accounts receivable is considered to be effective. In this case, although the
individual accounts may not be relatively large, the internal control structure is weak and the balances, since they
are delinquent, may be in dispute. Answer (c) would be an appropriate procedure but these balances are delinquent,
suggesting that there will be limited receipts subsequent to year end. Answer (d) is incorrect because internal
evidence is not as competent as external evidence.
32. (c) The amount of interest earned is based on face amount, interest rate, and time period. Since this is a bond
investment, the auditor can examine the actual bond instrument and recompute the interest earned. Such evidence,
obtained directly by the auditor's recalculation, is very competent. Answers (a) and (d) relate to cash received, not
interest earned. Answer (b) would only provide evidence about the interest rate, not the face amount and time
period.
33. (a) An auditor reviews a client's sales cut-off to determine if year-end sales are being recorded in the correct
period. Sales records are compared with shipping documents. If, assuming title passes at time of shipment, goods
were shipped before year end and no sale was recorded as of year end, the auditor will have detected unrecorded
sales. Similarly, if a sale was recorded as of year end, but goods were not shipped until the following year, sales
would be overstated.
34. (b) A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the
information furnished by management concerning litigation, claims, and assessments. The matters included in
answers (a), (c) and (d) could be covered in a letter of audit inquiry but the primary reason for the request is to
provide corroborative evidential matter.
35. (d) In some cases, the corroborating information that can be obtained by the application of auditing procedures
other than inquiry is limited. When a client plans to discontinue a line of business, for example, the auditor may not
be able to obtain information through other auditing procedures to corroborate the plan or intent. Accordingly, the
auditor should obtain a written representation to provide confirmation of management's intent. The client's plans
included in the other answers, in comparison to the plans to discontinue a line of business, could be more readily
corroborated by other evidence.
36. (b) A primary objective when auditing liabilities is to determine that they are all properly included. Accordingly,
the auditor has to search for liabilities that exist as of balance sheet date. In searching for contingent liabilities, the
auditor will typically review bank confirmation letters for any indication of direct or contingent liabilities, examine
invoices for professional services especially from attorneys who may be working on pending litigation, and read
minutes of the board of directors for indications of lawsuits or other contingencies. Answer (b) refers to customer
confirmations which are typically used to provide evidence about recorded amounts, not to search for unrecorded
items.

2S-3

37. (d) In determining the scope of work to be performed with respect to possible transactions with related parties,
the auditor should obtain an understanding of management responsibilities and the relationship of each component
to the total entity. Normally, the business structure is based on the abilities of management, tax and legal
considerations, product diversification, and geographical location. Experience has shown, however, that business
structure may be deliberately designed to obscure related party transactions. Therefore, when searching for related
party transactions the auditor should obtain an understanding of each subsidiary's relationship to the total entity.
38. (b) When an auditor concludes that an auditing procedure considered necessary at the time of the examination
was omitted from his examination of financial statements, he should assess the importance of the omitted procedure
to his present ability to support his previously expressed opinion. A review of his working papers, discussion of the
circumstances, and a reevaluation of the overall scope of the examination may be helpful in making this assessment.
For example, the results of other procedures that were applied may tend to compensate for the one omitted or make
its omission less important. Also, subsequent examinations may provide audit evidence in support of the previously
expressed opinion. This last comment is not the same as answer (d) which refers to tests of controls in subsequent
periods, not audit evidence.
39. (a) The auditor's objective is to obtain sufficient competent evidential matter to provide him with a reasonable
basis for forming an opinion. There should be a rational relationship between the cost of obtaining that evidence and
the usefulness of the information obtained. In determining the usefulness of evidence, relative risk may properly be
given consideration. Also, the auditor's understanding and evaluation of the internal control structure affects the
nature, timing, and extent of testing. The matter of difficulty and expense involved in testing a particular item is not
in itself a valid basis for omitting the test.
40. (c) If the auditor becomes aware of facts that existed at the report date, he should determine whether the facts
would have affected the audit report. If they would have affected his report and people are currently relying on the
report, the auditor should advise the client to make appropriate disclosures of the facts and their impact. Answer (a)
does not address what the auditor should do regarding the current year's audit. Answers (b) and (d) would be
considered only after the auditor determined that the lack of footnote disclosure affected his report.
41. (c) If the auditor decides to give an adverse opinion as a result of the report or findings of a specialist, reference
to and identification of the specialist may be made if it will facilitate an understanding of the reason for the modified
opinion. When expressing an unqualified opinion, the auditor should not refer to the work or findings of a
specialistregardless of whether or not the specialist's work provided reliable evidence [answer (b)] or the
specialist is independent of the client [answer (d)]. Such a reference might be misunderstood to be a qualification of
the auditor's opinion or a division of responsibility [answer (a)], neither of which is intended.
42. (c) A negative confirmation requests a response only if the debtor disagrees with the information given; thus, the
auditor infers from a nonresponse that the balance is correct. The auditor cannot, however, infer that all
nonrespondents have verified their account information. This is not a verification by the debtor because many
debtors simply do not respond for reasons other than agreeing with the balance. A positive confirmation requests a
response whether or not the debtor is in agreement with the client. The balance is verified only when the debtor
responds or the auditor is satisfied by performing other audit procedures. Answers (a) and (b) could apply to
positive or negative confirmations. Answer (d) is incorrect because the auditor can statistically quantify the result of
either confirmation approach.
43. (a) When auditing notes payable and long-term debt, the auditor should obtain copies of agreements and
determine if provisions are being adhered to. If the debt is in the form of bonds, the agreement is the bond trust
indenture. Answer (b) does not relate to long-term debt, but short-term payables. Answer (c) refers to interest
income, rather than interest expense. Answer (d) deals with existence of bondholders; the auditor is concerned with
existence of the debt.

2S-4

44. (d) There is a requirement that the independent auditor obtain certain written representations from management
as a part of an examination made in accordance with generally accepted auditing standards. The documentation
listed in the other answers is not required by auditing standards. An internal control questionnaire is one of several
approaches to documenting the auditor's understanding of the internal control structure. Auditors are encouraged to
obtain an engagement letter to eliminate misunderstandings. An audit program is required, a planning memorandum
is not.
45. (a) When the auditor becomes aware of information concerning a possible illegal act, the auditor should obtain
an understanding of the nature of the act, related circumstances, and sufficient other information to ascertain
whether an illegal act has occurred. In doing so, the auditor should inquire of management at a level above those
involved, if possible. If management does not provide satisfactory information that there has been no illegal act, the
auditor would consider the activities presented in answers (b), (c) and (d). Answer (c), reporting the matter to a
higher level of management, would not be appropriate until the auditor determines that an illegal act has occurred.
46. (c) The question is concerned with the completeness of the accounts payable balance, i.e., whether everything
that should be recorded as a payable is in fact included in the balance. To test the completeness of an item in the
financial statements, the auditor would draw a sample from the population that represents the source documents. In
this case the source document is the receiving report which indicates the date the company received the
merchandise and thus, depending on the shipping terms, when the title passes and a liability recognized.
47. (c) The completeness assertion made by management in the form of financial statements means that no
transactions that should be recorded on the books of the entity has been omitted. Answer (a) is incorrect because it
deals with items already recorded. Answer (b) is incorrect because it does not deal with the accounting records at
all. Answer (d) is incorrect because again it does not deal with accounting records. Answer (c) is correct because by
having the receiving reports prenumbered, the reconciliation process will include determining the status of each
receiving report as being matched with a vendor invoice and recorded, awaiting matching, voided, or unmatched
and thus unrecorded.
48. (a) By tracing bills of lading to sales invoices, the auditor will confirm that all shipments have been invoiced,
that is, that each shipment resulted in a sales invoice being prepared. Answer (b) is incorrect because the auditor
would have to trace sales invoices to the sales journal to prove that all shipments were recorded as sales. Answers
(c) and (d) are incorrect because the direction of the test will not prove that recorded sales were shipped or that
invoiced sales were shipped because the auditor's starting point is what has been shipped, not with what has been
recorded.
49. (d) Analytical procedures are substantive audit tests that are used in the planning phase of the audit to identify
unusual fluctuations or relationships among financial data. The discovery of unusual fluctuations or relationships
may indicate the presence of an error in the particular account so tested. The indication that an account may contain
an error will cause the auditor to modify subsequent substantive tests because of the risk that an account contains a
possible error.
50. (c) The question concerns unrecorded accounts payable at the balance date. Answer (a) is not valid because
other items in addition to accounts payable affect cash disbursements (payroll, for example). Answer (b) is incorrect
because receiving reports are matched with vendor invoices, not vendor statements. Answer (d) is incorrect because
the auditor would be testing accounts payable that have been recorded, not unrecorded. Such a test should start with
receiving reports, not accounts payable. Answer (c) is correct because in reviewing subsequent cash disbursements
the auditor would review whether an invoice paid in the current period actually was received in the prior period.
51. (a) Negative accounts receivable requests elicit a reply only if the confirmed amount is incorrect. The validity of
this form of confirmation request is less than if positive confirmations (elicit a reply whether or not the item is
correct) are used. For that reason negative confirmations are used when control risk is low (risk of error is small),
the number of small balances are many (auditor attempts to get wide coverage), and the likelihood of reply by the
recipient is high (willing to reply if account is incorrect).

2S-5

52. (c) The application of analytical procedures to financial statements is based upon the presumption that plausible
relationships exist among data (for example, that a company consistently marks up its products to earn a 30% gross
profit). An auditor applying analytical procedures would then expect the gross profit percentage to be approximately
30%.
53. (b) The presentation and disclosure assertion relates to the fact that the financial statements should reflect all
pertinent information necessary to reach an informed decision concerning the company. By reviewing the renewal
of a note payable after year end the auditor will be able to determine whether the year-end financial statements
include all pertinent information such as due date, interest rate and collateral, if any.
54. (d) The auditor's review of credit ratings of customers with delinquent accounts is normally accomplished
during an audit in order to test the adequacy of the allowance for doubtful accounts. The auditor is trying to validate
the proper dollar balance in the account. The valuation assertion is concerned with proper dollar valuation.
55. (d) A client's accounting data would include the books of original entry, the general ledger and the trial balance.
This source of evidence cannot be considered sufficient because entries could be made into the client's records
without sufficient documents. Thus recorded transactions must be traced to supporting documentation in order to
corroborate its validity.
56. (c) The existence assertion is concerned that all items recorded in the accounting records are valid (not
fictitious). Therefore, the auditor is testing what has been recorded and the direction of the test is from the
accounting records to the supporting documentation.
57. (a) The question asks what the auditor would be least likely to be concerned with in the audit of inventories.
The auditor would be least concerned about whether all inventory owed by the client is on hand at the time of the
inventory count. Why? Inventory may be stored at a public warehouse, or out on consignment, or in transit from a
vendor with freight terms of F.O.B. shipping point. In all the foregoing cases, these amounts should be included in
inventory even though they are not physically on hand.
58. (a) During the audit of financial statements, the auditor is required to send a letter of audit inquiry to the client's
legal counsel concerning claims, litigation and assessments. It is reasonable to assume that an attorney would be
responsible to respond concerning only those items that he has given substantive attention. He would not be able to
respond to items he has not given substantive attention (the attorney has no knowledge). Therefore, such a limited
response on the part of an attorney would not be considered a scope limitation.
59. (c) The existence assertion refers to the validity of the item. In other words, has a real transaction taken place or
is the accounts receivable real. The rights and obligations assertion refers to the ownership of assets or liabilities. It
answers the question, "Does the entity have a legal right to the asset?" When a customer replies to a confirmation
request obviously the customer must exist and the client must have legal title to the receivable. If either of these
were not correct the customer would take exception to the confirmation and/or it would be retained as undeliverable
by the post office.
60. (b) The completeness assertion means that nothing has been omitted from the financial statements that should be
recorded during a particular period. By performing a cutoff test the auditor is searching for items that have been
omitted from the financial statements of the current period.
61. (d) The purpose of analytical procedures is to identify unusual fluctuations in data. A variance report indicates
fluctuations from expected results, and thus would be helpful as an analytical procedure.
62. (d) The objective is to test whether recorded sales are valid (not overstated). The auditor is answering the
question, "Is this recorded sale a valid transaction?" In order to answer that question, the auditor would start with
the recorded sales and look for documentation corroborating its validity.

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63. (b) Negative confirmation requests ask the respondent to reply only if the stated receivable information is
incorrect. The presumption is that a non-reply to a confirmation request is evidence that the account balance is
correct. Thus, negative confirmation procedures would not be used when there is a likelihood that accounts are in
dispute. They would be used where a small number of accounts are in dispute.
64. (d) The question is a definition of the answer.
65. (a) Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense components
have been included in the financial statements at appropriate amounts. If the auditor is concluding that no excessive
costs were charged to inventory, he or she has gathered evidence regarding valuation of amounts in the inventory
account. Proper costing of inventory does not relate to the assertions presented in the other answers. The
completeness assertion in answer (b) deals with whether all accounts and transactions, such as those related to
inventory, that should be presented in the financial statements are so included. The existence or occurrence
assertion in answer (c) deals with whether assets of the entity, such as inventory, exist at a given date and whether
recorded transactions, such as those related to inventory, have occurred during a given period. The rights and
obligations assertion in answer (d) deals with whether assets, such as inventory, are the rights of the entity.
66. (a) Internal evidence, consisting of documents such as purchase orders that are produced within the clients
system, is generally considered low in competence and therefore the least persuasive. Answer (b), which is an
example of external-internal evidence, is considered more competent. Answer (c), which is evidence obtained
directly from an external source, is better than evidence that goes through the client before reaching the auditor.
Answer (d) is an example of the most persuasive evidence because it is obtained directly by the auditor through
physical observation.
67. (a) The auditor wants to determine that the addition exists, is properly valued and is owned by the client.
Physical examination by the auditor provides competent evidence of existence. Inspection of purchase and title
documents by the auditor provides evidence regarding amounts and ownership. Answers (b) and (d) involve
evidence-gathering procedures that rely on client claims, which are not very persuasive types of evidence. Answer
(c) is an analytical procedure that would be performed to determine the reasonableness of balances; it is only
suggestive of accuracy.
68. (c) Assertions about presentation and disclosure deal with whether particular components of the financial
statements are properly classified, described, and disclosed. An auditor would inspect loan agreements regarding
pledged inventories to determine that management has adequately disclosed the security arrangements.
69. (d) Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense components
have been included in the financial statements at appropriate amounts. An auditor would look at inventory turnover
rates to determine if the inventory amount on the balance sheet and the cost of goods sold amount on the income
statement are reasonable, in relation to each other.
70. (a) Assertions about completeness deal with whether all transactions and accounts that should be presented in
the financial statements are so included. To test managements assertion that all sales are included on the income
statement, the auditor would compare shipping documents, which typically provide evidence that a sale has
occurred and should be recorded, to related sales invoices, which provide the basis for recording the sales
transactions. Answers (b), (c) and (d) are tests that are designed to determine existence of transactions or balances.
The concern of the auditor in (b), (c) and (d) is with fictitious or overstated amounts, not omitted or incomplete
amounts.
71. (b) Substantive tests, which are comprised of analytical procedures and tests of details (transactions and account
balances), must be performed to substantiate the financial statement assertions. The decision about which
procedures to use to achieve a particular audit objective is based on the auditors judgment on the expected
effectiveness and efficiency of the available procedures.

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72. (a) The overall review would generally include reading the financial statements and notes and considering the
adequacy of evidence gathered in response to unusual or unexpected balances identified in planning the audit or in
the course of the audit, and unusual or unexpected balances or relationships that were not previously identified.
Answer (b), which is a substantive test of transactions, and answer (d), which is a test of controls, are not analytical
procedures. Answer (c) could include analytical procedures, but would typically be done in the course of the audit
not at the overall review stage.
73. (c) The understanding among the auditor, the client, and the specialist should be documented and should cover:
the specialist's understanding of the auditors corroborative use of the specialists findings, the objectives and scope
of the specialists work, the specialists relationship to the client, the methods or assumptions to be used, a
comparison of the methods and assumptions to those used in the preceding period, and the form and content of the
specialists report.
74. (c) Irregularities are intentional misstatements or omissions of amounts or disclosures in financial statements. A
typical client representation letter states that there have been no irregularities involving management or employees
who have significant roles in the internal control structure. Materiality could apply to irregularities involving other
employees as well as the matters listed in answers (b) and (d). Material losses are usually associated with purchase
commitments, not the sales commitments indicated in answer (a).
75. (a) Factors affecting the auditors judgment about the quantity, type, and content of the working papers for a
particular engagement include; the nature of the engagement, the nature of the auditors report, the nature of the
financial statements on which the auditor is reporting, the nature and condition of the clients records, the assessed
level of control risk, and the needs in the particular circumstances for supervision and review of the work. Although
answers (b) and (c) could be related to supervision and review, answer (a) is the best choice because it is
specifically included above as a factor. The content of the letter referred to in answer (d) is determined by the
auditor; it does not affect the auditor's judgment about working papers.
76. (d) Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market
rates prevailing at the time of the transaction would be an example of a transaction which, because of its very
nature, may be indicative of the existence of related parties. A borrowing between unrelated parties should be at or
near the market rate of interest.
77. (c) The auditor should inquire of the entitys legal counsel regarding any events occurring after year end as part
of the auditors search for subsequent events, which are events or transactions that occur subsequent to the balance
sheet date but prior to the issuance of the auditors report that have a material effect on the financial statements and
therefore require adjustment or disclosure in the statements. Answer (b) is a good choice since the auditor would
inquire of officers as to whether there was any change in capital stock. The reference to investigating in answer
(b), however, results in answer (c) being the better choice. An auditor would also review large-dollar transaction
after year-end to determine if they are recorded in the proper period, not for arithmetic accuracy as noted in answer
(a). Answer (d) has no direct impact on the current financial statements.
78. (c) An auditor is required to ensure that the audit committee receives information regarding the scope and results
of the audit. Included in the matters to be communicated are disagreements with management about significant
matters (whether or not resolved) and the initial selection of and changes in significant accounting policies.
79. (b) When using analytical procedures to identify predictable relationships, higher levels of evidence will be
obtained when those relationships are most predictable. Relationships involving income statement accounts, such as
interest expense, tend to be more predictable than relationships involving only balance sheet accounts, such as those
listed in answers (a) and (c), because income statement accounts represent transactions over a period of time rather
than a point in time. Also, interest expense, which can be related to debt, is more predictable than the travel and
entertainment expense listed in answer (d), which is more subject to management discretion.

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80. (b) Assertions about completeness deal with whether all accounts and transactions that should be presented in
the financial statements are so included. If an auditor test counts selected items while observing a client's physical
inventory and then traces those counts to the client's inventory listing, the auditor is obtaining evidence that all
inventory items that should be included in the listing, which becomes the basis for the financial statement amounts,
are so included. The assertions presented in answers (a), (c) and (d) are not tested by this procedure. If an
inventory item is test counted and on the listing, the client may not have the rights to that item. In order to test
existence, the auditor would compare the listing to the actual items on hand instead of comparing the test counts to
the listing. Valuation of inventory includes tests of lower of cost and market, not just quantities obtained during test
counts.
81. (b) Management's assertion of existence or occurrence deals with whether assets of the entity, such as plant and
equipment, exist at a given date and whether recorded transactions, such as plant and equipment additions, have
occurred during a given period. If the auditor physically examines new additions listed on an analysis of plant and
equipment, the auditor is obtaining evidence about the existence or occurrence assertion. The assertions presented
in answers (a), (c) and (d) are not tested by this procedure. The auditor would test in the opposite direction for
completeness. That is, the auditor would select items of plant and equipment or transactions involving plant and
equipment and determine if they have been properly included in the plant and equipment balance rather than
working from the account balance back to the physical item or transaction documentation. The presentation and
disclosure assertion deals with whether particular components of the financial statements are properly classified,
described and disclosed, not whether additions to an account exist or occurred. Valuation and allocation of plant
and equipment deal with whether plant and equipment has been included in the financial statements at appropriate
amounts. The auditor would test initial valuation at cost and the allocation of that cost to periods benefited, through
depreciation.
82. (d) The auditor's objective when evaluating accounting estimates is to obtain sufficient competent evidential
matter to provide reasonable assurance that all accounting estimates that could be material to the financial
statements have been developed; those accounting estimates are reasonable in the circumstances; and the accounting
estimates are presented in conformity with applicable accounting principles and are properly disclosed. Answers (a)
and (c) are incorrect because estimates are based on subjective as well as objective factors and may involve biased
judgments made by management. Answer (b) presents a procedure the auditor would perform to determine whether
the estimates are reasonable. In addition to consistency with industry data, the auditor would evaluate consistency
with other supporting and relevant historical data.
83. (a) The auditor reviews cash disbursements recorded in the period subsequent to the balance sheet date to
determine if they represent payments for goods and/or services received during the period ending on the balance
sheet date. If so, the auditor would then determine whether or not they have been properly recorded in the period
prior to the balance sheet date. This review of subsequent payments is designed to identify unrecorded trade
accounts payable and other unrecorded liabilities. Answer (b) would not detect unrecorded liabilities because it is
testing recorded payables, not potentially unrecorded payables. Answer (c) is incorrect because cash payments are
made for many items, not just for accounts payable. Therefore, the relationship between cash payments and
accounts payable balances may fluctuate based on other activity. Answer (d) is incorrect because reconciling
vendor statements to receiving reports would not disclose unrecorded liabilities unless comparisons were also made
with recorded payables and cash payments.
84. (a) The auditor can test for unrecorded retirements of equipment by selecting items of equipment listed in the
accounting records and trying to physically locate them. If the item of equipment has been retired, it will not exist
in the client's plant and the auditor will not be able to locate it. Answer (b) deals with fully depreciated equipment
that, if still in use, may not have been retired. Answer (c) tests whether or not equipment in use is included in the
accounting records, not whether assets not in use due to retirement are included in the accounting records. Answer
(d) focuses on additions of equipment rather than retirements, especially additions that may have been incorrectly
recorded as repairs and maintenance. This scanning of the general journal would not provide evidence about
unrecorded retirements except possibly for a retirement that was part of a trade-in.

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85. (c) If overpayments are discovered by the auditor, this suggests that errors and/or irregularities exist.
Accordingly, the auditor would extend substantive tests of payroll. Answer (a) presents a situation that may lead
the auditor to decrease substantive testing. Answer (b) is a trend that the auditor would evaluate as part of analytical
procedures work. If the increase in payroll expense is explained by plausible relationships with other financial and
other nonfinancial data, substantive testing would not be extended. Answer (d) is incorrect because overtime
concerns of employees do not suggest that the accounting for overtime is incorrect.
86. (d) Physically counting securities is a common audit procedure designed to test existence of an investment
portfolio at balance sheet date and to assure the auditor that the securities are not used to cover cash shortages. If
the auditor is unable to count securities that are kept in a bank safe deposit box on the balance sheet date, the auditor
would want the bank to secure the box until such time as the auditor could perform the count. Answer (a) is not an
option because a bank cannot typically access a safe deposit box without the depositor. Answer (b) is a procedure
that the auditor would perform during the year to test transactions; however, to test existence and to decrease the
likelihood that securities are used to cover shortages at balance sheet date, the auditor should count the securities.
Answer (c) is incorrect because the bank would not be able to confirm whether securities were added or removed; it
could only confirm whether or not the safe deposit box was accessed, as indicated by a broken seal.
87. (b) In planning the audit, the auditor should consider the nature, extent and timing of work to be done and
should prepare a written audit program. This program, or set of programs, should present in reasonable detail the
audit procedures considered necessary to accomplish the objectives of the audit. Answers (a) and (d) refer to
flowcharts and internal control questionnaires, which are optional methods used to document the auditor's
understanding of the client's internal control structure. Since there are alternatives available to the auditor,
flowcharts and questionnaires are not required documentation. Answer (c) refers to a planning memorandum,
which may be helpful in an audit but is not required by generally accepted auditing standards.
88. (b) When expressing an unqualified opinion, the auditor should not refer to the work of a specialist because such
a reference may be misunderstood. However, if as a result of the specialist's work, the auditor decides to depart
from an unqualified opinion or to add a paragraph describing an uncertainty, a going concern issue, or an emphasis
of a matter, the auditor may refer to the specialist in the auditor's report. Answers (a) and (c) would have no effect
on the auditor's report. The auditor, not the client, should consider the specialist's certification, reputation and
competency before using the specialist's work. Also, an understanding should exist among the auditor, client and
specialist regarding the work to be performed by the specialist. Answer (d) is incorrect because the auditor is
responsible for the audit opinion and the evidence-gathering procedures followed in the audit. The auditor can not
share responsibility with a specialist.
89. (d) An event or transaction that occurs after the balance sheet date but before the issuance of the financial
statements is referred to as a subsequent event, of which there are two types. The first type provides evidence about
conditions that existed at the balance sheet date and affect the estimates inherent in the process of preparing
financial statements. The financial statements should be adjusted for any changes in estimates resulting from this
first type of subsequent event. The second type of subsequent event consists of events that provide evidence with
respect to conditions that did not exist as of the balance sheet date. These events should not result in an adjustment
but may require disclosure if material. The situation presented in this question is an example of the second type of
subsequent event that would not result in financial statement adjustment but should be disclosed. Reporting on
consistency is not affected by subsequent events.
90. (a) The auditor is required to obtain written representations from management. The specific written
representations ordinarily confirm oral representations given to the auditor and relate to management knowledge
and intent. They ordinarily include disclosure of compensating balance or other arrangements involving restrictions
on cash balances, and disclosure of line-of-credit or similar arrangements. Answers (b) and (d) are not included in
the client representation letter. Management cannot acknowledge responsibility for illegal acts committed by
employees and cannot acknowledge that there are no material weaknesses in internal control. Answer (c) is
incorrect because the client does not determine the sufficiency of evidential matter necessary for an unqualified
opinion; the auditor does this.

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91. (c) The auditor should test material transactions with parties related to the entity being audited to determine that
the financial statements adequately disclose these related party transactions. Among the procedures an auditor
would follow to identify these transactions is to review accounting records for large, unusual, or nonrecurring
transactions or balances, paying particular attention to transactions recognized at or near the end of the reporting
period. Answer (a) is incorrect because retesting the effectiveness of control procedures will not help the auditor
identify related-party transactions. Answer (b) is a procedure that is followed when customers do not respond to
confirmation requests, which is less likely to be the case if the customer is a related party. Answer (d) is incorrect
because inquiry of lawyers may provide information about litigation, claims and assessments, not about related
party transactions.
92. (c) One of the factors the auditor should consider before performing substantive tests at an interim date prior to
the balance sheet date is whether or not the year-end balances of the accounts selected for interim examination are
reasonably predictable. The auditor should also consider whether there are changing conditions that might
predispose management to misstate financial statements in the remaining period and whether it is cost-effective to
perform interim tests. Answer (a) is incorrect because assessing control risk below the maximum is not required in
order to have a reasonable basis for extending audit conclusions from an interim date to the balance sheet date.
Answer (b) is incorrect because immaterial accounts are less likely to be tested at interim or at year end. Answer (d)
is incorrect because written representations from management about the availability of records and data are always
obtained, whether or not the auditor performs interim testing.
93. (a) QC 10-1.19 states that the purpose of a financial statement audit is to express an opinion regarding the
statements and if they are "presented fairly, in all material respects, in conformity with generally accepted
accounting principles." All the other choices are items that would be considered by the reviewing partner, but the
emphasis is on whether the financial statements support the opinion paragraph of the audit report.
94. (b) AU 312 states that detection risk should bear an inverse relationship to inherent and control risk. The less the
inherent and control risk the auditor believes exists, the greater the acceptable level of detection risk. Conversely,
when the inherent and control risk increases, the auditor must decrease the detection risk. These components of
audit risk may be assessed in quantitative terms such as percentages or in non-quantitative terms that range, for
example, from a minimum to a maximum.
95. (c) AU 317 states that the auditor may conclude that withdrawal is necessary when the client does not take the
remedial action that the auditor considers necessary in the circumstances, even when the illegal act is not material to
the financial statements. Factors that should affect the auditor's conclusion include the implications of the failure to
take remedial action, which may affect the auditor's ability to rely on management representations, and the effects
of continuing association with the client.
96. (d) AU 329 states that analytical procedures used in planning the audit generally use data aggregated at a high
level. An unusual combination of expense and revenue accounts in a journal entry might result in unusual aggregate
information. Choice (a) is incorrect because tracing proves completeness and would not detect unusual relationships
between the numbers. Choices (b) and (c) are incorrect because evaluating the effectiveness of the system of
internal control or reconciling controlling accounts to the subsidiary ledger would not detect unusual relationships
between the numbers.
97. (c) AU 311 states that an engagement letter is normally required by GAAS. However, it would be foolish these
days to operate without one. It focuses on the overall goals of the engagement, records to be provided by the client,
and the type of report, the scope of the engagement, the timing of the field work, a fraud disclaimer, and the set fee.
Choice (a) is incorrect because in planning the audit, the auditor should consider the nature, extent, and timing of
work to be performed and should prepare a written audit program. An audit program aids in instructing assistants in
the work to be done. It should set forth in reasonable detail the audit procedures that the auditor believes are
necessary to accomplish the objectives of the audit. Choice (b) is incorrect because the content of working papers
should be sufficient to show that the accounting records agree or reconcile with the financial statements or other
information reported on and that the applicable standards of field work have been observed. Choice (d) is incorrect
because the auditor should document his conclusion for assessing control risk below the max. However, for those

2S-11

assertions where control risk is assessed at the maximum level, the auditor should document that control risk is at
the maximum level but need not document the basis for that conclusion.
98. (d) AU 339 states that the purpose of a financial statement audit is to express an opinion regarding the
presentation of the statements. The quantity, type, and content of working papers vary with the circumstances, but
they should be sufficient to show that the accounting records agree or reconcile with the financial statements or
other information reported on and that the applicable standards of field work have been observed. Working papers
ordinarily should include documentation showing that:

The work has been adequately planned and supervised, indicating observance of the first standard of field
work.
A sufficient understanding of the internal control structure has been obtained to plan the audit and to determine
the nature, timing, and extent of tests to be performed.
The audit evidence obtained, the auditing procedures applied, and the testing performed have provided
sufficient competent evidential matter to afford a reasonable basis for an opinion.

99. (c) The permanent file would include information of continuing accounting significance, so that the auditor
could refer to it year after year. This information could include a schedule of accumulated depreciation, an analysis
of contingencies, bond and lease agreements which will be in effect in future years, and a flowchart of the internal
control structure. The trial balance is for a particular period and part of the current year working papers.
100. (d) AU 326 states that to be competent, evidence must be both valid and relevant. The more effective the
internal control structure, the more assurance it provides about the reliability of accounting data and financial
statements. The validity of evidential matter is so dependent on the circumstances under which it is obtained that
generalizations about the reliability of various types of evidence are subject to important exceptions. If the
possibility of important exceptions is recognized, however, the following presumptions, which are not mutually
exclusive, about the validity of evidential matter in auditing have some usefulness:

When evidential matter can be obtained from independent sources outside an entity, it provides greater
assurance of reliability for the purposes of an independent audit than that secured solely within the entity.
The more effective the internal control structure, the more assurance it provides about the reliability of the
accounting data and financial statements.
The independent auditor's direct personal knowledge, obtained through physical examination, observation,
computation, and inspection, is more persuasive than information obtained indirectly.

Choice (a) is incorrect because information obtained directly is most reliable. Choice (b) is incorrect because
evidence should be persuasive not convincing. Choice (c) is incorrect because corroborating evidence provides
assurance about the sufficiency and not the reliability of the data.
101. (a) AU 326 states that evidence about the valuation assertion that inventories are properly stated at cost (except
when market is lower) is provided by:

Examining paid vendors' invoices.

Reviewing direct labor rates.
Testing the computation of standard overhead rates.
Examining analyses of purchasing and manufacturing variances.

Choice (b) is incorrect because obtaining confirmation of inventories pledged under loan agreements provides
assurance about presentation and disclosures. Choice (c) is incorrect because reviewing shipping and cutoff
procedures for inventory provides assurance of clients completeness of accounting records. Choice (d) is incorrect
because tracing test counts to the entitys inventory listing provides assurance about completeness.

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102. (c) AU 332 states that evidential matter about the existence, ownership, and cost of long-term investments
includes accounting records and documents of the investor relating to acquisition. In the case of investments in the
form of securities (such as stocks, bonds, and notes), this evidential matter should be corroborated by inspection of
the securities, or in appropriate circumstances, by written confirmation from an independent custodian of securities
on deposit, pledged, or in safekeeping. Choice (a) is incorrect because the investee company may not have timely
and up-to-date information regarding ownership of stock. Choices (b) and (d) are incorrect because they support
valuation of the investment and not inspection of the securities.
103. (a) AU 326 states that assertions about valuation or allocation deal with whether asset, liability, revenue, and
expense components have been included in the financial statements at appropriate amounts. For example,
management asserts that property is recorded at historical cost and that such cost is allocated to the appropriate
accounting periods. Management asserts that AR included in the balance sheet are stated at net realizable value.
104. (a) AU 326 states that assertions about valuation or allocation deal with whether asset, liability, revenue, and
expense components have been included in the financial statements at appropriate amounts. For example,
management asserts that property is recorded at historical cost and that such cost is systematically allocated to
appropriate accounting periods. Similarly, management asserts that trade A/R included in the balance sheet are
stated at net realizable value. Determining that proper amounts of depreciation are expensed provides assurance
about the assertions of valuation or allocation amounts and presentation such as an expense on the I/S. The other
assertions relate to balance sheet items rights and obligations or to transactions about completeness or existence.
105. (b) AU 330 states that the negative confirmation form requests the recipient to respond only if he or she
disagrees with the information stated on the request. Negative confirmation requests may be used to reduce audit
risk to an acceptable level 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.

106. (a) AU 330 states that confirmation requests can be designed to elicit evidence that addresses the completeness
assertion: that is, if properly designed, confirmations may provide evidence to aid in assessing whether all
transactions and accounts that should be included in the financial statements are included. Their effectiveness in
addressing the completeness assertion depends in part on whether the auditor selects from an appropriate population
for testing. For example, when using confirmations to provide evidence about the completeness assertion for
accounts payable, the appropriate population might be a list of vendors rather than the amounts recorded in the
accounts payable subsidiary ledger. Choice (b) is incorrect because confirming amounts recorded would be
existence and not completeness. Choice (c) is incorrect because while these checks are investigated by the auditor,
the amount is not confirmed. Choice (d) is incorrect because some invoices could be excluded from the file,
impairing completeness.
107. (d) AU 342 states that the auditor should consider the historical experience of the entity in making past
estimates as well as the auditor's experience in the industry. However, changes in facts, circumstances, or the
entity's procedures may cause factors different from those in the past to become significant to the accounting
estimate. In evaluating the reasonableness of an estimate, the auditor concentrates on key factors that are:

Significant to the accounting estimate.

Sensitive to variations.
Deviations from historical patterns.
Subjective and susceptible to misstatement and bias.

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108. (d) AU 8012 states that auditors commonly use analytical procedures to provide evidence concerning payroll
when control risk is low. Analytical procedures include comparison of financial information with:

comparable information for a prior period or periods,

anticipated results, such as budgets or forecasts, and
similar industry information, such as a comparison of the entity's ratio of sales to accounts receivable with
industry averages or with other entities of comparable size in the same industry.
study relationships among elements of financial information that would be expected to conform to a predictable
pattern based on the entity's experience, such as a study of gross margin percentage.
study relationships between financial information and relevant non-financial information, such as a study of
payroll costs to number of employees.

Choice (a) is incorrect because to verify that checks are mailed does not prevent mailing the checks to nonexistent
personnel. Choice (b) is incorrect because tracing does not include observing payroll. Choice (c) is incorrect
because observing payroll distribution would be effective to prevent checks from being distributed to nonemployees, but the auditor is only satisfying that particular procedure. The question asked is of a general nature.
109. (c) AU 8502 states that auditors commonly use inquiries and analytical procedures to provide evidence
concerning loans when control risk is low. These procedures would include:

Obtain from management a schedule of loans payable and determine if the total agrees with the trial balance.
Inquire whether there are any loans where management has not complied with provisions of the loan agreement
and inquire as to management's actions and if appropriate adjustments have been made in the F/S.
Consider the reasonableness of interest expense in relation to loan balances.
Inquire whether loans payable are secured.
Inquire whether loans payable have been classified between noncurrent and current.

Choice (a) is incorrect because the auditor would recalculate the premium and discount rather than performing an
analytical procedure. Choice (b) is incorrect because the auditor would analyze the instrument rather than the assets
purchased document to check for liens. Choice (d) is incorrect because the auditor would confirm the balance, not
the existence of bondholders.
110. (d) The auditor would normally determine that a stock option was authorized by tracing the authorization to the
minutes of the board of directors. Choice (a) is incorrect because the Secretary of State would have no knowledge of
a stock option granted by a corporation. Choice (b) is incorrect because options might be issued to people or other
entities that do not currently own stock in the corporation and who do not work for the corporation. Choice (c) is
incorrect because stock options may be distributed from authorized common stock instead of using treasury shares
to fulfill the options.
111. (d) AU 326 states that an auditor who is analyzing the repairs and maintenance accounts is testing transactions
that have been recorded in the accounts. Sampling from transactions that have been recorded provides evidence in
support of the presentation and disclosure assertion. Assertions about presentation and disclosure deal with whether
particular components of the financial statements are properly classified, described, and disclosed. For example,
management asserts that obligations classified as long-term liabilities in the balance sheet will not mature within one
year. Or management asserts that amounts presented as extraordinary items in the income statement are properly
classified and described. The auditor is obtaining evidence that transactions recorded in repairs and maintenance
accounts do represent expenditures properly charged to expense, not assets which should be capitalized. The cost of
capitalized assets is allocated to the periods benefited in a systematic and rational manner, depreciated, depleted, or
amortized, not expensed in the period incurred. The other choices would not constitute the primary purpose because
the auditor should be selecting from expenditures that did occur, not from the expenditures that were recorded in the
repairs and maintenance accounts.

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112. (c) AU 313 states that before applying principal substantive tests to the details of asset or liability accounts at
an interim date, the auditor should assess the difficulty in controlling the incremental audit risk. In addition, the
auditor should consider the cost of the substantive tests that are necessary to cover the remaining period in a way
that will provide the appropriate audit assurance at the balance-sheet date. Applying principal substantive tests to
the details of asset and liability accounts at an interim date may not be cost-effective if substantive tests to cover the
remaining period cannot be restricted due to the assessed level of control risk. Choice (a) is incorrect because
assessing control risk at below a maximum is not required in order to have a reasonable basis for extending an
auditing conclusion from interim to the balance sheet date. Choices (b) and (d) are incorrect because inherent risk or
materiality of the accounts are generally not a factor in the decision to apply substantive tests at an interim date.
113. (c) AU 317 states that the auditor ordinarily obtains written representations from management concerning the
absence of violations or possible violations of laws or regulations whose effects should be considered for disclosure
in the financial statements or as a basis for recording a loss contingency.
114. (d) AU 336 states that an understanding should exist among the auditor, the client, and the specialist as to the
nature of the work to be performed by the specialist. Preferably, the understanding should be documented and
should cover the following:

The objectives and scope of the specialist's work.

The specialist's representations as to his relationship, if any, to the client.
The methods or assumptions to be used.
A comparison of the methods or assumptions to be used with those used in the preceding period.
The specialist's understanding of the auditor's corroborative use of the specialist's findings in relation to the
representations in the financial statements.

Although the appropriateness and reasonableness of methods or assumptions used and their application are the
responsibility of the specialist, the auditor should obtain an understanding of the methods or assumptions used by
the specialist to determine whether the findings are suitable for corroborating the representations in the financial
statements. The auditor should consider whether the specialist's findings support the related representations in the
financial statements and make appropriate tests of accounting data provided by the client to the specialist. Choices
(a) and (c) are incorrect because an understanding should exist between the auditor, the client, and the specialist as
per above. Choice (b) is incorrect because the auditor should consider performing substantive procedures to verify
the specialist findings only if the specialist is related to the client.
115. (b) AU 337 states that a letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining
corroboration of the information furnished by management concerning litigation, claims, and assessments. Choice
(a) is incorrect because the primary source of this information is management. Choice (c) is incorrect because the
attorneys opinion is secondary. Choice (d) is incorrect because the attorney is asked to comment on managements
description and evaluate litigation claims that exist at the balance sheet date.
116. (c) AU 334 states that after identifying related party transactions, the auditor should apply the procedures
necessary to obtain satisfaction concerning the purpose, nature, and extent of these transactions and their effect on
the financial statements. The procedures should be directed toward obtaining and evaluating sufficient competent
evidential matter and should extend beyond inquiry of management. Procedures that should be considered include:

Obtain an understanding of the business purpose of the transaction.

Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving
reports and shipping documents.
Determine whether the transaction has been approved by the board of directors or other appropriate officials.
Test for reasonableness the compilation of amounts to be disclosed, or considered for disclosure, in the
financial statements.

Choice (a) is incorrect because while an extra paragraph is added, related party transactions are generally disclosed
in the footnotes. Choice (b) is incorrect because analytical procedures are not effective to identify related party

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transactions. Choice (d) is incorrect because it is difficult to validate that the transactions were consummated on
terms equivalent to other arm's-length transactions.
117. (c) AU 329 states that the auditor's working trial balance includes the balances in the client's accounts which
will become the final financial statement balances. To produce those final figures, the initial figures are reclassified
to the correct accounts and adjusted to the correct balances required by generally accepted accounting principles.
This is done with reclassification and adjustment columns in the working trial balance.
118. (d) AU 339 states that the factors affecting the auditor's judgment about the quantity, type, and content of the
working papers for a particular engagement include:

the nature of the engagement,

the nature of the auditor's report,
the nature of the financial statements, schedules, or other information on which the auditor is reporting,
the nature and condition of the client's records,
the assessed level of control risk, and
the needs in the particular circumstances for supervision and review of the work.

119. (b) AU 380 states that accounting estimates are an integral part of the financial statements prepared by
management and are based upon management's current judgments. Those judgments are normally based on
knowledge and experience about past and current events and assumptions about future events. Certain accounting
estimates are particularly sensitive because of their significance to the financial statements and because of the
possibility that future events affecting them may differ markedly from management's current judgments. The auditor
should determine that the audit committee is informed about the process used by management in formulating
particularly sensitive accounting estimates and about the basis for the auditor's conclusions regarding the
reasonableness of those estimates. Choices (a), (c), and (d) are incorrect because they deal with the auditors
judgment and no explanation is needed to the committee.
120. (a) An illegal payment that is not recorded will directly misstate the financial statements by the amount
omitted. In addition, there is the potential for a material contingent liability for the fines and/or penalties that may
arise from the illegal activity. Answers (b), (c) and (d) present examples of misstatements that only affect the
financial statements by the amount of the misstatement, which if small will not have a material effect on the
financial statements.
121. (c) An auditor should prepare written audit programs, which aid in instructing assistants in the work to be
done. Although the form and extent of detail will vary, the audit program should set forth the audit procedures that
the auditor believes are necessary to accomplish the objectives of the audit. Answer (a) is incorrect because
substantive tests, which include tests of balances as well as tests of transactions, do not have to be designed to test
every material transaction, if the auditor can be satisfied by other procedures. Answer (b) is incorrect because for
some audit engagements it may be more efficient to perform selected substantive tests before year end. Answer (d)
is incorrect because the auditor does not test all transactions and balances.
122. (a) An audit program sets forth the audit procedures the auditor believes are necessary to accomplish the
objectives of the audit. Audit procedures consist of tests of controls and substantive tests. The audit program cannot
be finalized until the auditor completes his review of the internal control structure because substantive tests are
designed using the knowledge obtained from understanding the internal control structure. Answers (b), (c) and (d)
are incorrect because finalization of the audit program does not depend on signing an engagement letter, which
typically occurs at the very beginning of the audit; or communicating reportable conditions, which can occur during
or at the end of the audit; or searching for unrecorded liabilities, which is one of the last audit procedures performed
by the auditor.

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123. (b) The auditor is required to communicate certain matters to those having responsibility for oversight of the
financial reporting process, which is typically the audit committee. Generally the auditor must report items that
relate to the scope and results of the audit process that may assist the audit committee with its oversight
responsibility. Because materiality judgments made by the auditor do not directly affect the audit committee's
responsibility, they are not typically communicated to that committee. Answers (a), (c) and (d) are items that are
usually communicated because unusual transactions, indications of fraud, and disagreements with management do
affect the audit committee's responsibility.
124. (b) By tracing shipping documents to sales invoices, the auditor will obtain evidence that all shipments have
been invoiced; that is, that each shipment resulted in a sales invoice being prepared. Answer (a) is incorrect because
tracing shipping documents to invoices will not detect duplicate shipments if both a shipping document and invoice
were prepared for the duplicate shipment. Answer (c) is incorrect because the auditor would have to trace customer
orders to shipping documents to determine if all orders have been shipped. Answer (d) is incorrect because if the
auditor wants to account for all invoices, he should start his test with invoices, not shipping documents.
125. (b) An auditor examines approved clock card data to determine the number of hours an employee worked.
Comparing the payroll register to clock data provides assurance that the number of hours used to compute the
payroll is the number of hours worked. Answers (a), (c) and (d) are incorrect because looking at clock card data will
not provide information regarding pay rates, segregation of duties, or controls over unclaimed payroll checks.
126. (c) Evidence generated by external parties, such as a bank, is more competent, and therefore more persuasive,
than evidence generated internally by the client. A bank statement, even if obtained from the client rather than
directly from the bank, is more persuasive than internally-generated evidence. Answers (a), (b) and (d) are examples
of internally-generated documents, worksheets and letters, which are less persuasive than a bank statement.
127. (a) Assertions about presentation and disclosure deal with whether particular components of the financial
statements are properly classified, described, and disclosed. An auditor would inspect loan agreements regarding
pledged inventories to determine that management has adequately disclosed the security arrangements.
128. (a) Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense
components have been included in the financial statements at appropriate amounts. An auditor would review and
recompute amortization and determine if the amortization period is reasonable to support management's assertion
that amounts shown in the financial statements for intangible assets and amortization expense are appropriate.
129. (c) Assertions about completeness deal with whether all transactions and amounts that should be presented in
the financial statements are so included. Cutoff tests provide assurance that all purchases made before the end of the
year, which should therefore be included in that year's financial statements, are so included.
130. (a) Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense
components have been included in the financial statements at appropriate amounts. Inquiries and other tests
designed to determine if inventory is obsolete or slow-moving will help provide assurance that inventory, which
should be adjusted to lower of cost or market, is properly valued on the financial statements.
131. (b) Assertions about rights and obligations deal with whether assets are the rights of the entity and liabilities
are the obligations of the entity at a given date. Assertions about existence or occurrence deal with whether assets or
liabilities of the entity exist at a given date and whether recorded transactions have occurred during a given period.
Confirming that an outside agent is holding investment securities in the client's name provides evidence that the
securities exist at a given date and that they are owned by the client on that date.
132. (a) The negative form of confirmation requests the recipient to respond only if he or she disagrees with the
information stated on the request. If negative confirmation requests are not returned, the auditor infers that there
were no disagreements when, in fact, the intended third parties may not have received the confirmation requests
and/or may not have verified that the information contained on them is correct. Answer (b) is incorrect because
negative confirmation requests should only be used when the control risk and inherent risk are low, thus allowing
for a higher detection risk, not a low detection risk. Answer (c) is incorrect because an unreturned negative

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confirmation request requires no additional follow up. Answer (d) is incorrect because negative confirmations
provide some assurance about existence of accounts; that is, account balances are not overstated.
133. (c) When the auditor has not received replies to positive accounts receivable confirmation requests, he or she
should apply alternative procedures such as examining subsequent cash receipts. Before applying alternative
procedures, the auditor would typically mail a second request and ask the client to encourage the customer to
respond. Answer (a) is incorrect because the auditor, through confirmations, is testing the existence of the
receivable at year-end. Writing off an account after year-end provides no evidence that it was a valid asset. Answer
(b) is incorrect because the auditor must obtain sufficient evidence regarding the existence assertion and cannot
trade off one assertion with others. Answer (d) is incorrect because inherent risk would not be reassessed due to lack
of response to confirmation requests.
134. (c) The objective of analytical procedures in the final overall review stage of the audit is to assist the auditor in
assessing the conclusions reached and in the evaluation of the overall financial statement presentation. The overall
review would generally include considering unusual or unexpected balances or relationships that were not
previously identified. Answers (a) and (d) relate to substantive tests that are performed during the audit, not
analytical procedures used in the final stage of the audit. Answer (b) relates to tests of controls, which would not be
performed if control procedures appeared to be ineffective.
135. (b) Analytical procedures consist of evaluations of financial information made by a study of plausible
relationships among both financial and nonfinancial data, and involve comparisons of recorded amounts, or ratios
developed from recorded amounts, to expectations developed by the auditor. Projecting error rates based on sample
results relates more to tests of controls, rather than to analytical procedures. Answer (a), which involves developing
an expectation or estimate using financial and nonfinancial information, is an analytical procedure. Answer (c),
which involves computing ratios, and answer (d), which involves developing expectations based on prior year
trends, are also examples of analytical procedures.
136. (d) If physical inventory is higher than the perpetual record, as indicated by the test counts, then the client
either failed to record an addition to inventory or recorded a decrease in inventory that did not occur. Failing to
record sales returns, which increase the physical inventory, would explain why the perpetual record was
understated. Answers (a), (b) and (c) are incorrect because purchase discounts, purchase returns, and sales all
decrease the perpetual record of inventory, and if not recorded would overstate the perpetual record, rather than
understate it.
137. (c) In order to determine that items on an inventory listing are valid and in fact exist at physical inventory date,
the auditor would select items on that listing and trace them to inventory tags and count sheets that were prepared
during the physical inventory count. Answers (a) and (d) are tests that may provide some assurance regarding
completeness of the inventory listing rather than its validity, as the direction of testing is from supporting
documents, such as tags and invoices, to the inventory listing rather than from the listing to supporting documents.
Answer (b) is incorrect because comparing inventory tags to receiving reports and vendor invoices does not involve
any tracing to or from the inventory listing.
138. (d) When the auditor determines that the internal control structure is effective and thus the control risk is
assessed as low, the auditor may alter the nature, timing, and extent of substantive tests performed. In the case of
assertions related to payroll, the auditor may decide to limit substantive tests to performing analytical procedures,
which would evaluate the reasonableness of payroll-related amounts for the year, and recalculating payroll accruals,
which would provide some assurance that the year-end adjustments are proper. Answer (a) is typically a test of
controls, rather than a substantive test. Answers (b) and (c) are incomplete tests in that the payroll register and
payroll tax returns would have to be compared to other payroll records in order to provide any assurance that
payroll balances were fairly stated.

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139. (a) In searching for unrecorded retirements of fixed assets the auditor would select items included in the
property ledger and other records and then, by touring the client's facilities, look to see if they are on hand. A fixed
asset that is not on hand but is included in the records may indicate that a retirement was not recorded. Answer (b)
would not detect unrecorded retirements because the auditor, in touring the client facilities first, will note assets that
are on hand, rather than those which have been retired or otherwise disposed of. Answers (c) and (d) are incorrect
because the auditor analyzes the repair and maintenance account to find unrecorded fixed asset additions, not
retirements.
140. (d) The statement of cash flows presents amounts for financing and investing activities, which come from
changes in balance sheet accounts, and operating activities, which come from income statement accounts.
Therefore, the auditor, in auditing the statement of cash flows, would reconcile the amounts shown in that statement
to the other financial statements. Answer (a) is incorrect because cash flow activities typically vary from year to
year and do not follow predictable patterns. Answers (b) and (c) are procedures that are performed to audit the yearend balance in the cash account, not cash flow activity.
141. (c) When testing to determine that transactions have been recorded, which relates to the completeness
assertion, the auditor would select original source documents, such as sales invoices, and trace them to the records,
such as the sales journal. Answers (a), (b) or (d) could be the starting point if the auditor wanted to determine that
all recorded transactions were valid, which is the existence assertion. To test existence or occurrence, the auditor
would start with ledger balances, an adjusted trial balance, or journal entries and vouch them back to source
documents.
142. (a) Ordinarily, the auditor should attempt to obtain a specialist who is unrelated to the client. However, when
the circumstances so warrant, work of a specialist who has a relationship with the client may be acceptable.
Answers (b) and (d) are incorrect because the auditor would apply additional procedures if the specialist's
determinations are unreasonable or if the specialist's findings do not support the financial statement assertions, and,
depending on the results of those additional procedures, the auditor would issue the appropriate report. Answer (d)
is incorrect because a specialist, which is a person or firm that possesses skills in fields other than accounting and
auditing, can be used to evaluate inventory characteristics that fall outside the auditor's expertise.
143. (a) If the auditor, as a result of the report or findings of a specialist, decides to add explanatory language to the
auditor's report regarding a going concern issue, he or she may refer to and identify the specialist in that auditor's
report. Answers (b), (c) and (d) are incorrect because the auditor should only refer to the specialist if, as a result of
the specialist's work, the auditor decides to add explanatory language to his or her report or depart from an
unqualified opinion. Otherwise, such a reference may be misunderstood to be a qualification of the auditor's opinion
or a division of responsibility, neither of which is intended. Further, there may be an inference that the auditor
making such reference performed a more thorough audit than an auditor not making such a reference.
144. (b) A lawyer's refusal to furnish the information requested in an inquiry letter would be a limitation on the
scope of the audit. Such an inability to obtain sufficient competent evidence may require the auditor to qualify the
opinion or disclaim an opinion. An adverse opinion, answer (a), is issued when the financial statements are not
fairly stated, not when there is inadequate evidence. An auditor does not typically withdraw from an engagement,
answer (c), unless the client refuses to accept an auditor's report. A reportable condition, answer (d), is a deficiency
in the internal control structure, which is unrelated to legal letters.
145. (d) The auditor is concerned with subsequent events, which occur subsequent to the balance-sheet date but
prior to the issuance of the auditors's report, that may have a material affect on the financial statements and therefore
require adjustment or disclosure in the statements. Because changes in long-term debt occurring after year end may
require disclosure to keep the financial statements from being misleading, the auditor should investigate such
changes. The procedures described in answers (a), (b) and (c) would not likely reveal events that could have a
material affect on the current financial statements.

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146. (a) A typical management representation letter refers to the completeness and availability of all minutes of
meetings of stockholders, directors and committees of directors. Materiality does not apply to these minutes of
meetings. The management representation letter typically also refers to the matters listed in answers (b), (c) and (d),
but materiality limits could apply to losses from purchase commitments, related party disclosures, and inventory
reductions.
147. (c) Because the auditor is concerned with events occurring through the date of the auditor's report that may
require adjustment to or disclosure in the financial statements, the representations included in the management
representation letter should be dated as of the date of the auditor's report. The dates listed in answers (a), (b) and (d)
are incorrect.
148. (d) Established accounting principles ordinarily do not require transactions with related parties to be accounted
for on a basis different from that which would be appropriate if the parties were not related. Therefore, the auditor
should view related party transactions within the framework of existing pronouncements, placing primary emphasis
on the adequacy of disclosure of such transactions. Because transactions with related parties are more likely to raise
questions as to their economic substance, the auditor is more concerned with evaluating the disclosure of those
transactions than with determining the rights of related parties, answer (a), confirming the existence of related
parties, answer (b), or verifying the valuation of related party transactions, answer (c).
149. (d) The auditor is responsible for evaluating the reasonableness of accounting estimates made by management
and, as a first step, should obtain an understanding of how management developed its estimates. Based on that
understanding, the auditor should develop an independent expectation of the estimates, as indicated in answer (a),
and/or review and test the process used by management to develop the estimates, as reflected in answers (b) and (c),
and/or review subsequent events or transactions occurring prior to the completion of fieldwork.
150. (a) The interest income account should reflect interest earned during the period under audit. In analyzing
interest income, the auditor would also analyze accounts, such as notes receivable, that affect the balance in the
interest income account. Answers (b), (c) and (d) list accounts that are independent of each other; that is, activity in
the first account listed has no affect on the second account listed.
151. (a) Working papers are records kept by the auditor of the procedures applied, the tests performed, the
information obtained, and the pertinent conclusions reached in an engagement. Working papers serve mainly to
provide the principal support for the auditor's report and to aid the auditor in the conduct and supervision of the
engagement. Because workpapers are prepared for individual engagements, they do not address all of the broader
issues raised by answers (b), (c) and (d). For example, working papers do not address contingent fees, which are
dealt with in the Code of Conduct; hiring practices, which are part of CPA firm quality controls; and spousal
ownership of client stock, which is an independence issue.
152. (a) Confirming accounts payable is the least likely procedure, of those listed, that the auditor would perform
prior to the balance sheet date. The auditor would prefer to perform payables confirmation work as of year end
because, when auditing payables, the auditor is most concerned with the completeness of payables at the year end
balance sheet date. Answer (b) is incorrect because inventory observation is often done at an interim date, partly
because of practical business reasons such as the time needed to compile the physical inventory results. Answers (c)
and (d) are procedures that are typically performed at the earliest stages of the audit as they affect the planning of
other audit procedures.
153. (c) Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded
amounts, to expectations developed by the auditor. If the auditor wants to develop relationships among balance
sheet accounts, he or she would calculate and evaluate financial statement ratios such as the current ratio and debt to
equity ratio. Answers (a) and (b) are incorrect because they do not focus on relationships among accounts. Trend
analysis looks at relationships over time. Regression analysis measures the rate at which a dependent variable
changes in relation to an independent variable. Answer (d) is incorrect because risk analysis is a very broad term
that is not directly related to analytical procedures.

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154. (c) When the auditor concludes that an auditing procedure considered necessary at the time of the audit was
omitted, he should assess the importance of the omitted procedure to his present ability to support the previously
issued opinion. A review of his working papers and discussions with engagement personnel may be helpful in
making this assessment. He may decide not to apply the omitted procedure, for example, if the results of other
procedures that were applied compensate for the one omitted. Answers (a), (b) and (d) are incorrect because the
extent of reliance on the auditor's opinion, the type of opinion given, and the reasons for the omitted procedure
should not affect the auditor's decision to perform the omitted procedure.
155. (b) Among the matters to be communicated to the audit committee is information about the initial selection of
and changes in significant accounting policies and their application. Answer (a) is incorrect because the
communication must occur on a timely basis, which can be before or after the auditor's report is issued. Answer (c)
is incorrect because the auditor is not required to communicate with management regarding audit committee
concerns, although the auditor is not precluded from doing so. Answer (d) is incorrect because significant audit
adjustments, whether or not recorded, must be communicated to the audit committee.
156. (a) In obtaining evidential matter in support of financial statement assertions, the auditor develops specific
objectives in the light of those assertions. In order to achieve the audit objectives developed by the auditor, he or she
performs substantive tests. Since analytical procedures are a type of substantive test, they can be performed to
achieve audit objectives related to particular assertions. Answers (b), (c) and (d) are incorrect because they are not
audit procedures. Quality control systems are concerned with how CPA firms are organized. Working papers
document the work done by the auditor and the auditor's conclusions. The level of allowable detection risk depends
on audit risk, inherent risk and control risk.
157. (c) Accounts receivable confirmations are likely to be more effective for the existence assertion than for the
completeness assertion. Customers of a client are more likely to report a balance that is nonexistent or overstated,
rather than a balance that is incomplete or understated. Answer (a) is an incorrect statement because if customers do
not verify the details of a confirmation, evidence is not being gathered about any assertion, not just the completeness
assertion. Answer (b) is not true for positive confirmations and disagreements that would be reported by customers
would likely be related to overstatements, not understatements. Answer (d) in incorrect because when confirming
receivables, auditors focus on larger, material balances.
158. (b) The standard bank confirmation form is used to obtain bank confirmation of deposit and loan balances. The
confirmation of loan balances includes a request for due dates, interest rates, and collateral descriptions. Answer (a)
is incorrect because an accounts payable confirmation typically asks the vendor to indicate balances due; reference
to purchase commitments is not standard. Answer (c) is incorrect because the party who would be able to confirm
consigned inventory would not be in a position to confirm contingent liabilities. Answer (d) is incorrect because
accounts receivable confirmations typically ask the customer to indicate if the balance is correct; reference to
accrued interest receivable is not a standard part of that confirmation request.
159. (b) Analytical procedures involve comparisons of recorded amounts or ratios developed from recorded
amounts to expectations developed by the auditor. There are various sources of information, such as anticipated
results reflected in budgets, for developing these auditor expectations. Since a standard cost system that produces
variance reports is based on budgets, analytical procedures would be facilitated when such a system is used.
Answers (a) and (c) are unrelated to analytical procedures. Segregating obsolete inventory allows for a more
accurate physical inventory count and observation. Correcting internal control weaknesses could affect the auditor's
assessment of control risk. Answer (d) is incorrect because the level of assurance provided from analytical
procedures is affected by the reliability of the data being analyzed, and data generated solely within the entity is not
very reliable.
160. (b) Inventory turnover, which is an operations ratio that calculates how many times inventory is sold during a
period of time such as a year, is calculated by dividing average inventory into cost of goods sold. Answers (a), (c)
and (d) are incorrect because inventory is divided into cost of goods sold, not into net sales, operating income, or
gross sales.

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161. (d) The AICPA Standard Form to Confirm Account Balance Information With Financial Institutions is
designed to substantiate information that is stated on the confirmation request. If the bank employee who completes
the form is unaware of all financial relationships that the bank has with the client, the response may not provide
information beyond that which is specifically requested. This limits the usefulness of the standard bank
confirmation request. Answer (a) is incorrect because banks are typically responsive to a client's request of its bank
to verify information to a third party, the auditor. Answers (b) and (c) are incorrect because the employee who
completes the form does not need to inspect nor access the client's bank reconciliation and cutoff bank statement.
162. (b) If the control risk for the existence or occurrence assertion regarding sales transactions is assessed as low,
there is a reduced likelihood that sales are overstated. Substantive tests of sales would be limited as a result. If, in
addition, the auditor has already gathered evidence regarding cash receipts and accounts receivable, which are the
debit sides of the credits to the sales account, the auditor has already obtained some evidence about sales and would
therefore limit any additional testing of sales transactions. Answer (a) is incorrect because the inventory balances
are not directly related to the sales account. Answers (c) and (d) are incorrect because, although shipping activities
and cutoffs of sales relate to sales transactions, receiving activities and cutoffs of purchases do not.
163. (c) An auditor searches for unrecorded liabilities to determine if there are liabilities that were not recorded in
the year being audited that should be recorded in that year. A procedure performed to find these unrecorded
liabilities is to vouch a sample of cash disbursements recorded just after year-end to receiving reports and vendor
invoices. If the payment was for goods or services received before year-end, the auditor would review the details of
accounts payable and other liabilities to determine that a liability is properly recorded as of year end. Answer (a) is
incorrect because the auditor is concerned about omitted, unrecorded payables. Tracing recorded payables to
receiving reports is a test of recorded liabilities that will not detect unrecorded liabilities. Answer (b) is incorrect
because a liability is incurred when goods or services are received, not when a purchase order is issued. Answer (d)
is incorrect because cash disbursements made before year end are in payment of recorded liabilities, not unrecorded
liabilities.
164. (c) The purpose of a substantive audit procedure that traces a transaction forward in an accounting system is to
determine if that transaction was properly recorded for the correct amount in the correct accounting period. This
procedure primarily tests the completeness assertion. Tracing purchase orders to receiving reports to purchase
journals and cash disbursement journals will provide evidence that purchase transactions have been properly
recorded, and not omitted. Answer (a) is incorrect because testing a sample of purchase orders may not detect
unusually large purchases. Answers (b) and (d) are incorrect because the direction of testing would be from the cash
disbursements journal to receiving reports and purchase orders if the purpose was to determine if disbursements
were for goods received and ordered.
165. (b) When a plant asset, such as equipment, is retired, the asset account is credited and the related accumulated
depreciation account is debited. Therefore, an acceptable explanation for significant debits to the accumulated
depreciation accounts would be that plant assets were retired during the year. Answers (a) and (d) are incorrect
because they involve changes in estimates, which are accounted for prospectively in the future. Accumulated
depreciation accounts are not adjusted for changes in estimates such as changes in estimated useful lives and
revisions of overhead allocations. Answer (c) is incorrect because if the prior year's depreciation was understated,
the correction of this error would involve a credit to accumulated depreciation, not a debit.
166. (a) Standard labor cost is based on expectations and budgets. If actual labor cost is significantly different from
standard labor cost, the resultant variances should be analyzed by the auditor. If these variances are not readily
explainable, the auditor may suspect payroll fraud. Answers (b), (c) and (d) are desirable controls that reduce the
likelihood of payroll fraud. Payroll checks can be distributed by the same employee each pay day, particularly if that
individual is associated with the treasury or cash disbursements function. Employee time cards should be approved
by supervisors. Using a separate payroll account that is reimbursed from other general bank accounts provides
additional control over payroll disbursements.

2S-22

167. (c) Substantive tests are defined as tests of details and analytical procedures performed to detect material
misstatements in the account balance, transaction class, and disclosure components of financial statements. Answer
(a) is incorrect because the objective of tests of details of transactions performed as substantive tests is to detect
material misstatements, not to comply with generally accepted auditing standards (GAAS), Even though GAAS do
indicate that the auditor should perform substantive tests for significant account balances and transaction classes,
GAAS do not indicate that tests of details of transactions have to be performed and that the objective of such tests is
to comply with GAAS. Answers (b) and (d) are incorrect because tests of controls, not substantive tests, are
performed to attain assurance about the reliability of the accounting system and the effectiveness of management's
policies and procedures.
168. (d) The work of a specialist who has a relationship with the client may be acceptable under certain
circumstances. If the specialist has a relationship with the client, the auditor should assess the risk that the
specialist's objectivity might be impaired. If the auditor believes the relationship might impair the specialist's
objectivity, the auditor should perform additional procedures to determine that the specialist's findings are not
unreasonable or should engage another specialist for that purpose. Answer (a) is incorrect because the auditor
should obtain an understanding of the methods and assumptions used by the specialist. Answer (b) is incorrect
because the auditor may use the specialist's work in material matters. Answer (c) is incorrect because the
appropriateness and reasonableness of methods and assumptions used and their application are the responsibility of
the specialist, not the auditor.
169. (c) Since the events or conditions that should be considered in the accounting for and reporting of litigation,
claims, and assessments are matters within the direct knowledge of management of an entity, management is the
primary source about such matters. Accordingly, the auditor should inquire of and discuss with management the
policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments.
Answer (a) is incorrect because the auditor, not the client's lawyer, has the responsibility to evaluate whether a
going concern problem exists. Answer (b) is incorrect because the auditor is not responsible for examining
documents in the lawyer's possession. Answer (d) is incorrect because proper recording and disclosure are
accounting and auditing issues, not legal issues.
170. (d) The auditor should perform auditing procedures with respect to the period after the balance-sheet date for
the purpose of ascertaining the occurrence of subsequent events that may require adjustment or disclosure. Included
in those auditing procedures is inquiring of and discussing with officers and other executives having responsibility
for financial and accounting matters as to whether any unusual adjustments had been made during the period from
the balance-sheet date to the date of inquiry. Answer (a) is incorrect because confirmation of receivables is done
before year-end. Answer (b) is incorrect because this is an analytical review procedure that is done at the beginning
of the audit as part of audit planning. Answer (c) is incorrect because personnel changes in the accounting
department after year-end do not typically relate to subsequent events that could affect the financial statements.
171. (b) Although the specific representations obtained by the auditor in a management representation letter will
depend on the circumstances of the engagement and the nature and basis of presentation of the financial statements,
they ordinarily include the completeness and availability of all minutes of meetings of stockholders, directors, and
committees of directors. Answer (a) is incorrect because communications with the audit committee concerning
weaknesses in controls is the auditor's responsibility, not management's. Answer (c) is incorrect because plans to
acquire or merge with other entities in the future do not affect the current period's financial statements. Answer (d)
is incorrect because the management representation letter, which does include reference to irregularities involving
management or employees, does not indicate that management is responsible for detecting employee fraud.
172. (c) The auditor performs various procedures to identify material transactions with parties known to be related
and for identifying material transactions that may be indicative of the existence of previously undetermined
relationships. One such procedure is reviewing confirmations of loans receivable and payable for indications of
guarantees. When guarantees are indicated, the auditor should determine their nature and the relationships, if any, of
the guarantors to the reporting entity. Answers (a), (b) and (d) are incorrect because they do not focus on and may
not identify related party transactions; rather, they focus on discovering contingent liabilities, evaluating subsequent
events, and determining if there are going concern problems.

2S-23

173. (d) The permanent file of an auditor's working papers contains information and documents of continuing
interest. Examples of such items are debt agreements, the corporate charter and bylaws, contracts such as leases and
royalty agreements, and continuing schedules of accounts whose balances are carried forward for several years.
Answers (a), (b) and (c) relate to the current year under audit and would be included in the current file of an
auditor's working papers.
174. (b) Items that are usually communicated to the audit committee include significant accounting policies,
management's process involved in determining significant accounting estimates, significant audit adjustments,
disagreements with management and their resolution, consultation with other accountants, and difficulties
encountered in the audit. Significant errors discovered by the auditor and subsequently corrected by management
would fall under the items listed above. Answer (a) is incorrect because the auditor is not required to communicate
with management but may do so if the auditor feels that management will benefit from such communication.
Answer (c) is incorrect because the communication with the audit committee may be written or oral. Answer (d) is
incorrect because it is not necessary to repeat the communication of recurring matters each year.
175. (c) When the auditor becomes aware of information that relates to financial statements previously reported on
by the auditor, but which was not known to the auditor at the date of the auditor's report and which is of such a
nature that the auditor would have investigated it had it come to the auditor's attention during the course of the audit,
the auditor should make further inquiries about the previously issued financial statements. New information
concerning undisclosed lease transactions of the audited period would lead the auditor to make further inquiries to
determine if the new information is reliable and whether the facts existed at the date of the auditor's report. Answers
(a) and (d) are events that did not exist at the date of the auditor's report and would not require any additional
investigation by the auditor about the previously issued financial statements. Answer (b), which resolves a
contingency that had been properly accounted for, would not cause the auditor to reevaluate the previously issued
financial statements.

2S-24

Chapter Two - Solutions to Problems

The Third Standard of Field WorkEvidence
NUMBER 1
a.

The first type of subsequent events includes those events that provide additional evidence concerning
conditions that existed at the balance sheet date and affect the estimates inherent in the process of preparing
financial statements. This type of subsequent events requires that the financial statements be adjusted for any
changes in estimates resulting from the use of such additional evidence.
The second type of subsequent events consists of those events that provide evidence concerning conditions
that did not exist at the balance sheet date but arose subsequent to that date. These events should not result in
adjustment to the financial statements but may be such that disclosure is required to keep the financial
statements from being misleading.

b.

The auditing procedures Green should consider performing to gather evidence concerning subsequent events
include the following:

Compare the latest available interim statements with the financial statements being audited.
Ascertain whether the interim statements were prepared on the same basis as the audited financial
statements.
Inquire whether any contingent liabilities or commitments existed at the balance sheet date or the date of
inquiry.
Inquire whether there was any significant change in the capital stock, long-term debt, or working capital
to the date of inquiry.
Inquire about the current status of items in the audited financial statements that were accounted for on the
basis of tentative, preliminary, or inconclusive data.
Inquire about any unusual adjustments made since the balance sheet date.
Read or inquire about the minutes of meetings of stockholders or the board of directors.
Inquire of the client's legal counsel concerning litigation claims, and assessments.
Obtain a management representation letter, dated as of the date of Green's report, as to whether any
subsequent events would require adjustment or disclosure.
Make such additional inquiries or perform such additional procedures Green considers necessary and
appropriate.

NUMBER 2
a.

The factors Kent should consider in the process of selecting Park include:

Park's professional certification, license, or other recognition of Park's competence.

Park's reputation and standing in the views of Park's peers and others familiar with Park's capability or
performance.
Park's relationship, if any, to Davidson Corporation.

b. The understanding among Kent, Park, and Davidson's management as to the nature of the work to be performed
by Park should cover:
The objectives and scope of Park's work.
Park's representations as to Park's relationship, if any, to Davidson.
The methods or assumptions to be used.
A comparison of the methods or assumptions to be used with those used in the preceding period.
Park's understanding of Kent's corroborative use of Park's findings.
The form and content of Park's report that would enable Kent to evaluate Park's findings.

2S-25

c.

Kent may not refer to Park in the auditor's report if Kent decides to issue an unqualified opinion. Such a
reference might be misunderstood to be a qualification, a division of responsibility, or an inference that a more
thorough audit was performed.

d. Kent may refer to Park in the auditor's report if Kent decides to issue other than an unqualified opinion as a
result of Park's findings. Reference is permitted if it will facilitate an understanding of the reason for the
modification.

NUMBER 3
a.
Primary Assertion

Objective

4.

Existence or occurrence

To determine that the custodian holds the

securities as identified in the confirmation.

5.

Completeness

To determine that all income and related

collections from the investments are properly
recorded.

6.

Valuation or allocation

To determine that the market or other value

of the investments is fairly stated.

7.

Presentation and disclosure

To determine that the financial statement

presentation and disclosure of investments is in
conformity with generally accepted accounting
principles consistently applied.

8.

Valuation or allocation

To determine that the market or other value of

the investments is fairly stated and the loss is
properly recognized and recorded.

b. Larkin should consider applying the following additional substantive auditing procedures in auditing Vernon's
investments:

Inspect securities on hand in the presence of the custodian.

Examine supporting evidence (broker's advices, etc.) for transactions between the balance sheet date and the
inspection date.

Obtain confirmation from the issuers or trustees for investments in nonpublic entities.

Examine contractual terms of debt securities and preferred stock.

Determine that sales and purchases were properly approved by the Board of Directors or its designee.

Examine broker's advices in support of transactions or confirm transactions with broker.

Determine that gains and losses on dispositions have been properly computed.

Trace payments for purchases to canceled checks, and proceeds from sales to entries in the cash receipts
journal.

Determine that the amortization of premium and discount on bonds has been properly computed.

Determine that market value for both current and long-term portfolios has been properly computed by tracing
quoted market prices to competent published or other sources.

Compute the unrealized gains and losses on both current and long-term portfolios for marketable equity
securities.

Determine that the unrealized gains and losses on the current portfolio have been properly classified in the
income statement, and the unrealized gains and losses on the noncurrent portfolio have been properly
classified in the equity section of the balance sheet.

Ascertain whether any investments are pledged as collateral or encumbered by liens, and, if so, are properly
disclosed.

2S-26

NUMBER 4
a.

The means or techniques of gathering audit evidence, in addition to the example, are as follows:
Technique

Description

Inquiry

An auditor questions client personnel about events and

conditions, such as obsolete inventory.

Confirmation

An auditor obtains acknowledgments in writing from

third parties of transactions or balances, such as
inventory in public warehouses or on consignment.

Calculation or
Recomputation

An auditor recomputes certain amounts, such as the

multiplication of quantity times price to determine
inventory amounts.

Analysis

An auditor combines amounts in meaningful ways to allow

the application of audit judgment, such as determination
of whether a proper inventory cutoff was performed.

Inspection

An auditor examines documents relating to transactions

and balances, such as shipping and receiving records to
establish ownership of inventory.

Comparison

An auditor relates two or more amounts, such as

inventory cost in perpetual inventory records to costs as
shown on vendor invoices as part of the evaluation of
whether inventory is priced at the lower of cost or market.

2S-27

b. Substantive auditing procedures that would satisfy the five general assertions regarding a client's inventory
balance include the following:
(one different procedure required for each assertion)
Assertion
1.

Substantive Auditing Procedure

Existence or
Occurrence

2.

Completeness

3.

Rights and
Obligations

Observe physical inventory counts.

Analytically review the relationship of inventory
balances to recent purchasing, production,
and sales activities.
Test shipping and receiving cutoff procedures.
Obtain confirmation of inventories at locations
outside the entity.
Trace test counts recorded during the physical
inventory observation to the inventory listing.
Account for all inventory tags and count sheets
used in recording the physical inventory counts.

Test the clerical accuracy of inventory listings.

Reconcile physical counts to perpetual records and
general ledger balances and investigate significant
fluctuations.

Observe physical inventory counts.

Obtain confirmation of inventories at locations
outside the entity.
Examine paid vendors' invoices, consignment
agreements, and contracts.
Test shipping and receiving cutoff procedures.

2S-28

Observe physical inventory counts.

Obtain confirmation of inventories at locations
outside the entity.
Test inventory transactions between a preliminary
physical inventory date and the balance sheet date.
Review perpetual inventory records, production
records, and purchasing records for indications of
current activity.
Compare inventories with a current sales catalog and
subsequent sales and delivery reports.
Use the work of specialists to corroborate the
nature of specialized products.

Assertion
4.

Substantive Auditing Procedure

Valuation or
Allocation

5.

Presentation and
Disclosure

Examine paid vendors' invoices.

Review direct labor rates.
Test the computation of standard overhead rates.
Examine analyses of purchasing and manufacturing standard cost variances.
Examine an analysis of inventory turnover.
Review industry experience and trends.
Analytically review the relationship of
inventory balances to anticipated sales volume.
Tour the plant.
Inquire of production and sales personnel
concerning possible excess or obsolete inventory
items.
Obtain current market value quotations.
Review current production costs.
Examine sales after year-end and open purchase
order commitments.
Review drafts of the financial statements.
Compare the disclosures made in the financial
statements to the requirements of generally
accepted accounting principles.
Obtain confirmation of inventories pledged
under loan agreements.

NUMBER 5
The substantive audit procedures Kane should apply to Star's trade accounts payable balances include the following:

Foot the schedule of the trade accounts payable.

Agree the total of the schedule to the general ledger trial balance.
Compare a sample of individual account balances from the schedule with the accounts payable subsidiary
ledger.
Compare a sample of individual account balances from the accounts payable subsidiary ledger with the
schedule.
Investigate and discuss with management any old or disputed payables.
Investigate debit balances and, if significant, consider requesting positive confirmations and propose
reclassification of the amounts.
Review the minutes of board of directors' meetings and any written agreements and inquire of key employees
as to whether any assets are pledged to collateralize payables.
Performing cut-off tests.
Performing analytical procedures.

2S-29

Confirm or verify recorded accounts payable balances by:

Reviewing the voucher register or subsidiary accounts payable ledger and consider confirming payables of a
sample of vendors.
Requesting a sample of vendors to provide statements of account balances as of the date selected.
Investigating and reconciling differences discovered during the confirmation procedures.
Testing a sample of unconfirmed balances by examining the related vouchers, invoices, purchase orders, and
receiving reports.

Perform a search for recorded liabilities by:

Examining files of receiving reports unmatched with vendors' invoices, searching for items received before the
balance sheet date but not yet billed or on the schedule.
Inspecting files of unprocessed invoices, purchase orders, and vendors' statements.
Reviewing support for the cash disbursements journal, the voucher register, or canceled checks for
disbursements after the balance sheet date to identify transactions that should have been recorded at the
balance sheet date, but were not.
Inquiring of key employees about additional sources of unprocessed invoices or other trade payables.

NUMBER 6
a.

Before applying principal substantive tests to balance sheet accounts at April 30, 1993, the interim date, Cook
should assess the difficulty in controlling incremental audit risk. Cook should consider whether

Cook's experience with the reliability of the accounting records and management's integrity has been
good;
Rapidly changing business conditions or circumstances may predispose General's management to misstate
the financial statements in the remaining period;
The year-end balances of accounts selected for interim testing will be predictable;
General's procedures for analyzing and adjusting its interim balances and for establishing proper
accounting cutoffs will be appropriate;
General's accounting system will provide sufficient information about year-end balances and transactions
in the final two months of the year to permit investigation of unusual transactions, significant fluctuations,
and changes in balance compositions that may occur between the interim and balance sheet dates;
The cost of the substantive tests necessary to cover the final two months of the year and provide the
appropriate audit assurance at year end is substantial.

Assessing control risk at below the maximum would not be required to extend the audit conclusions from the
interim date to the year end; however, if Cook assesses control risk at the maximum during the final two
months, Cook should consider whether the effectiveness of the substantive tests and cover that period will be
impaired.
b. Cook should design the substantive tests so that the assurance from those tests and the tests to be applied as of
the interim date, and any assurance provided from the assessed level of control risk, achieve the audit objectives
at year end. Such tests should include the comparison of year-end information with comparable interim
information to identify and investigate unusual amounts. Other analytical procedures and/or substantive tests
should be performed to extend Cook's conclusions relative to the assertions tested at the interim date to the
balance sheet date.

2S-30

NUMBER 7
1.
2.
3.
4.
5.

E
F
B
E
C

6.
7.
8.
9.

F
D
G
B

NUMBER 8
99.

D
I

Confirm directly with bank.

Trace items on the bank reconciliation to cutoff statement.

The auditor would confirm the balance with the bank and trace the items to the cutoff statement.
100.

A
G
H
I
J

Trace to cash receipts journal.

Ascertain reason for unusual delay.
Inspect supporting documents for reconciling items not appearing on cutoff statement.
Trace items on the bank reconciliation to cutoff statement.
Trace items on the cutoff statement to bank reconciliation.

The auditor traces all deposits in transit to the reconciliation and to the cash receipts journal to prove
completeness. If there are any items that do not appear on the cutoff statement, the auditor should
investigate the delay.
101.

B
G
H
I
J

Trace to cash disbursements journal.

Ascertain reason for unusual delay.
Inspect supporting documents for reconciling items not appearing on cutoff statement.
Trace items on the bank reconciliation to cutoff statement.
Trace items on the cutoff statement to bank reconciliation.

The auditor traces the outstanding checks to the cash disbursement journal and to the bank cutoff
statement. In addition, the auditor traces all checks that cleared to make sure that they were properly
listed.
102.

Inspect bank credit memo.

The credit memo generally does not appear on the cutoff statement, nor is it confirmed with the bank.
103.

E
I

Inspect bank credit memo.

Trace items on the bank reconciliation to cutoff statement.

The bank credited the account for $720 instead of $270. The auditor should trace the item and reconcile
it.
104.

Compare to 9/30/94 general ledger.

The companys books and records should agree with the balance.

2S-31

NUMBER 9
A. SAS No 56 (AU 329) describes analytical procedures as:

Comparison of current year account balances to balances for one or more comparable periods.
Comparison of the current year account balances to anticipated results found in the company's budgets.
Evaluation of the relationships of current year account balances to other current year balances for
conformity with predictable patterns based on the company's experience.
Comparison of current year account balances and financial relationships; for example, ratios with similar
information for the industry in which the company operates.
Study of the relationships of current year account balances with relevant nonfinancial information.

Analytical procedures are performed at any of three times during an engagement. Analytical procedures are required
to be performed in the planning phase and during the completion phase of the audit. However, they are often done
during the testing phase.
The purpose of applying analytical procedures in planning the audit is to:

enhance the auditor's understanding of the client's business and the transactions and events that have
occurred since the last audit.
identify areas that may represent risks relevant to the audit.

Therefore the objective of the procedures is to identify unusual transactions and events, and amounts, ratios and
trends that might indicate matters that have financial statement and audit planning ramifications.
Analytical procedures used in planning the audit generally use data aggregated at a high level. Furthermore, the
sophistication, extent, and timing of the procedures which are based on the auditor's judgment may vary widely
depending on the size and complexity of the client. For some entities, the procedures may consist of reviewing
changes in account balances, or reviewing the minutes of the meetings of the board of directors. For other entities,
the procedures might involve an extensive analysis of quarterly financial statements, mathematical times series and
regression analysis, ratio, and trend analysis. In both cases, the analytical procedures, combined with the auditor's
knowledge of the business, serve as a basis for additional inquiries and effective planning. Although analytical
procedures used in planning the audit often use only financial data, sometimes relevant nonfinancial information is
considered as well, such as number of employees, square footage of selling space, volume of goods produced, and
similar information which may contribute to accomplishing the purpose of the procedures.
B. The auditor's decision to select analytical procedures as substantive tests is based on the auditor's judgment on
the expected effectiveness and efficiency of the available procedures. For some assertions, analytical
procedures are effective in providing the appropriate level of assurance. For other assertions, however,
analytical procedures may not be as effective or efficient as tests of details in providing the desired level of
assurance. The expected effectiveness and efficiency of an analytical procedure depends on several factors:

Nature of the assertion.

Plausibility and Predictability of the Relationship.
Availability and Reliability of the Data.
Precision of the Expectation.

C. The objective of analytical procedures used in the overall review stage of the audit is to assist the auditor in
assessing the conclusions reached and in the evaluation of the overall financial statement presentation. A wide
variety of analytical procedures may be useful for this purpose. The overall review would generally include
reading the financial statements and notes and considering:

the adequacy of evidence gathered in response to unusual or unexpected balances identified in planning the
audit or in the course of the audit and
unusual or unexpected balances or relationships that were not previously identified. Results of an overall
review may indicate that additional evidence may be needed.

2S-32

Analytical procedures may be effective and efficient tests for assertions in which potential misstatements would
not be apparent from an examination of the detailed evidence or in which detailed evidence is not readily
available. For example, comparisons of aggregate salaries paid with the number of personnel may indicate
unauthorized payments that may not be apparent from testing individual transactions. The auditor needs to
understand the reasons that make relationships plausible because data sometimes appear to be related when they
are not, which could lead the auditor to erroneous conclusions. In addition, the presence of an unexpected
relationship can provide important evidence when appropriately scrutinized. The auditor obtains assurance from
analytical procedures based upon the consistency of the recorded amounts with expectations developed from
data derived from other sources.

NUMBER 10
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Select 1
Select 1
Select 1
Select 2
Select 1
Select 1
Select 1
Select 1
Select 1
Select 2
Select 1
Select 2

E
D
H
K, L
P
Q
A
U
B
A, J
E
J, L

NUMBER 11
a.

Financial statement assertions are representations by management that are embodied in financial statement
components.

b.

In obtaining evidential matter in support of financial statement assertions, an auditor develops specific audit
objectives in the light of those assertions.

c.

In developing the audit objectives of a particular engagement, an auditor should consider the specific
circumstances of the entity, including the nature of its economic activity and the accounting practices unique to
its industry.

d.

There is not necessarily a one-to-one relationship between audit objectives and procedures. Some auditing
procedures may relate to more than one objective. On the other hand, a combination of auditing procedures
may be needed to achieve a single objective. The procedures adopted should be adequate to achieve the audit
objectives.

e.

In selecting particular substantive tests to achieve audit objectives, an auditor considers, among other things,
the risk of material misstatement in the financial statements, including the assessed levels of control risk, and
the expected effectiveness and efficiency of such tests. An auditors considerations also include the nature and
materiality of the items being tested, the kinds and competence of available evidential matter, and the nature of
the audit objective to be achieved.

2S-33

NUMBER 12
a.
Confirmation #11 -- Atom. Adler should determine that Superior received and deposited Atoms check on
December 28, 1996, by examining supporting documentation, e.g., the entry in the cash receipts journal and either
Superiors deposit ticket or its bank statement. Adler should also determine the account to which the check was
recorded and why it was not credited to Atoms account.
Confirmation #28 -- Baker. Adler should examine the terms of the sale and the shipping documents, especially
whether the sale/shipment was to be FOB shipping point or FOB destination and the date the goods were shipped to
Baker, to verify when the criteria for revenue recognition were met.
Confirmation #34 -- Clark. Adler should read Superiors correspondence files for evidence concerning the terms of
the shipment to Clark to determine whether the criteria for revenue recognition were met.
Confirmation #41 -- Delta. Adler should investigate whether the merchandise was ever shipped to Delta and, if so,
whether the sale was ever consummated, or whether the merchandise was returned, or whether Superior expects it to
be returned.
Confirmation #58 -- Eagle. Adler should send a second request to Eagle providing the individual invoice numbers
and amounts or attaching copies of the individual unpaid invoices that Eagles accounts payable voucher system can
verify. In the alternative, Adler should examine shipping documents and subsequent cash receipts.
Confirmation #67 -- Franklin. Adler should determine Franklins correct address and send a second request.
Confirmation #71 -- Grove. Adler should determine when the check was received and where it was recorded by
examining Superiors cash receipts records, bank statements, and accounts receivable detail.
Confirmation #86 -- Hall. No additional procedures are necessary to resolve this confirmation request, although
Adler may want to trace the cash receipt to verify that Halls check was actually received, deposited, and credited to
Halls account in January 1997.
b.

When replies to positive confirmation requests have not been received, Miller should apply alternative
substantive procedures to the nonresponding accounts receivable. Miller most likely would examine
subsequent cash receipts for the accounts that have been paid. This would include matching such receipts with
the actual items being paid. In addition, especially for receivables that have not been paid, Miller should
inspect shipping documents or other client documentation (e.g., sales invoices, customers purchase orders,
etc.) that may provide evidence for the existence assertion. Miller should also consider reading any
correspondence in Superiors files that may indicate disagreements with its customers about the amounts billed
or the terms of the sales. In addition, Miller may consider contacting a reputable credit agency to verify the
existence of customers who are new to the client or who Miller may be unfamiliar with.

c.

The additional substantive procedures that Miller should consider performing to complete the audit of
Superiors accounts receivable and related allowances include the following:

Test the cut-off of sales, cash receipts, and sales returns and allowances.
Evaluate the reasonableness of all allowances against receivables.
Perform analytical procedures for accounts receivable, such as sales returns and allowances to sales, bad
debt expense to net credit sales, accounts receivable turnover, and days sales in receivables.
Determine that Superiors revenue recognition policies are appropriate, including policies for
consignment sales.
Review activity after the balance sheet date for unusual transactions, such as large sales returns.
Determine whether any accounts receivable are pledged or factored.
Determine that the presentation and disclosure of accounts receivable and related allowances are in
conformity with general accepted accounting principles.

2S-34

NUMBER 13
a.

In searching for DollarMarts unrecorded liabilities, Cook most likely would review DollarMarts cash
disbursements journal near the conclusion of field work for checks written after year end and examine the
supporting documentation, such as receiving reports and vendors invoices, for selected disbursements to
determine that the related accounts payable were properly recorded and to verify the cutoff of DollarMarts
receipt of inventory. Alternatively, Cook could review DollarMarts voucher register for selected transactions
similarly recorded shortly after year end and examine the supporting detail to identify items that should have
been recorded at the balance sheet date, but were not.
Cook most likely would consider examining files of receiving reports and comparing them to recorded
accounts payable entries. This would assist Cook in searching for significant merchandise received before
year end to verify DollarMarts schedule of merchandise received but not yet billed. Cook may also consider
inspecting DollarMarts files of unprocessed vendors invoices, vendors statements, and outstanding purchase
orders, and comparing them with the receiving records and accounts payable entries for unrecorded liabilities.
Although confirmations are usually not the best source of evidence for unrecorded accounts payable, Cook
may consider confirming selected accounts payable with vendors, including regular suppliers showing small or
zero balances at year end.
Cook most likely would consider performing analytical procedures such as comparing gross margin,
purchases, or certain expense account balances with those of the prior year to identify any large changes that
should be investigated because they may represent unrecorded liabilities.
Additionally, Cook may tailor the management representation letter to impress upon DollarMart the need to be
concerned about unrecorded accounts payable.

b.

Cook most likely would perform more substantive auditing procedures at year end because of DollarMarts
deficient control environment. For example, Cook would be more likely to confirm DollarMarts accounts
payable. Tests would most likely be performed further into the subsequent year and at a lower dollar value or
materiality level than otherwise.

NUMBER 14
a.

Smith should inform Digits audit committee about the inventory adjustments arising from the audit. These
adjustments probably have a significant effect on the financial statements and should be included among the
required matters to be communicated to the audit committee.
Dodds consultation with another CPA firm concerning the previously unrecorded contingent liability should
also be discussed with the audit committee. Smith should make the audit committee aware of Smiths views
about any significant matters that were the subject of that consultation.
Smith should also inform the audit committee of any serious difficulties encountered in dealing with
management related to the performance of the audit. Specifically, the two-week delay in completing the
financial statements and the unavailability of Dodd, the controller, near the end of the field work should be
reported to the audit committee.
Smiths disagreement with Dodd over the write-off of the overdue account receivable, even though
satisfactorily resolved, should also be discussed with the audit committee.
Finally, the reportable conditions that Smith became aware of during the audit should be communicated to the
audit committee.

2S-35

b.

In order for Digits audit committee to understand the nature of the assurance that an audit provides, Smith
should communicate the level of responsibility assumed under generally accepted auditing standards. The
audit committee should understand that an audit is designed to obtain reasonable, rather than absolute,
assurance about the financial statements.
Smith should also determine that Digits audit committee is informed about the initial selection of and changes
in significant accounting policies and their application. The audit committee would be interested in the
methods Digit uses to account for significant unusual transactions and accounting policies in controversial or
emerging areas for which there is no authoritative guidance or consensus.
The audit committee should also be informed about the accounting estimates that are based upon
managements judgments, the processes used to formulate particularly sensitive estimates, and the basis for
Smiths conclusions regarding the reasonableness of those estimates.
Additionally, Smith should discuss with the audit committee Smiths responsibility for other information in
documents containing audited financial statements, such as the Managements Discussion and Analysis of
Financial Condition and Results of Operations that is presented in the annual report to shareholders. Smith
should also discuss any procedures performed and the results.
Smith should also discuss with the audit committee any major issues that were discussed with management in
connection with the recurring retention of Smiths CPA firm, including discussions regarding the application
of accounting principles and auditing standards.
Finally, Smith should be assured that the audit committee is informed about any irregularities and illegal acts
that Smith becomes aware of during the audit unless those matters are clearly inconsequential. However, if
senior management is involved in an irregularity or illegal act, Smith should communicate directly with the
audit committee.

NUMBER 15
The working paper contains the following deficiencies:
The working paper was not initialed and dated by the audit assistant.
Negative confirmations not returned cannot be considered to be accounts confirmed without exception.
The two positive confirmations that were sent but were unanswered are not accounted for.
There is no documentation of alternate procedures, possible scope limitation, or other working paper reference for
the six accounts selected for confirmation that the client asked the auditor not to confirm.
The dollar amount and percent of the six accounts selected for confirmation that the client asked the auditor not to
confirm is omitted from the Dollars columns for the Total selected for testing.
The Dollar--Percent for Confirmation Requests--Negatives is incorrectly calculated at 10%.
There is no indication of follow-up or cross-referencing of the account confirmed--related party transaction.
The tickmark is used but is not explained in the tickmark legend.
There is no explanation or proposed disposition of the 10 differences aggregating $12,000.
The overall conclusion reached is not appropriate.
There is no notation that a projection from the sample to the population was made.
There is no reference to second requests.
Cross-referencing is incomplete, such as the 18 Differences reported and resolved, no adjustment and
Confirmation Requests to confirmation control schedule.

2S-36

NUMBER 16
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.

Y
Y
N
Y
N
Y
Y
Y
Y
N
N
Y
Y
N

NUMBER 17
1.
2.
3.
4.
5.
6.
7.

H
A
G
F
D
B
E

2S-37

Chapter Three
Standards of Reporting
THE AUDITOR'S REPORTINTRODUCTION

The auditor's report is the means by which his opinion is expressed on the financial statements of an enterprise. The
financial statements are those of management, including all related disclosures. While the auditor may suggest
adjustments and even draft footnotes for management to append to the financial statements, it should be kept in
mind that the auditor's report is the only means by which the auditor can disclose without management's
acquiescence.
The wording of the auditor's short-form report is standard for a very important reason. The report contains
precisely the meaning the auditor wants to convey to readers of financial statements. Changes or the use of
substitute words could give rise to doubt as to the meaning of the report and cause confusion among users as to the
auditor's responsibility.
What does the standard short-form report meanwhat are its important elements? The AICPA recommended form:
Independent Auditor's Report

(Title Required)

To the Board of Directors and

Stockholders of ABC Company
We have audited the accompanying balance sheet of ABC Company as of [at] December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United
States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of ABC Company as of [at] December 31, 20XX, and the results of its
operations and its cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States of America.
Firm's signature
Report date (must coincide with date on client representation letter).
Note these important elements contained in the above standard short-form report:
1.

The auditor's opinion normally covers four financial statements:

Balance sheet
Income statement
Retained earnings
Statement of cash flows

3-1

2.

The examination was made in accordance with generally accepted auditing standards (GAAS). By this
statement, the auditor states that the General Standards, the Standards of Field Work and Reporting Standards
have been observed in forming an opinion. When the auditor makes this statement, the responsibility assumed
encompasses the total weight of these standards as formulated by the accounting profession.

3.

That the financial statements "present fairly." In this context, the term is not one of precise measurement, but
conveys an exactitude of presentation in which reasonable and qualified professionals may differ, but within
immaterial limits.

4.

That the financial statements are in conformity with generally accepted accounting principles (GAAP). GAAP
involve not only those principles that are the subject of pronouncements by the AICPA and other professional
groups and regulatory authorities, but those which become acceptable through common usage by business.
Issuances of the Financial Accounting Standards Board (FASB) and its predecessors prevail where a conflict
exists. Obviously, if a CPA makes this statement in his report, it presumes that he knows generally accepted
accounting principles and that he has determined that the management of the enterprise has followed these
principles in preparing their financial statements.

5.

An assertion by the auditor of a belief that the audit provides a reasonable basis for his opinion.
Note also that the report is in three paragraphs:
1. The first paragraph is called the "introductory" paragraph.
2. The second is called the "scope" paragraph, including any limitations.
3. The third is called the "opinion" paragraph.

The First Standard of Reporting

The report shall state whether the financial statements are presented in accordance with generally accepted
accounting principles.
A. Includes not only principles and practices but also methods of applying them.
B. May require exercise of auditor's judgment as to general acceptance where no formal pronouncement has been
made.
C. THE MEANING OF "PRESENT FAIRLY IN CONFORMITY WITH GENERALLY ACCEPTED
ACCOUNTING PRINCIPLES" IN THE INDEPENDENT AUDITOR'S REPORT (SAS No. 69)
1.

GAAP Defined
The first standard of reporting requires an auditor who has examined financial statements in accordance
with generally accepted auditing standards to state in his report whether the statements are presented in
accordance with generally accepted accounting principles. The phrase "generally accepted accounting
principles" is a technical accounting term which encompasses the conventions, rules, and procedures
necessary to define accepted accounting practice at a particular time. It includes not only broad guidelines
of general application, but also detailed practices and procedures. Those conventions, rules, and procedures
provide a standard by which to measure financial presentations.

2. Relationship of "Fairness" to GAAP

The independent auditor's judgment concerning the "fairness" of the over-all presentation of
financial statements should be applied within the framework of generally accepted accounting
principles. Without that framework, the auditor would have no uniform standard for judging the
presentation of financial position, results of operations, and cash flows in financial statements.

3-2

The auditor's opinion that financial statements present fairly should be based on his judgment as to whether:
a. The accounting principles selected and applied have general acceptance.
b. The accounting principles are appropriate in the circumstances.
c. The financial statements, including the related notes, are informative about matters that may affect their
use, understanding, and interpretation.
d. The information presented in the financial statements is classified and summarized in a reasonable
manner; that is, neither too detailed nor too condensed.
e. The financial statements reflect the underlying events and transactions in a manner that presents the
financial position, results of operations, and cash flows stated within a range of acceptable limits; that is,
limits that are reasonable and practicable to attain in financial statements.
Generally accepted accounting principles are relatively objective; that is, they are sufficiently established so that
independent auditors usually agree on their existence. Nevertheless, the identification of an accounting principle
as generally accepted in particular circumstances requires judgment. No single source of reference exists for all
established accounting principles. Rule 203 of the AICPA Code of Professional Ethics requires compliance with
accounting principles promulgated by the FASB and its predecessors. Other sources of established accounting
principles are AICPA accounting interpretations, AICPA industry audit guides and accounting guides, and
industry accounting practices. Depending on their relevance in the circumstances, the auditor may also wish to
refer to APB statements, AICPA statements of position, pronouncements of other professional associations and
regulatory agencies, such as the Securities and Exchange Commission, and accounting textbooks and articles.
Also, the Governmental Accounting Standards Board (GASB) is considered a source of GAAP for
governmental units.
Generally accepted accounting principles recognize the importance of recording transactions in accordance with
their substance. The auditor should consider whether the substance of transactions differs materially from
their form.
The auditor should be familiar with alternative accounting principles that may be applicable to the transaction or
facts under consideration and realize that an accounting principle may have only limited usage but still have
general acceptance. On occasion, established accounting principles may not exist for recording and presenting a
specific event or transaction because of developments such as new legislation or the evolution of a new type of
business transaction.
Specifying the circumstances in which one accounting principle should be selected from among alternative
principles is the function of bodies having authority to establish accounting principles. When criteria for
selection among alternative accounting principles have not been established to relate accounting methods
to circumstances, the auditor may conclude that more than one accounting principle is appropriate in the
circumstance. The auditor should recognize, however, that there may be unusual circumstances in which the
selection and application of specific accounting principles from among alternative principles may make the
financial statements taken as a whole misleading.
D. If the financial statements are not in accordance with GAAP, the auditor must so state in his report.
Generally, the effect would be an "except for" opinion (qualified). However, if in the auditor's judgment the
departure is sufficiently material and pervasive that the statements are not presented fairly in accordance with
GAAP, the auditor will issue an adverse opinion. The report must contain an additional explanatory paragraph
in which the auditor would disclose the effect of the departure on income, earnings per share, retained earnings
and the specific item in question. This paragraph would become the third paragraph of the report and it would
directly follow the "scope" (second) paragraph of the auditor's report. The opinion paragraph would include a
direct reference to the explanatory paragraph as a basis for the opinion.

3-3

EXHIBIT I
GAAP HIERARCHY SUMMARY* (SAS 69)

Nongovernmental Entities

Established Accounting Principles

a.

b.

c.

Other Accounting Literature**

d.

*
**

FASB Statements and

Interpretations, APB Opinions, and
AICPA Accounting Research
Bulletins.

FASB Technical Bulletins, AICPA

Industry Audit and Accounting
Guides, and AICPA Statements of
Position.

Consensus positions of the FASB

Emerging Issues Task Force and
AICPA Practice Bulletins.

AICPA accounting interpretations,

"Qs and As" published by the
FASB staff, as well as industry
practices widely recognized and
prevalent.

Other accounting literature,

including FASB Concepts
Statements; APB Statements;
AICPA Issues Papers; International
Accounting Standards Committee
Statements; GASB Statements,
Interpretations, and Technical
Bulletins; pronouncements of other
professional associations or
regulatory agencies; AICPA
Technical Practice Aids; and
accounting textbooks, handbooks,
and articles.

State and Local Governments

a.

b.

c.

d.

GASB Statements and Interpretations,

plus AICPA and FASB
pronouncements if made applicable to
state and local governments by a
GASB Statement or Interpretation.

GASB Technical Bulletins, and the

following pronouncements if
specifically made applicable to state
and local governments by the AICPA:
AICPA Industry Audit and Accounting
Guides and AICPA Statements of
Position.
Consensus positions of the GASB
Emerging Issues Task Force and
AICPA Practice Bulletins if
specifically made applicable to state
and local governments by the AICPA.

"Qs and As" published by the GASB

staff, as well as industry practices
widely recognized and prevalent.

Federal Government
a.

b.

c.

d.

Officially established accounting

principles, consisting of Federal
Accounting Standards Advisory
Board (FASAB) Statements and
interpretations, as well as AICPA
and FASB pronouncements
specifically made applicable to
federal governmental entities by
FASAB Statements or Interpretations.
FASAB Statements and
Interpretations will be
periodically incorporated in a
publication by the FASAB.
Consists of FASAB Technical Bulletins
and, if specifically made applicable to
federal governmental entities by the AICPA
and cleared by the FASAB, AICPA
Industry Audit and Accounting Guides and
AICPA Statements of Position.

Consists of AICPA AcSEC Practice

Bulletins if specifically made applicable
to federal governmental entities and
cleared by the FASAB, as well as Technical
Releases of the Accounting and Auditing
Policy Committee of the FASAB.

Consists of implementation guides

published by the FASAB staff, as well as
practices that are widely recognized
and prevalent in the federal
government.

Other accounting literature, including

GASB Concepts Statements;
pronouncements in categories (a)
through (d) of the hierarchy for
nongovernmental entities when not
specifically made applicable to state
and local governments; APB
Statements; FASB Concepts
Statements; AICPA Issues Papers;
International Accounting Standards
Committee Statements;
pronouncements of other professional
associations or regulatory agencies;
AICPA Technical Practice Aids; and
accounting textbooks, handbooks, and
articles.

Paragraph references correspond to the paragraphs of this Statement that describe the categories of the GAAP hierarchy.
In the absence of established accounting principles, the auditor may consider other accounting literature, depending on its
relevance in the circumstances.

3-4

Departures from GAAP

1. Defined as a material misrepresentation in the financial statements due to intentional (fraud) or unintentional
(mistake/error) departures from accounting pronouncements (i.e., Exhibit 1).
2. Materiality is a matter of auditor's judgment, and it is generally defined as what a "reasonable person" would
consider significant.
3. Material departures from GAAP would cause the auditor to issue either:
Qualified
Adverse
"Except for"
or
Opinion
Opinion
The choice is a matter of auditor's judgment.
4. Qualified "Except for" Opinion -- on the whole, the financial statements present fairly, but there are material
errors in the financial statement that the user should be concerned with.
5. Adverse Opinion -- the financial statements are, on the whole, misleading. Any potential user of the financial
statements may therefore reach conclusions about the entity's financial position and results of operations that
are inappropriate. In other words, the financial statements are not reliable and should not be used for decision
making purposes.
6. Report Example -- Departure from GAAP.
Departure Material "Except for" Opinion
Standard introductory paragraph
Standard Scope paragraph
(Explanatory paragraph)
"The company has excluded from property and debt in the accompanying balance sheet certain
lease obligations, which, in our opinion, should be capitalized in order to conform with generally
accepted accounting principles. If these lease obligations were capitalized, property would be
increased by $....... , long-term debt by $....... , and retained earnings by $....... as of December 31,
20XX, and net income and earnings per share would be increased (decreased) by $....... and $.......
respectively for the year then ended."
(Opinion Paragraph)
"In our opinion, except for the effects of not capitalizing lease obligations, as discussed in the
preceding paragraph, the financial statements present fairly..."
Departure Very Material Adverse Opinion (Financial statements are misleading).
Standard Introductory Paragraph
Standard Scope Paragraph
Explanatory Paragraph as above
(Opinion paragraph)
"In our opinion, because of the failure to capitalize lease obligations, as discussed in the preceding
paragraph, the financial statements do not present fairly..."

The Second Standard of Reporting

The report shall identify those circumstances in which such principles have not been consistently observed in
the current period in relation to the preceding period.
A.

The objective of this standard is to assure that the comparability of financial statements between periods has
not been affected by changes in accounting principles, practices, or methods of application. Note that the audit
report makes no reference to consistency unless there has been a change that would require the auditor's
report to be modified.

3-5

B. Types of accounting changes:

1. Accounting changesChanges in accounting principles or changes in the reporting entity.
a. Examples of changes in accounting principles:
LIFO to FIFO
Completed Contract to Percentage of Completion
Changes in depreciation methods
b. Examples of changes in the reporting entity:
Consolidated statements in place of combined statements
c. These changes require that the auditor modify his standard report if material (see Part C below):
2. An error in previously issued financial statements:
a. Does not require modification of the auditor's report; however, footnote disclosure is required in the
financial statements.
b. Prior years' financial statements must be restated to reflect the error correction.
3. Changes in classification of items in the financial statements:
a. Does not require modification of the auditor's report.
b. Prior years' financial statements should be restated, if applicable.
C. The auditor has a responsibility to determine if there is a sound business reason for the change. There is a
presumption that accounting principles, once adopted, should not be changed unless the new principle would
present the results of operations and financial position of the entity more fairly than the old principle. This is a
subjective decision on the part of the auditor, not the client, because the auditor is expressing the opinion on the
client's financial statements.
In arriving at the decision, the auditor would consider the guidance in SAS No. 69. (Refer to SAS No. 69
reproduced earlier in this chapter.)
If the auditor concludes that the client has sufficient justification for changing an accounting principle, the
auditor would be required to modify the audit report as follows:

AUDITOR'S REPORTREFERENCE TO CHANGE IN GAAP

Independent Auditor's Report
To the Board of Directors and
Stockholders of ABC Company
(Same first and second paragraphs as the standard report.)
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of X Company as of December 31, 20XX, and the results of its operations and its cash
flows for the year then ended in conformity with accounting principles generally accepted in the United
States of America.
As discussed in Note X to the financial statements, the Company changed its method of computing
depreciation in 20XX.
Firm's signature
Date of report

3-6

Note:

The above is not a qualified opinion. It is an unqualified opinion with an "emphasis of a matter"
paragraph.
Should the auditor conclude that sufficient justification has not been demonstrated by the client, a
qualified except for or adverse opinion should be issued on the financial statements. For audit report
purposes, a changing GAAP without sufficient justification is considered to be a departure from GAAP. A
qualified report because the auditor has concluded the client does not have reasonable justification for a
GAAP change is illustrated below:

MANAGEMENT DOES NOT HAVE REASONABLE JUSTIFICATION

FOR A CHANGE IN ACCOUNTING PRINCIPLE
Independent Auditor's Report
To the Board of Directors and
Stockholders of ABC Company
(Same first and second paragraphs as the standard report.)
As disclosed in Note X to the financial statements, the Company adopted the first-in, first-out method of
accounting for its inventories in 20XX, whereas it previously used the last-in, first-out method. Although
use of the first-in, first-out method is in conformity with generally accepted accounting principles, in our
opinion, the Company has not provided reasonable justification for making this change as required by
generally accepted accounting principles.
In our opinion, except for the change in accounting principle discussed in the preceding paragraph, the
financial statements referred to above present fairly, in all material respects, the financial position of X
Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then
ended in conformity with accounting principles generally accepted in the United States of America.
Firm's signature
Date of report

The Third Standard of Reporting

Informative disclosures in the financial statements are to be regarded as reasonably adequate unless
otherwise stated in the report.
A. No reference is made in the auditor's report with respect to disclosure unless the auditor feels that adequate
disclosure has not been made.
B. GAAP requires certain disclosures to be made in the footnotes to the financial statements or on the financial
statements themselves.
C. Inadequate disclosures in the financial statements are considered to be departures from GAAP and are handled
in the auditor's report in a similar manner. That is, the auditor must choose between issuing a qualified except
for or adverse opinion.

3-7

D. Following is an example of a qualified opinion:

QUALIFIED OPINION FOR A DISCLOSURE DEPARTURE
Independent Auditor's Report
To the Board of Directors and
Stockholders of X Company
We have audited the accompanying balance sheet of X Company as of December 31, 20XX, and the
related statements of income, retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable
basis for our opinion.
The Company's financial statements do not disclose the amount of future commitments under long-term
operating leases. In our opinion, disclosure of that information is required by generally accepted
accounting principles.
In our opinion, except for the omission of the information discussed in the preceding paragraph, the
financial statements referred to above present fairly, in all material respects, the financial position of X
Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then
ended in conformity with accounting principles generally accepted in the United States of America.
Firm's signature
Report date
E. Auditor's ResponsibilityDisclosure of Events Subsequent to the Audit Date (Subsequent Events)
1. The term "subsequent events" applies to events or transactions which occur after the balance sheet date, but
prior to the issuance of the financial statements and the auditor's report.
2.

Two Types of Subsequent Events

a. Events that provide additional evidence concerning conditions that existed at year-end.
These types of events require adjustment of the financial statements.

Examples:

b.

Settlement of an accrued liability in excess of its recorded amount.

Evidence that an account receivable is no longer collectible because of bankruptcy
proceedings.

Events that provide evidence of conditions that did not exist at year-end and should not result in
adjustment of the financial statements. These events require disclosure if material.

Examples:

Sale of a bond or capital stock issue.

Purchase of a business.
Settlement of litigation when the event giving rise to the claim took place
subsequent to the balance sheet date.
Loss of plant or inventories as a result of fire or flood.
Losses on receivables resulting from conditions arising subsequent to the
balance sheet date.
3-8

3.

Auditing Procedures in the Subsequent Period

The "subsequent period" extends from the balance sheet date to the date of the auditor's report. The
auditor's report is dated at the conclusion of field work.
While the auditor is not expected to conduct a continuing review of matters during the subsequent period,
there are certain specific procedures to be applied to transactions after the balance sheet date such as:
a.

Procedures to assure that proper cut-offs have been made. Cut-offs most generally relate to audit
procedures to assure that transactions have been recorded in the correct accounting period and that
material items have been given consistent treatment.
Cut-Off Examples:
(1) Invoices are received at year-end but arrival of the goods has been delayed and the goods were
not included in the ending inventory count. If the invoices are recorded as purchases, net income
will be understated.
(2) Sales orders are received at year-end, but shipment takes place at a later date. If sales are
recorded and the goods are included in the ending inventory count, net income will be
overstated.

b.

c.
d.
e.
f.
g.

Consideration of data to assist the auditor in evaluating the recorded amount of assets and liabilities as
of the balance sheet date. In this connection, any information which adds to the reliability of the
estimates made as of year-end should be used. Examples are: collectibility of receivables, realization
of investments, market value of inventory at year-end (if pertinent).
Read and compare the latest interim statements, if any, with the statements being reported upon. Make
inquiries as to officers and others responsible as to whether interim statements were prepared on the
same basis as those under examination.
Make further inquiries as to (1) any contingent liabilities or commitments, (2) significant changes in
capital stock, long-term debt, or working capital, (3) update the status of items in the financial
statements accounted for on a tentative basis, (4) any unusual adjustments have been made.
Read the minutes of meetings, directors' and others.
Obtain a lawyer's letter as to description and evaluation of litigation, claims, and contingent liabilities
as of the balance sheet date and during the subsequent period.
Obtain a letter of representation, dated as of the date of the auditor's report, from the chief executive
officer and chief financial officer as to subsequent events that might in the officer's opinion require
adjustment or disclosure of the financial statements as of year end. (Note: generally this date is
considered to be the date of client representation letter.)

4.

Dating of the Auditor's Report

The completion of field work should be used as the date of auditor's report. The auditor has no responsibility
for audit procedures as to events subsequent to the date of his report.

5.

Events Subsequent to Date of Report But Before Issuance

When events subsequent to the date of the report come to the auditor's attention, he should:
Adjust the financial statements if necessary.
The date of report need not be changed unless the event is disclosed.

If the event is disclosed, whether or not adjustment is made, the auditor should either:
a. Date his report as of the latest date. This extends his responsibility for all subsequent events up to
the new date.
b. Use "dual dating," in which his report date is unchanged except for the specific event. This
relieves the auditor of responsibility for other matters arising after the end of field work.
If the event results in a qualified opinion, the auditor should give the report a new date or use
"dual dating."

3-9

If for any reason the auditor reissues his report, he should use the original report date. Where
a subsequent event has been brought to the auditor's attention, a reissuance of the report may
not be desirable. Regardless, the auditor should use care to avoid the report dating problems
outlined previously.

The Fourth Standard of Reporting

The report shall either contain an expression of opinion regarding the financial statements, taken as a whole,
or an assertion to the effect that an opinion cannot be expressed; the reasons therefor should be stated. In all
cases where an auditor's name is associated with financial statements, the report should contain a clear-cut
indication of the character of the auditor's examination, if any, and the degree of responsibility he is taking.
The objective of this standard is to enable users of financial statements an opportunity to determine the extent to
which the financial statements may be relied upon. The audit report is the only means of communication that the
auditor has with the user of financial statements. The audit report is the representation of the auditor, and, as such,
sets forth the scope of examination and his opinion as to the fairness, adherence to GAAP, and consistency of the
financial statements and disclosures. Anytime an auditor is associated, whether in an auditing capacity or preparer
of financial statements, he must indicate the scope of his engagement and the conclusion reached (opinion) if any.

OTHER REPORTING CONSIDERATIONS

Scope Limitations
A. Definition of Scope Limitation: The inability to gather sufficient competent evidential matter upon which to
base an opinion.
B. May occur because of:
1. Timing of audit work
2. Inability to gather evidence
3. Inadequate internal controls
4. Inadequate accounting records
C. Usually, if material, results in a disclaimer of an opinion; however, a qualified "except for" opinion may be
issued.
D. Typical scope limitations tested on the audit exam include:
1. Receivable not confirmed
a. No restrictions imposed by client and auditor performs alternate proceduresunqualified opinion.
b. Client restricts confirmation proceduresusually results in disclaimer of opinion.
2.

Ending inventory observation omitted

a. Auditor is able to perform. Alternate procedures available (perpetual records, past year-end count and
reconcile to year-end amounts). Issue unqualified opinion.
b. Auditor is not able to perform. Alternate procedure unavailable. Disclaim or qualify opinion based
upon materiality.
c. Client does not allow observation of inventory count always disclaim if material.

E. Failure of the client to issue a representation letter as required by SAS No. 85 and failure of the client's attorney
to respond to a confirmation request (SAS No. 12) always are considered to be material scope limitations. The
auditor's report would thus have to be qualified or would contain a disclaimer of an opinion.

3-10

AUDITOR'S REPORT QUALIFIED FOR A SCOPE LIMITATION

Independent Auditor's Report
To the Board of Directors and
Stockholders of X Company
(Same first paragraph as the standard report)
Except as discussed in the following paragraph, we conducted our audit in accordance with auditing
standards generally accepted in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
We were unable to obtain audited financial statements supporting the Company's investment in a foreign
affiliate stated at $XXX at December 31, 20XX, or its equity in earnings of that affiliate of $XXX, which
is included in net income for the year then ended as described in Note X to the financial statements; nor
were we able to satisfy ourselves about the carrying value of the investments in the foreign affiliate or the
equity in its earnings by other auditing procedures.
In our opinion, except for the effects of such adjustments, if any, as might have been determined to be
necessary had we been able to examine evidence regarding the foreign affiliate investment and earnings,
the financial statements referred to in the first paragraph present fairly, in all material respects, the
financial position of X Company as of December 31, 20XX, and the results of its operations and its cash
flows for the year then ended in conformity with accounting principles generally accepted in the United
States of America.
Firm's signature
Date of report

DISCLAIMER OF OPINION FOR A SCOPE LIMITATION

Independent Auditor's Report
To the Board of Directors and
Stockholders of X Company
We were engaged to audit the accompanying balance sheet of X Company as of December 31, 20XX,
and the related statements of income, retained earnings, and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management.
(Second paragraph of standard report should be omitted)
The Company did not make a count of its physical inventory in 20XX, stated in the accompanying
financial statements at $XXX as of December 31, 20XX. Furthermore, evidence supporting the cost of
property and equipment acquired prior to December 31, 20XX, is no longer available. The Company's
records do not permit the application of other auditing procedures to inventories or property and
equipment.

3-11

Since the Company did not take physical inventories and we were not able to apply other auditing
procedures to satisfy ourselves as to inventory quantities and the cost of property and equipment, the
scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the
accompanying financial statements.
Firm's signature
Date of report

Uncertainties

A. Definition: Matters involving future events, the outcome of which is not susceptible of reasonable estimation at
the date of the auditor's report. The matter is expected to be resolved at a future date when sufficient evidence
concerning its outcome will be available.
B. Examples include: lawsuits, tax claims, contracts in dispute, questions concerning going concern.
C. FASB No. 5, Accounting for Contingencies, provides guidance regarding whether an uncertainty would be
reflected in the financial statements as an accrual or as a footnote disclosure only.
1. In order for a loss contingency (gain contingencies are never recognized) to be accrued, the loss must be both
probable and the amount of loss must be estimable. In this case the auditor would not need to modify his
report for the uncertainty, if the client agrees to reflect the liability in the financial statements.
2. If the loss contingency did not meet the criteria for accrual, then footnote disclosure would be made in the
financial statements and the auditor may modify his report to add a fourth paragraph immediately following
the opinion paragraph. Such a paragraph would be considered as an emphasis of matter in the financial
statements and not a qualification.
Note:

Modification of the auditor's report by adding an additional paper is not required for loss
contingencies that are footnoted in the financial statements. However, the auditor may
decide to emphasize the matter by including an additional paragraph to the standard
report.

Example:

(If auditor decides to refer to the uncertainty)

Standard Introductory Paragraph
Standard Scope Paragraph
Standard Opinion Paragraph

EXPLANATORY PARAGRAPH
DESCRIBING AN UNCERTAINTY
As discussed in Note X to the financial statements, the Company is a defendant in a lawsuit
alleging infringement of certain patent rights and claiming royalties and punitive damages. The
Company has filed a counteraction, and preliminary hearings and discovery proceedings on both
actions are in progress. The ultimate outcome of the litigation cannot presently be determined.
Accordingly, no provision for any liability that may result upon adjudication has been made in the
accompanying financial statements.
3. If the auditor is unable to obtain sufficient evidential matter to support management's assertions about the
nature of a matter involving an uncertainty and its presentation in the financial statements, the auditor should
consider the need to qualify or disclaim an opinion for a scope limitation.
4. If the auditor concludes that the matter involving an uncertainty is not adequately disclosed or valued
correctly in the financial statements, the auditor should express a qualified "except for" or adverse opinion
depending upon the materiality of the item.

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The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern

(SAS No. 59)
Going concern relates to the entity's ability to continue to meet its obligations as they become due without
substantial disposal of assets, restructuring of debt, externally forced revisions of its operations, or similar actions.
Auditing standards do not require any specific auditing procedures to be employed with respect to the going
concern issue. Rather the standards state that normal auditing procedures should be sufficient in determining
whether a going concern issue exists. Even though no specific procedures are required, the auditor must document
his/her conclusions with respect to the going concern issue in the audit workpapers.

The Auditor's ResponsibilityGoing Concern

A. The auditor is not responsible for predicting future conditions or events. The fact that the entity may cease to
exist as a going concern subsequent to receiving a report from the auditor that does not refer to substantial
doubt, even within one year following the date of the financial statements, does not, in itself, indicate inadequate
performance by the auditor.
B. The auditor has a responsibility to evaluate whether there is substantial doubt about the entity's ability to
continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the
financial statements being audited.
C. The auditor's evaluation is based on knowledge of relevant conditions and events that exist at or have occurred
prior to the completion of field work.
D. Information about such conditions or events is obtained from the application of auditing procedures planned and
performed to achieve audit objectives in the financial statements being audited. No special audit procedures
must be implemented.

The Auditor's Consideration of Conditions and Events

A. In performing audit procedures, the auditor may identify information about certain conditions or events that,
when considered in the aggregate, indicate that there could be substantial doubt. For example:
1. Negative trends (for example, recurring operating losses).
2. Other indications of possible financial difficulties (for example, default on loan or similar agreements).
3. Internal matters (for example, work stoppages or other labor difficulties).
4. External matters that have occurred (for example, legal proceedings, legislation, or similar matters that might
jeopardize an entity's ability to operate.

Consideration of Management's Plans

A. If, after considering the identified conditions and events in the aggregate, the auditor believes that there is
substantial doubt, he should consider management's plans for dealing with the adverse effects of the conditions
and events.
B. The auditor should obtain information about the plans and consider whether it is likely that the adverse effects
will be mitigated for a reasonable period of time and that such plans can be effectively implemented.
C. The auditor's considerations relating to management plans may include the following:
1. Plans to dispose of assets.
2. Plans to borrow money or restructure debt.
3. Plans to reduce or delay expenditures.
4. Plans to increase ownership equity.
D. When evaluating management's plans, the auditor should identify those elements that are particularly significant
to overcoming the adverse effects of the conditions and events and should plan and perform auditing procedures
to obtain evidence about them.

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Consideration of Financial Statement Effects

When, after considering management's plans, the auditor concludes that there is substantial doubt, he should
consider the possible effects on the financial statements and the adequacy of the related disclosures.

Consideration of the Effects on the Auditor's Report

A. If, after considering identified conditions and events and management's plans, the auditor concludes that
substantial doubt remains, the audit report should include an explanatory paragraph (following the opinion
paragraph) to reflect that conclusion. An example follows:
The accompanying financial statements have been prepared assuming that Company Y will
continue as a going concern. As discussed in Note X to the financial statements, Company Y has
suffered recurring losses from operations and has a net capital deficiency that raises substantial
doubt* about the entity's ability to continue as a going concern*. Management's plans in regard to
these matters are also described in Note X. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
*Must include these terms
This additional paragraph does not constitute a qualified opinion but rather it is regarded as an emphasis
paragraph.
B. If the auditor concludes that the entity's disclosures with respect to the entity's ability to continue as a going
concern for a reasonable period of time are inadequate, a departure from GAAP exists. This may result in either
a qualified (except for) or an adverse opinion.

USING THE WORK AND REPORTS OF OTHER AUDITORS

The auditor must decide whether he is the principal auditor. His decision is based on:
Materiality of the portion audited by him.
Extent of over-all knowledge of financial statements.
Importance of components audited by him.
If the auditor decides he is the principal auditor, depending on the circumstances, he may decide to:
1. Express an opinion without reference to other auditor(s).
2. Refer to the other auditor's examination and indicate the division of responsibility in the rendering of the
opinion.
3. Qualify or disclaim an opinion in that he cannot assume responsibility for the other auditor's work insofar as it
relates to the principal auditor's opinion.
Principal auditor would be able to use the other auditor's report, with or without reference, if:
1. The other auditor is an associated or correspondent firm whose work is acceptable to the principal auditor, or
2. The work is performed under the principal auditor's guidance and control, or
3. The principal auditor takes steps to satisfy himself as to the other auditor's examination, or
4. The portion of the financial statements involving the other auditor is not material.
Regardless, the principal auditor should:
1. Make inquiries concerning the professional reputation and independence of the other auditor to one or more of
the following:
a. AICPA and/or state society
b. Other practitioners
c. Bankers and other audit grantors
2. Obtain a representation from the other auditor that he is independent under AICPA and SEC requirements.

3-14

3. Ascertain through the other auditor:

a. That he is aware what component he is to examine and that his report will be relied on by the principal
auditor.
b. That he is familiar with GAAP and GAAS.
c. That he knows the required statements and schedules to be filed with regulatory agencies (SEC).
d. That a review of matters affecting elimination of intercompany transactions and uniformity of accounting
practices among the components will be made.
Note:

Inquiries under 1 and 3 (b) and (c) will ordinarily not be necessary if the principal auditor already
knows the professional reputation of the other auditor.

If he decides not to make reference to the other auditor's report, he should also consider one or more of the
following procedures:
1. Visit the other auditor and discuss the procedures followed.
2. Review the audit program and/or workpapers of the other auditor.
If the other auditor's report is qualified, the principal auditor must decide, based on the materiality and
nature of the qualification, the effect on his report. If it is not material, he may omit reference to the
qualification in his own unqualified opinion. When the other auditor's report is presented, the principal
auditor may wish to make reference to the qualification and its disposition.

3-15

USING THE WORK AND REPORTS OF OTHER AUDITORS

Del CPA utilizes work and reports
of other auditor, Lam CPA.

Is portion of financials examined by

No

Del material to portion

Yes

examined by Lam?
No

Does Del have adequate

knowledge of the overall

Yes

financials?
No

Is portion audited by Del

important to the enterprise

Yes

as a whole?

Del should investigate Lam

for (1) reputation and
(2) independence.

Is Del able to satisfy himself

Yes

as to reputation and

No

independence of Lam?

Del should not report

Issue qualified or disclaimer

as principal auditor.

of opinion of financials.
Yes

Is Del going to assume

No

responsibility for the

Consider performing

work of Lam?

Modify report to show

Note there

one or more of the

divided responsibility

is no requirement

following:

(scope and opinion).

for Del to name Lam

in the audit report.
However, Del may do

Visit Lam to discuss audit procedures

Disclose in audit report

so provided Lam

and results of audit.

percentage (total assets

agrees to be named

Review audit program of Lam.

and/or total revenue) of

and Lam's separate

work done by Lam

audit report is
included with Del's.

Review the working papers of Lam.

Perform supplemental audit test.

No change in audit report required

no mention of Lam.

3-16

EXAMPLE OF REFERENCE TO OTHER AUDITOR

Independent Auditor's Report
Stockholders and Board of Directors
XYZ Corporation
We have audited the accompanying consolidated balance sheets of XYZ Corporation as of July 31,
20XX and 20YY, and the related consolidated statements of income, retained earnings, and cash flows
for the years then ended. These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based on our audits. We did not
audit the financial statements of ABC Corporation, a consolidated subsidiary in which the Company had
an equity interest of 84% as of July 31, 20XX, which statements reflect total assets of $2,400,000 and
$2,200,000 as of July 31, 20XX and 20YY, respectively, and total revenues of $3,400,000 and
$3,000,000 for the years then ended. Those statements were audited by other auditors whose report has
been furnished to us, and our opinion, insofar as it relates to the amounts included for ABC Corporation,
is based solely on the report of the other auditors.
We conducted our audits in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audits and the report of
other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements
referred to above present fairly, in all material respects, the financial position of XYZ Corporation as of
December 31, 20XX and 20YY, and the results of its operations and its cash flows for the years then
ended in conformity with accounting principles generally accepted in the United States of America.
Signature
Date

3-17

SUMMARY OF AUDITOR'S REPORTS

Circumstances

Unqualified

Type of Opinion
Qualified
Adverse

1.

Departure from GAAP

2.

Inadequate Disclosure

3.

Uncertainty
a. Adequately disclosed or
adjusted in financial
statements
b. Adequately disclosed
but auditor unwilling
to issue unqualified opinion
because of potential adverse
impact of uncertainty.
c. Not adequately disclosed or
adjusted in financial statements*

4.

Going Concern
a. Adequately Disclosed
in financial statements.
b. Not adequately disclosed*

5.

Scope Limitations

6.

Auditor Lacks Independence

7.

Change in GAAP (consistency)

a. Newly adopted principle
not GAAP*
b. Adequate justification
for change
c. No adequate justification
for change*
d. Incorrect method for
accounting for the change*

8.

Using the work of other auditors

a. No reference in consolidated audit report
b. Reference in consolidated audit report
c. Other auditor refers
to a departure from GAAP
in separate report.
1). Not material to consolidated financial
statement presentation
2). Material to consolidated financial
statement presentation*

Disclaimer

X
X

X
X

* Reported on as departure from GAAP/inadequate disclosure.

3-18

3-19

3-20

OTHER INFORMATION IN DOCUMENTS CONTAINING AUDITED FINANCIAL

STATEMENTS (SAS No. 8)

An entity may publish various documents that contain "other information" in addition to audited financial
statements and the independent auditor's report thereon. This statement is applicable only to other information
contained in (a) annual reports to holders of securities or beneficial interests, annual reports of organizations for
charitable or philanthropic purposes distributed to the public, and annual reports filed with regulatory authorities
under the Securities and Exchange Act of 1934, or (b) other documents to which the auditor, at the client's request,
devotes attention.
Other information in a document may be relevant to an independent auditor's examination or to the continuing
propriety of his report. The auditor's responsibility with respect to information in a document does not extend
beyond the financial information identified in his report, and the auditor has no obligation to perform any
procedures to corroborate other information contained in a document. However, he should read the other
information and consider whether such information, or the manner of its presentation, is materially inconsistent with
information, or the manner of its presentation, appearing in the financial statements. If the auditor concludes that
there is a material inconsistency, he should determine whether the financial statements, his report, or both,
require revision. If he concludes that they do not require revision, he should request the client to revise the other
information. If the other information is not revised to eliminate the material inconsistency, he should consider
other actions such as (1) revising his report to include an explanatory paragraph describing the material
inconsistency, (2) withholding the use of his report in the document, or (3) withdrawing from the
engagement. The action he takes will depend on the particular circumstances and the significance of the
inconsistency in the other information.

Other Material Misstatements of Fact

If the auditor becomes aware of information that he believes is a material misstatement of fact that is not a material
inconsistency as previously described, he should discuss the matter with the client. In connection with this
discussion, the auditor should consider that he may not have the expertise to assess the validity of the statement, that
there may be no standards by which to assess its presentation, and that there may be valid differences of judgment
or opinion. If the auditor concludes he has a valid basis for concern, he should propose that the client consult with
some other party whose advice might be useful to the client, such as the client's legal counsel.
If, after discussing the matter, the auditor concludes that a material misstatement of fact remains, the action he takes
will depend on his judgment in the particular circumstances. He should consider steps such as notifying his client in
writing of his views concerning the information and consulting his legal counsel as to further appropriate action in
the circumstances.

REPORTS ON COMPARATIVE FINANCIAL STATEMENTS (SAS No. 58)

Auditor's Standard Report On Comparative Financial Statements

The fourth standard of reporting requires that an auditor's report contain either an expression of opinion regarding
the financial statements taken as a whole or an assertion to the effect that an opinion cannot be expressed. Reference
in the fourth reporting standard to the financial statements "taken as a whole" should now be considered to apply not
only to the financial statements of the current period but also to those of one or more prior periods that are presented
on a comparative basis with those of the current period. Therefore, a continuing auditor should update his report on
the individual financial statements of the one or more prior periods presented on a comparative basis with those of
the current period.

Report With Differing Opinions

Since the
presented,
statements
presented.

auditor's report on comparative financial statements applies to the individual financial statements
an auditor may modify his opinion or disclaim an opinion with respect to one or more financial
for one or more periods, while expressing an unqualified opinion on the other financial statements
When this situation occurs, the auditor should disclose all the substantive reasons for modifying or

3-21

disclaiming an opinion in a separate explanatory paragraph(s) of his report and should include in the opinion
paragraph an appropriate modification or disclaimer of opinion and a reference to the explanatory paragraph(s).

Report With an Updated Opinion Different From a Previous Opinion

If, during his current examination, an auditor becomes aware of circumstances or events that affect the financial
statements of a prior period, he should consider such matters when updating his report on the financial statements of
the prior period. The following circumstances or events ordinarily should cause an auditor to express an opinion
different from that expressed in an earlier report on the financial statements of the prior period:

Subsequent restatement of prior-period financial statements. If an auditor has previously modified his
opinion on financial statements of a prior period because of a departure from generally accepted accounting
principles, and the prior-period financial statements are restated in the current period to conform with generally
accepted accounting principles, the auditor's updated report on the financial statements of the prior period should
indicate that the statements have been restated and should express an unqualified opinion with respect to the
restated financial statements.

If, in an updated report, an auditor expresses an opinion different from his previous opinion on the financial
statements of a prior period, he should disclose all the substantive reasons for the different opinion in a separate
explanatory paragraph(s) of his report. The explanatory paragraph(s) should disclose:
a. The date of the auditor's previous report.
b. The type of opinion previously expressed.
c. The circumstances or events that caused the auditor to express a different opinion.
d. That the auditor's updated opinion on the financial statements of the prior period is different from his
previous opinion on those statements.

Report of Predecessor Auditor

A predecessor auditor ordinarily would be in a position to reissue his report on the financial statements of a prior
period at the request of a former client if he is able to make satisfactory arrangements with his former client to
perform this service and if he performs the procedures described.

Predecessor Auditor's Report Reissued

Before reissuing (or consenting to the reuse of) a report previously issued on the financial statements of a prior
period, a predecessor auditor should consider whether his previous opinion on those statements is still appropriate.
Consequently, a predecessor auditor should:
a. Read the financial statements of the current period.
b. Compare the prior-period financial statements that he reported on with the financial statements to be
presented for comparative purposes.
c. Obtain a letter of representations from the successor auditor. The letter of representations should state
whether the successor's examination revealed any matters that, in the successor's opinion, might have a
material effect on, or require disclosure in, the financial statements reported on by the predecessor auditor.
A predecessor auditor who has agreed to reissue his report may become aware of events or transactions occurring
subsequent to the date of his previous report on the financial statements of a prior period that may affect his
previous opinion. In such circumstances, the predecessor auditor should make inquiries and perform other
procedures that he considers necessary. He should then decide, on the basis of the evidential matter obtained,
whether to revise his opinion.
A predecessor auditor's knowledge of the current affairs of his former client is obviously limited in the absence of a
continuing relationship. Consequently, when reissuing his report on prior-period financial statements, a predecessor
auditor should use the date of his previous report to avoid any implication that he has examined any records,
transactions, or events after that date. If the predecessor auditor revises his report, or if the financial statements are
restated, he should dual-date his report.

3-22

Predecessor Auditor's Report Not Presented

If the financial statements of a prior period have been examined by a predecessor auditor whose report is not
presented, the successor auditor should indicate in the scope paragraph of his report:
a. That the financial statements of the prior period were examined by other auditors.
b. The date of their report.
c. The type of opinion expressed by the predecessor auditor.
d. The substantive reasons therefor, if it was other than unqualified.

ASSOCIATION WITH FINANCIAL STATEMENTS (SAS No. 26)

1.

The fourth standard of reporting is:

The report shall either contain an expression of opinion regarding the financial statements, taken
as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall
opinion cannot be expressed, the reasons therefor should be stated. In all cases where an auditor's
name is associated with financial statements, the report should contain a clear-cut indication of the
character of the auditor's examination, if any, and the degree of responsibility he is taking.
The objective of the fourth reporting standard is to prevent misinterpretation of the degree of responsibility the
accountant assumes when his name is associated with financial statements.

2.

An accountant is associated with financial statements when he has consented to the use of his name in a report,
document, or written communication containing the statements. Also, when an accountant submits to his client
or others financial statements that he has prepared or assisted in preparing, he is deemed to be associated even
though the accountant does not append his name to the statements.

3.

An accountant may be associated with audited or unaudited financial statements.

Disclaimer of Opinion on Unaudited Financial StatementsPublic Companies

(see Chapter Five for reports on review and compilation services for Nonpublic Companies.)
When an accountant is associated with the financial statements of a public entity, but has not audited or reviewed
such statements, the form of report to be issued is as follows:
The accompanying balance sheet of X Company as of December 31, 20XX, and the related
statements of income, retained earnings, and cash flows for the year then ended were not audited
by us and, accordingly, we do not express an opinion on them.
(Signature and date)
When an accountant issues this form of disclaimer of opinion, he has no responsibility to apply any procedures
beyond reading the financial statements for obvious material errors.
If the accountant is aware that his name is to be included in a client-prepared written communication of a public
entity containing financial statements that have not been audited or reviewed, he should request (a) that his name
not be included in the communication or (b) that the financial statements be marked as unaudited and that there be a
notation that he does not express an opinion on them. If the client does not comply, the accountant should advise the
client that he has not consented to the use of his name and should consider what other actions might be appropriate.

3-23

Disclaimer of Opinion When Not Independent

The second general standard requires that "in all matters relating to the assignment, an independence in mental
attitude is to be maintained by the auditor or auditors". Whether the accountant is independent is something he must
decide as a matter of professional judgment.
When an accountant is not independent, any procedures he might perform would not be in accordance with
generally accepted auditing standards, and he would be precluded from expressing an opinion on such statements.
Accordingly, he should disclaim an opinion with respect to the financial statements and should state specifically that
he is not independent.
An example of such a report is as follows:
We are not independent with respect to XYZ Company, and the accompanying balance sheet as of
December 31, 20XX, and the related statements of income, retained earnings, and cash flows for
the year then ended were not audited by us and, accordingly, we do not express an opinion on
them.
(Signature and date)

Circumstances Requiring a Modified Disclaimer

If the accountant concludes on the basis of facts known to him that the unaudited financial statements on which he
is disclaiming an opinion are not in conformity with generally accepted accounting principles, which include
adequate disclosure, he should suggest appropriate revision; failing that, he should describe the departure in his
disclaimer of opinion.
When the effects of the departure on the financial statements are not reasonably determinable, the disclaimer of
opinion should so state.
If the client will not agree to revision of the financial statements or will not accept the accountant's disclaimer of
opinion with the description of the departure from generally accepted accounting principles, the accountant should
refuse to be associated with the statements and, if necessary, withdraw from the engagement.

SUPPLEMENTARY INFORMATION REQUIRED BY THE FINANCIAL ACCOUNTING

STANDARDS BOARD (SAS No. 52)

The Financial Accounting Standards Board (FASB) develops standards for financial reporting, including standards
for financial statements and for certain other information supplementary to financial statements. This Statement
provides the independent auditor with guidance on the nature of procedures to be applied to supplementary
information required by the FASB, and it describes the circumstances that would require the auditor to report
concerning such information.

Involvement with Supplementary Information Required by the FASB

The auditor should apply certain limited procedures to supplementary information required by the FASB and should
report deficiencies in, or the omission of, such information.

Procedures

The auditor should consider whether supplementary information is required by the FASB in the circumstances. If
supplementary information is required, the auditor should ordinarily apply the following procedures to the
information.
a. Inquire of management regarding the methods of preparing the information, including (1) whether it is measured
and presented within guidelines prescribed by the FASB, (2) whether methods of measurement or presentation
have been changed from those used in the prior period and the reasons for any such changes, and (3) any
significant assumptions or interpretations underlying the measurement or presentation.
b. Compare the information for consistency with (1) management's responses to the foregoing inquiries, (2) audited
financial statements, and (3) other knowledge obtained during the examination of the financial statements.

3-24

c. Consider whether representations on supplementary information required by the FASB should be included in
specific written representations obtained from management.
d. Apply additional procedures, if any, that other Statements prescribe for specific types of supplementary
information required by the FASB.
e. Make additional inquiries if application of the foregoing procedures causes the auditor to believe that the
information may not be measured or presented within applicable guidelines.

Circumstances Requiring Reporting on Supplementary Information Required by

the FASB

Since the supplementary information is not audited and is not a required part of the basic financial statements, the
auditor need not expand his report on the audited financial statements to refer to the supplementary information or
to his limited procedures except in the following circumstances. The auditor's report should be expanded if:
a. the supplementary information that the FASB requires to be presented in the circumstances is omitted,
b. the auditor has concluded that the measurement or presentation of the supplementary information departs
materially from guidelines prescribed by the FASB, or
c. the auditor is unable to complete the prescribed procedures.
The following are examples of additional paragraphs an auditor might use in these circumstances.
Omission of Supplementary Information Required by the FASB
The Company has not presented (describe the supplementary information required by the FASB in the
circumstances) that the Financial Accounting Standards Board has determined is necessary to supplement,
although not required to be part of, the basic financial statements.
Material Departures from FASB Guidelines
The (specifically identify the supplementary information) on page xx is not a required part of the basic financial
statements, and we did not audit and do not express an opinion on such information. However, we have applied
certain limited procedures, which consisted principally of inquiries of management regarding the methods of
measurement and presentation of the supplementary information. As a result of such limited procedures, we
believe that the (specifically identify the supplementary information) is not in conformity with guidelines
established by the Financial Accounting Standards Board because (describe the material departure(s) from the
FASB guidelines).
Prescribed Procedures Not Completed
The (specifically identify the supplementary information) on page xx is not a required part of the basic financial
statements, and we did not audit and do not express an opinion on such information. Further, we were unable to
apply to the information certain procedures prescribed by professional standards because (state the reasons).
Even though he is unable to complete the prescribed procedures, if, on the basis of facts known to him, the auditor
concludes that the supplementary information has not been measured or presented within FASB guidelines, he
should suggest appropriate revision; failing that, he should describe the nature of any material departures(s) in his
report.

REPORTING ON CONDENSED FINANCIAL STATEMENTS AND SELECTED

FINANCIAL DATA (SAS No. 42)

1. This SAS discusses reporting on a client-prepared document on

a. Condensed financial statements (either for an annual or an interim period) that are derived from audited
financial statements of a public entity that is required to file, at least annually, complete audited financial
statements with a regulatory agency.
b. Selected financial data that are derived from audited financial statements of either a public or a nonpublic
entity and that are presented in a document that includes audited financial statements (or, with respect to a
public entity, that incorporates audited financial statements by reference to information filed with a
regulatory agency).

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Condensed Financial Statements

Condensed financial statements are presented in considerably less detail than complete financial statements. For this
reason, they should be read in conjunction with the entity's most recent complete financial statements that include
all the disclosures required by generally accepted accounting principles.
An auditor may be engaged to report on condensed financial statements that are derived from audited financial
statements. Because condensed financial statements do not constitute a fair presentation of financial position, results
of operations, and cash flows in conformity with generally accepted accounting principles, an auditor should not
report on condensed financial statements in the same manner as he reported on the complete financial statements
from which they are derived. To do so might lead users to assume, erroneously, that the condensed financial
statements include all the disclosures necessary for complete financial statements. For the same reason, it is
desirable that the condensed financial statements be so marked.
The auditor's report on condensed financial statements that are derived from financial statements that he has audited
should indicate (a) that the auditor has examined and expressed an opinion on the complete financial statements, (b)
the date of the auditor's report on the complete financial statements, (c) the type of opinion expressed, and (d)
whether, in the auditor's opinion, the information set forth in the condensed financial statements is fairly stated in all
material respects in relation to the complete financial statements from which it has been derived.
The following is an example of wording that an auditor may use in the circumstances:
We have examined, in accordance with auditing standards generally accepted in the United States
of America, the consolidated balance sheet of X Company and subsidiaries as of December 31,
20XX, and the related consolidated statements of income, retained earnings, and cash flows for
the year then ended (not presented herein); and in our report dated February 15, 20X1, we
expressed an unqualified opinion on those consolidated financial statements. In our opinion, the
information set forth in the accompanying condensed consolidated financial statements is fairly
stated in all material respects in relation to the consolidated financial statements from which it has
been derived.
A client might make a statement in a client-prepared document that names the auditor and also states that condensed
financial statements have been derived from audited financial statements. Such a statement does not, in itself,
require the auditor to report on the condensed financial statements, provided that they are included in a document
that contains audited financial statements (or that incorporates such statements by reference to information filed
with a regulatory agency). However, if such a statement is made in a client-prepared document of a public entity
that is required to file, at least annually, complete audited financial statements with a regulatory agency and that
document does not include audited financial statements (or does not incorporate such statements by reference to
information filed with a regulatory agency), the auditor should request that the client either (a) not include the
auditor's name in the document or (b) include the auditor's report on the condensed financial statements. If the client
will neither delete the reference to the auditor nor allow the appropriate report to be included, the auditor should
advise the client that he does not consent to either the use of his name or the reference to him, and he should
consider what other actions might be appropriate.

Selected Financial Data

An auditor may be engaged to report on selected financial data that are included in a client-prepared document that
contains audited financial statements. The report should indicate (a) that the auditor has examined and expressed an
opinion on the complete financial statements, (b) the type of opinion expressed, and (c) whether, in the auditor's
opinion, the information set forth in the selected financial data is fairly stated in all material respects in relation to
the complete financial statements from which it has been derived.

3-26

Chapter Three - Questions

Standards of Reporting
REPORTS ON AUDITED
FINANCIAL STATEMENTS
5. Limitation on the scope of the auditor's examination
may require the auditor to issue a qualified opinion or to
disclaim an opinion. Which of the following would
generally be a limitation on the scope of the auditor's
examination?
a. The unavailability of sufficient competent
evidential matter.
b. The engagement of the auditor to report on only
one basic financial statement.
c. The examination of a subsidiary's financial
statements by an auditor other than the one who
examines and reports on the consolidated financial
statements.
d. The engagement of the auditor after year end.

1. An auditor's opinion exception arising from a

limitation on the scope of his examination should be
explained in
a. A footnote to the financial statements.
b. The auditor's report.
c. Both a footnote to the financial statements and the
auditor's report.
d. Both the financial statements (immediately after
the caption of the item or items which could not be
verified) and the auditor's report.
2. An auditor's report makes reference to the basic
financial statements, which are customarily considered
to be the balance sheet and the statements of
a. Income and cash flows.
b. Income, changes in retained earnings, and cash
flows.
c. Income, retained earnings, and cash flows.
d. Income and retained earnings.

6. When an adverse opinion is expressed, the opinion

paragraph should include a direct reference to
a. A footnote to the financial statements which
discusses the basis for the opinion.
b. The scope paragraph which discusses the basis for
the opinion rendered.
c. A separate paragraph which discusses the basis for
the opinion rendered.
d. The consistency or lack of consistency in the
application of generally accepted accounting
principles.

3. When a client declines to make essential disclosures

in the financial statements or in the footnotes, the
independent auditor should
a. Provide the necessary disclosures in the auditor's
report and appropriately modify the opinion.
b. Explain to the client that an adverse opinion must
be issued.
c. Issue an unqualified report and inform the
stockholders of the improper disclosure in an
"unaudited" footnote.
d. Issue an opinion "subject to" the client's lack of
disclosure of supplementary information as
explained in a middle paragraph of the report.

7. A company issues audited financial statements under

circumstances which require the presentation of a
statement of cash flows. If the company refuses to
present a statement of cash flows, the independent
auditor should
a. Disclaim an opinion.
b. Prepare a statement of cash flows and note in a
middle paragraph of the report that this statement
is auditor-prepared.
c. Prepare a statement of cash flows and disclose in a
footnote that this statement is auditor-prepared.
d. Qualify his opinion with an "except for"
qualification and a description of the omission in a
middle paragraph of the report.

4. In determining the type of opinion to express, an

auditor assesses the nature of the report qualifications
and the materiality of their effects. Materiality will be
the primary factor considered in the choice between
a. An "except for" opinion and an adverse opinion.
b. An "except for" opinion and a qualified opinion.
c. An adverse opinion and a disclaimer of opinion.
d. A qualified opinion and a piecemeal opinion.

3Q-1

8. An auditor is confronted with an exception

considered sufficiently material as to warrant some
deviation from the standard unqualified auditor's report.
If the exception relates to a departure from generally
accepted accounting principles, the auditor must decide
between expressing a (an)
a. Adverse opinion and a "special report".
b. Adverse opinion and an "except for" opinion.
c. Adverse opinion and a disclaimer of opinion.
d. Disclaimer of opinion and a "special report".

The financial statements fail to disclose that

the debentures issued on July 15, 19X2, limit the
payment of cash dividends to the amount of
earnings after August 31, 19X3. The company's
statements of income for the years 19X4 and
19X5, both of which are unaudited, show this
amount to be $18,900. Generally accepted
accounting principles require disclosure of
matters of this nature.
Which of the following comments best describes the
appropriateness of this report?
a. The report is satisfactory.
b. The report is deficient because Loeb does not
describe the scope of the review.
c. The report is deficient because the second
paragraph gives the impression that some audit
work was done.
d. The report is deficient because the explanatory
comment in the second paragraph should precede
the opinion paragraph.

9. When, in the auditor's judgment, the financial

statements are not presented fairly in conformity with
generally accepted accounting principles, the auditor
will issue a(n)
a. Qualified opinion.
b. Special report.
c. Disclaimer of opinion.
d. Adverse opinion.
10. An auditor's report included an additional paragraph
disclosing that there is a difference of opinion between
the auditor and the client for which the auditor believed
an adjustment to the financial statements should be
made. The opinion paragraph of the auditor's report
most likely expressed a(n)
a. Unqualified opinion.
b. "Except for" opinion.
c. Modified opinion.
d. Disclaimer of opinion.

13. Morgan, CPA, is the principal auditor for a

multinational corporation. Another CPA has examined
and reported on the financial statements of a significant
subsidiary of the corporation. Morgan is satisfied with
the independence and professional reputation of the
other auditor, as well as the quality of the other auditor's
examination. With respect to Morgan's report on the
financial statements, taken as a whole, Morgan
a. Must not refer to the examination of the auditor.
b. Must refer to the examination of the other auditor.
c. May refer to the examination of the other auditor.
d. May refer to the examination of the other auditor,
in which case Morgan must include in the auditor's
report on the consolidated financial statements, a
qualified opinion with respect to the examination
of the other auditor.

11. An auditor refers to significant related party

transactions in a middle paragraph of the report. If the
ensuing opinion paragraph contains the words, "with the
foregoing explanation," the auditor's report would be
considered a(n)
a. Unqualified opinion with appropriate reference to
the middle paragraph.
b. Example of inappropriate reporting.
c. Adverse opinion.
d. Negative assurance opinion.

14. Which of the following material events occurring

subsequent to the balance sheet date would require an
adjustment to the financial statements before they could
be issued?
a. Sale of long-term debt or capital stock.
b. Loss of a plant as a result of a flood.
c. Major purchase of a business which is expected to
double the sale volume.
d. Settlement of litigation, in excess of the recorded
liability.

12. Loeb, CPA, has completed preparation of the Bloto

Company's unaudited financial statements and has
prepared the following report to accompany them:
The accompanying balance sheet of the Bloto
Company as of August 31, 19X5, and the related
statements of income, retained earnings, and
cash flows for the year then ended were not
audited by us and accordingly we do not express
an opinion on them.
3Q-2

15. In connection with the annual audit, which of the

following is not a "subsequent events" procedure?
a. Review available interim financial statements.
b. Read available minutes of meetings of
stockholders, directors, and committees, and as to
meetings for which minutes are not available,
inquire about matters dealt with at such meetings.
c. Make inquiries with respect to the financial
statements covered by the auditor's previously
issued report if new information has become
available during the current examination that
might affect that report.
d. Discuss with officers the current status of items in
the financial statements that were accounted for on
the basis of tentative, preliminary or inconclusive
data.

19. In connection with the examination of the

consolidated financial statements of Mott Industries,
Frazier, CPA, plans to refer to another CPA's
examination of the financial statements of a subsidiary
company. Under these circumstances Frazier's report
must disclose
a. The name of the other CPA and the type of report
issued by the other CPA.
b. The magnitude of the portion of the financial
statements examined by the other CPA.
c. The nature of Frazier's review of the other CPA's
work.
d. In a footnote the portions of the financial
statements that were covered by the examinations
of both auditors.
20. Jones, CPA, is the principal auditor who is auditing
the consolidated financial statements of his client. Jones
plans to refer to another CPA's examination of the
financial statements of a subsidiary company but does
not wish to present the other CPA's audit report. Both
Jones and the other CPA's audit reports have noted no
exceptions to generally accepted accounting principles.
Under these circumstances the opinion paragraph of
Jones' consolidated audit report should express
a. An unqualified opinion.
b. A referral report.
c. An "except for" opinion.
d. A principal opinion.

16. When a principal auditor decides to make reference

to the examination of another auditor, the principal
auditor's report should indicate clearly the division of
responsibility between the portions of the financial
statements covered by each auditor. In which
paragraph(s) of the report should the division of
responsibility be stated?
a. Only the opinion paragraph.
b. Either the scope or opinion paragraph.
c. Only the introductory paragraph.
d. The introductory, scope and opinion paragraphs.
17. When the report of a principal auditor makes
reference to the examination made by another auditor,
the other auditor may be named if express permission to
do so is given and
a. The report of the principal auditor names the other
auditor in the opinion paragraph.
b. The principal auditor accepts responsibility for the
work of the other auditor.
c. The report of the other auditor is presented
together with the report of the principal auditor.
d. The other auditor is not an associate or
correspondent firm whose work is done at the
request of the principal auditor.

21. Which of the following will not result in

modification of the auditor's report due to a scope
limitation?
a. Restrictions imposed by the client.
b. Reliance placed on the report of another auditor.
c. Inability to obtain sufficient competent evidential
matter.
d. Inadequacy in the accounting records.
22. An auditor's report contains the following sentences:
We did not examine the financial statements of
B Company, a consolidated subsidiary, which
statements reflect total assets and revenues
constituting 20 percent and 22 percent, respectively,
of the related consolidated totals. These statements
were examined by other auditors whose report
thereon has been furnished to us, and our opinion
expressed herein, insofar as it relates to the amounts
included for B Company, is based solely upon the
report of the other auditors.

18. An auditor performs interim work at various times

throughout the year. The auditor's subsequent events
work should be extended to the date of
a. A post-dated footnote.
b. The next scheduled interim visit.
c. The final billing for audit services rendered.
d. The auditor's report.

3Q-3

These sentences
a. Disclaim an opinion.
b. Qualify the opinion.
c. Divide responsibility.
d. Are an improper form of reporting.

26. When there has been a change in accounting

principle that materially affects the comparability of the
comparative financial statements presented and the
auditor concurs with the change, the auditor should

23. King, CPA, was engaged to audit the financial

statements of Newton Company after its fiscal year had
ended. King neither observed the inventory count nor
confirmed the receivables by direct communication with
debtors, but was satisfied concerning both after
applying alternative procedures. King's auditor's report
most likely contained a(an)
a. Qualified opinion.
b. Disclaimer of opinion.
c. Unqualified opinion.
d. Unqualified opinion with an explanatory
paragraph.

a.
b.
c.
d.

Concur
explicitly with
the change
No
Yes
Yes
No

Issue an
"except for"
qualified
opinion
No
No
Yes
Yes

Refer to the
change in an
explanatory
paragraph
Yes
Yes
No
No

27. Comparative financial statements include the prior

year's statements that were audited by a predecessor
auditor whose report is not presented. If the
predecessor's report was unqualified, the successor
should
a. Express an opinion on the current year's
statements alone and make no reference to the
prior year's statements.
b. Indicate in the auditor's report that the predecessor
auditor expressed an unqualified opinion.
c. Obtain a letter of representations from the
predecessor concerning any matters that might
affect the successor's opinion.
d. Request the predecessor auditor to reissue the
prior year's report.

24. In which of the following circumstances would an

auditor be most likely to express an adverse opinion?
a. Information comes to the auditor's attention that
raises substantial doubt about the entity's ability to
continue as a going concern.
b. The chief executive officer refuses the auditor
access to minutes of board of directors' meetings.
c. Tests of controls show that the entity's internal
control structure is so poor that it cannot be relied
upon.
d. The financial statements are not in conformity
with the FASB Statements regarding the
capitalization of leases.

28. A limitation on the scope of an auditor's

examination sufficient to preclude an unqualified
opinion will always result when management
a. Engages the auditor after the year-end physical
inventory count is completed.
b. Fails to correct a material internal control
weakness that had been identified during the prior
year's audit.
c. Refuses to furnish a management representation
letter to the auditor.
d. Prevents the auditor from reviewing the working
papers of the predecessor auditor.

25. A principal auditor decides not to refer to the audit

of another CPA who audited a subsidiary of the
principal auditor's client. After making inquiries about
the other CPAs professional reputation and
independence, the principal auditor most likely would
a. Add an explanatory paragraph to the auditor's
report indicating that the subsidiary's financial
statements are not material to the consolidated
financial statements.
b. Document in the engagement letter that the
principal auditor assumes no responsibility for the
other CPAs work and opinion.
c. Obtain written permission from the other CPA to
omit the reference in the principal auditor's report.
d. Contact the other CPA and review the audit
programs and working papers pertaining to the
subsidiary.

3Q-4

29. An auditor who qualifies an opinion because of an

insufficiency of evidential matter should describe the
limitation in an explanatory paragraph. The auditor
should also refer to the limitation in the

a.
b.
c.
d.

Scope
paragraph
Yes
No
Yes
Yes

Opinion
paragraph
No
Yes
Yes
Yes

32. Unaudited financial statements for the prior year

presented in comparative form with audited financial
statements for the current year should be clearly marked
to indicate their status and
I. The report on the prior period should be reissued
to accompany the current period report.
II. The report on the current period should include as
a separate paragraph a description of the
responsibility assumed for the prior period's
financial statements.

Notes to the
financial statements
Yes
No
No
Yes

a.
b.
c.
d.

30. An auditor concludes that there is a material

inconsistency in the other information in an annual
report to shareholders containing audited financial
statements. If the auditor concludes that the financial
statements do not require revision, but the client refuses
to revise or eliminate the material inconsistency, the
auditor may
a. Issue an "except for" qualified opinion after
discussing the matter with the client's board of
directors.
b. Consider the matter closed since the other
information is not in the audited financial
statements.
c. Disclaim an opinion on the financial statements
after explaining the material inconsistency in a
separate explanatory paragraph.
d. Revise the auditor's report to include a separate
explanatory paragraph describing the material
inconsistency.

I only.
II only.
Both I and II.
Either I or II.

33. When a publicly-held company refuses to include in

its audited financial statements any of the segment
information that the auditor believes is required, the
auditor should issue a(an)
a. Unqualified opinion with a separate explanatory
paragraph emphasizing the matter.
b. "Except for" qualified opinion because of
inadequate disclosure.
c. Adverse opinion because of the lack of conformity
with generally accepted accounting principles.
d. Disclaimer of opinion because of the significant
scope limitation.
34. When a client will not permit inquiry of outside
legal counsel, the audit report will ordinarily contain
a(an)
a. Disclaimer of opinion.
b. "Except for" qualified opinion.
c. Referral opinion.
d. Unqualified opinion with a separate explanatory
paragraph.

31. An auditor may not issue a qualified opinion when

a. A scope limitation prevents the auditor from
completing an important audit procedure.
b. The auditor's report refers to the work of a
specialist.
c. An accounting principle at variance with generally
accepted accounting principles is used.
d. The auditor lacks independence with respect to the
audited entity.

35. When there is a significant change in accounting

principle, an auditor's report should refer to the lack of
consistency in
a. The scope paragraph.
b. An explanatory paragraph between the second
paragraph and the opinion paragraph.
c. The opinion paragraph.
d. An explanatory paragraph following the opinion
paragraph.

3Q-5

36. How are management's responsibility and the

auditor's report represented in the standard auditor's
report?

a.
b.
c.
d.

Management's
responsibility
Explicitly
Implicitly
Implicitly
Explicitly

40. An auditor should disclose the substantive reasons

for expressing an adverse opinion in an explanatory
paragraph
a. Preceding the scope paragraph.
b. Preceding the opinion paragraph.
c. Following the opinion paragraph.
d. Within the notes to the financial statements.

Auditor's
responsibility
Explicitly
Implicitly
Explicitly
Implicitly

41. When management does not provide reasonable

justification that a change in accounting principle is
preferable and it presents comparative financial
statements, the auditor should express a qualified
opinion
a. Only in the year of the accounting principle
change.
b. Each year that the financial statements initially
reflecting the change are presented.
c. Each year until management changes back to the
accounting principle formerly used.
d. Only if the change is to an accounting principle
that is not generally accepted.

37. Restrictions imposed by a client prohibit the

observation of physical inventories, which account for
35% of all assets. Alternative audit procedures cannot
be applied, although the auditor was able to examine
satisfactory evidence for all other items in the financial
statements. The auditor should issue a(an)
a. "Except for" qualified opinion.
b. Disclaimer of opinion.
c. Unqualified opinion with a separate explanatory
paragraph.
d. Unqualified opinion with an explanation in the
scope paragraph.

42. When an independent CPA is associated with the

financial statements of a publicly held entity but has not
audited or reviewed such statements, the appropriate
form of report to be issued must include a(an)
a. Compilation report.
b. Disclaimer of opinion.
c. Unaudited association report.
d. Qualified opinion.

38. A limitation on the scope of an auditor's

examination sufficient to preclude an unqualified
opinion will usually result when management
a. Presents financial statements that are prepared in
accordance with the cash receipts and
disbursements basis of accounting.
b. States that the financial statements are not
intended to be presented in conformity with
generally accepted accounting principles.
c. Does not make the minutes of the Board of
Directors' meetings available to the auditor.
d. Asks the auditor to report on the balance sheet and
not on the other basic financial statements.

43. Which of the following audit procedures would

most likely assist an auditor in identifying conditions
and events that may indicate there could be substantial
doubt about an entity's ability to continue as a going
concern?
a. Review compliance with the terms of debt
agreements.
b. Confirmation of accounts receivable from
principal customers.
c. Reconciliation of interest expense with debt
outstanding.
d. Confirmation of bank balances.

39. Grant Company's financial statements adequately

disclose uncertainties that concern future events, the
outcome of which are not susceptible of reasonable
estimation. The auditor's report should include a(an)
a. Unqualified opinion.
b. Special report paragraph.
c. "Except for" qualified opinion.
d. Adverse opinion.

3Q-6

44. An explanatory paragraph following the opinion

paragraph of an auditor's report describes an uncertainty
as follows:

47. In which of the following circumstances would an

auditor usually choose between issuing a qualified
opinion or a disclaimer of opinion?
a. Departure from generally accepted accounting
principles.
b. Inadequate disclosure of accounting policies.
c. Inability to obtain sufficient competent evidential
matter.
d. Unreasonable justification for a change in
accounting principle.

As discussed in Note X to the financial

statements, the Company is a defendant in a
lawsuit alleging infringement of certain patent
rights and claiming damages. Discovery
proceedings are in progress. The ultimate
outcome of the litigation cannot presently be
determined. Accordingly, no provision for any
liability that may result upon adjudication has
been made in the accompanying financial
statements.

48. Which of the following phrases should be included

in the opinion paragraph when an auditor expresses a
qualified opinion?

What type of opinion should the auditor express under

these circumstances?
a. Unqualified.
b. "Subject to" qualified.
c. "Except for" qualified.
d. Disclaimer.

a.
b.
c.
d.

45. When a qualified opinion results from a limitation

on the scope of the audit, the situation should be
described in an explanatory paragraph
a. Preceding the opinion paragraph and referred to
only in the scope paragraph of the auditor's report.
b. Following the opinion paragraph and referred to in
both the scope and opinion paragraphs of the
auditor's report.
c. Following the opinion paragraph and referred to
only in the scope paragraph of the auditor's report.
d. Preceding the opinion paragraph and referred to in
both the scope and opinion paragraphs of the
auditor's report.

When read in
conjunction with
Note X
Yes
No
Yes
No

With the foregoing

explanation
No
Yes
Yes
No

49. When an auditor expresses an adverse opinion, the

opinion paragraph should include
a. The principal effects of the departure from
generally accepted accounting principles.
b. A direct reference to a separate paragraph
disclosing the basis for the opinion.
c. The substantive reasons for the financial
statements being misleading.
d. A description of the uncertainty or scope limitation
that prevents an unqualified opinion.
50. Under which of the following circumstances would
a disclaimer of opinion not be appropriate?
a. The financial statements fail to contain adequate
disclosure of related party transactions.
b. The client refuses to permit its attorney to furnish
information requested in a letter of audit inquiry.
c. The auditor is engaged after fiscal year-end and is
unable to observe physical inventories or apply
alternative procedures to verify their balances.
d. The auditor is unable to determine the amounts
associated with illegal acts committed by the
client's management.

46. Under which of the following circumstances would

a disclaimer of opinion not be appropriate?
a. The auditor is engaged after fiscal year-end and is
unable to observe physical inventories or apply
alternative procedures to verify their balances.
b. The auditor is unable to determine the amounts
associated with illegal acts committed by the
client's management.
c. The financial statements fail to contain adequate
disclosure concerning related party transactions.
d. The client refuses to permit its attorney to furnish
information requested in a letter of audit inquiry.

3Q-7

51. When reporting on comparative financial

statements, which of the following circumstances
ordinarily should cause the auditor to change the
previously issued opinion on the prior year's financial
statements?
a. The prior year's financial statements are restated
following a pooling of interests in the current year.
b. A departure from generally accepted accounting
principles caused an adverse opinion on the prior
year's financial statements and those statements
have been properly restated.
c. A change in accounting principle caused the
auditor to make a consistency modification in the
current year's auditor's report.
d. A scope limitation caused a qualified opinion on
the prior year's financial statements but the current
year's opinion was properly unqualified.

a.
b.
c.
d.

55. When an auditor concludes there is substantial

doubt about an entity's ability to continue as a going
concern for a reasonable period of time, the auditor's
responsibility is to
a. Prepare prospective financial information to verify
whether management's plans can be effectively
implemented.
b. Project future conditions and events for a period of
time not to exceed one year following the date of
the financial statements.
c. Issue a qualified or adverse opinion, depending
upon materiality, due to the possible effects on the
financial statements.
d. Consider the adequacy of disclosure about the
entity's possible inability to continue as a going
concern.

52. If an auditor is satisfied that there is only a remote

likelihood of a loss resulting from the resolution of a
matter involving an uncertainty, the auditor normally
would express a(an)
a. Unqualified opinion.
b. Unqualified opinion with a separate explanatory
paragraph.
c. Qualified opinion or disclaimer of opinion,
depending upon the materiality of the loss.
d. Qualified opinion or disclaimer of opinion,
depending on whether the uncertainty is
adequately disclosed.

56. The following explanatory paragraph was included

in an auditor's report to indicate a lack of consistency:

53. When an auditor qualifies an opinion because of

inadequate disclosure, the auditor should describe the
nature of the omission in a separate explanatory
paragraph and modify the

a.
b.
c.
d.

Introductory
paragraph
Yes
Yes
No
No

Scope
paragraph
No
Yes
Yes
No

Is appropriate and would not negate the

unqualified opinion.
Is considered an "except for" qualification of the
opinion.
Violates generally accepted auditing standards if
this information is already disclosed in footnotes
to the financial statements.
Necessitates a revision of the opinion paragraph to
include the phrase "with the foregoing
explanation."

"As discussed in note T to the financial

statements, the company changed its method of
computing depreciation in 1990."
How should the auditor report on this matter if the
auditor concurred with the change?

Opinion
paragraph
No
No
Yes
Yes

a.
b.
c.
d.

54. An auditor includes a separate paragraph in an

otherwise unmodified report to emphasize that the entity
being reported upon had significant transactions with
related parties. The inclusion of this separate paragraph

3Q-8

Type of
opinion
Unqualified
Unqualified
Qualified
Qualified

Location of
explanatory paragraph
Before opinion paragraph
After opinion paragraph
Before opinion paragraph
After opinion paragraph

57. After issuing a report, an auditor has no obligation

to make continuing inquiries or perform other
procedures concerning the audited financial statements,
unless
a. Information, which existed at the report date and
may affect the report, comes to the auditor's
attention.
b. Management of the entity requests the auditor to
reissue the auditor's report.
c. Information about an event that occurred after the
end of field work comes to the auditor's attention.
d. Final determinations or resolutions are made of
contingencies that had been disclosed in the
financial statements.

a.
b.
c.
d.

a.
b.
c.
d.

Specifically
use the
words "going
concern"
Yes
Yes
No
Yes

Specifically
use the
words
"substantial
doubt
Yes
No
Yes
Yes

61. When audited financial statements are presented in a

client's document containing other information, the
auditor should
a. Perform inquiry and analytical procedures to
ascertain whether the other information is
reasonable.
b. Add an explanatory paragraph to the auditor's
report without changing the opinion on the
financial statements.
c. Perform the appropriate substantive auditing
procedures to corroborate the other information.
d. Read the other information to determine that it is
consistent with the audited financial statements.

58. How does an auditor make the following

representations when issuing the standard auditor's
report on comparative financial statements?
Examination of
evidence on a
test basis
Explicitly
Implicitly
Implicitly
Explicitly

Include an
explanatory
paragraph
following the
opinion
paragraph
Yes
Yes
Yes
No

Consistent
application of
accounting principles
Explicitly
Implicitly
Explicitly
Implicitly

62. An auditor's report contains the following sentences:

59. An auditor was unable to obtain sufficient
competent evidential matter concerning certain
transactions due to an inadequacy in the entity's
accounting records. The auditor would choose between
issuing a(an)
a. Qualified opinion and an unqualified opinion with
an explanatory paragraph.
b. Unqualified opinion with an explanatory
paragraph and an adverse opinion.
c. Adverse opinion and a disclaimer of opinion.
d. Disclaimer of opinion and a qualified opinion.

We did not audit the financial statements of JK

Co., a wholly-owned subsidiary, which
statements reflect total assets and revenues
constituting 17 percent and 19 percent,
respectively, of the related consolidated totals.
Those statements were audited by other auditors
whose report has been furnished to us, and our
opinion, insofar as it relates to the amounts
included for JK Co., is based solely on the report
of the other auditors.
These sentences
a. Are an improper form of reporting.
b. Divide responsibility.
c. Disclaim an opinion.
d. Qualify the opinion.

60. Green, CPA, concludes that there is substantial

doubt about JKL Co.'s ability to continue as a going
concern. If JKL's financial statements adequately
disclose its financial difficulties, Green's auditor's report
should

3Q-9

63. When an independent CPA assists in preparing the

financial statements of a publicly held entity, but has
not audited or reviewed them, the CPA should issue a
disclaimer of opinion. In such situations, the CPA has
no responsibility to apply any procedures beyond
a. Documenting that the internal control structure is
not being relied on.
b. Reading the financial statements for obvious
material misstatements.
c. Ascertaining whether the financial statements are
in conformity with GAAP.
d. Determining whether management has elected to
omit substantially all required disclosures.

a.
b.
c.
d.

Dual date the reissued report.

Use the release date of the reissued report.
Use the original report date on the reissued report.
Use the current-period auditor's report date on the
reissued report.

67. An auditor includes a separate paragraph in an

otherwise unmodified report to emphasize that the entity
being reported on had significant transactions with
related parties. The inclusion of this separate paragraph
a. Is considered an "except for" qualification of the
opinion.
b. Violates generally accepted auditing standards if
this information is already disclosed in footnotes
to the financial statements.
c. Necessitates a revision of the opinion paragraph to
include the phrase "with the foregoing
explanation."
d. Is appropriate and would not negate the
unqualified opinion.

64. When an auditor concludes there is substantial

doubt about a continuing audit client's ability to
continue as a going concern for a reasonable period of
time, the auditor's responsibility is to
a. Issue a qualified or adverse opinion, depending
upon materiality, due to the possible effects on the
financial statements.
b. Consider the adequacy of disclosure about the
client's possible inability to continue as a going
concern.
c. Report to the client's audit committee that
management's accounting estimates may need to
be adjusted.
d. Reissue the prior year's auditor's report and add an
explanatory paragraph that specifically refers to
"substantial doubt" and "going concern."

68. On March 15, 1994, Kent, CPA, issued an

unqualified opinion on a client's audited financial
statements for the year ended December 31, 1993. On
May 4, 1994, Kent's internal inspection program
disclosed that engagement personnel failed to observe
the client's physical inventory. Omission of this
procedure impairs Kent's present ability to support the
unqualified opinion. If the stockholders are currently
relying on the opinion, Kent should first
a. Advise management to disclose to the
stockholders that Kent's unqualified opinion
should not be relied on.
b. Undertake to apply alternative procedures that
would provide a satisfactory basis for the
unqualified opinion.
c. Reissue the auditor's report and add an explanatory
paragraph describing the departure from generally
accepted auditing standards.
d. Compensate for the omitted procedure by
performing tests of controls to reduce audit risk to
a sufficiently low level.

65. Reference in a principal auditor's report to the fact

that part of the audit was performed by another auditor
most likely would be an indication of the
a. Divided responsibility between the auditors who
conducted the audits of the components of the
overall financial statements.
b. Lack of materiality of the portion of the financial
statements audited by the other auditor.
c. Principal auditor's recognition of the other
auditor's competence, reputation, and professional
certification.
d. Different opinions the auditors are expressing on
the components of the financial statements that
each audited.

69. For an entity that does not receive governmental

financial assistance, an auditor's standard report on
financial statements generally would not refer to
a. Significant estimates made by management.
b. An assessment of the entity's accounting
principles.
c. Management's responsibility for the financial
statements.
d. The entity's internal control structure.

66. In May 1994, an auditor reissues the auditor's report

on the 1992 financial statements at a continuing client's
request. The 1992 financial statements are not restated
and the auditor does not revise the wording of the
report. The auditor should

3Q-10

70. Due to a scope limitation, an auditor disclaimed an

opinion on the financial statements taken as a whole,
but the auditor's report included a statement that the
current asset portion of the entity's balance sheet was
fairly stated. The inclusion of this statement is
a. Not appropriate because it may tend to
overshadow the auditor's disclaimer of opinion.
b. Not appropriate because the auditor is prohibited
from reporting on only one basic financial
statement.
c. Appropriate provided the auditor's scope
paragraph adequately describes the scope
limitations.
d. Appropriate provided the statement is in a separate
paragraph preceding the disclaimer of opinion
paragraph.

74. Park, CPA, was engaged to audit the financial

statements of Tech Co., a new client, for the year ended
December 31, 1993. Park obtained sufficient audit
evidence for all of Tech's financial statement items
except Tech's opening inventory. Due to inadequate
financial records, Park could not verify Tech's January
1, 1993, inventory balances. Park's opinion on Tech's
1993 financial statements most likely will be
a.
b.
c.
d.

Income statement
Disclaimer
Disclaimer
Adverse
Adverse

Balance sheet
Disclaimer
Unqualified
Disclaimer
Unqualified

75. Which paragraphs of an auditor's standard report on

financial statements should refer to generally accepted
auditing standards (GAAS) and generally accepted
accounting principles (GAAP) in which paragraphs?

71. When there has been a change in accounting

principles, but the effect of the change on the
comparability of the financial statements is not material,
the auditor should
a. Refer to the change in an explanatory paragraph.
b. Explicitly concur that the change is preferred.
c. Not refer to consistency in the auditor's report.
d. Refer to the change in the opinion paragraph.

a.
b.
c.
d.

72. When single-year financial statements are presented,

an auditor ordinarily would express an unqualified
opinion in an unmodified report if the
a. Auditor is unable to obtain audited financial
statements supporting the entity's investment in a
foreign affiliate.
b. Entity declines to present a statement of cash
flows with its balance sheet and related statements
of income and retained earnings.
c. Auditor wishes to emphasize an accounting matter
affecting the comparability of the financial
statements with those of the prior year.
d. Prior year's financial statements were audited by
another CPA whose report, which expressed an
unqualified opinion, is not presented.

GAAS
Opening
Scope
Scope
Opening

GAAP
Scope
Scope
Opinion
Opinion

76. What is an auditor's responsibility for

supplementary information, such as segment
information, which is outside the basic financial
statements, but required by the FASB?
a. The auditor has no responsibility for required
supplementary information as long as it is outside
the basic financial statements.
b. The auditor's only responsibility for required
supplementary information is to determine that
such information has not been omitted.
c. The auditor should apply certain limited
procedures to the required supplementary
information, and report deficiencies in, or
omissions of, such information.
d. The auditor should apply tests of details of
transactions and balances to the required
supplementary information, and report any
material misstatements in such information.

73. When financial statements contain a departure from

GAAP because, due to unusual circumstances, the
statements would otherwise be misleading, the auditor
should explain the unusual circumstances in a separate
paragraph and express an opinion that is
a. Unqualified.
b. Qualified.
c. Adverse.
d. Qualified or adverse, depending on materiality.

3Q-11

77. In auditing the financial statements of Star Corp.,

Land discovered information leading Land to believe
that Star's prior year's financial statements, which were
audited by Tell, require substantial revisions. Under
these circumstances, Land should
a. Notify Star's audit committee and stockholders
that the prior year's financial statements cannot be
relied on.
b. Request Star to reissue the prior year's financial
statements with the appropriate revisions.
c. Notify Tell about the information and make
inquiries about the integrity of Star's management.
d. Request Star to arrange a meeting among the three
parties to resolve the matter.

I.
II.

a.
b.
c.
d.

82. An auditor issued an audit report that was dual dated

for a subsequent event occurring after the completion of
field work but before issuance of the auditor's report.
The auditor's responsibility for events occurring
subsequent to the completion of field work was
a. Limited to include only events occurring up to the
date of the last subsequent event referenced.
b. Limited to the specific event referenced.
c. Extended to subsequent events occurring through
the date of issuance of the report.
d. Extended to include all events occurring since the
completion of field work.

79. When qualifying an opinion because of an

insufficiency of audit evidence, an auditor should refer
to the situation in the

a.
b.
c.
d.

I only.
II only.
Both I and II.
Either I or II.

81. An auditor expressed a qualified opinion on the

prior year's financial statements because of a lack of
adequate disclosure. These financial statements are
properly restated in the current year and presented in
comparative form with the current year's financial
statements. The auditor's updated report on the prior
year's financial statements should
a. Be accompanied by the auditor's original report on
the prior year's financial statements.
b. Continue to express a qualified opinion on the
prior year's financial statements.
c. Make no reference to the type of opinion
expressed on the prior year's financial statements.
d. Express an unqualified opinion on the restated
financial statements of the prior year.

78. In which of the following circumstances would an

auditor be most likely to express an adverse opinion?
a. The chief executive officer refuses the auditor
access to minutes of board of directors' meetings.
b. Tests of controls show that the entity's internal
control structure is so poor that it cannot be relied
upon.
c. The financial statements are not in conformity
with the FASB Statements regarding the
capitalization of leases.
d. Information comes to the auditor's attention that
raises substantial doubt about the entity's ability to
continue as a going concern.

Opening
(introductory)
paragraph
No
Yes
Yes
No

The report on the unaudited financial statements

should be released.
The report on the audited financial statements
should include a separate paragraph describing the
responsibility assumed for the unaudited financial
statements.

Scope
paragraph
No
No
Yes
Yes

80. When unaudited financial statements of a nonpublic

entity are presented in comparative form with audited
financial statements in the subsequent year, the
unaudited financial statements should be clearly marked
to indicate their status and

83. Which of the following conditions or events most

likely would cause an auditor to have substantial doubt
about an entity's ability to continue as a going concern?
a. Cash flows from operating activities are negative.
b. Research and development projects are postponed.
c. Significant related party transactions are
pervasive.
d. Stock dividends replace annual cash dividends.

3Q-12

84. Before reissuing the prior year's auditor's report on

the financial statements of a former client, the
predecessor auditor should obtain a letter of
representations from the
a. Former client's management.
b. Former client's attorney.
c. Former client's board of directors.
d. Successor auditor.

88. Harris, CPA, has been asked to audit and report on

the balance sheet of Fox Co. but not on the statements
of income, retained earnings, or cash flows. Harris will
have access to all information underlying the basic
financial statements. Under these circumstances, Harris
may
a. Not accept the engagement because it would
constitute a violation of the profession's ethical
standards.
b. Not accept the engagement because it would be
tantamount to rendering a piecemeal opinion.
c. Accept the engagement because such engagements
merely involve limited reporting objectives.
d. Accept the engagement but should disclaim an
opinion because of an inability to apply the
procedures considered necessary.

85. Subsequent to the issuance of an auditor's report, the

auditor became aware of facts existing at the report date
that would have affected the report had the auditor then
been aware of such facts. After determining that the
information is reliable, the auditor should next
a. Determine whether there are persons relying or
likely to rely on the financial statements who
would attach importance to the information.
b. Request that management disclose the newly
discovered information by issuing revised
financial statements.
c. Issue revised pro forma financial statements taking
into consideration the newly discovered
information.
d. Give public notice that the auditor is no longer
associated with financial statements.

89. Which of the following statements is a basic

element of the auditor's standard report?
a. The disclosures provide reasonable assurance that
the financial statements are free of material
misstatement.
b. The auditor evaluated the overall internal control
structure.
c. An audit includes assessing significant estimates
made by management.
d. The financial statements are consistent with those of
the prior period.

86. An auditor concludes that a client's illegal act,

which has a material effect on the financial statements,
has not been properly accounted for or disclosed.
Depending on the materiality of the effect on the
financial statements, the auditor should express either
a(an)
a. Adverse opinion or a disclaimer of opinion.
b. Qualified opinion or an adverse opinion.
c. Disclaimer of opinion or an unqualified opinion
with a separate explanatory paragraph.
d. Unqualified opinion with a separate explanatory
paragraph or a qualified opinion.

90. An auditor may not issue a qualified opinion when

a. An accounting principle at variance with GAAP is
used.
b. The auditor lacks independence with respect to the
audited entity.
c. A scope limitation prevents the auditor from
completing an important audit procedure.
d. The auditor's report refers to the work of a
specialist.

87. Cooper, CPA, believes there is substantial doubt

about the ability of Zero Corp. to continue as a going
concern for a reasonable period of time. In evaluating
Zero's plans for dealing with the adverse effects of
future conditions and events, Cooper most likely would
consider, as a mitigating factor, Zero's plans to
a. Discuss with lenders the terms of all debt and loan
agreements.
b. Strengthen
internal
controls
over
cash
disbursements.
c. Purchase production facilities currently being leased
from a related party.
d. Postpone expenditures for research and development
projects.

91. An auditor would express an unqualified opinion

with an explanatory paragraph added to the auditor's
report for

a.
b.
c.
d.

3Q-13

An unjustified
accounting change
Yes
Yes
No
No

A material weakness
in the internal
control structure
Yes
No
Yes
No

92. Under which of the following circumstances would

a disclaimer of opinion not be appropriate?
a. The auditor is unable to determine the amounts
associated with an employee fraud scheme.
b. Management does not provide reasonable
justification for a change in accounting principles.
c. The client refuses to permit the auditor to confirm
certain accounts receivable or apply alternative
procedures to verify their balances.
d. The chief executive officer is unwilling to sign the
management representation letter.

96. An explanatory paragraph following the opinion

paragraph of an auditor's report describes an uncertainty
as follows:
As discussed in Note X to the financial statements,
the Company is a defendant in a lawsuit alleging
infringement of certain patent rights and claiming
damages. Discovery proceedings are in progress.
The ultimate outcome of the litigation cannot
presently be determined. Accordingly, no
provision for any liability that may result upon
adjudication has been made in the accompanying
financial statements.

93. Digit Co. uses the FIFO method of costing for its
international subsidiary's inventory and LIFO for its
domestic inventory. Under these circumstances, the
auditor's report on Digit's financial statements should
express an
a. Unqualified opinion.
b. Opinion qualified because of a lack of consistency.
c. Opinion qualified because of a departure from
GAAP.
d. Adverse opinion.

What type of opinion should the auditor express under

these circumstances?
a. Adverse.
b. Qualified due to a scope limitation.
c. Qualified due to a GAAP violation.
d. Unqualified.

97. Which of the following phrases would an auditor

most likely include in the auditor's report when
expressing a qualified opinion because of inadequate
disclosure?
a. Subject to the departure from generally accepted
accounting principles, as described above.
b. With the foregoing explanation of these omitted
disclosures.
c. Except for the omission of the information discussed
in the preceding paragraph.
d. Does not present fairly in all material respects.

94. The fourth standard of reporting requires the

auditor's report to contain either an expression of
opinion regarding the financial statements taken as a
whole or an assertion to the effect that an opinion
cannot be expressed. The objective of the fourth
standard is to prevent
a. An auditor from expressing different opinions on
each of the basic financial statements.
b. Restrictions on the scope of the audit, whether
imposed by the client or by the inability to obtain
evidence.
c. Misinterpretations regarding the degree of
responsibility the auditor is assuming.
d. An auditor from reporting on one basic financial
statement and not the others.

98. Kane, CPA, concludes that there is substantial doubt

about Lima Co.'s ability to continue as a going concern
for a reasonable period of time. If Lima's financial
statements adequately disclose its financial difficulties,
Kane's auditor's report is required to include an
explanatory paragraph that specifically uses the
phrase(s)

95. In which of the following circumstances would an

auditor not express an unqualified opinion?
a. There has been a material change between periods in
accounting principles.
b. Quarterly financial data required by the SEC has
been omitted.
c. The auditor wishes to emphasize an unusually
important subsequent event.
d. The auditor is unable to obtain audited financial
statements of a consolidated investee.

a.
b.
c.
d.

3Q-14

"Possible
discontinuance
of operations"
Yes
Yes
No
No

"Reasonable period
of time, not to
exceed one year"
Yes
No
Yes
No

99. Mead, CPA, had substantial doubt about Tech Co.'s

ability to continue as a going concern when reporting on
Tech's audited financial statements for the year ended
June 30, 1994. That doubt has been removed in 1995.
What is Mead's reporting responsibility if Tech is
presenting its financial statements for the year ended
June 30, 1995, on a comparative basis with those of
1994?
a. The explanatory paragraph included in the 1994
auditor's report should not be repeated.
b. The explanatory paragraph included in the 1994
auditor's report should be repeated in its entirety.
c. A different explanatory paragraph describing Mead's
reasons for the removal of doubt should be included.
d. A different explanatory paragraph describing Tech's
plans for financial recovery should be included.

I. Not name Jewel as the predecessor auditor

II. Indicate the type of report issued by Jewel.
III. Indicate the substantive reasons for
qualification.
a.
b.
c.
d.

Jewel's

I only.
I and II only.
II and III only.
I, II, and III.

103. The introductory paragraph of an auditor's report

contains the following sentences:
We did not audit the financial statements of EZ
Inc., a wholly-owned subsidiary, which statements
reflect total assets and revenues constituting 27
percent and 29 percent, respectively, of the related
consolidated totals. Those statements were audited
by other auditors whose report has been furnished
to us, and our opinion, insofar as it relates to the
amounts included for EZ Inc., is based solely on
the report of the other auditors.

100. In the first audit of a new client, an auditor was

able to extend auditing procedures to gather sufficient
evidence about consistency. Under these circumstances,
the auditor should
a. Not report on the client's income statement.
b. Not refer to consistency in the auditor's report.
c. State that the consistency standard does not apply.
d. State that the accounting principles have been
applied consistently.

These sentences
a. Indicate a division of responsibility.
b. Assume responsibility for the other auditor.
c. Require a departure from an unqualified opinion.
d. Are an improper form of reporting.

101. When reporting on comparative financial

statements, an auditor ordinarily should change the
previously issued opinion on the prior-year's financial
statements if the
a. Prior year's financial statements are restated to
conform with generally accepted accounting
principles.
b. Auditor is a predecessor auditor who has been
requested by a former client to reissue the
previously issued report.
c. Prior year's opinion was unqualified and the opinion
on the current year's financial statements is modified
due to a lack of consistency.
d. Prior year's financial statements are restated
following a pooling of interests in the current year.

104. March, CPA, is engaged by Monday Corp., a

client, to audit the financial statements of Wall Corp., a
company that is not March's client. Monday expects to
present Wall's audited financial statements with March's
auditor's report to 1st Federal Bank to obtain financing
in Monday's attempt to purchase Wall. In these
circumstances, March's auditor's report would usually
be addressed to
a. Monday Corp., the client that engaged March.
b. Wall Corp., the entity audited by March.
c. 1st Federal Bank.
d. Both Monday Corp. and 1st Federal Bank.

102. Jewel, CPA, audited Infinite Co.'s prior-year

financial statements. These statements are presented
with those of the current year for comparative purposes
without Jewel's auditor's report, which expressed a
qualified opinion. In drafting the current year's auditor's
report, Crain, CPA, the successor auditor, should

3Q-15

105. An auditor concludes that there is substantial doubt

about an entity's ability to continue as a going concern
for a reasonable period of time. If the entity's financial
statements adequately disclose its financial difficulties,
the auditor's report is required to include an explanatory
paragraph that specifically uses the phrase(s)
"Reasonable period
of time, not to exceed
one year"
a.
b.
c.
d.

Yes
Yes
No
No

CPA Exam Tip:

You do not have to answer multiple choice
questions in the order they are presented
within a testlet. You can navigate the
questions by clicking on their corresponding
number located at the bottom of the screen.

"Going concern"
Yes
No
Yes
No

106. In the first audit of a client, an auditor was not able

to gather sufficient evidence about the consistent
application of accounting principles between the current
and the prior year, as well as the amounts of assets or
liabilities at the beginning of the current year. This was
due to the client's record retention policies. If the
amounts in question could materially affect current
operating results, the auditor would
a. Be unable to express an opinion on the current year's
results of operations and cash flows.
b. Express a qualified opinion on the financial
statements because of a client-imposed scope
limitation.
c. Withdraw from the engagement and refuse to be
associated with the financial statements.
d. Specifically state that the financial statements are
not comparable to the prior year due to an
uncertainty.

CPA Exam Tip:

When you have completed a multiple choice
testlet you click on the Done button on the top
right hand corner of the screen. When you
click on the Done button you are given three
choices. The three choices are Quit Exam,
Review, Continue. Clicking on the Review
button allows you to check your answers
within the testlet for the final time. Clicking
the Continue button moves you to the next
testlet and you cannot go back and check the
previous testlet. Clicking on the Quit Exam
button ends your examination. You would
choose the Quit Exam option if you have
completed the exam or if you decided not to
finish the test.

107. What is an auditor's reporting responsibility

concerning information accompanying the basic
financial statements in an auditor-submitted document?
a. The auditor should report on all the accompanying
information included in the document.
b. The auditor should report on the accompanying
information only if the auditor participated in its
preparation.
c. The auditor should report on the accompanying
information only if the auditor did not participate in
its preparation.
d. The auditor should report on the accompanying
information only if it contains obvious material
misstatements.

3Q-16

Chapter Three - Problems

Standards of Reporting

NUMBER 1
The auditor's standard report consists of a statement describing the nature of the examination, and an expression of
the auditor's opinion. There are circumstances where the auditor's standard report is modified by adding one or more
separate explanatory paragraphs, and/or modifying the wording of the scope paragraph or opinion paragraph.
For purposes of this question, assume the auditor is independent and has previously expressed an unqualified
opinion on the prior year's financial statements. For the current year, only single-year (not comparative) statements
are presented.
Required: Identify the circumstances necessitating modification of the auditor's standard report. For each
circumstance indicate the types of opinion that would be appropriate and describe the report modifications.
Organize the answer as indicated in the following example:

Circumstances
1. The financial statements are
materially affected by a
departure from generally
accepted accounting principles.

Type of Opinion
1. The auditor should express
an "except for" qualified
opinion or an adverse
opinion.

3Q-17

Report Modification
1. The auditor should explain
the basis and effects of
the departure in an explanatory paragraph and modify
the opinion paragraph.

NUMBER 2
Number 2 consists of 7 items. Select the best answer for each item. Answer all items.
Required:
Items 1 through 7 present various independent factual situations an auditor might encounter in conducting an audit.
List A represents the types of opinions the auditor ordinarily would issue and List B represents the report
modifications (if any) that would be necessary. For each situation, select one response from List A and one item
from List B. Select as the best answer for each item, the action the auditor normally would take. The types of
opinions in List A and the report modifications in List B may be selected once, more than once, or not at all.
Assume:
The auditor is independent.
The auditor previously expressed an unqualified opinion on the prior years financial statements.
Only single-year (not comparative) statements are presented for the current year.
The conditions for an unqualified opinion exist unless contradicted in the factual situations.
The conditions stated in the factual situations are material.
No report modifications are to be made except in response to the factual situation.

Items to be Answered:
1.

In auditing the long-term investments account, an auditor is unable to obtain audited financial statements for an
investee located in a foreign country. The auditor concludes that sufficient competent evidential matter
regarding this investment cannot be obtained.

2.

Due to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an
entitys ability to continue as a going concern for a reasonable period of time. However, the financial statement
disclosures concerning these matters are adequate.

3.

A principal auditor decides to take responsibility for the work of another CPA who audited a wholly-owned
subsidiary of the entity and issued an unqualified opinion. The total assets and revenues of the subsidiary
represent 17% and 18%, respectively, of the total assets and revenues of the entity being audited.

4.

An entity issues financial statements that present financial position and results of operations but omits the
related statement of cash flows. Management discloses in the notes to the financial statements that it does not
believe the statement of cash flows to be a useful financial statement.

5.

An entity changes its depreciation method for production equipment from the straight-line to a units-ofproduction method based on hours of utilization. The auditor concurs with the change although it has a material
effect on the comparability of the entitys financial statements.

6.

An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, the ultimate
outcome of the litigation cannot be reasonably estimated by management. The auditor believes there is a
reasonable possibility of a significantly material loss, but the lawsuit is adequately disclosed in the notes to the
financial statements.

7.

An entity discloses in the notes to the financial statements certain lease obligations. The auditor believes that
the failure to capitalize these leases is a departure from generally accepted accounting principles.

3Q-18

List A
Types of Opinions
A.

An except for qualified opinion

B.

An unqualified opinion

C.

An adverse opinion

D.

A disclaimer of opinion

E.

Either an except for qualified opinion or an

adverse opinion

F.

Either a disclaimer of opinion or an except

for qualified opinion

G.

Either an adverse opinion or a disclaimer of

opinion

List B
Report Modifications
H.

Describe the circumstances in an explanatory

paragraph preceding the opinion paragraph
without modifying the three standard paragraphs.

I.

Describe the circumstances in an explanatory

paragraph following the opinion paragraph
without modifying the three standard paragraphs.

J.

Describe the circumstances in an explanatory

paragraph preceding the opinion paragraph
and modify the opinion paragraph.

K.

Describe the circumstances in an explanatory

paragraph following the opinion paragraph
and modify the opinion paragraph.

L.

Describe the circumstances in an explanatory

paragraph preceding the opinion paragraph
and modify the scope and opinion
paragraphs.

M.

Describe the circumstances in an explanatory

paragraph following the opinion paragraph
and modify the scope and opinion
paragraphs.

N.

Describe the circumstances within the scope

paragraph without adding an explanatory
paragraph.

O.

Describe the circumstances within the opinion paragraph without adding an explanatory
paragraph.

P.

Describe the circumstances within the scope

and opinion paragraphs without adding an
explanatory paragraph.

Q.

Issue the standard auditors report without

modification.

3Q-19

NUMBER 3
Number 3 consists of 8 items. Select the best answers for each item. Answer all items. Your grade will be based
on the total number of correct answers.
Required:
Items 91 through 98 present various independent factual situations an auditor might encounter in conducting an
audit. List A represents the types of opinions the auditor ordinarily would issue and List B represents the report
modifications (if any) that would be necessary. For each situation, select one response from List A and one from
List B. Select as the best answers for each item, the action the auditor normally would take. The types of opinions in
List A and the report modifications in List B may be selected once, more than once, or not at all.
Assume:
The auditor is independent.

The auditor previously expressed an unqualified opinion on the prior year's financial statements.

Only single-year (not comparative) statements are presented for the current year.

The conditions for an unqualified opinion exist unless contradicted by the facts.

The conditions stated in the factual situations are material.

No report modifications are to be made except in response to the factual situation.

91. An auditor hires an actuary to assist in corroborating a client's complex pension calculations concerning
accrued pension liabilities that account for 35% of the client's total liabilities. The actuary's findings are
reasonably close to the client's calculations and support the financial statements.
92. A client holds a note receivable consisting of principal and accrued interest payable in 1998. The note's maker
recently filed a voluntary bankruptcy petition, but the client failed to reduce the recorded value of the note to its
net realizable value, which is approximately 20% of the recorded amount.
93. An auditor is engaged to audit a client's financial statements after the annual physical inventory count. The
accounting records are not sufficiently reliable to enable the auditor to become satisfied as to the year-end
inventory balances.
94. Big City is required by GASB to present supplementary information outside the basic financial statements
concerning the disclosure of pension information. Big City's auditor determines that the supplementary
information, which is not required to be part of the basic financial statements, is omitted.
95. A client's financial statements do not disclose certain long-term lease obligations. The auditor determines that
the omitted disclosures are required by FASB.
96. A principal auditor decides not to take responsibility for the work of another CPA who audited a wholly-owned
subsidiary of the principal auditor's client. The total assets and revenues of the subsidiary represent 27% and
28%, respectively, of the related consolidated totals.
97. A client changes its method of accounting for the cost of inventories from FIFO to LIFO. The auditor concurs
with the change although it has a material effect on the comparability of the financial statements.
98. Due to losses and adverse key financial ratios, an auditor has substantial doubt about a client's ability to
continue as a going concern for a reasonable period of time. The client has adequately disclosed its financial
difficulties in a note to its financial statements, which do not include any adjustments that might result from the
outcome of this uncertainty.

3Q-20

List A

List B

Types of Opinions

Report Modifications

A.

Either an "except for" qualified opinion or

an adverse opinion

B.

Either a disclaimer of opinion or an

"except for" qualified opinion

I.

C.

Either an adverse opinion or a disclaimer

of opinion

J.

D.

An "except for" qualified opinion

K.

E.

An unqualified opinion

L.

F.

An adverse opinion

M.

G.

A disclaimer of opinion

N.

H.

O.
P.

Describe the circumstances in an explanatory

paragraph without modifying the three standard
paragraphs.
Describe the circumstances in an explanatory
paragraph and modify the opinion paragraph.
Describe the circumstances in an explanatory
paragraph and modify the scope and opinion
paragraphs.
Describe the circumstances in an explanatory
paragraph and modify the introductory, scope, and
opinion paragraphs.
Describe the circumstances within the scope
paragraph without adding an explanatory paragraph.
Describe the circumstances within the opinion
paragraph without adding an explanatory paragraph.
Describe the circumstances within the scope and
opinion paragraphs without adding an explanatory
paragraph.
Describe the circumstances within the introductory,
scope, and opinion paragraphs without adding an
explanatory paragraph.
Issue the standard auditor's report without
modification.

NUMBER 4
Number 4 consists of 15 items. Select the best answer for each item.
Required:
Items 91 through 105 represent a series of unrelated statements, questions, excerpts, and comments taken from
various parts of an auditors working paper file. Below the items is a list of the likely sources of the statements,
questions, excerpts, and comments. Select, as the best answer for each item, the most likely source. Select only one
source for each item. A source may be selected once, more than once, or not at all.
Statements, Questions, Excerpts, and Comments
91. There are no material transactions that have not been properly recorded in the accounting records underlying
the financial statements.
92. In connection with an audit of our financial statements, management has prepared, and furnished to our
auditors, a description and evaluation of certain contingencies.
93. Provision has been made for any material loss to be sustained in the fulfillment of, or from the inability to
fulfill, any sales commitments.
94. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses.
95. The objective of our audit is to express an unqualified opinion on the financial statements, although it is
possible that facts or circumstances encountered may preclude us from expressing an unqualified opinion.
3Q-21

96. There have been no fraudulent activities involving employees that could have a material effect on the financial
statements.
97. Are you aware of any facts or circumstances that may indicate a lack of integrity by any member of senior
management?
98. If a difference of opinion on a practice problem existed between engagement personnel and a specialist or
other consultant, was the difference resolved in accordance with firm policy and appropriately documented?
99. Although we have not conducted a comprehensive, detailed search of our records, no other deposit or loan
accounts have come to our attention except as noted below.
100. At the conclusion of our audit, we will request certain written representations from you about the financial
statements and related matters.
101. We have no plans or intentions that may materially affect the carrying value or classification of assets and
liabilities.
102. As discussed in Note 14 to the financial statements, the Company has had numerous dealings with businesses
controlled by, and people who are related to, the officers of the Company.
103. There were unreasonable delays by management in permitting the commencement of the audit and in
providing needed information.
104. If this statement is not correct, please write promptly, using the enclosed envelope, and give details of any
differences directly to our auditors.
105. The Company has suffered recurring losses from operations and has a net capital deficiency that raises
substantial doubt about its ability to continue as a going concern.

List of Sources
A. Partners engagement review program.
B.

Communication with predecessor auditor.

C.

Auditors engagement letter.

D.

Management representation letter.

E.

Standard financial institution confirmation request.

F.

Auditors communication with the audit committee.

G.

Auditors report.

H.

Letter for underwriters.

I.

Audit inquiry letter to legal counsel.

J.

Accounts receivable confirmation.

3Q-22

NUMBER 5
Perry & Price, CPAs, audited the consolidated financial statements of Bond Company for the year ended December
31, 1998, and expressed an adverse opinion because Bond carried its plant and equipment at appraisal values and
provided for depreciation on the basis of such values.
Perry & Price also audited Bond's financial statements for the year ended December 31, 1999. These consolidated
financial statements are being presented on a comparative basis with those of the prior year, and an unqualified
opinion is being expressed.
Smith, the engagement supervisor, instructed Adler, an assistant on the engagement, to draft the auditor's report on
May 3, 2000, the date of completion of the field work. In drafting the report, Adler considered the following:

Bond recently changed its method of accounting for plant and equipment and restated its 1998 consolidated
financial statements to conform with GAAP. Consequently, the CPA firm's present opinion on those
statements is different (unqualified) from the opinion expressed on May 12, 1999.

Larkin & Lake, CPAs, audited the financial statements of BX, Inc., a consolidated subsidiary of Bond, for
the year ended December 31, 1999. The subsidiary's financial statements reflected total assets and
revenues of 2% and 3%, respectively, of the consolidated totals. Larkin and Lake expressed an unqualified
opinion and furnished Perry & Price with a copy of the auditor's report. Perry & Price has decided to
assume responsibility for the work of Larkin & Lake insofar as it relates to the expression of an opinion on
the consolidated financial statements taken as a whole.

Bond is a defendant in a lawsuit alleging patent infringement. This is adequately disclosed in the notes to
Bond's financial statements, but no provision for liability has been recorded because the ultimate outcome
of the litigation cannot presently be determined.
Auditor's Report

We have audited the accompanying consolidated balance sheets of Bond Company and subsidiaries as of December
31, 1999 and 1998, and the related consolidated statements of income, retained earnings, and cash flows for the
years then ended. These financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our previous report, we expressed an opinion that the 1998 financial statements did not fairly present financial
position, results of operations, and cash flows in conformity with generally accepted accounting principles because
the Company carried it plant and equipment at appraisal values and provided for depreciation on the basis of such
values. As described in Note 12, the Company has changed its method of accounting for these items and restated its
1998 financial statements to conform with generally accepted accounting principles. Accordingly, our present
opinion on the 1998 financial statements, as presented herein, is different from that expressed in our previous report.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the
financial position of Bond Company and subsidiaries as of December 31, 1999 and 1998, and the results of its
operations and its cash flows for the years then ended in conformity with generally accepted accounting principles
except for the change in accounting principles, with which we concur, and the uncertainty, which is discussed in the
following explanatory paragraph.
The Company is a defendant in a lawsuit alleging infringement of certain patent rights. The Company has filed a
counteraction, and preliminary hearings and discovery proceedings are in progress. The ultimate outcome of the
litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon
adjudication has been made in the accompanying financial statements.
Perry & Price, CPAs
May 3, 2000

3Q-23

Required:
Smith reviewed Adler's draft and indicated in the Supervisor's Review Notes below that were deficiencies in Adler's
draft. Items 1 through 15 represent the deficiencies noted by Smith. For each deficiency, indicate whether Smith is
correct (C) or incorrect (I) in the criticism of Adler's draft.

Supervisor's Review Notes

1.

The report is improperly titled.

2.

All the basic financial statements are not properly identified in the introductory paragraph.

3.

There is no reference to the American Institute of Certified Public Accountants in the introductory paragraph.

4.

Larkin & Lake are not identified in the introductory and opinion paragraphs.

5.

The subsidiary, BX, Inc., is not identified, and the magnitude of BX's financial statements is not disclosed in
the introductory paragraph.

6.

The report does not state in the scope paragraph that generally accepted auditing standards require analytical
procedures to be performed in planning an audit.

7.

The report does not state in the scope paragraph that an audit includes assessing internal control.

8.

The report does not state in the scope paragraph that an audit includes assessing significant estimates made
by management.

9.

The date of the previous report (May 12, 1999) is not disclosed in the first explanatory paragraph.

10.

It is inappropriate to disclose in the first explanatory paragraph the circumstances that caused Perry & Price
to express a different opinion on the 1998 financial statements.

11.

The concurrence with the accounting change is inappropriate in the opinion paragraph.

12.

Reference to the (litigation) uncertainty should not be made in the opinion paragraph.

13.

The last explanatory paragraph describing the (litigation) uncertainty needs not to be added to the report.

14.

The letter of inquiry to Bond's lawyer concerning litigation, claims, and assessments is not referred to in the
scope paragraph.

15.

The report is not dual dated, but it should be because of the change of opinion on the 1998 financial
statements.

3Q-24

NUMBER 6
Number 6 consists of 13 items pertaining to possible deficiencies in an accountant's review report. Select the best
answer for each item.
Jordan & Stone, CPAs, audited the financial statements of Tech Co., a nonpublic entity, for the year ended
December 31, 1991, and expressed an unqualified opinion. For the year ended December 31, 1992, Tech issued
comparative financial statements. Jordan & Stone reviewed Tech's 1992 financial statements and Kent, an assistant
on the engagement, drafted the accountants' review report below. Land, the engagement supervisor, decided not to
reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year's
review report describing the responsibility assumed for the prior year's audited financial statements. This is an
appropriate reporting procedure.
Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several
deficiencies in Kent's draft.
Accountant's Review Report
We have reviewed and audited the accompanying balance sheets of Tech Co. as of December 31, 1992 and 1991,
and the related statements of income, retained earnings, and cash flows for the years then ended, in accordance with
Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public
Accountants and generally accepted auditing standards. All information included in these financial statements is the
representation of the management of Tech Co.
A review consists principally of inquiries of company personnel and analytical procedures applied to financial data.
It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective
of which is the expression of an opinion regarding the financial statements taken as a whole.
Based on our review, we are not aware of any material modifications that should be made to the accompanying
financial statements. Because of the inherent limitations of a review engagement, this report is intended for the
information of management and should not be used for any other purpose.
The financial statements for the year ended December 31, 1991, were audited by us and our report was dated March
2, 1992. We have no responsibility for updating that report for events and circumstances occurring after that date.
Jordan and Stone, CPAs
March 1, 1993
Required:
Items 61 through 73 represent deficiencies noted by Land. For each deficiency, indicate whether Land is correct
(C) or incorrect (I) in the criticism of Kent's draft.
Items to be Answered:
Supervisor's Review Notes
61. There should be no reference to the prior year's audited financial statements in the first (introductory)
paragraph.
62. All the current-year basic financial statements are not properly identified in the first (introductory) paragraph.
63. There should be no reference to the American Institute of Certified Public Accountants in the first
(introductory) paragraph.

3Q-25

64. The accountant's review and audit responsibilities should follow management's responsibilities in the first
(introductory) paragraph.
65. There should be no comparison of the scope of a review to an audit in the second (scope) paragraph.
66. Negative assurance should be expressed on the current year's reviewed financial statements in the second
(scope) paragraph.
67. There should be a statement that no opinion is expressed on the current year's financial statements in the
second (scope) paragraph.
68. There should be a reference to "conformity with generally accepted accounting principles" in the third
paragraph.
69. There should no restriction on the distribution of the accountant's review report in the third paragraph.
70. There should be no reference to "material modifications" in the third paragraph.
71. There should be an indication of the type of opinion expressed on the prior year's audited financial statements
in the fourth (separate) paragraph.
72. There should be an indication that no auditing procedures were performed after the date of the report on the
prior year's financial statements in the fourth (separate) paragraph.
73. There should be no reference to "updating the prior year's auditor's report for events and circumstances
occurring after that date" in the fourth (separate) paragraph.

3Q-26

Chapter Three - Solutions to Questions

Standards of Reporting
1. (b) The auditor's scope of examination was limited in this case, and since the first paragraph of the auditor's
report indicates his scope, this exception should be reported here.
2. (c) These statements are required for complete presentation under GAAP.
3. (a) Disclosure is the third standard of reporting and thus failure to disclose would result in a qualified report.
Answer (b) is incorrect because a qualified report would be issued instead of an adverse opinion. The key is that this
item was material to qualify, but not pervasive which would result in an adverse opinion.
4. (a) "Except for" and "adverse" opinions are concerned with departures from GAAP. The difference in which
opinion to render is determined by materiality and pervasiveness.
5. (a) Limitations on the scope of the audit can come about by client restrictions, inability to obtain sufficient
competent evidential matter or inadequacy of client accounting records. Answer (b) is incorrect because the auditor
can report on only one basic financial statement. Answer (c) is incorrect because the use of another auditor is not a
scope limitation. Answer (d) is incorrect because this would not necessarily result in a scope limitation.
6. (c) An explanatory paragraph is used when the opinion paragraph is to be modified. A reference in the opinion
paragraph to middle paragraph explains the reason for the modification.
7. (d) The statement of cash flows is required by GAAP and its omission results in a qualified except for opinion.
The statement of cash flows, for reporting purposes, is considered the omission of a disclosure.
8. (b) Deviations from GAAP result in either an "except for" qualification or an adverse opinion.
9. (d) The question states the auditor concludes the statements are not in conformity with GAAP. In order to make
this statement in his report, the auditor must issue an adverse opinion. A qualification, rather than an adverse
opinion, still states the financial statements present fairly, except for... An adverse opinion states the "financial
statements do not present fairly..."
10. (b) An adjustment represents a departure from GAAP. Thus an "except for" opinion is in order.
11. (b) The auditor cannot use his report to explain problems with or disclosures required by the client in their
financial statements. "With the foregoing explanation" implies the auditor's opinion is conditional upon the
disclosure in his report, and it is not.
12. (a) The report is satisfactory because when the CPA is preparing unaudited statements, he has the responsibility
to ensure that the statements are in accordance with GAAP. If they are not, the CPA must propose adjustments, and
if the client refuses to book said adjustments, to so disclose in his report.
13. (c) The principal auditor may or may not refer to the other auditor's examination. If he does, he is sharing the
responsibility for his opinion. If he accepts full responsibility, no reference is made to the other auditor. Choices (a)
and (b) are wrong because of the word "must." Choice (d) is incorrect because it does not result in a qualified
opinion.

3S-1

14. (d) There are two types of subsequent events. 1) Requires disclosure of events of importance subsequent to the
balance sheet date but prior to issuance of the report. The important point here is the amounts on the statements are
correct as of year end. 2) Requires a change in the amount previously determined as of the balance sheet date. New
information is available that sheds new light on amounts previously estimated. Answers (a), (b), (c), are type 1, and
answer (d) is type 2.
15. (c) This item refers to the prior year's report. The auditor is responsible for subsequent events only through the
date of his report.
16. (d) The auditor should refer to the division of responsibility in the introductory, scope and opinion paragraphs.
See example in text.
17. (c) When the other auditor is named, his report must be presented.
18. (d) The auditor's subsequent events work extends through the date of his audit report.
19. (b) When referring to another auditor's work, the principal auditor must disclose the scope of the second
auditor's examination in relation to the total consolidated assets of both companies.
20. (a) Part of the examination may be performed by another CPA with no effect on the principal auditor's opinion
unless, of course, there is a problem that would normally require modification of the auditor's report.
21. (b) If the CPA relies on the work of another auditor, it does not constitute a scope limitation. Answers (a), (c),
and (d) constitute scope limitations.
22. (c) The reference is to work performed by other auditors. This does not constitute a reporting problem, but
rather divides the responsibility for the opinion between the principal auditor (the auditor signing the opinion) and
another auditor who has performed part of the examination.
23. (c) Observation of the inventory count and confirmation of receivables is normally performed during an audit.
However, if circumstances do not permit these procedures to be performed, the auditor may apply alternative audit
procedures that may include observation of an inventory count at a later date and the verification of receivable
balances by auditing subsequent cash receipts. If the auditor is able to employ alternative procedures he considers
appropriate in the circumstances, no modification or qualification of the audit report is necessary.
24. (d) Adverse opinions may be issued when there is a material and pervasive departure from GAAP or substantial
deficiencies in disclosures (footnotes to financial statements). Answer (d) is a departure from GAAP and could be
the basis for the issuance of an adverse opinion. Answers (a) and (c) may result in a disclaimer of opinion, not an
adverse opinion. Answer (b) is a scope limitation and may result in a qualified opinion or a disclaimer of an
opinion.
25. (d) If an auditor decides that he or she is the principal auditor and that he or she can use the other auditor's
report, because the other auditor is reputable and independent, the principal auditor must decide whether or not to
make reference to the other auditor. If the principal auditor decides not to refer to the other auditor, he or she should
visit the other auditor, discuss the procedures followed, and review the audit program and working papers of the
other auditor. Answer (a) is incorrect because if the principal auditor decides not to refer to the other auditor, no
references of any kind would be made in the report. Answer (b) would not fulfill the principal auditor's reporting
responsibilities. Answer (c) is incorrect because permission would only be necessary if the principal auditor decides
to refer to and name the other auditor.
26. (a) The only reporting requirement necessary when there has been an accounting change is for the auditor to add
a fourth paragraph to his report. The fourth paragraph would be placed directly after the opinion paragraph and it
would refer to a footnote in the financial statements that describes the nature of the change in the accounting
principle.

3S-2

27. (b) GAAS explicitly states that if the predecessor's report is not presented with the comparative financial
statements, the current (successor) auditor's report must refer to the fact that the predecessor expressed an
unqualified opinion on the prior year's financial statements. In order to do this the successor should modify the
introductory paragraph of his report to include information about the prior year's audit.
28. (c) Generally accepted auditing standards require the auditor to obtain written representations from
management. Management's refusal to furnish those written representations, therefore, would always constitute a
limitation on the scope of the auditor's examination which in turn would preclude an unqualified opinion. Answers
(a) and (d) could result in scope limitations if the auditor is unable to satisfy himself by alternative procedures.
29. (c) When a qualified opinion results from a limitation on the scope of the audit or an insufficiency of evidential
matter, the situation should be described in an explanatory paragraph preceding the opinion paragraph and referred
to in both the scope and opinion paragraphs of the auditor's report. It is not appropriate for the scope of the audit to
be explained in a note to the financial statements, since the description of the audit scope is the responsibility of the
auditor and not that of his client.
30. (d) The auditor's responsibility with respect to information in an annual report does not extend beyond the
financial information identified in his report. However, he should read the other information and consider whether it
is materially inconsistent with information appearing in the financial statements. If he concludes that the other
information is inconsistent and the client refuses to correct the inconsistency, the auditor should either revise his
report to include an explanatory paragraph describing the material inconsistency, withhold the use of his report in
the annual report, or withdraw from the engagement.
31. (d) When an accountant is not independent, any procedures he might perform would not be in accordance with
generally accepted auditing standards, and he would be precluded from expressing an opinion on such statements.
Accordingly, he should disclaim an opinion on such statements. Accordingly, he should disclaim an opinion with
respect to those financial statements. The other answers could result in qualified opinions, but lack of independence
will always result in a disclaimer of opinion.
32. (d) When unaudited financial statements are presented in comparative form with audited financial statements in
any document, other than in documents filed with the Securities and Exchange Commission, the financial statements
that have not been audited should be clearly marked to indicate their status and either the report on the prior period
should be reissued or the report on the current period should include as a separate paragraph an appropriate
description of the responsibility assumed for the financial statements of the prior period.
33. (b) Segment information is one of the disclosures required by generally accepted accounting principles. If the
entity refuses to include in the financial statements part or all of the segment information that the auditor believes is
required to be disclosed, the auditor should modify his opinion on the financial statements because of inadequate
disclosure and should describe the type of information omitted. The auditor is not required to provide the omitted
segment information in his report. When the financial statements, including the accompanying notes, fail to disclose
required information, the auditor should express a qualified or adverse opinion. Answer (b) refers to a qualified
opinion because of inadequate disclosure. Answer (c) refers to an adverse opinion because of lack of conformity
with generally accepted accounting principles, not because of inadequate disclosure.
34. (a) When restrictions that significantly limit the scope of the audit are imposed by the client, ordinarily the
auditor should disclaim an opinion on the financial statements. A letter of inquiry to the client's lawyer is the
primary means of obtaining corroboration of the information furnished by management concerning litigation,
claims, and assessments. Accordingly, the client not permitting the auditor to inquire of outside legal counsel is a
significant scope limitation that would result in a disclaimer of opinion.
35. (d) When there has been a change in accounting principles or in the method of their application, the auditor
should refer to the change in an explanatory paragraph (following the opinion paragraph) which identifies the nature
of the change and refers the reader to the note in the financial statements that discusses the change. The other
paragraphs in the auditor's report are not affected.

3S-3

36. (a) The auditor's standard report includes a statement that the financial statements are the responsibility of the
Company's management and that the auditor's responsibility is to express an opinion on the financial statements
based on his audit.
37. (b) Restrictions on the scope of an audit such as the timing of the work, inability to obtain sufficient competent
evidential matter, or an inadequacy in the accounting records, may require an auditor to qualify his opinion or
disclaim an opinion. When restrictions that significantly limit the scope of the audit are imposed by the client,
ordinarily the auditor should disclaim an opinion on the financial statements.
38. (c) The auditor will typically want the client to make all minutes of meetings of stockholders, directors and
committees of directors available. If management does not make these minutes available to the auditor, this would
be considered a scope restriction which could result in the auditor qualifying his opinion or disclaiming an opinion.
Answer (a) refers to financial statements prepared in conformity with a basis of accounting other than GAAP. The
auditor can express an unqualified opinion on whether these financial statements are presented fairly in conformity
with the cash basis. The auditor's report on these cash-basis financial statements would include a statement that they
were prepared using a basis of accounting other than GAAP and would refer the reader to a note in the financial
statements where management states that the financial statements are not intended to be presented in accordance
with GAAP [answer (b)]. Answer (d) involves a situation which has limited reporting objectives; the auditor can
issue an unqualified opinion on one basic financial statement and not on the others.
39. (a) An uncertainty exists when the outcome of future events that may affect the financial statements is not
susceptible of reasonable estimation by management and it cannot be determined whether the financial statements
should be adjusted or in what amount. Such uncertainties may require an explanatory paragraph in the auditor's
report. The uncertainties would not affect the other paragraphs in the report and would not result in a qualified
opinion [answer (c)] or adverse opinion [answer (d)]. Answer (b) is no longer a reporting option.
40. (b) When the auditor expresses an adverse opinion, he should disclose in a separate explanatory paragraph
preceding the opinion paragraph of his report all the substantive reasons for his adverse opinion and the principal
effects of the subject matter of the adverse opinion on financial position, results of operations, and cash flows, if
practicable.
41. (b) If management has not provided reasonable justification for a change in accounting principle, the auditor
should express a qualified opinion or, if the effect of the change is sufficiently material, express an adverse opinion
on the financial statements. The auditor would express the same opinion each year those financial statements are
presented. The auditor would not qualify the report only the year of the change [answer (a)] and would not qualify
his opinion on financial statements covering periods subsequent to the year of change [answer (c)]. The auditor's
exception relates to the accounting change and does not affect the status of the newly adopted principle.
Accordingly, while expressing an exception for the year of change, the opinion regarding the subsequent years'
statements need not express an exception to use of the newly adopted principle.
42. (b) When an accountant is associated with the financial statements of a public entity, but has not audited or
reviewed such statements, the report to be issued is a disclaimer of opinion. Answer (a) applies only to financial
statements of nonpublic entities. Answer (c) is made up. Answer (d) applies to audits of financial statements.
43. (a) Review of compliance with terms of debt and loan agreements is an audit procedure that may identify
conditions and events that indicate there could be substantial doubt about an entity's ability to continue as a going
concern for a reasonable period of time. Default on such agreements may indicate possible financial difficulty. The
audit procedures listed in answers (b), (c) and (d) would be less likely to identify information about an entity's
ability to continue as a going concern.
44. (a) The paragraph is referring to the uncertainty that the company will remain a going concern. Material
uncertainties cause the auditor to modify the audit report by adding a fourth paragraph that follows the opinion
paragraph. However, the type of opinion issued is unqualified.

3S-4

45. (d) Since the opinion resulted from a scope limitation, reference to the explanatory paragraph needs to be made
in the scope paragraph. This is done by adding the phrase, "Except as discussed in the following paragraph, we
conducted ...," to the beginning of the scope paragraph. The opinion paragraph is also modified as follows: "In my
opinion, except for ..., the financial statements ... ."
46. (c) Answers (a), (b) and (d) are scope limitations which, depending upon materiality, usually lead to a disclaimer
of an opinion. Answer (c) refers to inadequate disclosure which is a departure from GAAP and, if material, would
lead to a qualified except for opinion or an adverse opinion.
47. (c) Answers (a), (b) and (d) are all departures from GAAP and, as such, would lead to qualified or adverse
opinions. Answer (c) is a description of a scope limitation which would lead to a qualified except for opinion or a
disclaimer of an opinion depending on materiality.
48. (d) A qualified opinion should include the word except or exception in a phrase such as except for or
with the exception of. Phrases such as subject to and with the foregoing explanation are not clear or forceful
enough and should not be used. Since accompanying notes are part of the financial statements, wording such as
fairly presented, in all material respects, when read in conjunction with Note X is likely to be misunderstood and
should not be used.
49. (b) When an adverse opinion is expressed, the opinion paragraph should include a direct reference to a separate
paragraph preceding the opinion paragraph that discloses all the substantive reasons for the adverse opinion and the
principal effects on the financial statements, if practicable. Answers (a) and (c) apply to the separate paragraph, not
the opinion paragraph. Answer (d) does not refer to adverse opinions, but to uncertainties and scope limitations,
which would be described in a separate paragraph, not the opinion paragraph.
50. (a) A disclaimer of opinion should not be used when the auditor believes that there are material departures from
generally accepted accounting principles, including inadequate disclosure. A disclaimer is appropriate in answers
(b), (c) and (d), which are situations where the auditor may be unable to express an opinion because he has not
performed an audit sufficient in scope to enable him to form an opinion.
51. (b) An auditor may update an opinion on prior period financial statements. An updated opinion means that an
auditor may change (update) his opinion on previously issued financial statements because of new facts coming to
the auditor's attention in the current period that affect a prior period. Such a situation is described in this question.
The client departed from GAAP in the prior period; however, in the current period, the client wishes to restate the
prior period financial statements to be in conformity with GAAP.
52. (a) Uncertainties may cause the auditor to expand the standard unqualified opinion by adding a fourth paragraph
referring to a footnote in the financial statement describing the uncertainty. However, since this uncertainty was
described as remote, no footnote disclosure is necessary. Therefore, the auditor would issue a standard threeparagraph unqualified opinion.
53. (d) The explanatory paragraph would be inserted between the scope paragraph and opinion paragraph. The
opinion paragraph would refer to the explanatory paragraph as a basis for the qualification. The scope and
introductory paragraph would not be modified.
54. (a) The inclusion of such a paragraph is appropriate. The auditor is emphasizing a matter in the financial
statements.
55. (d) The client has a responsibility to disclose in the financial statements concerns regarding the entity's ability to
continue as a going concern. The auditor has a responsibility to consider whether the disclosure should be made
and, if made, is it adequate. If the auditor concludes that disclosure is not adequate, then the auditor should issue a
qualified except-for opinion.

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56. (b) A justified change in an accounting principle results in the auditor issuing an unqualified opinion. However,
the auditor must include a separate paragraph in the audit report referring to a footnote in the financial statements
describing the change. This additional paragraph would follow the opinion paragraph.
57. (a) An auditor has no responsibility to perform any additional auditing procedures after the audit report is issued
except in the following two situations:
1. The auditor omitted an auditing procedure that should have been performed, for example, obtaining a client
representation letter, and
2. Information that comes to the auditor's attention that existed at the report date, and this information, if known,
may have affected the auditor's report.
58. (d) There is a specific statement in the audit report to examining evidence on a test basis. However, there is no
reference to the consistent application of GAAP. The reference is implicit because the phrase, "presents fairly in
accordance with GAAP," includes the fact that GAAP has been consistently applied.
59. (d) The inability to obtain sufficient competent evidential matter is the definition of a scope limitation. A scope
limitation would lead the auditor to issue a qualified except-for opinion or disclaim an opinion.
60. (a) If the auditor concludes that there is substantial doubt about an entitys ability to continue as a going concern
for a reasonable time, he should express that conclusion through the use of the phrase substantial doubt about its
(the entitys) ability to continue as a going concern. That conclusion should be reflected in an explanatory
paragraph following the opinion paragraph.
61. (d) The auditors report does not extend beyond the financial information identified in the report and the auditor
has no obligation to perform any procedures to corroborate other information. However, the auditor should read the
other information in a clients document that includes audited financial statements and consider whether such
information is materially inconsistent with information appearing in the audited financial statements.
62. (b) In a situation where a principal auditor uses the work and report of another auditor who has audited the
financial statements of a subsidiary, the principal auditor may decide to take responsibility for the work and report
of the other auditor and would make no reference to the other auditor. If the principal auditor decides not to assume
that responsibility, his report should make reference to the audit of the other auditor and should indicate clearly the
division of responsibility between himself and the other auditor. Appropriate wording is illustrated in the question.
63. (b) When a CPA is associated with the financial statements of a public entity but has not audited or reviewed
such statements, the CPA should issue a disclaimer of opinion. When a CPA issues such a disclaimer, he or she has
no responsibility to apply any procedures beyond reading the financial statements for obvious material errors.
Answers (a) and (c) are incorrect because the CPA has a responsibility to read the financial statements, not to
document the internal control structure or ascertain whether the financial statements are in conformity with GAAP.
Answer (d) is incorrect because the CPA is not responsible for determining whether management elected to omit
substantially all disclosures, although the CPA will likely discover this when reading the financial statements.
64. (b) When, after considering management's plans, the auditor concludes there is substantial doubt about the
entity's ability to continue as a going concern for a reasonable period of time, the auditor should consider the
possible effects on the financial statements and the adequacy of the related disclosure. In addition, the auditor's
report should include an explanatory paragraph after the opinion paragraph to reflect the conclusion about the
entity's ability to continue as a going concern. The auditor would not issue a qualified or adverse opinion, as
indicated in answer (a), unless the disclosure was inadequate. Answer (c) is incorrect because the auditor's
responsibility to determine that the audit committee is informed about significant accounting estimates is separate
from the auditor's consideration of the going concern issue. Answer (d) is incorrect because substantial doubt about
an entity's ability to continue as a going concern that arose in the current period does not imply that a basis for such
doubt existed in the prior period, and, therefore should not affect the auditor's report on prior periods.

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65. (a) When a principal auditor uses the work and reports of other auditors who conducted audits of components of
the overall financial statements, he or she must decide whether to make reference to those other auditors. If the
principal auditor decides to assume responsibility for the other auditor's work, no reference is made to the other
auditor in the principal auditor's audit report. If the principal auditor decides not to assume that responsibility, the
principal auditor's report will refer to the other auditor and will indicate the division of responsibility between the
principal and other auditors. Answer (b) is incorrect because the principal auditor would not make reference to the
other auditor if the portion audited by the other auditor were immaterial. Answer (c) is incorrect because the
principal auditor would inquire as to the other auditor's competency, reputation and certification whether or not
reference is made to the other auditor in the principal auditor's report. Answer (d) is incorrect because different
opinions would not necessarily result in a reference in the principal auditor's report. The principal auditor does,
however, consider the other auditor's opinion in arriving at the overall opinion.
66. (c) When an auditor is requested by a client to reissue a previously issued report, the auditor has no
responsibility to make further investigation or inquiry as to events that may have occurred during the period
between the original report date and the release of reissued reports. Accordingly, the auditor should use the original
report date on the reissued report because use of the original report date removes any implication that records,
transactions, or events after that date have been examined or reviewed. Answers (a), (b) and (d) are incorrect
because if the auditor used dual dates, release date, or current report date, there would be an implication that the
report was revised and/or additional work was done by the auditor.
67. (d) The auditor may wish to emphasize a matter regarding the client's financial statements while expressing an
unqualified opinion. Examples of matters that could be emphasized include the client entity being part of a larger
business enterprise, an unusual subsequent event, or significant transactions with related parties. Adding an
explanatory emphasis paragraph does not qualify the opinion, as incorrectly indicated in answer (a). Answer (b) is
incorrect because generally accepted auditing standards allow the auditor to emphasize information that is
adequately disclosed in the financial statements. If disclosure were inadequate, the auditor would issue a qualified
or adverse opinion. Answer (c) is incorrect because the opinion is not qualified because of the emphasis paragraph
and therefore phrases such as "with the foregoing explanation" should not be used.
68. (b) If an auditor concludes that the omission of an auditing procedure considered necessary at the time of the
audit, such as physical inventory observation, impairs his or her present ability to support the previously expressed
opinion on the financial statements, and the auditor believes that there are currently people relying on the opinion,
the auditor should promptly undertake to apply the omitted procedure or alternative procedures that would provide a
satisfactory basis for the opinion. Answer (a) is incorrect because the auditor's unqualified opinion should be relied
on if the auditor performs procedures that now provide a satisfactory basis for that unqualified opinion. Answer (c)
is incorrect because if the auditor is now able to perform the omitted procedure or alternative procedures that
provide a basis for the opinion, GAAS is not violated. Answer (d) is incorrect because observation of inventory is a
required substantive test that cannot be replaced by tests of controls.
69. (d) The auditor obtains an understanding of the internal control structure to plan the audit and to determine the
nature, extent and timing of tests to be performed, but makes no reference to the entity's internal control structure in
the standard report on financial statements. In an audit of an entity that receives governmental financial assistance,
the auditor's report would refer to internal control structure and compliance with laws and regulations. The
estimates and accounting principles noted in answers (a) and (b) are referred to in the scope paragraph.
Management's responsibility, answer (d), is included in the introductory paragraph.
70. (a) When an auditor disclaims an opinion or issues an adverse opinion on the financial statements as a whole, he
or she should not then express any opinion on other identified items in the financial statements. Such piecemeal
opinions would tend to overshadow or contradict a disclaimer or adverse opinion. Answer (b) is incorrect because
the auditor is allowed to accept limited reporting engagements that involve reporting on one basic financial
statement and not the others. Answer (c) is incorrect because describing the scope limitation, which is required,
would not eliminate the prohibition on issuing a piecemeal opinion. Answer (d) is incorrect because the auditor
cannot include a statement that a piece of the financial statements was correct when a disclaimer is issued on the
financial statements as a whole.

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71. (c) If the change in accounting principles or in the method of their application has an immaterial affect on the
comparability of the financial statements, the auditor would not refer to consistency in the report. Answer (a) would
be correct if the effect of the change was material. Answer (b) is incorrect because the auditor's concurrence with a
change is implicit unless the auditor takes exception to the change by expressing a qualified or adverse opinion on
the financial statements. Answer (d) is incorrect because a change in accounting principle, if material, is not
referred to in the opinion paragraph, but in an explanatory paragraph following the opinion paragraph.
72. (d) The auditor is required to report on the financial statements presented. If single-year financial statements are
presented and the prior year's financial statements are not presented, the auditor will report on the single-year only.
If the auditor has performed an audit in accordance with generally accepted auditing standards and has concluded
that the single-year financial statements are presented fairly in accordance with generally accepted accounting
principles, he or she can express an unqualified opinion in an unmodified report. Answer (a) is incorrect because a
scope limitation, such as not being able to obtain audited financial statements of a material investee, would cause
the auditor to qualify or disclaim the opinion. Answer (b) is incorrect because if the statement of cash flows is
omitted, the auditor will typically qualify the opinion for inadequate disclosure. Answer (c) is incorrect because if
the auditor wants to emphasize an accounting matter affecting the comparability of financial statements with those
of the preceding year, the auditor will modify the report by adding a separate emphasis paragraph.
73. (a) Rule 203 of the AICPA Code of Professional Conduct states that an auditor shall not express an opinion that
financial statements are presented in conformity with GAAP if such statements contain a departure from
promulgated accounting principles. The rule provides, however, that if the statements contain such a departure from
GAAP and the auditor can demonstrate that due to unusual circumstances the financial statements would otherwise
have been misleading, the auditor can express an unqualified opinion but must describe the departure, its
approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading
statement. This type of situation is very rare. Typically, a departure from GAAP will result in a qualified or
adverse opinion, depending on materiality, as indicated in answer (d). Answers (b), (c) and (d) are incorrect in this
case because an unqualified opinion would be appropriate.
74. (b) The auditor can express an unqualified opinion on the balance sheet because he or she has obtained
sufficient audit evidence for the year-end inventory balance, which is the amount that appears on the year-end
balance sheet. If the auditor is unable to obtain sufficient audit evidence for the opening inventory, the auditor
cannot conclude that cost of goods sold for the year, which is affected by beginning inventory, is fairly stated.
Accordingly, the auditor could not express an unqualified opinion on the income statement. Answers (a), (c) and
(d) are incorrect because the auditor would issue an unqualified opinion on the balance sheet and a disclaimer for
the income statement.
75. (c) The auditor's standard report identifies the financial statements audited in an opening introductory paragraph.
The nature of an audit, which is an examination in accordance with GAAS, is described in a scope paragraph. The
auditor's conclusion regarding the fairness of the financial statements in accordance with GAAP is expressed in a
separate opinion paragraph. Answers (a), (b) and (d) are incorrect because GAAS is referred to in the scope
paragraph and GAAP is referred to in the opinion paragraph.
76. (c) Although the auditor has no responsibility to audit information outside the basic financial statements, he or
she does have some responsibility regarding such information. The extent of such responsibility varies with the
nature of the information. If the supplementary information is required by the FASB or GASB, the auditor should
apply certain limited procedures and should report deficiencies in, or omission of, such information. Answer (a) is
incorrect because the auditor has to perform limited procedures. Answer (b) is incorrect because the auditor's
responsibility extends beyond determining if the information has not been omitted. The auditor is also concerned
with the measurement and presentation of required supplementary information. Answer (d) is incorrect because the
auditor is required to perform limited procedures such as inquires and comparisons, not tests of details of
transactions and balances.

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77. (d) If during his audit the successor auditor becomes aware of information that leads him to believe that
financial statements reported on by the predecessor auditor may require revision, he should request his client to
arrange a meeting among the three parties to discuss the information and to resolve the matter. Answers (a) and (b)
are actions that would not be taken until after discussion with the predecessor auditor. Answer (c) is incorrect
because the client should participate in the initial discussions with the predecessor auditor and because making
inquiries about management integrity will not help to resolve the matter.
78. (c) If financial statements are not in conformity with the FASB Statements regarding the capitalization of leases,
those financial statements are not in accordance with GAAP. If such a departure from GAAP is material, the auditor
would issue a qualified opinion. If the auditor believes that the financial statements as a whole are not presented
fairly in accordance with GAAP as a result of this departure from FASB Statements, he or she would issue an
adverse opinion. Answer (a) is incorrect because this would be a scope restriction that could result in a qualified
opinion or disclaimer, not an adverse opinion. Answer (b) is incorrect because a poor internal control structure
would affect control risk assessment and the design of tests, not the type of auditor's report. Answer (d) is incorrect
because this would result in an explanatory paragraph describing the going concern uncertainty or a disclaimer, not
an adverse opinion.
79. (d) An insufficiency of audit evidence is a scope limitation that would result in a qualified opinion or disclaimer.
The restriction on the audit scope would be described in an explanatory paragraph preceding the opinion paragraph
and referred to in both the scope and opinion paragraphs. Answer (a) is incorrect because reference to the scope
limitation is made in the scope paragraph. Answers (b) and (c) are incorrect because no reference is made to the
scope limitation in the introductory paragraph.
80. (d) When unaudited financial statements are presented in comparative form with audited financial statements,
the financial statements that have not been audited should be clearly marked to indicate their status and either the
report of the prior period should be reissued or the report on the current period should include as a separate
paragraph an appropriate description of the responsibility assumed for the financial statements of the prior period.
Answers (a), (b) and (c) are incorrect because either reissuance or reference in a separate paragraph is acceptable.
81. (d) A continuing auditor should update his or her report on the financial statements of the prior periods
presented on a comparative basis with those of the current period. If the prior period financial statements have been
restated to conform with GAAP, including adequate disclosure, the auditor should express an unqualified opinion
with respect to the restated financial statements. The auditor should disclose all the substantive reasons for the
different opinion in a separate explanatory paragraph preceding the opinion paragraph. The explanatory paragraph
discloses the date of the prior report, the type of opinion expressed, the circumstances causing the auditor to express
a different opinion, and that the updated opinion is different from the previous opinion. Answer (a) is incorrect
because the original report on the prior period does not accompany the updated report. Answer (b) is incorrect
because the updated opinion would be unqualified if the financial statements were restated to include adequate
disclosure, which was the reason for originally qualifying the opinion. Answer (c) is incorrect because the
explanatory paragraph in the updated report would disclose the type of opinion expressed on the prior year's
financial statements.
82. (b) AU 530 states that the independent auditor has two methods available for dating the report when a
subsequent event disclosed in the financial statements occurs after completion of field work but before issuance of
the report. He may use "dual dating," for example, "February 16, 19??, except for Note ?, as to which the date is
March 1, 19??" or he may date the report as of the later date. In the former instance, the responsibility for events
occurring subsequent to the completion of field work is limited to the specific event referred to in the note or
otherwise disclosed. In the latter instance, the independent auditor's responsibility for subsequent events extends to
the date of the report and, accordingly, the subsequent events procedures should be extended to that date.
83. (a) AU 341 states that in performing audit procedures the auditor may identify information about certain
conditions or events that, when considered in the aggregate, indicate there could be substantial doubt about the
entity's ability to continue as a going concern for a reasonable period of time. The significance of such conditions
and events will depend on the circumstances, and some may have significance only when viewed in conjunction
with others. The following are examples of such conditions and events:

3S-9

Negative trends--for example, recurring operating losses, working capital deficiencies, negative cash flows
from operating activities, adverse key financial ratios.
Other indications of possible financial difficulties: default on loan or similar agreements, arrearages in
dividends, denial of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory
capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets.
Internal matters: work stoppages or other labor difficulties, substantial dependence on the success of a
particular project, uneconomic long-term commitments, need to significantly revise operations. External
matters that have occurred-for example, legal proceedings, legislation, or similar matters that might jeopardize
an entity's ability to operate; loss of a key franchise, license, or patent; loss of a principal customer or supplier;
uninsured or underinsured catastrophe such as a drought, earthquake, or flood.

84. (d) AU 508 states that before reissuing (or consenting to the reuse of) a report previously issued on the financial
statements of a prior period, a predecessor auditor should consider whether his previous report on those statements
is still appropriate. Either the current form or manner of presentation of the financial statements of the prior period
or one or more subsequent events might make a predecessor auditor's previous report inappropriate. Consequently, a
predecessor auditor should:
read the financial statements of the current period, compare the prior-period financial statements that he
reported on with the financial statements to be presented for comparative purposes, and
obtain a letter from the successor auditor. The letter of representations should state whether the successor's
audit revealed any matters that in the successor's opinion might have a material effect on, or require disclosure
in, the financial statements reported on by the predecessor auditor.
85. (a) AU 561 states that when subsequently discovered information is found both to be reliable and to have
existed at the date of the auditor's report, the auditor should take action if the nature and effect of the matter are such
that:
the report would have been affected if the information had been known at the date of the report and had not
been reflected in the financial statements and
he believes there are persons currently relying or likely to rely on the financial statements who would attach
importance to the information. Consideration should be given, among other things, to the time elapsed since the
financial statements were issued.
86. (b) If a client does not properly account for or disclose an illegal act, and as a result the financial statements are
materially misstated, the auditor cannot issue an unqualified opinion. Because the auditor knows that the financial
statements contain material departures from GAAP, the auditor should issue a qualified or adverse opinion.
Answers (a) and (c) are incorrect because in this situation the auditor knows that the financial statements are not in
accordance with GAAP and therefore the auditor cannot issue a disclaimer, which is reserved for situations when
the auditor cannot conclude as to whether or not the financial statements are fairly presented. Answer (d) is
incorrect because an unqualified opinion can only be issued when the financial statements are fairly presented in all
material respects, not when the financial statements are materially misstated.
87. (d) If the auditor believes there is substantial doubt about the ability of an entity to continue as a going concern
for a reasonable period of time, the auditor should consider management's plans for dealing with the adverse effects
of the conditions and events that gave rise to the substantial doubt. The auditor's considerations relating to
management's plans may include plans to dispose of assets, plans to borrow money or restructure debt, plans to
reduce or delay expenditures, and plans to increase ownership equity. Postponing expenditures for research and
development projects would be a way of delaying expenditures, which could mitigate the effects of conditions or
events that gave rise to the auditor's substantial doubt. Answer (a) involves discussion of debt terms, which are not
as meaningful as plans to restructure debt. Answer (b) refers to internal controls, which are not mitigating factors
that the auditor would consider. Answer (c) involves the purchase of assets, rather than plans to dispose of assets.

3S-10

88. (c) The auditor may be asked to report on one basic financial statement and not on the others. Such engagements
involve limited reporting objectives. If the auditor has access to information underlying the basic financial
statements and if he applies all the procedures he considers necessary in the circumstances, these engagements do
not involve scope limitations, and the auditor can accept them. Answer (a) is incorrect because there would be no
violation of ethical standards in accepting such an engagement. Answer (b) is incorrect because an opinion on the
balance sheet is not a piecemeal opinion, which is an expression of an opinion as to certain identified items in the
financial statements, not a complete financial statement. Answer (d) is incorrect because a disclaimer would not be
given if there are no scope limitations.
89. (c) The auditor's standard report identifies the financial statements in an opening introductory paragraph,
describes the nature of an audit in a scope paragraph, and expresses the auditor's opinion in a separate opinion
paragraph. A statement included in the scope paragraph is "An audit also includes assessing the accounting
principles used and significant estimates made by management..." Answers (a), (b) and (d) are incorrect because
they are not explicitly stated in the auditor's standard report.
90. (b) If the auditor lacks independence, the auditor should issue a disclaimer of opinion. A qualified opinion is
expressed when there is a lack of sufficient competent evidential matter or there are restrictions on the scope of the
audit, or when the auditor believes that the financial statements contain a material departure from GAAP. Answers
(a) and (c) are reasons for issuing a qualified opinion because they refer to departures from GAAP and to
restrictions on the scope of the audit. Answer (d) is incorrect because the auditor may refer to the work of a
specialist when issuing a qualified opinion if the auditor believes such reference will facilitate an understanding of
the reason for departing from an unqualified opinion.
91. (d) If the auditor is not satisfied that management's justification for a change in accounting principle is justified,
his opinion should be qualified for a departure from GAAP. Material weaknesses in internal control must be
reported to the audit committee and affect the design of substantive tests, but are not noted in the auditor's opinion.
Answers (a), (b) and (c) are incorrect because an unqualified opinion would not be issued when there is a departure
from GAAP, and an explanatory paragraph would not be added for internal control weaknesses.
92. (b) A disclaimer of opinion states that the auditor does not express an opinion on the financial statements. It is
appropriate when the auditor has not performed an audit sufficient in scope to enable him to form an opinion on the
financial statements. A disclaimer would not be appropriate when the auditor determines that the financial
statements contain a departure from GAAP, such as when the client's management does not adequately justify a
change in accounting principle. The other answers are incorrect because they are situations that could give rise to a
disclaimer. Answers (a) and (c) illustrate lack of sufficient competent evidence about the financial statement effects
of a fraud scheme and accounts receivable balances. Answer (d) is a specific departure from generally accepted
auditing standards, which require the auditor to obtain written representations from management.
93. (a) An auditor can issue an unqualified opinion when segments of an entity use different accounting methods, if
those methods are in accordance with GAAP, which they are in this case. Answer (b) is incorrect because lack of
consistency does not give rise to a qualified opinion, and consistency from period to period in accounting methods
is the issue in a consistency paragraph, not consistent use of methods across business segments. Answer (c) is
incorrect because FIFO and LIFO are GAAP. Answer (d) is incorrect because an adverse opinion is issued when the
financial statements as a whole are not presented fairly in accordance with GAAP, which is not the case here.
94. (c) The objective of the fourth standard of reporting is to prevent misinterpretation of the degree of
responsibility the auditor is assuming when his or her name is associated with financial statements. Answer (a) is
incorrect because the auditor may express an unqualified opinion on one of the financial statements and express a
qualified or adverse opinion or disclaim an opinion on another. Answer (b) is incorrect because scope restrictions
are not addressed by reporting standards. Answer (d) is incorrect because the auditor is not prohibited from
reporting on one financial statement and not the others. Reference in the fourth reporting standard to financial
statements taken as a whole applies equally to a complete set of financial statements and to an individual financial
statement.

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95. (d) The auditor's inability to obtain sufficient competent evidential matter, such as being unable to obtain
audited financial statements of a consolidated investee, is a scope limitation that, if material, may cause the auditor
to qualify his opinion or to disclaim an opinion. Answers (a), (b) and (c) are situations that could result in a
paragraph being added to the auditor's report, but would not result in a departure from an unqualified opinion.
Specifically, the auditor can add a paragraph to an unqualified opinion that refers to a change in accounting
principle, omitted quarterly data that are required by the SEC, or a matter that the auditor wants to emphasize such
as a subsequent event.
96. (d) If the financial statements are affected by an uncertainty concerning future events, the outcome of which is
not susceptible of reasonable estimation at the date of the auditor's report, the auditor could add an explanatory
paragraph to the auditor's report to identify the uncertainty. The addition of an uncertainty paragraph does not cause
a departure from an unqualified opinion. However, the auditor is not precluded from disclaiming an opinion in cases
involving uncertainties. Answers (a) and (c) are incorrect because the auditor would consider expressing an adverse
or qualified opinion due to a GAAP violation only if the auditor concludes that a matter involving an uncertainty is
not adequately disclosed in the financial statements. Answer (b) is incorrect because a qualified opinion due to a
scope limitation would only be expressed if the auditor has not obtained sufficient competent evidence to support
management's assertions about the nature of a matter involving an uncertainty.
97. (c) If the financial statements, including footnotes, fail to disclose information that is required by GAAP, the
auditor should express a qualified or adverse opinion. If the opinion is qualified, an additional paragraph would be
added to the report describing the nature of the omitted disclosures, and the opinion paragraph of the report would
include the phrase "except for the omission of the information discussed in the preceding paragraph." Answers (a)
and (b) are incorrect because a qualified opinion should include the word "except" or "exception." The phrases
"subject to" and "with the foregoing explanation" are not clear or forceful enough and should not be used. Answer
(d) is incorrect because the phrase "does not present fairly" is used in an adverse opinion, not a qualified opinion.
98. (d) If the auditor concludes that there is substantial doubt about an entity's ability to continue as a going concern
for a reasonable period of time, the audit report should include an explanatory paragraph following the opinion
paragraph to reflect that conclusion. The auditor's conclusion should be expressed through use of the phrase
"substantial doubt about its (the entity's) ability to continue as a going concern" (or similar wording that includes the
terms "substantial doubt" and "going concern"). Answers (a), (b) and (c) are incorrect because the report is not
required to include phrases such as "possible discontinuance of operations" or "reasonable period of time, not to
exceed one year."
99. (a) If substantial doubt about the entity's ability to continue as a going concern existed at the date of prior period
financial statements that are presented on a comparative basis, and that doubt has been removed in the current
period, the explanatory paragraph included in the auditor's report on the financial statements of the prior period
should not be repeated. Answers (b), (c) and (d) are incorrect because the explanatory paragraph is not repeated. nor
is any other explanatory paragraph regarding the going concern issue of the prior period included.
100. (b) The auditor's standard report implies that the auditor is satisfied that the comparability of financial
statements between periods has not been materially affected by changes in accounting principles and that such
principles have been consistently applied between periods. Therefore. if the auditor is able to gather sufficient
evidence about consistency in the first audit of a new client or in a recurring audit, no reference to consistency
would be made in the report. Answer (a) is incorrect because the auditor can report on the income statement in this
case. If the auditor were unable to obtain sufficient evidence about the consistent application of accounting
principles as well as to the amounts of assets and liabilities at the beginning of the current period, then the auditor
would be unable to express an opinion on the current year's income statement. Answer (c) is incorrect because the
consistency standard of reporting, which states that the report shall identify those circumstances in which such
principles have not been consistently observed in the current period in relation to the preceding period, applies to
new and continuing audit clients. Answer (d) is incorrect because reference is not made to consistency when
accounting principles have been consistently applied.

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101. (a) If, during the current audit, an auditor becomes aware of circumstances or events that affect the financial
statements of a prior period, the auditor should consider such matters when updating his or her report on the
financial statements of the prior period. For example, if a qualified or adverse opinion had been expressed on
financial statements of a prior period because of a departure from GAAP, and those financial statements are restated
in the current period to conform with GAAP, the auditor's updated report should indicate that the financial
statements have been restated and should express an unqualified opinion with respect to those restated financial
statements. Answer (b) is incorrect because the predecessor auditor would not change a previously issued opinion if
that auditor's report was still appropriate. Answer (c) is incorrect because a lack of consistency in the current period
would not result in a change of an opinion on prior period financial statements. Answer (d) is incorrect because the
auditor's opinion on prior period financial statements is not affected if those financial statements are properly
restated for a pooling of interests, as required by GAAP.
102. (d) If the financial statements of a prior period have been audited by a predecessor auditor whose report is not
presented, the successor auditor should indicate in the introductory paragraph of his report that the financial
statements of the prior period were audited by another auditor, the date of his report, the type of report issued by the
predecessor auditor, and if the report was other than a standard report, the substantive reasons therefor. Answers (a),
(b) and (c) are incorrect because the successor auditor should not name the predecessor auditor, should indicate the
type of report issued by the predecessor auditor, and should indicate the substantive reasons for the predecessor
auditor's qualification.
103. (a) When a principal auditor decides not to assume responsibility for the work of an other auditor insofar as
that work relates to the principal auditor's expression of an opinion on the financial statements as a whole, the
principal auditor's report should make reference to the audit of the other auditor. In such a case, the introductory
paragraph of the principal auditor's report should disclose the magnitude of the portion of the financial statements
audited by the other auditor, as was done in this example. Answer (b) is incorrect because if the principal auditor
decides to assume responsibility for the work of the other auditor, no reference would be made to the other auditor's
work or report. Answer (c) is incorrect because reference to the fact that part of the audit was made by another
auditor is not to be construed as a qualification of the opinion but rather as an indication of divided responsibility.
Answer (d) is incorrect because reference to an other auditor is proper in certain circumstances.
104. (a) If an auditor is retained to audit the financial statements of a company that is not his client, the report is
customarily addressed to the client and not to the directors or stockholders of the company whose financial
statements are being audited. Answers (b), (c) and (d) are incorrect because, in this situation, the report would not
be addressed to the entity being audited nor to users of the financial statements, but rather to Monday Corp., who is
the client.
105. (c) Per S.A.S. #59, if there is substantial doubt about an entity's ability to continue as a going concern and the
financial statements adequately disclose that fact, the auditor must add a fourth paragraph to his/her report referring
to the footnote that discloses the problem. The additional paragraph must use the terms "Substantial doubt" and
"going concern," but nothing about "reasonable period of time, not to exceed one year."
106. (a) The results of operations (income statement) and cash flows (statement of cash flows) of financial
statements are for a period of time, usually for a year. If the auditor is unable to establish a starting point (beginning
of year), an opinion cannot be formed because the opening balances cannot be verified. Therefore, the audit may be
able to establish ending balance but if the opening balance cannot be established, it is impossible to conclude on
what transpired during the year.
107. (a) Information that accompanies the basic financial statements is known as supplementary information. Under
GAAS, the auditor must report on the responsibility he/she is taking with respect to such material.

3S-13

Chapter Three - Solutions to Problems

Standards of Reporting

NUMBER 1
Circumstances

Type of Opinion

Report Modification

2. The scope of the auditors

examination is affected by
conditions that preclude the
application of a necessary auditing
procedure.

2. The auditor should express an

except for qualified opinion or a
disclaimer of opinion.

2. The auditor should indicate the

scope limitation in the scope
paragraph, give the substantive
reasons for the limitation in an
explanatory paragraph, and modify
the opinion paragraph.

3. The auditor decides to make

reference to the report of another
auditor as a basis, in part, for
expressing an opinion.

3. The auditor should express an

unqualified opinion.

3. The auditor should disclose this

division of responsibility in the
scope paragraph and refer to the
other auditors report in the opinion
paragraph.

4. The financial statements are

affected by an alternative
accounting treatment that is a
departure from an accounting
principle promulgated by the body
designated by the AICPA Council
to establish such principles. The use
of the promulgated principle would
cause the financial statements to be
misleading.

4. The auditor should express an

unqualified opinion.

4. The auditor should give all of the

substantive reasons why unusual
circumstances justify the use of an
alternative accounting treatment in
an explanatory paragraph.

5. The generally accepted accounting

principles have not been applied
consistently.

5. The auditor should express an

unqualified opinion as to
consistency.

5. The auditor would add an

additional paragraph to his report
discussing the change.

6. The auditor wishes to emphasize a

matter that is properly accounted
for and adequately disclosed in the
financial statements.

6. The auditor should express an

unqualified opinion.

6. The auditor should describe the

matter in an explanatory paragraph.

3S-14

NUMBER 2

1.
2.
3.
4.
5.
6.
7.

Types of
Opinions
F
B
B
A
B
B
E

Report
Modifications
L
I
Q
J
I
H
J

NUMBER 3
91.

E,P

When the auditor expresses an unqualified opinion, the report should not refer to the work or findings
of the specialist because it might be misunderstood to be a qualification of the auditor's opinion or a
division of responsibility, neither of which is intended. If the specialist's findings which constitute
sufficient competent evidential matter do not support the financial statements, the auditor can refer to
them in an explanatory paragraph if the reference facilitates understanding for a possible qualified
opinion. This is not the case and does not apply here.

92.

A,I

This is a departure from generally accepted accounting principles, due to the failure to adjust for the
decline of the note which results in either a qualified or adverse opinion due to its materiality. The
introductory and scope paragraphs of the standard report are not modified. An explanatory paragraph
is added and the opinion paragraph is modified to include a reference to the separate paragraph that
discloses the basis for the qualified or adverse opinion.

93.

B,J

This is a scope limitation which leads to either a qualified opinion or a disclaimer, depending on the
materiality of the missing evidence. An explanatory paragraph describing the scope limitation should
be added and both the scope and opinion paragraphs are modified to reflect the information contained
in the explanatory paragraph.

94.

E,H

The supplementary information which is not audited and not a required part for the fair presentation of
the financial statements would not alter the unqualified opinion rendered by the auditor. However,
since GASB requires for the information to be presented, an explanatory paragraph would have to be
added to disclose the omission.

95.

A,I

This is a departure from a generally accepted accounting principle due to inadequate disclosure, and
depending on how pervasive and material the effect is, a qualified or adverse opinion should be
rendered. The auditor should disclose in a separate explanatory paragraph, preceding the opinion, the
substantive reasons that have led him/her to conclude that there has been a departure from GAAP.
Furthermore, the opinion paragraph of the report should be modified to include appropriate language
and a reference to the explanatory paragraph.

96.

E,O

AU 543 states that if a principal auditor decides not to assume responsibility for the work of the other
auditor insofar as that work relates to the principal auditor's expression of an opinion, the report should
make reference to the audit of the other auditor and should indicate clearly the division of
responsibility. When the principal auditor decides to make reference to the audit of the other auditor,
the report should indicate clearly, in the introductory, scope, and opinion paragraphs, the division of
responsibility between that portion of the financial statements covered by his or her own audit and that
covered by the audit of the other auditor. The report should disclose the magnitude of the portion of
the financial statements audited by the other auditor. This does not preclude the auditor from issuing
an unqualified opinion.

3S-15

97. E,H This is a consistency problem due to a change in accounting principles that has a material effect on the
comparability of the company's financial statements. The auditor should refer to the change in an explanatory
paragraph of the report following the opinion, identifying the nature of the change and refer the reader to the note in
the financial statements that discusses the change in detail.
98.

E,H

AU 341 states that the auditor has a responsibility to evaluate whether there is substantial doubt about
the entity's ability to continue as a going concern for a reasonable period of time, not to exceed one
year beyond the date of the financial statements being audited. Depending on the magnitude, when
going concern questions exist, the auditor may issue:

A standard report with an unqualified opinion paragraph and an additional explanatory paragraph to
direct attention to management's disclosures about the problem.
A disclaimer of opinion, resulting from massive uncertainty about the ability of the business to
continue. Both the introductory and scope paragraphs are modified, an explanatory paragraph is added,
and no opinion is rendered.
An adverse or qualified opinion for GAAP departure if the auditor believes the company's disclosures
about financial difficulties and going concern problems are inadequate.
A report qualified for a scope limitation if evidence that does exist or did exist is not made available to
the auditor, leading to an "except for" type of qualified opinion.

NUMBER 4
91.

92.

93.

94.

95.

96.

97.

98.

99.

100.

101.

102.

103.

104.

105.

3S-16

NUMBER 5
1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

NUMBER 6
Land's criticism is Correct/Incorrect
61.

Correct

62.

Incorrect

63.

Incorrect

64.

Incorrect

65.

Incorrect

66.

Incorrect

67.

Correct

68.

Correct

69.

Correct

70.

Incorrect

71.

C.

Correct

72.

Correct

73.

Correct

3S-17

Chapter Four
Attestation Standards, Government Auditing
Standards, Quality Control Standards
ATTESTATION STANDARDSSSAE No. 10, Section 101
I.

Applies to both public and non-public entities.

II. Attestation Engagement DefinedAn engagement that must have the following three elements:
1. A practitioner is engaged to issue or does issue a written communication.
2. The written communication expresses a conclusion about the reliability of a written assertion made by a
party on certain subject matter or directly on the presentation of the subject matter itself.
3. The practitioners report and the written assertion is or is reasonably expected to be used by a third party.
III. Levels of attestation:
1. Positive AssuranceReports that express conclusions on the basis of an "examination".
2. Negative AssuranceReports that express conclusions on the basis of a review.
3. Reporting on the application of agreed-upon procedures.
IV. Examples of attestation engagements:
Descriptions of the internal control structure.
Descriptions of computer software.
Compliance with statutory, regulatory and contractual requirements.
Investment performance statistics.
Information supplementary to financial statements.
V. Types of engagements that are not considered to be attest engagements:
Auditing, reviewing or compiling historical financial statements.
Management consulting engagements in which the practitioner is engaged to provide advice or
recommendations to a client.
Engagements in which the practitioner is engaged to advocate a client's position (e.g., tax matters under
review by the IRS).
Tax preparation or tax advice engagements.
Engagements in which the practitioner's role is solely to assist the client, for example:
Acting as the company accountant in preparing information other than financial statements.
Serving as an expert witness.
Providing an expert opinion on certain points of principle, such as the application of tax laws or
accounting standards, based on facts provided by another party (so long as the expert opinion does not
express a conclusion about the reliability of the facts provided by the other party).

4-1

VI. The Eleven Attestation Standards:

STANDARDS

EXPLANATION
GENERAL STANDARDS

1.

The engagement shall be performed by a

practitioner or practitioners having adequate
technical training and proficiency in the attest
function.

Formal education and experience in gathering

evidence as well as technical expertise in the
field of public accounting.

2.

The engagement shall be performed by a

practitioner having adequate knowledge in the
subject matter of the assertion.

A practitioner may obtain adequate knowledge

through formal or continuing education, or
through the use of specialists.

3.

The practitioner shall perform an engagement

only if he or she has reason to believe that the
following two conditions exist:

The assertion is capable of evaluation

against reasonable criteria that either
have been established by a recognized
body or are stated in the presentation of
the assertion in a sufficiently clear and
comprehensive manner for a
knowledgeable reader to be able to
understand them.
The assertion is capable of reasonably
consistent estimation or measurement
using such criteria.

Examples include AICPA designated bodies

(i.e., FASB), regulatory agencies, industry
associations, etc.

Reasonable criteria are those which yield useful

information. To be useful, the information must
be both relevant and reliable. Thus, subjective
criteria are not subject to attestation.

4.

In all matters relating to the engagement, an

independence in mental attitude shall be
maintained by the practitioner or practitioners.

The practitioner should maintain intellectual

honesty and impartiality necessary to reach an
unbiased conclusion. See the discussion of
independence in Rule 101 of the Code of
Conduct.

5.

Due professional care shall be exercised in the

performance of the engagement.

Requires the critical review at every level of

supervision of the work done and the judgment
exercised by members participating in the
engagement.

STANDARDS OF FIELD WORK

1.

The work shall be adequately planned and

assistants, if any, shall be properly supervised.

Refer to Chapter 1 for guidance with respect to

planning and supervision.

2.

Sufficient evidence shall be obtained to provide

a reasonable basis for the conclusion that is
expressed in the report.

The attestor should select and apply procedures

that will accumulate evidence that is sufficient in
the circumstances to afford a reasonable basis
for the level of assurance to be expressed.

4-2

STANDARDS OF REPORTING
1.

The report shall identify the assertion being

reported on and state the character of the
engagement.

See report examples that follow.

2.

The report shall state the practitioner's

conclusion about whether the assertion is
presented in conformity with the established or
stated criteria against which it was measured.

See report examples that follow.

3.

The report shall state all of the practitioner's

significant reservations about the engagement,
subject matter, and, if applicable, the assertion
related thereto.

See report examples that follow.

4.

The report on an engagement to evaluate an

assertion that has been prepared in conformity
with agreed-upon criteria or on an engagement
to apply agreed-upon criteria should contain a
statement limiting its use to the parties who have
agreed upon such criteria or procedures.

See report examples that follow.

VII. Description of Procedures and Nature of Report

A. Examination
An examination engagement is intended to provide the highest level of assurance on an assertion. The
objective is to accumulate sufficient evidence to limit attestation risk to a level that is appropriately low for
the high level of assurance to be given by the report. The auditor should perform whatever procedures are
necessary to limit attestation risk to an appropriately low level. The report may express a positive opinion
(or a qualified or modified opinion) on the presentation of assertions taken as a whole (positive assurance).
B. Review
A review engagement should be designed to accumulate sufficient evidence to limit attestation risk to a
moderate level. Generally this is accomplished by performing inquiries and analytical procedures. The
report should state whether any information came to our attention, on the basis of the work performed, that
indicates that the assertions are not presented in all material respects in conformity with established or
stated criteria (negative assurance).
C. Agreed-upon procedures or criteria
These engagements are designed solely to meet the needs of specified users who have participated in
establishing the nature and scope of the engagement. Only those procedures that have been designed or
agreed to by such users need be performed. Such procedures generally may be as limited or extensive as
the users desire, except that the mere reading of the assertions ordinarily is not adequate for the auditor to
report on the results of applying agreed-upon procedures.
VIII. Examples of Attestation Reports
A. Examinations
1. Highest level of assurance
2. Expresses positive opinion on assertions
3. Report may be unqualified or qualified or otherwise modified for some aspect of the presentation.
4. Example of unqualified report:

4-3

I have examined the accompanying statistics and operating data included in the
ABC brochure dated September 30, 19X1. My examination was conducted in
accordance with the standards established by the AICPA and accordingly
included such procedures as we considered necessary in the circumstances.
In my opinion, the statistics and operating data included in the ABC brochure
dated September 30, 19X1, fairly present the information in conformity with the
criteria explained in Note 1 to the data.
B. Review
1. Provides negative assurance
2. Disclaims an opinion (positive assurance)
3. Report may be modified if anything comes to the attestor's attention that the assertions are not
presented in conformity with the established criteria.
4. Example of review report:
I have reviewed the accompanying statistics and operating data included in the
ABC brochure dated September 30, 19X1. My review was conducted in
accordance with the standards established by the AICPA.
A review is substantially less in scope than an examination, the objective of
which is the expression of an opinion on the fairness of the statistics and
operating data in the ABC brochure in conformity with the criteria explained in
Note 1 accompanying the data. Accordingly, we do not express an opinion.
Based upon my review, nothing came to my attention that caused me to believe
that the accompanying statistics and operating data included in the ABC
brochure dated September 30, 19X1, are not presented in accordance with the
criteria explained in Note 1 accompanying the data.
C. Agreed-Upon Procedures
1. Provides a summary of findings.
2. Disclaims an opinion and restricts use of report to named parties.
3. Example of attestor's report on agreed-upon procedures:

Independent Accountant's Report

on Applying Agreed-Upon Procedures
To the Audit Committees and Managements of ABC Inc. and XYZ Fund:
We have performed the procedures enumerated below, which were agreed to by the audit
committees and managements of ABC Inc. and XYZ Fund, solely to assist you in evaluating the
accompanying Statement of Investment Performance Statistics of XYZ Fund (prepared in
accordance with the criteria specified therein) for the year ended December 31, 19X1. This
agreed-upon procedures engagement was performed in accordance with standards established by
the American Institute of Certified Public Accountants. The sufficiency of these procedures is
solely the responsibility of the specified users of the report. Consequently, we make no
representation regarding the sufficiency of the procedures described below either for the purpose
for which this report has been requested or for any other purpose.
[Include paragraphs to enumerate procedures and findings.]

4-4

We were not engaged to, and did not, perform an examination, the objective of which would be
the expression of an opinion on the accompanying Statement of Investment Performance Statistics
of XYZ Fund. Accordingly, we do not express such an opinion. Had we performed additional
procedures, other matters might have come to our attention that would have been reported to you.
This report in intended solely for the use of the audit committees and managements of ABC Inc.
and XYZ Fund, and should not be used by those who have not agreed to the procedures and taken
responsibility for the sufficiency of the procedures for their purposes.

REPORTING ON AN ENTITY'S INTERNAL CONTROL OVER FINANCIAL

REPORTING SSAE No. 10, Section 501
I.

The standard applies to opinions on a client's internal control.

II. Under the SSAE, the client makes an assertion about the effectiveness of its internal control over financial
reporting.

The assertion can be explicit (that is, in a report) or implicit (that is, in a representation letter to the
accountant).

Management's assertion is as of a point in time; not for period of time.

III. The following conditions have to exist in order for an accountant to accept an engagement to examine and
provide an opinion on internal control:

Management presents its written assertion about the effectiveness of control either in a separate report or in
a representation letter to the accountant. If management presents its assertion only in a representation letter,
the accountant should limit the distribution of his or her report to management and specified regulatory
agencies.

Management accepts responsibility for the effectiveness of the internal control.

Management evaluates internal control using reasonable criteria established by a recognized body.

Sufficient competent evidential matter exists to support management's evaluation.

IV. In performing the examination, the accountant should:

Obtain an understanding of the internal control components.

Test and evaluate the effectiveness of the design and operation of internal control policies and procedures
in the internal control components.

These tests are similar to tests of controls done as part of an audit. They focus on: how the control policy or
procedure was applied, who applied it, and how consistently it was applied.

Although the report is as of a point in time, the accountant should perform the tests of control over a period
of time that is adequate to determine, as of the date of management's assertion, whether the policies and
procedures necessary for achieving the control objectives are operating effectively.

If management's assertion about the control structure includes the effectiveness of controls over the
preparation of interim financial statements, the accountant should test those controls as well.

4-5

Obtain a representation letter in which management acknowledges its responsibility for the controls, states
its assertion about their effectiveness, and discusses the existence of any reportable conditions,
irregularities, or subsequent changes in the control structure. Refusal of management to supply a
representation constitutes a scope limitation and the accountant is precluded from issuing an unqualified
opinion.

V. Accountant's examination report:

If the internal control structure over financial reporting is effective, the accountant renders an unqualified
report.

If the internal control structure contains one or more material weaknesses, it is not wholly effective. In
that case, the accountant's report should be modified to discuss the weakness. The specific modification
depends on whether management's report acknowledges the weakness and the pervasiveness of the effect
on the control structure's effectiveness.

VI.

Report on Internal Control When Management's Assertion is

Presented in a Separate Report -- Unqualified Opinion
Independent Accountant's Report
We have examined management's assertion (identify management's assertion - for example, that
W Company maintained effective internal control over financial reporting as of December 31,
19XX) included in the accompanying (title of management's report).
Our examination was made in accordance with standards established by the American Institute of
Certified Public Accountants and, accordingly, included obtaining an understanding of the
internal controls over financial reporting, testing and evaluating the design and operating
effectiveness of the internal control structure, and such other procedures as we considered
necessary in the circumstances. We believe that our examination provides a reasonable basis for
our opinion.
Because of the inherent limitations in internal control, errors or irregularities may occur and not be
detected. Also, projections of any evaluation of internal control over financial reporting to future
periods are subject to the risk that internal control may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assertion (identify management's assertion - for example, that W
Company maintained an effective internal control structure over financial reporting as of
December 31, 19XX) is fairly stated, in all material respects, based upon (identify established or
stated criteria).

4-6

Material Weakness -- Qualified Opinion

Independent Accountant's Report
Opinion paragraph:
In our opinion, management's assertion that, except for the effect of the material weakness
described in its report, (identify management's assertion) is fairly stated, in all material respects,
based upon (identify established or stated criteria).
Explanatory paragraph:
As discussed in management's assertion, the following material weakness exists in the design or
operation of the internal controls of W Company in effect at (date). (Describe the material
weakness and its effect on the achievement of the objectives of the control criteria.) A material
weakness is a condition that precludes the entity's internal control from providing reasonable
assurance that material misstatements in the financial statements will be prevented or detected on
a timely basis.

Material Weakness -- Adverse Opinion

Independent Accountant's Report
Explanatory paragraph (after introductory, scope, and inherent limitations paragraphs):
Our examination disclosed the following condition, which we believe is a material weakness in
the design or operation of the internal controls of W Company in effect at (date). (Describe the
material weakness and its effect on the achievement of the objectives of the control criteria.) A
material weakness is a condition that precludes the entity's internal controls from providing
reasonable assurance that material misstatements in the financial statements will be prevented or
detected on a timely basis.
Opinion paragraph:
In our opinion, because of the effect of the material weakness described above on the achievement
of the objectives of the control criteria, management's assertion (identify management's assertion)
is not fairly stated based upon (identify established or stated criteria).

VII.

Report on Internal Control When Management's Assertion is

Presented Only in the Representation Letter
Independent Accountant's Report
We have examined management's assertion, included in its representation letter dated February
14, 19XY, that (identify management's assertion - for example, that W Company maintained
effective internal control over financial reporting as of December 31, 19XX).
Our examination was made in accordance with standards established by the American Institute of
Certified Public Accountants and, accordingly, included obtaining an understanding of the
internal control structure over financial reporting, testing and evaluating the design and operating
effectiveness of the internal controls, and such other procedures as we considered necessary in the
circumstances. We believe that our examination provides a reasonable basis for our opinion.
Because of the inherent limitations in internal control, errors or irregularities may occur and not be
detected. Also, projections of any evaluation of internal control over financial reporting to future

4-7

periods are subject to the risk that internal control may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assertion (identify management's assertion - for example, that W
Company maintained effective internal control over financial reporting as of December 31, 19XX)
is fairly stated, in all material respects, based upon (identify established or stated criteria).
This report is intended for the information and use of the board of directors and management of W
Company (and, if applicable, a specified regulatory agency) and should not be used by third
parties for any other purpose.

COMPLIANCE ATTESTATION SSAE No. 10, Section 601

This SSAE provides general guidance to auditors who are engaged to perform services on management's written
assertion about its compliance with specified requirements, such as laws and regulations.
I.

Types of engagements are examinations of and application of agreed-upon procedures to:

An entity's compliance with requirements of specified laws, regulations, rules, contracts, or grants and/or

The effectiveness of an entity's internal control structure over compliance with such requirements.

The accountant is prohibited from performing a review of these matters.

II. The CPA should:

Plan the engagement

Obtain an understanding of the client's internal controls over compliance with specified requirements in an
examination engagement.

Test the entity's compliance with the specified requirements.

Report on management's assertion.

III. Illustrative Report

Independent Accountant's Report
on Applying Agreed-Upon Procedures
We have performed the procedures enumerated below, which were agreed to by [list specified
users of report], solely to assist the users in evaluating management's assertion about [name of
entity]'s compliance with [list specified requirements] during the [period] ended [date], included in
the accompanying [title of management report]. This agreed-upon procedures engagement was
performed in accordance with standards established by the American Institute of Certified Public
Accountants. The sufficiency of these procedures is solely the responsibility of the specified users
of the report. Consequently, we make no representation regarding the sufficiency of the procedures
described below either for the purpose for which this report has been requested or for any other
purpose.
[Include paragraphs to enumerate procedures and findings.]

4-8

We were not engaged to, and did not, perform an examination, the objective of which would be the
expression of an opinion on management's assertion. Accordingly, we do not express such an
opinion. Had we performed additional procedures, other matters might have come to our attention
that would have been reported to you.
This report is intended solely for the use of [list or refer to specified users] and should not be used
by those who have not agreed to the procedures and taken responsibility for the sufficiency of the
procedures for their purposes.

FINANCIAL FORECASTS AND PROJECTIONS (PROSPECTIVE FINANCIAL

INFORMATION) SSAE No. 10, Section 301
A. Standards for these engagements part of SSAE No. 1 referred to earlier.
B. These standards apply to financial statements for a future period that take the form of historical financial
statements. These standards do not apply to cash budgets, sales forecasts, and the like.
C. Definitions:
1. Financial ForecastProspective financial statements that present to the best of the preparing party's
knowledge and belief, an entity's expected financial position, results of operations, and cash flows. A
forecast is based upon assumptions reflecting conditions the entity expects to exist and the course of action
management expects to take.
2. Financial ProjectionProspective financial statements that present to the best of the responsible party's
knowledge and belief, given one or more hypothetical assumptions, an entity's financial position, results of
operations, and cash flows.
3. Hypothetical AssumptionAssociated with financial projections only. Takes the form of a "what if"
statement (i.e., what would happen if ...).
4 Responsible PartyThe entity and the individuals within the entity responsible for the preparation of the
Prospective Information.
5. General use -- Refers to the use of the prospective financial statements by users that the responsible party is
not negotiating with directly. Users are not able to discuss the contents of the financial statements and
possible outcomes directly with the responsible party. Only financial forecasts are appropriate for general
use.
6. Limited use -- Refers to the use of prospective financial statements by the responsible party alone or by the
responsible party and a third party that the responsible party is negotiating with directly. Third party users
would then be able to ask questions of the responsible party. Any type of prospective financial statements
(forecast or projection) would thus be appropriate.
D. Format for Prospective Financial Statements
1. The format is the same format used by the entity to prepare its historical financial statements including all
footnotes.
2. Must include summary of significant assumptions.
3. The AICPA has separately issued guidelines for the preparation of prospective financial statements (refer
subsequently herein as AICPA presentation guidelines).
E. Accountant's Services
1. Compilation
a. Involves an assembly to the extent necessary
b. Involves consideration of whether, in the accountant's judgment, the underlying assumptions appear to
be obviously inappropriate with respect to the financial forecast
c. Involves reading the financial forecast and considering whether it appears to be presented in
conformity with AICPA presentation guidelines.

4-9

2.

3.

Examination
a. Evaluating the preparation of the prospective financial statements
b. Evaluating the support underlying the significant assumptions
c. Evaluating the presentation for conformity with AICPA presentation guidelines
d. Issuing a report
Agreed-upon Procedures
a.The service, applying agreed-upon procedures, may be performed only if:
1) The specified users involved have participated in establishing the nature and scope of the
engagement and take responsibility for the adequacy of the procedures.
2) Distribution of the report is restricted to specified users.
3) The prospective statements include a summary of significant assumptions.
4) The accountant is independent.
b. The accountant's procedures, in general, may be as limited or extensive as the specified users desire, as
long as the specified users take responsibility for their adequacy. However, merely reading the
statements does not constitute a procedure sufficient to permit an accountant to report on the results of
applying agreed-upon procedures.

F. Report Examples
1. CompilationStandard Report - Forecast:
We have compiled the accompanying forecasted balance sheet, statements of income, retained
earnings, and cash flows of XYZ Company as of December 31, 19XX, and for the year then
ending, in accordance with standards established by the American Institute of Certified Public
Accountants.
A compilation is limited to presenting in the form of a forecast information that is the
representation of management and does not include evaluation of the support for the assumptions
underlying the forecast. We have not examined the forecast and, accordingly, do not express an
opinion or any other form of assurance on the accompanying statements or assumptions.
Furthermore, there will usually be differences between the forecasted and actual results, because
events and circumstances frequently do not occur as expected, and those differences may be
material. We have no responsibility to update this report for events and circumstances occurring
after the date of this report.
A compilation report on a financial projection would require the following paragraph restricting its
distribution:
The accompanying projection and this report were prepared for (state purpose,
for example, "the DEF Bank for the purpose of negotiating a loan to expand
XYZ Company's plant,") and should not be used for any other purpose.
Potential modifications to compilation reports on forecasts or projections:

Lack of independence - must be disclosed.

Presentation not in conformity with AICPA Presentation Guidelines.
Omission of disclosures other than significant assumptions.

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2.

Examinations
a. Standard unqualified opinion:
Projection
We have examined the accompanying projected balance sheet, statements of income, retained
earnings, and cash flows of XYZ Company as of December 31, 19XX, and for the year then
ending. Our examination was made in accordance with standards for an examination of a
projection established by the American Institute of Certified Public Accountants and,
accordingly, included such procedures as we considered necessary to evaluate both the
assumptions used by management and the preparation and presentation of the projection.
The accompanying projection and this report were prepared for [state special purpose, for
example, "the DEF National Bank for the purpose of negotiating a loan to expand XYZ
Company's plant"], and should not be used for any other purpose. **
In our opinion, the accompanying projection is presented in conformity with guidelines for
presentation of a projection established by the American Institute of Certified Public
Accountants, and the underlying assumptions provide a reasonable basis for management's
projection [describe the hypothetical assumption, for example, "assuming the granting of the
requested loan for the purpose of expanding XYZ Company's plant as described in the
summary of significant assumptions"]. However, even if [describe hypothetical assumption,
for example, "the loan is granted and the plant is expanded"], there will usually be differences
between the projected and actual results, because events and circumstances frequently do not
occur as expected, and those differences may be material. We have no responsibility to
update this report for events and circumstances occurring after the date of this report.
**

In the report on Financial Forecast, this paragraph would not be needed.

b.

Summary of Modifications to Accountants' Examination of a Financial Projection or Financial

Forecast
1) Departure from AICPA Presentation Guidelines
Qualified or Adverse
2) Failure to Disclose Significant Assumptions
Adverse
3) Assumptions Not Consistent with Forecast or Projection
Adverse
4) Scope Limitations
Disclaim

c.

Example of an examination report resulting in an adverse opinion:

We have examined the accompanying forecasted balance sheet, statements of income,
retained earnings, and cash flows of XYZ Company as of December 31, 19XX, and for the
year then ending. Our examination was made in accordance with standards for an
examination of a financial forecast established by the American Institute of Certified Public
Accountants and, accordingly, included such procedures as we considered necessary to
evaluate both the assumptions used by management and the preparation and presentation of
the forecast.
As discussed under the caption "Sales" in the summary of significant forecast assumptions,
the forecasted sales include, among other things, revenue from the Company's federal defense
contracts continuing at the current level. The Company's present federal defense contracts

4-11

will expire in March 19XX. No new contracts have been signed and no negotiations are under
way for new federal defense contracts. Furthermore, the federal government has entered into
contracts with another company to supply the items being manufactured under the Company's
present contracts.
In our opinion, the accompanying forecast is not presented in conformity with guidelines for
presentation of a financial forecast established by the American Institute of Certified Public
Accountants because management's assumptions, as discussed in the preceding paragraph, do
not provide a reasonable basis for management's forecast. We have no responsibility to
update this report for events or circumstances occurring after the date of this report.
3.

Agreed-Upon ProceduresFollowing is an example of a report resulting from applying agreed-upon

procedures:
Independent Accountant's Report
on Applying Agreed-Upon Procedures
Board of Directors -- XYZ Corporation
Board of Directors -- ABC Company
At your request, we have performed certain agreed-upon procedures, as enumerated below, with
respect to the forecasted balance sheet and the related forecasted statements of income, retained
earnings, and cash flows of DEF Company, a subsidiary of ABC Company, as of December 31,
19XX, and for the year then ending. These procedures, which were agreed to by the Boards of
Directors of XYZ Company and ABC Company, were performed solely to assist you in
evaluating the forecast in connection with the proposed sale of DEF Company to XYZ
Corporation. This agreed-upon procedures engagement was performed in accordance with
standards established by the American Institute of Certified Public Accountants. The sufficiency
of these procedures is solely the responsibility of the specified users of the report. Consequently,
we make no representation regarding the sufficiency of the procedures described below either for
the purpose for which this report has been requested or for any other purpose.
[Include paragraphs to enumerate procedures and findings.]
We were not engaged to, and did not, perform an examination, the objective of which would be
the expression of an opinion on the accompanying prospective financial statements. Accordingly,
we do not express an opinion on whether the prospective financial statements are presented in
conformity with AICPA presentation guidelines or on whether the underlying assumptions
provide a reasonable basis for the presentation. Had we performed additional procedures, other
matters might have come to our attention that would have been reported to you. Furthermore,
there will usually be differences between the forecasted and actual results, because events and
circumstances frequently do not occur as expected, and those differences may be material. We
have no responsibility to update this report for events and circumstances occurring after the date
of this report.
This report is intended solely for the use of the Boards of Directors of ABC Company and XYZ
Corporation and should not be used by those who have not agreed to the procedures and taken
responsibility for the sufficiency of the procedures for their purposes.

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REPORTING ON PRO FORMA FINANCIAL INFORMATION SSAE No. 10,

Section 401
I.

APPLICABILITY
A. This standard provides guidance when an accountant is engaged to examine or review and report on pro
forma financial information.
B. The accountant should comply with the general and field work standards set forth in the Statement on
Standards for Attestation Engagement.

II. DESCRIPTIONPRO FORMA FINANCIAL INFORMATION

A. The objective of pro forma financial information is to show what the significant effects on historical
financial information might have been had a consummated or proposed transaction or event occurred
at an earlier date.
B. Exampleseffect of:
Business combination
Disposition of part of business
Proposed sale of securities
III. CONDITIONS FOR REPORTING
A. The accountant may agree to report on pro forma information if the following conditions are met:
1. The document that contains the pro forma financial information includes complete historical financial
statements of the entity for the most recent year or interim period, if applicable.
2. The historical financial statements on which the pro forma financial information is based have been
audited or reviewed.
3. The accountant who is reporting on the pro forma information should have an appropriate level of
knowledge of the accounting and financial reporting practices of the reporting entity.
IV. ACCOUNTANTS OBJECTIVES
A. The objective of the accountants examination procedures applied to pro forma financial information is to
provide reasonable assurance as to whether
Managements assumptions provide a reasonable basis for presenting the significant effects directly
attributable to the underlying transaction (or event).
The related pro forma adjustments give appropriate effect to those assumptions.
The pro forma column reflects the proper application of those adjustments to the historical financial
statements.
B. The objective of the accountants review procedures applied to pro forma financial information is to
provide negative assurance as to whether any information came to the accountants attention to cause him
or her to believe that:
Managements assumptions do not provide a reasonable basis for presenting the significant effects
directly attributable to the transaction (or event).
The related pro forma adjustments do not give appropriate effect to those assumptions.
The pro forma column does not reflect the proper application of those adjustments to the historical
financial statements.
V. PROCEDURES
A. Obtain an understanding of the underlying transaction (or event), for example, by reading relevant
contracts and minutes of meetings of the board of directors and by making inquiries of appropriate officials
of the entity, and, in some cases, of the entity acquired or to be acquired.
B. Obtain a level of knowledge of each significant constituent part of the combined entity in a business
combination that will enable the accountant to perform the required procedures. Procedures to obtain this
knowledge may include communicating with other accountants who have audited or reviewed the historical
financial information on which the pro forma financial information is based. Matters that may be
considered include accounting principles and financial reporting practices followed, transactions between
the entities, and material contingencies.
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C. Discuss with management their assumptions regarding the effects of the transaction (or event).
D. Evaluate whether pro forma adjustments are included for all significant effects directly attributable to the
transaction (or event).
E. Obtain sufficient evidence in support of such adjustments. The evidence required to support the level of
assurance given is a matter of professional judgment. The accountant typically would obtain more evidence
in an examination engagement than in a review engagement. Examples of evidence that the accountant
might consider obtaining are purchase, merger or exchange agreements, appraisal reports, debt agreements,
employment agreements, actions of the board of directors, and existing or proposed legislation or
regulatory actions.
F. Evaluate whether managements assumptions that underlie the pro forma adjustments are presented in a
sufficiently clear and comprehensive manner. Also, evaluate whether the pro forma adjustments are
consistent with each other and with the data used to develop them.
G. Determine that computations of pro forma adjustments are mathematically correct and that the pro forma
column reflects the proper application of those adjustments to the historical financial statements.
H. Obtain written representations from management concerning their
Responsibility for the assumptions used in determining the pro forma adjustments.
Belief that the assumptions provide a reasonable basis for presenting all of the significant effects
directly attributable to the transaction (or event), that the related pro forma adjustments give
appropriate effect to those assumptions, and that the pro forma column reflects the proper application
of those adjustments to the historical financial statements.
Belief that the significant effects directly attributable to the transaction (or event) are appropriately
disclosed in the pro forma financial information.
I. Read the pro forma financial information and evaluate whether
The underlying transaction (or event), the pro forma adjustments, the significant assumptions and the
significant uncertainties, if any, about those assumptions have been appropriately described.
The source of the historical financial information on which the pro forma financial information is
based has been appropriately identified.
VI. REPORTING ON PRO FORMA FINANCIAL INFORMATION
A. The accountants report on pro forma financial information should be dated as of the completion of the
appropriate procedures. The accountants report on pro forma financial information may be added to the
accountants report on historical financial information, or it may appear separately. If the reports are
combined and the date of completion of the procedures for the examination or review of the pro forma
financial information is after the date of completion of the fieldwork for the audit or review of the
historical financial information, the combined report should be dual-dated. (For example, February 15,
19X2, except for the paragraphs regarding pro forma financial information as to which the date is March
20, 19X2.)
B. An accountants report on pro forma financial information should include
1. An identification of the pro forma financial information.
2. A reference to the financial statements from which the historical financial information is derived and a
statement as to whether such financial statements were audited or reviewed. The report on pro forma
financial information should refer to any modification in the accountants report on the historical
financial statements.
3. A statement that the examination or review of the pro forma financial information was made in
accordance with standards established by the American Institute of Certified Public Accountants. If a
review is performed, the report should include the following statement:
A review is substantially less in scope than an examination, the objective of which is the expression of an
opinion on the pro forma financial information. Accordingly, we do not express such an opinion.

4.
5.

A separate paragraph explaining the objective of pro forma financial information and its limitations.
(a) If an examination of pro forma financial information has been performed, the accountants
opinion as to whether managements assumptions provide a reasonable basis for presenting the
significant effects directly attributable to the transaction (or event), whether the related pro forma
adjustments give appropriate effect to those assumptions, and whether the pro forma column
reflects the proper application of those adjustments to the historical financial statements.

4-14

6.

(b) If a review of pro forma financial information has been performed, the accountants conclusion as
to whether any information came to the accountants attention to cause him or her to believe that
managements assumptions do not provide a reasonable basis for presenting the significant effects
directly attributable to the transaction (or event), or that the related pro forma adjustments do not
give appropriate effect to those assumptions, or that the pro forma column does not reflect the
proper application of those adjustments to the historical financial statements.
Restrictions on the scope of the engagement, significant uncertainties about the assumptions that could
materially affect the transaction (or event), reservations about the propriety of the assumptions and the
conformity of the presentation with those assumptions (including inadequate disclosure of significant
matters), or other reservations may require the accountant to qualify the opinion, render an adverse
opinion, disclaim an opinion or withdraw from the engagement. The accountant should disclose all
substantive reasons for any report modifications. Uncertainty as to whether the transaction (or event)
will be consummated would not ordinarily require a report modification.

VII. ILLUSTRATIVE EXAMINATION REPORT

Report of Independent Certified Public Accountants
Board of Directors
X Company
We have examined the pro forma adjustments reflecting the transaction (or event) described in
Note 1 and the application of those adjustments to the historical amounts in (the assembly of) the
accompanying pro forma condensed balance sheet of X Company as of December 31, 19X1, and
the pro forma condensed statement of earnings for the year then ended. The historical condensed
financial statements are derived from the historical financial statements of X Company, that were
audited by us, and of Y Company, that were audited by other accountants appearing elsewhere
herein (or incorporated by reference). Such pro forma adjustments are based upon management's
assumptions described in Note 2. Our examination was made in accordance with standards
established by the American Institute of Certified Public Accountants and, accordingly, included
such procedures as we considered necessary in the circumstances.
The objective of this pro forma financial information is to show what the significant effects on the
historical financial information might have been had the transaction (or event) occurred at an
earlier date. However, the pro forma condensed financial statements are not necessarily indicative
of the results of operations or related effects on financial position that would have been attained
had the above mentioned transaction (or event) actually occurred earlier.
(Additional paragraphs may be added to emphasize certain matters relating to the attest
engagement.)
In our opinion, management's assumptions provide a reasonable basis for presenting the
significant effects directly attributable to the above mentioned transaction (or event) described in
Note 1, the related pro forma adjustments give appropriate effect to those assumptions, and the
pro forma column reflects the proper application of those adjustments to the historical financial
statement amounts in the pro forma condensed balance sheet as of December 31, 19X1, and the
pro forma condensed statement of earnings for the year then ended.

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Illustrative Examination Report Combined with Report on Historical Statements

Report of Independent Certified Public Accountants
Board of Directors
X Company
We have audited the accompanying balance sheet of X Company, Inc. as of December 31, 19X2,
and the related statements.... Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards .... We believe
our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of X Company, Inc.... in conformity with generally accepted accounting
principles.
We have also examined the pro forma adjustments reflecting the transaction described in Note 1
and the application of those adjustments to the historical amounts in the accompanying pro forma
condensed balance sheet of X Company as of December 31, 19X2, and the pro forma condensed
statement of earnings for the year then ended. The historical condensed financial statements are
derived from the historical financial statements of X Company, that were audited by us, and of Y
Company, that were audited by other accountants, appearing elsewhere herein. Such pro forma
adjustments are based upon management's assumptions described in Note 2. Our examination was
made in accordance with standards established by the American Institute of Certified Public
Accountants and, accordingly, included such procedures as we considered necessary in the
circumstances.
The objective of this pro forma financial information is to show what the significant effects on the
historical financial information might have been had the transaction occurred at an earlier date.
However, the pro forma condensed financial statements are not necessarily indicative of the
results of operations or related effects on financial position that would have been attained had the
above-mentioned transaction actually earlier.
(Additional paragraphs may be added to emphasize certain matters relating to the attest
engagement.)
In our opinion, management's assumptions provide a reasonable basis for presenting the
significant effects directly attributable to the above-mentioned transaction described in Note 1, the
related pro forma adjustments give appropriate effect to those assumptions, and the pro forma
column reflects the proper application of those adjustments to the historical financial amounts in
the pro forma condensed balance sheet as of December 31, 19X2, and the pro forma condensed
statement of earnings for the year then ended.

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VIII. ILLUSTRATIVE REVIEW REPORT

Board of Directors
X Company
We have reviewed the pro forma adjustments reflecting the transaction (or event) described in
Note 1 and the application of those adjustments to the historical amounts in (the assembly of) the
accompanying pro forma condensed balance sheet of X Company as of March 31, 19X1, and the
pro forma condensed statement of earnings for the three months then ended. These historical
condensed financial statements are derived from the historical unaudited financial statements of X
Company, that were reviewed by us, and of Y Company, that were reviewed by other accountants
appearing elsewhere (or incorporated by reference). Such pro forma adjustments are based on
management's assumptions as described in Note 2. Our review was conducted in accordance with
standards established by the American Institute of Certified Public Accountants.
A review is substantially less in scope than an examination, the objective of which is the
expression of an opinion on management's assumptions, the pro forma adjustments and the
application of those adjustments to historical financial information. Accordingly, we do not
express such an opinion.
The objective of this pro forma financial information is to show what the significant effects on the
historical information might have been had the transaction (or event) occurred at an earlier date.
However, the pro forma condensed financial statements are not necessarily indicative of the
results of operations or related effects on financial position that would have been attained had the
above mentioned transaction (or event) actually occurred earlier.
(Additional paragraphs may be added to emphasize certain matters relating to the attest
engagement.)
Based on our review, nothing came to our attention that caused us to believe that management's
assumptions do not provide a reasonable basis for presenting the significant effects directly
attributable to the above-mentioned transaction (or event) described in Note 1, that the related pro
forma adjustments do not give appropriate effect to those assumptions, or that the pro forma
column does not reflect the proper application of those adjustments to the historical financial
statement amounts in the pro forma condensed balance sheet as of March 31, 19X1, and the pro
forma condensed statement of earnings for the three months then ended.

AGREED UPON PROCEDURES SSAE No. 10, Section 201

A. Definition - An engagement to apply agreed-upon procedures is one in which an accountant is engaged by a
client to issue a report of findings based on specific procedures performed on the specific subject matter of
specified elements accounts, or items of a financial statement.
Specified elements, accounts, or items of a financial statement refers to accounting information that is part of, but
significantly less than, a financial statement.
1. Such information may be directly identified in a financial statement or notes thereto; or they may be
derived therefrom by analysis, aggregation, summarization, or mathematical computation.
2. Examples:
a. Schedule of accounts receivable.
b. The components under the caption on the financial statements identified as "property and
equipment."

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B.

Conditions for Engagement Performance

1. The accountant is independent.
2. The accountant and the specified users agree upon the procedures performed or to be performed by the
accountant.
3. The specified users take responsibility for the sufficiency of the agreed-upon procedures for their
purposes.
4. The procedures to be performed are expected to result in reasonably consistent findings.
5. The basis of accounting of the specified elements, accounts, or items of a financial statement is clearly
evident to the specified users and the accountant.
6. The specific subject matter to which the procedures are to be applied is subject to reasonably
consistent estimation or measurement.
7. Evidential matter related to the specific subject matter to which the procedures are applied is expected
to exist to provide a reasonable basis for expressing the findings in the accountant's report.
8. Where applicable, the accountant and the specified users agree on any materiality limits for reporting
purposes.
9. Use of the report is restricted to the specified users.

C. Agreement on and Sufficiency of Procedures

1. Responsibility on the user of the accountant's report.
2. Normally the accountant should communicate directly with and obtain affirmative acknowledgment
from each of the specific users (an engagement letter is encouraged but not required).
3. If the accountant is not able to communicate directly with all the specified users, this requirement can
be satisfied by applying any one or more of the following:
a. Compare the procedures to the written requirements of the users.
b. Discuss the procedures with an appropriate representative of the users involved.
c. Review relevant contracts with or correspondence from the specified users.
4. The accountant should not report unless the specified users agree among themselves as to the specific
procedures.
D. Nature, Timing, and Extent of Procedures
1. Specified users are responsible for the sufficiency (nature, timing, and extent) of the agreed-upon
procedures, because they best understand their needs.
2. The accountant is responsible for carrying out the procedures and reporting the finding in accordance
with the applicable general, field work and reporting standards.
a. The accountant assumes the risk that misapplication of the procedures may result in appropriate
findings being reported.
b. The accountant also assumes the risk that appropriate findings may not be reported or be reported
inaccurately.
c. The accountant should have adequate knowledge in the specific subject matter of the specified
elements, accounts, or items, including the basis of accounting.
3. The procedures to be performed may be as limited or extensive as the specific users desire. The
accountant should not agree to perform procedures that are overly subjective and open to varying
interpretations.
Examples of appropriate procedures:
Execution of a sampling application after agreeing on relevant parameters.
Inspection of specified documents evidencing certain types of transactions or detailed
attributes thereof.
Confirmation of specific information with third parties.
Comparison of documents, schedules, or analyses with certain specified attributes.
Performance of mathematical computations.

4-18

Examples of inappropriate procedures:

Mere reading of the work performed by others solely to describe their findings.
Evaluating the competency or objectivity of another party.
Obtaining an understanding about a particular subject.
Interpreting documents outside the scope of the accountant's professional expertise.
4.

5.

6.

7.

The accountant should prepare and maintain workpaper that indicates that
The work was adequately planned and supervised.
Evidential matter was obtained to provide a reasonable basis for the findings expressed in the
accountant's report.
Representation Letter
a. The need for such a letter may depend on the nature of the engagement and users.
b. The responsible party's refusal to furnish written representation determined to be appropriate for
the engagement constitutes a limitation on the performance of the engagement and the accountant
should do one of the following:
Disclose in his or her report the inability to obtain representations from the responsible party.
Withdraw from the engagement.
Change the engagement to another form of engagement.
Knowledge of matters outside agreed-upon procedures
a. The accountant does not need to perform procedures outside those agreed to.
b. If matters come to the accountant's attention by means other than those agreed to, that contradict
the basis of accounting for the elements, account, or item referred to in the accountant's report, he
or she should include the matter in the accountant's report.
When circumstances impose restrictions on the performance of the agreed-upon procedures, the
accountant should attempt to obtain agreement from the specified users for such modification. Failing
that, the accountant should describe any restrictions on the performance of procedures in his or her
report or withdraw from the engagement.

E. Change in Terms of Engagement

1. An accountant engaged to perform another form of engagement may be requested, before completion
of the original engagement, to change the nature of the engagement to agreed-upon procedures.
2. Before an accountant who was engaged to perform another form of engagement agrees to change the
engagement to an engagement to apply agreed-upon procedures, he or she should consider the
following:
The possibility that certain procedures performed as part of another type of engagement are not
appropriate for inclusion in an engagement to apply agreed-upon procedures.
The reason given for the request, particularly the implications of a restriction on the scope of the
original engagement or the matters to be reported.
The additional effort required to complete the original engagement.
If applicable, the reasons for changing from a general-distribution report to a restricted-use report.
3. If the specified users acknowledge agreement to the procedures performed or to be performed and
assume responsibility for the sufficiency of the procedures to be included in the agreed-upon
procedures engagement, either of the following would be considered a reasonable basis for requesting
a change in the engagement.
A change in circumstances that requires another form of engagement.
A misunderstanding concerning the nature of the original engagement or the available
alternatives.
4. If the accountant concludes that there is reasonable justification for the change, the accountant should
issue the appropriate agreed-upon procedures report. The report should not make reference to the
original engagement.

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F. Accountants' Reports
The accountant's report should contain the following elements:
1. A title that includes the word independent.
2. Reference to the specified elements, accounts, or items of a financial statement of an identified entity
and the character of the engagement.
3. Identification of specified users.
4. The basis of accounting of the specified elements, accounts, or items of a financial statement unless
clearly evident.
5. A statement that the procedures performed were those agreed to by the specified users identified in the
report.
6. Reference to standards established by the American Institute of Certified Public Accountants.
7. A statement that the sufficiency of the procedures is solely the responsibility of the specified users and
a disclaimer of responsibility for the sufficiency of those procedures.
8. A list of the procedures performed (or reference thereto) and related findings (the accountant should
not provide negative assurance).
9. Where applicable, a description of any agreed-upon materiality limits.
10. A statement that the accountant was not engaged to, and did not, perform an audit of the specified
elements, accounts, or items; a disclaimer of opinion on the specified elements, accounts, or items; and
a statement that if the accountant had performed additional procedures, other matters might have come
to his or her attention that would have been reported.
11. A disclaimer of opinion on the effectiveness of the internal control structure over financial reporting or
any part thereof when the accountant has performed procedures.
12. A statement of restrictions on the use of the report because it is intended to be used solely by the
specified users. (However, if the report is a matter of public record, the accountant should include the
following sentence: "However, this report is a matter of public record and its distribution is not
limited.")
13. Where applicable, reservations or restrictions concerning procedures or findings.
14. Where applicable, a description of the nature of the assistance provided by a specialist.

Illustrative Report:
The following is an illustration of a report on applying agreed-upon procedures to specified elements, accounts, or
items of a financial statement.
Independent Accountant's Report on Applying Agreed-Upon Procedures
We have performed the procedures enumerated below, which were agreed to by [list specified
users], solely to assist you with respect to [refer to the specified elements, accounts, or items of a
financial statement for an identified entity and the character of the engagement]. This engagement
to apply agreed-upon procedures was performed in accordance with standards established by the
American Institute of Certified Public Accountants. The sufficiency of the procedures is solely the
responsibility of the specified users of the report. Consequently, we make no representation
regarding the sufficiency of the procedures described below either for the purpose for which this
report has been requested or for any other purpose.
[Include paragraphs to enumerate procedures and findings.]
We were not engaged to, and did not, perform an audit, the objective of which would be the
expression of an opinion on the specified elements, accounts, or items. Accordingly, we do not
express such an opinion. Had we performed additional procedures, other matters might have come
to our attention that would have been reported to you.
This report is intended solely for the use of the specified users listed above and should not be used
by those who have not agreed to the procedures and taken responsibility for the sufficiency of the
procedures for their purposes.

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STATEMENT ON GOVERNMENT AUDITING STANDARDS

I.

INTRODUCTION
A. Purpose
1. These standards apply to audits of government organizations, programs, activities, and functions, and
of government funds received by contractors, nonprofit organizations, and other nongovernment
organizations.
2. The standards are to be followed by auditors and audit organizations when required by law, regulation,
agreement or contract, or policy.

II. TYPES OF GOVERNMENT AUDITS

A. Financial Audits
1. Financial statement audits determine (a) whether the financial statements of an audited entity present
fairly the financial position, results of operations, and cash flows or changes in financial position in
accordance with generally accepted accounting principles, and (b) whether the entity has complied
with laws and regulations for those transactions and events that may have a material effect on the
financial statements.
2. Financial related audits include determining (a) whether financial reports and related items, such as
elements, accounts, or funds are fairly presented, (b) whether financial information is presented in
accordance with established or stated criteria, and (c) whether the entity has adhered to specific
financial compliance requirements.
B. Performance Audits
1. Economy and efficiency audits include determining (a) whether the entity is acquiring, protecting,
and using its resources (such as personnel, property, and space) economically and efficiently, (b) the
causes of inefficiencies or uneconomical practices, and (c) whether the entity has complied with laws
and regulations concerning matters of economy and efficiency.
2. Program audits include determining (a) the extent to which the desired results or benefits established
by the legislature or other authorizing body are being achieved, (b) the effectiveness of organizations,
programs, activities, or functions, and (c) whether the entity has complied with laws and regulations
applicable to the program.

III. GENERAL STANDARDS FOR FINANCIAL AUDITS

A. Qualifications: The staff assigned to conduct the audit should collectively possess adequate professional
proficiency for the tasks required.
B. Independence: In all matters relating to the audit work, the audit organization and the individual auditors,
whether government or public, should be free from personal and external impairments to independence,
should be organizationally independent, and should maintain an independent attitude and appearance.
C. Due Professional Care: Due professional care should be used in conducting the audit and in preparing
related reports.
D. Quality Control: Audit organizations conducting government audits should have an appropriate internal
quality control system in place and participate in an external quality control review program.

IV. FIELD WORK STANDARDS FOR FINANCIAL AUDITS

A. Relationship to AICPA Standards
1. The standards of field work for government financial audits incorporate the AICPA standards of
field work for financial audits, and prescribes supplemental standards of field work needed to
satisfy the unique needs of government financial audits.
2. The field work standards of the AICPA and the supplemental standards in this statement apply to both
financial statement audits and financial related audits.

4-21

B. Supplemental Field Work Standards

1. Planning -- Follow-up:
Auditors should follow up on known material findings and recommendations from previous
audits.
2. Compliance with laws and regulations:
When laws, regulations, and other compliance requirements are significant to audit objectives, auditors
should design the audit to provide reasonable assurance about compliance with them. In all
performance audits, auditors should be alert to situations or transactions that could be indicative of
illegal acts or abuse.
3. Management controls:
Auditors should obtain an understanding of management controls that are relevant to the audit. When
management controls are significant to audit objectives, auditors should obtain sufficient evidence to
support their judgments about those controls.
4. Evidence:
Sufficient, competent, and relevant evidence is to be obtained to afford a reasonable basis for the
auditors' findings and conclusions. A record of the auditors' work should be retained in the form of
working papers. Working papers should contain sufficient information to enable an experienced
auditor having no previous connection with the audit to ascertain from them the evidence that supports
the auditors' significant conclusions and judgments.

V. REPORTING STANDARDS FOR FINANCIAL AUDITS

A. Relationship to AICPA Standards
1. The standards of reporting for government financial audits incorporate the AICPA standards of
reporting for financial audits, and prescribes supplemental standards of reporting needed to satisfy the
unique needs of government financial audits.
2. The reporting standards of the AICPA and the supplemental standards in this statement apply to both
financial statement audits and financial related audits.
B. Supplemental reporting standards for government financial audits are:
1. Form:
Auditors should prepare written audit reports communicating the results of each audit.
2. Timeliness:
Auditors should appropriately issue the reports to make the information available for timely use by
management, legislative officials, and other interested parties.
3. Report contents:
Auditors should report the audit objectives and the audit scope and methodology.
4. Report presentation:
The report should be complete, accurate, objective, convincing, and as clear and concise as the subject
permits.
5. Report distribution:
Written audit reports are to be submitted by the audit organization to the appropriate officials of the
auditee and to the appropriate officials of the organizations requiring or arranging for the audits,
including external funding organizations, unless legal restrictions prevent it. Copies of the reports
should also be sent to other officials who have legal oversight authority or who may be responsible for
acting on audit findings and recommendations and to others authorized to receive such reports. Unless
restricted by law or regulation, copies should be made available for public inspection.

4-22

COMPLIANCE AUDITING APPLICABLE TO GOVERNMENTAL ENTITIES AND

OTHER RECIPIENTS OF GOVERNMENTAL FINANCIAL ASSISTANCE, SAS No. 74
Introduction
1. This Statement establishes standards for testing and reporting on compliance with laws and regulations in the
following engagements:
Audits under Generally Accepted Auditing Standards.
Audits under Government Auditing Standards.
Audits under OMB Circular A-133, Audits of States, Local Governments and Other Nonprofit Institutions.
2. The Statement also addresses reporting on internal control structure under Government Auditing Standards.
Compliance Auditing in Audits Conducted in Accordance with GAAS
1. In audits performed in accordance with GAAS, the auditors responsibility for consideration of laws and
regulations and how they affect the audit is described in SAS Nos. 53 and 54.
2. The auditor should design the audit to provide reasonable assurance that the financial statements are free of
material misstatements resulting from violations of laws and regulations that have a direct and material effect
on the determination of financial statement amounts.
3. It is important that the auditor understand the laws and regulations that are generally recognized to have a
direct and material effect on the determination of amounts in a governmental entity's financial statements.
4. The auditor should consider audit risk in assessing compliance with laws and regulations.
5. Working paper documentation of procedures performed to evaluate compliance with laws and regulations is
required along with a written representation letter from management that includes a statement on compliance
with applicable laws and regulations.
Reporting Under Government Auditing Standards
1. In performing an audit in accordance with Governmental Auditing Standards (GAS), the auditor assumes
responsibilities beyond those assumed in an audit conducted in accordance with GAAS to report on
compliance with laws and regulations and on internal control structure.
2. GAS require that the audit be designed to provide reasonable assurance of detecting errors, irregularities, and
illegal acts resulting from violations of laws and regulations that have a direct and material effect on the
determination of financial statement amounts that are material to the financial statements.
3. The report issued under GAS on compliance with laws and regulations must indicate either there were no
instances of noncompliance or list specific findings of noncompliance.
4. Material instances of noncompliance with laws and regulations will normally result in a qualified report. If the
report is qualified, the following features should be included:

The definition of the material instances of noncompliance.

An identification of material instances of noncompliance noted in the audit.

A statement that the noncompliance noted was considered in forming an opinion on whether the entitys
financial statements are presented fairly, in all material respects, in conformity with GAAP.
5. Material instances of noncompliance should be reported whether or not they have been corrected in the entitys
financial statements.
6. Reporting on internal control structure under GAS differs from reporting under SAS No. 60. GAS requires a
written report on the internal control structure in all audits; SAS No. 60 requires communication oral or
written only when the auditor has noted reportable conditions.
7. In reporting on the internal control structure under GAS, the auditor is required to identify all reportable
conditions noted and indicate which of the reportable conditions are considered to be material weaknesses.
8. When reporting on internal control structure in an audit under GAS, the following items must be
communicated:
Identification of the categories of the internal control structure.
Description of the scope of the auditors work in obtaining an understanding of the internal control
structure and in assessing control risk.
Description of deficiencies in the internal control structure not considered significant enough to be
reportable conditions.

4-23

REPORTING EXAMPLESGOVERNMENTAL AUDITING STANDARDS

1.

Report on Internal Control Structure

Required Elements

Addressee
We have audited the financial statements of (name of entity) as of and for the
year ended June 30, 19X1, and have issued our report thereon dated August 15,
19X1.

1. Reference to Audit

We conducted our audit in accordance with generally accepted auditing

standards and Government Auditing Standards, issued by the Comptroller
General of the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement.

2. Reference to Standards

In planning and performing our audit of the financial statement of (name of

entity) for the year ended June 30, 19X1, we considered its internal control
structure in order to determine our auditing procedures for the purpose of
expressing our opinion on the financial statements and not to provide assurance
on the internal control structure.

3. Reference to I.C.

The management of (name of entity) is responsible for establishing and

maintaining an internal control structure. In fulfilling this responsibility,
estimates and judgments by management are required to assess the expected
benefits and related costs of internal control structure policies and procedures.
The objectives of an internal control structure are to provide management with
reasonable, but not absolute, assurance that assets are safeguarded against loss
from unauthorized use or disposition and that transactions are executed in
accordance with management's authorization and recorded properly to permit
the preparation of financial statements in accordance with generally accepted
accounting principles. Because of inherent limitations in any internal control
structure, errors or irregularities may nevertheless occur and not be detected.
Also, projection of any evaluation of the structure to future periods is subject to
the risk that procedures may become inadequate because of changes in
conditions or that the effectiveness of the design and operation of policies and
procedures may deteriorate.

4. Management responsibility

5. Objective of I.C.

6. Limitations of I.C.

For the purpose of this report, we have classified the significant internal control
structure policies and procedures in the following categories (identify internal
control structure categories).
For all the internal control structure categories listed above, we obtained an
understanding of the design of relevant policies and procedures and whether
they have been placed in operation, and we assessed control risk.

7. Procedures followed

We noted certain matters involving the internal control structure and its
operation that we consider to be reportable conditions under standards
established by the American Institute of Certified Public Accountants.
Reportable conditions involve matters coming to our attention relating to
significant deficiencies in the design or operation of the internal control
structure that, in our judgment, could adversely affect the entity's ability to
record, process, summarize, and report financial data consistent with the
assertions of management in the financial statements.
.

8. Reportable conditions

4-24

(Include paragraphs to describe the reportable conditions noted.)

A material weakness is a reportable condition in which the design or operation
of one or more of the internal control structure elements does not reduce to a
relatively low level the risk that errors or irregularities in amounts that would
be material in relation to the financial statements being audited may occur and
not be detected within a timely period by employees in the normal course of
performing their assigned functions.

9. Material weaknesses

Our consideration of the internal control structure would not necessarily

disclose all matters in the internal control structure that might be reportable
conditions, and, accordingly, would not necessarily disclose all reportable
conditions that are also considered to be material weaknesses as defined above.
However, we believe none of the reportable conditions described above is a
material weakness.

10. Limitations of procedures

We also noted other matters involving the internal control structure and its
operation that we have reported to the management of (name of entity) in a
separate letter dated August 15, 19X1.
This report is intended for the information of the audit committee, management
and (specify legislative or regulatory body). However, this report is a matter of
public record and its distribution is not limited.

11. Distribution of report

Signature, Date

2.

Report on Compliance with Laws and Regulations

Required Elements

Addressee
We have audited the general-purpose financial statements of City X,
Any State, as of and for the year ended June 30, 19X4, and have issued
our report thereon dated August 15, 19X4.

Reference to the audited

financial statements and audit
report

We conducted our audit in accordance with generally accepted auditing

standards and Government Auditing Standards, issued by the
Comptroller General of the United States. Those standards require that
we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement.

Audit conducted in accordance

with GAAS and Government
Auditing Standards (GAS)
What GAAS and GAS require

Compliance with laws, regulations, contracts, and grants applicable to

City X is the responsibility of City X's management. As part of
obtaining reasonable assurance about whether the financial statements
are free of material misstatement, we performed tests of City X's
compliance with certain provisions of laws, regulations, contracts, and
grants. However, the objective of our audit of the general-purpose
financial statements was not to provide an opinion on overall
compliance with such provisions. Accordingly, we do not express such
an opinion.

Management is responsible for

compliance.

4-25

Tests of compliance were

performed as part of audit, not
to provide on opinion on
compliance - disclaimer on
compliance.

The results of our tests disclosed no instances of noncompliance that are

required to be reported herein under Government Auditing Standards.

No reportable instances of
noncompliance

This report is intended for the information of the audit committee,

management, and city council. However, this report is a matter of public
record and its distribution is not limited.

Intended use of report

Signature, date

SINGLE AUDIT ACT

I.

Requirements of Single Audit Act

A. Determine and report on whether the financial statements are presented fairly according to GAAP.
B. Determine and report on whether the "schedule of expenditures of federal awards" is presented fairly in
relation to the financial statements.
C. Determine whether the entity has complied with laws, regulations and contracts with respect to programs
or grants.
D. Report on a schedule of findings and questioned costs.

II. Nonfederal entities that expend federal awards may be subject to a single audit or program
specific audit
A. Entities that expend $300,000 or more of federal awards are required to have a single audit.
B. Entities that expend less than $300,000 of federal awards may have a program specific audit or elect a
single audit.
III. With respect to I-C above, auditors should refer to OMB Circular A-133 "Audits of States,
Local Governments, and Non-Profit Organizations" for guidance and the specific compliance
requirements of various federal awards.
A. Auditors are required to report on compliance with specific requirements of each federal program award
received and expended.
B. With respect to instances of non-compliance, the auditor must report on the frequency of non-compliance
(referred to as questioned costs).
IV. Responsibilities Under OMB Circular A-133
A. OMB Circular A-133, Audits of States, Local Governments and Other Nonprofit Institutions, prescribes
audit requirements for entities receiving federal awards.
B. If a nonprofit institution receives $300,000 or more per year in federal awards it is required to have an
audit performed in accordance with Circular A-133.
C. The auditor is to test and report on matters pertaining to:
Compliance with laws and regulations that may have a direct and material effect on the entitys
financial statement amounts.
Compliance with general requirements applicable to the federal award programs.
Compliance with specific requirements that may have a direct and material effect on each major
program, as defined in OMB Circular A-133.
Compliance with certain laws and regulations applicable to nonmajor federal financial assistance
programs.

4-26

SYSTEM OF QUALITY CONTROL FOR A CPA FIRM'S ACCOUNTING AND

AUDITING PRACTICE
I.

Introduction and Applicability

A. This Statement provides that a CPA firm shall have a system of quality control for its accounting and
auditing practice.

II. System of Quality Control

A. A firm has a responsibility to ensure its personnel comply with professional standards applicable to its
accounting and auditing practice.
B. A system of quality control is broadly defined as a process to provide the firm with reasonable assurance
that its personnel comply with applicable professional standards and the firm's standards of quality.
C. Any system of quality control has inherent limitations that can reduce its effectiveness.
D. The system of quality control should provide the firm with reasonable assurance that the segments of the
firm's engagements performed by its foreign offices or by its domestic or foreign affiliates or
correspondents are performed in accordance with professional standards in the United States when such
standards are applicable.
III. Quality Control Policies and Procedures
A. Elements of Quality Control
1. Independence, Integrity, and Objectivity
a. Policies and procedures should be established to provide the firm with reasonable assurance that
personnel maintain independence (in fact and in appearance) in all required circumstances,
perform all professional responsibilities with integrity, and maintain objectivity in discharging
professional responsibilities.
2. Personnel Management
a. A firm's quality control system depends heavily on the proficiency of its personnel. In making
assignments, the nature and extent of supervision to be provided should be considered. Generally,
the more able and experienced the personnel assigned to a particular engagement, the less direct
supervision is needed.
3. Acceptance and Continuance of Clients and Engagements
a. Policies and procedures should be established for deciding whether to accept or continue a client
relationship and whether to perform a specific engagement for that client. Such policies and
procedures should provide the firm with reasonable assurance that the likelihood of association
with a client whose management lacks integrity is minimized.
b. Such policies and procedures should also provide reasonable assurance that the firm --1). Undertakes only those engagements that the firm can reasonably expect to be completed with
professional competence.
2). Appropriately considers the risks associated with providing professional services in the
particular circumstances.
4. Engagement Performance
a. Policies and procedures should be established to provide the firm with reasonable assurance that
the work performed by engagement personnel meets applicable professional standards, regulatory
requirements, and the firm's standards of quality.
b. Policies and procedures should also be established to provide reasonable assurance that personnel
refer to authoritative literature or other sources and consult, on a timely basis, with individuals
within or outside the firm, when appropriate (for example, when dealing with complex, unusual,
or unfamiliar issues). Individuals consulted should have appropriate levels of knowledge,
competence, judgment, and authority.

4-27

5.

Monitoring
a. Policies and procedures should be established to provide the firm with reasonable assurance that
the policies and procedures established by the firm for each of the other elements of quality
control described are suitably designed and are being effectively applied.

IV. Administration of a Quality Control System

A. Assignment of Responsibilities
1. Responsibility for the design and maintenance of the various quality control policies and procedures
should be assigned to an appropriate individual or individuals in the firm.
B. Communication
1. A firm should communicate its quality control policies and procedures to its personnel in a manner
that provides reasonable assurance that those policies and procedures are understood and complied
with.
C. Documentation of Quality Control Policies and Procedures
1. The size, structure, and nature of the practice of the firm should be considered in determining whether
documentation of established quality control policies and procedures is required for effective
communication and, if so, the extent of such documentation.
D. Documentation of Compliance with Quality Control Policies and Procedures
1. A firm should prepare appropriate documentation to demonstrate compliance with its policies and
procedures for the quality control system discussed herein.
2. The form and content of such documentation is a matter of judgment and depends on a number of
factors, such as the size of a firm, the number of offices, the degree of authority allowed its personnel
and its offices, the nature and complexity of the firm's practice, its organization, and appropriate costbenefit considerations.

MONITORING A CPA FIRM'S ACCOUNTING AND AUDITING PRACTICE

I.

Monitoring Procedures
A. Monitoring procedures taken as a whole should enable the firm to obtain reasonable assurance that its
system of quality control is effective.
B. A firm's monitoring procedures may include --1. Inspection procedures.
2. Preissuance or postissuance review of selected engagements.
3. Analysis and assessment of:
New professional pronouncements.
Results of independence confirmations.
Continuing professional education and other professional development activities undertaken by
firm personnel.
Decisions related to acceptance and continuance of client relationships and engagements.
Interviews of firm personnel.
4. Determination of any corrective actions to be taken and improvements to be made in the quality
control system.
5. Communication to appropriate firm personnel of any weaknesses identified in the quality control
system or in the level of understanding or compliance therewith.
6. Follow-up by appropriate firm personnel to ensure that any necessary modifications are made to the
quality control policies and procedures on a timely basis.

4-28

II. Monitoring in Small Firms with a Limited Number of Management-Level Individuals

A. In small firms with a limited number of management-level individuals, monitoring procedures may need to
be performed by some of the same individuals who are responsible for compliance with the firm's quality
control policies and procedures.
B. To effectively monitor one's own compliance with the firm's policies and procedures, an individual must be
able to critically review his or her own performance, assess his or her own strengths and weaknesses, and
maintain an attitude of continual improvement.
C. A firm in this circumstance may find it beneficial to engage a qualified individual from outside the firm to
perform inspection procedures.
D. A peer review does not substitute for monitoring procedures.

4-29

Chapter Four - Questions

Attestation Standards, Government Auditing
Standards, Quality Control Standards
1. A CPA's report on a forecast should include all of the
following except
a. A description of what the forecast information is
intended to represent.
b. A caveat as to the ultimate attainment of the
forecasted results.
c. A statement that the CPA assumes no responsibility
to update the report for events occurring after the
date of the report.
d. An opinion as to whether the forecast is fairly
presented.

6. When third party use of prospective financial

statements is expected, an accountant may not accept an
engagement to
a. Perform a review.
b. Perform a compilation.
c. Perform an examination.
d. Apply agreed-upon procedures.
7. Which of the following bodies promulgates standards
for audits of federal financial assistance recipients?
a. Governmental Accounting Standards Board.
b. Financial Accounting Standards Board.
c. General Accounting Office.
d. Governmental Auditing Standards Board.

2. A CPA firm's personnel partner periodically studies

the CPA firm's personnel advancement experience to
ascertain whether individuals meeting stated criteria are
assigned increased degrees of responsibility. This is
evidence of the CPA firm's adherence to prescribed
standards of
a. Quality control.
b. Due professional care.
c. Supervision and review.
d. Fieldwork.

8. A CPA firm's quality control procedures pertaining to

the acceptance of a prospective audit client would most
likely include
a. Inquiry of management as to whether
disagreements between the predecessor auditor
and the prospective client were resolved
satisfactorily.
b. Consideration of whether sufficient competent
evidential matter may be obtained to afford a
reasonable basis for an opinion.
c. Inquiry of third parties, such as the prospective
client's bankers and attorneys, about information
regarding the prospective client and its
management.
d. Consideration of whether the internal control
structure is sufficiently effective to permit a
reduction in the extent of required substantive
tests.

3. In pursuing a CPA firm's quality control objectives, a

CPA firm may maintain records indicating which
partners or employees of the CPA firm were previously
employed by the CPA firm's clients. Which quality
control objective would this be most likely to satisfy?
a. Professional relationship.
b. Supervision.
c. Independence.
d. Advancement.
4. The party responsible for assumptions identified in
the preparation of prospective financial statements is
usually
a. A third-party lending institution.
b. The client's management.
c. The reporting accountant.
d. The client's independent auditor.

9. An accountant's standard report on a compilation of a

projection should not include
a. A separate paragraph that describes the limitations
on the presentation's usefulness.
b. A statement that a compilation of a projection is
limited in scope.
c. A disclaimer of responsibility to update the report
for events occurring after the report's date.
d. A statement that the accountant expresses only
limited assurance that the results may be achieved.

5. Which of the following is a prospective financial

statement for general use upon which an accountant
may appropriately report?
a. Financial projection.
b. Partial presentation.
c. Pro forma financial statement.
d. Financial forecast.

4Q-1

10. An examination of a financial forecast is a

professional service that involves
a. Compiling or assembling a financial forecast that
is based on management's assumptions.
b. Limiting the distribution of the accountant's report
to management and the board of directors.
c. Assuming responsibility to update management on
key events for one year after the report's date.
d. Evaluating the preparation of a financial forecast
and the support underlying management's
assumptions.

b.
c.
d.

To specific legislative and regulatory bodies when

reporting under Government Auditing Standards.
To a court-appointed creditors' committee when
the client is operating under Chapter 11 of the
Federal Bankruptcy Code.
To shareholders with significant influence (more
than 20% equity ownership) when the reportable
conditions are deemed to be material weaknesses.

15. Which of the following professional services would

be considered an attest engagement?
a. A management consulting engagement to provide
EDP advice to a client.
b. An engagement to report on compliance with
statutory requirements.
c. An income tax engagement to prepare federal and
state tax returns.
d. The compilation of financial statements from a
client's accounting records.

11. When an accountant compiles projected financial

statements, the accountant's report should include a
separate paragraph that
a. Describes the differences between a projection and
a forecast.
b. Identifies the accounting principles used by
management.
c. Expresses limited assurance that the actual results
may be within the projection's range.
d. Describes the limitations on the projection's
usefulness.

16. Accepting an engagement to compile a financial

projection for a publicly held company most likely
would be inappropriate if the projection were to be
distributed to
a. A bank with which the entity is negotiating for a
loan.
b. A labor union with which the entity is negotiating a
contract.
c. The principal stockholder, to the exclusion of the
other stockholders.
d. All stockholders of record as of the report date.

12. When an accountant examines a financial forecast

that fails to disclose several significant assumptions
used to prepare the forecast, the accountant should
describe the assumptions in the accountant's report and
issue a(an)
a. "Except for" qualified opinion.
b. "Subject to" qualified opinion.
c. Unqualified opinion with a separate explanatory
paragraph.
d. Adverse opinion.

17. A CPA firm would be reasonably assured of

meeting its responsibility to provide services that
conform with professional standards by
a. Adhering to generally accepted auditing standards.
b. Having an appropriate system of quality control.
c. Joining professional societies that enforce ethical
conduct.
d. Maintaining an attitude of independence in its
engagements.

13. Which of the following statements concerning

prospective financial statements is correct?
a. Only a financial forecast would normally be
appropriate for limited use.
b. Only a financial projection would normally be
appropriate for general use.
c. Any type of prospective financial statements
would normally be appropriate for limited use.
d. Any type of prospective financial statements
would normally be appropriate for general use.

18. One of a CPA firms basic objectives is to provide

professional services that conform with professional
standards. Reasonable assurance of achieving this basic
objective is provided through
a. A system of quality control.
b. A system of peer review.
c. Continuing professional education.
d. Compliance with generally accepted reporting
standards.

14. An auditor most likely would be responsible for

communicating significant deficiencies in the design of
the internal control structure
a. To the Securities and Exchange Commission when
the client is a publicly held entity.

4Q-2

19. In reporting on an entity's internal control structure

over financial reporting, a practitioner should include a
paragraph that describes the
a. Documentary evidence regarding the control
environment factors.
b. Changes in the internal control structure since the
prior report.
c. Potential benefits from the practitioner's suggested
improvements.
d. Inherent limitations of any internal control
structure.

b.
c.
d.

Report the engagements findings to the entitys

audit committee, the continuing CPA, and
management.
Disclaim any opinion that the hypothetical
application of accounting principles conforms with
generally accepted accounting principles.
Notify the entity that the report is for the restricted
use of management and outside parties who are
aware of all relevant facts.

23. Comfort letters ordinarily are signed by the clients

a. Independent auditor.
b. Underwriter of securities.
c. Audit committee.
d. Senior management.

20. When reporting on an entitys internal control

structure under Government Auditing Standards, an
auditor should issue a written report that includes a
a. Statement of negative assurance that nothing came
to the auditors attention that caused the auditor to
believe reportable conditions were present.
b. Statement of positive assurance that the results of
tests indicate that the internal control structure
either can, or cannot, be relied on to reduce control
risk to an acceptable level.
c. Description of the weaknesses considered to be
reportable conditions and the strengths that the
auditor can rely on in reducing the extent of
substantive testing.
d. Description of the scope of the auditors work in
obtaining an understanding of the internal control
structure and in assessing control risk.

24. Accepting an engagement to examine an entity's

financial projection most likely would be appropriate if
the projection were to be distributed to
a. All employees who work for the entity.
b. Potential stockholders who request a prospectus or
a registration statement.
c. A bank with which the entity is negotiating for a
loan.
d. All stockholders of record as of the report date.
25. Which of the following is an element of a CPA
firm's quality control system that should be considered
in establishing its quality control policies and
procedures?
a. Complying with laws and regulations.
b. Using statistical sampling techniques.
c. Assigning personnel to engagements.
d. Considering audit risk and materiality.

21. Hill, CPA, is auditing the financial statements of

Helping Hand, a not-for-profit organization that
receives financial assistance from governmental
agencies. To detect misstatements in Helping Hands
financial statements resulting from violations of laws
and regulations, Hill should focus on violations that
a. Could result in criminal prosecution against the
organization.
b. Involve reportable conditions to be communicated
to the organizations trustees and the funding
agencies.
c. Have a direct and material effect on the amounts in
the organizations financial statements.
d. Demonstrate the existence of material weaknesses
in the organizations internal control structure.

26. In reporting on compliance with laws and

regulations during a financial statement audit in
accordance with Government Auditing Standards, an
auditor should include in the auditor's report
a. A statement of assurance that all controls over
fraud and illegal acts were tested.
b. Material instances of fraud and illegal acts that
were discovered.
c. The materiality criteria used by the auditor in
considering whether instances of noncompliance
were significant.
d. An opinion on whether compliance with laws and
regulations affected the entity's goals and
objectives.

22. Blue, CPA, has been asked to render an opinion on

the application of accounting principles to a specific
transaction by an entity that is audited by another CPA.
Blue may accept this engagement, but should
a. Consult with the continuing CPA to obtain
information relevant to the transaction.

4Q-3

27. An accountant's report on a review of pro forma

financial information should include a
a. Statement that the entity's internal control structure
was not relied on in the review.
b. Disclaimer of opinion on the financial statements
from which the pro forma financial information is
derived.
c. Caveat that it is uncertain whether the transaction
or event reflected in the pro forma financial
information will ever occur.
d. Reference to the financial statements from which
the historical financial information is derived.

a.
b.
c.
d.

The practitioner anticipates relying on the entity's

internal control structure in a financial statement
audit.
Management presents its written assertion about
the effectiveness of the internal control structure.
The practitioner is a continuing auditor who
previously has audited the entity's financial
statements.
Management agrees not to present the
practitioner's report in a general-use document to
stockholders.

31. The primary purpose of establishing quality control

policies and procedures for deciding whether to accept a
new client is to
a. Enable the CPA firm to attest to the reliability of
the client.
b. Satisfy the CPA firm's duty to the public
concerning the acceptance of new clients.
c. Minimize the likelihood of association with clients
whose management lacks integrity.
d. Anticipate before performing any field work
whether an unqualified opinion can be expressed.

28. Because of the pervasive effects of laws and

regulations on the financial statements of governmental
units, an auditor should obtain written management
representations acknowledging that management has
a. Identified and disclosed all laws and regulations
that have a direct and material effect on its
financial statements.
b. Implemented internal control policies and
procedures designed to detect all illegal acts.
c. Expressed both positive and negative assurance to
the auditor that the entity complied with all laws
and regulations.
d. Employed internal auditors who can report their
findings, opinions, and conclusions objectively
without fear of political repercussion.

32. Snow, CPA, was engaged by Master Co. to examine

and report on management's written assertion about the
effectiveness of Master's internal control structure over
financial reporting. Snow's report should state that
a. Because of inherent limitations of any internal
control structure, errors or irregularities may occur
and not be detected.
b. Management's assertion is based on criteria
established by the American Institute of Certified
Public Accountants.
c. The results of Snow's tests will form the basis for
Snow's opinion on the fairness of Master's
financial statements in conformity with GAAP.
d. The purpose of the engagement is to enable Snow
to plan an audit and determine the nature, timing,
and extent of tests to be performed.

29. An auditor notes reportable conditions in a

financial statement audit conducted in accordance with
Government Auditing Standards. In reporting on the
internal control structure, the auditor should state that
a. Expressing an opinion on the entity's financial
statements provides no assurance on the internal
control structure.
b. The auditor obtained an understanding of the
design of relevant policies and procedures, and
determined whether they have been placed in
operation.
c. The specified government funding or legislative
body is responsible for reviewing the internal
control structure as a condition of continued
funding.
d. The auditor has not determined whether any of the
reportable conditions described in the report are so
severe as to be material weaknesses.

33. Wolf is auditing an entity's compliance with

requirements governing a major federal financial
assistance program in accordance with Government
Auditing Standards. Wolf detected noncompliance with
requirements that have a material effect on the program.
Wolf's report on compliance should express
a. No assurance on the compliance tests.
b. Reasonable assurance on the compliance tests.
c. A qualified or adverse opinion.
d. An adverse or disclaimer of opinion.

30. Which of the following conditions is necessary for a

practitioner to accept an attest engagement to examine
and report on an entity's internal control structure over
financial reporting?

4Q-4

34. Which of the following statements is a standard

applicable to financial statement audits in accordance
with Government Auditing Standards?
a. An auditor should assess whether the entity has
reportable measures of economy and efficiency
that are valid and reliable.
b. An auditor should report on the scope of the
auditor's testing of internal controls.
c. An auditor should briefly describe in the auditor's
report the method of statistical sampling used in
performing tests of controls and substantive tests.
d. An auditor should determine the extent to which
the entity's programs achieve the desired level of
results.

38. In auditing a not-for-profit entity that receives

governmental financial assistance, the auditor has a
responsibility to
a. Issue a separate report that describes the expected
benefits and related costs of the auditor's suggested
changes to the entity's internal control structure.
b. Assess whether management has identified laws and
regulations that have a direct and material effect on
the entity's financial statements.
c. Notify the governmental agency providing the
financial assistance that the audit is not designed to
provide any assurance of detecting errors and
irregularities.
d. Render an opinion concerning the entity's continued
eligibility for the governmental financial assistance.

35. The nature and extent of a CPA firm's quality

control policies and procedures depend on
The nature
The CPA
of the CPA
Cost-benefit
firm's practice
considerations
firm's size
a.
Yes
Yes
Yes
b.
Yes
Yes
No
c.
Yes
No
Yes
d.
No
Yes
Yes

39. In auditing compliance with requirements governing

major federal financial assistance programs under the
Single Audit Act, the auditor's consideration of
materiality differs from materiality under generally
accepted auditing standards. Under the Single Audit
Act, materiality is
a. Calculated in relation to the financial statements
taken as a whole.
b. Determined separately for each major federal
financial assistance program.
c. Decided in conjunction with the auditor's risk
assessment.
d. Ignored, because all account balances, regardless of
size, are fully tested.

36. Brown, CPA, has accepted an engagement to

examine and report on Crow Company's written
assertion about the effectiveness of Crow's internal
control structure. In what form may Crow present its
written assertion?
I. In a separate report that will accompany Brown's
report.
II. In a representation letter to Brown.
a.
b.
c.
d.

40. Which of the following statements represents a

quality control requirement under government auditing
standards?
a. A CPA who conducts government audits is required
to undergo an annual external quality control review
when an appropriate internal quality control system
is not in place.
b. A CPA seeking to enter into a contract to perform an
audit should provide the CPA's most recent external
quality control review report to the party contracting
for the audit.
c. An external quality control review of a CPA's
practice should include a review of the working
papers of each government audit performed since
the prior external quality control review.
d. A CPA who conducts government audits may not
make the CPA's external quality control review
report available to the public.

I only.
II only.
Either I or II.
Neither I nor II.

37. When an accountant examines projected financial

statements, the accountant's report should include a
separate paragraph that
a. Describes the limitations on the usefulness of the
presentation.
b. Provides an explanation of the differences between
an examination and an audit.
c. States that the accountant is responsible for events
and circumstances up to one year after the report's
date.
d. Disclaims an opinion on whether the assumptions
provide a reasonable basis for the projection.

4Q-5

41. Although the scope of audits of recipients of federal

financial assistance in accordance with federal audit
regulations varies, these audits generally have which of
the following elements in common?
a. The auditor is to determine whether the federal
financial assistance has been administered in
accordance with applicable laws and regulations.
b. The materiality levels are lower and are determined
by the government entities that provided the federal
financial assistance to the recipient.
c. The auditor should obtain written management
representations that the recipient's internal auditors
will report their findings objectively without fear of
political repercussion.
d. The auditor is required to express both positive and
negative assurance that illegal acts that could have a
material effect on the recipient's financial statements
are disclosed to the inspector general.

CPA Exam Tip:

At the bottom of the screen for a multiple
choice testlet there is an option called Mark
For Review. By clicking this button you can
mark a particular question that you want to
go back and check later. When you use this
option a checkmark will appear underneath
the number of the selected question at the
bottom of the screen.

4Q-6

Chapter Four - Problems

Attestation Standards, Government Auditing
Standards, Quality Control Standards
NUMBER 1
An accountant is sometimes called on by clients to report on or assemble prospective financial statements for use by
third parties.
Required:
a. 1. Identify the types of engagements that an accountant may perform under these circumstances.
2. Explain the difference between "general use" of and "limited use" of prospective financial statements.
3. Explain what types of prospective financial statements are appropriate for "general use" and what types
are appropriate for "limited use".
b.

Describe the contents of the accountant's standard report on a compilation of a financial projection.

NUMBER 2
Toxic Waste Disposal Co., Inc. (TWD) is a not-for-profit organization that receives grants and fees from various
state and municipal governments as well as grants from several federal government agencies.
TWD engaged Hall & Hall, CPAs, to audit its financial statements for the year ended July 31, 1991, in accordance
with Government Auditing Standards. Accordingly, the auditors' reports are to be submitted by TWD to the granting
government agencies, which make the reports available for public inspection.
The auditors' separate report on compliance with laws and regulations that was drafted by a staff accountant of Hall
& Hall at the completion of the engagement contained the statements below. It was submitted to the engagement
partner who reviewed matters thoroughly and properly concluded that no material instances of noncompliance were
identified.
1. A statement that the audit was conducted in accordance with generally accepted auditing standards and
with Government Auditing Standards issued by the Comptroller General of the United States.
2. A statement that the auditors' procedures included tests of compliance.
3. A statement that the standards require the auditors to plan and to perform the audit to detect all instances
of noncompliance with applicable laws and regulations.
4. A statement that management is responsible for compliance with laws, regulations, contracts, and grants.
5. A statement that the auditors' objective was to provide an opinion on compliance with the provisions of
laws and regulations equivalent to that to be expressed on the financial statements.
6. A statement that the auditor's tests disclosed no instances of noncompliance.
7. A statement that the report is intended only for the information of the specific legislative or regulatory
bodies, and that this restriction is intended to limit the distribution of the report.
Required:
For each of the above statements indicate whether each is an appropriate or inappropriate element within the report
on compliance with laws and regulations. If a statement is not appropriate, explain why.

4Q-7

Chapter Four - Solutions to Questions

Attestation Standards, Government Auditing
Standards, Quality Control Standards
1. (a) Statements on Standards for Accountant's Services on Prospective Financial Information states that forecasts
take the form of historical financial statements. Thus, there is no need to explain what the information is since the
forecast represents financial statements. Answers (b), (c) and (d) are part of the accountant's report (see examples in
text).
2. (a) See Quality Control Standards.
3. (c) A record is kept of previous employees in order to ensure independence. Rule 101 of the Code of Conduct
states that there is an independence problem when a CPA or member of his firm was employed by a client during
the time period covered by the financial statements.
4. (b) As with all financial information, the client's management is responsible for the assertions in the information,
not the user or the CPA reporting on the information.
5. (d) A financial forecast is defined by Statements on Standards for Accountants' Reports on Prospective Financial
Information as a general use financial statement.
6. (a) Statements on Standards for Accountants' Reports on Prospective Financial Information do not permit the
CPA performing reviews of such information.
7. (c) The General Accounting Office performs the audit function for Congress and has published Standards for
Audits of Governmental Organizations, Programs, Activities, and Functions. The Governmental Accounting
Standards Board (GASB) and the Financial Accounting Standards Board (FASB) establish accounting standards,
not auditing standards. Answer (d) does not exist.
8. (c) The quality control element that is concerned with acceptance and continuance of clients suggests that a firm
be selective in determining its professional relationships. Answer (a) would be done if there were a predecessor
auditor and only if there were disagreements between the predecessor auditor and the client. Answers (b) and (d)
relate primarily to field standards, not acceptance issues.
9. (d) The accountant's standard report on a compilation of prospective financial statements should include an
identification of the financial statements, a statement that the accountant compiled the statements in accordance with
AICPA standards, a statement that a compilation is limited in scope [answer (b)] and does not enable the accountant
to express an opinion or any other form of assurance [answer (d)], a caveat that the results may not be achieved, a
statement that the accountant assumes no responsibility to update the report for events and circumstances occurring
after the date of the report [answer (c)]. When the presentation is a projection, the report should include a separate
paragraph that describes the limitations on the usefulness of the presentation [answer (a)].
10. (d) An accountant may be engaged to examine, compile, or apply agreed-upon procedures to financial forecasts
or other prospective financial statements. An examination of a financial forecast involves evaluating the preparation
of the forecasted statements, evaluating the support underlying the assumptions used in preparing the statements,
evaluating the presentation of the statements for conformity with AICPA guidelines, and issuing an examination
report. Answer (a) is a compilation, not an examination. Answer (b) is incorrect because the accountant's report on
the examination of a financial forecast can be distributed to parties outside of the reporting entity. Answer (c) is
incorrect because the accountant's report specifically states that the accountant assumes no responsibility to update
the report for events and circumstances occurring after the date of the report.

4S-1

11. (d) Projected financial statements present to the best of the responsible party's knowledge, given one or more
hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. These
projected statements are for the limited use of parties with whom the responsible party is dealing directly. When
compiling projected financial statements, the accountant's report should include a paragraph that describes these
limitations on the usefulness of the presentation. The accountant's report does not include references to the items in
answers (a), (b) and (c).
12. (d) An accountant should not examine a presentation that omits all disclosures of assumptions. If the
presentation fails to disclose assumptions that appear to be significant, the accountant should describe the
assumptions in his report and issue an adverse opinion. Answer (a) would be appropriate if, in the accountant's
opinion, the prospective financial statements depart from AICPA presentation guidelines, other than a failure to
disclose significant assumptions. Answers (b) and (c) are not examples of modified accountant's reports involving a
financial forecast examination.
13. (c) According to the, "Statements on Standards for Prospective Financial Information," there are two types of
prospective financial information: forecasts and projections. Forecasts are appropriate for "general use," meaning
the CPA's report does not have to name a specific user. Projections are appropriate only for "limited use," meaning
the CPA's report must specify a named user. Answer (c) is correct because both a forecast and a projection can be
issued and specify a named user, thus "limited use."
14. (b) Significant deficiencies in the design or operation of the internal control structure that come to the auditor's
attention are referred to as reportable conditions. Generally Accepted Auditing Standards require that these
deficiencies be reported to the audit committee or others with equivalent authority and responsibility. Government
Auditing Standards require that these deficiencies be reported to the auditee and to the appropriate officials of the
organizations requiring or arranging for the audits, including legislative and regulatory bodies. Answers (a), (c) and
(d) are incorrect because the auditor has no responsibility to communicate reportable conditions, including those
that may be of such magnitude as to be considered a material weakness, to the SEC, court-appointed committees, or
influential stockholders.
15. (b) An attestation engagement is an engagement that provides either positive or negative assurance concerning
financial information. An engagement to report on compliance with a statutory requirement provides negative
assurance that thus is an attestation engagement.
16. (d) A report on a financial projection is identified as a "limited use" report, which means that the report is not for
general distribution. Such a report is restricted to be used only the parties named in the report. Since the
stockholders could have changed from the report date it would be inappropriate to distribute a report on a financial
projection to those individuals who are no longer stockholders.
17. (b) The objective of a system of quality controls within a CPA firm is to be reasonably assured of complying
with the professional standards of the profession.
18. (a) A system of quality control for a CPA firm, which usually encompasses quality control policies and
procedures, assignment of responsibilities, communication, and monitoring, can provide a CPA firm with
reasonable assurance of conforming with professional standards. Answer (b) refers to peer review which, as an
external study of a firms quality controls, can help evaluate a firms professional practice but is not done on a
regular, ongoing basis. Answer (c) lists one example of an element of quality control. Answer (d) could be
considered an example of a professional standard with which a firm should conform.
19. (d) A practitioner's report on an examination of management's assertion about the effectiveness of the entity's
internal control structure should include a paragraph stating that, because of inherent limitations of any internal
control structure, errors or irregularities may occur and not be detected. In addition, the report should include a title
with the word independent, identify management's assertion, state that the examination was made in accordance
with AICPA standards, and include the practitioner's opinion. The report would not include the statements presented
in answers (a), (b) and (c).

4S-2

20. (d) Government Auditing Standards requires a written report on the internal control structure in all audits. Those
standards also require description of any reportable conditions noted, identification of the categories of the internal
control structure, description of the scope of the auditors work in obtaining an understanding of the internal control
structure and in assessing control risk, and description of deficiencies in the internal control structure not considered
significant enough to be reportable conditions. Regarding answer (a), if the auditor notes no reportable conditions
during an audit he may so state, rather than give negative assurance. The report does not include the comments
about reliable controls and strengths noted in answers (b) and (c).
21. (c) The auditor should design the audit to provide reasonable assurance that the financial statements are free of
material misstatements resulting from violations of laws and regulations that have a direct and material effect on the
determination of financial statement amounts. This responsibility exists for all audits conducted in accordance with
generally accepted auditing standards. The auditor undertakes the same responsibility in an audit, in accordance
with Government Auditing Standards, of financial statements of a not-for-profit organization that accepts financial
assistance from a governmental entity.
22. (a) The reporting accountant Blue, CPA, should consult with the continuing accountant to ascertain all the
available facts relevant to forming a professional judgment. This is a service which can be rendered and an opinion
can be given, thus eliminating answer (c). Answers (b) and (d) include activities that are not required when
undertaking this type of engagement.
23. (a) The services of independent auditors include audits of financial statements and schedules contained in
registration statements filed with the Securities and Exchange Commission. In connection with this type of service,
they are often called upon to perform other services, including the issuance of letters to underwriters, commonly
called comfort letters.
24. (c) A financial projection is a prospective financial statement that presents, to the best of the knowledge of the
party responsible for its preparation, given one or more hypothetical assumptions, an entity's financial position,
results of operations, and changes in cash flows. As compared to a financial forecast, which is available for general
use, a financial projection is a limited use report that is not appropriate for general distribution. Limited use refers to
the use of prospective financial statements by the responsible party and third parties with whom the responsible
party is dealing directly, such as a bank, that is able to question the responsible party directly about the information.
Answers (a), (b) and (d) refer to general users of financial information who are typically not dealing directly with
those responsible for preparing the prospective information.
25. (c) A CPA firm should consider nine elements of quality control, including the adoption of policies and
procedures for assigning personnel to engagements to provide the firm with reasonable assurance that work will be
performed by persons having the degree of technical training and proficiency required in the circumstances. The
other eight elements of quality control are independence, consultation, supervision, hiring, professional
development, advancement, acceptance and continuation of clients, and inspection. Answers (a), (b) and (d) affect
audits, but are not quality control policies and procedures.
26. (b) Government Auditing Standards include additional reporting standards for financial statement audits. One of
those standards requires that the report on the financial statements describe the scope of the auditors' testing of
compliance with laws and regulations and internal controls and present the results of those tests. The standard goes
on to state that in presenting the results of those tests, auditors should report irregularities, illegal acts, and other
material noncompliance. Discoveries of fraud, which is a type of illegal act involving the obtaining of something of
value through willful misrepresentation, would also be reported. Answer (a) is incorrect because the auditor does
not test all controls. Answer (c) is incorrect because materiality criteria are not specified in the auditor's report.
Answer (d) is incorrect because affects of compliance on an entity's goals and objectives, which relate more to
performance audits than to financial audits, would not be included in the auditor's report.
27. (d) The objective of pro forma financial information is to show what the significant effects on historical
financial information might have been had a consummated or proposed transaction occurred at an earlier date. An
accountant can be engaged to examine or review pro forma financial information. In a review report, the accountant
should identify the pro forma information, refer to the financial statements from which the historical information is

4S-3

derived and state whether such financial statements were audited or reviewed, state that the review was in
accordance with AICPA standards, explain the objective of pro forma information and its limitations, and provide
negative assurance regarding the pro forma information. No reference is made to the internal control structure, as
noted in answer (a). Answer (b) is incorrect because the historical information had to have been audited or
reviewed. Answer (c) is incorrect because such a statement regarding achievability is included in reports on
prospective financial statements, not on pro forma financial information.
28. (a) An auditor is required to obtain a client representation letter from management as part of every audit
conducted in accordance with generally accepted auditing standards. Among the items covered in such a letter are
violations or possible violations of laws and regulations whose effects should be considered for disclosure in the
financial statements or as a basis for recording a loss contingency. In audits of governmental entities, auditors
should consider obtaining additional representations from management acknowledging that management is
responsible for the entity's compliance with laws and regulations applicable to it and that management has identified
and disclosed to the auditor all laws and regulations that have a direct and material effect on the determination of
financial statement amounts. Answer (b) is unrealistic in that it refers to detecting all illegal acts, which could
include immaterial ones. Answer (c) is incorrect because the auditor would want positive assurance only; negative
assurance from management would be inadequate in regard to compliance with laws and regulations. Answer (d) is
desirable and at the discretion of management, but not typically included in a representation letter.
29. (b) When the auditor has noted reportable conditions in a financial statement audit conducted in accordance with
Government Auditing Standards, the auditor's report on the internal control structure should contain a description of
the scope of the auditor's work, stating that the auditor obtained an understanding of the design of relevant policies
and procedures, determined whether these policies and procedures have been placed in operation, and assessed
control risk. The auditor's report also includes a statement that the auditor considered the internal control structure
in determining audit procedures for purposes of expressing an opinion on the financial statements and not to provide
assurance on the internal control structure, rather that stating that no assurance on the internal control structure was
provided, as indicated in answer (a). The auditor's report also contains a statement about whether the auditor
believes any of the reportable conditions described in the report are material weaknesses, which is the opposite of
what is stated in answer (d). No reference is made to responsibilities of funding or legislative bodies, as stated in
answer (c).
30. (b) AT 400 states that a practitioner may examine and report on management's assertion about the effectiveness
of an entity's internal control structure if the following conditions are met:
Management accepts responsibility for the effectiveness of the entity's internal control structure.
Management evaluates the effectiveness of the entity's internal control structure using reasonable "control
criteria" for effective internal control structures established by a recognized body.
Sufficient evidential matter exists or could be developed to support management's evaluation.
Management presents its written assertion about the effectiveness of the entity's internal control structure based
upon the control criteria referred to in its report.
Choice (a) is incorrect because the examination may be separate or in conjunction with an audit. Choice (c) is
incorrect because no requirement for previous engagement exists in order to issue a report on the clients internal
control. Choice (d) is incorrect because, if managements assertion is presented in a report that accompanies the
practitioners report, then it is considered appropriate for general distribution.
31. (c) QC 90 states that policies and procedures should be established for deciding whether to accept or continue a
client in order to minimize the likelihood of association with a client whose management lacks integrity. Suggesting
that there should be procedures for this purpose does not imply that a firm vouches for the integrity or reliability of
a client, nor does it imply that a firm has a duty to anyone but itself with respect to the acceptance, rejection, or
retention of clients.

4S-4

32. (a) AT 400.50 states that when management presents its assertion in a separate report that will accompany the
practitioner' s report, the practitioner' s report should include:
A title that includes the word independent.
An identification of management's assertion about the effectiveness of the entity's internal control structure over
financial reporting.
A statement that the examination was made in accordance with standards established by the AICPA and,
accordingly, that it included obtaining an understanding of the internal control structure over financial
reporting, testing and evaluating the design and operating effectiveness of the internal control structure, and
performing other such procedures as the practitioner considered necessary in the circumstances. In addition, the
report should include a statement that the practitioner believes the examination provides a reasonable basis for
his or her opinion.
A paragraph stating that because of inherent limitations of any internal control structure, errors or irregularities
may occur and not be detected. In addition, the paragraph should state that projections of any evaluation of the
internal control structure over financial reporting to future periods are subject to the risk that the internal
control structure may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
The practitioner's opinion on whether management's assertion about the effectiveness of the entity's internal
control structure over financial reporting as of the specified date is fairly stated, in all material respects, based
on the control criteria.
33. (c) AU 801 states that when the audit of an entity's compliance with requirements governing a major federal
financial assistance program detects noncompliance with those requirements which the auditor believes have a
material effect on that program, the auditor should express a qualified or adverse opinion. The auditor should state
the basis for such an opinion in the report.
34. (b) Government Auditing Standards include additional reporting standards for financial statement audits. One of
those standards requires that the report on the financial statements describe the scope of the auditor's testing of
compliance with laws and regulations and internal controls. Answers (a) and (d) relate to performance audits, which
include economy and efficiency and program audits, rather than financial statement audits. Answer (c) is incorrect
because specific descriptions of statistical testing methods are not included in an auditor's report.
35. (a) A system of quality control for a CPA firm encompasses the firm's organizational structure and the policies
adopted and procedures established to provide the firm with reasonable assurance of conforming with professional
standards. The nature and extent of a firm's quality control policies and procedures depend on a number of factors,
such as its size, the degree of operating autonomy allowed its personnel and its practice offices, the nature of its
practice, its organization, and appropriate cost-benefit considerations.
36. (c) A CPA may be engaged to examine and report on management's written assertion about the effectiveness of
an entity's internal control structure. Management may present its written assertion in a separate report that will
accompany the CPA's report or in a representation letter to the CPA. In the latter case, the CPA should restrict the
use of his or her report to management and others within the entity and, if applicable, to specified regulatory
agencies. Answers (a), (b) and (d) are incorrect because management's assertion can be presented in a separate
report or in a representation letter.
37. (a) Financial projections are prospective financial statements that are based on one or more hypothetical
assumptions. Projected financial statements should be distributed only to those who are negotiating directly with the
party responsible for those financial statements because the negotiating parties are able to ask the responsible party
directly about the presentation; specifically, the hypothetical assumptions. Thus, when an accountant examines a
projection, his report should include a separate paragraph that describes the limitations on the usefulness of the
presentation. That paragraph states that the projection and the accountant's report were prepared for a special
purpose and should not be used for any other purpose. Answer (b) is incorrect because the accountant's report does
explain that an examination was made in accordance with AICPA standards, but does not explain differences
between an examination and an audit. Answer (c) is incorrect because the report includes a statement that the
accountant assumes no responsibility to update the report. Answer (d) is incorrect because, in an examination, the

4S-5

report does include the accountant's opinion that the underlying assumptions provide a reasonable basis for the
projection given the hypothetical assumptions.
38. (b) When auditing recipients of governmental financial assistance, the auditor must design the audit to provide
reasonable assurance that the financial statements are free of material misstatements resulting from violations of
laws and regulations that have a direct and material effect on the determination of financial statement amounts. The
auditor must understand the laws and regulations that are generally recognized to have a direct and material effect
on the financial statements, and to assess whether management has identified such laws and regulations. Answer (a)
is incorrect because although the auditor reports on internal control structure when auditing a recipient of
governmental financial assistance, the auditor's report does not describe costs and benefits of control changes.
Answer (c) is incorrect because the audit is designed to detect material errors and irregularities. Answer (d) is
incorrect because the auditor's opinion does not address eligibility for financial assistance.
39. (b) In an audit of an entity's financial statements conducted in accordance with generally accepted auditing
standards, the auditor considers materiality in relation to the financial statements. In auditing an entity's compliance
with requirements governing each major federal financial assistance program in accordance with the Single Audit
Act, the auditor considers materiality in relation to each such program. When reaching a conclusion as to whether
the effect of noncompliance is material to a major federal financial assistance program, an auditor ordinarily should
consider the nature of the noncompliance and the amount affected by the noncompliance in relation to the nature
and amount of the major federal financial assistance program under audit. Answer (a) is incorrect because
materiality is determined in relation to each major program, not in relation to the financial statements taken as a
whole. Answer (c) is incorrect because materiality and risk, although related, are evaluated independently by the
auditor. Answer (d) is incorrect because an auditor always considers materiality in an audit.
40. (b) Government auditing standards include a general standard stating that each audit organization conducting
government audits should have an appropriate internal quality control system in place and participate in an external
quality control review program. A CPA seeking to enter into a contract to perform an audit subject to government
auditing standards should provide the CPA's most recent external quality review report to the party contracting for
the audit. Answer (a) is incorrect because the external quality control review must take place at least every three
years, not annually. Answer (c) is incorrect because an external quality control review involves reviewing working
papers from a sample of audits, not reviewing working papers of each government audit. Answer (d) is incorrect
because there is no restriction on making the external quality control review report available to the public.
41. (a) The audit of recipients of federal financial assistance is conducted under Generally Accepted Governmental
Auditing Standards. Because the recipient has a legal obligation to spend monies in accordance with applicable laws
and regulations, the auditor has the responsibility to audit and report on compliance.

4S-6

Chapter Four - Solutions to Problems

Attestation Standards, Government Auditing
Standards, Quality Control Standards
NUMBER 1
a.

1.
2.

3.

An accountant who reports on or assembles prospective financial statements for use by third parties should
perform any one of three engagements. The accountant may compile, examine, or apply agreed-upon
procedures to the prospective financial statements.
"General use" of prospective financial statements refers to use of the statements by persons (creditors,
stockholders, etc.) with whom the responsible party (management) is not negotiating directly. "Limited
use" of prospective financial statements refers to the use of prospective financial statements by the
responsible party alone or by the responsible party and third parties with whom the responsible party is
negotiating directly.
Only a financial forecast is appropriate for general use, but any type of prospective financial statements
(either a financial forecast or a financial projection) would normally be appropriate for limited use.

b. The accountant's standard report on a compilation of a financial projection should include

An identification of the projection presented by the responsible party.

A statement that the accountant has compiled the projection in accordance with standards established by
the AICPA.
A separate paragraph that describes the limitations on the use of the presentation.
A statement that a compilation is limited in scope and does not enable the accountant to express an
opinion or any other form of assurance on the projection or the assumptions.
A caveat that the prospective results may not be achieved.
A statement that the accountant assumes no responsibility to update the report for events and
circumstances occurring after the date of the report.

NUMBER 2
1.
2.
3.
4.
5.
6.
7.

Statement 1 is appropriate.
Statement 2 is appropriate.
Statement 3 is not appropriate because the auditors are required to plan and perform the audit to provide
reasonable assurance of detecting instances of noncompliance having a direct and material effect on the
financial statements, not all instances of noncompliance.
Statement 4 is appropriate.
Statement 5 is not appropriate because rendering an opinion is a higher level of reporting than the positive and
negative assurance required by Government Auditing Standards.
Statement 6 is appropriate.
Statement 7 is not appropriate because Government Auditing Standards require that, unless restricted by law or
regulation, copies of the reports should be made available for public inspection.

4S-7

Chapter Five
Reviews, Compilations, Special Reports and Other
Reports
COMPILATION ENGAGEMENTS AND REVIEW ENGAGEMENTS,
Non-Public Companies (SSARS No. 1)
I. DEFINITIONS:
SSARS:
1. Statements on Standards for Accounting and Review Services.
2. Applies only to non-public entities.
3. Issued by the Accounting and Review Services Committee of the AICPA.
A compilation is the presentation in the form of financial statements, information that is the representation of
management without undertaking to express any assurance on the statements.
A review involves inquiry and analytical procedures that provide the accountant with a reasonable basis for
expressing limited assurance that there are no material modifications that should be made to the statements in
order for them to be in conformity with generally accepted accounting principles or OCBOA.
A nonpublic entity is any entity other than one (a) whose securities trade publicly either locally, regionally,
nationally, or in foreign markets, or (b) that makes a filing with a regulatory agency in preparation for the sale
of any class of its securities in a public market.

II. FINANCIAL STATEMENTS DEFINED FOR PURPOSES OF THIS STATEMENT

A presentation of financial data, including accompanying notes, derived from accounting records and intended
to communicate an entity's economic resources or obligations at a point in time, or the changes therein for a
period of time, in accordance with GAAP or OCBOA.
Examples:
Balance sheet; Income statement-Statement of retained earnings; Statement of cash flows; Statement of changes
in owners' equity; Statement of assets and liabilities; Statement of revenue and expenses; Summary of
operations; Statement of operations by product lines; Statement of cash receipts and disbursements.
Financial statements may be that of a corporation, a consolidated group, a combined group of affiliated entities,
a not-for-profit organization, a government unit, an estate or trust, a partnership, a proprietorship, a segment of
any of these or an individual.
Excluded for purposes of this statement are financial forecasts, projections, and financial presentations included
in tax returns.

5-1

III. COMPILATION OF FINANCIAL STATEMENTS

A. Statements compiled without audit or review should be accompanied by a report stating that:
1. A compilation has been performed.
2. It is limited to presenting, in the form of financial statements, information that is the representation of
management.
3. The statements have not been audited or reviewed and no opinion is expressed or any other form of
assurance given.
No procedures performed by the accountant should be described in the report. The report should be dated as of
the completion of the compilation. Each page of the statements should include a reference such as "See
Accountant's Compilation Report".
Addressee
I (we) have compiled the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements, information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them.
Signature, date

Reporting on a Compilation When Substantially All Disclosures are Omitted

Statements may be prepared omitting substantially all disclosures provided the omission is clearly indicated in the
accountant's report. When the entity wishes to disclose only a few matters in the form of notes, such disclosures
should be labeled, "Selected InformationSubstantially All Disclosures Required by Generally Accepted
Accounting Principles Are Not Included."
If the statements are prepared on a comprehensive basis of accounting other than GAAP, the basis should be
disclosed in the accountant's report.
The following form of report should be used when substantially all disclosures have been omitted.
Addressee
I (we) have compiled the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them.
Management has elected to omit substantially all of the disclosures (and the statement of cash
flows) required by generally accepted accounting principles. If the omitted disclosures were
included in the financial statements, they might influence the user's conclusions about the
company's financial position, results of operations, and cash flows. Accordingly, these financial
statements are not designed for those who are not informed about such matters.
Signature, date

5-2

B. Procedures to be FollowedCompilation
1. The accountant should possess a level of knowledge of the accounting principles and practices of the
industry in which the entity operates. This will allow him to compile financial statements that are
appropriate in turn with the industry.
2. Through a continuing relationship with the client or inquiry of client personnel, the accountant should
obtain an understanding of the nature of the entity's business transactions, the form of accounting
records, the qualifications of accounting personnel, and the form and content of the financial
statements. On the basis of this understanding, the accountant may decide to provide other accounting
services such as assistance in adjusting the accounting records.
3. The accountant is not required to make inquiries or perform other procedures. However, the
accountant may have done so, and as such, it may come to the accountant's attention that the
information supplied by the entity is in error, incomplete, or otherwise unsatisfactory. Under such
circumstances, the accountant should obtain additional or revised information. If the entity refuses to
cooperate, the accountant should withdraw from the engagement.

Reporting on a Compilation That Has Departures from GAAP

If the accountant concludes that modification of his standard report is appropriate, the departure should be disclosed
in a separate paragraph of his report, including disclosure of the effects of the departure on the financial statements
if such effects have been determined by management or are known as the result of the accountant's procedures.
Example:
Addressee
I (we) have compiled the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them. However, I (we) did become aware of a departure (certain departures) from generally
accepted accounting principles that is (are) described in the following paragraph(s).
(Separate paragraph)
As disclosed in note X to the financial statements, generally accepted accounting principles
require that land be stated at cost. Management has informed me (us) that the company has stated
its land at appraised value and that, if generally accepted accounting principles had been followed,
the land account and stockholders' equity would have been decreased by $500,000.
C. Compilation Engagements Issuance of Management Use Only Financial Statements (SSARS No.
8)
1. Management use only engagements are compilations and thus follow all the standards for performing
(performance standards) a compilation. The difference is that no compilation report is issued by the
accountant.
2. Conditions necessary to conduct the engagement:
a. A written understanding must be reached with management regarding the services to be performed
and the limitations on the use of the financial statements.
b. Each page of the financial statements must include a reference such as:
Restricted for Management Use Only.

5-3

IV. REVIEW OF FINANCIAL STATEMENTS

A. Requirements for a Review
1. The accountant should obtain a level of knowledge of both the industry and entity's accounting
principles and practices. Such an understanding will serve as a basis for the performance of inquiry
and analytical procedures which lead to the accountant's limited assurance that there are no material
modifications that should be made to the financial statements.
2. The accountant should have a thorough understanding of the entity's operation characteristics, the
nature of its assets, liabilities, revenue and expenses, and the entity's production and distribution
patterns. Such an understanding is usually obtained through experience with the entity or inquiry of
the entity's personnel.
3. The accountant's inquiry and analytical procedures should ordinarily consist of the following:
Inquiry concerning the entity's accounting principles.
Inquiry concerning the entity's procedures for recording, classifying, and summarizing
transactions.
Analytical procedures designed to identify relationships and individual items that appear to be
unusual.
Inquiry concerning meetings of stockholders, directors, or committees of the board of directors.
Reading the financial statements, with the information the accountant has gathered to date, to
determine whether the statements appear to conform with GAAP.
Obtaining reports from other accountants, if any, who have been engaged to audit or review the
financial statements of significant subsidiaries.
Inquiry of persons having responsibility for financial and accounting matters concerning (1)
whether the financial statements are in conformity with GAAP, (2) changes in the entity's business
activities or accounting principles, (3) matters as to which questions have arisen in the course of
the review, and (4) events subsequent to the date of the financial statements that would have a
material effect on the statements.
4. Knowledge acquired in the performance of audits of the entity's financial statements, compilation of
the financial statements, or other accounting services may require modification of the aforementioned
procedures.
5. A review is not as complete an examination of financial statements as an audit. Thus, a review does
not provide assurance that the accountant will become aware of all significant matters that would be
disclosed in an audit.
6. The accountant must obtain a representation letter signed by the manager, owner, or chief
executive officer. Failure to obtain such a letter renders the review incomplete and the accountant is
prohibited from issuing a review report. Also the accountant may not step down the service and issue a
compilation report.
B. Report on Review of Financial Statements
1. A report on a review of financial statements should include information that:
a. A review was performed in accordance with the standards for such engagements established by
the AICPA.
b. The financial statements are representations of management.
c. The review consists principally of inquiries and analytical procedures.
d. The review is less in scope than an audit and, as such, no opinion expressed on the financial
statements.
e. The accountant is not aware of any material modifications that should be made to the financial
statements.

5-4

Example
Addressee
I (we) have reviewed the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year
then ended, in accordance with Statements on Standards for Accounting and Review Services
issued by the American Institute of Certified Public Accountants. All information included in
these financial statements is the representation of the management (owners) of XYZ
Company.
A review consists principally of inquiries of company personnel and analytical procedures
applied to financial data. It is substantially less in scope than an examination in accordance
with generally accepted auditing standards, the objective of which is the expression of an
opinion regarding the financial statements taken as a whole. Accordingly, I (we) do not
express such an opinion.
Based on my (our) review, I am (we are) not aware of any material modifications that should
be made to the accompanying financial statements in order for them to be in conformity with
generally accepted accounting principles.
Signature, date
C. Reporting on a Review That Has Departures from GAAP
When the accountant determines that the statements are not in accordance with GAAP, the accountant
should revise his report on the financial statements. Such a report should disclose the effects of the
departure, if determined by management or known to the accountant as the result of his procedures.
Example:
Addressee
I (we) have reviewed the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants. All information included in these
financial statements is the representation of the management (owners) of XYZ Company.
A review consists principally of inquiries of company personnel and analytical procedures applied
to financial data. It is substantially less in scope than an examination in accordance with generally
accepted auditing standards, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, I (we) do not express such an opinion.
Based on my (our) review, with the exception of the matter(s) described in the following
paragraph(s), I am (we are) not aware of any material modifications that should be made to the
accompanying financial statements in order for them to be in conformity with generally accepted
accounting principles.
As disclosed in note X to the financial statements, generally accepted accounting principles
require that inventory cost consist of material, labor, and overhead. Management has informed me
(us) that the inventory of finished goods and work in process is stated in the accompanying
financial statements at material and labor cost only, and that the effects of this departure from
generally accepted accounting principles on financial position, results of operations, and cash
flows have not been determined.
or

5-5

As disclosed in note X to the financial statements, the company has adopted (description of newly
adopted method), whereas it previously used (description of previous method). Although the
(description of newly adopted method) is in conformity with generally accepted accounting
principles, the company does not appear to have reasonable justification for making a change as
required by Opinion No. 20 of the Accounting Principles Board.

V. OTHER MATTERSCOMPILATION AND REVIEW ENGAGEMENTS

A. Change in the nature of engagement
An accountant who has been engaged to examine the financial statements of a nonpublic entity in
accordance with GAAS, may, before completion of his engagement, be requested to change the scope of
his engagement to a review or compilation.
Such a request, if it results from the entity's requirement for an audit or a misunderstanding concerning the
nature of an audit, would ordinarily be considered a reasonable basis for a change in the scope of
examination.
If a request was a result of a restriction on the scope of an audit examination, the accountant should
evaluate the possibility that information affected by the scope restriction may be incorrect or incomplete.
If, however, the accountant was prohibited from corresponding with the client's legal counsel, or when
management refuses to sign a client representation letter, the accountant ordinarily would be precluded
from issuing a review or compilation report.
B. Engagement letters
In all cases the accountant should (although not required to) prepare an engagement letter. Such a letter
would outline the degree of responsibility the accountant is taking for the financial statements.

5-6

SUMMARY OF
COMPILATION AND REVIEW
ENGAGEMENTS
FACTOR

COMPILATION

REVIEW

Level of
Assurance

None

Limited
(Negative Assurance)

Type of Entity

Non-Public

Non-Public

Type of Evidence
Obtained

None Required

1. Inquiry
2. Analytical
procedures

Knowledge of client's
industry and business

Yes

Yes

Responsibility for
information in financial
statements

Client

Client

Required Reasons to
modify standard report

1. Known GAAP or
disclosure departures
2. Election by client to
omit all disclosures and/or
statements of cash flows
3. Accountant not
independent

1. Known GAAP or
disclosure departures

Representation Letter
required

No

Yes

Account needs to be
independent

No

Yes

Engagement Letter
required

No, but should reach

understanding with client*

No, but should reach

understanding with client

*If engaged to prepare management use only financial statements, must document terms of
engagement in a written form with the entity.

5-7

REPORTING ON COMPARATIVE FINANCIAL STATEMENTS,

COMPILATION AND REVIEW ENGAGEMENTSNON-PUBLIC COMPANIES
(SSARS No. 2)
I.

This section establishes standards for reporting on comparative financial statements of a nonpublic entity when
financial statements of one or more periods presented have been compiled or reviewed in accordance with
SSARS No. 1.

II. An example of a continuing accountant's standard report on comparative financial statements for two periods
when the financial statements of the current period have been reviewed and those of the prior period have been
compiled is presented below:
Addressee
I (we) have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20XX,
and the related statements of income, retained earnings, and cash flows for the year then ended, in
accordance with Statements on Standards for Accounting and Review Services issued by the American
Institute of Certified Public Accountants. All information included in these financial statements is the
representation of the management (owners) of XYZ Company.
A review consists principally of inquiries of company personnel and analytical procedures applied to
financial data. It is substantially less in scope than an examination in accordance with generally
accepted auditing standards, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, I (we) do not express such an opinion.
Based on my (our) review, I am (we are) not aware of any material modifications that should be made
to the 20XX financial statements in order for them to be in conformity with generally accepted
accounting principles.
The accompanying 20X0 financial statements of XYZ Company were compiled by me (us). A
compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the 20X0 financial
statements and, accordingly, do not express an opinion or any other form of assurance on them.
Signature
Date
III. A continuing accountant who performs a compilation of the current-period financial statements and has
previously reviewed one or more prior-period financial statements should report as indicated in either (a) or (b)
below:
a. Issue a compilation report on the current-period financial statements that includes a description of the
responsibility assumed for the financial statements of the prior period. The description should include the
original date of the accountant's report and should also state that he has not performed any procedures in
connection with that review engagement after that date.
b. Combine his compilation report on the financial statements of the current period with his reissued review
report on the financial statements of the prior period or present them separately. The combined report
should state that the accountant has not performed any procedures in connection with that review
engagement after the date of his review report.
An example of a paragraph that may be added to a compilation report on the current-period financial
statements describing the responsibilities assumed when prior-period financial statements were reviewed
follows:

5-8

The accompanying 20X0 financial statements of XYZ Company were previously reviewed by me
(us) and my (our) report dated March 1, 20XX, stated that I was (we were) not aware of any
material modifications that should be made to those statement in order for them to be in
conformity with generally accepted accounting principles. I (we) have not performed any
procedures in connection with that review engagement after the date of my (our) report on the
20X0 financial statements.
IV. Continuing Accountant's Changed Reference to a Departure from Generally Accepted Accounting Principles
A. During his current engagement, the accountant should be aware that circumstances or events may affect the
prior-period financial statements presented, including the adequacy of informative disclosures. The
accountant should consider the effects on his report on the prior-period financial statements of
circumstances or events coming to his attention.
B. When the accountant's report on the financial statements of the prior period contains a changed reference to
a departure from generally accepted accounting principles, his report should include a separate explanatory
paragraph indicating
1. The date of the accountant's previous report.
2. The circumstances or events that caused the reference to be changed.
3. When applicable, that the financial statements of the prior period have been changed.
The following is an example of an explanatory paragraph appropriate when an accountant's report contains
a changed reference to a departure from generally accepted accounting principles:
In my (our) previous (compilation) (review) report dated March 1, 19X2, on the 19X1 financial
statements, I (we) referred to a departure from generally accepted accounting principles because
the company carried its land at appraised values. However, as disclosed in note X, the company
has restated its 19X1 financial statements to reflect its land at cost in accordance with generally
accepted accounting principles.
V. Predecessor's Compilation or Review Report
A predecessor may reissue his report at the client's request if he is able to make satisfactory arrangements with
his former client and performs additional procedures outlined below. However, a predecessor is not required to
reissue his compilation or review report on the financial statements of a prior period. If he does not reissue his
compilation or review report on the financial statements of a prior period, a successor should either (a) make
reference to the report of the predecessor, or (b) perform a compilation, review, or audit of the financial
statements of the prior period and report on them accordingly.
A. Predecessor's Compilation or Review Report Not Presented
When the financial statements of a prior period have been compiled or reviewed by a predecessor whose
report is not presented and the successor has not compiled or reviewed those financial statements, the
successor should make reference in an additional paragraph(s) of his report on the current-period financial
statements to the predecessor's report on the prior-period financial statements. This reference should
include the following matters:
1. A statement that the financial statements of the prior period were compiled or reviewed by another
accountant (other accountants).
2. The date of his (their) report.
3. A description of the standard form of disclaimer or limited assurance, as applicable, included in the
report.
4. A description or a quotation of any modifications of the standard report and of any paragraphs
emphasizing a matter regarding the financial statements.

5-9

When the predecessor reviewed the financial statements of the prior period, an example of the last
paragraph of the successor's report is as follows:
The 20X0 financial statements of XYZ Company were reviewed by other accountants whose
report dated March 1, 20XX, stated that they were not aware of any material modifications that
should be made to those statements in order for them to be in conformity with generally accepted
accounting principles.
When the predecessor compiled the financial statements of the prior period, an example of the last
paragraph of the successor's report is as follows:
The 20X0 financial statements of XYZ Company were compiled by other accountants whose
report dated February 1, 20XX, stated that they did not express an opinion or any other form of
assurance on those statements.
B. Predecessor's Compilation or Review Report Reissued
Before reissuing a compilation or review report on the financial statements of a prior period, a predecessor
should consider whether his report is still appropriate. In making this determination, the predecessor should
consider (a) the current form and manner of presentation of the prior-period financial statements, (b)
subsequent events not previously known, and (c) changes in the financial statements that require the
addition or deletion of modifications to the standard report.
A predecessor should perform the following procedures before reissuing his compilation or review report
on the financial statements of a prior period:
1. Read the financial statements of the current period and the successor's report.
2. Compare the prior-period financial statements with those previously issued and with those of the
current period.
3. Obtain a letter from the successor that indicates whether he is aware of any matter that, in his opinion,
might have a material effect on the financial statements, including disclosures, reported on by the
predecessor. The predecessor should not refer in his reissued report to this letter or to the report of the
successor.
If a predecessor becomes aware of information, including information about events or transactions
occurring subsequent to the date of his previous report, that he believes may affect the prior-period
financial statements or his report on them, he should (a) make inquiries or perform analytical procedures
similar to those he would have performed if he had been aware of such information at the date of his report
on the prior-period financial statements and (b) perform any other procedures he considers necessary in the
circumstances.
A predecessor's knowledge of the current affairs of his former client is obviously limited in the absence of
a continuing relationship. Consequently, when reissuing his report on the prior-period financial statements,
a predecessor should use the date of his previous report to avoid any implication that he has performed
procedures after that date. If the predecessor revises his report or if the financial statements are restated, he
should dual-date his report (for example, "March 1, 20XX, except for note X, as to which the date is March
15, 20XX"). The predecessor's responsibility for events occurring subsequent to the completion of his
engagement is limited to the specific event referred to in the note or otherwise disclosed. He should also
obtain a written statement from the former client setting forth the information currently acquired and its
effect on the prior-period financial statements and, if applicable, expressing an understanding to its effect
on the predecessor's reissued report.
If a predecessor is unable to complete the procedures described, he should not reissue his report and may
wish to consult with his attorney regarding the appropriate course of action.

5-10

VI. Changed Prior-Period Financial Statements

When the financial statements of the prior period have been changed, either the predecessor or the successor
should report on them as restated. If a successor reports on the restated financial statements, he should not refer
in his report to the predecessor's previously issued report.
If the restatement does not involve a change in accounting principles or their application (for example, the
correction of an error), the accountant may wish to include an explanatory paragraph in his report with respect
to the restatement, but he should not otherwise modify his standard report provided the financial statements
appropriately disclose such matters.
VII. Reporting When One Period is Audited
The accountant should follow the guidance in statement on auditing standards, which provide guidance on
reporting on comparative financial statements when the current-period financial statements have been audited
and those for one or more prior periods have been compiled or reviewed.
When the current-period financial statements of a nonpublic entity have been compiled or reviewed and those
of the prior period have been audited, the accountant should issue an appropriate compilation or review report
on the current-period financial statements and either (a) the report on the prior period should be reissued or (b)
the report on the current period should include as a separate paragraph an appropriate description of the
responsibility assumed for the financial statements of the prior period. In the latter case, the separate paragraph
should indicate (a) that the financial statements of the prior period were examined previously, (b) the date of
the previous report, (c) the type of opinion expressed previously, (d) if the opinion was other than unqualified,
the substantive reasons therefor, and (e) that no auditing procedures were performed after the date of the
previous report. An example of such a separate paragraph is the following:
The financial statements for the year ended December 31, 20X0, were examined by us (other
accountants) and we (they) expressed an unqualified opinion on them in our (their) report dated
March 1, 20XX, but we (they) have not performed any auditing procedures since that date.
VIII. Reporting on Financial Statement That Previously Did Not Omit Substantially All Disclosures
An accountant who has compiled, reviewed, or audited financial statements that did not omit substantially all
of the disclosures required by generally accepted accounting principles may subsequently be requested to
compile statements for the same period that do omit substantially all of those disclosures when they are to be
presented in comparative financial statements. In these circumstances the accountant may report on
comparative financial statements that omit such disclosures if he includes in his report an additional paragraph
indicating the nature of the previous service rendered with respect to those financial statements and the date of
his previous report.
An example of a report appropriate when prior-period financial statements that omit substantially all
disclosures have been compiled from previous reviewed financial statements for the same period follows:
Addressee
I (we) have compiled the accompanying balance sheet of XYZ Company as of December 31,
20XX, and the related statements of income, retained earnings, and cash flows for the year then
ended, in accordance with Statements on Standards for Accounting and Review Services issued
by the American Institute of Certified Public Accountants.

5-11

A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them.
Management has elected to omit substantially all of the disclosures required by generally accepted
accounting principles. If the omitted disclosures were included in the financial statements, they
might influence the user's conclusions about the company's financial position, results of
operations, and cash flows. Accordingly, these financial statements are not designed for those who
are not informed about such matters.
The accompanying 20X0 financial statements were compiled by me (us) from financial statements
that did not omit substantially all of the disclosures required by generally accepted accounting
principles and that I (we) previously reviewed as indicated in my (our) report dated March 1,
20X0.
Signature
Date
IX. Change of StatusPublic/Nonpublic Entity
When reporting on comparative financial statements for either interim or annual periods, the current status of
the entity should govern whether the accountant is guided by statements on auditing standards or statements on
standards for accounting and review services. A previously issued report that is not appropriate for the current
status of the entity should not be reissued or referred to in the report on the financial statements of the current
period.
For example, if the entity is a public entity in the current period and was a nonpublic entity in the prior period, a
compilation or review report previously issued on the financial statements of the prior period should not be
reissued or referred to in the report on the financial statements of the current and one or more prior periods. If
an entity is a nonpublic entity in the current period and was a public entity in the prior period, the annual
financial statements of the prior period may have been audited. In these circumstances, the accountant should
refer to the prior section, "Reporting When One Period is Audited."

COMPILATION REPORTS ON FINANCIAL STATEMENTS INCLUDED IN CERTAIN

PRESCRIBED FORMS, NON-PUBLIC COMPANIES (SSARS No. 3)
A prescribed form is any standard preprinted form designed or adopted by the body to which it is to be submitted.
There is a presumption that the information required by a prescribed form is sufficient to meet the needs of the body
that designed or adopted the form and that there is no need for that body to be advised of departures from generally
accepted accounting principles required by the prescribed form or related instructions. Therefore, in the absence of a
requirement or a request for a review report on the financial statements included in a prescribed form, the following
form of standard compilation report may be used when the unaudited financial statements of a nonpublic entity are
included in a prescribed form that calls for departure from generally accepted accounting principles.

5-12

If the accountant becomes aware of a departure from the requirements of the prescribed form or related instructions,
he should consider that departure as the equivalent of a departure from generally accepted accounting principles in
determining its effect on his report.

COMMUNICATIONS BETWEEN PREDECESSOR AND SUCCESSOR

ACCOUNTANTS, NON-PUBLIC COMPANIES (SSARS No. 4)
I.

The following definitions apply:

Successor accountant. An accountant who has been invited to make a proposal for an
engagement to compile or review financial statements or who has accepted such an engagement.
Predecessor accountant. An accountant who has resigned or who has been notified that his
services have been terminated and who, at a minimum, was engaged to compile the financial
statements of the entity for the prior year or for a period ended within twelve months of the date of
the financial statements to be compiled or reviewed by the successor.

II. Inquiries Regarding Acceptance of an Engagement

A successor accountant is not required to communicate with a predecessor accountant in connection with
acceptance of a compilation or review engagement, but he may decide to do so, for example, when
circumstances such as the following exist:
1. The information obtained about the prospective client and its management and principals is limited or
appears to require special attention.
2. The change in accountants takes place substantially after the end of the accounting period for which
financial statements are to be compiled or reviewed.
3. There have been frequent changes in accountants.
When the successor accountant decides to communicate with the predecessor, he should request the client (a) to
permit him to make inquiries of the predecessor accountant and (b) to authorize the predecessor accountant to
respond fully to those inquiries. If the client refuses to comply fully with this request, the successor accountant
should consider the reasons for, and implications of, that refusal in connection with acceptance of the
engagement.
When the successor accountant decides to communicate with the predecessor, his inquiries may be oral or
written and ordinarily would include inquiries concerning (a) information that might bear on the integrity of
management (owners), (b) disagreements with management (owners) about accounting principles or the
necessity for the performance of certain procedures, (c) the cooperation of management (owners) in providing
additional or revised information, if necessary, and (d) the predecessor's understanding of the reason for the
change of accountants.
III. Other Inquiries
The successor accountant may wish to make other inquiries of the predecessor to facilitate the conduct of his
compilation or review engagement. Examples of such inquiries, which may be made either before or after
acceptance of the engagement, might include questions about prior periods regarding (a) inadequacies noted in
the entity's underlying financial data, (b) the necessity to perform other accounting services, and (c) areas that
have required inordinate time in prior periods.

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A successor accountant also may wish to obtain access to the predecessor's working papers. In these
circumstances, the successor should request the client to authorize the predecessor to allow such access.
Ordinarily, the predecessor should provide the successor access to working papers relating to matters of
continuing accounting significance and those relating to contingencies. Valid business reasons (including but
not limited to unpaid fees), however, may lead the predecessor to decide not to allow access to his working
papers.

REVIEW OF INTERIM FINANCIAL INFORMATIONPublic Companies

(SAS No. 71)
I.

OBJECTIVE OF A REVIEW OF INTERIM FINANCIAL INFORMATION

The objective of a review of interim financial information differs from an audit of financial statements in
accordance with GAAS. The examination of financial statements provides a reasonable basis for the expression
of an opinion on the financial statements taken as a whole. A review of interim financial information does not
provide a basis for the expression of an opinion because the review does not contemplate a study and evaluation
of internal control, tests of accounting records, and obtaining corroborating evidence to support responses to
auditor inquiries.
Timely reporting is essential when performing a review of interim financial data. At an interim period most
accounting data is estimated, especially deferrals, accruals and estimates. The accountant should be aware of
this and plan the conduct of the review to account for such factors.

II. PROCEDURES FOR A REVIEW OF INTERIM FINANCIAL INFORMATION

The accountant should be concerned with (a) the nature of procedures, (b) timing of procedures, and (c) extent
of procedures.
A. Nature of procedures
1. Inquiry concerning (a) the accounting system in order to obtain an understanding of how transactions
are recorded, classified, and summarized for the preparation on interim financial information, (b) any
significant changes in the system of internal accounting control and how such changes could affect the
generation of interim financial information.
2. Application of analytical review procedures such as comparison with prior periods, anticipated results,
and adherence to a predictable pattern of results based upon the entity's experience. These procedures
provide a basis for inquiry about relationships or results that seem unusual.
3. Reading the minutes of committees of the entity such as stockholders, board of directors, and related
subcommittees.
4. Reading the interim information to consider whether such information is in accordance with GAAP. In
applying this procedure the accountant would use all information that has come to his attention from
applying the aforementioned procedures.
5. Obtaining and reading the reports of other accountants who have been engaged to make interim
reviews of significant components of the reporting entity.
6. Inquire of officers and other executives who have responsibility for financial and accounting matters
concerning:
a. Whether the financial information is in accordance with GAAP.
b. Changes in the entity's business activity or accounting practices.
c. Questions concerning items that have arisen in applying the foregoing procedures.
d. Subsequent events that would have effect on the presentation of such interim financial
information.

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7.

Obtaining written representations from management concerning its responsibility for the financial
information, completeness of minutes, availability of accounting data, subsequent events, and other
matters the accountant believes appropriate.

B. Timing of Procedures
Adequate planning by the accountant is contemplated so that the review can be completed in an
expeditious manner. As such, the accountant should consider performing some procedures prior to the
ending of the interim period.
C. Extent of Procedures
The extent of procedures referred to under "Nature of Procedures" would be determined by:
1. The accountant's knowledge of the client's accounting and reporting practices.
2. The accountant's knowledge of weakness in internal controlIf the system of internal control appears
to contain weaknesses that do not permit the preparation of interim financial information, the
accountant should consider whether the weakness represents a restriction of the scope of his
engagement sufficient to preclude completion of such a review. In this case the accountant should also
advise senior management and the board of directors.
3. The accountant's knowledge of changes in nature or volume of activity or accounting changes
Unusual or infrequent transactions require inquiry of management in order to determine the effects and
disclosure requirements to be reported in the interim financial information.
4. Issuance of accounting pronouncementsThe accountant should be aware of any new
pronouncements on financial accounting standards and consider their potential effect on the interim
financial information.
5. Accounting records maintained at multiple locationsA client who maintains records at multiple
locations must be treated in a manner similar to the manner used in the examination of audited
financial statements. Usually this involves applying procedures both at corporate headquarters and
other locations selected by the accountant.
6. Questions raised in performing other proceduresIf the auditor questions whether the interim
information is in conformity with GAAP, he should employ procedures he considers appropriate to
permit him to report on the interim financial information.
7. Modification of review proceduresThe procedures for a review of interim financial information may
be modified to take into consideration the results of auditing procedures applied in performing an
examination in accordance with GAAP.
D. Communication with Audit Committees
The following matters should be reported to the Audit Committee:
1. Any material irregularities
2. Any material illegal acts
If, in the accountants opinion, the audit committee does not respond appropriately to the accountants
communication within a reasonable period of time, the accountant should evaluate:
1. Whether to resign from the engagement, and
2. Whether to remain as the entitys auditor.

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III. REPORTING ON INTERIM FINANCIAL INFORMATION PRESENTED OTHER

THAN IN A NOTE TO AUDITED FINANCIAL STATEMENTS
A. No modification necessary
Form of Report
Address: Board of Directors, Company or Stockholders
We have made a review of (describe the information or statements reviewed) of ABC Company and
consolidated subsidiaries as of September 30, 20X0, and for the three-month and nine-month periods then
ended, in accordance with standards established by the American Institute of Certified Public Accountants.
A review of interim financial information consists principally of obtaining an understanding of the system
for the preparation of interim financial information, applying analytical review procedures to financial data,
and making inquiries of persons responsible for financial and accounting matters. It is substantially less in
scope than an examination in accordance with generally accepted auditing standards, the objective of
which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we
do not
express such an opinion. These financial (information or statements) is(are) the responsibility of the
companys management.
Based on our review, we are not aware of any material modifications that should be made to the
accompanying financial (information or statements) for them to be in conformity with generally accepted
accounting principles.
Date: Completion of review
Signature
B. Departures from GAAP
Report example:
(Explanatory third paragraph)
Based on information furnished us by management, we believe that the Company has excluded from
property and debt in the accompanying balance sheet certain lease obligations that should be capitalized in
order to conform with generally accepted accounting principles. This information indicates that if these
lease obligations were capitalized at September 30, 20XX, property would be increased by $........, and
long-term debt by $........, and net income and earnings per share would be increased (decreased) by $........,
$........, $........, and $........, respectively, for the three-month and nine-month periods then ended.
(Concluding paragraph)
Based on our review, with the exception of the matter(s) described in the preceding paragraph(s), we are
not aware of any material modifications that should be made to the accompanying financial (information or
statements) for them to be in conformity with generally accepted accounting principles.

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C. Inadequate Disclosure
Report example:
(Explanatory third paragraph)
Management has informed us that the Company is presently contesting deficiencies in federal income taxes
proposed by the Internal Revenue Service for the years 20X0 through 20XX in the aggregate amount of
approximately $......., and that the extent of the Company's liability, if any, and the effect on the
accompanying (information or statements) are not determinable at this time. The (information or
statements) fail to disclose these matters, which we believe are required to be disclosed in conformity with
generally accepted accounting principles.
(Concluding paragraph)
Based on our review, with the exception of the matter(s) described in the preceding paragraph(s), we are
not aware of any material modifications that should be made to the accompanying financial (information or
statements) for them to be in conformity with generally accepted accounting principles.
D. Normally, neither an uncertainty nor lack of consistency in the application of accounting principles
affecting interim financial information would cause the accountant to modify his report, provided that the
interim financial information or statements appropriately describe such matters.

IV. REPORTING ON INTERIM FINANCIAL INFORMATION PRESENTED IN A NOTE TO AUDITED

FINANCIAL STATEMENTS
A. The procedures set forth previously are appropriate for the accountant's review of the interim financial
information designated as unaudited and presented in a note to audited financial statements.
B. There is no requirement to perform these procedures at other than the time of examination of the financial
statements under audit.
C. The auditor ordinarily need not modify his report for unaudited interim financial information. Such
information is not needed for a fair presentation of financial statements.
D. The auditors' report on the audited financial statements should be expanded if the scope of his review of
the interim financial information was restricted or if the interim financial information does not appear to be
presented in conformity with GAAP. The auditor should also expand his report if the interim financial
information was not reviewed unless that fact is stated in the footnote.
Example of modification:
Note X, "Unaudited Interim Financial Information," contains information that we did not audit and,
accordingly, we do not express an opinion on the information. We attempted but were unable to make a
review of such interim information in accordance with standards established by the American Institute of
Certified Public Accountants because we believe that the Company's system for preparing interim financial
information does not provide an adequate basis to enable us to complete such a review.
E. The auditor's report should also be modified if the unaudited financial information is not clearly marked
unaudited, or the footnote does not contain a clear statement that a review of interim financial information
is substantially less in scope than an audit is in accordance with GAAP.

5-17

SPECIAL REPORTS (SAS No. 62)

I.

AUDITING STANDARDS PROVIDE GUIDANCE ON REPORTS (KNOWN AS SPECIAL REPORTS)

ISSUED IN CONNECTION WITH THE FOLLOWING TYPES OF SERVICE:
A. Financial statements prepared in conformity with a comprehensive basis of accounting other than generally
accepted accounting principles.
B. Specified elements, accounts or items of a financial statement.
C. Compliance with aspects of contractual agreements or regulatory requirements related to audited financial
statements.
D. Financial presentations to comply with contractual agreements or regulatory provisions.
E. Other matters, including financial information presented in prescribed forms or schedules that require a
prescribed form of auditor's report.

II. FINANCIAL STATEMENTS PRESENTED IN CONFORMITY WITH COMPREHENSIVE BASIS

OF ACCOUNTING OTHER THAN GAAP (OCBOA)
Generally accepted auditing standards are applicable when an auditor conducts an audit of and reports on any
financial statement. The term "financial statement" refers to a presentation of financial data, including
accompanying notes, derived from accounting records and intended to communicate an entity's economic
resources or obligations at a point in time, or the changes therein for a period of time, in accordance with a
comprehensive basis of accounting.
Normally, the auditor's judgment concerning the overall presentation of financial statements is in relation to
generally accepted accounting principles. However, a comprehensive basis of accounting other than GAAP
may be used. OCBOA statements include the following:
A basis of accounting that the reporting entity uses to comply with the requirements or financial reporting
provisions of a governmental regulatory agency.
A basis of accounting that the reporting entity uses or expects to use to file its income tax return.
The cash receipts and disbursements basis of accounting, and modifications of the cash basis having
substantial support.
A definite set of criteria having substantial support that is applied to all material items appearing in
financial statements, such as the price-level basis of accounting.
A.

Reporting Requirements
When reporting on OCBOA financial statements, the report should include:
1. A title that includes the word "independent".
2. Introductory and scope paragraphs which include the same elements as the standard auditor's report.
3. A paragraph that (1) states the basis of presentation and refers to the note to the financial statements
that describes such basis; (2) states that the basis of presentation is a comprehensive basis of
accounting other than generally accepted accounting principles.
4. An opinion paragraph that expresses the auditor's opinion (or disclaims an opinion) on whether the
financial statements are presented fairly, in all material respects, in conformity with the basis of
accounting described. If the auditor concludes that the financial statements are not presented fairly on
the basis of accounting described, or if there has been a limitation on the scope of the audit, all the
substantive reasons for that conclusion should be disclosed in an explanatory paragraph(s), preceding
the opinion paragraph, and the opinion paragraph should be appropriately modified and include a
reference to such explanatory paragraph(s).

5-18

5.

6.
7.

If the financial statements are prepared in accordance with the requirements or financial reporting
provisions of a governmental regulatory agency, a paragraph that restricts the distribution of the report
solely to those within the entity and for filing with the regulatory agency. Such a restrictive paragraph
is appropriate, even though by law or regulation, the auditor's report may be made a matter of public
record. Such restrictions may also be used if any additional distribution of the financial statements is
recognized as appropriate by an AICPA accounting or audit guide or auditing interpretation.
The signature of the Firm.
The date.

If the financial statements do not meet the criteria for OCBOA presentation, the standard form auditor's report
should be used with appropriate modifications because of the departures from GAAP.

An illustrative report on income-tax basis statements follows:

The Partners
ABC Partnership

Report of Independent Certified Public Accountants

We have audited the accompanying statements of assets, liabilities and capitalincome tax basis of
ABC Partnership as of December 31, 20XX and 20X0, and the related statements of revenue and
expensesincome tax basis and changes in partners' capital accountsincome tax basis for the years
then ended. These financial statements are the responsibility of the Partnership's management. Our
responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audits provide a reasonable basis for
our opinion.
As described in Note _____, these financial statements were prepared on the same basis of accounting
the Partnership uses for income tax purposes, which is a comprehensive basis of accounting other
than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
assets, liabilities, and capital of ABC Partnership as of December 31, 20XX and 20X0, and its
revenue and expenses and changes in partners' capital accounts for the years then ended, on the basis
of accounting described in Note______.
Signature
Date

5-19

B. Statement Titles and Disclosures

The auditor should consider whether the financial statements are suitably titled. Titles such as balance
sheet, statement of income, statement of cash flows, etc., are generally understood to be applicable only to
financial statements that are intended to present financial position, results of operations or cash flows in
conformity with generally accepted accounting principles. Accordingly, titles of OCBOA statements
should be appropriately modified; if they are not, the auditor should disclose his or her reservations in an
explanatory paragraph and qualify the opinion.
The auditor should consider whether the financial statements (including the accompanying notes) include
all informative disclosures that are appropriate for the basis of accounting used. The auditor should apply
essentially the same criteria to OCBOA financial statements as for GAAP statements.
Notes to OCBOA financial statements should include a summary of significant accounting policies that
discusses the basis of presentation and describes how that basis differs from GAAP. However, the effects
of the differences between GAAP and OCBOA need not be quantified. When the statements presented
contain items that are the same or similar to GAAP financial statements, similar disclosures are
appropriate. For example, income tax basis statements usually reflect depreciation, long-term debt and
owners' equity; disclosures about such items should be comparable to those for GAAP financial statements.
The auditor should also consider the adequacy of disclosures about matters not specifically identified on
the face of the statements, such as related party transactions, restrictions on assets and owners' equity,
subsequent events and uncertainties.

5-20

SUMMARY OF ENGAGEMENTS ON
OCBOA FINANCIAL STATEMENTS

AUDIT

REVIEW

COMPILATION

Level of Assurance

Positive

Negative

None

Standards Followed

GAAS

SSARS

SSARS

Procedures Followed

Same as for GAAP

Presentations

Statements Usually
Presented

1. Statements of Assets,
Liabilities and Equity

As stated

As stated

As stated

As stated

1. Essentially standard
audit report for
GAAP but modified
for statement titles
and basis of
presentation

As stated

As stated

2. Reference in report
(separate paragraph)
that discusses the
basis of accounting
in statements

Not needed

2. Statement of
Revenues Earned and
Expenses Paid
3. Statement of Equity
Report

As stated

3. Must be modified
for
a) departures from
Basis of
Accounting,
b) inadequate
disclosures,
or
c) improper
statement
titles

5-21

Not needed except

need to include
information on basis
of accounting in
compiling without
disclosures
As stated

III. SPECIFIED ELEMENTS, ACCOUNTS, OR ITEMS OF A FINANCIAL STATEMENT

A. Audit Engagements in Accordance with GAAS
An auditor may be requested to express an opinion on one or more specified elements, accounts or items
(referred to hereinafter as "item(s)") of a financial statement, such as rentals, royalties, profit participation,
provision for income taxes, etc. The specified item may be presented in the auditor's report or in a
document accompanying such report.
Generally accepted auditing standards are applicable to such an engagement, except that the auditor's
report should indicate whether the presentation is in conformity with GAAP only when the item being
reported on is intended to be in conformity with GAAP.
An engagement to express an opinion on one or more items may be undertaken as a separate engagement
or in conjunction with an audit of financial statements. However, materiality must be measured in relation
to each individual item being reported on rather than the aggregate of all items or the financial statements
taken as a whole. Accordingly, an audit of a specified item(s) is usually more extensive than if the same
information were being considered in conjunction with an audit of financial statements taken as a whole.
The auditor should also be satisfied that other items that are interrelated with the item being reported on
have also been considered (e.g., sales and receivables; inventory and accounts payable; buildings and
equipment and depreciation).
If the auditor has expressed an adverse opinion or disclaimed an opinion on the financial statements taken
as a whole, an opinion should not be expressed on specified items within those statements if such reporting
would be tantamount to expressing a piecemeal opinion on the financial statements. However, the auditor
may be able to express an opinion on specified items if they do not constitute a major portion of the
financial statements. For example, it may be appropriate to express an opinion on accounts receivable when
the auditor has disclaimed an opinion on the financial statements due to an uncertainty regarding legal
action against the entity. In such cases, the report on the specified item should be presented separately from
the report on the financial statements.
Reporting Requirements
When reporting on one or more specified elements, accounts or items of a financial statement, the report
should include:
1.
2.

3.
4.

A title that includes the word "independent".

A paragraph that:
States that the specified elements, accounts or items identified in the report were audited. If
applicable, the paragraph should also state that the audit was made in conjunction with an audit of
the company's financial statements and indicate the date of the auditor's report on those financial
statements. Furthermore, any departure from the standard report on those statements should also
be disclosed if considered relevant to the presentation of the specified element, account or item.
States the specified elements, accounts or items are the responsibility of the company's
management and that the auditor is responsible for expressing an opinion on the specified
elements, accounts or items based on the audit.
A scope paragraph which includes the same elements as the standard auditor's report.
A paragraph that (1) states the basis on which the specified elements, accounts or items are presented
and, when applicable, any agreements specifying such basis (if the presentation is not prepared in
conformity with GAAP); and (2) if considered necessary, includes a description and source of
significant interpretations, if any, made by the company's management relating to the provisions of a
relevant agreement.

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5.

6.

7.
8.

An opinion paragraph that expresses the auditor's opinion (or disclaims an opinion) on whether the
specified elements, accounts or items are presented fairly, in all material respects, in conformity with
the basis of accounting described. If the auditor concludes that the specified elements, accounts or
items are not presented fairly on the basis of accounting described, or if there has been a limitation on
the scope of the audit, all the substantive reasons for that conclusion should be disclosed in an
explanatory paragraph(s), preceding the opinion paragraph, and the opinion paragraph should be
appropriately modified and include a reference to such explanatory paragraph(s).
If the specified element, account or item is prepared to comply with the requirements or financial
reporting provisions of a contract or agreement that results in a presentation that is not in conformity
with GAAP or OCBOA, a paragraph that restricts the distribution of the report solely to those within
the entity and the parties to the contract or agreement. (Such a restriction is necessary because the
basis of presentation is determined by reference to a document that would not generally be available to
other third parties.)
Signature of the Firm.
The date.

Illustrative Reports:
Example of an audit report when auditing an item in accordance with GAAP:

Report of Independent Certified Public Accountants

Board of Directors
ABC Company
We have audited the accompanying schedule of accounts receivable of ABC Company as of December 31,
19X2. This schedule is the responsibility of the Company's management. Our responsibility is to express an
opinion on this schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the schedule of accounts
receivable is free of material misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the schedule. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall schedule presentation. We
believe that our audit provides a reasonable basis for our opinion.
In our opinion, the schedule of accounts receivable referred to above presents fairly, in all material respects,
the accounts receivable of ABC Company as of December 31, 19X2, in conformity with generally accepted
accounting principles.
Signature
Date

5-23

Example of an audit report when auditing an item in accordance with the terms of a contract:

Report of Independent Certified Public Accountants

Board of Directors
ABC Company
We have audited, in accordance with generally accepted auditing standards, the financial statements of
ABC Company for the year ended December 31, 19X2, and have issued our report thereon dated March
10, 19X3. We have also audited ABC Company's schedule of profit-sharing contribution for the year
ended December 31, 19X2. This schedule is the responsibility of the Company's management. Our
responsibility is to express an opinion on this schedule based on our audit.
We conducted our audit of the schedule in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the
schedule of profit-sharing contribution is free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the schedule. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall schedule presentation. We believe that our audit provides a reasonable basis for our
opinion.
Management has informed us that the document that governs the determination of the Company's profitsharing documentation is the ABC Company Employees' Profit-Sharing Plan, dated January 10, 19XX, as
amended February 12, 19XX.
In our opinion, the schedule of profit-sharing contribution referred to above presents fairly, in all material
respects, ABC Company's profit-sharing contribution for the year ended December 31, 19X2, in
accordance with the provisions of the Plan referred to above.
This report is intended solely for the information and use of the board of directors and management of
ABC Company and the trustees (members) of ABC Company Employees' Profit-Sharing Plan.
Signature
Date

5-24

IV. COMPLIANCE WITH ASPECTS OF CONTRACTUAL AGREEMENTS OR REGULATORY

REQUIREMENTS RELATED TO AUDITED FINANCIAL STATEMENTS
An auditor may be requested to provide a compliance report, in conjunction with an audit of financial
statements, as required by a bond indenture, loan agreement or regulatory agencies to give assurance about
compliance with loan covenants, payments into sinking funds, dividend restrictions, etc. The auditor normally
satisfies this request by giving negative assurance relative to the applicable covenants, either in a separate
report or in one or more paragraphs of the auditor's report on the financial statements. Such assurance should
not be given unless the auditor has audited the financial statements related to the contractual agreements or
regulatory requirements and should not extend to covenants that relate to matters not subjected to audit
procedures. Assurances should not be given if the auditor has expressed an adverse opinion or disclaimed an
opinion on the related financial statements.
A. Reporting Requirements
When reporting on compliance with contractual agreements or regulatory provisions in a separate report,
the report should include:
1. A title that includes the word "independent".
2. A paragraph that states that the financial statements were audited in accordance with generally
accepted auditing standards and includes the date of that auditor's report on those financial statements.
Any departure from the standard report on those financial statements should be disclosed.
3. A paragraph that includes a reference to the specific covenants or paragraphs of the agreement,
provides negative assurance relative to compliance with the applicable covenants of the agreement
insofar as they relate to accounting matters, and specifies that the negative assurance is being given in
connection with an audit of financial statements. The report should ordinarily state that the audit was
not directed primarily toward obtaining knowledge regarding compliance.
4. A paragraph that includes a description and source of significant interpretations, if any, made by the
company's management in the course of the engagement relating to the provisions of a relevant
agreement.
5. A paragraph that restricts the distribution of the report solely to those within the entity and the parties
to the contract or for filing with the regulatory agency (since the matters on which the auditor is
reporting are set forth in a document that is generally not available to other third parties).
6. Signature of the Firm.
7. The date.
When a report on compliance is included in the report on the financial statements, the auditor should
include a paragraph, after the opinion paragraph, that provides negative assurance relative to compliance
with the applicable covenants of the agreement, insofar as they relate to accounting matters, and specifies
that it is being given in connection with the audit of financial statements. The auditor should also ordinarily
state that the audit was not directed primarily toward obtaining knowledge regarding compliance. In
addition, the report should include a paragraph that describes any significant interpretations made by
management as well as a paragraph that restricts its distribution.

5-25

An illustrative separate negative assurance report follows:

Report of Independent Certified Public Accountants
Board of Directors
ABC Company
We have audited, in accordance with generally accepted auditing standards, the balance sheet of ABC
Company as of December 31, 20XX, and the related statements of earnings, retained earnings and
cash flows for the year then ended, and have issued our report thereon dated February 16, 2XXX.
In connection with our audit, nothing came to our attention that caused us to believe that the
Company failed to comply with the terms, covenants, provisions or conditions of sections ____ to
____, inclusive, of the Indenture dated July 21, 20X0, with XYZ Bank insofar as they relate to
accounting matters. However, our audit was not directed primarily toward obtaining knowledge of
such noncompliance.
This report is intended solely for the information and use of the boards of directors and managements
of ABC Company and XYZ Bank and should not be used for any other purpose.
Signature
February 16, 2XXX

V. SPECIAL-PURPOSE FINANCIAL PRESENTATIONS TO COMPLY WITH CONTRACTUAL

AGREEMENTS OR REGULATORY PROVISIONS
An auditor may be asked to report on special-purpose financial statements prepared to comply with a contractual
agreement or regulatory provisions, including:
A special-purpose financial presentation prepared in compliance with a contractual agreement or regulatory
provision that does not constitute a complete presentation of the entity's assets, liabilities, revenues and
expenses, but is otherwise prepared in conformity with GAAP or OCBOA.
A special-purpose financial presentation (may be a complete presentation of financial statements or a single
financial statement) prepared on a basis of accounting prescribed in an agreement that does not result in a
presentation in conformity with GAAP or OCBOA.
A.

Incomplete Presentations
A contractual agreement or regulatory provision may prescribe the form for financial statements which are
in conformity, except for the omission of certain items, with GAAP or OCBOA.
Examples of such financial statements include:
A governmental agency may require a schedule of gross income and certain expenses of an entity's
real estate operation in which income and expenses are measured in conformity with GAAP, but
expenses are defined to exclude certain items such as interest, depreciation and income taxes.
A buy-sell agreement may specify a schedule of gross assets and liabilities of the entity measured in
conformity with GAAP, but limited to the assets to be sold and liabilities to be transferred pursuant to
the agreement.
Such presentations, which differ from complete financial statements only to the extent necessary to meet
the special purpose for which they were prepared, should be considered financial statements as defined by
this Statement. Accordingly, the measurement of materiality should be related to the presentation taken as a
whole. The statements should include appropriate disclosures and be suitably titled.

5-26

B.

Reports on incomplete presentations should include:

1. A title that includes the word "independent".
2. Introductory and scope paragraphs which include the same elements as for the standard auditor's
report.
3. A paragraph that: (1) explains what the presentation is intended to present and refers to the note that
describes the basis of presentation; (2) if the presentation is in conformity with GAAP, states that the
presentation is not intended to be a complete presentation of the entity's assets, liabilities, revenues and
expenses. (If the presentation is prepared on a basis of accounting prescribed in an agreement that
results in an incomplete OCBOA presentation, the paragraph should state that the presentation is in
conformity with a comprehensive basis of accounting other than GAAP and is not intended to be a
complete presentation on such basis.)
4. An opinion paragraph that expresses the auditor's opinion related to the fair presentation, in all
material respects, of the information in conformity with GAAP or OCBOA. If the auditor concludes
that the information intended to be presented is not presented fairly on the basis of accounting
described, or if there has been a limitation on the scope of the audit, the auditor should disclose all the
substantive reasons for that conclusion in an explanatory paragraph(s), preceding the opinion
paragraph. The opinion paragraph should include appropriate modifying language and a reference to
such explanatory paragraph(s).
5. A paragraph that restricts the distribution of the report solely to those within the entity; to parties to the
contract or agreement; for filing with a regulatory agency; or to those with whom the entity is
negotiating directly. However, a restrictive paragraph is not appropriate when the report and related
financial presentation are to be filed with a regulatory agency (e.g., the SEC) and are to be included in
a document (e.g., a prospectus) which is distributed to the general public.
6. Signature of the Firm.
7. The date.
Report of Independent Certified Public Accountants
Board of Directors
ABC Company
We have audited the accompanying statement of net assets sold of ABC Company as of June 30,
20XX. This statement of net assets sold is the responsibility of ABC Company's management. Our
responsibility is to express an opinion on the statement of net assets sold based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the statement
of net assets sold is free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the statement. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as evaluating
the overall presentation of the statement of net assets sold. We believe that our audit provides a
reasonable basis of our opinion.
The accompanying statement was prepared to present the net assets of ABC Company sold to XYZ
Corporation pursuant to the purchase agreement described in Note ______, and is not intended to be a
complete presentation of ABC Company's assets and liabilities.
In our opinion, the accompanying statement of net assets sold presents fairly, in all material respects,
the net assets of ABC Company, as of June 30, 20XX, sold pursuant to the purchase agreement
referred to in Note _____, in conformity with generally accepted accounting principles.
This report is intended solely for the information and use of the boards of directors and managements
of ABC Company and XYZ Corporation and should not be used for any other purpose.
Signature
Date

5-27

C.

Presentation Not in Conformity with GAAP or OCBOA

An auditor may be asked to report on special-purpose financial statements prepared in conformity with a
basis of accounting that departs from GAAP or OCBOA. For example, an acquisition agreement may
require financial statements of an entity being acquired to be prepared in conformity with GAAP principles
except for certain assets which are to be valued in accordance with the terms of the acquisition agreement.
These are not considered to be OCBOA financial statements because they do not conform to "criteria
having substantial support."
When reporting on such financial presentations, the auditor's report should include:
1.

A title that includes the word "independent".

2.

Introductory and scope paragraphs which include the same elements as for the standard auditor's
report.

3.

A paragraph that: (1) explains what the presentation is intended to present and refers to the note that
describes the basis of presentation; (2) states that the presentation is not intended to be a presentation
in conformity with GAAP.

4.

A paragraph that includes a description and source of significant interpretations, if any, made by the
Company's management relating to the provisions of a relevant agreement.

5.

An opinion paragraph that expresses the auditor's opinion related to the fair presentation, in all
material respects, of the information the presentation is intended to present on the basis of accounting
specified. If the auditor concludes that the information intended to be presented is not presented fairly
on the basis of accounting described, or if there has been a limitation on the scope of the audit, all the
substantive reasons for that conclusion should be described in an explanatory paragraph(s), preceding
the opinion paragraph. The opinion paragraph should include appropriate modifying language and a
reference to such explanatory paragraph(s).

6.

A paragraph that restricts the distribution of the report solely to those within the entity; to the parties to
the contracts or agreement; for filing with a regulatory agency; or to those with whom the entity is
negotiating directly.

7.

Signature of the Firm.

8.

The date.

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Report of Independent Certified Public Accountants

Board of Directors
ABC Company
We have audited the accompanying special-purpose statement of assets and liabilities of ABC
Company as of December 31, 20XX and 20X0, and the related special-purpose statements of
revenues and expenses and cash flows for the years then ended. These statements are the
responsibility of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the basis of accounting used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
The accompanying special-purpose financial statements were prepared for the purpose of
complying with Section 4 of a loan agreement between DEF Bank and the Company, as
discussed in Note X, and are not intended to be a presentation in conformity with generally
accepted accounting principles.
In our opinion, the special-purpose financial statements referred to above present fairly, in all
material respects, the assets and liabilities of ABC Company at December 31, 20XX and
20X0, and the revenues, expenses and cash flows for the years then ended, on the basis of
accounting described in Note X.
This report is intended solely for the information and use of the boards of directors and
managements of ABC Company and DEF Bank and should not be used for any other
purpose.
Signature
Date

5-29

SUMMARY OF ENGAGEMENTS
TO REPORT ON SPECIAL
PURPOSE FINANCIAL PRESENTATIONS
IN COMPLIANCE WITH CONTRACTUAL
OR REGULATORY AGREEMENTS
Type of Service
Incomplete presentation of
assets, liabilities, equities,
revenues and expenses, but
otherwise prepared in
conformity with GAAP or
OCBOA.

Standards Followed

Report

GAAS

Special Purpose Financial

Statements prepared in
accordance with a
contractual or regulatory
requirement that does not
result in a GAAP or OCBOA
presentation.

GAAS

Basic Audit report modified as

appropriate for:

Basic Audit report modified

as needed for:

1) reference to the financial

presentation

1) reference to the titles of

the financial statements as
named in the contract or
regulatory provision

2) reference to the document

that specifies the basis of
presentation
3) a restriction on the
distribution of the report

2) reference to the document

that specifies the basis of
presentation
3) a reference that the
financial statements are not
intended to be GAAP
presentations
4) a reference that the
financial statements are
"special purpose"
5) a restriction on the
distribution of the report

5-30

VI. OTHER MATTERS

Prescribed Forms or Schedules
Printed forms or schedules adopted or designed by the bodies with which they are to be filed often prescribe
wording for an auditor's report. If such wording does not conform to professional reporting standards, the
auditor should reword the form or attach a separate report.

REPORTS ON THE APPLICATION OF ACCOUNTING PRINCIPLES (SAS No. 50)

CPAs are often called upon to report to a client on the application of an accounting principle. Such a report may
result in:
a. Preparing a written report on the application of accounting principles to specified transactions, either completed
or proposed.
b. A written report on the type of opinion that may be rendered on a specific entity's financial statements.
c. Preparing a written report to intermediaries on the application of accounting principles not involving facts or
circumstances of a particular principal.
d. Oral advice on the application of accounting principles to a specific transaction, or the type of opinion that may
be rendered on an entity's financial statements, when the reporting accountant concludes the advice is intended
to be used by a principal to the transaction as an important factor considered in reaching a decision.

I.

PROCEDURES
To aid in forming a judgment, the reporting accountant should perform the following procedures:
A. Obtain an understanding of the form and substance of the transaction(s);
B. Review applicable generally accepted accounting principles;
C. If appropriate, consult with other professionals or experts; and
D. If appropriate, perform research or other procedures to ascertain and consider the existence of creditable
precedents or analogies.

II. REPORTING STANDARDS

The accountant's written report should be addressed to the principal to the transaction or to the intermediary,
and should ordinarily include the following:
A. A brief description of the nature of the engagement and a statement that the engagement was performed in
accordance with applicable AICPA standards.
B. A description of the transaction(s), a statement of the relevant facts, circumstances, and assumptions, and a
statement about the source of the information. Principals to specific transactions should be identified, and
hypothetical transactions should be described as involving nonspecific principals (for example, Company
A, Company B).
C. A statement describing the appropriate accounting principle(s) to be applied or type of opinion that may be
rendered on the entity's financial statements, and, if appropriate, a description of the reasons for the
reporting accountant's conclusion.
D. A statement that the responsibility for the proper accounting treatment rests with the preparers of the
financial statements, who should consult with their continuing accountants.
E. A statement that any difference in the facts, circumstances, or assumptions presented may change the
report.

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The following is an illustration of sections of the report described above.

Introduction
We have been engaged to report on the appropriate application of generally accepted accounting
principles to the specific (hypothetical) transaction described below. This report is being issued to the
ABC Company (XYZ Intermediaries) for assistance in evaluating accounting principles for the
described specific (hypothetical) transaction. Our engagement has been conducted in accordance with
standards established by the American Institute of Certified Public Accountants.
Description of Transaction
The facts, circumstances, and assumptions relevant to the specific (hypothetical) transaction as
provided to us by the management of the ABC Company (XYZ Intermediaries) are as follows:
Appropriate Accounting Principles
(Text discussing principles)
Concluding Comments
The ultimate responsibility for the decision on the appropriate application of generally accepted
accounting principles for an actual transaction rests with the preparers of financial statements, who
should consult with their continuing accountants. Our judgment on the appropriate application of
generally accepted accounting principles for the described specific (hypothetical) transaction is based
solely on the facts provided to us as described above; should these facts and circumstances differ, our
conclusion may change.

REPORTING ON FINANCIAL STATEMENTS PREPARED FOR

USE IN OTHER COUNTRIES (SAS No. 51)
A U.S. entity ordinarily prepares financial statements for use in the United States in conformity with accounting
principles generally accepted in the United States, but it may also prepare financial statements that are intended for
use outside the United States and are prepared in conformity with accounting principles generally accepted in
another country.
I.

GENERAL AND FIELDWORK STANDARDS

When examining the financial statements of a U.S. entity prepared in conformity with accounting principles
generally accepted in another country, the auditor should perform the procedures that are necessary to comply
with the general and fieldwork standards of U.S. generally accepted auditing standards (GAAS).
In those circumstances in which the auditor is requested to apply the auditing standards of another country
when reporting on financial statements prepared in conformity with accounting principles generally accepted in
that country, the auditor should comply with the general and fieldwork standards of that country as well as with
those standards in the U.S. GAAS.

II. REPORTING STANDARDS

If financial statements prepared in conformity with accounting principles generally accepted in another country
are prepared for use only outside the United States, the auditor may report using either (a) a U.S.-style report
modified to report on the accounting principles of another country, or (b) if appropriate, the report form of the
other country.

5-32

Financial statements prepared in conformity with accounting principles generally accepted in another country
ordinarily are not useful to U.S. users. Therefore, if financial statements are needed for use both in another
country and within the United States, the auditor may report on two sets of financial statements for the entity
one prepared in conformity with accounting principles generally accepted in another country for use outside the
United States, and the other prepared in accordance with accounting principles generally accepted in the United
States.

III. USE ONLY OUTSIDE THE UNITED STATES

A U.S.-style report modified to report on financial statements prepared in conformity with accounting
principles generally accepted in another country that are intended for use only outside the United States should:
A. Identify the financial statements examined.
B. Refer to the note to the financial statements that describes the basis of presentation of the financial
statements on which the auditor is reporting, including identification of the nationality of the
accounting principles.
C. State that the examination was made in accordance with auditing standards generally accepted in the
United States (and, if appropriate, with the auditing standards of the other country).
D. Include a paragraph that expresses the auditor's opinion (or disclaims an opinion) on the following:
(1) Whether the financial statements are presented fairly in conformity with the basis of accounting
described. If the auditor concludes that the financial statements are not presented fairly on the
basis of accounting described, all of the substantive reasons for that conclusion should be
disclosed in an additional explanatory paragraph(s) of the report, and the opinion paragraph
should include appropriate modifying language as well as a reference to the explanatory
paragraph(s).
(2) Whether the disclosed basis of accounting used has been applied in a consistent manner.
The following is an illustration of such a report.
Addressee
We have examined the balance sheet of the International Company as of December 31, 20XX, and
the related statements of income, retained earnings, and cash flows for the year then ended, which,
as described in Note X, have been prepared on the basis of accounting principles generally
accepted in (name of country). Our examination was made in accordance with the auditing
standards generally accepted in the United States (and in [name of country]) and, accordingly,
included such tests of the accounting records and such other auditing procedures as we considered
necessary in the circumstances.
In our opinion, the financial statements referred to above present fairly the financial position of
the International Company at December 31, 20XX, and the results of its operations and cash flows
for the year then ended, in conformity with accounting principles generally accepted in (name of
country) applied on a basis consistent with that of the preceding year.
Signature, date
The independent auditor may also use the auditor's standard report of another country, provided that:
a. Such a report would be used by auditors in the other country in similar circumstances.
b. The auditor understands, and is in a position to make, the attestations contained in such a report.

5-33

Use in the United States

If the auditor is requested to report on the fair presentation of financial statements, prepared in conformity with the
accounting principles generally accepted in another country, that will have more than limited distribution in the
United States, he should use the U.S. standard form of report, modified as appropriate, because of departures from
accounting principles generally accepted in the United States. The auditor may also, in a separate paragraph to the
report, express an opinion on whether the financial statements are presented in conformity with accounting
principles generally accepted in another country.

REPORTING ON INFORMATION ACCOMPANYING THE BASIC FINANCIAL

STATEMENTS IN AUDITOR-SUBMITTED DOCUMENTS (SAS No. 29)
Applicability

This section describes the form and content of the audit report when a CPA submits to his client or to others a
document that contains information in addition to the client's basic financial statements and the auditor's standard
report thereon.
The following presentations are considered part of the basic financial statements: descriptions of accounting
policies, notes to financial statements, and schedules and explanatory material that are identified as being part of the
basic financial statements.
The information covered by this Statement is presented outside the basic financial statements and is not considered
necessary for presentation of financial position, results of operations, or cash flows in conformity with generally
accepted accounting principles. Such information includes additional details or explanations of items in or related to
the basic financial statements.

Reporting Responsibility

An auditor's report on information accompanying the basic financial statements in an auditor-submitted document
has the same objective as an auditor's report on the basic financial statements: to describe clearly the character of the
auditor's examination and the degree of responsibility, if any, he is taking.
The following guidelines apply to an auditor's report on information accompanying the basic financial statements in
an auditor-submitted document:
a. The report should state that the examination has been made for the purpose of forming an opinion on the basic
financial statements taken as a whole.
b. The report should identify the accompanying information. (Identification may be by descriptive title or page
number of the document.)
c. The report should state that the accompanying information is presented for purposes of additional analysis and is
not a required part of the basic financial statements.
d. The report should include either an opinion on whether the accompanying information is fairly stated in all
material respects in relation to the basic financial statements taken as a whole or a disclaimer of opinion,
depending on whether the information has been subjected to the auditing procedures applied in the examination
of the basic financial statements. The auditor may express an opinion on a portion of the accompanying
information and disclaim an opinion on the remainder.
e. The report on the accompanying information may be added to the auditor's standard report on the basic financial
statements or may appear separately in the auditor-submitted document.

5-34

If the auditor concludes, on the basis of facts known to him, that any accompanying information is materially
misstated in relation to the basic financial statements taken as a whole, he should discuss the matter with the client
and propose appropriate revision of the accompanying information. If the client will not agree to revision of the
accompanying information, the auditor should either modify his report on the accompanying information and
describe the misstatement or refuse to include the information in the document.
The auditor should consider the effect of any modifications in his standard report when reporting on accompanying
information. When the auditor expresses a qualified opinion on the basic financial statements, he should make clear
the effects upon any accompanying information as well. When the auditor expresses an adverse opinion, or
disclaims an opinion, on the basic financial statements, he should not express an opinion.
A client may request that nonaccounting information and certain accounting information not directly related to the
basic financial statements be included in an auditor-submitted document. Ordinarily, such information would not
have been subjected to the auditing procedures applied in the examination of the financial statements, and,
accordingly, the auditor would disclaim an opinion on it.

Reporting Examples
Unqualified
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole.
The (identify accompanying information) is presented for purposes of additional analysis and is not a required
part of the basic financial statements. Such information has been subjected to the auditing procedures applied in
the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to
the basic financial statements taken as a whole.
Disclaimer on All of the Information
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole.
The (identify the accompanying information) is presented for purposes of additional analysis and is not a
required part of the basic financial statements. Such information has not been subjected to the auditing
procedures applied in the audit of the basic financial statements, and, accordingly, we express no opinion on it.
Disclaimer on Part of the Information
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole.
The information on pages XX-YY is presented for purposes of additional analysis and is not a required part of
the basic financial statements. Such information, except for that portion marked "unaudited," on which we
express no opinion, has been subjected to the auditing procedures applied in the audit of the basic financial
statements; and, in our opinion, the information is fairly stated in all material respects in relation to the basic
financial statements taken as a whole.
Qualification
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole.
The schedules of investments (page 7), property (page 8), and other assets (page 9) as of December 31, 19XX,
are presented for purposes of additional analysis and are not a required part of the basic financial statements.
The information in such schedules has been subjected to the auditing procedures applied in the audit of the basic
financial statements; and, in our opinion, except for the effects on the schedule of investments of not accounting
for the investments in certain companies by the equity method as explained in the second preceding paragraph
[second paragraph of our report on page 1], such information is fairly stated in all material respects in relation to
the basic financial statements taken as a whole.

5-35

LETTERS FOR UNDERWRITERS AND CERTAIN OTHER REQUESTING PARTIES

(SAS No. 76 as amended)
The services of independent certified public accountants include examination of financial statements and schedules
contained in registration statements filed with the Securities and Exchange Commission (the SEC) under the
Securities Act of 1933 (the Act). In connection with this type of service, accountants often are called upon to confer
with clients, underwriters, and their respective counsel concerning the accounting and auditing requirements of the
Act and of the SEC, as well as to perform other services. One of these other services is the issuance of letters for
underwriters, commonly called comfort letters.
Comfort letters are not required under the Act, and copies are not filed with the SEC. It is nonetheless a common
condition of an underwriting agreement in connection with the offering for sale of securities registered with the SEC
under the Act that the accountants are to furnish a comfort letter.
Because the underwriter will expect the accountants to furnish a comfort letter of a scope to be specified in the
underwriting agreement, the client and the underwriter, when they have tentatively agreed upon a draft of the
agreement, are well advised to furnish a copy of it to the accountants so that the latter can indicate whether they will
be able to furnish a letter in acceptable form. A desirable practice is for the accountants, promptly after they have
received the draft of the agreement (or have been informed that a letter covering specified matters, although not a
condition of the agreement, will nonetheless be requested), to prepare a draft of the form of letter that they expect to
furnish. The draft letter should be identified as a draft in order to avoid giving the impression that the procedures
described therein have been performed. Unless otherwise indicated by the underwriter, the accountants may
reasonably assume that the underwriter, by indicating his acceptance of the draft comfort letter, and subsequently,
by his acceptance of the letter in final form, considers the procedures described sufficient for his purposes.
The letter ordinarily is dated at or shortly before the closing date (the date on which the issuer or selling security
holder delivers the securities to the underwriter in exchange for the proceeds of the offering). The underwriting
agreement ordinarily specifies the date, often referred to as the cutoff date, to which the letter is to relate (for
example, a date five business days before the date of the letter); the accountants should see that the cutoff date will
not place an unreasonable burden on them. The letter should state that the inquiries and other procedures carried out
in connection with the letter did not cover the period from the cutoff date to the date of the letter.
Because the letter is a result of the underwriter's request, many accountants address the letter only to the
underwriter, with a copy furnished to the client.
Underwriters occasionally request the accountants to repeat in the comfort letter their opinion on the audited
financial statements included in the registration statement. Because of the special significance of the date of an
accountants' report, the accountants should not repeat their opinion.
The matters covered in a typical comfort letter are described below:
1.
2.
3.
4.
5.
6.
7.

A statement regarding the independence of the accountants.

An opinion regarding whether the audited financial statements and schedules included in the registration
statement comply in form in all material respects with the applicable accounting requirements of the
Securities Act of 1933 and the published rules and regulation thereunder.
A description of the procedures requested and performed.
A disclaimer of an opinion on the financial information covered by the comfort letter.
A statement of specific findings as a result of applying the procedures in part (c) above.
A statement that restricts distribution of the report.
A statement that the CPA has no responsibility to update report for events after a specified cutoff date.

5-36

Chapter Five - Questions

Reviews, Compilations, Special Reports and Other
Reports
1. An auditor's report would be designated as a special
report when it is issued in connection with which of the
following?
a. Financial statements for an interim period which
are subjected to limited review.
b. Financial statements which are prepared in
accordance with a comprehensive basis of
accounting other than generally accepted
accounting principles.
c. Financial statements which purport to be in
accordance with generally accepted accounting
principles but do not include a presentation of the
statement of cash flows.
d. Financial statements which are unaudited and are
prepared from a client's accounting records.

5. Which of the following procedures is not included in

a review engagement of a nonpublic entity?
a. Inquiries of management.
b. Inquiries regarding events subsequent to the
balance sheet date.
c. Any procedures designed to identify relationships
among data that appear to be unusual.
d. A study and evaluation of internal control.
6. An auditor is reporting on cash-basis financial
statements. These statements are best referred to in his
opinion by which one of the following descriptions?
a. Financial position and results of operations arising
from cash transactions.
b. Assets and liabilities arising from cash
transactions, and revenue collected and expenses
paid.
c. Balance sheet and income statement resulting from
cash transactions.
d. Cash balance sheet and the source and application
of funds.

2. When making a review of interim financial

information the auditor's work consists primarily of
a. Studying and evaluating limited amounts of
documentation supporting the interim financial
information.
b. Scanning and reviewing client-prepared, internal
financial statements.
c. Making inquiries and performing analytical
procedures concerning significant accounting
matters.
d. Confirming and verifying significant account
balances at the interim date.

7. When an independent CPA is associated with the

financial statements of a publicly held entity, but has
not audited or reviewed such statements, the
appropriate form of report to be issued must include a
(an)
a. Negative assurance.
b. Compilation opinion.
c. Disclaimer of opinion.
d. Explanatory paragraph.

3. One example of a "special report," as defined by

Statements on Auditing Standards, is a report issued in
connection with
a. A feasibility study.
b. A limited review of interim financial information.
c. Price-level basis financial statements.
d. Compliance with a contractual agreement not
related to the financial statements.

8. The objective of a review of the interim financial

information of a publicly held company is to
a. Provide the accountant with a basis for the
expression of an opinion.
b. Estimate the accuracy of financial statements
based upon limited tests of accounting records.
c. Provide the accountant with a basis for reporting
to the board of directors or stockholders.
d. Obtain corroborating evidential matter through
inspection, observation and confirmation.

4. Whenever special reports, filed on a printed form

designed by authorities, call upon the independent
auditor to make an assertion that the auditor believes is
not justified, the auditor should
a. Submit a short-form report with explanations.
b. Reword the form or attach a separate report.
c. Submit the form with questionable items clearly
omitted.
d. Withdraw from the engagement.

5Q-1

9. A CPA who is associated with the financial

statements of a public entity, but has not audited or
reviewed such statements, should
a. Insist that they be audited or reviewed before
publication.
b. Read them to determine whether there are obvious
material errors.
c. State these facts in the accompanying notes to the
financial statements.
d. Issue a compilation report.

13. Each page of the financial statements compiled by

an accountant should include a reference such as
a. See accompanying accountant's footnotes.
b. Unaudited, see accountant's disclaimer.
c. See accountant's compilation report.
d. Subject to compilation restrictions.
14. A CPA who is not independent may issue
a. A review report.
b. A comfort letter.
c. A qualified opinion.
d. A compilation report.

10. In performing a compilation of financial statements

of a nonpublic entity, the accountant decides that
modification of the standard report is not adequate to
indicate deficiencies in the financial statements taken as
a whole, and the client is not willing to correct the
deficiencies. The accountant should therefore
a. Perform a review of the financial statements.
b. Issue a special report.
c. Withdraw from the engagement.
d. Express an adverse audit opinion.

15. When an auditor performs a review of interim

financial statements, which of the following steps would
not be a part of the review?
a. Review of computer controls.
b. Inquiry of management.
c. Review of ratios and trends.
d. Reading the minutes of the stockholders' meetings.
16. Baker, CPA, was engaged to review the financial
statements of Hall Company, a nonpublic entity.
Evidence came to Baker's attention that indicated
substantial doubt as to Hall's ability to continue as a
going concern. The principal conditions and events that
caused the substantial doubt have been fully disclosed
in the notes to Hall's financial statements. Which of the
following statements best describes Baker's reporting
responsibility concerning this matter?
a. Baker is not required to modify the accountant's
review report.
b. Baker is not permitted to modify the accountant's
review report.
c. Baker should issue an accountant's compilation
report instead of a review report.
d. Baker should express a qualified opinion in the
accountant's review report.

11. An auditor who was engaged to perform an

examination of the financial statements of a nonpublic
entity has been asked by the client to refrain from
performing various audit procedures and change the
nature of the engagement to a review of the financial
statements in accordance with standards established by
the AICPA. The client's request was made because the
cost to complete the examination was significant. Under
the circumstances the auditor would most likely
a. Qualify the auditor's report and refer to the scope
limitation.
b. View the request as an indication of a possible
irregularity.
c. Complete the examination which was in progress.
d. Honor the client's request.
12. During a review of the financial statements of a
nonpublic entity, the CPA finds that the financial
statements contain a material departure from generally
accepted accounting principles. If management refuses
to correct the financial statement presentations, the CPA
should
a. Disclose the departure in a separate paragraph of
the report.
b. Issue an adverse opinion.
c. Attach a footnote explaining the effects of the
departure.
d. Issue a compilation report.

17. An auditor's report on financial statements prepared

in accordance with another comprehensive basis of
accounting should include all of the following except
a. An opinion as to whether the basis of accounting
used is appropriate under the circumstances.
b. An opinion as to whether the financial statements
are presented fairly in conformity with the other
comprehensive basis of accounting.
c. Reference to the note to the financial statements
that describes the basis of presentation.
d. A statement that the basis of presentation is a
comprehensive basis of accounting other than
generally accepted accounting principles.

5Q-2

18. An accountant who is not independent of a client is

precluded from issuing a
a. Report on management advisory services.
b. Compilation report on historical financial
statements.
c. Compilation report on prospective financial
statements.
d. Special report on compliance with contractual
agreements.

22. Inquiry and analytical procedures ordinarily

performed during a review of a nonpublic entity's
financial statements include
a. Analytical procedures designed to identify
material weaknesses in internal accounting
control.
b. Inquiries concerning actions taken at meetings of
the stockholders and the board of directors.
c. Analytical procedures designed to test the
accounting records by obtaining corroborating
evidential matter.
d. Inquiries of knowledgeable outside parties such as
the client's attorneys and bankers.

19. The authoritative body designated to promulgate

standards concerning an accountant's association with
unaudited financial statements of an entity that is not
required to file financial statements with an agency
regulating the issuance of the entity's securities is the
a. Financial Accounting Standards Board.
b. General Accounting Office.
c. Accounting and Review Services Committee.
d. Auditing Standards Board.

23. A CPA should not submit unaudited financial

statements of a nonpublic company to a client or others
unless, as a minimum, the CPA complies with the
provisions applicable to
a. Compilation engagements.
b. Review engagements.
c. Statements on auditing standards.
d. Attestation standards.

20. If requested to perform a review engagement for a

nonpublic entity in which an accountant has an
immaterial direct financial interest, the accountant is
a. Not independent and, therefore, may issue a
review report, but may not issue an auditor's
opinion.
b. Not independent and, therefore, may not issue a
review report.
c. Not independent and, therefore, may not be
associated with the financial statements.
d. Independent because the financial interest is
immaterial and, therefore, may issue a review
report.

24. When providing limited assurance that the financial

statements of a nonpublic entity require no material
modifications to be in accordance with generally
accepted accounting principles, the accountant should
a. Understand the system of internal accounting
control that the entity uses.
b. Test the accounting records that identify
inconsistencies with the prior year's financial
statements.
c. Understand the accounting principles of the
industry in which the entity operates.
d. Develop audit programs to determine whether the
entity's financial statements are fairly presented.

21. An accountant has been asked to issue a review

report on the balance sheet of a nonpublic company but
not to report on the other basic financial statements. The
accountant may not do so
a. Because compliance with this request would result
in an incomplete review.
b. Because compliance with this request would result
in a violation of the ethical standards of the
profession.
c. If the scope of the inquiry and analytical procedures has been restricted.
d. If the review of the balance sheet discloses
material departures from generally accepted
accounting principles.

25. Which of the following procedures is not usually

performed by the accountant in a review engagement of
a nonpublic entity?
a. Communicating
any
material
weaknesses
discovered during the study and evaluation of
internal accounting control.
b. Reading the financial statements to consider
whether they conform with generally accepted
accounting principles.
c. Writing an engagement letter to establish an
understanding regarding the services to be
performed.
d. Issuing a report stating that the review was
performed in accordance with standards established by the AICPA.
5Q-3

30. One of the conditions required for an accountant to

submit a written personal financial plan containing
unaudited financial statements to a client without
complying with the requirements of SSARS 1
(Compilation and Review of Financial Statements) is
that the
a. Client agrees that the financial statements will not
be used to obtain credit.
b. Accountant compiled or reviewed the client's
financial statements for the immediate prior year.
c. Engagement letter acknowledges that the financial
statements will contain departures from generally
accepted accounting principles.
d. Accountant expresses limited assurance that the
financial statements are free of any material
misstatements.

26. Performing inquiry and analytical procedures is the

primary basis for an accountant to issue a (an)
a. Compilation report on financial statements for a
nonpublic entity in its first year of operations.
b. Review report on comparative financial statements
for a nonpublic entity in its second year of
operations.
c. Management advisory report prepared at the
request of a client's audit committee.
d. Internal accounting control report for a
governmental agency in accordance with GAO
standards.
27. Which of the following circumstances requires
modification of the accountant's report on a review of
interim financial information of a publicly held entity?

a.
b.
c.
d.

An
uncertainty
Yes
No
Yes
No

31. An accountant has been asked to compile the

financial statements of a nonpublic company on a
prescribed form that omits substantially all the
disclosures required by generally accepted accounting
principles. If the prescribed form is a standard
preprinted form adopted by the company's industry
trade association, and is to be transmitted only to such
association, the accountant
a. Need not advise the industry trade association of
the omission of all disclosures.
b. Should disclose the details of the omissions in
separate paragraphs of the compilation report.
c. Is precluded from issuing a compilation report
when all disclosures are omitted.
d. Should express limited assurance that the financial
statements are free of material misstatements.

Inadequate
disclosure
Yes
No
No
Yes

28. If compiled financial statements presented in

conformity with the cash receipts and disbursements
basis of accounting do not disclose the basis of
accounting used, the accountant should
a. Disclose the basis in the notes to the financial
statements.
b. Clearly label each page, "Unaudited".
c. Disclose the basis of accounting in the accountant's report.
d. Recompile the financial statements using generally
accepted accounting principles.

32. An auditor who conducts an examination in

accordance with generally accepted auditing standards
and concludes that the financial statements are fairly
presented in accordance with a comprehensive basis of
accounting other than generally accepted accounting
principles, such as the cash basis of accounting, should
issue a
a. Special report.
b. Disclaimer of opinion.
c. Review report.
d. Qualified opinion.

29. The objective of a review of interim financial

information of a public entity is to provide an
accountant with a basis for reporting whether
a. Material modifications should be made to conform
with generally accepted accounting principles.
b. A reasonable basis exists for expressing an
updated opinion regarding the financial statements
that were previously audited.
c. Condensed financial statements or pro forma
financial information should be included in a
registration statement.
d. The financial statements are presented fairly in
accordance with generally accepted accounting
principles.

33. Comfort letters ordinarily are addressed to

a. The Securities and Exchange Commission.
b. Underwriters of securities.
c. Creditor financial institutions.
d. The client's audit committee.

5Q-4

34. An accountant who reviews the financial statements

of a nonpublic entity should issue a report stating that a
review
a. Is substantially less in scope than an audit.
b. Provides negative assurance that the internal
control structure is functioning as designed.
c. Provides only limited assurance that the financial
statements are fairly presented.
d. Is substantially more in scope than a compilation.

38. If information accompanying the basic financial

statements in an auditor-submitted document has been
subjected to auditing procedures, the auditor may
include in the auditor's report on the financial
statements an opinion that the accompanying
information is fairly stated in
a. Accordance with generally accepted auditing
standards.
b. Conformity with generally accepted accounting
principles.
c. All material respects in relation to the basic
financial statements taken as a whole.
d. Accordance with attestation standards expressing a
conclusion about management's assertions.

35. When an accountant compiles a nonpublic entity's

financial statements that omit substantially all
disclosures required by generally accepted accounting
principles, the accountant should indicate in the
compilation report that the financial statements are
a. Restricted for internal use only by the entity's
management.
b. Not to be given to financial institutions for the
purpose of obtaining credit.
c. Compiled in conformity with a comprehensive
basis of accounting other than generally accepted
accounting principles.
d. Not designed for those who are uninformed about
the omitted disclosures.

39. If information accompanying the basic financial

statements in an auditor-submitted document has been
subjected to auditing procedures, the auditor may
express an opinion that the accompanying information
is fairly stated in
a. Conformity with generally accepted accounting
principles.
b. All material respects in relation to the basic
financial statements taken as a whole.
c. Conformity with standards established by the
AICPA.
d. Accordance with generally accepted auditing
standards.

36. The objective of a review of interim financial

information is to provide an accountant with a basis for
reporting whether
a. The financial statements are presented fairly in
accordance with generally accepted accounting
principles.
b. A reasonable basis exists for expressing an
updated opinion regarding the financial statements
that were previously audited.
c. Material modifications should be made to conform
with generally accepted accounting principles.
d. The financial statements are presented fairly in
accordance with standards of interim reporting.

40. Before performing a review of a nonpublic entity's

financial statements, an accountant should
a. Complete a series of inquiries concerning the
entity's procedures for recording, classifying, and
summarizing transactions.
b. Apply analytical procedures to provide limited
assurance that no material modifications should be
made to the financial statements.
c. Obtain a sufficient level of knowledge of the
accounting principles and practices of the industry
in which the entity operates.
d. Inquire whether management has omitted
substantially all of the disclosures required by
generally accepted accounting principles.

37. When an auditor is requested to express an opinion

on the rental and royalty income of an entity, the auditor
may
a. Not accept the engagement because to do so would
be tantamount to agreeing to issue a piecemeal
opinion.
b. Not accept the engagement unless also engaged to
audit the full financial statements of the entity.
c. Accept the engagement provided the auditor's
opinion is expressed in a special report.
d. Accept the engagement provided distribution of
the auditor's report is limited to the entity's
management.
5Q-5

41. If requested to perform a review engagement for a

nonpublic entity in which an accountant has an
immaterial direct financial interest, the accountant is
a. Independent because the financial interest is
immaterial and, therefore, may issue a review
report.
b. Not independent and, therefore, may not be
associated with the financial statements.
c. Not independent, and therefore, may not issue a
review report.
d. Not independent and, therefore, may issue a
review report, but may not issue an auditor's
opinion.

d.

Disclose the basis of accounting in the accountant's report.

45. An auditor's report would be designated a special

report when it is issued in conjunction with
a. Interim financial information of a publicly held
company that is subject to a limited review.
b. Compliance
with
aspects
of
regulatory
requirements related to audited financial
statements.
c. Application of accounting principles to specified
transactions.
d. Limited use prospective financial statements such
as a financial projection.

42. When reporting on financial statements prepared on

the same basis of accounting used for income tax
purposes, the auditor should include in the report a
paragraph that
a. Emphasizes that the financial statements are not
intended to have been examined in accordance
with generally accepted auditing standards.
b. Refers to the authoritative pronouncements that
explain the income tax basis of accounting being
used.
c. States that the income tax basis of accounting is a
comprehensive basis of accounting other than
generally accepted accounting principles.
d. Justifies the use of the income tax basis of
accounting.

46. Which of the following procedures would most

likely be included in a review engagement of a
nonpublic entity?
a. Preparing a bank transfer schedule.
b. Inquiring about related party transactions.
c. Assessing the internal control structure.
d. Performing cutoff tests on sales and purchases
transactions.
47. When compiling a nonpublic entity's financial
statements, an accountant would be least likely to
a. Perform analytical procedures designed to identify
relationships that appear to be unusual.
b. Read the compiled financial statements and
consider whether they appear to include adequate
disclosure.
c. Omit substantially all of the disclosures required
by generally accepted accounting principles.
d. Issue a compilation report on one or more, but not
all, of the basic financial statements.

43. During a review of the financial statements of a

nonpublic entity, an accountant becomes aware of a
lack of adequate disclosure that is material to the
financial statements. If management refuses to correct
the financial statement presentations, the accountant
should
a. Issue an adverse opinion.
b. Issue an "except for" qualified opinion.
c. Disclose this departure from generally accepted
accounting principles in a separate paragraph of
the report.
d. Express only limited assurance on the financial
statement presentations.

48. The objective of a review of interim financial

information of a public entity is to provide the
accountant with a basis for
a. Determining whether the prospective financial
information is based on reasonable assumptions.
b. Expressing a limited opinion that the financial
information is presented in conformity with
generally accepted accounting principles.
c. Deciding whether to perform substantive audit
procedures prior to the balance sheet date.
d. Reporting whether material modifications should
be made for such information to conform with
generally accepted accounting principles.

44. If compiled financial statements presented in

conformity with the cash receipts and disbursements
basis of accounting do not disclose the basis of
accounting used, the accountant should
a. Recompile the financial statements using generally
accepted accounting principles.
b. Disclose the basis in the notes to the financial
statements.
c. Clearly label each page, "Unaudited."
5Q-6

49. Financial statements of a nonpublic entity that have

been reviewed by an accountant should be accompanied
by a report stating that
a. The scope of the inquiry and analytical procedures
performed by the accountant has not been
restricted.
b. All information included in the financial
statements is the representation of the management
of the entity.
c. A review includes examining, on a test basis,
evidence supporting the amounts and disclosures
in the financial statements.
d. A review is greater in scope than a compilation,
the objective of which is to present financial
statements that are free of material misstatements.

53. Which of the following procedures is not usually

performed by the accountant during a review
engagement of a nonpublic entity?
a. Inquiring about actions taken at meetings of the
board of directors that may affect the financial
statements.
b. Issuing a report stating that the review was
performed in accordance with standards
established by the AICPA.
c. Reading the financial statements to consider
whether they conform with generally accepted
accounting principles.
d. Communicating
any
material
weaknesses
discovered during the consideration of the internal
control structure.

50. Which of the following accounting services may an

accountant perform without being required to issue a
compilation or review report under the Statements on
Standards for Accounting and Review Services?

54. Which of the following procedures ordinarily

should be applied when an independent accountant
conducts a review of interim financial information of a
publicly held entity?
a. Verify changes in key account balances.
b. Read the minutes of the board of directors
meetings.
c. Inspect the open purchase order file.
d. Perform cut-off tests for cash receipts and
disbursements.

I. Preparing a working trial balance.

II. Preparing standard monthly journal entries.
a.
b.
c.
d.

I only.
II only.
Both I and II.
Neither I nor II.

55. Jones Retailing, a nonpublic entity, has asked

Winters, CPA, to compile financial statements that omit
substantially all disclosures required by generally
accepted accounting principles. Winters may compile
such financial statements provided the
a. Reason for omitting the disclosures is explained in
the engagement letter and acknowledged in the
management representation letter.
b. Financial statements are prepared on a
comprehensive basis of accounting other than
generally accepted accounting principles.
c. Distribution of the financial statements is
restricted to internal use only.
d. Omission is not undertaken to mislead the users of
the financial statements and is properly disclosed
in the accountants report.

51. Which of the following inquiry or analytical

procedures ordinarily is performed in an engagement to
review a nonpublic entitys financial statements?
a. Analytical procedures designed to test the
accounting records by obtaining corroborating
evidential matter.
b. Inquiries concerning the entitys procedures for
recording and summarizing transactions.
c. Analytical
procedures
designed
to
test
managements assertions regarding continued
existence.
d. Inquiries of the entitys attorney concerning
contingent liabilities.
52. When compiling the financial statements of a
nonpublic entity, an accountant should
a. Review agreements with financial institutions for
restrictions on cash balances.
b. Understand the accounting principles and practices
of the entitys industry.
c. Inquiry of key personnel concerning related parties
and subsequent events.
d. Perform ratio analyses of the financial data of
comparable prior periods.

5Q-7

56. The standard report issued by an accountant after

reviewing the financial statements of a nonpublic entity
states that
a. A review includes assessing the accounting
principles used and significant estimates made by
management.
b. A review includes examining, on a test basis,
evidence supporting the amounts and disclosures
in the financial statements.
c. The accountant is not aware of any material
modifications that should be made to the financial
statements.
d. The accountant does not express an opinion or any
other form of assurance on the financial
statements.

59. Smith, CPA, has been asked to issue a review report

on the balance sheet of Cone Company, a nonpublic
entity, and not on the other related financial statements.
Smith may do so only if
a. Smith compiles and reports on the related
statements of income, retained earnings, and cash
flows.
b. Smith is not aware of any material modifications
needed for the balance sheet to conform with
GAAP.
c. The scope of Smith's inquiry and analytical
procedures is not restricted.
d. Cone is a new client and Smith accepts the
engagement after the end of Cone's fiscal year.
60. May an accountant accept an engagement to
compile or review the financial statements of a not-forprofit entity if the accountant is unfamiliar with the
specialized industry accounting principles, but plans to
obtain the required level of knowledge before compiling
or reviewing the financial statements?

57. An auditors special report on financial statements

prepared in conformity with the cash basis of
accounting should include a separate explanatory
paragraph before the opinion paragraph that
a. Justifies the reasons for departing from generally
accepted accounting principles.
b. States whether the financial statements are fairly
presented
in
conformity
with
another
comprehensive basis of accounting.
c. Refers to the note to the financial statements that
describes the basis of accounting.
d. Explains how the results of operations differ from
financial statements prepared in conformity with
generally accepted accounting principles.

a.
b.
c.
d.

a.
b.
c.
d.

Review
No
No
Yes
Yes

61. An accountant should perform analytical procedures

during an engagement to

58. Davis, CPA, accepted an engagement to audit the

financial statements of Tech Resources, a nonpublic
entity. Before the completion of the audit, Tech
requested Davis to change the engagement to a
compilation of financial statements. Before Davis
agrees to change the engagement, Davis is required to
consider the
Additional audit
effort necessary to
complete the audit
No
Yes
Yes
No

Compilation
No
Yes
No
Yes

a.
b.
c.
d.

Compile a
nonpublic entity's
financial statements
No
Yes
Yes
No

Review a
nonpublic's entity's
financial statements
No
Yes
No
Yes

62. Which of the following procedures most likely

would not be included in a review engagement of a
nonpublic entity?
a. Obtaining a management representation letter.
b. Considering whether the financial statements
conform with GAAP.
c. Assessing control risk.
d. Inquiring about subsequent events.

Reason given for

Tech's request
No
Yes
No
Yes

5Q-8

63. Investment and property schedules are presented for

purposes of additional analysis in an auditor-submitted
document. The schedules are not required parts of the
basic financial statements, but accompany the basic
financial statements. When reporting on such additional
information, the measurement of materiality is the
a. Same as that used in forming an opinion on the
basic financial statements taken as a whole.
b. Lesser of the individual schedule of investments or
schedule of property taken by itself.
c. Greater of the individual schedule of investments
or schedule of property taken by itself.
d. Combined total of both the individual schedules of
investments and property taken as a whole.

Not undertaken with the intention of misleading

the financial statement users.

a.
b.
c.
d.

I only.
II only.
Both I and II.
Either I or II.

67. An accountant's standard report on a review of the

financial statements of a nonpublic entity should state
that the accountant
a. Does not express an opinion or any form of
limited assurance on the financial statements.
b. Is not aware of any material modifications that
should be made to the financial statements for
them to conform with GAAP.
c. Obtained reasonable assurance about whether the
financial statements are free of material
misstatement.
d. Examined evidence, on a test basis, supporting the
amounts and disclosures in the financial
statements.

64. In connection with a proposal to obtain a new client,

an accountant in public practice is asked to prepare a
written report on the application of accounting
principles to a specific transaction. The accountant's
report should include a statement that
a. Any difference in the facts, circumstances, or
assumptions presented may change the report.
b. The engagement was performed in accordance
with Statements on Standards for Consulting
Services.
c. The guidance provided is for management use
only and may not be communicated to the prior or
continuing auditors.
d. Nothing came to the accountant's attention that
caused the accountant to believe that the
accounting principles violated GAAP.

68. An accountant has been asked to issue a review

report on the balance sheet of a nonpublic company but
not to report on the other basic financial statements. The
accountant may not do so
a. Because compliance with this request would result
in a violation of the ethical standards of the
profession.
b. Because compliance with this request would result
in an incomplete review.
c. If the review of the balance sheet discloses
material departures from GAAP.
d. If the scope of the inquiry and analytical
procedures has been restricted.

65. Compiled financial statements should be

accompanied by a report stating that
a. A compilation is substantially less in scope than a
review or an audit in accordance with generally
accepted auditing standards.
b. The accountant does not express an opinion but
expresses only limited assurance on the compiled
financial statements.
c. A compilation is limited to presenting in the form
of financial statements information that is the
representation of management.
d. The accountant has compiled the financial
statements in accordance with standards
established by the Auditing Standards Board.

69. Which of the following statements is correct

concerning an auditor's responsibilities regarding
financial statements?
a. Making suggestions that are adopted about the
form and content of an entity's financial statements
impairs an auditor's independence.
b. An auditor may draft an entity's financial
statements
based
on
information
from
management's accounting system.
c. The fair presentation of audited financial
statements in conformity with GAAP is an implicit
part of the auditor's responsibilities.
d. An auditor's responsibilities for audited financial
statements are not confined to the expression of
the auditor's opinion.

66. An accountant may compile a nonpublic entity's

financial statements that omit all of the disclosures
required by GAAP only if the omission is
I.

II.

Clearly indicated in the accountant's report.

5Q-9

70. An accountant has been engaged to review a

nonpublic entity's financial statements that contain
several departures from GAAP. If the financial
statements are not revised and modification of the
standard review report is not adequate to indicate the
deficiencies, the accountant should
a. Withdraw from the engagement and provide no
further services concerning these financial
statements.
b. Inform management that the engagement can
proceed only if distribution of the accountant's
report is restricted to internal use.
c. Determine the effects of the departures from
GAAP and issue a special report on the financial
statements.
d. Issue a modified review report provided the entity
agrees that the financial statements will not be
used to obtain credit.

73. Which of the following procedures would an

accountant least likely perform during an engagement to
review the financial statements of a nonpublic entity?
a. Observing the safeguards over access to and use of
assets and records.
b. Comparing the financial statements with
anticipated results in budgets and forecasts.
c. Inquiring of management about actions taken at
the board of directors' meetings.
d. Studying the relationships of financial statement
elements expected to conform to predictable
patterns.
74. Which of the following procedures should an
accountant perform during an engagement to review the
financial statements of a nonpublic entity?
a. Communicating reportable conditions discovered
during the assessment of control risk.
b. Obtaining a client representation letter from
members of management.
c. Sending bank confirmation letters to the entity's
financial institutions.
d. Examining cash disbursements in the subsequent
period for unrecorded liabilities.

71. Statements on Standards for Accounting and

Review Services (SSARS) require an accountant to
report when the accountant has
a. Typed client-prepared financial statements,
without modification, as an accommodation to the
client.
b. Provided a client with a financial statement format
that does not include dollar amounts, to be used by
the client in preparing financial statements.
c. Proposed correcting journal entries to be recorded
by the client that change client-prepared financial
statements.
d. Generated, through the use of computer software,
financial statements prepared in accordance with a
comprehensive basis of accounting other than
GAAP.

75. When an independent CPA is associated with the

financial statements of a publicly held entity but has not
audited or reviewed such statements, the appropriate
form of report to be issued must include a(an)
a. Regulation S-X exemption.
b. Report on pro forma financial statements.
c. Unaudited association report.
d. Disclaimer of opinion.
76. An accountant who had begun an audit of the
financial statements of a nonpublic entity was asked to
change the engagement to a review because of a
restriction on the scope of the audit. If there is
reasonable justification for the change, the accountant's
review report should include reference to the

72. An accountant may accept an engagement to apply

agreed-upon procedures to prospective financial
statements provided that
a. Distribution of the report is restricted to the
specified users.
b. The prospective financial statements are also
examined.
c. Responsibility for the adequacy of the procedures
performed is taken by the accountant.
d. Negative assurance is expressed on the prospective
financial statements taken as a whole.

Scope limitation
that caused the
changed engagement
a.
b.
c.
d.

5Q-10

Yes
No
No
Yes

Original
engagement
that was agreed to
No
Yes
No
Yes

77. Gole, CPA, is engaged to review the 1994 financial

statements of North Co., a nonpublic entity. Previously,
Gole audited North's 1993 financial statements and
expressed an unqualified opinion. Gole decides to
include a separate paragraph in the 1994 review report
because North plans to present comparative financial
statements for 1994 and 1993. This separate paragraph
should indicate that
a. The 1994 review report is intended solely for the
information of management and the board of
directors.
b. The 1993 auditor's report may no longer be relied
on.
c. No auditing procedures were performed after the
date of the 1993 auditor's report.
d. There are justifiable reasons for changing the level
of service from an audit to a review.

a.
b.
c.
d.

Not designed for those who are uninformed about

the omitted disclosures.
Prepared in conformity with a comprehensive
basis of accounting other than GAAP.
Not compiled in accordance with Statements on
Standards for Accounting and Review Services.
Special-purpose financial statements that are not
comparable to those of prior periods.

81. An accountant's compilation report on a financial

forecast should include a statement that
a. The forecast should be read only in conjunction
with the audited historical financial statements.
b. The accountant expresses only limited assurance
on the forecasted statements and their
assumptions.
c. There will usually be differences between the
forecasted and actual results.
d. The hypothetical assumptions used in the forecast
are reasonable in the circumstances.

78. Which of the following statements should be

included in an accountant's standard report based on the
compilation of a nonpublic entity's financial statements?
a. A compilation consists principally of inquiries of
company personnel and analytical procedures
applied to financial data.
b. A compilation is limited to presenting in the form
of financial statements information that is the
representation of management.
c. A compilation is not designed to detect material
modifications that should be made to the financial
statements.
d. A compilation is substantially less in scope than an
audit in accordance with generally accepted
auditing standards.

82. In the standard report on condensed financial

statements that are derived from a public entity's audited
financial statements, a CPA should indicate that the
a. Condensed financial statements are prepared in
conformity with another comprehensive basis of
accounting.
b. CPA has audited and expressed an opinion on the
complete financial statements.
c. Condensed financial statements are not fairly
presented in all material respects.
d. CPA expresses limited assurance that the financial
statements conform with GAAP.

79. Miller, CPA, is engaged to compile the financial

statements of Web Co., a nonpublic entity, in
conformity with the income tax basis of accounting. If
Web's financial statements do not disclose the basis of
accounting used, Miller should
a. Disclose the basis of accounting in the
accountant's compilation report.
b. Clearly label each page "Distribution RestrictedMaterial Modifications Required."
c. Issue a special report describing the effect of the
incomplete presentation.
d. Withdraw from the engagement and provide no
further services to Web.

83. Before reporting on the financial statements of a

U.S. entity that have been prepared in conformity with
another country's accounting principles, an auditor
practicing in the U.S. should
a. Understand the accounting principles generally
accepted in the other country.
b. Be certified by the appropriate auditing or
accountancy board of the other country.
c. Notify management that the auditor is required to
disclaim an opinion on the financial statements.
d. Receive a waiver from the auditor's state board of
accountancy to perform the engagement.

80. When an accountant is engaged to compile a

nonpublic entity's financial statements that omit
substantially all disclosures required by GAAP, the
accountant should indicate in the compilation report that
the financial statements are
5Q-11

84. If requested to perform a review engagement for a

nonpublic entity in which an accountant has an
immaterial direct financial interest, the accountant is
a. Not independent and, therefore, may not be
associated with the financial statements.
b. Not independent and, therefore, may not issue a
review report.
c. Not independent and, therefore, may issue a
review report, but may not issue an auditor's
opinion.
d. Independent because the financial interest is
immaterial and, therefore, may issue a review
report.

b.
c.
d.

Obtaining
written
representations
from
management indicating that the compiled financial
statements will not be used to obtain credit.
Making inquiries of management concerning
actions taken at meetings of the stockholders and
the board of directors.
Applying analytical procedures designed to
corroborate management's assertions that are
embodied in the financial statement components.

88. Compiled financial statements should be

accompanied by an accountant's report stating that
a. A compilation includes assessing the accounting
principles used and significant management
estimates, as well as evaluating the overall
financial statement presentation.
b. The accountant compiled the financial statements
in accordance with Statements on Standards for
Accounting and Review Services.
c. A compilation is substantially less in scope than an
audit in accordance with GAAS, the objective of
which is the expression of an opinion.
d. The accountant is not aware of any material
modifications that should be made to the financial
statements to conform with GAAP.

85. Kell engaged March, CPA, to submit to Kell a

written personal financial plan containing unaudited
personal financial statements.
March anticipates
omitting certain disclosures required by GAAP because
the engagement's sole purpose is to assist Kell in
developing a personal financial plan. For March to be
exempt from complying with the requirements of
SSARS 1, Compilation and Review of Financial
Statements, Kell is required to agree that the
a. Financial statements will not be presented in
comparative form with those of the prior period.
b. Omitted disclosures required by GAAP are not
material.
c. Financial statements will not be disclosed to a
non-CPA financial planner.
d. Financial statements will not be used to obtain
credit.

89. Moore, CPA, has been asked to issue a review

report on the balance sheet of Dover Co., a nonpublic
entity. Moore will not be reporting on Dover's
statements of income, retained earnings, and cash flows.
Moore may issue the review report provided the
a. Balance sheet is presented in a prescribed form of
an industry trade association.
b. Scope of the inquiry and analytical procedures has
not been restricted.
c. Balance sheet is not to be used to obtain credit or
distributed to creditors.
d. Specialized accounting principles and practices of
Dover's industry are disclosed.

86. When providing limited assurance that the financial

statements of a nonpublic entity require no material
modifications to be in accordance with generally
accepted accounting principles, the accountant should
a. Assess the risk that a material misstatement could
occur in a financial statement assertion.
b. Confirm with the entity's lawyer that material loss
contingencies are disclosed.
c. Understand the accounting principles of the
industry in which the entity operates.
d. Develop audit programs to determine whether the
entity's financial statements are fairly presented.

90. Baker, CPA, was engaged to review the financial

statements of Hall Co., a nonpublic entity. During the
engagement Baker uncovered a complex scheme
involving client illegal acts and irregularities that
materially affect Hall's financial statements. If Baker
believes that modification of the standard review report
is not adequate to indicate the deficiencies in the
financial statements, Baker should
a. Disclaim an opinion.
b. Issue an adverse opinion.
c. Withdraw from the engagement.
d. Issue a qualified opinion.

87. Which of the following procedures is ordinarily

performed by an accountant in a compilation
engagement of a nonpublic entity?
a. Reading the financial statements to consider
whether they are free of obvious mistakes in the
application of accounting principles.

5Q-12

91. Each page of a nonpublic entity's financial

statements reviewed by an accountant should include
the following reference:
a. See Accompanying Accountant's Footnotes.
b. Reviewed, No Material Modifications Required.
c. See Accountant's Review Report.
d. Reviewed, No Accountant's Assurance Expressed.

95. Field is an employee of Gold Enterprises. Hardy,

CPA, is asked to express an opinion on Field's profit
participation in Gold's net income. Hardy may accept
this engagement only if
a. Hardy also audits Gold's complete financial
statements.
b. Gold's financial statements are prepared in
conformity with GAAP.
c. Hardy's report is available for distribution to Gold's
other employees.
d. Field owns controlling interest in Gold.

92. An auditor's report on financial statements prepared

on the cash receipts and disbursements basis of
accounting should include all of the following except
a. A reference to the note to the financial statements
that describes the cash receipts and disbursements
basis of accounting.
b. A statement that the cash receipts and
disbursements basis of accounting is not a
comprehensive basis of accounting.
c. An opinion as to whether the financial statements
are presented fairly in conformity with the cash
receipts and disbursements basis of accounting.
d. A statement that the audit was conducted in
accordance with generally accepted auditing
standards.

96. An auditor is engaged to report on selected financial

data that are included in a client-prepared document
containing audited financial statements. Under these
circumstances, the report on the selected data should
a. Be limited to data derived from the audited financial
statements.
b. Be distributed only to senior management and the
board of directors.
c. State that the presentation is a comprehensive basis
of accounting other than GAAP.
d. Indicate that the data are not fairly stated in all
material respects.

93. Financial statements of a nonpublic entity that have

been reviewed by an accountant should be accompanied
by a report stating that a review
a. Provides only limited assurance that the financial
statements are fairly presented.
b. Includes examining, on a test basis, information that
is the representation of management.
c. Consists principally of inquiries of company
personnel and analytical procedures applied to
financial data.
d. Does not contemplate obtaining corroborating
evidential matter or applying certain other
procedures ordinarily performed during an audit.

97. A registration statement filed with the SEC contains

the reports of two independent auditors on their audits
of financial statements for different periods. The
predecessor auditor who audited the prior-period
financial statements generally should obtain a letter of
representation from the
a. Successor independent auditor
b. Client's audit committee.
c. Principal underwriter.
d. Securities and Exchange Commission.

94. Financial statements of a nonpublic entity compiled

without audit or review by an accountant should be
accompanied by a report stating that
a. The scope of the accountant's procedures has not
been restricted in testing the financial information
that is the representation of management.
b. The accountant assessed the accounting principles
used and significant estimates made by
management.
c. The accountant does not express an opinion or any
other form of assurance on the financial statements.
d. A compilation consists principally of inquiries of
entity personnel and analytical procedures applied to
financial data.

5Q-13

Chapter Five - Problems

Reviews, Compilations, Special Reports and Other
Reports
NUMBER 1
Rose & Co., CPAs, has satisfactorily completed the examination of the financial statements of Bale & Booster, a
partnership, for the year ended December 31, 1985. The financial statements which were prepared on the entity's
income tax (cash) basis include footnotes which indicate that the partnership was involved in continuing litigation
of material amounts relating to alleged infringement of a competitor's patent. The amount of damages, if any,
resulting from this litigation could not be determined at the time of completion of the engagement. The prior years'
financial statements were not presented.
Required:
Based upon the information presented, prepare an auditor's report which includes appropriate explanatory disclosure
of significant facts.

NUMBER 2
The auditor's report below was drafted by a staff accountant of Baker and Baker, CPAs, at the completion of the
audit of the comparative financial statements of Ocean Shore Partnership for the years ended December 31, 1990
and 1989. Ocean Shore prepares its financial statements on the income tax basis of accounting. The report was
submitted to the engagement partner who reviewed matters thoroughly and properly concluded that an unqualified
opinion should be expressed.
Auditor's Report
We have audited the accompanying statements of assets, liabilities, and capital-income tax basis of Ocean
Shore Partnership as of December 31, 1990 and 1989, and the related statements of revenue and expensesincome tax basis and changes in partners' capital accounts-income tax basis for the years then ended.
We conducted our audits in accordance with standards established by the American Institute of Certified
Public Accountants. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used as well as evaluating the overall financial
statement presentation.
As described in Note A, these financial statements were prepared on the basis of accounting the
Partnership uses for income tax purposes. Accordingly, these financial statements are not designed for
those who do not have access to the Partnership's tax returns.
In our opinion, the financial statements referred to above present fairly, in all material respects, the assets,
liabilities, and capital of Ocean Shore Partnership as of December 31, 1990 and 1989, and its revenue and
expenses and changes in partners' capital accounts for the years then ended, in conformity with generally
accepted accounting principles applied on a consistent basis.
Baker and Baker, CPAs
April 3, 1991

5Q-14

Required:
Identify the deficiencies contained in the auditors' report as drafted by the staff accountant. Group the deficiencies
by paragraph, where applicable. Do not redraft the report.

NUMBER 3
Number 3 consists of 15 items. Select the best answer for each item.
Required:
Items 106 through 120 represent a series of unrelated procedures that an accountant may consider performing in
separate engagements to review the financial statements of a nonpublic entity (a review) and to compile the
financial statements of a nonpublic entity (a compilation). Select, as the best answer for each item, whether the
procedure is required (R) or not required (N) for both review and compilation engagements. Make two selections
for each item.
Procedures
106. The accountant should establish an understanding with the entity regarding the nature and limitations of the
services to be performed.
107. The accountant should make inquiries concerning actions taken at the board of directors' meetings.
108. The accountant, as the entity's successor accountant, should communicate with the predecessor accountant to
obtain access to the predecessor's working papers.
109. The accountant should obtain a level of knowledge of the accounting principles and practices of the entity's
industry.
110. The accountant should obtain an understanding of the entity's internal control.
111. The accountant should perform analytical procedures designed to identify relationships that appear to be
unusual.
112. The accountant should make an assessment of control risk.
113. The accountant should send a letter of inquiry to the entity's attorney to corroborate the information furnished
by management concerning litigation.
114. The accountant should obtain a management representation letter from the entity.
115. The accountant should study the relationships of the financial statement elements that would be expected to
conform to a predictable pattern.
116. The accountant should communicate to the entity's senior management illegal employee acts discovered by the
accountant that are clearly inconsequential.
117. The accountant should make inquiries about events subsequent to the date of the financial statements that
would have a material effect on the financial statements.
118. The accountant should modify the accountant's report if there is a change in accounting principles that is
adequately disclosed.

5Q-15

119. The accountant should submit a hard copy of the financial statements and accountant's report when the
financial statements and accountant's report are submitted on a computer disk.
120. The accountant should perform specific procedures to evaluate whether there is substantial doubt about the
entity's ability to continue as a going concern.

NUMBER 4
Number 4 consists of 17 items pertaining to possible deficiencies in an accountant's report on comparative financial
statements.
Wallace & Wallace, CPAs, audited the financial statements of West Co., a nonpublic entity, for the year ended
September 30, 1995, and expressed an unqualified opinion. For the year ended September 30, 1996, West issued
comparative financial statements. Wallace & Wallace reviewed West's 1996 financial statements and Gordon, an
assistant on the engagement, drafted the accountant's review report below. Martin, the engagement supervisor,
decided not to reissue the prior year's auditor's report, but instructed Gordon to include a separate paragraph in the
current year's review report describing the responsibility assumed for the prior year's audited financial statements.
Martin reviewed Gordon's draft and indicated in Martin's Review Notes that there were many deficiencies in
Gordon's draft.
Accountant's Review Report
We have reviewed the accompanying balance sheet of West Company as of September 30, 1996, and the related
statements of income and cash flows for the year then ended, in accordance with standards issued by the American
Institute of Certified Public Accountants. All information included in these financial statements is the
representation of the management of West Company. Our responsibility is to express limited assurance on these
financial statements based on our review.
A review consists principally of inquiries of company personnel and analytical procedures applied to financial data.
A review also includes assessing the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation.
Based on our review, we are not aware of any material modifications that should be made to the accompanying
financial statements. Accordingly, the accompanying financial statements have been prepared assuming that the
company will continue as a going concern. Furthermore, we have no responsibility to update this report for events
and circumstances occurring after the date of this report.
The financial statements for the year ended September 30, 1995, were audited by us and we expressed an
unqualified opinion on them in our report dated November 7, 1995, but we have not performed any auditing
procedures since that date. In our opinion, the financial statements referred to above are presented fairly, in all
material respects, for the year then ended in conformity with generally accepted accounting principles.
Wallace & Wallace, CPAs
November 6, 1996
Required:
Items 1 through 17 represent the deficiencies noted by Martin. For each deficiency, indicate whether Martin is
correct and Gordon is incorrect (M); Gordon is correct and Martin is incorrect (G); or both Martin and Gordon are
incorrect (B).

5Q-16

Martin's Review Notes

1. There should be a reference to the prior year's audited financial statements in the first (introductory) paragraph.
2.

All of the current year's basic financial statements are not properly identified in the first (introductory)
paragraph.

3.

The standards referred to in the first (introductory) paragraph should not be standards issued by the American
Institute of Certified Public Accountants, but should be standards for the compilation and review of financial
statements.

4.

The accountant's responsibility to express limited assurance on the financial statements, mentioned in the first
(introductory) paragraph, should be in the second (scope) paragraph.

5.

There should be a reference to the prior year's audited financial statements in the second (scope) paragraph.

6.

There should be a comparison of the scope of a review to an audit in the second (scope) paragraph.

7.

There should be no reference to "assessing the accounting principles used," "significant estimates made by
management," and "evaluating the overall financial statement presentation" in the second (scope) paragraph.

8.

There should be a statement that no opinion is expressed on the current year's financial statements in the
second (scope) paragraph.

9.

There should be a reference to "conformity with generally accepted accounting principles" in the third
paragraph.

10. There should be a reference to consistency in the third paragraph.

11. There should be a restriction on the distribution of the accountant's review report in the third paragraph.
12. The reference to "going concern" in the third paragraph should be in the second (scope) paragraph.
13. The accountant's lack of responsibility to update the report in the third paragraph should be in the second
(scope) paragraph.
14. There should be no mention of the type of opinion expressed on the prior year's audited financial statements in
the fourth (separate) paragraph.
15. All of the prior year's basic financial statements are not properly identified in the fourth (separate) paragraph.
16. The reference in the fourth (separate) paragraph to the fair presentation of the prior year's audited financial
statements in accordance with generally accepted accounting principles should be omitted.
17. The report should be dual dated to indicate the date of the prior year's auditor's report.

5Q-17

NUMBER 5
The auditors' report below was drafted by a staff accountant of Baker & Baker, CPAs, at the completion of the audit
of the comparative financial statements of Ocean Shore Partnership for the years ended December 31, 1998 and
1999. Ocean Shore prepares its financial statements on the income tax basis of accounting. The report was
submitted to the engagement partner who reviewed matters thoroughly and properly concluded that an unqualified
opinion should be expressed.

Auditor's Report
To:

The Board of Directors

We have audited the accompanying statements of assets, liabilities, and capital income tax basis of Ocean Shore
Partnership as of December 31, 1999 and 1998, and the related statements of revenue and expenses income tax
basis and changes in partners' capital accounts income tax basis for the years then ended.
We conducted our audits in accordance with standards established by the American Institute of Certified Public
Accountants. Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used as well as evaluating the overall financial statement presentation.
As described in Note A, these financial statements were prepared on the basis of accounting the Partnership uses for
income tax purposes. Accordingly, these financial statements are not designed for those who do not have access to
the Partnership's tax returns.
In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities,
and capital of Ocean Shore Partnership as of December 31, 1999 and 1998, and its revenue and expenses and
changes in partners' capital accounts for the years then ended, in conformity with generally accepted accounting
principles applied on a consistent basis.
Baker & Baker, CPAs
April 3, 2000

Required:
This report contains deficiencies. For the following statements, indicate (Y for Yes, N for No) whether the noted
correction should be made to correct the deficiencies in the report.
1.

"External" should be added to the title of the report.

2.

Management's responsibility for the financial statements should be referred to in the introductory paragraph.

3.

The auditors' responsibility to express an opinion on the financial statements should be referred to in the
introductory paragraph.

4.

A reference to assessing "significant estimates made by the auditor" should be included in the scope paragraph.

5.

Reference to the income tax basis of accounting as "a comprehensive basis of accounting other than generally
accepted accounting principles" should be included in the explanatory paragraph.

6.

The statement that the auditors' "audits provide a reasonable basis for our opinion" should be included in the
scope paragraph.

5Q-18

7.

"Generally accepted accounting standards" should be referred to in the scope paragraph, not standards
established by the AICPA.

8.

The income tax basis of accounting "described in Note A" should be referred to in the opinion paragraph, not
"generally accepted accounting principles."

9.

The statement that the financial statements are "not designed for those who do not have access to the
Partnership tax returns" is inappropriate in the explanatory paragraph.

10. There should be no reference to consistency in the opinion paragraph.

NUMBER 6
Lambers & Lambers, CPAs, audited the financial statements of East Co., a nonpublic entity, for the year ended
September 30, 1998 and expressed an unqualified opinion. For the year ended September 30, 1999, East issued
comparative financial statements. Lambers & Lambers reviewed East's 1999 financial statements, and Del, an
assistant on the engagement, drafted the accountant's review report below. Cutler, the engagement supervisor,
decided not to reissue the prior year's auditor's report but instructed Del to include a separate paragraph in the
current year's review report describing the responsibility assumed for the prior year's audited financial statements.
Cutler reviewed Del's draft and indicated in Cutler's Review Notes that there were many deficiencies in Del's draft.
Accountant's Review Report
We have reviewed the accompanying balance sheet of East Company as of September 30, 1999 and the related
statements of income and cash flows for the year then ended, in accordance with standards issued by the American
Institute of Certified Public Accountants. All information included in these financial statements is the
representation of the management of East Company. Our responsibility is to express limited assurance on these
financial statements based on our review.
A review consists principally of inquiries of company personnel and analytical procedures applied to financial data.
A review also includes assessing the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation.
Based on our review, we are not aware of any material modifications that should be made to the accompanying
financial statements. Accordingly, the accompanying financial statements have been prepared assuming that the
company will continue as a going concern. Furthermore, we have no responsibility to update this report for events
and circumstances occurring after the date of this report.
The financial statements for the year ended September 30, 1998 were audited by us, and we expressed an
unqualified opinion on them in our report dated November 7, 1998, but we have not performed any auditing
procedures since that date. In our opinion, the financial statements referred to above are presented fairly, in all
material respects, for the year then ended in conformity with generally accepted accounting principles.
Lambers & Lambers, CPAs
November 6, 1999

5Q-19

Required:
Items 1 through 17 represent the deficiencies noted by Cutler. For each deficiency, indicate whether Cutler is
correct and Del is incorrect (C), Del is correct and Cutler is incorrect (D), or both Cutler and Del are incorrect (B).
Cutler's Review Notes
1. The first (introductory) paragraph should refer to the prior year's audited financial statements.
2.

All of the current year's basic financial statements are not properly identified in the first (introductory)
paragraph.

3.

The standards referred to in the first (introductory) paragraph should not be standards issued by the American
Institute of Certified Public Accountants but should be standards for the compilation and review of financial
statements.

4.

The accountant's responsibility to express limited assurance on the financial statements, mentioned in the first
(introductory) paragraph, should be in the second (scope) paragraph.

5.

The second (scope) paragraph should refer to the prior year's audited financial statements.

6.

The second (scope) paragraph should compare the scope of a review with that of an audit.

7.

References to "assessing the accounting principles used," "significant estimates made by management," and
"evaluating the overall financial statement presentation" should not be in the second (scope) paragraph.

8.

A statement that no opinion is expressed on the current year's financial statements should be in the second
(scope) paragraph.

9.

A reference to "conformity with generally accepted accounting principles" should be in the third paragraph.

10. A reference to consistency should be in the third paragraph.

11. A restriction on the distribution of the accountant's review report should be in the third paragraph.
12. The reference to "going concern" in the third paragraph should be in the second (scope) paragraph.
13. The accountant's lack of responsibility to update the report in the third paragraph should be in the second
(scope) paragraph.
14. The type of opinion expressed on the prior year's audited financial statements should not be mentioned in the
fourth (separate) paragraph.
15. All of the prior year's basic financial statements are not properly identified in the fourth (separate) paragraph.
16. The reference in the fourth (separate) paragraph to the fair presentation of the prior year's audited financial
statements in accordance with generally accepted accounting principles should be omitted.
17. The report should be dual dated to indicate the date of the prior year's auditor's report.

5Q-20

Chapter Five - Solutions to Questions

Reviews, Compilations, Special Reports and Other
Reports
1. (b) Special Reports are reports issued in connection with (a) financial statements that are prepared in accordance
with a comprehensive basis of accounting other than generally accepted accounting principles, (b) specified
elements, accounts, or items of a financial statement, (c) compliance with aspects of contractual agreements or
regulatory requirements related to audited financial statements, (d) financial information presented in prescribed
forms or schedules that require a prescribed form of auditor's report. Reports that meet the foregoing criteria are
special reports or special purpose reports.
2. (c) Review engagements, whether for a public or non-public company, include, among other procedures, an
analytical review and inquiries of company personnel.
3. (c) There are four types of special reports, one of which in a definite set of criteria having substantial support that
is applied to all material items appearing in financial statements. Price-level financial statements qualify as a basis
of accounting having substantial authoritative support.
4. (b) Reports on preprinted forms is a type of special report. GAAS specifically states that if the auditor is not
satisfied with the wording of the form, it should be reworded.
5. (d) A study and evaluation of internal control is associated with audit engagements, not review engagements.
6. (b) Statements upon which the CPA reports that are not GAAP representations but rather "special reports" should
not use the terms "Balance Sheet," "Income Statement," etc. Such terms are associated with GAAP and should not
be used with statements that are not GAAP.
7. (c) If the CPA has not audited he must disclaim an opinion.
8. (c) Answer (a) is incorrect because the CPA has not audited. Answer (b) is incorrect because the CPA does not
report on accuracy. Answer (d) is incorrect because it implies an audit. (c) is correct because a limited review
provides a basis for reporting to the Board of Directors.
9. (b) For a non-public entity the type of service described would be a compilation. The only work the accountant
must do for this service is described by the answer.
10. (c) Should the client refuse to make changes and the modifications in the accountant's report are not sufficient,
the CPA should withdraw from the engagement.
11. (d) The client has changed the type of service that it wishes the CPA to perform. Before honoring the request,
the CPA should determine whether the client has a sound business reason for the change. In this case, the cost of the
audit was excessive and could be honored by the CPA.
12. (a) If the financial statements contain a departure from GAAP that the client refuses to change, the CPA should
disclose this fact in a separate paragraph of his Review Report.
13. (c) Each page of the accountant's compilation report should contain a reference to the Compilation Report.
14. (d) A CPA may issue a compilation report even though he is not independent, but his report must clearly state
that he is not independent.

5S-1

15. (a) During a review of a client's financial statements, a CPA will:

1.
2.
3.

Discuss with management the nature of the accounting system used to generate the financial statements
(answer b)
Perform an analytical review (answer c)
Read the minutes of meetings in order to determine if disclosure is adequate (answer d)

The CPA will not review any controls since this is associated with an audit.
16. (a) An accountant's review report must be modified for departures from GAAP and/or inadequate disclosure
only. The going concern problem is adequately disclosed in the financial statements, therefore no modification of
the accountant's review report is necessary. The accountant may modify his review report but again it is not
necessary to do so.
17. (a) Answers (b), (c) and (d) include information that would be included in the auditor's report on financial
statements prepared in accordance with another comprehensive basis of accounting other than GAAP. It would be
inappropriate to justify the basis of accounting used in the auditor's report. Therefore, answer (a) is the correct
answer to the question because the method of accounting does not have to be justified in the auditor's report.
18. (d) Answers (b) and (c) do not require the accountant to render any assurance on the fairness of presentation of
the information contained in the financial statements (historical or prospective). Answer (a) (report on management
advisory services) does not require that an accountant to be independent. However, when issuing a report on
compliance with a contractual agreement the CPA must be independent before a negative assurance is issued.
19. (c) The FASB promulgates GAAP. The GAO promulgated Governmental Auditing Standards. There is no such
body designated as the Auditing Standards Board. The Accounting and Review Services Committee promulgates
standards for nonpublic companies (entities not subject to SEC reporting) called Statements on Standards for
Accounting and Review Services (SSARS).
20. (b) The magnitude of the financial interest has no bearing. Any financial interest makes the CPA not
independent. Answer (b) is correct because the CPA may not issue a review report. Answer (c) is not correct
because the CPA may be associated in a compilation even though he is not independent.
21. (c) An accountant may report (audit or review) on only one basic financial statement as long as he has access to
all evidence and the scope of his procedures are not restricted.
22. (b) Answer (a) is incorrect because there is no testing of internal control in a review. Answer (c) is incorrect
because corroborating evidence is sought only in an audit; (d) is incorrect because these procedures imply
confirmations and that is an audit procedure.
23. (a) Since the CPA is associated with the financial statements (he is submitting them), he must indicate the
degree of responsibility he is taking with respect to the statements. Since the statements are unaudited and the
company is nonpublic, the appropriate standards are compilation standards.
24. (c) Answers (a), (b) and (d) are normally performed in an audit engagement. Answer (c) is performed in a
review engagement.
25. (a) There is no requirement to study and evaluate internal controls in a review engagement.
26. (b) Inquiry and analytical review procedures are the basis for a review engagement.
27. (d) There are only two reasons an auditor would modify a review report, and they are (1) departures from GAAP
and (2) inadequate disclosure. Uncertainties would not require modification of a review report.

5S-2

28. (c) If not disclosed in the footnotes to the financial statements, the CPA would disclose the basis of accounting
in his report.
29. (a) The objective of a review is to provide the accountant, based on applying his or her knowledge of financial
reporting practices to significant accounting matters of which he or she becomes aware through inquiries and
analytical procedures, with a basis for reporting whether material modifications should be made for such
information to conform with generally accepted accounting principles. Answers (b) and (d) are incorrect because a
review, which does not provide assurance that the accountant will become aware of all significant matters that
would be disclosed in audit, does not provide the basis for expressing or updating an audit opinion. Answer (c) is
incorrect because a review does not provide a basis for reporting on whether certain information should or should
not be included in a registration statement under the Securities Act of 1933.
30. (a) An accountant may submit a written personal financial plan containing unaudited personal financial
statements to a client without complying with the requirements of SSARS 1 when all of the following conditions
exist: the accountant establishes an understanding with the client that the financial statements will be used solely to
assist the client and the client's advisors to develop the client's personal goals and objectives, and will not be used to
obtain credit or for any purposes other than developing these goals and objectives; nothing comes to the
accountant's attention during the engagement that would cause the accountant to believe that the financial statements
will be used to obtain credit or for any other purposes other than developing the client's financial goals and
objectives. Answer (a) is one of the above conditions.
31. (a) There is a presumption that the information required by a prescribed form is sufficient to meet the needs of
the body that designed or adopted the form and that there is no need for that body to be advised of departures from
generally accepted accounting principles required by the prescribed form or related instructions.
32. (a) Special reports, or special purpose reports, include reports issued in connection with: financial statements
that are prepared in accordance with a comprehensive basis of accounting other than generally accepted accounting
principles; specified elements, accounts, or items of a financial statement; compliance with aspects of contractual
agreements or regulatory requirements related to audited financial statements; financial information presented in
prescribed forms or schedules that require a prescribed form of auditor's report. A comprehensive basis of
accounting other than GAAP, which is the first type of report listed above, includes the cash basis of accounting.
33. (b) The services of CPAs include examination of financial statements and schedules contained in registration
statements filed with the Securities and Exchange Commission under the Securities Act of 1933. In connection with
this type of service, accountants are often called upon to issue letters to underwriters, commonly called comfort
letters.
34. (a) Financial statements of a nonpublic entity that are reviewed by an accountant should be accompanied by a
report stating that a review is substantially less in scope than an audit. Answers (c) and (d) are true regarding
reviews of financial statements of a nonpublic entity, but they are not referred to in the accountant's report. Answer
(b) does not apply to a review of financial statements.
35. (d) When a nonpublic entity's financial statements that an accountant has compiled omit substantially all
disclosures, a paragraph is added to the compilation report indicating that the financial statements are not designed
for those who are not informed about the omitted disclosures. The accountant may compile such financial
statements provided the omissions are not undertaken with the intention of misleading users of those statements.
There is no requirement that these statements be restricted for internal use [answer (a)] and no prohibition on giving
them to financial institutions [answer (b)]. Answer (c) has nothing to do with omitting disclosures.
36. (c) The objective of a review of interim financial information is to provide the accountant, based on objectively
applying his knowledge of financial reporting practices to significant accounting matters of which he becomes
aware through inquiries and analytical procedures, with a basis for reporting whether material modifications should
be made for such information to conform with GAAP. A review does not provide a basis for the expression of an
opinion regarding the financial statements. Answer (a) is the objective of an audit. Answer (b) also refers to audits.
Answer (d) involves expressing an opinion.

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37. (c) An independent auditor may be requested to express an opinion on one or more specified elements, accounts,
or items of a financial statement. Examples include rentals and royalties. The auditor's opinion should be expressed
in a special report presented separately from the report on the financial statements of the entity. The auditor should
not express an opinion on specified elements, accounts, or items included in financial statements on which he has
expressed an adverse opinion or disclaimed an opinion based on an audit, if such reporting would be tantamount to
expressing a piecemeal opinion on the financial statements. An opinion on rental and royalty income would not
typically be equivalent to issuing a piecemeal opinion [answer (a)]. An engagement to express an opinion on
specified elements, accounts, or items of a financial statement may be undertaken as a separate engagement [answer
(b)] or in conjunction with an audit of financial statements. There are no limitations on the distribution of the special
report [answer (d)].
38. (c) When an auditor submits a document containing audited financial statements to his client, he has a
responsibility to report on all the information included in the document. If accompanying information is included,
the auditor's report should describe clearly the degree of responsibility the auditor is taking, which is to evaluate the
accompanying information in relation to the audited financial statements. The report, therefore, should include
either an opinion on whether the accompanying information is fairly stated in all material respects in relation to the
basic financial statements taken as a whole or a disclaimer of opinion. Answer (a) is incorrect because generally
accepted auditing standards deal with how an audit is performed, not with the fairness of information presented.
Answer (b) is incorrect because the accompanying information, some of which may come from sources outside the
accounting system and therefore not be subject to accounting principles, is presented outside the financial
statements and is not considered necessary for those statements to conform with generally accepted accounting
principles. Answer (d) is incorrect because the auditor's responsibility regarding information that has been subjected
to auditing procedures is addressed in the auditing standards, not the attestation standards.
39. (b) An auditor's report on information accompanying the basic financial statements in an auditor-submitted
document has the same objective as an auditor's report on the basic financial statements: to describe clearly the
character of the auditor's work and the degree of responsibility the auditor is taking. The report should include either
an opinion on whether the accompanying information is fairly stated in all material respects in relation to the basic
financial statements taken as a whole or a disclaimer of opinion.
40. (c) The accountant should possess a level of knowledge of the accounting principles and practices of the
industry in which the entity operates and an understanding of the entity's business that will provide him, through the
performance of inquiry and analytical procedures, with a reasonable basis for expressing limited assurance that there
are no material modifications that should be made to the financial statements in order for the statements to be in
conformity with GAAP. This level of knowledge should be obtained before performing a review of a nonpublic
entity's financial statements. The procedures in answers (a), (b) and (d) would be performed as part of the review.
41. (c) The CPA must be independent when performing a review service. Independence is considered impaired if
the accountant had or was committed to acquire any direct or material indirect financial interest in the client.
Answer (a) is incorrect because materiality is not a factor when the accountant has a direct interest. Answer (b)
ignores the compilation level of association with a client's financial statements, which is permitted when the
accountant is not independent. Answer (d) is incorrect in stating that a review report can be issued when the
accountant is not independent.
42. (c) Financial statements prepared on the income tax basis of accounting are a type of special report as defined by
auditing standards. Those standards state that the income tax basis of accounting is, "a comprehensive basis of
accounting other than GAAP." In writing a report on such a basis, the auditor must expand the standard report to
include a separate paragraph that states the income tax basis of accounting is a comprehensive basis of accounting
other than GAAP.
43. (c) Answers (a) and (b) only apply to audit reports, not review reports. Answer (d) is true about review reports.
A review does express limited assurance, but (d) does not answer the question posed. Answer (c) is correct because
the accountant (CPA) must disclose the departure from GAAP in the review report.

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44. (d) The accountant may compile financial statements that omit all footnote disclosures. Normally, the footnotes
to the financial statements would disclose the basis of accounting in preparing the financial statements. If all
disclosures are omitted, then the CPA must disclose the basis of accounting followed in the compilation report.
45. (b) There are five types of reports designated as special reports by auditing standards. These are:
1.
2.
3.
4.
5.

Financial statements prepared on a comprehensive basis of accounting other than GAAP.

Reports on specified elements, accounts, or items of a financial statement.
Compliance with aspects of a contractual agreement or regulatory requirements related to audited
financial statements.
Financial presentations to comply with contractual agreements.
Financial information presented in prescribed forms.

Answer (b) is the third type of special report enumerated above.

46. (b) A review consists primarily of analytical review procedures and inquiry of the client personnel. Answer (a),
(c) and (d) are usually performed in an audit, not a review.
47. (a) Analytical procedures are performed in a review, not a compilation.
48. (d) Answer (a) is incorrect because interim financial information is a historical financial presentation and has
nothing to do with prospective financial information. Answer (c) is incorrect because substantive procedures are
used in an audit, not a review. Answer (b) is incorrect because a review does not express an opinion. Only an audit
expresses an opinion. Answer (d) is correct because a review report provides limited assurance and refers to
whether or not material modifications should be made to the information.
49. (b) Answer (a) is incorrect because no reference is made in a review report about the scope of procedures.
Answer (c) is incorrect because this statement would appear in an audit report. Answer (d) is incorrect due to the
fact that a review is greater in scope than a compilation.
50. (c) An accountant is required to issue a report whenever he compiles or reviews financial statements in
accordance with Statements on Standards for Accounting and Review Services (SSARS). SSARS does not establish
procedures for other accounting and bookkeeping services such as preparing a working trial balance and standard
monthly journal entries.
51. (b) A review consists principally of inquiries of company personnel and analytical procedures applied to
financial data. The review should ordinarily include inquiries concerning the entitys procedures for recording and
summarizing transactions. A review does not contemplate tests of records and assertions, as illustrated in answers
(a) and (c), and inquiries of non-company personnel, such as the entitys attorney in answer (d).
52. (b) In order to compile financial statements that are appropriate in form, the accountant should possess a level of
knowledge of the accounting principles and practices of the industry in which the client operates. The accountant is
not required to make inquiries or perform other procedures to verify, corroborate, or review information supplied by
the entity unless the accountant becomes aware that information supplied by the client may be unsatisfactory.
53. (d) A review does not contemplate obtaining an understanding of the internal control structure or assessing
control risk. Accordingly, in a review engagement of a nonpublic entity, the accountant will not typically
communicate material weaknesses discovered during the consideration of the internal control structure. Answers
(a), (b) and (c) are examples of review procedures that should ordinarily be performed.
54. (b) Procedures for conducting a review of interim financial information are generally limited to inquiries and
analytical procedures. Included in these procedures is reading the minutes of meetings of stockholders, the board of
directors, and committees of the board of directors. A review does not typically include tests of balances and
transactions such as those reflected in answers (a), (c) and (d).

5S-5

55. (d) Even though the accountant gives no opinion or other explicit assurances on compiled financial statements,
if he becomes aware that information is incorrect, incomplete, or otherwise unsatisfactory, he should obtain
additional or revised information. The accountant may, however, compile financial statements that omit
substantially all of the disclosures required by generally accepted accounting principles, provided the omission is
clearly indicated in the accountants report and is not, to his knowledge, undertaken with the intention of misleading
those who might reasonably be expected to use such financial statements.
56. (c) Statements on Standards for Accounting and Review Services require the accountants review report for a
nonpublic entity to state that a review is less in scope than an audit and that the accountant is not aware of any
material modifications that should be made to the financial statements. Thus, a review does not typically include
assessing accounting principles and examining evidence, as presented in answers (a) and (b) and a review report
does not include an opinion, as noted in answer (d), but does provide negative assurance.
57. (c) When reporting on financial statements prepared in conformity with a comprehensive basis of accounting
other than generally accepted accounting principles (GAAP), an independent auditors report should include a
paragraph that states the basis of presentation and refers to the note in the financial statements that discusses the
basis of presentation and describes how that basis differs from GAAP. The separate paragraph in the auditors
report does not include any justification, opinion, or explanation as presented in answers (a), (b) and (d).
58. (b) A CPA who has been engaged to audit the financial statements of a nonpublic entity may, before the
completion of the engagement, be requested to change the engagement to a compilation. Such a request may result
from a change in circumstances affecting the client's requirement for an audit, a misunderstanding regarding the
nature of an audit, or a restriction on the scope of the audit. Before agreeing to the change to a compilation, the
CPA should consider the reason for the client's request, the additional audit effort required to complete the audit,
and the estimated cost to complete the audit. Answers (a) and (d) are incorrect because the CPA is required to
consider the additional audit effort necessary to complete the audit. Answer (c) is incorrect because the CPA is
required to consider the reason given for the client's request, particularly the implications of a restriction on the
scope of the audit, whether imposed by the client or by circumstances.
59. (c) A CPA may be asked to issue a review report on one financial statement, such as a balance sheet, and not on
related financial statements such as statements of income, retained earnings, and cash flows. The CPA may do so if
the scope of his or her inquiry and analytical procedures has not been restricted. Answer (a) is incorrect because the
CPA can issue a review report on a balance sheet without reporting on other related financial statements. Answer
(b) is incorrect because the CPA can issue a review report on a balance sheet that is modified to disclose a departure
from GAAP. Answer (d) is incorrect because whether the client is a new or continuing client, and whether the
engagement is accepted before or after the end of the client's fiscal year are irrelevant. The CPA can issue a review
report on a balance sheet for new or continuing clients, and for engagements accepted before or after fiscal year end.
60. (d) When accepting an engagement to compile or review the financial statements of a nonpublic entity, the
accountant should possess a level of knowledge of the accounting principles and practices of the industry in which
the entity operates. This requirement does not preclude the accountant from accepting an engagement for an entity
in an industry with which the accountant has no previous experience, if the accountant plans to obtain the required
level of knowledge before compiling or reviewing the financial statements. In this context, the term industry
includes not-for-profit activities and the requirement to obtain the necessary knowledge applies to not-for-profit
entities. Answers (a), (b) and (c) are incorrect because the accountant can accept a compilation or review
engagement if the accountant has or plans to obtain the required knowledge.
61. (d) A compilation is defined as presenting in the form of financial statements information that is the
representation of management without undertaking to express any assurance on the statements. In a compilation,
the accountant is not required to make inquiries or to perform other procedures to verify, corroborate, or review
information supplied by the entity. A review is defined as performing inquiry and analytical procedures that
provide the accountant with a reasonable basis for expressing limited assurance that there are no material
modifications that should be made to the financial statements in order for them to be in conformity with GAAP, or,
if applicable, with another comprehensive basis of accounting. Answers (a) and (c) are incorrect because analytical

5S-6

procedures are required in a review engagement. Answer (b) is incorrect because analytical procedures are not
required in a compilation engagement.
62. (c) A review engagement for a nonpublic entity does not include obtaining an understanding of the internal
control structure or assessing control risk, testing accounting records and responses to inquiries by obtain
corroborating evidential matter, and certain other procedures ordinarily performed during an audit. The accountant
is required to obtain a representation letter from management, as indicated in answer (a). The accountant also must
consider whether the financial statements conform with GAAP, as indicated in answer (b), in order for the
accountant to state in his or her report that the accountant is not aware of any material modifications that should be
made to the financial statements in order for them to be in conformity with GAAP. Additionally, as part of the
inquiry and analytical procedures that are performed in a review, the accountant would inquire about events
subsequent to the date of the financial statements that would have a material affect on the financial statements, as
indicated in answer (d).
63. (a) When an auditor submits a document containing financial statements to a client or others, the auditor has a
responsibility to report on all the information included in the document. If the auditor-submitted document contains
information that is presented outside the basic financial statements that is not required for those financial statements
to be presented in accordance with GAAP, such as investment and property schedules presented for purposes of
additional analysis, the auditor must express an opinion on that accompanying information. When reporting on this
information, the measurement of materiality is the same as that used in forming an opinion on the basic financial
statements taken as a whole. Answers (b), (c) and (d) are incorrect because the auditor is not expressing an opinion
on the additional information taken by itself. Instead, the auditor is expressing an opinion on whether the
accompanying information is fairly stated in relation to the basic financial statements taken as whole.
64. (a) Accountants in public practice are sometimes engaged to report on the application of accounting principles
to specific transactions and financial products. When providing such a service, in connection with a proposal to
obtain a new client or otherwise, the accountant should follow AICPA guidance, which includes reporting
guidelines. The written report should include a description of the nature of the engagement; a description of the
transaction; a statement describing the appropriate accounting treatment; a statement that the responsibility for
proper accounting rests with the financial statement preparers; and a statement that any difference in the facts,
circumstances, or assumptions presented may change the report. Answer (b) is incorrect because an engagement to
report on the application of accounting principles is performed in accordance with AICPA standards, not with
Statements on Standards for Consulting Services. Answer (c) is incorrect because there is generally no restriction
on distribution of the report. Answer (d) is incorrect because the accountant's report includes a statement that
describes the appropriate accounting principles to be applied instead of negative assurance.
65. (c) Compiled financial statements should be accompanied by a report stating that: a compilation has been
performed in accordance with Statements on Standards for Accounting and Review Services (SSARS) issued by the
AICPA; a compilation is limited to presenting in the form of financial statements information that is the
representation of management; and the financial statements have not been audited or reviewed and, accordingly, the
accountant does not express an opinion or any other form of assurance on them. Answer (a) is incorrect because,
although it is true that a compilation is substantially less in scope than a review or audit in accordance with GAAS,
the compilation report does not include such a statement. Answer (b) is incorrect because the accountant expresses
no assurance on the compiled financial statements. Answer (d) is incorrect because the accountant follows SSARS
issued by the AICPA Accounting and Review Services Committee, not Statements on Auditing Standards (SAS) or
any other standards issued by the Auditing Standards Board.
66. (c) An entity may request an accountant to compile financial statements that omit substantially all of the
disclosures required by GAAP, including disclosures that might appear in the body of the financial statements. The
accountant may compile such financial statements provided the omission is clearly indicated in the accountant's
report and is not, to his or her knowledge, undertaken with the intention of misleading those who might reasonably
be expected to use such financial statements. Answer (a), (b) and (d) are incorrect because both statements are
correct.

5S-7

67. (b) Financial statements of a nonpublic entity reviewed by an accountant should be accompanied by a report
stating that: a review was performed in accordance with Statements on Standards for Accounting and Review
Services issued by the AICPA; all information presented in the financial statements is the representation of
management; a review consists principally of inquiries and analytical procedures; a review is substantially less in
scope than an audit; and the accountant is not aware of any material modifications that should be made to the
financial statements in order for them to be in conformity with GAAP. Answer (a) is incorrect because the
accountant expresses limited negative assurance when the accountant states that he or she is not aware of any
material modifications that should be made to the financial statements in order for them to be in conformity with
GAAP. Answers (c) and (d) are incorrect because in an audit, the auditor obtains reasonable assurance about
whether the financial statements are free of material misstatement by examining evidence. Whereas, in a review,
the accountant performs inquiry and analytical procedures and expresses limited assurance on the financial
statements.
68. (d) An accountant may be asked to issue a review report on one financial statement of a nonpublic entity, such
as a balance sheet, and not on other related financial statements, such as the statements of income, retained earnings,
and cash flows. He or she may do so if the scope of the accountant's inquiry and analytical procedures has not been
restricted. Answer (a) is incorrect because the accountant is allowed to accept an engagement to review just the
balance sheet and, therefore, would not violate any ethical standards by doing so. Answer (b) is incorrect because
this type of engagement would be considered a complete review of the balance sheet. Answer (c) is incorrect
because if the review of the balance sheet discloses material departures from GAAP and the financial statements are
not revised, the accountant's review report on the balance sheet would be modified to reflect the GAAP departure.
69. (b) AU 110 states that the financial statements are management's responsibility. Management is responsible for
adopting sound accounting policies and for establishing and maintaining an internal control structure that will
record, process, summarize, and report financial data that is consistent with management's assertions embodied in
the financial statements. The internal control structure should include an accounting system to identify, assemble,
analyze, classify, record, and report an entity's transactions and to maintain accountability for the related assets and
liabilities, the entity's transactions and the related assets and liabilities which are within the direct knowledge and
control of management. The auditor's knowledge of these matters is limited to that acquired through the audit. Thus,
the fair presentation of financial position, results of operations, and cash flows in conformity with generally
accepted accounting principles is an implicit and integral part of management's responsibility. The auditor's
responsibility for the financial statements is confined to the expression of an opinion on them.
70. (a) AR 100 states that if the accountant believes that modification of the standard report is not adequate to
indicate the deficiencies in the financial statements taken as a whole, he should withdraw from the compilation or
review engagement and provide no further services with respect to those financial statements. The accountant may
wish to consult with legal counsel in those circumstances. Choices (b), (c), and (d) are incorrect because in the
stated facts, the auditor has no alternatives but to withdraw from the engagement.
71. (d) AR 100 states that the accountant should not submit unaudited financial statements of a nonpublic entity to
his or her client or others unless, as a minimum, he or she complies with the provisions of this statement applicable
to a compilation engagement. Submission of financial statements is defined as presenting to a client or others
financial statements that the accountant has:

Generated, either manually or through the use of computer software, or

Modified by materially changing account classification, amounts, disclosures directly on client-prepared
F/S.

The following services do not constitute a submission of financial statements:

Reading client-prepared financial statements.

Typing or reproducing client-prepared financial statements, without modification, as a service to a client.
Proposing correcting journal entries or disclosures to the financial statements, either orally or in written
form, that materially change client-prepared financial statements, as long as the accountant does not
directly modify the client-prepared financial statements.

5S-8

Preparing standard monthly journal entries such as entries for depreciation and expiration of prepaid
expenses.
Providing a client with a financial statement format that does not include dollar amounts, to be used by the
client to prepare financial statements.
Advising a client about the selection or use of computer software that the client will use to generate
statements.
Providing the client with the use of, or access to, computer hardware or software that the client will use to
generate statements.

72. (a) AT 200.49 states that an accountant may accept an engagement to apply agreed-upon procedures to
prospective financial statements provided that:

the specified users involved have participated in establishing the nature and scope of the engagement and
take responsibility for the adequacy of the procedures,
distribution of the report is to be restricted to the specified users involved, and
the prospective financial statements include a summary of significant assumptions.

Choice (b) is incorrect because the work performed was less in scope than an examination. Choice (c) is incorrect
because responsibility is assumed by the specific users and not the accountant. Choice (d) is incorrect because
negative assurance is not expressed.
73. (a) AR 100 states that the review of financial statements involves performing inquiry and analytical procedures
that provide the accountant with a reasonable basis for expressing limited assurance that there are no material
modifications that should be made to the statements in order for them to be in conformity with generally accepted
accounting principles or, if applicable, with another comprehensive basis of accounting. The objective of a review
differs significantly from the objective of a compilation. The inquiry and analytical procedures performed in a
review should provide the accountant with a reasonable basis for expressing limited assurance that there are no
material modifications that should be made to the financial statements. No expression of assurance is contemplated
in a compilation. The objective of a review also differs significantly from the objective of an audit of financial
statements in accordance with generally accepted auditing standards. The objective of an audit is to provide a
reasonable basis for expressing an opinion regarding the financial statements taken as a whole. A review does not
provide a basis for the expression of such an opinion because a review does not contemplate obtaining an
understanding of the internal control structure or assessing control risk, tests of accounting records and of responses
to inquiries by obtaining corroborating evidential matter through inspection, observation or confirmation, and
certain other procedures ordinarily performed during an audit. A review may bring to the accountant's attention
significant matters affecting the financial statements, but it does not provide assurance that the accountant will
become aware of all significant matters that would be disclosed in an audit.
74. (b) AR 100 states that in an engagement to review the financial statements of a nonpublic entity, the accountant
is required to obtain a representation letter from members of management whom the accountant believes are
responsible for and knowledgeable, directly or through others in the organization, about the matters covered in the
representation letter. Normally, the chief executive officer and chief financial officer should sign the representation
letter. Choices (a), (c), and (d) are incorrect because they are not performed during a review.
75. (d) AU 504 states that when an accountant is associated with financial statements of a public entity, but has not
audited or reviewed such statements, the report to be issued is as follows:

The accompanying balance sheet of X Company as of December 31, 19X1, and the related statements of
income, retained earnings, and cash flows for the year then ended were not audited by us and, accordingly,
we do not express an opinion on them. (Signature and date)
This disclaimer of opinion is the means by which the accountant complies with the fourth standard of
reporting when associated with unaudited financial statements in these circumstances. The disclaimer may
accompany the unaudited financial statements or it may be placed directly on them. In addition, each page
of the statements should be clearly and conspicuously marked as unaudited.

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76. (c) AR 100 states that if the accountant concludes that there is reasonable justification to change the engagement
and if he or she complies with the standards applicable to the changed engagement, the accountant should issue an
appropriate review or compilation report. The report should not include reference to:

the original engagement,

any auditing or review procedures that may have been performed, or
scope limitations that resulted in the changed engagement.

77. (c) AR 200 states that when the current-period financial statements of a nonpublic entity have been compiled or
reviewed and those of the prior period have been audited, the accountant should issue an appropriate compilation or
review report on the current-period financial statements and either:

the report on the prior period should be reissued or

the report on the current period should include, as a separate paragraph, an appropriate description of the
responsibility assumed for the financial statements of the prior period.

In the latter case, the separate paragraph should indicate:

that the financial statements of the prior period were audited previously,
the date of the previous report,
the type of opinion expressed previously,
if the opinion was other than unqualified, the substantive reasons therefore, and
that no auditing procedures were performed after the date of the previous report.

An example of such a separate paragraph is the following:

The financial statements for the year ended December 31, 19X1, were audited by us (other
accountants) and we (they) expressed an unqualified opinion on them in our (their) report dated
March 1, 19X2, but we (they) have not performed any auditing procedures since that date.
Choice (a) is incorrect because there is no limitation on the distribution. Choice (b) is incorrect because the
previous years audit can still be relied upon. Choice (d) is incorrect because there is no mention of the
changing of services.
78. (b) AR 100 states that the following form of standard report is appropriate for a compilation:
We have compiled the accompanying balance sheet of XYZ Company as of December 31, 19XX,
and the related statements of income, retained earnings, and cash flows for the year then ended, in
accordance with Statements on Standards for Accounting and Review Services issued by the
American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them.
79. (a) AR 100 states that if financial statements compiled in conformity with a comprehensive basis of accounting
other than generally accepted accounting principles do not include disclosure of the basis of accounting used, the
basis should be disclosed in the accountant's report.

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80. (a) AR 100 states that when financial statements that the accountant has compiled omit substantially all
disclosures, the following form of standard report is appropriate:
We have compiled the accompanying balance sheet of XYZ Company as of December 31, 19XX,
and the related statements of income, retained earnings, and cash flows for the year then ended, in
accordance with Statements on Standards for Accounting and Review Services issued by the
American Institute of Certified Public Accountants.
A compilation is limited to presenting in the form of financial statements information that is the
representation of management (owners). I (we) have not audited or reviewed the accompanying
financial statements and, accordingly, do not express an opinion or any other form of assurance on
them.
Management has elected to omit substantially all of the disclosures (and the statement of cash
flows) required by generally accepted accounting principles. If the omitted disclosures were
included in the financial statements, they might influence the user's conclusions about the
company's financial position, results of operations, and cash flows. Accordingly, these financial
statements are not designed for those who are not informed about such matters.
Choice (b) is incorrect because a compilation is prepared in conformity with SSARS issued by the AICPA and not a
comprehensive basis of accounting. Choice (c) is incorrect because a compilation is prepared in conformity with
SSARS issued by the AICPA. Choice (d) is incorrect because this disclosure is not appropriate for a compilation.
81. (c) AT 200 states that the following is the form of the accountant's standard report on the compilation of a
forecast that does not contain a range:
We have compiled the accompanying forecasted balance sheet, statements of income, retained
earnings, and changes in financial position of XYZ Company as of December 31, 19XX, and for
the year then ending, in accordance with standards established by the American Institute of
Certified Public Accountants.
A compilation is limited to presenting in the form of a forecast information that is the
representation of management and does not include evaluation of the support for the assumptions
underlying the forecast. We have not examined the forecast and, accordingly, do not express an
opinion or any other form of assurance on the accompanying statements or assumptions.
Furthermore, there will usually be differences between the forecasted and actual results, because
events and circumstances frequently do not occur as expected, and those differences may be
material. We have no responsibility to update this report for events and circumstances occurring
after the date of this report.
82. (b) AU 552 states that the following is an example of wording that an auditor may use to report on condensed
financial statements that are derived from financial statements that he has audited and on which he has issued a
standard report:
Independent Auditor's Report
We have audited, in accordance with generally accepted auditing standards, the consolidated
balance sheet of X Company and subsidiaries as of December 31, 19X0, and the related
consolidated statements of income, retained earnings, and cash flows for the year then ended (not
presented herein); and in our report dated February 15, 19X1, we expressed an unqualified
opinion on those consolidated financial statements.
In our opinion, the information set forth in the accompanying condensed consolidated financial
statements is fairly stated, in all material respects, in relation to the consolidated financial
statements from which it has been derived.

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83. (a) AU 534 states that when auditing the financial statements of a US entity prepared in conformity with
accounting principles generally accepted in another country, the auditor should perform the procedures that are
necessary to comply with the general and fieldwork standards of US Generally Accepted Auditing Standards. The
auditor should understand the accounting principles generally accepted in the other country. Such knowledge may
be obtained by reading the statutes or professional literature that establish or describe the accounting principles
generally accepted in the other country. Choice (b) is incorrect because the standard report of another country may
also require that the auditor provide explicit or implicit assurance of statutory compliance or otherwise require
understanding of the local law. The requirement of the other country may vary significantly. Choice (c) is incorrect
because the auditor need not disclaim opinion on the financial statements prepared in conformity with another
countrys principles. Choice (d) is incorrect because a waiver is not necessary.
84. (b) Since a CPA, when performing a review, provides negative assurance about the financial statements, he must
be independent of the client. If the accountant has a direct financial interest in the client, even if immaterial, the
accountant is not considered independent according to the Code of Professional Conduct. Answer (a) is incorrect
because an accountant who is not independent can compile financial statements. Answers (c) and (d) are incorrect
because the accountant is not independent if he holds any direct financial interest, and if not independent, he cannot
issue a review report or give any assurances about the financial statements.
85. (d) An accountant may submit a written personal financial plan containing unaudited financial statements to a
client without complying with SSARS 1 when the client agrees that the financial statements will be used solely to
assist the client and the client's advisers to develop the client's personal financial goals and objectives, and will not
be used to obtain credit or for any purposes other than developing these goals and objectives. Answer (a) is
incorrect because there is no prohibition against presenting these financial statements in comparative form. Answer
(b) is incorrect because such financial statements frequently contain departures from GAAP and omit material
disclosures required by GAAP. Answer (c) is incorrect because these financial statements can be used by the client's
advisers, which includes non-CPA financial planners.
86. (c) A review of a nonpublic entity's financial statements provides limited assurance that there are no material
modifications that should be made to the statements in order for them to be in conformity with generally accepted
accounting principles. The accountant, in order to perform the inquiry and analytical procedures required in a
review engagement, should possess a level of knowledge of the accounting principles and practices of the industry
in which the entity operates and an understanding of the entity's business. Answers (a), (b) and (d) are incorrect
because a review does not contemplate procedures that are typically performed in an audit to understand the internal
control structure and obtain corroborating evidence, such as assessing risks, sending confirmations, and developing
audit programs.
87. (a) A compilation is the presentation in the form of financial statements information that is the representation of
management without undertaking to express any assurance on the statements. Before issuing his or her compilation
report, the accountant should read the compiled financial statements and consider whether such financial statements
appear to be appropriate in form and free from obvious material errors, including mistakes in the application of
accounting principles. Answer (b) is incorrect because a written representation letter is not typically obtained in a
compilation engagement and compiled financial statements can be used to obtain credit. Answers (c) and (d) are
incorrect because although in a review engagement the accountant is required to make inquires and perform
analytical procedures, in a compilation the accountant has no such requirement.
88. (b) Financial statements compiled by an accountant should be accompanied by a report stating that a
compilation has been performed in accordance with Statements on Standards for Accounting and Review Services
issued by the AICPA, a compilation is limited to presenting in the form of financial statements information that is
the representation of management, and the financial statements have not been audited or reviewed and no opinion is
expressed or any other form of assurance given. Answer (a) is found in reports on audited financial statements.
Answers (c) and (d) include statements that are properly included in reports on reviewed financial statements.

5S-12

89. (b) An accountant may be asked to issue a review report on one financial statement, such as a balance sheet, and
not on related financial statements. He may do so if the scope of his inquiry and analytical procedures has not been
restricted. Answer (a) is incorrect because an accountant may be asked to compile, rather than review, financial
statements included in prescribed forms, such as forms used by industry trade associations. Answers (c) and (d) are
incorrect because a reviewed balance sheet, whether issued alone or with other financial statements, can be used to
obtain credit and distributed to creditors, and should contain necessary disclosures.
90. (c) If the accountant believes that modification of his standard report is not adequate to indicate the deficiencies
in the financial statements taken as a whole, he or she should withdraw from the review engagement and provide no
further services with respect to those financial statements. Answer (a) is incorrect because the standard review
report states that no opinion is expressed. Answers (b) and (d) are incorrect because a review does not provide the
basis for the expression of an opinion.
91. (c) Statements on Standards for Accounting and Review Services (SSARS), which provide guidance for reviews
of nonpublic entities, specifically require that each page of the nonpublic entity's financial statements include the
phrase "see Accountant's Review Report." SSARS do not require the references listed in answers (a), (b) and (d).
92. (b) Generally accepted auditing standards are applicable when an auditor conducts an audit of and reports on
any financial statements, including those prepared in conformity with an Other Comprehensive Basis Of
Accounting (OCBOA). The cash receipts and disbursements basis is an OCBOA, and the auditor's report would
include a statement to that effect. The report should also include a reference to the note that describes the OCBOA,
answer (a); an opinion on whether the financial statements are fairly presented in conformity with the OCBOA,
answer (c); and a standard scope paragraph that refers to generally accepted auditing standards, answer (d).
93. (c) Financial statements of a nonpublic entity reviewed by an accountant should be accompanied by a report
stating that a review consists principally of inquiries of company personnel and analytical procedures applied to
financial data. Answer (a) is incorrect because the report does not state that a review provides only limited
assurance; rather, the report states that the accountant is not aware of any material modifications that should be
made to the financial statements in order for them to be in conformity with GAAP. Answer (b) is incorrect because
a review does not involve examining information that is the representation of management, as is done in an audit.
Answer (d) is incorrect because although a review does not contemplate obtaining corroborating evidence or
applying certain other procedures ordinarily performed during an audit, the review report does not include a
statement to that effect.
94. (c) Financial statements of a nonpublic entity compiled without audit or review by an accountant should be
accompanied by a report stating that the financial statements have not been audited or reviewed, and, accordingly,
the accountant does not express an opinion or any other form of assurance on them. Answer (a) is incorrect because
the accountant, when compiling financial statements, is not required to make inquiries or perform other procedures
to test the financial information. Answer (b) is incorrect because assessing accounting principles and estimates,
which is done in an audit and is stated in an auditor's report, is not part of a compilation. Answer (d) is incorrect
because a review, rather than a compilation, consists of inquiries and analytical procedures.
95. (a) An auditor may be requested to express an opinion on a specified element, account, or item of a financial
statement, such as rentals, royalties, a profit participation, or a provision for income taxes. If the specified item is
based on an entity's net income, as is the case with profit participation, the auditor should have audited the complete
financial statements to express an opinion on the specified item. Answer (b) is incorrect because the financial
statements could be prepared in conformity with GAAP or an other comprehensive basis of accounting (OCBOA).
Answer (c) is incorrect because distribution of the report on profit participation could be limited to Field, the
individual who hired the auditor. Answer (d) is incorrect because whether or not Field owns a controlling interest
has nothing to do with the decision to accept the engagement.

5S-13

96. (a) When an auditor is engaged to report on selected financial data that are included in a client-prepared
document that contains audited financial statements, the auditor's report should be limited to the data that are
derived from the audited financial statements. If the selected financial data that management presents include both
data derived from audited financial statements and from other information, the auditor's report should specifically
identify the data on which he is reporting. Answer (b) is incorrect because there is no necessary restriction on the
distribution of an auditor's report on selected financial data. Answer (c) is incorrect because the selected data are
derived from the audited financial statements, which would have been prepared in accordance with GAAP or an
other comprehensive basis of accounting (OCBOA). Answer (d) is incorrect because the auditor's report on selected
financial data should indicate whether, in the auditor's opinion, the information set forth in the selected financial
data is fairly stated in all material respects in relation to the complete financial statements from which it has been
derived.
97. (a) An auditor who has audited the financial statements for prior periods but has not audited the financial
statements for the most recent audited period included in a registration statement filed with the SEC has a
responsibility relating to events subsequent to the date of the prior-period financial statements, and extending to the
effective date of the registration statement, that bear materially on the prior-period financial statements on which he
reported. Generally, the predecessor auditor should read pertinent portions of the registration statement and obtain a
letter of representation from the successor independent auditor regarding whether his audit revealed any matters that
might have a material effect on the financial statements reported on by the predecessor auditor. Answers (b), (c) and
(d) are incorrect because the necessary letter of representation is from the successor auditor, not from the client's
audit committee, the underwriter, or the SEC.

5S-14

Chapter Five - Solutions to Problems

Reviews, Compilations, Special Reports and Other
Reports
NUMBER 1
Addressee:
We have audited the statement of assets, liabilities, and capital (income tax basis) of Bale &
Booster, a partnership, as of December 31, 1985, and the related statement of revenue and
expenses (income tax basis) and the related statement of changes in partners' capital accounts for
the year then ended. These financial statements are the responsibility of the partnership's
management. Our responsibility is to express an opinion on the financial statements based upon
our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
As described in note X, the partnership's policy is to prepare its financial statements on the
accounting basis used for income tax purposes; which is a comprehensive basis of accounting
other than generally accepted accounting principles.
In addition, the company is involved in continuing litigation relating to patent infringement. The
amount of damages, if any, resulting from this litigation cannot be determined at this time.
In our opinion, the financial statements referred to above present fairly the assets, liabilities, and
capital of the Bale & Booster partnership as of December 31, 1985, and its revenue and expenses
and changes in its partners' capital accounts for the year then ended, on the income tax (cash)
basis of accounting as described in note X.
Date

Firm Name

NUMBER 2
The auditors' report contains the following deficiencies:
1.

"Independent" is omitted from the title of the auditor's report.

Introductory paragraph
2. Management's responsibility for the financial statements is omitted.
3.

The auditor's responsibility to express an opinion on the financial statements is omitted.

Scope paragraph
4. "Generally accepted auditing standards" should be referred to, not standards established by the AICPA.

5S-15

5.

Reference to assessing "significant estimates made by management" is omitted.

6.

The concluding statement that the auditors "believe that our audits provide a reasonable basis for our opinion"
is omitted.

Explanatory paragraph
7. Reference to the income tax basis of accounting as "a comprehensive basis of accounting other than generally
accepted accounting principles" is omitted.
8.

The statement that the financial statements are "not designed for those who do not have access to the
Partnership tax returns" is inappropriate.

Opinion paragraph
9. The income tax basis of accounting "described in Note A" should be referred to, not "generally accepted
accounting principles."
10. There should be no reference to consistency unless the accounting principles have not been applied
consistently.

NUMBER 3
106.

Review
R
Required

Compilation
R
Required

107.

Required

Not required

108.

Not required

Not required

109.

Required

Required

110.

Not required

Not required

111.

Required

Not required

112.

Not required

Not required

113.

Not required

Not required

114.

Required

Not required

115.

Required

Not required

116.

Not required

Not required

117.

Required

Not required

118.

Not required

Not required

119.

Not required

Not required

120.

Not required

Not required

5S-16

NUMBER 4
1.

Gordon is correct and Martin is incorrect.

2.

Martin is correct and Gordon is incorrect.

3.

Both Martin and Gordon are incorrect.

4.

Both Martin and Gordon are incorrect.

5.

Gordon is correct and Martin is incorrect.

6.

Martin is correct and Gordon is incorrect.

7.

Martin is correct and Gordon is incorrect.

8.

Martin is correct and Gordon is incorrect.

9.

Martin is correct and Gordon is incorrect.

10.

Gordon is correct and Martin is incorrect.

11.

Gordon is correct and Martin is incorrect.

12.

Both Martin and Gordon are incorrect.

13.

Both Martin and Gordon are incorrect.

14.

Gordon is correct and Martin is incorrect.

15.

Gordon is correct and Martin is incorrect.

16.

Martin is correct and Gordon is incorrect.

17.

Gordon is correct and Martin is incorrect.

NUMBER 5
1.

No

2.

Yes

3.

Yes

4.

No

5.

Yes

6.

Yes

7.

No

8.

Yes

9.

Yes

10. Y

Yes

5S-17

NUMBER 6
1.

Del is correct and Cutler is incorrect.

2.

Cutler is correct and Del is incorrect.

3.

Both Cutler and Del are incorrect.

4.

Both Cutler and Del are incorrect.

5.

Del is correct and Cutler is incorrect.

6.

Cutler is correct and Del is incorrect.

7.

Cutler is correct and Del is incorrect.

8.

Cutler is correct and Del is incorrect.

9.

Cutler is correct and Del is incorrect.

10.

Del is correct and Cutler is incorrect.

11.

Del is correct and Cutler is incorrect.

12.

Both Cutler and Del are incorrect.

13.

Both Cutler and Del are incorrect.

14.

Del is correct and Cutler is incorrect.

15.

Del is correct and Cutler is incorrect.

16.

Cutler is correct and Del is incorrect.

17.

Del is correct and Cutler is incorrect.

5S-18

Chapter Six
The Audit Sampling Process
AUDIT SAMPLING DEFINED: Application of an audit procedure to less than 100% of the items within an
account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class.
The following questions apply to planning any audit sampling procedure, whether statistical or nonstatistical:
1.
2.
3.
4.
5.
6.

What is the objective of the test? What do you want to learn or be able to infer about the population?
What is to be sampled? Define what the population is under study.
What is the auditor looking for in the sample? Define what constitutes an error.
How is the population to be sampled? What is the sampling method and how are items selected in the sample?
How much is to be sampled (size of sample)?
What do the results mean? (Interpret results.)

TYPES OF SAMPLING
1.

Nonstatistical SamplingInvolves the selection of items on a judgment basis. This method is sometimes
referred to as judgment sampling.

2.

Statistical Sampling(a) Involves the selection of items according to a systematic, unbiased process; (b)
statistical sampling helps the auditor design an efficient sample, measure the sufficiency of the evidence
obtained and evaluate the sample results; (c) statistical sampling measures the sampling risks associated with
the sampling procedure. This process is not employed with nonstatistical sampling.

GLOSSARY OF SAMPLING TERMS

Allowance for sampling risk (precision, sampling error)A measure of the difference between a sample estimate
and the corresponding population characteristic at a specified sampling risk.
Alpha riskSee risk of incorrect rejection and risk of underreliance on the internal control structure.
AttributeAny characteristic that is either present or absent. In tests of controls the presence or absence of
evidence of the application of a specified internal control structure procedure is sometimes referred to as an
attribute.
Attributes samplingStatistical sampling that reaches a conclusion about a population in terms of a rate of
occurrence.
Audit riskSee ultimate risk.
Audit samplingThe application of an audit procedure to less than 100 percent of the items within an account
balance or class of transactions for the purpose of evaluating some characteristic of the balance or class.
Beta riskSee risk of incorrect acceptance and risk of overreliance on the internal control structure.
Block sample (cluster sample)A sample consisting of contiguous transactions.
Classical variables samplingA sampling approach that measures sampling risk using the variation of the
underlying characteristic of interest. This approach includes methods such as mean-per-unit, ratio estimation,
and difference estimation.
CMA samplingSee probability-proportional-to-size sampling.
Confidence level (reliability level)The complement of the applicable sampling risk (see risk of incorrect
acceptance, risk of overreliance on the internal control structure, risk of incorrect rejection, risk of
underreliance on the internal control structure).
Control riskThe auditor's assessment of the risk that error exceeding tolerable error that may occur will not be
prevented or detected on a timely basis by the system of the internal control structure.
Detection riskThe auditor's assessment of the risk that his procedures will lead him to conclude the error
exceeding tolerable error does not exist when in fact it does exist.

6-1

Difference estimationA classical variables sampling technique that uses the average difference between audited
amounts and individual recorded amounts to estimate the total audited amount of a population and an
allowance for sampling risk.
Discovery samplingA procedure for determining the sample size required to have a stipulated probability of
observing at least one occurrence when the expected population occurrence rate is at a designated level.
Dollar-unit samplingSee probability-proportional-to-size sampling.
Dollar-value estimationA decision model to estimate the dollar amount of the population.
Expansion factorA factor used in the calculation of sample size in a probability-proportional-to-size sampling
application if errors are expected.
Expected population deviation rateAn anticipation of the deviation rate in the entire population. It is used in
determining an appropriate sample size for an attributes sample.
FieldSee population.
Haphazard sampleA sample consisting of sampling units selected without any conscious bias, that is, without
any special reason for including or omitting items from the sample. It does not consist of sampling units
selected in a careless manner, and is selected in a manner that can be expected to be representative of the
population.
Hypothesis testingA decision model to test the reasonableness of an amount.
Inherent riskThe auditor's assessment of the susceptibility of an account balance or class of transactions to errors
exceeding tolerable error before considering the operation of related internal control structure.
Logical unitThe balance or transaction that includes the selected dollar in a probability-proportional-to-size
sample.
Mean-per-unit approachA classical variables sampling technique that projects the sample average to the total
population by multiplying the sample average by the total number of items in the population.
Nonsampling riskAll aspects of ultimate risk not due to sampling.
Nonstatistical samplingA sampling technique for which the auditor considers sampling risk in evaluating an
audit sample without using statistical theory to measure that risk.
Population (field, universe)The items constituting the account balance or class of transactions of interest. The
population excludes individually significant items that the auditor has decided to examine 100 percent or other
items that will be tested separately.
PrecisionSee allowance for sampling risk.
Probability-proportional-to-size (PPS) sampling (dollar-unit sampling, CMA sampling)A variables sampling
procedure that uses attributes theory to express a conclusion in dollar amounts.
Random sample A sample selected so that every combination of the same number of items in the population has
an equal probability of selection.
Ratio estimationA classical variables sampling technique that uses the ratio of audited amounts to recorded
amounts in the sample to estimate the total dollar amount of the population and an allowance for sampling risk.
Reliability levelSee confidence level.
Risk of incorrect acceptance (beta risk, Type II error)The risk that the sample supports the conclusion that the
recorded account balance is not materially misstated when it is materially misstated.
Risk of incorrect rejection (alpha risk, Type I error)The risk that the sample supports the conclusion that the
recorded account balance is materially misstated when it is not.
Risk of overreliance on the internal control structure (beta risk, Type II error)The risk that the sample
supports the auditor's planned degree of reliance on the control when the true compliance rate does not justify
such reliance.
Risk of underreliance on the internal control structure (alpha risk, Type I error)The risk that the sample does
not support the auditor's planned degree of reliance on the control when the true compliance rate supports the
reliance.
SampleItems selected from a population to reach a conclusion about the population.
Sampling errorSee allowance for sampling risk.
Sampling riskThe risk that the auditor's conclusion based on a sample might be different from the conclusion he
would reach if the test were applied in the same way to the entire population. For tests of controls, sampling
risk is the risk of overreliance on the internal control structure or the risk of underreliance on the internal
control structure. For substantive testing, sampling risk is the risk of incorrect acceptance or the risk of
incorrect rejection.
Sampling unitAny of the individual elements, as defined by the auditor, that constitute the population.

6-2

Sequential sampling (stop-or-go sampling)A sampling plan for which the sample is selected in several steps,
with each step conditional on the results of the previous steps.
Standard deviationA measure of the dispersion among the respective amounts of a particular characteristic as
measured for all items in the population for which a sample estimate is developed.
Statistical samplingAudit sampling that uses the laws of probability for selecting and evaluating a sample from a
population for the purpose of reaching a conclusion about the population.
Stop-or-go samplingSee sequential sampling.
StratificationDivision of the population into relatively homogeneous groups.
Systematic sampling - A method of selecting a sample in which every nth item is selected.
TaintingIn a probability-proportional-to-size sample, the proportion of error present in a logical unit. It is usually
expressed as the ratio of the amount of error in the item to the item's recorded amount.
Tolerable errorAn estimate of the maximum monetary error that may exist in an account balance or class of
transactions, when combined with error in other accounts, without causing the financial statements to be
materially misstated.
Tolerable rateThe maximum population rate of deviations from a prescribed control procedure that the auditor
will tolerate without modifying the planned reliance on the internal control structure.
Type I errorSee risk of incorrect rejection and risk of underreliance on the internal control structure.
Type II errorSee risk of incorrect acceptance and risk of overreliance on the internal control structure.
Ultimate risk (audit risk)A combination of the risk that material errors will occur in the accounting process used
to develop the financial statements and the risk that any material errors that occur will not be detected by the
auditor.
UniverseSee population.
Variables samplingStatistical sampling that reaches a conclusion on the monetary amounts of a population.

SAMPLING IN TESTS OF THE INTERNAL CONTROL STRUCTURE

Audit sampling for tests of controls (might also be referred to as compliance testing) generally involves the
following eight considerations, and they apply equally to statistical and nonstatistical sampling plans.
1.

Consideration OneDetermining the objectives of the test.

a. The objective of tests of controls is to provide reasonable assurance that internal control structure
procedures are being applied as prescribed.
b. Tests of controls are concerned with three questions:
1) Where were the necessary procedures performed?
2) How were they performed?
3) By whom were they performed?
c. The auditor tests controls he plans to rely on in determining the nature, timing and extent of substantive
tests.

2.

Consideration TwoDefining the deviation conditions.

a. For tests of controls, a deviation is a departure from the prescribed internal control structure procedure.
b. Based upon the auditor's knowledge of the internal control structure, the auditor should identify the
characteristics that would indicate compliance with a control procedure on which he plans to rely. The
auditor then defines the possible deviation conditions.

3.

Consideration ThreeDefining the population.

a. Consists of the items constituting the account balance or class of transactions of interest.
b. The auditor should determine that the population from which the sample is drawn is appropriate for the
specific audit objective (i.e., if the auditor wishes to test that all shipments are billed, it would be
inappropriate to test items that have been billed, because some items might have been shipped but not
billed).

6-3

c.

d.

e.

Once the population is defined, the auditor should then define the period covered by the test.
1) Per GAAS, "Tests of controls ... ideally should be applied to transactions executed throughout the
period under audit because of the general sampling concept that the items to be examined should be
selected from the entire set of data to which the resulting conclusions are to be applied."
2) In some cases it might be more efficient to test transactions for the period from the beginning of the
year to an interim date. This procedure is sufficient as long as the auditor is aware that conditions may
change during the interim period and he should design procedures to detect such changes (i.e., inquiry
of client personnel, results of substantive tests, etc.).
Within the population the auditor must define the sampling unit.
1) A sampling unit is any of the individual elements constituting the population (i.e., a document, an
entry, or a line item in a report).
2) The sampling unit should be defined in terms of the control procedure being tested. For example, if the
objective of the test is to determine whether disbursements have been authorized, the sampling unit
may be defined as the authorized voucher.
It is also necessary for the auditor to consider the completeness of the population.
1) The auditor will actually select items (sampling units) from a physical representation of the population
(i.e., a printout of customer accounts receivable).
2) It is important that the physical representation includes the entire population because any conclusions
based upon the sample related only to the physical representation. Thus, if the physical representation
and the population differ, the auditor may make erroneous conclusions about the population.

4.

Consideration FourDetermining the method of selecting the sample.

a. Sample items should be selected in a way that the sample can be expected to be representative of the
population. Thus, all items in the population must have the same opportunity to be selected.
b. The various selection methods are:
1) Random-number samplingA method where every sampling unit has the same probability of being
selected as every other sampling unit in the population. This approach is appropriate for both statistical
and nonstatistical sampling.
2) Systematic samplingIn this method the auditor determines a uniform interval by dividing the
number of physical units by the sample size. A starting point is selected in the first interval and one
item is selected from the population at each of the uniform intervals from the starting point. This
method can be used in both statistical and nonstatistical sampling.
3) Block samplingThis method consists of contiguous transactions. For example, for invoices
numbered 1 through 1000, the auditor may select five blocks of ten consecutive invoice numbers.
Generally used with nonstatistical sampling.
4) Haphazard samplingSelection of sampling units without any conscious bias, thus there is no
special reason for including or excluding items from the sample. Used with nonstatistical sampling.

5.

Consideration FiveDetermining the sample size.

The following five factors must be considered by the auditor when determining the sample size:
a. Consider the acceptable risk of overreliance on the internal control structure.
1) The risk of overreliance on the internal control structure is the risk that the sample supports the
auditor's planned degree of reliance on internal control when the true compliance rate for the
population does not. As opposed to overreliance, the risk of underreliance on the internal control
structure is the risk that the sample does not support the auditor's planned degree of reliance on the
control when the true compliance rate of the population does.
2) The risk of underreliance causes the auditor to do more substantive testing than he ordinarily would.
3) Because the test of controls is the primary source of evidence of whether a control procedure is being
applied as prescribed, the auditor generally wishes to obtain a high degree of assurance that the
conclusions reached on the basis of a sample would not differ from the conclusions that would be
reached if the test were applied to the population. Therefore, the auditor should allow for a low level
of risk for overreliance.
4) There is an inverse relationship between the risk of overreliance on the internal control structure and
sample size.

6-4

b.

c.

d.
e.

Consider the tolerable rate.

1) The tolerable rate is the maximum rate of deviation from a prescribed control that an auditor is willing
to accept without altering the planned reliance on internal control.
2) There is an inverse relationship between the tolerable rate and the sample size.
Consider the expected population deviation rate.
1) The auditor may control the risk of underreliance on internal control by adjusting the sample size for
his assessment of the deviation rate he expects to find in the population.
2) The expected population deviation rate should not equal or exceed the tolerable rate. If so, the auditor
would omit tests of controls and perform substantive tests of 100% on the account.
3) There is a direct relationship between the expected deviation rate and sample size.
Consider the effect of population size.
The size of the population has very little effect on the determination of sample size (i.e., it is generally
appropriate to treat any population over 5,000 sampling units as if it were infinite).
Consider a sequential or a fixed sample size approach.
1) Fixed sample size planThe auditor examines a single sample of a specified size.
2) Sequential sampling planThe auditor samples in steps; each step is conditional on the results of the
previous step.

6.

Consideration SixPerforming the sampling plan.

a. After the sampling plan has been designed, the auditor selects the sample and examines the selected items
to determine if they contain deviations from the prescribed control procedure.
b. The auditor may decide to stop the testing before completion if a large number of deviations are identified
during the initial phase of the test. The auditor may conclude that even if he were to complete the test and
no additional deviations are found, the sample would not support the planned reliance on the internal
control structure.

7.

Consideration SevenEvaluating sample results.

Whether the sample is statistical or nonstatistical, the auditor would compile the sample results and apply
judgment in evaluating the results and reach an overall conclusion on reliability. The steps involved in this
process are as follows:
a. Calculate the Deviation Rate.
1) Computed as follows:
Deviations
Sample Size

b.

c.

= Deviation Rate

2) The deviation rate is the auditor's best estimate of the deviation rate in the population.
Consider sampling risk.
1) Sampling risk is the risk that the estimate of the population deviation rate is less than the tolerable rate
for the population and that conclusion is incorrect!
2) If an auditor is using statistical sampling, he can estimate the sampling risk inherent in the sampling
process.
3) If an auditor is using nonstatistical sampling, sampling risk cannot be measured directly, and the
auditor must use professional judgment in evaluating sampling risk.
Consider the qualitative aspects of the deviations.
In addition to evaluating the quantitative aspects of the deviations, the auditor should also consider the
qualitative (nature of deviation) aspects of the deviations. As such, an irregularity (intentional) deviation
would be viewed as qualitatively more serious than an error (unintentional) deviation.

6-5

8.

Consideration EightDocumenting the sampling procedure.

a) The auditor must document the work performed during any phase of the audit and the documentation of
tests of controls is no exception.
b) Some items that may be included in the workpaper documentation include:
1) A description of the control being tested
2) A definition of the population and the sampling unit
3) A definition of what would constitute a deviation
4) The method of sample size determination
5) The method of sample selection
6) Overall evaluation of the test and conclusions reached.

SAMPLING IN SUBSTANTIVE TESTS OF DETAILS

The objective of substantive tests is to obtain evidence to support an opinion that the balances of all accounts
"presents fairly in accordance with GAAP." Depending upon the conclusions reached in the auditor's study and
evaluation of the internal control structure, the auditor may decide to apply audit sampling to test less than 100% of
the monetary value of an account. The following eight considerations are applicable to the use of sampling in
substantive tests of details. The considerations apply equally to statistical as well as nonstatistical sampling.
1.

Consideration OneDetermining the audit objective of the test.

a. A sampling plan for substantive testing may be designed to do either of the following:
1) Test the reasonableness of an amount (referred to as hypothesis testing). An example of this might be
to test the balance of accounts receivable.
2) To make an independent estimate of same amount (referred to as dollar-value estimation). The
objective of dollar-value estimation is to develop an original estimate of an amount, for example,
estimating LIFO inventory values when the client has been employing FIFO valuation.
3) Hypothesis testing is primarily used by an auditor when examining financial statements, since the
balances of accounts are known.

2.

Consideration TwoDefining the population.

a. The population consists of the items constituting the account balance or class of transactions.
b. The auditor should determine that the population that the sample is drawn from is appropriate for the
specific audit objective.
c. The auditor would then define the sampling unit.
1) A sampling unit is any of the individual elements that constitute the population.
2) The definition of a sampling unit depends on the nature of the audit procedures being applied and may
be a customer account balance, an individual transaction or part of a transaction, etc.
d. The auditor then determines the completeness of the population.
1) The auditor selects a sample from a physical representation of the population, for example, an aged
trial balance of accounts receivable.
2) Before selecting the sample, the auditor should conduct tests to determine that the physical
representation actually represents the entire population. For example, in the case of accounts
receivable, the auditor would reconcile the aged trial balance to the general ledger.

3.

Consideration ThreeChoosing an audit sampling technique.

a) The auditor would choose between nonstatistical and statistical sampling techniques.
b) The most common statistical approaches are classical variables sampling and probability-proportion-to-size
(PPS) sampling. These techniques are discussed beginning on page 6-10.

6-6

4.

Consideration FourDetermining the sample size.

a. An important consideration in determining the sample size is the variation of the items in a population.
1) A measure of variation in the population is called the standard deviation.
2) Generally speaking, the larger the variation of items in the population, the larger the sample size.
b. The auditor is concerned with two aspects of sampling risk when performing substantive tests of details.
1) The risk of incorrect acceptance:
a) Risk that the sample supports a conclusion that the recorded account balance is not materially
misstated when it is misstated.
b) In assessing this risk the auditor considers (1) the level of audit risk that he is willing to accept,
and (2) the level of reliance to be placed on internal control.
2) The risk of incorrect rejection:
a) The risk of incorrect rejection is related to the efficiency of the audit.
b) The risk of concluding that a balance is incorrect when it is in fact correct. This would lead to the
auditor performing more work than was necessary.
c) There is an inverse relationship between the sample size and the amount of risk of incorrect
rejection the auditor is willing to accept.
c. The auditor must consider, in planning a sample, the amount of monetary error (tolerable risk) that could
exist in the population without the amount being materially misstated.
d. In determining sample size, the auditor considers the rate and amount of error expected in the population.
As the estimate approaches the tolerable error, the auditor would consider increasing the sample size
because more information is needed from the sample.

5.

Consideration FiveDetermine the method for selecting the sample.

a. The auditor should select the sample in a way that the sample will be representative of the population.
b. See pages 6-9 through 6-11 for methods of selection that involve statistical sampling techniques.

6.

Consideration SixPerforming the sampling plan.

a. Appropriate audit procedure should be applied to each item in the sample.
b. The selection of a particular audit procedure is based upon the audit objective under review. For example,
in auditing for proper value in accounts receivable, the auditor would use confirmation.

7.

Consideration SevenEvaluating the sample results.

a. The auditor must project the error results in the sample to the population from which the sample was
drawn.
b. The auditor should also consider the qualitative aspects of the errors in reaching an overall conclusion
about the population. These would include:
1) the nature and cause of the misstatements, and
2) the possible relationship of the misstatements to other phases of the audit.

8.

Consideration EightDocumenting the sample procedure.

a. The auditor should appropriately document the sampling procedures and results obtained.
b. Generally this would involve documenting the first seven considerations discussed above.

6-7

APPLICATION OF STATISTICAL SAMPLING IN THE AUDIT PROCESS

I.

Types of Statistical Sampling Plans

A. Attributes Sampling
1. Used to reach a conclusion about a population in terms of rate of occurrence.
2. Used most commonly in auditing to test the rate of deviation from a prescribed internal control.
3. The dollar amount of the transaction is not important, but rather the rate of occurrence of, or deviation
from, a prescribed control.
B. Variables Sampling
1. Used to reach conclusions about a population in terms of dollar amount.
2. Used to answer either of the following questions:
a) How much? (i.e., dollar value estimation).
b) Is the account materially misstated? (i.e., by hypothesis testing).
3. Principally used in substantive testing.

II. Statistical Sampling Basics

A. Sample results may not be indicative of the true population (sampling risk) whether the auditor is using
attribute or variables sampling, in order to measure and control sampling error by calculating precision and
confidence levels.
1. PrecisionRange within which the true value of the population characteristic being measured is likely
to lie. The range is set by plus and minus limits. For example, in attribute sampling, an auditor
determines that there is a 3% error rate in his sample, +/- 1%. Thus, the auditor concludes that the true
error rate of the population is between 2% and 4%. In variables sampling, the precision limits would
be set in terms of dollars and become the limits of the tolerable error that the auditor will accept. Less
precision means a wider interval. More precision means a narrower interval.
2. Confidence levelIndicates the percentage of time the true population characteristics lie with the
specified precision interval. Confidence level is the reliability (synonymous with confidence level) of
the sample. The inverse of the confidence level (reliability) is risk. Thus, if we are 95% confident, then
we are accepting a 5% risk. There is an inverse relationship between precision and reliability.
AS PRECISION DECREASES,
CONFIDENCE LEVEL INCREASES.
3.

Sample sizeSample size has a direct effect upon precision and confidence level. As the sample size
approaches the total population, confidence level and degree of precision are increased.

B. Statistical approach to tests of controls

1. Precision and confidence level
a) The auditor is usually concerned with the upper precision limit, since the concern is that
deviations do not exceed an acceptable level. This level is considered to be the maximum
tolerable deviation rate.
b) The risk of overreliance on a control procedure is controlled through the specified confidence
level. The risk of overreliance is the complement of the confidence level.
c) Tables have been developed with which the auditor can easily determine the sample size given the
expected population deviation rate and desired precision and confidence levels. The following
table is an example of such for a 95% confidence level (5% risk of overreliance):

6-8

TABLE 1
Statistical Sample Sizes for Compliance Testing
Five-Percent Risk of Overreliance
(with number of expected errors in parentheses)

Using this table for an expected population deviation rate of .5% and a maximum tolerable deviation rate
of 6%, the auditor would use a sample size of 78 and would expect one deviation in the sample.
C. Discovery sampling
1. Used when the auditor expects a low error rate. Thus, it is used for testing for irregularities (intentional
errors).
2. In applying this method, the auditor can determine, given a specific level of confidence, say 95%, that
a sample will include at least one error. If the error rate in the sample is less than one, then the auditor
has at least 95% confidence that the error rate in the population is within tolerable limits.
3. To illustrate, assume an auditor is concerned about fraudulent transactions involving writeoffs of
accounts receivable. By reference to the table above for 95% confidence level, the auditor would use
an expected deviation rate of 0% and assume some population deviation rate, say 2%. Based upon this,
the auditor would select a sample size of 149 items. If the auditor does not find a fraudulent
transaction in the sample, then he is 95% sure there are not more than 2% errors in the population.
D. Nonstatistical samplingThe use of nonstatistical sampling involves the use of judgment in applying the
factors discussed on pages 6-8 through 6-10. The following table summarizes the effect of various factors
on the determination of sample size in judgment sampling:

6-9

Factor
Tolerable rate
Increases
Decreases

Effect on sample size

Smaller
Larger

Risk of overreliance
on Internal Control
Increase
Decrease

Smaller
Larger

Expected population
deviation rate
Increase
Decrease

Larger
Smaller

Population size

No effect

III. Substantive Tests of Details

A. Classical variables sampling
1. Statistical sampling that reaches a conclusion on the monetary amounts of a population.
2. Types:
a) Mean-per-unit approachUse of this method involves the auditor making estimates of the
population value by using the audited sample amount to project the population value. For
example, if an auditor selects a sample of 200 items from a population of 1,000 items and
determines that, on the average, the cost of each item in the sample is $100, then the value of the
population is estimated to be $100,000 ($100 1,000).
b) Difference estimation approachThe use of this method involves the auditor calculating the
difference between audited amounts and book amounts and projecting that amount to the
population. For example, if the average difference between book amounts and audited amounts for
a sample of 100 items is $10, then the auditor infers that the difference in the population of 10,000
items to be $100,000 ($10 10,000). The amount so calculated is compared to previous estimates
of materiality (tolerable error) to determine if the account is fairly stated or not.
c) Ratio approachUse of this method involves the auditor calculating the ratio between the sum of
the audited amounts and the sum of the recorded amounts and projecting this ratio to the
population. For example, should the auditor determine that the ratio of audited value to book value
of a sample to be 1.10 (audit $110,000; book $100,000) and the book value of the population to
be $500,000, then the auditor would infer that the audited value of the population would be
$550,000 (1.10 $500,000). Again the auditor would consider materiality.
B. Probability-proportional-to-size sampling
1. Use of this method gives each individual dollar in the population an equal chance of selection.
2. Helps the auditor to direct audit effort toward large balances or transactions because every dollar has
an equal chance of being selected; items having more dollars have a greater chance of being selected.
Each balance or transaction in the population has a probability of selection proportional to its recorded
dollar amount.
3. Selecting a sample:
a) Divide the population into equal groups of dollars (sampling interval).
b) Select a random number between one and the sampling interval.
c) The auditor then selects the first sampling unit (random number in b) above) and then adds the
sampling interval to the random start to obtain each successive sampling unit.
d) Example:
Sampling interval $5,000
Random start 2,000 dollars
Sample then becomes 2000th, 7000th, 12000th dollars in the population.

6-10

AUDIT SAMPLING (SAS No. 39)

Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account
balance or class of transactions for the purpose of evaluating some characteristic of the balance or class. This
Statement provides guidance for planning, performing, and evaluating audit samples.
There are two general approaches to audit sampling: nonstatistical and statistical. Both approaches require that the
auditor use professional judgment in planning, performing, and evaluating a sample and in relating the evidential
matter produced by the sample to other evidential matter when forming a conclusion about the related account
balance or class of transactions.
The third standard of field work states, "Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial
statements under examination." Either approach to audit sampling, when properly applied, can provide sufficient
evidential matter.
Some degree of uncertainty is implicit in the concept of "a reasonable basis for an opinion." The justification for
accepting some uncertainty arises from the relationship between such factors as the cost and time required to
examine all of the data and the adverse consequences of possible erroneous decisions based on the conclusions
resulting from examining only a sample of the data.
For purposes of this Statement, the uncertainty inherent in applying auditing procedures will be referred to as audit
risk. Audit risk is a combination of the risk that material errors will occur in the accounting process used to develop
the financial statements and the risk that any material errors that occur will not be detected by the auditor. The risk
of these adverse events occurring jointly can be viewed as the product of the respective individual risks. The auditor
may rely on the internal control structure to reduce the first risk and on substantive tests (tests of details of
transactions and balances and analytical review procedures) to reduce the second risk.
Audit risk includes both uncertainties due to sampling and uncertainties due to factors other than sampling. These
aspects of ultimate risk are sampling risk and nonsampling risk, respectively.
Sampling risk arises from the possibility that, when a test of controls or a substantive test is restricted to a sample,
the auditor's conclusions may be different from the conclusions he would reach if the test were applied in the same
way to all items in the account balance or class of transactions.
Nonsampling risk includes all the aspects of ultimate risk that are not due to sampling. Nonsampling risk includes
the possibility of selecting audit procedures that are not appropriate to achieve the specific objective.
The auditor should apply professional judgment in assessing sampling risk. In performing substantive tests of
details the auditor is concerned with two aspects of sampling risk:
The risk of incorrect acceptance is the risk that the sample supports the conclusion that the recorded
account balance is not materially misstated when it is materially misstated.
The risk of incorrect rejection is the risk that the sample supports the conclusion that the recorded account
balance is materially misstated when it is not materially misstated.
The auditor is also concerned with two aspects of sampling risk in performing tests of controls of the internal
control structure:
The risk of overreliance on the internal control structure is the risk that the sample supports the auditor's
planned degree of reliance on the control when the true compliance rate does not justify such reliance.
The risk of underreliance on the internal control structure is the risk that the sample does not support the
auditor's planned degree of reliance on the control when the true compliance rate supports such reliance.

6-11

Sampling in Substantive Tests of Details

Planning Samples
Planning involves developing a strategy for conducting an audit of financial statements. For general guidance on
planning.
When planning a particular sample for a substantive test of details, the auditor should consider
The relationship of the sample to the relevant audit objective.
Preliminary estimates of materiality levels.
The auditor's allowable risk of incorrect acceptance.
Characteristics of the population; that is, the items comprising the account balance or class of transactions
of interest.
When planning a particular sample, the auditor should consider the specific audit objective to be achieved and
should determine that the audit procedure, or combination of procedures, to be applied will achieve that objective.
The auditor should determine that the population from which he draws the sample is appropriate for the specific
audit objective.
When planning a sample for a substantive test of details, the auditor should consider how much monetary error in
the related account balance or class of transactions may exist without causing the financial statements to be
materially misstated. This maximum monetary error for the balance or class is called tolerable error for the sample.
Tolerable error is a planning concept and is related to the auditor's preliminary estimates of materiality levels in
such a way that tolerable error, combined for the entire audit plan, does not exceed those estimates.
The second standard of field work states, "The auditor should obtain a sufficient understanding of the internal
control structure to plan the audit and to determine the nature, timing, and extent of tests to be performed." The
second standard of field work recognizes that the extent of substantive tests required to obtain sufficient evidential
matter under the third standard should vary inversely with the auditor's reliance on the internal control structure.
These standards taken together imply that the combination of the auditor's reliance on the internal control structure
and his reliance on his substantive tests should provide a reasonable basis for his opinion, although the portion of
reliance derived from the respective sources may vary.
To determine the number of items to be selected in a sample for a particular substantive test of details, the auditor
should consider the tolerable error, the allowable risk of incorrect acceptance, and the characteristics of the
population.
The auditor should project the error results of the sample to the items from which the sample was selected. There
are several acceptable ways to project errors from a sample. For example, an auditor may have selected a sample of
every twentieth item (50 items) from a population containing one thousand items. If he discovered overstatement
errors of $3,000 in that sample, the auditor could project a $60,000 overstatement by dividing the amount of error in
the sample by the fraction of total items from the population included in the sample. The auditor should add that
projection to the errors discovered in any items examined 100 percent. This total projected error should be
compared with the tolerable error for the account balance or class of transactions, and appropriate consideration
should be given to sampling risk. If the total projected error is less than tolerable error for the account balance or
class of transactions, the auditor should consider the risk that such a result might be obtained even though the true
monetary error for the population exceeds tolerable error.
In addition to the evaluation of the frequency and amounts of monetary misstatements, consideration should be
given to the qualitative aspects of the errors. These include (a) the nature and cause of misstatements, such as
whether they are differences in principle or in application, are errors or irregularities, or are due to misunderstanding
of instructions or to carelessness, and (b) the possible relationship of the misstatements to other phases of the audit.
The discovery of an irregularity ordinarily requires a broader consideration of possible implications than does the
discovery of an error.

6-12

Sampling in Tests of Controls of the Internal Control Structure

Planning Samples
When planning a particular audit sample for a control testing, the auditor should consider
The relationship of the sample to the objective of the test of controls.
The maximum rate of deviations from prescribed control procedures that would support his planned
reliance.
The auditor's allowable risk of overreliance.
Characteristics of the population; that is, the items comprising the account balance or class of transactions
of interest.
When designing samples for the purpose of tests of controls with internal control structure procedures that leave an
audit trail of documentary evidence, the auditor ordinarily should plan to evaluate compliance in terms of deviations
from (or compliance with) pertinent control procedures, as to either the rate of such deviations or the monetary
amount of the related transactions. In this context, pertinent control procedures are ones that, had they not been
included in the design of the internal control structure, would have adversely affected the auditor's preliminary
evaluation of the system.
The auditor should assess the maximum rate of deviations from a prescribed control procedure that he would be
willing to accept without altering his planned reliance on the control. This is the tolerable rate. In assessing the
tolerable rate, the auditor should consider the relationship of procedural deviations to (a) the accounting records
being tested, (b) any related internal control structure procedures, and (c) the purpose of the auditor's evaluation.
Samples taken for tests if controls are intended to provide a basis for the auditor to conclude whether internal
control structure procedures are being applied as prescribed. Because the test of controls is the primary source of
evidence of whether the procedure is being applied as prescribed, the auditor should allow for a low level of risk of
overreliance.
To determine the number of items to be selected for a particular sample for a control test, the auditor should
consider the tolerable rate of deviation from the control(s) being tested, based on the planned degree of reliance; the
likely rate of deviations; and the allowable risk of overreliance on the internal control structure. An auditor applies
professional judgment to relate these factors in determining the appropriate sample size.
Auditing procedures that are appropriate to achieve the objective of the tests of controls should be applied to each
sample item. If the auditor is not able to apply the planned audit procedures or appropriate alternative procedures to
selected items, he should consider the reasons for this limitation and he should ordinarily consider those selected
items to be deviations from the procedures for the purpose of evaluating the sample.
The deviation rate in the sample is the auditor's best estimate of the deviation rate in the population from which it
was selected. If the estimated deviation rate is less than the tolerable rate for the population, the auditor should
consider the risk that such a result might be obtained even though the true deviation rate for the population exceeds
the tolerable rate for the population.
In addition to the evaluation of the frequency of deviations from pertinent procedures, consideration should be
given to the qualitative aspects of the deviations. These include (a) the nature and cause of the deviations, such as
whether they are errors or irregularities or are due to misunderstanding of instructions or to carelessness, and (b) the
possible relationship of the deviations to other phases of the audit. The discovery of an irregularity ordinarily
requires a broader consideration of possible implications than does the discovery of an error.

6-13

Dual-Purpose Samples
In some circumstances the auditor may design a sample that will be used for dual purposes: testing compliance with
a control procedure that provides documentary evidence of performance, and testing whether the recorded monetary
amount of transactions is correct. In general, an auditor planning to use a dual-purpose sample would have made a
preliminary assessment that there is an acceptably low risk that the rate of compliance deviations in the population
exceeds the tolerable rate. The size of a sample designed for dual purposes should be the larger of the samples that
would otherwise have been designed for the two separate purposes. In evaluating such tests, deviations from
pertinent procedures and monetary errors should be evaluated separately using the risk levels applicable for the
respective purposes.

Selecting a Sampling Approach

Either a nonstatistical or statistical approach to audit sampling, when properly applied, can provide sufficient
evidential matter.
Statistical sampling helps the auditor (a) to design an efficient sample, (b) to measure the sufficiency of the
evidential matter obtained, and (c) to evaluate the sample results. By using statistical theory, the auditor can
quantify sampling risk to assist himself in limiting it to a level he considers acceptable. However, statistical
sampling involves additional costs of training auditors, designing individual samples to meet the statistical
requirements, and selecting the items to be examined. Because either nonstatistical or statistical sampling can
provide sufficient evidential matter, the auditor chooses between them after considering their relative cost and
effectiveness in the circumstances.
Table 2
Factors Influencing Sample Sizes for a
Substantive Test of Details in Sample Planning

Factor

Conditions
Leading to
Smaller sample
size

Conditions
Leading to
Larger Sample
Size

Related factor for

substantive sample
planning

a.

Reliance on internal accounting

controls.

Greater reliance on
internal accounting
controls.

Lesser reliance on
internal accounting
controls.

Allowable risk of
incorrect
acceptance.

b.

Reliance on other substantive

tests related to same account
balance or class of transactions
(including analytical review
procedures and other relevant
substantive tests).

Substantial reliance
to be placed on
other relevant
substantive tests.

Little or no reliance
to be placed on
other relevant
substantive tests.

Allowance risk of
incorrect
acceptance.

c.

Measure of tolerable error for a

specific account.

Larger measure of
tolerable error.

Smaller measure of
tolerable error.

Tolerable error.

d.

Expected size and frequency of

errors.

Smaller errors or
lower frequency.

Larger errors or
higher frequency.

Assessment of
population
characteristics.

e.

Number of items in population.

Virtually no effect
on sample size
unless population
is very small.

Virtually no effect
on sample size
unless population
is very small.

6-14

AUDIT RISK AND MATERIALITY IN CONDUCTING AN AUDIT (SAS No. 47)

Audit Risk Model
AR = IR x CR x DR
where:
AR
IR
CR
DR

=
=
=
=

Audit Risk
Inherent Risk
Control Risk
Detection Risk

Audit Risk
1.
2.

3.

The risk that the auditor may unknowingly fail to modify his opinion on a set of financial statements that are
materially misstated.
The auditor's opinion that states "the financial statements present fairly in conformity with GAAP" implicitly
means that the statements taken as a whole do not contain material errors or irregularities.
a. errorsunintentional mistakes
b. fraudintentional misrepresentations
An auditor's consideration of materiality is a matter of professional judgment. The auditor should consider audit
risk and materiality in both (a) planning the audit and (b) evaluating whether the financial statements taken as a
whole are presented fairly.
Planning the Audit
1. The auditor should consider audit risk and materiality in (a) planning the audit and designing audit
procedures and (b) evaluating whether the financial statements taken as a whole are presented fairly in
accordance with GAAP.
2. Considerations at the Financial Statement Level
a. At the financial statement level the auditor should establish an overall materiality level for each
statement giving appropriate consideration to the interrelationship of the statements.
b. The auditor plans for the lowest aggregate level of errors that could be material to any one of the
statements. For example, if the auditor concludes that $100,000 is material to the income statement,
and that $200,000 is material to the balance sheet, the auditor should plan to detect errors or
irregularities of $100,000.
c. Generally the auditor looks for quantitative errors; however, he should also be aware that qualitative
factors are also important (i.e., the type of error and its potential effect even though not material in
dollar value).
3. Considerations at the Individual Account Balance or Class-of-Transaction-Level
a. There is an inverse relationship between audit risk and materiality.
b. As it relates to account balances, or classes of transactions, audit risk is a combination of three
component risks.
1. Inherent Riskthe susceptibility of an account balance or class-of-transactions to an error that
could be material.
2. Control Riskthe risk that an error that could occur in an account balance or class of
transactions will not be prevented or detected on a timely basis by the client's system of internal
control.
3. Detection Riskthe risk that an auditor's procedures will lead him to conclude that an error in an
account balance does not exist, when in fact such an error does exist.
Detection risk is a function of the effectiveness of an auditing procedure and its application
by the auditor.
Detection risk arises partly from uncertainties that exist when an auditor does not examine
100% of an account balance, and partly because of uncertainties that exist even if the auditor
were to examine every item. These risks are referred to as:

6-15

a)

Sampling riskrelates to selection of items in a sample that are not representative of the
population.
b) Nonsampling riskrelated to the misinterpretation of facts and is controlled through proper
audit planning, supervision, and firm quality control review.
Detection risk bears an inverse relationship to inherent and control risk.

Evaluating Audit Findings

1.

The auditor should aggregate errors that the entity has not corrected in a way that enables him to consider
whether in relation to individual amounts, subtotals, or totals in the statements, they materially misstate the
financial statements taken as a whole.
a. An aggregating procedure generally used is an "adjustment passed (not made) schedule". This schedule
allows the auditor to determine the aggregate effect of seemingly immaterial adjustments on the financial
statements by aggregating them.
b. In evaluating the effect of errors on the financial statements, the auditor should consider
Likely errors - best estimate of errors in an account balance, and
Known errors - the actual errors discovered in account balances
When an auditor uses Audit Sampling to test an account balance or class of transactions, the auditor
projects the amount of known errors identified in the sample to the population balance (projected
error). The projected error contributes to the auditors assessment of the likely error in the account
balance.
c. The risk of material misstatements in the financial statements is generally greater when account balances
include accounting estimates rather than factual data.

2.

If the auditor concludes, based upon his accumulation of sufficient evidential matter, that the aggregation of
likely errors causes the financial statements to be materially misstated, he should request management to
eliminate the material misstatement.
a. If the material misstatement is not eliminated, he should issue a qualified or adverse opinion.
b. If the aggregate of likely errors does not cause the statements to be materially misstated, the risk (audit
risk) that the financial statements are in fact misstated increases. If the auditor believes that this causes the
risk to be unacceptably high, he should perform additional auditing procedures to reduce audit risk to an
acceptable level.

6-16

Chapter Six - Questions

The Audit Sampling Process
Items 1 through 5 apply to an examination by Robert
Lambert, CPA, of the financial statements of Rainbow
Manufacturing Corporation for the year ended
December 31, 19X3. Rainbow manufactures two
products: Product A and Product B. Product A requires
raw materials which have a very low per-item cost, and
Product B requires raw materials which have a very
high per-item cost. Raw materials for both products are
stored in a single warehouse. In 19X2, Rainbow
established the total value of raw materials stored in the
warehouse by physically inventorying an unrestricted
random sample of items selected without replacement.

a.
b.
c.
d.

Larger than the 19X2 sample size.

Equal to the 19X2 sample size.
Smaller than the 19X2 sample size.
Of a size that is indeterminate based upon the
information given.

3. Rainbow wants to use unrestricted random sampling

without replacement in 19X3. Compared to 19X2, the
population size of the raw-materials inventory is
approximately the same, and the variability of the items
in the inventory is approximately the same. Rainbow
specifies the same precision but desires to change the
specified reliability from 90% to 95%. Under these
assumptions, the required sample size for 19X3 should
be
a. Larger than the 19X2 sample size.
b. Equal to the 19X2 sample size.
c. Smaller than the 19X2 sample size.
d. Of a size that is indeterminate based upon the
information given.

Mr. Lambert is evaluating the statistical validity of

alternative sampling plans Rainbow is considering for
19X3. Lambert knows the size of the 19X2 sample and
that Rainbow did not use stratified sampling in 19X2.
Assumptions about the population, variability, specified
precision (confidence interval), and specified reliability
(confidence level) for a possible 19X3 sample are given
in each of the following five items. You are to indicate
in each case the effect upon the size of the 19X3 sample
as compared to the 19X2 sample. Each of the five cases
is independent of the other four and is to be considered
separately.

4. Rainbow wants to use unrestricted random sampling

without replacement in 19X3. Compared to 19X2, the
population size of the raw-materials inventory has
increased, and the variability of the item in the
inventory has increased. The specified precision and
specified reliability are to remain the same. Under these
assumptions, the required sample size for 19X3 should
be
a. Larger than the 19X2 sample size.
b. Equal to the 19X2 sample size.
c. Smaller than the 19X2 sample size.
d. Of a size that is indeterminate based upon the
information given.

1. Rainbow wants to use stratified sampling in 19X3

(the total population will be divided into two strata, one
each for the raw materials for Product A and Product
B). Compared to 19X2, the population size of the raw
materials inventory is approximately the same, and the
variability of the items in the inventory is approximately
the same. The specified precision and specified
reliability are to remain the same. Under these
assumptions, the required sample size for 19X3 should
be
a. Larger than the 19X2 sample size.
b. Equal to the 19X2 sample size.
c. Smaller than the 19X2 sample size.
d. Of a size that is indeterminate based upon the
information given.

5. Rainbow wants to use unrestricted random sampling

without replacement in 19X3. Compared to 19X2, the
population size of the raw-materials inventory has
increased, but the variability of the items in the
inventory has decreased. The specified precision and
specified reliability are to remain the same. Under these
assumptions, the required sample size for 19X3 should
be
a. Larger than the 19X2 sample size.
b. Equal to the 19X2 sample size.
c. Smaller than the 19X2 sample size.
d. Of a size that is indeterminate based upon the
information given.

2. Rainbow wants to use stratified sampling in 19X3.

Compared to 19X2, the population size of the raw
materials inventory is approximately the same, and the
variability of the items in the inventory is approximately
the same. Rainbow specified the same precision but
desires to change the specified reliability from 90% to
95%. Under these assumptions, the required sample size
for 19X3 should be
6Q-1

6. As the specified reliability is increased in a discovery

sampling plan for any given population and maximum
occurrence rate, the required sample size
a. Increases.
b. Decreases.
c. Remains the same.
d. Cannot be determined.

11. For a large population of cash disbursement

transactions, Smith, CPA, is testing compliance with
internal control by using attribute sampling techniques.
Anticipating an occurrence rate of 3% Smith found
from a table that the required sample size is 400 with a
desired upper precision limit of 5% and reliability of
95%. If Smith anticipated an occurrence rate of only 2%
but wanted to maintain the same desired upper precision
limit and reliability the sample size would be closest to
a. 200.
b. 400.
c. 533.
d. 800.

7. A CPA who believes the occurrence rate of a certain

characteristic in a population being examined is 3% and
who has established a maximum acceptable occurrence
rate at 5% should use a (an)
a. Attribute sampling plan.
b. Discovery sampling plan.
c. Stratified sampling plan.
d. Variable sampling plan.

12. An auditor makes separate compliance and

substantive tests in the accounts payable area which has
good internal control. If the auditor uses statistical
sampling for both of these tests, the confidence level
established for the substantive tests is normally
a. The same as that for tests of compliance.
b. Greater than that for tests of compliance.
c. Less than that for tests of compliance.
d. Totally independent of that for tests of
compliance.

8. The auditor's failure to recognize an error in an

amount or an error in an internal-control dataprocessing procedure is described as a
a. Statistical error.
b. Sampling error.
c. Standard error of the mean.
d. Nonsampling error.

13. An example of sampling for attributes would be

estimating the
a. Quantity of specific inventory items.
b. Probability of losing a patent infringement case.
c. Percentage of overdue accounts receivable.
d. Dollar value of accounts receivable.

9. Precision is a statistical measure of the maximum

likely difference between the sample estimate and the
true but unknown population total, and is directly
related to
a. Reliability of evidence.
b. Relative risk.
c. Materiality.
d. Cost benefit analysis.

14. The purpose of tests of controls is to provide

reasonable assurance that the accounting control
procedures are being applied as prescribed. The
sampling method that is most useful when testing for
compliance is
a. Judgment sampling.
b. Attribute sampling.
c. Unrestricted
random
sampling
with
replacement.
d. Stratified random sampling.

10. Which of the following is an advantage of

systematic sampling over random number sampling?
a. It provides a stronger basis for statistical
conclusions.
b. It enables the auditor to use the more efficient
"sampling with replacement" tables.
c. There may be correlation between the location of
items in the population, the feature of sampling
interest, and the sampling interval.
d. It does not require establishment of correspondence between random numbers and items in the
population.

6Q-2

15. In performing a review of his client's cash

disbursements, a CPA uses systematic sampling with a
random start. The primary disadvantage of systematic
sampling is that population items
a. Must be reordered in a systematic pattern before
the sample can be drawn.
b. May occur in a systematic pattern, thus negating
the randomness of the sample.
c. May occur twice in the sample.
d. Must be replaced in the population after sampling
to permit valid statistical inference.

19. Approximately 5% of the 10,000 homogeneous

items included in Barletta's finished-goods inventory are
believed to be defective. The CPA examining Barletta's
financial statements decides to test this estimated 5%
defective rate. He learns that by sampling without
replacement that a sample of 284 items from the
inventory will permit specified reliability (confidence
level) of 95% and specified precision (confidence
interval) of -.025. If specified precision is changed to
-.05, and specified reliability remains 95%, the required
sample size is
a. 72.
b. 335.
c. 436.
d. 1,543.

16. From prior experience, a CPA is aware of the fact

that cash disbursements contain a few unusually large
disbursements. In using statistical sampling, the CPA's
best course of action is to
a. Eliminate any unusually large disbursements
which appear in the sample.
b. Continue to draw new samples until no unusually
large disbursements appear in the sample.
c. Stratify the cash-disbursements population so that
the unusually large disbursements are reviewed
separately.
d. Increase the sample size to lessen the effect of the
unusually large disbursements.

20. The "reliability" (confidence level) of an estimate

made from sample data is a mathematically determined
figure that expresses the expected proportion of possible
samples of a specified size from a given population
a. That will yield an interval estimate that will
encompass the true population value.
b. That will yield an interval estimate that will not
encompass the true population value.
c. For which the sample value and the population
value are identical.
d. For which the sample elements will not exceed the
population elements by more than a stated amount.

17. In connection with his test of the accuracy of

inventory counts, a CPA decides to use discovery
sampling. Discovery sampling may be considered a
special case of
a. Judgmental sampling.
b. Sampling for variables.
c. Stratified sampling.
d. Sampling for attributes.

21. In an examination of financial statements, a CPA

generally will find stratified-sampling techniques to be
least appropriate to
a. Examining charges to the maintenance account
during the audit year.
b. Tests of transactions for compliance with internal
control.
c. The recomputation of a sample of factory workers'
net pay.
d. Year-end confirmation of bank balances.

18. A CPA's test of the accuracy of inventory counts

involves two storehouses. Storehouse A contains 10,000
inventory items and Storehouse B contains 5,000 items.
The CPA plans to use sampling without replacement to
test for an estimated 5% error rate. If the CPA's
sampling plan calls for a specified reliability of 95%
and a maximum tolerable error occurrence rate of 7.5%
for both storehouses, the ratio of the size of the CPA's
sample from Storehouse A to the size of the sample
from Storehouse B should be
a. More than 1:1 but less than 2:1.
b. 2:1.
c. 1:1.
d. More than .5:1 but less than 1:1.

6Q-3

22. A CPA's client wishes to determine inventory

shrinkage by weighing a sample of inventory items. If a
stratified random sample is to be drawn, the strata
should be identified in such a way that
a. The overall population is divided into
subpopulations of equal size so that each
subpopulation can be given equal weight when
estimates are made.
b. Each stratum differs as much as possible with
respect to expected shrinkage but the shrinkages
expected for items within each stratum are as close
as possible.
c. The sample mean and standard deviation of each
individual stratum will be equal to the means and
standard deviation of all other strata.
d. The items in each stratum will follow a normal
distribution so that probability theory can be used
in making inferences from the sample data.

Physical count and perpetual record differences have

been minor. Now, the client wishes to minimize the cost
of physically counting the inventory by changing to a
sampling method in which many inventory items will
not be counted during a given year. For purposes of
expressing an opinion on his client's financial
statements, the CPA will accept the sampling method
only if
a. The sampling method has statistical validity.
b. A stratified sampling plan is used.
c. The client is willing to accept an opinion
qualification in the auditor's report.
d. The client is willing to accept a scope qualification
in the auditor's report.
__________
Items 26 to 30 apply to an examination by Lee
Melinda, CPA, of the financial statements of Summit
Appliance Repair Co. for the year ended June 30, 19X2.
Summit has a large fleet of identically stocked repair
trucks. It establishes the total quantities of materials and
supplies stored on the delivery trucks at year-end by
physically inventorying a random sample of trucks.

23. In estimating the total value of supplies on repair

trucks, Baker Company draws random samples from
two equal-sized strata of trucks. The mean value of the
inventory stored on the larger trucks (stratum 1) was
computed at $1,500 with a standard deviation of $250.
On the smaller trucks (stratum 2), the mean value of
inventory was computed as $500, with a standard
deviation of $45. If Baker had drawn an unstratified
sample from the entire population of trucks, the
expected mean value of inventory per truck would be
$1,000, and the expected standard deviation would be
a. Exactly $147.50.
b. Greater than $250.
c. Less than $45.
d. Between $45 and $250, but not $147.50.

Mr. Melinda is evaluating the statistical validity of

Summit's 19X2 sample. He knows that there were 74
trucks in the 19X1 required sample. Assumptions about
the size, variability, specified precision (confidence
interval), and specified reliability (confidence level) for
he 19X2 sample are given in each of the following five
items. You are to indicate in each case the effect upon
the size of the 19X2 sample as compared to the 19X1
sample. Each of the five cases is independent of the
other four and is to be considered separately.
26. Summit has the same number of trucks in 19X2, but
supplies are replenished more often, meaning that there
is less variability in the quantity of supplies stored on
each truck. The specified precision and specified
reliability remain the same. Under these assumptions
the required sample size for 19X2 should be
a. Larger than the 19X1 sample size.
b. Equal to the 19X1 sample size.
c. Smaller than the 19X1 sample size.
d. Of a size that is indeterminate based upon the
assumptions as given.

24. Omaha Sales Company asked a CPA's assistance in

planning the use of multiple regression analysis to
predict district sales. An equation has been estimated
based upon historical data, and a standard error has
been computed. When regression analysis based upon
past periods is used to predict for a future period, the
standard error associated with the predicted value, in
relation to the standard error for the base equation, will
be
a. Smaller.
b. Larger.
c. The same.
d. Larger or smaller, depending upon the circumstances.

27. Summit has the same number of trucks; supplies are

replenished less often (greater variability); Summit
specifies the same precision but decides to change the
specified reliability from 95% to 90%. Under these
assumptions, the required sample size for 19X2 should
be
a. Larger than the 19X1 sample size.

25. A CPA's client maintains perpetual inventory

records. In the past, all inventory items have been
counted on a cycle basis at least once during the year.
6Q-4

b.
c.
d.

Equal to the 19X1 sample size.

Smaller than the 19X1 sample size.
Of a size that is indeterminate based upon the
assumptions as given.

32. To satisfy the auditing standard to make a proper

study and evaluation of internal control, Harvey Jones,
CPA, uses statistical sampling to test compliance with
internal control procedures. Why does Jones use this
statistical-sampling technique?
a. It provides a means of measuring mathematically the
degree of reliability that results from examining only
a part of the data.
b. It reduces the use of judgment required of Jones
because the AICPA has established numerical
criteria for this type of testing.
c. It increases Jones' knowledge of the client's
prescribed procedures and their limitations.
d. It is specified by generally accepted auditing
standards.

28. Summit has more trucks in 19X2. Variability and

specified reliability remain the same, but with Melinda's
concurrence Summit decides upon a wider specified
precision. Under these assumptions the required sample
size for 19X2 should be
a. Larger than the 19X1 sample size.
b. Equal to the 19X1 sample size.
c. Smaller than the 19X1 sample size.
d. Of a size that is indeterminate based upon the
assumptions as given.

33. There are many kinds of statistical estimates that an

auditor may find useful, but basically every accounting
estimate is either of a quantity or of an error rate. The
statistical terms that roughly correspond to "quantities"
and "error rate," respectively, are
a. Attributes and variables.
b. Variables and attributes.
c. Constants and attributes.
d. Constants and variables.

29. The number of trucks and variability remain the

same, but with Melinda's concurrence Summit decides
upon a wider specified precision and a specified
reliability of 90% rather than 95%. Under these
assumptions the required sample size for 19X2 should
be
a. Larger than the 19X1 sample size.
b. Equal to the 19X1 sample size.
c. Smaller than the 19X1 sample size.
d. Of a size that is indeterminate based upon the
assumptions as given.

The following items apply to random sampling for

attributes, a sampling technique often employed in
transaction testing. Assume that all samples are to
be drawn from large populations.

30. The number of trucks increases, as does the

variability of quantities stored on each truck. The
specified reliability remains the same, but the specified
precision is narrowed. Under these assumptions the
required sample size for 19X2 should be
a. Larger than the 19X1 sample size.
b. Equal to the 19X1 sample size.
c. Smaller than the 19X1 sample size.
d. Of a size that is indeterminate based upon the
assumptions as given.
__________

34. Which of the following is an application of

sampling for attributes?
a. Estimating the total dollar value of accounts
receivable.
b. Estimating the reliability of a sample estimate.
c. Estimating the precision of a sample estimate.
d. Estimating the percentage of sales invoices with
totals of less than $10.

31. What is the primary objective of using stratification

as a sampling method in auditing?
a. To increase the confidence level at which a
decision will be reached from the results of the
sample selected.
b. To determine the occurrence rate for a given
characteristic in the population being studied.
c. To decrease the effect of variance in the total
population.
d. To determine the precision range of the sample
selected.

35. In a random sample of 1,000 records, a CPA

determines that the rate of occurrence of errors is 2%.
He can state that the error rate in the population is
a. Not more than 3%.
b. Not less than 2%.
c. Probably about 2%.
d. Not less than 1%.

6Q-5

36. From a random sample of items listed from a client's

inventory count, a CPA estimates with 90% confidence
that the error occurrence rate is between 4% and 6%.
The CPA's major concern is that there is one chance in
twenty that the true error rate in the population is
a. More than 6%.
b. Less than 6%.
c. More than 4%.
d. Less than 4%.

41. An advantage of statistical sampling over

nonstatistical sampling is that statistical sampling helps
an auditor to
a. Eliminate the risk of nonsampling errors.
b. Reduce the level of audit risk and materiality to a
relatively low amount.
c. Measure the sufficiency of the evidential matter
obtained.
d. Minimize the failure to detect errors and
irregularities.
__________

37. If from a particular random sample, a CPA can state

with 90% confidence that the occurrence rate in the
population does not exceed 20%, he can state that the
occurrence rate does not exceed 25% with
a. 95% confidence.
b. Greater reliability on his sample.
c. The same reliability on his sample.
d. Less reliability on his sample.

Items 42 through 46 are based on the following

information:
An audit partner is developing an office training
program to familiarize his professional staff with
statistical decision models applicable to the audit of
dollar-value balances. He wishes to demonstrate the
relationship of sample sizes to population size and
variability and the auditor's specifications as to
precision and confidence level. The partner prepared the
following table to show comparative population
characteristics and audit specifications of two
populations.

38. If a CPA wishes to select a random sample which

must have a 90% confidence level and an upper
precision limit of 10%, the size of the sample he must
select will decrease as his estimate of the
a. Occurrence rate increases.
b. Occurrence rate decreases.
c. Population size increases.
d. Reliability of the sample decreases.

Characteristics of
Population 1
Relative to
Population 2
Size
Equal
Equal
Larger
Smaller
Larger

Variability
Equal
Larger
Equal
Smaller
Equal

Audit Specifications
as to a Sample from
Population 1 Relative
to a Sample from
Population 2
Specified
Specified Confidence
Precision
Level
Equal
Higher
Wider
Equal
Tighter
Lower
Equal
Lower
Equal
Higher

39. If a CPA selects a random sample for which he

specified a confidence level of 99% and upper precision
limit of 5% and subsequently changes the confidence
level to 90%, the sample will produce an estimate which
is
a. More reliable and more precise.
b. More reliable and less precise.
c. Less reliable and more precise.
d. Less reliable and less precise.

Case 1
Case 2
Case 3
Case 4
Case 5

40. If the result obtained from a particular sample will

be critical, e.g., the CPA would not be able to render an
unqualified opinion (unless every item in the population
were examined), which of the following is the most
important to the CPA?
a. Size of the population.
b. Estimated occurrence rate.
c. Specified upper precision limit.
d. Specified confidence level.

42. In case 1 the required sample size from population 1

is
a. Larger than the required sample size from
population 2.
b. Equal to the required sample size from population
2.
c. Smaller than the required sample size from
population 2.
d. Indeterminate relative to the required sample size
from population 2.

In each item 42 through 46 you are to indicate for the

specified case from the above table the required sample
size to be selected from population 1 relative to the
sample from population 2.

6Q-6

43. In case 2 the required sample size from population 1

is
a. Larger than the required sample size from
population 2.
b. Equal to the required sample size from population
2.
c. Smaller than the required sample size from
population 2.
d. Indeterminate relative to the required sample size
from population 2.

a.
b.
c.
d.

Incorrect rejection.
Incorrect acceptance.
Overreliance.
Underreliance.

48. Which of the following would be designed to

estimate a numerical measurement of a population, such
as a dollar value?
a. Sampling for variables.
b. Sampling for attributes.
c. Discovery sampling.
d. Numerical sampling.

44. In case 3 the required sample size from population 1

is
a. Larger than the required sample size from
population 2.
b. Equal to the required sample size from population
2.
c. Smaller than the required sample size from
population 2.
d. Indeterminate relative to the required sample size
from population 2.

49. Which of the following combinations results in a

decrease in sample size in a sample for attributes?

a.
b.
c.
d.

45. In case 4 the required sample size from population 1

is
a. Larger than the required sample size from
population 2.
b. Equal to the required sample size from population
2.
c. Smaller than the required sample size from
population 2.
d. Indeterminate relative to the required sample size
from population 2.

Risk of
overreliance
Increase
Decrease
Increase
Increase

Tolerable
rate
Decrease
Increase
Increase
Increase

Expected population
deviation rate
Increase
Decrease
Decrease
Increase

50. What is an auditor's evaluation of a statistical

sample for attributes when a test of 100 documents
results in 4 deviations if tolerable rate is 5%, the
expected population deviation rate is 3%, and the
allowance for sampling risk is 2%?
a. Accept the sample results as support for planned
reliance on the control because the tolerable rate
less the allowance for sampling risk equals the
expected population deviation rate.
b. Modify planned reliance on the control because
the sample deviation rate plus the allowance for
sampling risk exceeds the tolerable rate.
c. Modify planned reliance on the control because
the tolerable rate plus the allowance for sampling
risk exceeds the expected population deviation
rate.
d. Accept the sample results as support for planned
reliance on the control because the sample
deviation rate plus the allowance for sampling risk
exceeds the tolerable rate.

46. In case 5 the required sample size from population 1

is
a. Larger than the required sample size from
population 2.
b. Equal to the required sample size from population
2.
c. Smaller than the required sample size from
population 2.
d. Indeterminate relative to the required sample size
from population 2.
__________

51. A principal advantage of statistical methods of

attribute sampling over nonstatistical methods is that
they provide a scientific basis for planning the
a. Risk of overreliance.
b. Tolerable rate.
c. Expected population deviation rate.
d. Sample size.

47. While performing a substantive test of details during

an audit, the auditor determined that the sample results
supported the conclusion that the recorded account
balance was materially misstated. It was, in fact, not
materially misstated. This situation illustrates the risk of

6Q-7

52. As the acceptable level of detection risk decreases,

an auditor may change the
a. Timing of substantive tests by performing them at
an interim date rather than at year end.
b. Nature of substantive tests from a less effective to
a more effective procedure.
c. Timing of tests of controls by performing them at
several dates rather than at one time.
d. Assessed level of inherent risk to a higher amount.

c.
d.

Decrease.
Become indeterminate.

58. Statistical sampling generally may be applied to test

compliance with internal accounting control when the
client's internal accounting control procedures
a. Depend primarily on appropriate segregation of
duties.
b. Are carefully reduced to writing and are included
in client accounting manuals.
c. Leave an audit trail in the form of documentary
evidence of compliance.
d. Enable the detection of material irregularities in
the accounting records.

53. If all other factors specified in a sampling plan

remain constant, changing the specified reliability from
90% to 95% would cause the required sample size to
a. Increase.
b. Remain the same.
c. Decrease.
d. Become indeterminate.

59. Which of the following best describes what the

auditor means by the rate of occurrence in an attribute
sampling plan?
a. The number of errors that can reasonably be
expected to be found in a population.
b. The frequency with which a certain characteristic
occurs within a population.
c. The degree of confidence that the sample is
representative of the population.
d. The dollar range within which the true population
total can be expected to fall.

54. If all other factors specified in a sampling plan

remain constant, changing the specified precision from
8% to 12% would cause the required sample size to
a. Increase.
b. Remain the same.
c. Decrease.
d. Become indeterminate.
55. If all other factors specified in a sampling plan
remain constant, changing the estimated occurrence rate
from 2% to 4% would cause the required sample size to
a. Increase.
b. Remain the same.
c. Decrease.
d. Become indeterminate.

60. An auditor selects a preliminary sample of 100

items out of a population of 1,000 items. The sample
statistics generate an arithmetic mean of $120, a
standard deviation of $12 and a standard error of the
mean of $1.20. If the sample was adequate for the
auditor's purposes and the auditor's desired precision
was plus or minus $2,000, the minimum acceptable
dollar value of the population would be
a. $122,000.
b. $120,000.
c. $118,000.
d. $117,600.

56. In the evaluation of the results of a sample of a

specified reliability and precision, the fact that the
occurrence rate in the sample was 2% rather than the
estimated occurrence rate of 4% would cause the
required sample size to
a. Increase.
b. Remain the same.
c. Decrease.
d. Become indeterminate.

61. In estimation sampling for variables, which of the

following must be known in order to estimate the
appropriate sample size required to meet the auditor's
needs in a given situation?
a. The total amount of the population.
b. The desired standard deviation.
c. The desired confidence level.
d. The estimated rate of error in the population.

57. In the evaluation of the results of a sample of a

specified reliability and precision, the fact that the
occurrence rate in the sample was the same as the
estimated occurrence rate would cause the reliability of
the sample estimate to
a. Increase.
b. Remain the same.
6Q-8

62. Which of the following sampling plans would be

designed to estimate a numerical measurement of a
population, such as a dollar value?
a. Numerical sampling.
b. Discovery sampling.
c. Sampling for attributes.
d. Sampling for variables.

67. In which of the following cases would the auditor

be most likely to conclude that all of the items in an
account under consideration should be examined rather
than tested on a sample basis?

a.
b.
c.
d.

63. Auditors who prefer statistical to judgmental

sampling believe that the principal advantage of
statistical sampling flows from its unique ability to
a. Define the precision required to provide audit
satisfaction.
b. Provide a mathematical measurement of
uncertainty.
c. Establish conclusive audit evidence with
decreased audit effort.
d. Promote a more legally defensible procedural
approach.

The measure of
tolerable error is
Large
Small
Large
Small

Error frequency is
expected to be
Low
High
High
Low

68. The risk of incorrect acceptance and the risk of

overreliance on internal accounting control relate to the
a. Preliminary estimates of materiality levels.
b. Allowable risk of tolerable error.
c. Efficiency of the audit.
d. Effectiveness of the audit.
69. When assessing the tolerable rate, the auditor should
consider that, while deviations from control procedures
increase the risk of material errors, such deviations do
not necessarily result in errors. This explains why
a. A recorded disbursement that does not show
evidence of required approval may nevertheless be
a transaction that is properly authorized and
recorded.
b. Deviations would result in errors in the accounting
records only if the deviations and the errors
occurred on different transactions.
c. Deviations from pertinent control procedures at a
given rate ordinarily would be expected to result in
errors at a higher rate.
d. A recorded disbursement that is properly
authorized may nevertheless be a transaction that
contains a material error.

64. Failure to detect material dollar errors in the

financial statements is a risk which the auditor primarily
mitigates by
a. Performing substantive tests.
b. Performing compliance tests.
c. Evaluating internal control.
d. Obtaining a client representation letter.
65. An auditor selects a preliminary sample of 100
items out of a population of 1,000 items. The sample
statistics generate an arithmetic mean of $60, a standard
deviation of $6 and a standard error of the mean of
$.60. If the sample was adequate for the auditor's
purposes and the auditor's desired precision was plus or
minus $1,000, the minimum acceptable dollar value of
the population would be
a. $61,000.
b. $60,000.
c. $59,000.
d. $58,800.

70. As lower acceptable levels of both audit risk and

materiality are established, the auditor should plan more
work on individual accounts to
a. Find smaller errors.
b. Find larger errors.
c. Increase the tolerable error in the accounts.
d. Decrease the risk of overreliance.

66. In the application of statistical techniques to the

estimation of dollar amounts, a preliminary sample is
usually taken primarily for the purpose of estimating the
population.
a. Variability.
b. Mode.
c. Range.
d. Median.

6Q-9

71. A number of factors influences the sample size for a

substantive test of details of an account balance. All
other factors being equal, which of the following would
lead to a larger sample size?
a. Greater reliance on internal accounting controls.
b. Greater reliance on analytical review procedures.
c. Smaller expected frequency of errors.
d. Smaller measure of tolerable error.

76. An advantage of using statistical over nonstatistical

sampling methods in tests of controls is that the
statistical methods
a. Afford greater assurance than a nonstatistical
sample of equal size.
b. Provide an objective basis for quantitatively
evaluating sample risks.
c. Can more easily convert the sample into a dualpurpose test useful for substantive testing.
d. Eliminate the need to use judgment in determining appropriate sample sizes.

72. Which of the following audit risk components may

be assessed in nonquantitative terms?

a.
b.
c.
d.

Inherent
risk
Yes
Yes
No
Yes

Control
risk
Yes
No
Yes
Yes

Detection
risk
No
Yes
Yes
Yes

77. In a probability-proportional-to-size sample with a

sampling interval of $10,000, an auditor discovered that
a selected account receivable with a recorded amount of
$5,000 had an audit amount of $2,000. The projected
error of this sample was
a. $3,000
b. $4,000
c. $6,000
d. $8,000

73. As a result of tests of controls, an auditor overrelied

on internal control and decreased substantive testing.
This overreliance occurred because the true deviation
rate in the population was
a. Less than the risk of overreliance on the auditor's
sample.
b. Less than the deviation rate in the auditor's
sample.
c. More than the risk of overreliance on the auditor's
sample.
d. More than the deviation rate in the auditor's
sample.

78. An auditor is performing substantive tests of pricing

and extensions of perpetual inventory balances
consisting of a large number of items. Past experience
indicates numerous pricing and extension errors. Which
of the following statistical sampling approaches is most
appropriate?
a. Unstratified mean-per-unit.
b. Probability-proportional-to-size.
c. Stop or go.
d. Ratio estimation.

74. An auditor who uses statistical sampling for

attributes in testing internal controls should reduce the
planned reliance on a prescribed control when the
a. Sample rate of deviation is less than the expected
rate of deviation used in planning the sample.
b. Tolerable rate less the allowance for sampling risk
exceeds the sample rate of deviation.
c. Sample rate of deviation plus the allowance for
sampling risk exceeds the tolerable rate.
d. Sample rate of deviation plus the allowance for
sampling risk equals the tolerable rate.

79. As the acceptable level of detection risk increases,

an auditor may change the
a. Assessed level of control risk from below the
maximum to the maximum level.
b. Assurance provided by tests of controls by using a
larger sample size than planned.
c. Timing of substantive tests from year end to an
interim date.
d. Nature of substantive tests from a less effective to
a more effective procedure.

75. Which of the following factors is generally not

considered in determining the sample size for a test of
controls?
a. Population size.
b. Tolerable rate.
c. Risk of overreliance.
d. Expected population deviation rate.

6Q-10

80. In planning a statistical sample for a test of controls,

an auditor increased the expected population deviation
rate from the prior years rate because of the results of
the prior years test of controls and the overall control
environment. The auditor most likely would then
increase the planned
a. Tolerable rate.
b. Allowance for sampling risk.
c. Risk of assessing control risk too low.
d. Sample size.

c.
d.

Extent of tests of details.

Level of inherent risk.

85. An auditor uses the assessed level of control risk to

a. Evaluate the effectiveness of the entity's internal
control policies and procedures.
b. Identify transactions and account balances where
inherent risk is at the maximum.
c. Indicate whether materiality thresholds for
planning and evaluation purposes are sufficiently
high.
d. Determine the acceptable level of detection risk
for financial statement assertions.

81. An auditor may decide to increase the risk of

incorrect rejection when
a. Increased reliability from the sample is desired.
b. Many differences (audit value minus recorded
value) are expected.
c. Initial sample results do not support the planned
level of control risk.
d. The cost and effort of selecting additional sample
items is low.

86. While performing a test of details during an audit,

an auditor determined that the sample results supported
the conclusion that the recorded account balance was
materially misstated. It was, in fact, not materially
misstated. This situation illustrates the risk of
a. Assessing control risk too high.
b. Assessing control risk too low.
c. Incorrect rejection.
d. Incorrect acceptance.

82. Which of the following courses of action would an

auditor most likely follow in planning a sample of cash
disbursements if the auditor is aware of several
unusually large cash disbursements?
a. Increase the sample size to reduce the effect of the
unusually large disbursements.
b. Continue to draw new samples until all the
unusually large disbursements appear in the
sample.
c. Set the tolerable rate of deviation at a lower level
than originally planned.
d. Stratify the cash disbursements population so that
the unusually large disbursements are selected.

87. The sample size of a test of controls varies inversely

with

a.
b.
c.
d.

Expected population
deviation rate
Yes
No
Yes
No

Tolerable
rate
Yes
No
No
Yes

88. Inherent risk and control risk differ from detection

risk in that they
a. Arise from the misapplication of auditing
procedures.
b. May be assessed in either quantitative or
nonquantitative terms.
c. Exist independently of the financial statement
audit.
d. Can be changed at the auditor's discretion.

83. For which of the following audit tests would an

auditor most likely use attribute sampling?
a. Making an independent estimate of the amount of
a LIFO inventory.
b. Examining invoices in support of the valuation of
fixed asset additions.
c. Selecting accounts receivable for confirmation of
account balances.
d. Inspecting employee time cards for proper
approval by supervisors.
84. When an auditor increases the assessed level of
control risk because certain control procedures were
determined to be ineffective, the auditor would most
likely increase the
a. Extent of tests of controls.
b. Level of detection risk.
6Q-11

89. The existence of audit risk is recognized by the

statement in the auditor's standard report that the
a. Auditor is responsible for expressing an opinion
on the financial statements, which are the
responsibility of management.
b. Financial statements are presented fairly, in all
material respects, in conformity with GAAP.
c. Audit includes examining, on a test basis,
evidence supporting the amounts and disclosures
in the financial statements.
d. Auditor obtains reasonable assurance about
whether the financial statements are free of
material misstatement.

93. Which of the following sample planning factors

would influence the sample size for a substantive test of
details for a specific account?

a.
b.
c.
d.

Expected
amount of
misstatements
No
Yes
No
Yes

Measure of
tolerable
misstatement
No
Yes
Yes
No

94. Which of the following audit risk components may

be assessed in nonquantitative terms?
90. Which of the following statements is correct
concerning statistical sampling in tests of controls?
a. As the population size increases, the sample size
should increase proportionately.
b. Deviations from specific internal control
procedures at a given rate ordinarily result in
misstatements at a lower rate.
c. There is an inverse relationship between the
expected population deviation rate and the sample
size.
d. In determining tolerable rate, an auditor considers
detection risk and the sample size.

a.
b.
c.
d.

Control
risk
Yes
Yes
Yes
No

Detection
risk
Yes
No
Yes
Yes

Inherent
risk
No
Yes
Yes
Yes

95. As a result of tests of controls, an auditor assessed

control risk too low and decreased substantive testing.
This assessment occurred because the true deviation
rate in the population was
a. Less than the risk of assessing control risk too
low, based on the auditor's sample.
b. Less than the deviation rate in the auditor's
sample.
c. More than the risk of assessing control risk too
low, based on the auditor's sample.
d. More than the deviation rate in the auditor's
sample.

91. Which of the following sampling methods would be

used to estimate a numerical measurement of a
population, such as a dollar value?
a. Attributes sampling.
b. Stop-or-go sampling.
c. Variables sampling.
d. Random-number sampling.

96. In determining the sample size for a test of controls,

an auditor should consider the likely rate of deviations,
the allowable risk of assessing control risk too low, and
the
a. Tolerable deviation rate.
b. Risk of incorrect acceptance.
c. Nature and cause of deviations.
d. Population size.

92. Which of the following courses of action would an

auditor most likely follow in planning a sample of cash
disbursements if the auditor is aware of several
unusually large cash disbursements?
a. Set the tolerable rate of deviation at a lower level
than originally planned.
b. Stratify the cash disbursements population so that
the unusually large disbursements are selected.
c. Increase the sample size to reduce the effect of the
unusually large disbursements.
d. Continue to draw new samples until all the
unusually large disbursements appear in the
sample.

6Q-12

97. An advantage of using statistical over nonstatistical

sampling methods in tests of controls is that the
statistical methods
a. Can more easily convert the sample into a dualpurpose test useful for substantive testing.
b. Eliminate the need to use judgment in determining
appropriate sample sizes.
c. Afford greater assurance than a nonstatistical
sample of equal size.
d. Provide an objective basis for quantitatively
evaluating sample risk.

101. The diagram below depicts an auditor's estimated

maximum deviation rate compared with the tolerable
rate, and also depicts the true population deviation rate
compared with the tolerable rate.
Auditor's
estimate
based on
sample results
Maximum
deviation rate
is less than
tolerable rate

98. In confirming a client's accounts receivable in prior

years, an auditor found that there were many differences
between the recorded account balances and the
confirmation replies. These differences, which were not
misstatements, required substantial time to resolve. In
defining the sampling unit for the current year's audit,
the auditor most likely would choose
a. Individual overdue balances.
b. Individual invoices.
c. Small account balances.
d. Large account balances.

Maximum
deviation rate
exceeds
tolerable rate

True state of population

Deviation rate
Deviation rate
is less than
exceeds
tolerable rate
tolerable rate
I.

III.

II.

IV.

As a result of tests of' controls, the auditor assesses

control risk too low and thereby decreases substantive
testing. This is illustrated by situation
a. I.
b. II.
c. III.
d. IV.

99. In statistical sampling methods used in substantive

testing, an auditor most likely would stratify a
population into meaningful groups if
a. Probability proportional to size (PPS) sampling is
used.
b. The population has highly variable recorded
amounts.
c. The auditor's estimated tolerable misstatement is
extremely small.
d. The standard deviation of recorded amounts is
relatively small.

102. The risk of incorrect acceptance and the likelihood

of assessing control risk too low relate to the
a. Allowable risk of tolerable misstatement.
b. Preliminary estimates of materiality levels.
c. Efficiency of the audit.
d. Effectiveness of the audit.
103. An auditor who uses statistical sampling for
attributes in testing internal controls should reduce the
planned reliance on a prescribed control when the
a. Sample rate of deviation plus the allowance for
sampling risk equals the tolerable rate.
b. Sample rate of deviation is less than the expected
rate of deviation used in planning the sample.
c. Tolerable rate less the allowance for sampling risk
exceeds the sample rate of deviation.
d. Sample rate of deviation plus the allowance for
sampling risk exceeds the tolerable rate.

100. The use of the ratio estimation sampling technique

is most effective when
a. The calculated audit amounts are approximately
proportional to the client's book amounts.
b. A relatively small number of differences exist in
the population.
c. Estimating populations whose records consist of
quantities, but not book values.
d. Large overstatement differences and large
understatement differences exist in the population.

6Q-13

104. In addition to evaluating the frequency of

deviations in tests of controls, an auditor should also
consider certain qualitative aspects of the deviations.
The auditor most likely would give broader
consideration to the implications of a deviation if it was
a. The only deviation discovered in the sample.
b. Identical to a deviation discovered during the prior
year's audit.
c. Caused by an employee's misunderstanding of
instructions.
d. Initially concealed by a forged document.

CPA Exam Tip:

The time remaining to complete the exam is
constantly displayed at the top of the screen.

105. Which of the following factors is(are) considered

in determining the sample size for a test of controls?

a.
b.
c.
d.

Expected
deviation rate
Yes
No
No
Yes

Tolerable
deviation rate
Yes
No
Yes
No

CPA Exam Tip:

Between multiple choice testlets you have the
option to take a break. This option appears on
the screen if you select the Done button
followed by the Continue button which takes
you to the next testlet. You are presented with
a yes or no option to take a break. Your time
continues to run if you select the break option.
Clicking No will allow you to proceed to the
next testlet.

106. How would increases in tolerable misstatement and

assessed level of control risk affect the sample size in a
substantive test of details?

a.
b.
c.
d.

Increase in tolerable
misstatement
Increase sample size
Increase sample size
Decrease sample size
Decrease sample size

Increase in assessed
level of control risk
Increase sample size
Decrease sample size
Increase sample size
Decrease sample size

107. An advantage of statistical sampling over

nonstatistical sampling is that statistical sampling helps
an auditor to
a. Eliminate the risk of nonsampling errors.
b. Reduce the level of audit risk and materiality to a
relatively low amount.
c. Measure the sufficiency of the evidential matter
obtained.
d. Minimize the failure to detect errors and
irregularities.

6Q-14

Chapter Six - Problems

The Audit Sampling Process
NUMBER 1
One of the generally accepted auditing standards states that sufficient competent evidential matter is to be obtained
through inspections, observation, inquiries, and confirmation to afford a reasonable basis for an opinion regarding
the financial statements under examination. Some degree of uncertainty is implicit in the concept of "a reasonable
basis for an opinion," because the concept of sampling is well established in auditing practice.
Required:
a. Explain the auditor's justification for accepting the uncertainties that are inherent in the sampling process.
b. Discuss the uncertainties which collectively embody the concept of ultimate audit risk.
c. Discuss the nature of the sampling risk and nonsampling risk. Include the effect of sampling risk on
substantive tests of details and on compliance tests of internal accounting control.

NUMBER 2
Edwards has decided to use Probability Proportional to Size (PPS) sampling, sometimes called dollar-unit sampling,
in the audit of a client's accounts receivable balance. Few, if any, errors of account balance overstatement are
expected.
Edwards plans to use the following PPS sampling table:

TABLE
Reliability Factors for Errors of Overstatement
Number
of Overstatement
Errors
0
1
2
3
4

Risk of Incorrect Acceptance

1%
4.61
6.64
8.41
10.05
11.61

5%
3.00
4.75
6.30
7.76
9.16

10%
2.31
3.89
5.33
6.69
8.00

Required:
a. Identify the advantages of using PPS sampling over classical variables sampling.
Note: Requirements b and c are not related.

6Q-15

15%
1.90
3.38
4.72
6.02
7.27

20%
1.61
3.00
4.28
5.52
6.73

b.

Calculate the sampling interval and the sample size Edwards should use given the following information:
Tolerable error....................................................................................................$15,000
Risk of incorrect acceptance ..................................................................................... 5%
Number of errors allowed .............................................................................................0
Recorded amount of accounts receivable.........................................................$300,000
Note: Requirements b and c are not related.

c.

Calculate the total projected error if the following three errors were discovered in a PSS sample:
Recorded
Amount
$ 400
500
3,000

1st error
2nd error
3rd error

Audit
Amount
$ 320
0
2,500

Sampling
Interval
$1,000
1,000
1,000

NUMBER 3
During the course of an audit engagement, a CPA attempts to obtain satisfaction that there are no material
misstatements in the accounts receivable of a client. Statistical sampling is a tool that the auditor often uses to obtain
representative evidence to achieve the desired satisfaction. On a particular engagement, an auditor determined that a
material misstatement in a population of accounts would be $35,000. To obtain satisfaction the auditor had to be
95% confident that the population of accounts was not in error by $35,000. The auditor decided to use unrestricted
random sampling with replacement and took a preliminary random sample of 100 items (n) from a population of
1,000 items (N). The sample produced the following data:
Arithmetic mean of sample items (x)
Standard deviation of sample items (SD)

$4,000
$ 200

The auditor also has available the following information:

Standard error of the mean (SE) = SD

Population precision (P) = N R SE

Partial List of Reliability Coefficients
If Reliability
Coefficient (R) is
1.70
1.75
1.80
1.85
1.90
1.95
1.96
2.00
2.05
2.10
2.15

Then Reliability
is
91.086%
91.988
92.814
93.568
94.256
94.882
95.000
95.450
95.964
96.428
96.844

6Q-16

Required:
a. Define the statistical terms "reliability" and "precision" as applied to auditing.
b. If all necessary audit work is performed on the preliminary sample items and no errors are detected,
1. What can the auditor say about the total amount of accounts receivable at the 95% reliability level?
2. At what confidence level can the auditor say that the population is not in error by $35,000?
c.

Assume that the preliminary sample was sufficient,

1. Compute the auditor's estimate of the population total.
2. Indicate how the auditor should relate this estimate to the client's recorded amount.

NUMBER 4
Jiblum, CPA, is planning to use attribute sampling in order to determine the degree of reliance to be placed on an
audit client's system of internal accounting control over sales. Jiblum has begun to develop an outline of the main
steps in the sampling plan as follows:
1. State the objective(s) of the audit test (e.g. to test the reliability of internal accounting controls over sales).
2. Define the population (define the period covered by the test; define the sampling unit, define the completeness of
the population).
3. Define the sampling unit (e.g. client copies of sales invoices).
Required:
a. What are the remaining steps in the above outline which Jiblum should include in the statistical test of sales
invoices? Do not present a detailed analysis of tasks which must be performed to carry out the objectives
of each step. Parenthetical examples need not be provided.
b. How does statistical methodology help the auditor to develop a satisfactory sampling plan?

NUMBER 5
Smith, CPA, has decided to rely on an audit client's internal accounting controls affecting receivables. Smith plans
to use sampling to obtain substantive evidence concerning the reasonableness of the client's accounts receivable
balances. Smith has identified the first few steps in an outline of the sampling plan as follows:
1. Determine the audit objectives of the test.
2. Define the population.
3. Define the sampling unit.
4. Consider the completeness of the population.
5. Identify individually significant items.
Required:
Identify the remaining steps which Smith should include in the outline of the sampling plan. Illustrations and
examples need not be provided.

6Q-17

NUMBER 6
Audit risk and materiality should be considered when planning and performing an examination of financial
statements in accordance with generally accepted auditing standards. Audit risk and materiality should also be
considered together in determining the nature, timing, and extent of auditing procedures and in evaluating the
results of those procedures.
Required:
a. 1. Define audit risk.
2. Describe its components of inherent risk, control risk, and detection risk.
3. Explain how these components are interrelated.
b.

1. Define materiality.
2. Discuss the factors affecting its determination.
3. Describe the relationship between materiality for planning purposes and materiality for evaluation
purposes.

NUMBER 7
Sampling for attributes is often used to allow an auditor to reach a conclusion concerning a rate of occurrence in a
population. A common use in auditing is to test the rate of deviation from a prescribed internal accounting control
procedure to determine whether planned reliance on that control is appropriate.
Required:
a. When an auditor samples for attributes, identify the factors that should influence the auditor's judgment
concerning the determination of
1. Acceptable level of risk of overreliance,
2. Tolerable deviation rate, and
3. Expected population deviation rate.
b. State the effect on sample size of an increase in each of the following factors, assuming all other factors are
held constant:
1. Acceptable level of risk of overreliance,
2. Tolerable deviation rate, and
3. Expected population deviation rate.
c.

Evaluate the sample results of a test for attributes if authorizations are found to be missing on 7 check requests
out of a sample of 100 tested. The population consists of 2500 check requests, the tolerable deviation rate is
8%, and the acceptable level of risk of overreliance is low.

d. How may the use of statistical sampling assist the auditor in evaluating the sample results described in (c)
above?

6Q-18

NUMBER 8
Baker, CPA, was engaged to audit Mill Company's financial statements for the year ended September 30, 1991.
After obtaining an understanding of Mill's internal control structure, Baker decided to obtain evidential matter about
the effectiveness of both the design and operation of the policies and procedures that may support a low assessed
level of control risk concerning Mill's shipping and billing functions. During the prior years' audits Baker used
nonstatistical sampling, but for the current year Baker used a statistical sample in the tests of controls to eliminate
the need for judgment.
Baker wanted to assess control risk at a low level, so a tolerable rate of deviation or acceptable upper precision limit
(UPL) of 20% was established. To estimate the population deviation rate and the achieved UPL, Baker decided to
apply a discovery sampling technique of attribute sampling that would use a population expected error rate of 3%
for the 8,000 shipping documents, and decided to defer consideration of allowable risk of assessing control risk too
low (risk of overreliance) until evaluating the sample results. Baker used the tolerable rate, the population size, and
the expected population error rate to determine that a sample size of 80 would be sufficient. When it was
subsequently determined that the actual population was about 10,000 shipping documents, Baker increased the
sample size to 100.
Baker's objective was to ascertain whether Mill's shipments had been properly billed. Baker took a sample of 100
invoices by selecting the first 25 invoices from the first month of each quarter. Baker then compared the invoices to
the corresponding prenumbered shipping documents.
When Baker tested the sample, eight errors were discovered. Additionally, one shipment that should have been
billed at $10,443 was actually billed at $10,434. Baker considered this $9 to be immaterial and did not count it as an
error.
In evaluating the sample results Baker made the initial determination that a reliability level of 95% (risk of assessing
control risk too low 5%) was desired and, using the appropriate statistical sampling table, determined that for eight
observed deviations from a sample size of 100, the achieved UPL was 14%. Baker then calculated the allowance for
sampling risk to be 5%, the difference between the actual sample deviation rate (8%) and the expected error rate
(3%). Baker reasoned that the actual sample deviation rate (8%) plus the allowance for sampling risk (5%) was less
than the achieved UPL (14%); therefore, the sample supported a low level of control risk.

Required:
Describe each incorrect assumption, statement, and inappropriate application of attribute sampling in Baker's
procedures.

6Q-19

Chapter Six - Solutions to Questions

The Audit Sampling Process
Sampling for Variables

Many of the questions on Statistical Sampling are concerned with the effect of increases and decreases on the size
of a sample. This is caused by increases and decreases in the following four elements: standard deviation, reliability,
precision and population. The following are the formulas expressed in the AICPA statistical notation and also on a
mnemonic basis.

n=

SX

UR
A

or

sample =

SD

REL. POP.
PREC.

Any element in the numerator that increases will cause a corresponding increase in the size of the sample. In the
denominator (precision interval), as the amount gets smaller or narrower the sample size will increase, while as the
precision increases or gets wider the sample will be smaller. When any two elements are given in a question which
causes an increase and a decrease in sample sizes, the answer is of necessity indeterminate, unless the actual figures
are given.
The addition of the finite population correction factor

1 n / N is always required when sampling without

replacement is mentioned in a problem. While this would complicate the mathematics, the effect is always a
decrease in sample size or precision.

Sampling for Attributes

The formulas for attribute sampling are complex and the determination of sample size is generally taken from a
table. The subject is quite abstract so the following memory aides are recommended:
Sample
Size

Add population as an additional factor

to the numerator when "sampling without
replacement" is indicated.

*E.O.R. REL.
PREC. %

*Estimated Occurrence Rate

1. (c) (Smaller). Stratification will cause the standard deviation to decrease; as this is the only element affected, the
sample will be smaller.
2. (d) (Indeterminate). Stratification reduces the standard deviation and the sample size; however, the increase in
reliability from 90% to 95% will increase the sample size, and, accordingly, the answer is indeterminate.
3. (a) (Larger). Sampling without replacement was in use for the two years compared and the finite population
correction factor will not have any effect. An increase in the reliability from 90 to 95% will cause an increase in the
sample size.
4. (a) (Larger). The standard deviation (variability) and population are larger in 1973 and, therefore, the sample will
be larger.

6S-1

5. (d) (Indeterminate). The standard deviation (variability) decreases while the population increases and the effect
on the sample size is, therefore, indeterminate.
6. (a) Increasing reliability in any kind of a sampling plan, including discovery, while the other elements stay the
same, will always cause the required sample size to increase.
7. (a) Occurrence rates and maximum acceptable occurrence rates are always an indication of an attribute sampling
plan. There is no maximum acceptable occurrence rate applicable to discovery sampling plans. Stratified sampling
and variable sampling apply to the estimation of some dollar amount.
8. (d) Failing to recognize an error in an amount, or error in an internal control data processing procedure, is not
related to statistical sampling and therefore would be characterized as a nonsampling error.
9. (c) Precision or confidence interval represents the range of values within which the true but unknown population
total will fall and this is directly related to materiality.
10. (d) Systematic sampling is a method of using every nth item in a population as a sample. Its advantage, of
course, is that it does not require the use of a random number system and the establishing of correspondence with
the population.
11. (a) In this problem, the occurrence rate of 3% and the other factors indicated call for a sample of 400. If the
occurrence rate is made smaller, then the sample would decrease and the only possible answer would be 200.
12. (c) A confidence level of 95% indicates that a good system of internal control has been determined by means of
a sample. Having met that test, the auditor could place much less reliance on the substantive tests.
13. (c) Attribute sampling always deals with the rate of occurrence, and, accordingly, the percentage of overdue
accounts receivable would be one type of application. Items (a) and (d) are examples of variable sampling. (b), of
course, is not related to sampling.
14. (b) Testing for compliance is always related to attribute sampling.
15. (b) Systematic sampling is one in which every nth item in a population is selected as a sample. Its disadvantage,
however, is that the items selected may occur in a systematic pattern which would negate the randomness of the
sample.
16. (c) The inclusion of large amounts in accounting populations will cause a larger standard deviation with a
resulting increase in sample size. By separating the population into two or more strata, and reviewing the large
amounts as a separate stratum, the standard deviation or variability of the remaining items will be less with the result
that the sample size will be smaller.
17. (d) Discovery sampling is a type of attribute sampling. However, the objective is not one of estimation of a
specific occurrence rate. Rather, the basic objective of discovery sampling is to provide a sample size large enough
that we will have a prescribed change of seeing at least one example of some designated attribute.
18. (a) The AICPA attribute sampling tables do not provide for differences in population. If the CPA had used
sampling with replacement, the sample size from Storehouse A and Storehouse B would have been equal and (c)
would have been the correct answer. By using sampling without replacement, smaller samples would result and
there would be a slight difference in the sample size as between Storehouse A and Storehouse B because of the
finite population correction factor. Therefore, (a) is the best answer.

6S-2

19. (a) This is an example of an attribute sampling plan. A sample of 284 items was determined based on a
reliability of 95% and a specified precision of plus or minus .025. If the specified precision is made wider to plus or
minus .05 and the reliability stays the same, the required sample size will be smaller and item (a) would be the only
possible answer.
20. (a) The reliability of an estimate made from sample data is a mathematically determined figure that expresses the
expected proportion of possible samples of a specified size from a given population that will yield an interval
estimate that will encompass the true population value.
21. (d) Stratified sampling techniques would be least appropriate in the confirmation of the year-end bank balances.
Confirmation of bank balances would always be done at 100% and sampling would not be involved.
22. (b) A stratified sample used to determine inventory shrinkage would identify the strata in such a way that each
stratum differs as much as possible with respect to expected shrinkage, but the shrinkages expected for items within
each stratum are as close as possible.
23. (b) The problem states that the standard deviation of stratum 1 is 250, and the standard deviation of stratum 2 is
$45. If the sample was not based on stratification and all the amounts were combined into one sample, it is obvious
that the standard deviation would have to be greater than 250.
24. (b) The standard error associated with the predicted value, in relation to the standard error for the base equation
will always be larger. The calculation of the standard error of the base equation is based on a regression line which
makes it smaller.
25. (a) For purposes of expressing an opinion on the client's financial statements, the CPA will accept the sampling
method only if it has statistical validity.
26. (c) (Smaller). The only element in this problem that is changed is the standard deviation (variability) which is
decreasing and this would cause the sample size to be smaller.
27. (d) (Indeterminate). The problem states that there will be greater variability which would increase the sample
while the reliability will be decreased from 95% to 90%. Accordingly, the effect on sample size would be
indeterminate.
28. (d) (Indeterminate). The population has increased in 19X2, which would cause an increase in sample size, while
the precision is being made wider, which would cause a decrease in sample size. Accordingly, the increases and
decreases would make this indeterminate.
29. (c) (Smaller). A wider precision and a smaller reliability would cause the sample in 19X2 to be smaller than
19X1.
30. (a) (Larger). The number of trucks or population increases as does the variability, and, in addition, the precision
is made smaller. All of these items would cause an increase in the sample size, and, therefore, the sample in 19X2
would be larger than that in 19X1.
31. (c) The primary objective of using stratification as a sampling method in auditing is to decrease the effect of the
standard deviation (variability) in the total population.
32. (a) Testing compliance by the use of statistical sampling provides a means of measuring mathematically the
degree of reliability that results from the examination of only part of the data.
33. (b) The statistical terms that roughly correspond to "quantities" and "error rate," respectively, are variables and
attributes.

6S-3

34. (d) Estimating the percentage of sales invoices with totals of less than $10 would be an application of sampling
for attributes. Item (a) would be a case of sampling for variables. Items (b) and (c) are items used in the
determination of sample size in both sampling for attributes and variables.
35. (c) Sampling generally deals with ranges within which error rates will fall, and (c) would be the best answer.
36. (a) The precision interval in this case is 90%; however, the upper precision would be 95% or one chance in 20
that the rate exceeds 6%.
37. (b) When precision ranges are widened, the reliability is increased.
38. (b) An increase in sample size varies directly with an increase in the estimated occurrence rate, all other factors
remaining the same.
39. (c) Decreasing the confidence level (reliability) will make the estimate less reliable but more precise.
40. (d) If the results of a sample estimate are critical, then the highest possible confidence level would be selected.
41. (c) Statistical sampling provides a mathematical model for determining sample size. Because of this the auditor
is able to quantify the selection of sample size rather than rely on judgment.
42. (a) (Larger). In case number one, the specified confidence level (reliability) increases; therefore, the sample size
will increase.
43. (d) (Indeterminate). In case two, the variability is larger while the precision is wider. The former increases the
sample size and the latter decreases the sample size; therefore, the result is indeterminate.
44. (d) (Indeterminate). In case three, the increase in population and the tighter precision will cause the sample size
to increase, while decreasing the confidence level will cause it to decrease. Therefore, in the facts given, the answer
is indeterminate.
45. (c) (Smaller). The decrease in population, variability and confidence level all will tend to decrease the sample
size.
46. (a) (Larger). In case five, the population is larger as well as the specified confidence level; therefore, both will
cause an increase in the sample.
47. (a) Incorrect rejection occurs when the auditor concludes, based on a sample, that a recorded account balance is
materially misstated when it is not materially misstated. The auditor rejects an acceptable balance. Answer (b) refers
to incorrect acceptance, which occurs when the auditor concludes, based on a sample, that a recorded account
balance is not materially misstated when it is. Answers (c) and (d) are risks associated with tests of controls, not
substantive tests.
48. (a) Variables sampling, which is typically associated with substantive testing, is a type of sampling that reaches
a conclusion on the monetary amounts of a population. Answers (b) and (c) refer to measurement of the presence or
absence of control deviations. They are typically associated with tests of controls.
49. (c) There is an inverse relationship between acceptable level of risk of overreliance on the internal control
structure and sample size (as risk of overreliance increases, sample size decreases). There is also an inverse
relationship between the tolerable deviation rate and sample size (as tolerable rate increases, sample size decreases).
There is a direct relationship between expected population deviation rate and sample size (as expected rate
decreases, sample size decreases).

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50. (b) The tolerable rate is the maximum population rate of deviation from a prescribed control procedure that the
auditor will tolerate without modifying the planned reliance on the control procedure. The sample deviation rate is
the rate of deviation found in the sample. The allowance for sampling risk is a measure of the difference between a
sample result and the corresponding population characteristic. The auditor adds the allowance for sampling risk to
the sample deviation rate to estimate the population deviation rate. Since the rate of deviation found in this sample
(4 deviations in a test of 100 documents = 4%) plus an allowance for sampling risk (2%) results in a population rate
(6%) which exceeds the tolerable rate (5%), the auditor would modify planned reliance on the control.
51. (d) In attribute sampling, the auditor considers factors which determine sample size. These factors include the
risk of overreliance [answer (a)], the tolerable rate [answer (b)], and the expected population deviation rate [answer
(c)]. Based on these factors, statistical methods of sampling, which use the laws of probability, can provide a
scientific basis for planning the sample size.
52. (a) Detection risk is defined as the risk that the auditor's procedures will not detect an error or irregularity when
one exists in the account being audited. As detection risk is decreased the auditor will select (1) a greater sample
size of items to be tested, and (2) change audit tests (substantive procedures) to more effective procedures. In this
way the auditor is minimizing the risk of not detecting an error when one in fact exists.
53. (a) Increasing reliability while the factors remain the same will increase the sample size.
54. (c) Widening the precision range from 8% to 12% will cause a decrease in sample size.
55. (a) Increasing the estimated occurrence rate will directly increase the sample size, all other factors remaining the
same.
56. (b) Evaluation of sample results in attribute sampling does not use the estimated occurrence rate, and,
accordingly, there is no effect on sample size.
57. (b) Evaluation of sample results in attribute sampling would use the table at the same reliability level, and,
accordingly, it would remain the same.
58. (c) Compliance testing using attribute sampling techniques requires the analysis of some sort of document such
as an invoice, ledger card, etc.
59. (b) Attribute sampling is designed to test the frequency of specified characteristics that occur within a given
population.
60. (c) The best estimate of the population total and the associated precision is as follows:
Population
$1,000

Mean of the Sample

$120

Point Estimate
$120,000

With a desired precision of plus or minus $2,000 the range around the point estimate would be from $118,000 to
$122,000. The minimum acceptable value of the population would be $118,000.
61. (c) Confidence level measures the reliability of the sample and the probability that the true population
characteristic value lies within the precision interval of the sample.
62. (d) This plan enables auditors to estimate numerical quantities such as the dollar value of a population, with
prescribed precision and reliability.
63. (b) Statistical sampling is preferable to judgmental sampling in that it provides a mathematical measurement of
uncertainty.
64. (a) Material dollar errors in the financial statements are best detected by adequate substantive testing.

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65. (c) The best estimate of the population total and the associated precision is as follows:
Population
$1,000

Sample Mean
$60

Point Estimate
$60,000

With a desired precision of plus or minus $1,000, the range around the point estimate would be from $59,000 to
$61,000. The minimum acceptable value of the population would be $59,000.
66. (a) A preliminary sample suggests that the auditor is trying to determine an overall characteristic of the
population. Answers (b), (c) and (d) are specific characteristics developed during the audit.
67. (b) The tolerable error is what the CPA will accept as a material exception. The smaller the tolerable error, then
the higher the likelihood of occurrence. For example, if the auditor considers a tolerable error to be $1,000 in an
audited amount rather than $10,000, the more likely the frequency of deviation.
68. (d) The risk of incorrect acceptance is accepting a transaction as being correct when in fact it is incorrect.
Overreliance on internal control will lead the auditor to reduce the scope of the audit. These two affect the
effectiveness of the audit since they bear directly on the auditor's opinion.
69. (a) The question states that a deviation from a control procedure does not necessarily mean that there will be an
error in the account balance. Thus, answer (a) is correct because this answer fits the requirements of the question.
70. (a) As the level of audit risk (risk of an incorrect opinion) and materiality are decreased, the auditor would have
to plan to find smaller errors. This is based upon the fact that with a lower materiality level the risk of an incorrect
opinion is increased because of the probability that the number of smaller errors is greater.
71. (d) There is an inverse relationship between sample size and tolerable error. As the tolerable error is decreased
the sample size would increase because of the need to examine more items to discover smaller errors if they exist.
72. (d) Audit risk may be assessed in quantitative (i.e., 5%, 10%) or nonquantitative (i.e., high, low, moderate)
terms. At the account-balance or class-of-transactions level, audit risk consists of inherent risk, control risk and
detection risk. GAAS does not differentiate among these components of audit risk in terms of assessing the risks
quantitatively or nonquantitatively. Each of these components of audit risk can, therefore, be assessed
nonquantitatively.
73. (d) The purpose of a test of controls is to determine if the client is adequately following the prescribed controls.
The auditor assesses the maximum rate of deviations from a prescribed control that he would be willing to accept
and still rely on the control (tolerable deviation rate). The auditor then tests a sample, computes a sample deviation
rate and projects that sample result to the population. If he decides to rely on the control, he runs the risk that the
true deviation rate in the population is more than the deviation rate in the sample. In such a case, the auditor will
have overrelied on the control.
74. (c) In a test of controls, the auditor takes a sample, determines the sample deviation rate, compares this rate to
the maximum rate he can tolerate and still rely on the control, and decides whether to rely on the control or not.
When sampling, the auditor runs the risk that the sample is not representative of the population. Statistical sampling,
which in a test of controls is termed statistical sampling for attributes, can measure that risk by computing an
allowance for sampling risk. This allowance is added to the sample deviation rate to give a statistically-sound
estimate of the true population rate. If this population deviation rate exceeds the tolerable deviation rate for the
control, the auditor should not rely on the control.
75. (a) Population size has little or no effect on sample size except for very small populations. Tolerable rate and
risk of overreliance are inversely related to sample size, resulting in larger samples when these factors are set low.
The expected population deviation rate has a direct relationship with sample size, resulting in a larger sample when
this factor is set high.
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76. (b) When sampling, the auditor runs sampling risk, which is the risk that the sample is not representative of the
population. If the sample is not representative, the auditor may reach incorrect conclusions about the population.
Statistical sampling, which is based on the laws of probability, can quantitatively measure this sampling risk. This
allowance for sampling risk can then provide the auditor with an objective basis for evaluating sample results.
77. (c) The projected error is computed by determining the relationship between the error ($5,000 $2,000) and the
recorded amount ($5,000), and applying that percentage to the sampling interval. The projected error is $6,000, with
is 60% ($3,000 $5,000) of $10,000.
78. (d) Ratio estimation is used to measure the total estimated error amount in a population. This sampling method
is most appropriate when the size of the errors are proportionate to the recorded amounts. Since the auditor is
performing tests of pricing and extensions of inventory and the auditor expects numerous errors, the auditor is most
interested in estimating the total dollar error and the ratio estimation approach would be the best choice of those
listed. The mean-per-unit method is used when the auditor wants to estimate the audited value, rather than the error
amount. An unstratified approach means that the population has not been divided into groups. Stop or go sampling
is an approach in which the sample is selected in several steps, with each step conditional on the results of the
previous steps. Probability-proportional-to-size is used when the auditor believes that there are not many errors in
the population.
79. (c) In determining the nature, timing, and extent of substantive tests, the auditor considers how much detection
risk, which is the risk that he will not detect a material misstatement that exists in an assertion, he is willing to
accept. As the level of acceptable detection risk increases, which it does when the auditors assessment of inherent
risk and control risk decreases, the auditor may perform substantive tests that are less effective (nature), are
performed at other than year end (timing) and/or use smaller samples (extent). Answer (a) is incorrect because
control risk affects acceptable detection risk, not vice versa.
80. (d) There is a direct relationship between expected population deviation rate and sample size. If the auditor
expects to find more deviations from a control, he must test a larger sample. Answers (a) and (b) are factors
affecting sample size and are not affected by the expected population deviation rate. Answer (c) is an aspect of
sampling risk and has nothing to do with the expected deviation rate.
81. (d) When an auditor uses a sample to substantively test a balance, the auditor runs the risk of incorrectly
rejecting the balance. If the sample result causes the auditor to reject the balance, the auditor may perform additional
substantive tests which, if the balance was incorrectly rejected, will lead to the conclusion that the balance should be
accepted as fairly stated. The auditor performed additional, unnecessary testing because he incorrectly rejected the
balance. If the cost and effort of these extra tests is low, the auditor may be more willing to increase the risk of
incorrect rejection and possibly end up performing the extra tests. Answers (a) and (b) are incorrect because in those
situations the auditor would want to minimize sampling risk, including the risk of incorrect rejection. Answer (c)
relates to tests of controls whereas the risk of incorrect rejection relates to substantive testing.
82. (d) If an auditor wants to test the large items in a population, he may want to stratify, or divide, that population
into relatively homogeneous groups. When stratifying a population of cash disbursements, one group could be all
the balances over a certain amount (e.g., over $10,000), another group could be a range of disbursement amounts
($1,000 $10,000), and a third group could be all the disbursements below a certain amount (under $1,000). With
this stratification, the auditor could test all the disbursements in the first group and samples selected from the other
groups. Answers (a) and (b) result in larger sample sizes that may or may not include the large disbursements which
the auditor wants to test. Answer (b) would be very inefficient.
83. (d) Attribute sampling is audit sampling in which auditors look for the presence or absence of a control
condition. It is a type of sampling that reaches a conclusion about a population in terms of a rate of occurrence.
Inspecting time cards for proper approval is an example of attribute sampling because it is a test of controls
designed to determine how frequently an approval control is complied with. Answers (a), (b) and (c) are incorrect
because they are examples of variables sampling, not attribute sampling. Variables sampling is audit sampling in
which auditors are testing monetary amounts of inventory, fixed assets, accounts receivable, etc.
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84. (c) Control risk is the risk that a material misstatement that could occur in an assertion will not be prevented or
detected on a timely basis by an entity's internal control structure policies or procedures. The auditor assesses the
level of control risk to determine the acceptable level of detection risk for financial statement assertions. Detection
risk is defined as the risk that the auditor will not detect a material misstatement that exists in an assertion. The
auditor uses the acceptable level of detection risk to determine the nature, timing and extent of the auditing
procedures to be used to detect material misstatements in the financial statement assertions. Auditing procedures
designed to detect such misstatements are referred to as substantive tests, which include tests of details and
analytical procedures. If certain control procedures are ineffective, the auditor will increase the assessed level of
control risk, decrease the acceptable detection risk, and increase substantive tests of details. Answer (a) is incorrect
because if a control is found to be ineffective, the auditor would increase substantive tests, not tests of controls.
Answer (b) is incorrect because the level of acceptable detection risk would decrease, not increase. Answer (d) is
incorrect because inherent risk, which is defined as the susceptibility of an assertion to a material misstatement
assuming there are no related internal control structure policies or procedures, is independent of control risk and
would not change with a change in assessed control risk.
85. (d) According to the audit risk model, acceptable detection risk is a function of allowable audit risk, inherent
risk, and control risk. This question is concerned with control risk, which is defined as the risk that a material
misstatement that could occur in an assertion will not be prevented or detected on a timely basis by an entity's
internal control structure policies or procedures, and detection risk, which is defined as the risk that the auditor will
not detect a material misstatement that exists in an assertion. The auditor uses the assessed level of control risk to
determine the acceptable level of detection risk for financial statement assertions. Answer (a) is incorrect because
the auditor's assessment of control risk reflects his or her evaluation of the effectiveness of the entity's internal
control structure policies and procedures. Answer (b) is incorrect because inherent risk assessment is independent
from control risk assessment. Answer (c) is incorrect because materiality levels are based on factors other than
assessed control risk.
86. (c) Incorrect rejection occurs when the auditor concludes, based on a sample, that a recorded account balance is
materially misstated when it is not materially misstated. As a result, the auditor rejects an acceptable balance.
Answers (a) and (b) refer to risks associated with tests of controls, not substantive tests of details. Answer (d) refers
to incorrect acceptance, which occurs when the auditor concludes, based on a sample, that a recorded account
balance is not materially misstated when it is, resulting in the auditor accepting an incorrect balance.
87. (d) In determining sample size for a test of controls, the auditor will consider the expected population deviation
rate and tolerable rate. If, based on prior experience with the client or a preliminary sample, the auditor expects to
find few deviations from a control, the expected population deviation rate would be low and sample size would be
small. Thus, there is a direct relationship between the expected population deviation rate and sample size, not an
inverse relationship. The tolerable rate is the maximum rate of deviation from a prescribed control that an auditor is
willing to accept without altering the planned reliance on internal control. If the auditor can tolerate a higher rate,
he or she will test a smaller sample. Thus, tolerable rate varies inversely with sample size. Answers (a) and (c) are
incorrect because sample size does not vary inversely with the expected population deviation rate. Answer (b) is
incorrect because sample size does vary inversely with tolerable rate.
88. (c) AU 312 states that inherent risk and control risk differ from detection risk in that they exist independently of
the audit, whereas detection risk relates to the auditor' s procedures and can be changed at his or her discretion.
Detection risk should have an inverse relationship to inherent and control risk. The less the inherent and control risk
the auditor believes exists, the greater the acceptable level of detection risk. Conversely, when the inherent and
control risk increase, the auditor must decrease the detection risk. These components of audit risk may be assessed
in quantitative terms such as percentages or in non-quantitative terms such as a minimum to a maximum.
89. (d) AU 312 states that the existence of audit risk is recognized by the statement in the auditor's standard report
that the auditor obtained reasonable assurance about whether the financial statements are free of material
misstatement. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on
financial statements that are materially misstated. Choice (a) is incorrect because the sentence in the opinion is a
division of responsibilities between management and auditor. Choice (b) is incorrect because that portion of the
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report is supporting the opinion rendered. Choice (c) is incorrect because the statement explains that due to timing
and cost constraints the auditor has to audit less than all evidence available through the use of statistical sampling.
90. (b) AU 350 states that in assessing the tolerable rate of deviations, the auditor should consider that, while
deviations from pertinent control structure policies or procedures increase the risk of material misstatements in the
accounting records, such deviations do not necessarily result in misstatements. For example, a recorded
disbursement that does not show evidence of required approval may nevertheless be a transaction that is properly
authorized and recorded. Deviations would result in misstatements in the accounting records only if the deviations
and the misstatements occurred on the same transactions. Deviations from pertinent control procedures at a given
rate ordinarily would be expected to result in misstatements at a lower rate. Choice (a) is incorrect because
population size has no effect on sample size when testing for compliance, unless the population is really small.
Choice (c) is incorrect because there is a direct relationship between expected population and sample size. Choice
(d) is incorrect because the tolerable rate is the maximum rate of deviation the auditor is willing to accept without
changing his level of risk.
91. (c) Variables sampling estimates numerical measures of a population, such as the quantity of units or a dollar
value. Choice (a) is incorrect because attributes sampling is used when testing internal control and estimates the
percentage of items in the population that possess a desired attribute, not a dollar value. Choice (b) is incorrect
because stop-or-go sampling continues to select additional sample items until a desired level of assurance has been
obtained. Choice (d) is incorrect because random-number sampling is a technique used to select items and assure
that each population item has an equal chance of being selected for the sample.
92. (b) An auditor would normally select 100% of unusually large cash disbursements and a lower percentage of
smaller cash disbursements because the larger disbursements are more material to the financial statements. Stratified
sampling divides the population into strata, or groups of transactions that possess the same characteristics. The
auditor would select 100% of the items in the category that includes the unusually large disbursements and a smaller
percentage of the other categories. Choice (a) is incorrect because rate of deviation relates to tests of controls and
not substantive tests. Choice (c) is incorrect because the auditor selects the sample so that 100 % of the larger
disbursements are selected. You cant increase more than 100%. Choice (d) is incorrect because you dont continue
to draw new samples since you already have 100%.
93. (b) AU 350 states that when planning a particular sample for a substantive test of details, the auditor should
consider how much monetary misstatement in the account may exist without causing the financial statements to be
materially misstated, as well as the expected size and frequency of misstatements. The factors influencing sample
sizes for a substantive test of details in sample planning include:
Factor:

Conditions leading to
Smaller Sample Size

Conditions leading to
Larger Sample Size

Measure of tolerable
misstatement for an account

Larger measure of
tolerable misstatement

Smaller measure of.

tolerable misstatement

Expected size and

frequency of misstatements

Smaller misstatements
or lower frequency

Larger misstatements
or higher frequency

94. (c) Audit risk may be assessed in quantitative (i.e., 5%, 10%) or nonquantitative (i.e., high, low, moderate)
terms. At the account-balance or class-of-transactions level, audit risk consists of control risk, detection risk, and
inherent risk. GAAS does not differentiate among these components of audit risk in terms of assessing the risks
quantitatively or nonquantitatively. Each of these components of audit risk can, therefore, be assessed
nonquantitatively.

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95. (d) The purpose of a test of controls is to determine if the client is adequately following the prescribed controls.
Before testing the controls, the auditor determines the tolerable deviation rate, which is the maximum rate of
deviations from a prescribed control that he or she would be willing to accept and still rely on the control. The
auditor then tests a sample, computes a sample deviation rate and projects that result to the population. If the auditor
decides to rely on the control, he or she runs the risk that the true deviation rate in the population is more than the
deviation rate in the sample. When this happens, the auditor will overrely on the control, assess control risk too low,
and decrease substantive testing. Answers (a) and (c) are incorrect because deviation rates are independent of and
not compared to the risk of assessing control risk too low. Answer (b) is the incorrect, opposite conclusion.
96. (a) To determine the number of items to be selected for a particular sample for a test of controls, the auditor
should consider the tolerable rate of deviation from the control structure policies or procedures being tested, the
likely rate of deviations, and the allowable risk of assessing control risk too low. An auditor applies professional
judgment to relate these factors in determining the appropriate sample size. Answer (b) relates to substantive tests,
not to tests of controls. Answer (c) is considered by the auditor in evaluating the sample results, not in determining
the sample size. Answer (d) has very little effect on the determination of sample size.
97. (d) When sampling, the auditor runs sampling risk, which is the risk that the sample is not representative of the
population. If the sample is not representative, the auditor may reach incorrect conclusions about the population.
Statistical sampling, which is based on the laws of probability, can quantitatively measure the sampling risk. This
allowance for sampling risk can then provide the auditor with an objective basis for evaluating sample results.
Answer (a) is incorrect because samples used for the dual purposes of assessing control risk and substantiating
monetary amounts can be statistically or nonstatistically based. Answer (b) is incorrect because factors that affect
sample size, such as the tolerable deviation rate and acceptable risk of assessing control risk too low, involve
judgment. Answer (c) is incorrect because although statistical sampling helps the auditor evaluate sample results,
the extent of assurance provided by a sample does not differ if done statistically or nonstatistically.
98. (b) A sampling unit is any of the individual elements, as defined by the auditor, that constitute the population. In
the case of accounts receivable, each customer's account balance could be defined as the sampling unit. If
confirming these balances is inefficient because of the time needed to resolve differences, the auditor could decide
to define the sampling unit as a smaller part of the population, such as individual invoices. The auditor can then
confirm and test invoices rather than balances. Because answers (a), (c) and (d) are account balances, choosing any
of them as the sampling unit would not eliminate the difficulties that were encountered.
99. (b) If a population is highly variable or spread out, such as would be the case when individual accounts
receivable balances range from $10 to $1,000,000, the auditor would have to select many items to get a
representative sample. To reduce the total sample size and thus be more efficient, the auditor may decide to stratify
a population that has highly variable recorded amounts by dividing it into subpopulations, such as $1 to $1,000,
$1,001 to $10,000, and over $10,000. Answer (a) is incorrect because PPS sampling automatically stratifies the
population by selecting all amounts greater than the sampling interval. Answer (c) is incorrect because estimated
tolerable misstatement has nothing to do with sample selection techniques. Answer (d) is incorrect because a
population with a small standard deviation, which occurs when the population is not highly variable, does not need
to be stratified.
100. (a) Ratio estimation is a sampling technique that is appropriate when auditors want to estimate a population
value based on the ratio of audited amounts and recorded amounts. Therefore, the technique can be used most
effectively when the calculated audit amounts are approximately proportional to the client-furnished book amounts.
Answer (b) is incorrect because if a small number of differences exist in the population a larger sample may be
needed to ensure that the sample is representative of the population, thereby erasing the benefits of ratio estimation.
Answer (c) is incorrect because ratio estimation is used to estimate book values. Answer (d) is incorrect because
when using ratio estimation, the amount and direction of the differences can vary as long as the ratios of audited to
book amounts are fairly consistent.

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101. (c) The purpose of a test of controls is to determine if the client is adequately following the prescribed controls.
Before testing the controls, the auditor determines the tolerable deviation rate, which is the maximum rate of
deviation from a prescribed control that the auditor is willing to accept at a given level of control risk. For example,
if the auditor plans to assess control risk as low, the auditor would only tolerate a low rate of deviation from that
control. After setting the tolerable deviation rate, the auditor then tests a sample, computes a sample deviation rate
and projects that rate to the population. In projecting the sample result to the population, the auditor is concerned
with the maximum deviation rate that could exist in the population. If the maximum deviation rate is less than the
tolerable deviation rate, the auditor will assess control risk at the level that was originally planned. If the true
population deviation rate (which is unknown since the auditor only tests a sample) is greater than the tolerable
deviation rate, as depicted in situations III and IV, the auditor should assess control risk higher than originally
planned. In situation III, based on the sample, which was not representative of the population, the auditor assessed
control risk lower than he should have. As a result of assessing control risk too low, the auditor will perform less
substantive testing. Answers (a) and (d) are incorrect because in situations I and IV the auditor's estimate based on
the sample results was the same as the result that would have been obtained by testing the entire population. Answer
(b) is incorrect because in situation II the auditor would assess control risk too high, not too low.
102. (d) When sampling, the auditor runs the risk that the sample is unrepresentative of the population. As a result,
the auditor may reach the wrong conclusion. When the auditor performs substantive tests, he runs the risk of
incorrect acceptance, which is the risk of accepting a balance as fairly stated when, in fact, the balance is not fairly
stated. When the auditor performs tests of controls, he runs the risk of assessing control risk too low, which is the
risk of deciding, based on the sample, that the controls are operating effectively when, in fact, they are not. These
risks relate to the effectiveness of the audit because these erroneous conclusions, based on sampling, could cause the
auditor to issue the wrong audit opinion and therefore be ineffective. Answers (a) and (b) are incorrect because
allowable risk of tolerable misstatement and estimated materiality levels, which relate to the auditor's judgments
about how much risk he is willing to take that the financial statements are materially misstated, are judgments the
auditor makes in planning a sample. The risk of incorrect acceptance and the risk of assessing control risk too low
are related to evaluating the results of a sample. Answer (c) is incorrect because it refers to efficiency of the audit,
which is related to the sampling risk of incorrect rejection, which occurs when the sample results cause the auditor
to reject a balance when it is fairly stated, and the risk of assessing control risk too high, which occurs when the
auditor's sample results cause the auditor to assess control risk higher than it really is. As a result, the auditor is
inefficient because he performs additional unnecessary testing.
103. (d) In a test of controls, the auditor takes a sample, determines the sample deviation rate, compares this rate to
the maximum rate he can tolerate and still rely on the control, and decides whether to rely on the control as planned
or not. When sampling, the auditor runs the risk that the sample is not representative of the population. Statistical
sampling, which in a test of controls is termed statistical sampling for attributes, can measure that risk by computing
an allowance for sampling risk. This allowance is added to the sample deviation rate to compute a statistical
estimate of the maximum population deviation rate, based on that sample result. If this population deviation rate
exceeds the tolerable deviation rate for the control, the auditor should reduce the planned reliance on the control.
Answers (a) and (c) are incorrect because if the sample deviation rate plus the allowance for sampling risk is less
than or equal to the tolerable deviation rate, the test results support the auditor's planned reliance on the control.
Answer (b) is incorrect because the expected rate of deviation is used to determine sample size, not to evaluate the
results of a sample.
104. (d) When evaluating the qualitative aspects of deviations discovered in tests of controls, the auditor should
consider the nature and cause of the deviations and the possible relationship of the deviations to other phases of the
audit. The discovery of an irregularity, such as a forged document, ordinarily requires a broader consideration of
possible implications than does the discovery of an error. Answer (a) is incorrect because the discovery of only one
error would not typically give rise to additional concern. Answer (b) is incorrect because an error recurring in a
subsequent year would not be uncommon. Answer (c) is an unintentional error that would cause less concern than
an intentional irregularity.

6S-11

105. (a) To determine the number of items to be selected for a particular sample for a test of controls, the auditor
should consider the tolerable rate of deviation from the control structure policies or procedures being tested, the
expected rate of deviations, and the allowable risk of assessing control risk too low. An auditor uses professional
judgment to relate these factors in determining the appropriate sample size. Answers (b), (c) and (d) are incorrect
because the expected deviation rate and the tolerable deviation rate are considered in determining sample size.
106. (c) If the auditor can tolerate a larger misstatement in an account, the auditor would need less assurance from a
sample that the account is fairly stated in all material respects; thus, sample size would decrease. If the auditor
assesses a higher control risk, there is a greater likelihood that accounts are misstated. As a result, the extent of
substantive testing, and thus sample sizes in substantive tests, will increase. Answers (a), (b) and (d) are incorrect
because an increase in tolerable misstatement results in a decrease in sample size, and an increase in assessed level
of control risk results in an increase in sample size.
107. (c) When sampling, the auditor runs sampling risk, which is the risk that the sample is not representative of the
population. If the sample is not representative, the auditor may reach incorrect conclusions about the population. By
using statistical theory, which is based on the laws of probability, the auditor can quantify sampling risk to assist
himself in limiting it to a level he considers acceptable. Statistical sampling thus helps the auditor to design an
efficient sample, to measure the sufficiency of the evidential matter obtained, and to evaluate the sample results.
Answer (a) is incorrect because the risk of nonsampling errors exists in all sampling plans, whether statistical or not.
Answer (b) is incorrect because the level of audit risk and materiality are auditor judgments that are made whether
or not the sampling is statistical. Answer (d) is incorrect because the failure to detect errors and irregularities, which
is referred to as detection risk, exists in statistical and nonstatistical sampling.

6S-12

Chapter Six - Solutions to Problems

The Audit Sampling Process
NUMBER 1
a.

The auditor's justification for accepting the uncertainties that are inherent in the sampling process are based
upon the premise that the
Cost of examining all of the financial data would usually outweigh the benefit of the added reliability of a
complete (100%) examination.
Time required to examine all of the financial data would usually preclude issuance of a timely auditor's
report.

b. The uncertainties inherent in applying auditing procedures are collectively referred to as ultimate audit risk.
Ultimate audit risk, with respect to a particular account balance or class of transactions, is the risk that there is a
monetary error greater than tolerable error in the balance or class that the auditor fails to detect. Ultimate audit
risk is a combination of three types of risks as follows:
Inherent risk is the risk that errors will occur in the accounting system.
Control risk is the risk that material errors will not be detected by the client's system of internal accounting
control.
Detection risk is the risk that any material errors that occur will not be detected by the auditor.
Ultimate audit risk includes both uncertainties due to sampling and uncertainties due to factors other than
sampling. These aspects of ultimate audit risk are referred to as sampling risk and nonsampling risk,
respectively.
c.

Sampling risk arises from the possibility that, when a compliance or a substantive test is restricted to a sample,
the auditor's conclusions may be different from the conclusions that might be reached if the test were applied in
the same way to all items in the account balance or class of transactions. That is, a particular sample may
contain proportionately more or less monetary errors or compliance deviations than exist in the balance or class
as a whole.
Nonsampling risk includes all the aspects of ultimate audit risk that are not due to sampling. An auditor may
apply a procedure to all transactions or balances and still fail to detect a material misstatement or a material
internal accounting control weakness. Nonsampling risk includes the possibility of selecting audit procedures
that are not appropriate to achieve the specific objective, or failing to recognize errors in documents examined,
which would render the procedure ineffective even if all items were examined. The auditor should apply
professional judgment in assessing sampling risk. In performing substantive tests of details the auditor is
concerned with two aspects of sampling risk:
The risk of incorrect acceptance is the risk that the sample supports the conclusion that the recorded
account balance is not materially misstated when it is materially misstated.
The risk of incorrect rejection is the risk that the sample supports the conclusion that the recorded account
balance is not materially misstated when it is materially misstated.
The auditor is also concerned with two aspects of sampling risk in performing compliance tests of internal
accounting control:
The risk of overreliance of internal accounting control is the risk that the sample supports the auditor's
planned degree of reliance on the control when the true compliance rate does not justify such reliance.
The risk of underreliance on internal accounting control is the risk that the sample does not support the
auditor's planned degree of reliance on the control when the true compliance rate supports such reliance.

6S-13

The risk of incorrect acceptance and the risk of overreliance on internal accounting control relate to the
effectiveness of an audit in detecting an existing material misstatement. The risk of incorrect rejection and the
risk of underreliance on internal accounting control relate to the efficiency of the audit.

NUMBER 2
a.

The advantages of PPS sampling over classical variables sampling are as follows:
PPS sampling is generally easier to use than classical variables sampling.
Size of a PPS sample is not based on the estimated variation of audited amounts.
PPS sampling automatically results in a stratified sample.
Individually significant items are automatically identified.
If no errors are expected, PPS sampling will usually result in a smaller sample size than classical variables
sampling.
A PPS sample can be easily designed and sample selection can begin before the complete population is
available.

b.
Sampling Interval

Sample Size

c.
1st error
2nd error
3rd error
Total Projected Error

Tolerable Error
Reliability Factor for Errors of Overstatement

$15,000
$ 3.00

$5,000

Recorded Amount
Sampling Interval

$300,000
$5,000

60

Recorded
Amount
$ 400
500
3,000

Audit
Amount
$ 320
0
2,500

Tainting
20%
100%
*

Sampling
Interval
$1,000
1,000
1,000

Projected
Error
$ 200
1,000
500
$1,700

*The recorded amount is greater than the sampling interval; therefore, the projected error equals the actual error.

6S-14

NUMBER 3
a.

Reliability and precision are statistical terms that are interdependent and inseparable. Precision is expressed as a
range of values, plus or minus, around the sample result, and "reliability," or confidence, is expressed as the
proportion of such ranges from all possible similar samples of the same size that would include the actual
population value. Stated in another way, precision expresses the range or limits within which the sample result
is expected to be accurate, while reliability expresses the mathematical probability of achieving that degree of
accuracy.
The terms are usefully adapted to the auditor's purposes by relating precision to materiality and reliability to the
reasonableness of the basis for the auditor's opinion.

b.
(1) At the 95% confidence level the auditor can be assured that the estimated population total is not in error by
more than or less than $39,200.
P = N R SE

200
200
P = 1,000 1.96
= 1,000 1.96
= 1,000 1.96 20 = $39,200
100
10

(2) The auditor can be 91.988% confident that the estimated population total is not in error by more or less than
$35,000.
P = N R SE
$35,000
P
R =
=
= 1.75
N E
1,000 20

R = 91.988%

c.
(1) The estimated population total, or point estimate, based on the preliminary sample data would be equal to the
arithmetic mean multiplied by the number of items in the population or $4,000 1,000 = $4,000,000.
(2) If the original sample is sufficient, the auditor would be willing to accept an accounts receivable balance that is
within plus or minus $35,000 from this amount. The auditor would be willing to accept an accounts receivable
balance anywhere between $3,965,000 ($4,000,000 $35,000) and $4,035,000 ($4,000,000 + $35,000). If the
client's accounts receivable balance is not within this range, the auditor could not accept the client's balance
based on the work performed on the preliminary sample items. The auditor would likely extend the sample by
selecting additional items until the recorded amount fell within the precision limits. The additional sample items
would have to change the sample mean by an amount sufficient enough to make the point estimate acceptable.

6S-15

NUMBER 4
a.

The remaining steps are as follows:

4.
5.
6.
7.
8.
9.
10.
11.
12.
13.

Define the attributes (characteristics) of interest to be tested (including the criteria for establishing the
existence of errors or deviant conditions).
Set the maximum rate of deviations from a prescribed control procedure that would support the planned
reliance on the control (tolerable rate).
Select a confidence level (quantify the risk of over-reliance).
Estimate the population error rate (deviation rate).
Determine the sample size.
Choose a method for randomly selecting a sample.
Perform the compliance audit procedures.
Perform error analysis (calculate the deviation rate and consider the qualitative aspects of the deviations).
Interpret sample results (calculate a population deviation rate).
Decide on the acceptability of the results of the sample.

b. Statistical sampling methodology helps the auditor (1) to design an efficient sample, (2) to measure the
sufficiency of the evidential matter obtained, and (3) to evaluate the sample results. By using a statistical
sampling methodology, the auditor can quantify sampling risk to assist in limiting it to an acceptable level.

NUMBER 5
The remaining steps are as follows:
6.
7.
8.

9.
10.
11.
12.
13.

Treat the individually significant items as a separate population.

Choose an audit sampling technique.
Determine the sample size, giving consideration for -a. Variations within the population.
b. Acceptable level of risk.
c. Tolerable error.
d. Expected amount of error.
e. Population size.
Determine the method of selecting a representative sample.
Select the sample items.
Apply appropriate audit procedures to the sample items.
Evaluate the sample results.
a. Project the error to the population and consider sampling risk.
b. Consider the qualitative aspects of errors and reach an overall conclusion.
Document the sampling procedure.

6S-16

NUMBER 6
a.

1.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the auditor's opinion on
financial statements that are materially misstated.

2.

Inherent risk is the susceptibility of an account balance or class of transactions to error that could be
material, when aggregated with error in other balances or classes, assuming that there were no related
internal accounting controls.
Control risk is the risk that error that could occur in an account balance or class of transactions and that
could be material, when aggregated with error in other balances or classes, will not be prevented or
detected on a timely basis by the system of internal accounting control.
Detection risk is the risk that an auditor's procedures will lead the auditor to conclude that error in an
account balance or class of transactions that could be material, when aggregated with error in other
balances or classes, does not exist when in fact such error does exist.

3.

Inherent risk and control risk differ from detection risk in that they exist independently of the audit of
financial statements, whereas detection risk relates to the auditor's procedures and can be changed at the
auditor's discretion. Detection risk should bear an inverse relationship to inherent and control risk. The less
the inherent and control risk the auditor believes exists, the greater the acceptable detection risk.
Conversely, the greater the inherent and control risk the auditor believes exists, the less the acceptable
detection risk.

b. 1.

Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of
surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the omission or misstatement. This concept
recognizes that some matters, either individually or in the aggregate, are important for the fair presentation
of financial statements in conformity with generally accepted accounting principles, while other matters are
not important.

2.

Materiality is affected by the nature and amount of an item in relation to the nature and amount of items in
the financial statements under examination, and the auditor's judgment as influenced by the auditor's
perception of the needs of a reasonable person who will rely on the financial statements.

3.

The auditor's judgment about materiality for planning purposes is ordinarily different from materiality for
evaluation purposes because the auditor, when planning an audit, cannot anticipate all of the circumstances
that may ultimately influence judgment about materiality in evaluating the audit findings at the completion
of the audit. If significantly lower materiality levels become appropriate in evaluating the audit findings,
the auditor should reevaluate the sufficiency of the audit procedures already performed.

NUMBER 7
a.

1.
2.
3.

In determining an acceptable level of risk of overreliance, an auditor should consider the importance of the
control to be tested in determining the extent to which substantive tests will be restricted and the planned
degree of reliance on that control.
In determining the tolerable deviation rate, an auditor should consider the planned degree of reliance on the
control to be tested and how materially the financial statements would be affected if the control does not
function properly. For example, how likely is the control to prevent or detect material errors.
In determining the expected population deviation rate, an auditor should consider the results of prior years'
tests, the overall control environment, or utilize a preliminary sample.

6S-17

b. 1.
2.
3.
c.

There is a decrease in sample size if the acceptable level of risk of overreliance is increased.
There is a decrease in sample size if the tolerable deviation rate is increased.
There is an increase in sample size if the population deviation rate is increased.

For a low risk of overreliance it is generally appropriate to reconsider the planned reliance as the calculated
estimate of the population deviation rate identified in the sample (7%) approaches the tolerable deviation rate
(8%). This is because there may be an unacceptably high sampling risk that these sample results could have
occurred with an actual population deviation rate higher than the tolerable deviation rate.

d. If statistical sampling is used, an allowance for sampling risk can be calculated. If the calculated estimate of the
population deviation rate plus the allowance for sampling risk is greater than the tolerable deviation rate, the
sample results should be interpreted as not supporting the planned reliance on the control.

NUMBER 8
1.
2.

Statistical sampling does not eliminate the need for professional judgment.
The tolerable rate of deviation or acceptable upper precision limit (UPL) is too high (20%) if Baker plans to
assess control risk at a low level (substantial reliance).
3. Discovery sampling is not an appropriate sampling technique in this attribute sampling application.
4. The sampling technique employed is not discovery sampling.
5. The increase in the population size has little or no effect on determining sample size.
6. Baker failed to consider the allowable risk of assessing control risk too low (risk of overreliance) in
determining the sample size.
7. The population from which the sample was chosen (invoices) was an incorrect population.
8. The sample selected was not randomly selected.
9. Baker failed to consider the difference of an immaterial amount to be an error.
10. The allowance for sampling risk was incorrectly calculated.
11. Baker's reasoning concerning the decision that the sample supported a low assessed level of control risk was
erroneous.

6S-18

Chapter Seven
Auditing with Technology
AUDITOR RESPONSIBILITIES / METHODOLOGY
INTERNAL CONTROLS
I.

RESPONSIBILITIES
A. Gain sufficient understanding of the Internal Control Elements (refer to Chapter 1 for a complete
discussion of this responsibility) to plan the audit and determine the nature, timing, and extent of tests to be
performed.
B. Assess Control Risk.
C. Communicate reportable conditions and internal control weaknesses to appropriate level of management.

II. METHODOLOGY
START
Gain sufficient
understanding
(1)

(1) Planning Phase of the Review

Purpose
Understand accounting system including both EDP and non-EDP segments:
Flow of transactions and significance of output.
Extent to which EDP is used in significant accounting applications.
Basic structure of accounting control, including both EDP and user controls.
Methods
Inquiry and discussion; observation; review of documentation; tracing of
transactions; control questionnaires and checklists.

Document
understanding
(2)

(2) Document Understanding

Purpose
Exhibit compliance with GAAS.
Point of reference for Audit staff.

(3) Assess Control risk

Purpose
Determine need for further understanding of Internal Control.
Method
Judgment.

Assess Control
Risk
(3)

Control
Risk at
Maximum

Yes

Designed Substantive tests without reliance on controls.

NO
Completion of
Review -General Controls
(4)

(4) Completion of ReviewGeneral Controls

Purpose
Identify general controls on which reliance is planned and determine how
they operate.
Determine the effect of strengths and weaknesses on application controls.
Consider tests of controls that may be performed.
Methods
Detailed examination of documentation; interviewing internal auditors, EDP
and user department personnel; observing operation of general controls.

(Continued Next Page)

7-1

(5) Completion of ReviewApplication Controls

Completion of
Review -Application Controls
(5)

Purpose
Identify application controls on which reliance is planned, and determine how
the controls operate.
Consider tests of controls that may be performed.
Consider the potential effect of identified strengths and weaknesses on tests of
controls.
Methods
Detailed examination of documentation; interviewing internal auditors, EDP,
and user department personnel; observing operation of application controls.

(6) Completion of ReviewPreliminary Evaluation

Purpose
For each significant accounting application
Consider the types of errors or irregularities that could occur.
Determine the accounting control procedures that prevent or detect such errors
and irregularities.
Assess effectiveness of EDP and non-EDP accounting controls.
Method
Judgment.

Completion of
Review -Assessment
(6)

(7) Tests of Controls

Purpose
Determine whether the necessary control procedures are prescribed and
followed satisfactorily.
Provide reasonable assurance that controls are functioning properly.
Consider and, to the extent appropriate, document when, how, and by whom
controls are provided.
Methods
Examination of records; test of control procedures; inquiry; observation.

Tests of Controls
(7)

Assess Control Risk

(8)

Control
risk at
maximum
NO
YES
Document and design
substantive tests without reliance
on controls

(8) Assess Control Risk

Purpose
For each significant accounting application
Consider the types of errors or irregularities that could occur.
Determine the accounting control procedures that prevent or detect such errors
and irregularities.
Determine whether the necessary control procedures are prescribed and
followed satisfactorily.
Evaluate weaknesses and assess their effect on the nature, timing, and extent of
auditing procedures to be applied.
Method
Judgment.

Document and design

substantive tests giving
consideration to reliance
on controls
END

7-2

ELECTRONIC COMMERCE
I.
II.

III.

IV.

In general, electronic commerce includes individuals, businesses and other organizations involved in
various transactions involving communication via computers.
Risks
A. Confidentiality of information.
B. Transaction Integrity Proper controls must be in place to ensure that transactions cannot be
changed, altered, duplicated or incorrectly processed.
Types of Transactions
A. Electronic funds transfers (i.e., online banking)
B. Electronic Data Interchange
1. Business transactions accomplished between one entity and another through electronic
communications networks.
2. Traditional paper transactions are replaced by electronic transactions, thereby obscuring audit
trails.
3. Communication Methods
Point to Point: Direct privately managed system linking two or more computers. The major
advantages of such a network include access control and no reliance on third parties for
communication.
Public Networks (i.e., internet): The major advantages include cost of developing dedicated
networks and widespread use. The major disadvantages are risks associated with
confidentiality, hackers, and viruses.
Benefits and Risks of Using EDI
A. Benefits
1. Speed
2. Cost savings
3. Reduced paperwork
4. Ability to remain competitive
5. Efficient communication
B. Risks
1. Security of information
2. Concentration of control
3. Loss of flexibility

Computer-Assisted Audit Techniques (CAAT)

The use of computer audit programs is probably advisable when the auditor needs an efficient means of analyzing
large masses of machine-readable data and of selecting those items which require review.
Three different methods for using computer programs for the evaluation of client machine-readable records are as
follows:
1.

Client programs tested by the auditor and run under his/her control to produce the analysis needed.

2.

Generalized computer audit routines.

3.

Special audit routines prepared under the supervision of the auditor and run under his/her control.

The use of these computer audit routines must be considered in the context of the economic advisability of a
computer approach versus that of alternative methods. The use of generalized computer audit routines is probably
the least expensive of the computer alternatives; the use of a tested, controlled client program is more expensive and
the use of a routine written especially for an audit is the most expensive.

7-3

Substantive
Audit Techniques
Using Computer
Custom Designed
Audit Software

Advantage

Custom
Nature

Generalized Audit
Software
Mathematical
operations

Disadvantage

Data output
a. confirms
b. workpapers

High cost

Statistical
sampling
Comparison
of files
Using the Computer as an Audit Tool

The auditor may use the computer as a "tool" in the audit process. The computer may be used to:
1.
2.
3.
4.
5.
6.
7.
8.

Select data for testing.

Compare source document data to data recorded in computer files.
Recompute or compute data.
Prepare confirmations.
Select accounts to be confirmed from a population based upon the auditor's predetermined criteria.
Test account distributions.
Analyze accounts and print out schedules.
Examine populations to extract items exceeding certain limits.

7-4

Using Microcomputers in Audits

The potential benefits to an auditor of using microcomputer software in an audit as compared to performing an audit
without the use of a computer include the following:
1. Time may be saved by eliminating manual footing, cross-footing, and other routine calculations.
2. Calculations, comparison, and other data manipulations are more accurately performed.
3. Analytical procedures calculations may be more efficiently performed.
4. The scope of analytical procedures may be broadened.
5. Audit sampling may be facilitated.
6. Potential conditions in a clients internal control system may be more readily identified.
7. Preparation and revision of flowcharts depicting the flow of financial transactions in a clients system may be
facilitated.
8. Working papers may be easily stored and accessed.
9. Graphics capabilities may allow the auditor to generate, display, and evaluate various financial and nonfinancial
relationships graphically.
10.Engagement-management information such as time budgets and the monitoring of actual time vs. budgeted
amounts may be more easily generated and analyzed.
11. Customized working papers may be developed with greater ease.
12. Standardized audit correspondence such as engagement letters, client representation letters, and attorney leters
may be stored and easily modified.
13. Supervisory-review time may be reduced.
14. Staff morale and productivity may be improved by reducing the time spent on clerical tasks.
15. Clients personnel may not need to manually prepare as many schedules and otherwise spend as much time
assisting the auditor.
16. Computer-generated working papers are generally more legible and consistent.

Computer Audit Tools

Generalized audit software Developed to perform many tasks, including the testing of transactions
and controls, sampling, data selection, and analytical procedures.
Automated workpaper software Designed to generate a trial balance, lead schedules, and other
reports useful for the auditor. The schedules and reports can be created once the auditor has either
manually entered or electronically imported through using the clients account balance information
into the system.
Database management systems Manages the creation, maintenance, and processing of information.
The data are organized in the form of predefined records, and the database software is used to select,
update, sort, display, or print the records.
Text retrieval systems Allow the user to view any text that is available in an electronic format. The
software programs allow the user to browse through text files much as a user would browse through
books.
Public databases May be used to obtain accounting information related to particular companies and
industries.
Word processing software Considered an audit-assist function.
Electronic spreadsheets Contain a variety of predefined mathematical operations and functions that
can be applied to data entered into the cells of a spreadsheet.

AUDITING A COMPUTER SYSTEM WITHOUT USING THE COMPUTER

This audit approach to a computer-based system is as follows:
1.
2.

Evaluation of internal control, involving (a) review of the system to ascertain how it is purported to work and
what controls should be operable, and (b) tests of systems to accumulate evidence of how system actually does
work.
Evaluation of computer-prepared records.

7-5

A system which performs relatively uncomplicated processing and produces detailed output can be audited without
examination or direct testing of the computer program. The computer processing system is tested indirectly by
tracing transactions and examining error and control lists. The auditor views the computer program as a black box;
that is, an unknown which can be understood by inferring what must take place in order for a known input to result
in a known output. (See diagram below.) The records produced by the computer are evaluated by comparison with
source documents, by outside confirmations, or by similar tests which do not depend on the program. All computer
records to be used must be available in printout form (or at least capable of being printed out at the auditor's
request). The tests also furnish additional evidence on the processing which has taken place.
Known
Input

Processing

Known
Output

The computer program as a black box.

Auditing by testing the input and output instead of the program itself does not detect program errors which do not
show up in the output sampled. An erroneous input transaction rejected by the program (as shown by the error
listing) is evidence that a control to detect such an error is present in the program, but missing controls are not
revealed. However, the auditor can rely upon procedural and output controls to detect many errors even if some
program controls are missing. Batch totals or ledger controls are examples.
An audit which does not use the computer is implemented by the following general steps:
AUDIT APPROACH

IMPLEMENTATION

Review of system

Interviews with personnel in data processing.

Use of questionnaire.
Examination of general system description.
General review of major controls.
Review of controls for each application vital to the audit.
Examination of evidence for controls (error listings, batch control
records, authorizations, etc.).
Use of printouts to trace items in output to source documents, source
documents to reports, report totals to controls, etc.
Checking of transaction sample for correct processing.
Other typical tests.
Tests to check correctness of summary accounts (foot, crossfoot, etc.).
Tests of samples of detail items by confirmation, reasonableness
tests, etc.

Tests of systems

Evaluation of records

The system review is not limited to the electronic data processing portion. The work steps and procedures for an
application are traced through the entire processing systemmanual, electromechanical and computerand
through all departments involved. Thus, the specific controls for an application are considered within the framework
of general controls imposed by the organization and management of the business.
In the area of computer data processing, an application is reviewed for:
1.
2.
3.
4.

Adequacy of control over input and output.

Adequacy of control over processing.
Adequacy of control over programs and files.
Adequacy of audit trail.

These data processing controls are evaluated within the framework of controls established by the organization and
management of the data processing department.

7-6

When to Audit Without Using the Computer

The data processing systems which may be audited without the use of the computer are usually batch-processed or
batch-controlled systems having detailed audit trails. This type of system is characterized by:
1.
2.
3.

The collection of transactions in batches, to be sorted and processed sequentially against a master file (this
process normally involves the development of batch totals to control the movement of data within the system).
The recording of transactions manually, followed by conversion to machine-readable form.
The production of numerous printouts (often at each processing run).

The feasibility of auditing the processing without testing the program directly depends on the auditor's being able to
obtain evidence about the quality of processing by means of tests on the input and output, sample computations,
tests of the controls, etc. Complicating conditions which obscure or impair the auditor's ability to obtain such
evidence may include the following:
1.
2.
3.

Processing may result in a summarized end-product output, so that individual items are not identifiable by
manual means. A knowledge of the computer program is then necessary for tracing items from source to output
or from output to source.
There may be so many transactions and transaction types that the tracing of processing becomes difficult
without the use of the computer.
The system may be integrated so that a transaction is posted to several files at the same time without
intermediate printout. It may also trigger a variety of systems responses. Tracing transactions and testing the
system without an understanding of the computer program may be difficult. The number of printouts is reduced
and the feasibility of using printouts for understanding system performance is usually lessened in comparison to
simpler non-integrated systems.

REPORTS ON THE PROCESSING OF TRANSACTIONS BY SERVICE

ORGANIZATIONS (SAS No. 70) AS AMENDED BY SAS NO. 88
For purposes of this Statement, the following definitions apply:

Client organization. The entity whose financial statements are being examined.
User auditor. The auditor who reports on the financial statements of the client organization.
Service organization. The entity (or a segment of that entity) that provides services to the client organization.
Service auditor. The auditor who reports on certain aspects of the system of internal accounting control of the
service organization.

The guidance in this Statement is applicable to the examination of the financial statements of a client organization
that obtains the following services from another organization:

Executing transactions and maintaining the related accountability

Recording transactions and processing related data
Various combinations of these services

Examples of service organizations include:

bank trust departments that invest and hold assets for employee benefit plans or others.
EDP service centers that process transactions and related data for others.
mortgage bankers that service mortgages for others.
organizations that develop, provide, and maintain the software being used by client organizations.

SAS No. 70 provides guidance on:

the user auditors consideration of the effect of the service organization on the internal control structure of the
user and the availability of sufficient evidence for the audit of the user organization.
considerations in using a service auditors report.
responsibilities of service auditors, such as due care, independence, and performance in accordance with
standards.

7-7

The User Auditors Consideration

When the audit client uses a service organization, part of the accounting system and internal control structure are
not internal. The processing of the transactions is physically and operationally separate from the client.
SAS No. 55 on internal control structure requires the auditor to

obtain the necessary understanding of the user organizations internal control structure to plan the audit of the
financial statements.
assess control risk.
perform substantive procedures.

The most important factors to be considered in deciding whether additional information, such as a service auditors
report, is needed are:

the degree of interaction between the policies and procedures at the service organization and those at the user
organization.
the nature of the transactions processed.
the materiality of the transactions processed.

The auditor of the user organization decides whether he or she has sufficient information. If the user organization is
relying on the service organizations accurate processing or their control procedures, the auditor needs information
about the processing and control procedures. Additional information from the service center or a service auditors
report may not be necessary if the auditor has already obtained a sufficient understanding to:

identify types of potential misstatements,

consider factors that affect the risk of material misstatement, and
design substantive tests.

If the user auditor is unable to obtain sufficient evidence to achieve his or her audit objectives, the user auditor
should qualify the audit opinion or disclaim an opinion on the financial statements because of a scope limitation.

Considerations in Using a Service Auditor Report

The service auditors professional reputation.

Whether the service auditors report (in both scope and results) is sufficient to meet the user auditors
objectives.
Assessment of policies and procedures in conjunction with the users internal control structure policies and
procedures.

Reports

Two types of reports are defined:

opinion on a description of policies and procedures placed in operation at a service organization

opinion on a description of policies and procedures placed in operation and tests of operating effectiveness.

Report on Policies and Procedures Placed in Operation

Purpose: This type of report helps the user auditor obtain an understanding of the entitys internal control structure
sufficient to plan the audit. This report has two aspects:
The service auditors report on whether the service organizations description of its policies and procedures
presents fairly the policies and procedures placed in operation as of a specified date.
The service auditors opinion on whether the policies and procedures are suitably designed to provide
reasonable assurance that stated control objectives would be achieved if the control policies and procedures
were complied with satisfactorily.

7-8

Report on Policies and Procedures Placed in Operation and

Tests of Operating Effectiveness
This report covers both aspects of a placed in operation report and provides an additional element. It lists tests
performed by the service auditor, and states the service auditors opinion that the tested policies and procedures
were operating with sufficient effectiveness to provide reasonable, but not absolute, assurance that the specified
control objectives were achieved during the period covered by the tests.
The user auditor decides what evidential matter is needed to reduce the assessed level of control risk for his or her
client. In some cases, the tests of operating effectiveness performed by the service auditor may provide this
evidence.

SERVICE AUDITORS REPORT ON POLICIES AND PROCEDURES PLACED

IN OPERATIONNo Exceptions Noted
To XYZ Service Organization:
We have examined the accompanying description of the ________________________ application of XYZ Service
Organization. Our examination included procedures to obtain reasonable assurance about whether (1) the
accompanying description presents fairly, in all material respects, the aspects of XYZ Service Organizations
policies and procedures that may be relevant to a user organizations internal control structure, (2) the control
structure policies and procedures included in the description were suitably designed to achieve the control
objectives specified in the description, if those policies and procedures were complied with satisfactorily [and user
organizations applied the internal control structure policies and procedures contemplated in the design of XYZ
Service Organization's policies and procedures], and (3) such policies and procedures had been placed in operation
as of [date]. The control objectives were specified by [the service organization, regulatory authorities, a user group
or others]. Our examination was performed in accordance with standards established by the American Institute of
Certified Public Accountants and included those procedures we considered necessary in the circumstances to obtain
a reasonable basis for rendering our opinion.
We did not perform procedures to determine the operating effectiveness of policies and procedures for any period.
Accordingly, we express no opinion on the operating effectiveness of any aspects of XYZ Service Organization's
policies and procedures, individually or in the aggregate.
In our opinion, the accompanying description of the aforementioned application presents fairly, in all material
respects, the relevant aspects of XYZ Service Organization's policies and procedures that had been placed in
operation as of [date]. Also, in our opinion, the policies and procedures, as described, are suitably designed to
provide reasonable assurance that the specified control objectives would be achieved if the described policies and
procedures were complied with satisfactorily [and user organizations applied the internal control structure policies
and procedures contemplated in the design of XYZ Service Organization's policies and procedures].
The description of policies and procedures at XYZ Service Organization is as of [date] and any projection of such
information to the future is subject to the risk that, because of change, the description may no longer portray the
system in existence. The potential effectiveness of specific policies and procedures at the Service Organization is
subject to inherent limitations and, accordingly, errors or irregularities may occur and not be detected. Furthermore,
the projection of any conclusions, based on our findings, to future periods is subject to the risk that changes may
alter the validity of such conclusions.
This report is intended solely for use by the management of XYZ Service Organization, its customers, and the
independent auditors of its customers.

7-9

SERVICE AUDITORS REPORT ON POLICIES AND PROCEDURES PLACED

IN OPERATION AND TESTS OF OPERATING EFFECTIVENESS
No Exceptions Noted
To XYZ Service Organization:
We have examined the accompanying description of the ________________________ application of XYZ Service
Organization. Our examination included procedures to obtain reasonable assurance about whether (1) the
accompanying description presents fairly, in all material respects, the aspects of XYZ Service Organizations
policies and procedures that may be relevant to a user organizations internal control structure, (2) the control
structure policies and procedures included in the description were suitably designed to achieve the control
objectives specified in the description, if those policies and procedures were complied with satisfactorily [and user
organizations applied the internal control structure policies and procedures contemplated in the design of XYZ
Service Organization's policies and procedures], and (3) such policies and procedures had been placed in operation
as of [date]. The control objectives were specified by [the service organization, regulatory authorities, a user group
or others]. Our examination was performed in accordance with standards established by the American Institute of
Certified Public Accountants and included those procedures we considered necessary in the circumstances to obtain
a reasonable basis for rendering our opinion.
In our opinion, the accompanying description of the aforementioned application presents fairly, in all material
respects, the relevant aspects of XYZ Service Organization's policies and procedures that had been placed in
operation as of [date]. Also, in our opinion, the policies and procedures, as described, are suitably designed to
provide reasonable assurance that the specified control objectives would be achieved if the described policies and
procedures were complied with satisfactorily [and user organizations applied the internal control structure policies
and procedures contemplated in the design of XYZ Service Organization's policies and procedures].
In addition to the procedures we considered necessary to render our opinion as expressed in the previous paragraph,
we applied tests to specific policies and procedures, listed in Schedule X, to obtain evidence about their
effectiveness in meeting the control objectives, described in Schedule X, during the period from [date] to [date].
The specific policies and procedures and the nature, timing, and extent, and results of the tests are listed in Schedule
X. This information has been provided to user organizations of XYZ Service Organization and to their auditors to
be taken into consideration, along with information about the internal control structure at user organizations, when
making assessments of control risk for user organizations. In our opinion the policies and procedures that were
tested, as described in Schedule X, were operating with sufficient effectiveness to provide reasonable, but not
absolute, assurance that the control objectives specified in Schedule X were achieved during the period from [date]
to [date]. [However, the scope of our engagement did not include tests to determine whether control objectives not
listed in Schedule X were achieved; accordingly we express no opinion on the achievement of control objectives not
included in Schedule X.]
The relative effectiveness and significance of specific policies and procedures at XYZ Service Organization and
their effect on assessments of control risk at user organizations are dependent on their interaction with the policies,
procedures, and other factors present at individual user organizations. We have performed no procedures to evaluate
the effectiveness of policies and procedures at individual user organizations.
The description of policies and procedures at XYZ Service Organization is as of [date], and information about tests
of the operating effectiveness of specified policies and procedures covers the period from [date] to [date]. Any
projection of such information to the future is subject to the risk that, because of change, the description may no
longer portray the system in existence. The potential effectiveness of specific policies and procedures at the Service
Organization is subject to inherent limitations and, accordingly, errors or irregularities may occur and not be
detected. Furthermore, the projection of any conclusions, based on our findings, to future periods is subject to the
risk that changes may alter the validity of such conclusions.
This report is intended solely for use by the management of XYZ Service Organization, its customers, and the
independent auditors of its customers.

7-10

DEFINITIONS
APPLICATION CONTROLS: Internal controls relating to a specific computer operation such as the processing
of customer invoices.
BATCH PROCESSING: A technique in which items to be processed are collected into groups (batched) to permit
convenient and efficient processing. Note: The records of all transactions affecting a particular master file are
accumulated over a period of time (one day, for example), then arranged in sequence and processed against the
master file; most business applications are of the batch processing type.
BATCH TOTAL: A sum of a set of items which is used to check the accuracy of operations on a particular batch
of records.
BUG: A mistake in the design of a program or computer system, or an equipment fault.
CHANGE REQUEST LOG: A log of suggested changes to existing programs requested by users experiencing
difficulties with employing programs.
CHECK BIT: A binary check digit. Note: A parity check usually involves the appending of a check bit of
appropriate value to an array of bits.
CHECK DIGIT: A digit associated with a word or part of a word for the purpose of checking for the absence of
certain classes of errors.
CODING: (1) An ordered list or lists of the successive instructions which direct a computer to perform a particular
process; (2) the act of preparing a coding.
CONTROL CLERK: A person having responsibility for performing duties associated with the control over data
processing operations. Note: Such duties usually include the checking of control totals, the checking of run-to-run
controls, the checking of output before distribution, etc.
DATA BASE SYSTEM: A system whereby data is stored for multiple computer applications in an integrated data
base. Eliminates the need to duplicate data storage for two or more computer routines.
DOCUMENTATION: Preparation of documents during programming that describe the program and document its
preparation, its approval, and any subsequent changes; usually assembled in a run manual.
DUAL READ: The use of two separate reading stations to read the same record; results of the two operations are
compared to detect reading errors.
DUMP: (1) To copy the contents of a set of storage locations, usually from an internal storage device (such as core
storage) to an external storage medium (such as magnetic tape) and usually for diagnostic or rerun purposes; (2)
Data that results from the process as defined in (1).
ECHO CHECK: A check upon the accuracy of a data transfer operation in which data received (usually by an
output device) is transmitted back to its source (usually a control unit) and compared with the original data; for
example, an echo check on a output operation usually can verify that the proper print hammers or punch pins were
actuated at the proper moments, though it cannot ensure that the proper marks were actually recorded on the output
medium.
EDIT: To modify the form or format of data; may involve the rearrangement, addition (for example, insertion of
dollar signs and decimal points) and deletion (for example, suppression of leading zeros) of data, code translation
and the control of layouts for printing (for example, provision for headings and page numbers).
FIELD: (1) In a punched card, a group of columns whose punchings represent one item; (2) a subdivision of a
computer word or instruction (for example, a group of bit positions within an instruction that hold an address); (3) a
subdivision of a record; that is, an item.
FILE: A collection of related information. For example, a payroll file.
FILE LABEL: A label identifying a file. Note: An internal label is recorded as the first or last record of a file and is
machine-readable; an external label is attached to the outside of the file holder and is not machine-readable.

7-11

FILE PROTECTION RING: A removable plastic or metal ring, the presence or absence (depending on the
computer manufacturer) of which prevents an employee from writing on a magnetic tape and thereby prevents the
accidental destruction of a magnetic tape file. Note: The most common method involves the insertion of the ring to
allow writing and the removal of the ring to prevent writing.
FLOWCHART: A diagram showing by means of symbols and interconnecting lines, (1) the structure and general
sequence of operations of a program (program flowchart), or (2) a system of processing (system flowchart).
GENERAL CONTROLS: Control procedures applicable to all computer systems in an organization.
GENERALIZED AUDIT SOFTWARE: Auditor used computer software used to perform various routine audit
procedures such as comparing records, selecting samples or making calculations.
HARD COPY: Documentation containing data printed by data processing equipment in a form suitable for
permanent retention (printed reports, listings and logs). Note: Volatile output, by contrast, is data such as that
displayed on the screen of a cathode ray tube.
HASH TOTAL: A sum of numbers in a specified field of a record, or of a batch of records, used for checking and
control purposes. For example, the number of hours worked by everyone in a department.
HEADER LABEL: A machine-readable record at the beginning of a file containing data identifying the file and
data used in file control.
INTEGRATED TEST FACILITY: A set of auditor-generated dummy transactions that is processed with valid
client transactions. The objective is to test the effectiveness of the client's processing system.
INTERBLOCK GAP: The distance on a magnetic tape between the end of one block and the beginning of the
next. Note: Within this distance the tape can be stopped and brought up to normal speed again; since, therefore, the
tape speed may be changing, no reading or writing is permitted in the gap.
LIMIT TEST: A programmed check for errors in input data or processing. Note: For this test, a data item is
compared with a test amount larger (or smaller) than the data item should be if it is correct; if the checked item is
larger (or smaller) than the test amount, an error is indicated.
LOCAL AREA NETWORK (LAN): A communication facility that interconnects computers with a specific area.
LOG: A record of the operations of data processing equipment; each job or run, the time it required, operator
actions, and other pertinent data are listed.
MANUAL INPUT: (1) The entry of data into a device by manual means at the time of processing; (2) data entered
into a device by manual means at the time of processing; for example, data entered by means of a keyboard, or by
setting switches, dials or levers.
MASTER FILE: A file containing relatively permanent information which is used as a source of reference and is
generally updated periodically.
NETWORKING SYSTEM: A method of interconnecting computers in different locations.
OFF-LINE (OR OFFLINE): Pertaining to equipment or devices that are not in direct communication with the
central processor of a computer system. Note: Off-line devices cannot be controlled by a computer except through
human intervention. Contrast with "on-line".
ON-LINE (OR ONLINE): Pertaining to equipment or devices that are in direct communication with the central
processor of a computer system. Note: On-line devices are usually under the direct control of the computer with
which they are in communication.
PARALLEL SIMULATION: A testing process used by the auditor where actual client data are processed on the
auditor's EDP equipment. The output is then compared with information processed on the client's equipment.
PARITY BIT: A bit (binary digit) appended to an array of bits to make the sum of all the "1" bits in the array either
always even (even parity) or always odd (odd parity); for example:

7-12

Data bits

Parity bit

0
0
0
0
0
1
1

Even Parity
1
1
1
1
1
1
0

1
0
0
1
1
0
1

0
0
0
0
0
1
0

Odd Parity
1
1
1
1
1
1
1

1
0
0
1
1
0
0

PROGRAM FLOWCHART: A flowchart diagramming the processing steps and logic of a computer program;
contrast with "system flowchart."
RANDOM ACCESS: Pertaining to a storage device whose access time is not significantly affected by the location
of the data to be accessed. Note: Any item of data stored on-line can be accessed within a relatively short time
(usually less than one second).
REAL-TIME (OR REALTIME): (1) Pertaining to the time during which a physical process actually takes place;
(2) pertaining to a mode of operation in which the moments of occurrence of certain events in a system must satisfy
restrictions determined by the moments of occurrence of events in some other independent system; for example,
realtime operation is essential in computers associated with process control systems, message switching and
reservation systems.
RECORD COUNT: A count of the number of records in a file or the number of records processed by a program.
Note: Such a count is used in error control to detect the nonprocessing of records.
RECORD MARK: A special character used in some computers either to limit the number of characters in a data
transfer operation or to separate blocked records on tape.
RUN MANUAL: A manual documenting the processing system, program logic, controls, program changes and
operating instructions associated with a computer run.
SELF-CHECKING NUMBER: A numeral that contains redundant information (such as an appended check digit)
permitting it to be checked for accuracy after it has been transferred from one medium or device to another (for
example, by means of a residue check); see "check digit."
SOURCE DOCUMENT: A document from which data is extracted; for example, a document that contains typed
or handwritten data to be keypunched.
SYSTEM FLOWCHART: A flowchart diagramming the flow of work, documents and operations in a data
processing application.
TEST DATA: A set of transactions developed by the auditor with a known output result. Some of the transactions
may include errors. The transactions are processed on the client's system. The objective is to test the effectiveness of
the client's system by comparing the processed information with the known output.
TRANSACTION CODE: One or more characters that form a part of a record and signify the type of transaction
represented by that record; in inventory control, for example, a transaction code may signify deliveries to stock,
disbursements from stock, orders, etc.
VALIDITY CHECK: A hardware check that determines whether or not a particular character is a legitimate
member of the permissible character set.

7-13

PROGRAM FLOWCHARTING

The major symbols used in program flowcharting are shown below:

Terminal
Any start or stop point in the program

Input/Output
Any function of an Input or Output Device

Processing
Operation or operations to be performed

Decision
A choice is to be made from two or more options
(yes/no; greater than; less than/equal)

Onpage Connector
An entry to or exit from a point on the same page

Offpage Connector
An entry to or exit from different page

Flowline
The rule for direction of flow is always down and to the right unless an arrow
indicates otherwise.

7-14

SYSTEM FLOWCHARTING

The major symbols used in system flowcharting refer to tapes, hardcopy printouts, paper handling, and the like. The
system flowchart represents an entire accounting system, while a program flowchart will be the specific computer
activity in just one part of the system. Major system symbols are shown below:

Document or Hardcopy printouts

Manual Operation
Any non-machine operations in the system

Magnetic Tape
Appears where magnetic tape is used or produced

Online Storage

Offline Storage

Display or Video Devices

Flowlines

7-15

Chapter Seven - Questions

Auditing with Technology
1. When an accounting application is processed by
computer, an auditor cannot verify the reliable
operation of programmed control procedures by
a. Manually comparing detail transaction files
used by an edit program to the program's
generated error listings to determine that errors
were properly identified by the edit program.
b. Constructing a processing system for
accounting applications and processing actual
data from throughout the period through both
the client's program and the auditor's program.
c. Manually reperforming, as of a point in time,
the processing of input data and comparing the
simulated results to the actual results.
d. Periodically submitting auditor-prepared test
data to the same computer process and
evaluating the results.

4. Which of the following computer documentation

would an auditor most likely utilize in obtaining an
understanding of the internal control structure?
a. Systems flowcharts.
b. Record counts.
c. Program listings.
d. Record layouts.

2. To obtain evidence that user identification and

password controls are functioning as designed, an
auditor would most likely
a. Attempt to sign-on to the system using invalid
user identifications and passwords.
b. Write a computer program that simulates the
logic of the client's access control software.
c. Extract a random sample of processed
transactions and ensure that the transactions
were appropriately authorized.
d. Examine statements signed by employees
stating that they have not divulged their user
identifications and passwords to any other
person.

6. Data Corporation has just completely

computerized its billing and accounts receivable
recordkeeping. You want to make maximum use of
the new computer in your audit of Data Corporation.
Which of the following audit techniques could not be
performed through a computer program?
a. Tracing audited cash receipts to accounts
receivable credits.
b. Selecting on a random number basis accounts to
be confirmed.
c. Examining sales invoices for completeness,
consistency between different items, valid
conditions and reasonable amounts.
d. Resolving differences reported by customers on
confirmation requests.

3. Computer systems are typically supported by a

variety of utility software packages that are important
to an auditor because they
a. May enable unauthorized changes to data files
if not properly controlled.
b. Are very versatile programs that can be used on
hardware of many manufacturers.
c. May be significant components of a client's
application programs.
d. Are written specifically to enable auditors to
extract and sort data.

7. Which of the following best describes the principal

advantage of the use of flowcharts in reviewing
internal control?
a. Standard flowcharts are available and can be
effectively used for describing most company
internal operations.
b. Flowcharts aid in the understanding of the
sequence and relationships of activities and
documents.
c. Working papers are not complete unless they
include flowcharts as well as memoranda on
internal control.
d. Flowcharting is the most efficient means
available for summarizing internal control.

5. When an auditor tests a computerized accounting

system, which of the following is true of the test data
approach?
a. Test data must consist of all possible valid and
invalid conditions.
b. The program tested is different from the
program used throughout the year by the client.
c. Several transactions of each type must be tested.
d. Test data are processed by the client's computer
programs under the auditor's control.

7Q-1

8. Daylight Corporation's organization chart provides

for a controller and an EDP manager, both of whom
report to the financial vice-president. Internal control
would not be strengthened by
a. Assigning the programming and operating of
the computer to an independent control group
which reports to the controller.
b. Providing for maintenance of input data
controls by an independent control group which
reports to the controller.
c. Rotating periodically among machine operators
the assignments of individual application runs.
d. Providing for review and distribution of
computer output by an independent control
group which reports to the controller.

12. An auditor who is testing EDP controls in a

payroll system would most likely use test data that
contain conditions such as
a. Deductions not authorized by employees.
b. Overtime not approved by supervisors.
c. Time tickets with invalid job numbers.
d. Payroll checks with unauthorized signatures.

9. The primary purpose of a generalized computer

audit program is to allow the auditor to
a. Use the client's employees to perform routine
audit checks of the electronic data processing
records that otherwise would be done by the
auditor's staff accountants.
b. Test the logic of computer programs used in the
client's electronic data processing systems.
c. Select larger samples from the client's electronic
data processing records than would otherwise
be selected without the generalized program.
d. Independently process client electronic data
processing records.

14. Which of the following computer-assisted

auditing techniques allows fictitious and real
transactions to be processed together without client
operating personnel being aware of the testing
process?
a. Parallel simulation.
b. Generalized audit software programming.
c. Integrated test facility.
d. Test data approach.

10. An auditor can use a generalized computer audit

program to verify the accuracy of
a. Data processing controls.
b. Accounting estimates.
c. Totals and sub-totals.
d. Account classifications.
11. Which of the following client electronic data
processing (EDP) systems generally can be audited
without examining or directly testing the EDP
computer programs of the system?
a. A
system
that
performs
relatively
uncomplicated processes and produces detailed
output.
b. A system that affects a number of essential
master files and produces a limited output.
c. A system that updates a few essential master
files and produces no printed output other than
final balances.
d. A system that performs relatively complicated
processing and produces very little detailed
output.

7Q-2

13. Which of the following is not a major reason

why an accounting audit trail should be maintained
for a computer system?
a. Monitoring purposes.
b. Analytical procedures.
c. Query answering.
d. Deterrent to irregularities.

15. In a computerized payroll system environment,

an auditor would be least likely to use test data to test
controls related to
a. Missing employee numbers.
b. Proper approval of overtime by supervisors.
c. Time tickets with invalid job numbers.
d. Agreement of hours per clock cards with hours
on time tickets.
16. An auditor using audit software probably would
be least interested in which of the following fields in
a computerized perpetual inventory file?
a. Economic order quantity.
b. Warehouse location.
c. Date of last purchase.
d. Quantity sold.
17. Processing data through the use of simulated files
provides an auditor with information about the
operating effectiveness of control policies and
procedures. One of the techniques involved in this
approach makes use of
a. Controlled reprocessing.
b. An integrated test facility.
c. Input validation.
d. Program code checking.

18. An auditor most likely would test for the

presence of unauthorized EDP program changes by
running a
a. Program with test data.
b. Check digit verification program.
c. Source code comparison program.
d. Program that computes control totals.
19. An auditor most likely would introduce test data
into a computerized payroll system to test internal
controls related to the
a. Existence of unclaimed payroll checks held by
supervisors.
b. Early cashing of payroll checks by employees.
c. Discovery of invalid employee I.D. numbers.
d. Proper approval of overtime by supervisors.
20. Lake, CPA, is auditing the financial statements of
Gill Co. Gill uses the EDP Service Center, Inc. to
process its payroll transactions. EDP's financial
statements are audited by Cope, CPA, who recently
issued a report on EDP's internal control structure.
Lake is considering Cope's report on EDP's internal
control structure in assessing control risk on the Gill
engagement. What is Lake's responsibility
concerning making reference to Cope as a basis, in
part, for Lake's own opinion?
a. Lake may refer to Cope only if Lake is satisfied
as to Cope's professional reputation and
independence.
b. Lake may refer to Cope only if Lake relies on
Cope's report in restricting the extent of
substantive tests.
c. Lake may refer to Cope only if Lake's report
indicates the division of responsibility.
d. Lake may not refer to Cope under the
circumstances above.
21. Using microcomputers in auditing may affect the
methods used to review the work of staff assistants
because
a. The audit field work standards for supervision
may differ.
b. Documenting the supervisory review may require
assistance of consulting services personnel.
c. Supervisory personnel may not have an
understanding of the capabilities and limitations
of microcomputers.
d. Working paper documentation may not contain
readily observable details of calculations.

7Q-3

22. Which of the following computer-assisted

auditing techniques allows fictitious and real
transactions to be processed together without client
operating personnel being aware of the testing
process?
a. Integrated test facility.
b. Input controls matrix.
c. Parallel simulation.
d. Data entry monitor.

23. When an auditor tests a computerized accounting

system, which of the following is true of the test
data approach?
a. Several transactions of each type must be tested.
b. Test data are processed by the client's computer
programs under the auditor's control.
c. Test data must consist of all possible valid and
invalid conditions.
d. The program tested is different from the program
used throughout the year by the client.

24. Able Co. uses an online sales order processing

system to process its sales transactions. Able's sales
data are electronically sorted and subjected to edit
checks. A direct output of the edit checks most likely
would be a
a. Report of all missing sales invoices.
b. File of all rejected sales transactions.
c. Printout of all user code numbers and passwords.
d. List of all voided shipping documents.

25. Which of the following types of evidence would

an auditor most likely examine to determine whether
internal control structure policies and procedures are
operating as designed?
a. Gross margin information regarding the client's
industry.
b. Confirmations of receivables verifying account
balances.
c. Client records documenting the use of EDP
programs.
d. Anticipated results documented in budgets or
forecasts.

26. Computer Services Company (CSC) processes

payroll transactions for schools. Drake, CPA, is
engaged to report on CSC's policies and procedures
placed in operation as of a specific date. These
policies and procedures are relevant to the schools'
internal control structure, so Drake's report will be
useful in providing the schools' independent auditors
with information necessary to plan their audits.
Drake's report expressing an opinion on CSC's
policies and procedures placed in operation as of a
specific date should contain a(an)
a. Description of the scope and nature of Drake's
procedures.
b. Statement that CSC's management has disclosed
to Drake all design deficiencies of which it is
aware.
c. Opinion on the operating effectiveness of CSC's
policies and procedures.
d. Paragraph indicating the basis for Drake's
assessment of control risk.
27. A primary advantage of using generalized audit
software packages to audit the financial statements of
a client that uses an EDP system is that the auditor
may
a. Access information stored on computer files
while having a limited understanding of the
client's hardware and software features.
b. Consider increasing the use of substantive tests of
transactions in place of analytical procedures.
c. Substantiate the accuracy of data through selfchecking digits and hash totals.
d. Reduce the level of required tests of controls to a
relatively small amount.

7Q-4

Chapter Seven - Problems

Auditing with Technology
NUMBER 1
A CPA's client, Boos and Baumkirchner, Inc., is a medium-sized manufacturer of products for the leisure-time
activities market (camping equipment, scuba gear, bows and arrows, etc.). During the past year, a computer system
was installed, and inventory records of finished goods and parts were converted to computer processing. The
inventory master file is maintained on a disk. Each record of the file contains the following information:
Item or part number
Description
Size
Unit of measure code
Quantity on hand
Cost per unit

Total value of inventory on hand at cost

Date of last sale or usage
Quantity used or sold this year
Economic order quantity
Code number of major vendor
Code number of secondary vendor

In preparation for year-end inventory the client has two identical sets of preprinted inventory count cards. One set is
for the client's inventory counts, and the other is for the CPA's use to make audit test counts. The following
information has been keypunched into the cards and interpreted on their face:
Item or part number
Description
Size
Unit of measure code
In taking the year-end inventory, the client's personnel will write the actual counted quantity on the face of each
card. When all counts are complete, the counted quantity will be keypunched into the cards. The cards will be
processed against the disk file, and quantity-on-hand figures will be adjusted to reflect the actual count. A computer
listing will be prepared to show any missing inventory count cards and all quantity adjustments of more than $100
in value. These items will be investigated by client personnel, and all required adjustments will be made. When
adjustments have been completed, the final year-end balances will be computed and posted to the general ledger.
The CPA has available a general purpose computer audit software package that will run on the client's computer and
can process both card and disk files.
Required:
a. In general and without regard to the facts above, discuss the nature of general purpose computer audit software
packages and list the various types and uses of such packages.
b. List and describe at least five ways a general purpose computer audit software package can be used to assist in
all aspects of the audit of the inventory of Boos and Baumkirchner, Inc. (For example, the package can be used
to read the disk inventory master file and list items and parts with a high unit cost or total value. Such items
can be included in the test counts to increase the dollar coverage of the audit verification.)

7Q-5

NUMBER 2
The following five topics are part of the relevant body of knowledge for CPAs having field work or immediate
supervisory responsibility in audits involving a computer:
1. Electronic data processing (EDP) equipment and its capabilities.
2. Organization and management of the data processing function.
3. Characteristics of computer based systems.
4. Fundamentals of computer programming.
5. Computer center operations.
CPAs who are responsible for computer audits should possess certain general knowledge with respect to each of
these five topics. For example, on the subject of EDP equipment and its capabilities, the auditor should have a
general understanding of computer equipment and should be familiar with the uses and capabilities of the central
processor and the peripheral equipment.
Required:
For each of the topics numbered 2 through 5 above, describe the general knowledge that should be possessed by
those CPAs who are responsible for computer audits.

NUMBER 3
An auditor is conducting an examination of the financial statements of a wholesale cosmetics distributor with an
inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution
center and in two public warehouses. An inventory computer file is maintained on a computer disc and at the end of
each business day the file is updated. Each record of the inventory file contains the following data:
Item number
Location of item
Description of item
Quantity on hand
Cost per item
Date of last purchase
Date of last sale
Quantity sold during year
The auditor is planning to observe the distributor's physical count of inventories as of a given date. The auditor will
have available a computer tape of the data on the inventory file on the date of the physical count and a general
purpose computer software package.
Required: The auditor is planning to perform basic inventory auditing procedures. Identify the basic inventory
auditing procedures and describe how the use of the general purpose software package and the tape of the inventory
file data might be helpful to the auditor in performing such auditing procedures.
Organize your answer as follows:

How general purpose computer software

package and tape of the inventory
file data might be helpful
Determining which items are to be test
counted by selecting a random sample of a
representative number of items from the
inventory file as of the date of the physical
count.

Basic inventory auditing procedure

Observe the physical count, making
and recording test counts where
applicable.

7Q-6

NUMBER 4
In the past, the records to be evaluated in an audit have been printed reports, listings, documents and written papers,
all of which are visible output. However, in fully computerized systems which employ daily updating of transaction
files, output and files are frequently in machine-readable forms such as cards, tapes, or disks. Thus, they often
present the auditor with an opportunity to use the computer in performing an audit.
Required:
Discuss how the computer can be used to aid the auditor in examining accounts receivable in such a fully
computerized system.

NUMBER 5
After determining that computer controls are valid, Hastings is reviewing the sales system of Rosco Corporation in
order to determine how a computerized audit program may be used to assist in performing tests of Rosco's sales
records.
Rosco sells crude oil from one central location. All orders are received by mail and indicate the preassigned
customer identification number, desired quantity, proposed delivery date, method of payment and shipping terms.
Since price fluctuates daily, orders do not indicate a price. Price sheets are printed daily and details are stored in a
permanent disc file. The details of orders are also maintained in a permanent disc file.
Each morning the shipping clerk receives a computer printout which indicates details of customers' orders to be
shipped that day. After the orders have been shipped, the shipping details are inputted in the computer which
simultaneously updates the sales journal, perpetual inventory records, accounts receivable, and sales accounts.
The details of all transactions, as well as daily updates, are maintained on discs which are available for use by
Hastings in the performance of the audit.
Required:
a. How may a computerized audit program be used by Hastings to perform substantive tests of Rosco's sales
records in their machine readable form? Do not discuss accounts receivable and inventory.
b. After having performed these tests with the assistance of the computer, what other auditing procedures should
Hastings perform in order to complete the examination of Rosco's sales records?

7Q-7

Chapter Seven - Solutions to Questions

Auditing with Technology
1. (c) An auditor can verify the reliable operation of programmed control procedures by auditing around the
computer, comparing the results from manually reperforming the processing of input data with the actual results;
however, doing this as of a point in time will not determine if the controls are operating reliably over the period of
time affected by the programmed control procedures. Answers (a), (b) and (d) go beyond one point in time,
involving tests of several listings, data from throughout the period, and periodic submissions of test data.
2. (a) This will provide the auditor with the most competent evidence that the user identification and password
controls are functioning as designed. The other answers do not relate directly to actual system access; they refer to
programming, authorization and written statements.
3. (a) Utility programs perform common data processing tasks such as copying, sorting, merging, reorganizing data
in a file, and printing. They can also be used to enter and change data. Utility software packages are important to the
auditor because if not properly controlled, unauthorized changes to data files may occur. Answers (b) and (c) may
be true regarding utility software packages but are less important to the auditor. Answer (d) is an incorrect statement
since these packages are not specifically written for the auditor.
4. (a) A systems flowchart is a pictorial representation of the processing steps in moving an item through
processing. The question deals with understanding the internal control structure. Therefore, a flowchart would aid
the auditor in understanding the flow of the system.
5. (d) The purpose of a test data approach is to validate the processing of accounting data by the client's EDP
equipment. The test data has a known outcome and this known outcome is compared with the processing outcome
to validate the processing of data.
6. (d) The computer could be used to perform items (a), (b) and (c). However, resolving differences reported by
customers on confirmation request would have to be done manually.
7. (b) A flow chart is a diagram showing by means of symbols and interconnecting lines (1) the structure and
general sequence of operations of a program (program flow chart) or (2) a system of processing (system flow chart).
Accordingly, a system flow chart would be the best means in the understanding of the sequence and relationships of
activities and documents.
8. (a) The assignment of programmers and the operation of a computer are the prime responsibilities of an EDP
manager. An independent control group should function between the user department and the EDP department.
Items (b), (c) and (d) are good examples of internal control within an EDP system.
9. (d) The primary use of a generalized computer audit program is to allow the auditor to independently process and
verify client electronic data processing records.
10. (c) A generalized computer program provides an independent means of checking totals and subtotals using the
client's data processing records.
11. (a) A system that, for instance, debits, credits and computes the balances of customer accounts receivable
subsidiary ledger, but also printed out all the entries made plus the beginning and ending balances could be audited
without directly testing it because external documentation is provided as evidence of each transaction.

7S-1

12. (c) EDP controls can be tested by processing test data using the client's program. The auditor's test data must
include valid and invalid transactions in order to determine if the programs will react correctly to the different kinds
of data. In a test of the payroll system, the auditor would want to determine that the programs are processing time
tickets and other data correctly and would, therefore, include in his test data time tickets with invalid job numbers.
The other answers refer primarily to authorizations, not to data processing.
13. (b) Analytical procedures are substantive audit tests, not a reason why an accounting audit trail should be
maintained for a computer system. An audit trail is a change of evidence connecting account balances and other
summary results with original transaction data. The trail is used by management to monitor the system, to respond to
inquiries, and to deter misuse. Auditors use the accounting audit trail to vouch and trace transactions.
14. (c) An integrated test facility is a method of testing programmed controls by creating a small subsystem within
the regular EDP system. Dummy files and records are appended to existing client files and fictitious test
transactions, specifically coded to correspond with the dummy files and records, are introduced into a system
together with actual real transactions. Answer (a) is an approach which involves reprocessing actual company data
using auditor-controlled programs. Answer (d) is an approach which involves dummy transactions prepared and
processed by the auditor using the client's computer program.
15. (b) A department supervisor would indicate approval of overtime by signing the employee's time card. Visual
inspection of the time card by the auditor would determine whether or not total hours worked were properly
approved.
16. (a) Answer (b) is incorrect because the auditor would be interested in the warehouse location of inventory
because he(she) would be concerned with the existence of the inventory. Answer (c) is incorrect because the auditor
could use the date of the last purchase to test for obsolete inventory. Answer (d) is incorrect because the auditor
could use this information to test for slow moving inventory. Answer (a) is correct because the auditor would be
least concerned with the quantities purchased (E.O.Q.).
17. (b) An integrated test facility is a method of testing the effectiveness of programmed controls by creating a small
subsystem within the regular EDP system. Simulated files and records are appended to existing client files and
fictitious test transactions, specifically coded to correspond with the simulated files and records, are introduced into
a system together with actual real transactions. Answer (a) involves reprocessing actual data, not simulated files.
Answer (c) is a client control procedure. Answer (d) may be something an auditor does, but it does not involve
processing data and does not use simulated files.
18. (c) If the auditor wants to discover unauthorized changes to an EDP program, he could compare the authorized
programs source code with the unauthorized programs source code. Answers (a), (b) and (d) are programs that are
designed primarily to test a clients application programs and programmed controls, not controls over unauthorized
program changes.
19. (c) Auditors may run test data, which simulate actual transactions, on a client's computerized system to
determine if the controls related to processing those transactions are operating effectively. The types of controls
that can be tested in this manner are control procedures that can be programmed, such as discovering invalid
employee I.D. numbers. The auditor could introduce simulated payroll data that have invalid I.D. numbers to
determine if the computerized payroll system detects the error. Answers (a), (b) and (d) are not programmable
controls, which exist in a computerized payroll system, that can be tested using test data. Control over the existence
of unclaimed payroll checks held by supervisors, answer (a), is outside of the computer system and could be tested
through inquiry and observation. Control over early cashing of payroll checks, answer (b), is outside the computer
system and could be tested by inquiry, observation and examination of canceled checks. Control over approval of
overtime by supervisors, answer (d), is typically outside the computer system and can be tested by examining
timecards or other documentation for authorization.

7S-2

20. (d) When an entity uses a service organization to process certain transactions, part of its accounting system and
internal control structure are not internal. Such an entity is referred to as a user organization and its auditor is
referred to as the user auditor. In this situation, the user auditor may consider work done by the service auditor,
which is the term used to describe the auditor of the service organization, in evaluating the internal control structure
and assessing control risk. If a report by the service auditor on the service organization's internal control structure is
considered, the user auditor should not make reference to the report of the service auditor as a basis for his or her
opinion on the user organization's financial statements. Since the service auditor is not responsible for examining
any portion of the user organization's financial statements, there cannot be a division of responsibility for the audit
of the user organization's financial statements. Answer (a) is incorrect because the user auditor, Lake, would not
consider the report of the service auditor, Cope, if the service auditor were not reputable and independent. Answers
(b) and (c) are incorrect because the user auditor cannot refer to the service auditor in his or her report.
21. (d) Work performed by assistants should be reviewed to determine whether it was adequately performed and to
evaluate whether the results are consistent with the conclusions to be presented in the auditor's report. Working
papers, which may be in the form of data stored on tapes or other media, are used to document procedures applied,
tests performed, information obtained, and conclusions reached by the audit staff. Examples of working papers are
audit programs, analyses, memoranda, letters, abstracts of documents, and schedules or commentaries. When
prepared manually, working paper documentation would typically contain readily observable details of calculations.
This may not be true when using microcomputers since working paper documentation may be in the form of
computer files. Answer (a) is incorrect because the field work standard for planning and supervision is the same
whether or not microcomputers are used in the audit. Answers (b) and (c) are incorrect because audit supervisors
should be able to document their review of staff assistants' work and should understand the capabilities and
limitations of microcomputers.
22. (a) AU 8016 states that test data techniques are used in conducting audit procedures by entering data into an
entity's computer system, and comparing the results obtained with predetermined results. Examples are:
Test data used to test specific controls in computer programs, such as password and data access controls.
Test transactions selected from previously processed transactions or created by the auditor to test specific
processing characteristics of an entity's computer system. Such transactions are generally processed separately
from the entity's normal processing.
Test transactions used in an integrated test facility where a "dummy" unit is established, and to which test
transactions are posted during the normal processing cycle.
Choices (b) and (d) are incorrect because they are an input control. Choice (c) is incorrect because a parallel
simulation involves rewriting a program with the clients data and comparing the output to test the programs logic.
23. (b) The test data approach tests computer controls by processing the auditor's test data, which consist of valid
and invalid transactions, using the client's program. Answer (a) is incorrect because the basic concept of test data is
that a computer program will handle every transaction exactly the same way, therefore only one transaction of each
type has to be tested. Answer (c) is incorrect because the auditor needs only to prepare a limited number of
simulated transactions to determine whether controls are operating. Answer (d) is incorrect because the test data are
processed with the client program that is supposed to have been used during the period under audit.
24. (b) Edit checks are computer-programmed routines that are designed to detect data entry errors. Accordingly, a
direct output of the edit checks of sales data being entered into a system would be a file or list of all sales
transactions rejected by the edit checks. Answers (a) and (d) are incorrect because missing sales invoices and voided
shipping documents would not be reflected on output generated from edit checks on data entry because sales
invoices and shipping documents are generated after sales data are entered into the system. Answer (c) is incorrect
because a printout of user codes and passwords would relate to general controls over access rather than application
controls over data entry.

7S-3

25. (c) In a computerized environment, there are general controls that are pervasive in their effect and relate to all
computerized accounting activities. Control over access to electronic data processing (EDP) programs is an example
of a general control. In order to test control over access, the auditor would most likely examine client records
documenting the use of EDP programs. Answers (a), (b) and (d) are incorrect because they are examples of
substantive tests, not tests of controls. The examples in (a) and (d) that refer to analysis and comparisons of gross
margins and budgeted results are examples of analytical procedures that can be performed as part of substantive
testing. Example (b) refers to confirmation of receivables, which is a substantive test of balances.
26. (a) A service auditor's report expressing an opinion on a description of policies and procedures placed in
operation at a service organization should contain a description of the scope and nature of the service auditor's
procedures. The report should also contain a reference to applications, services, products, or other aspects of the
service organization covered; identification of the party specifying the control objectives; an indication of the
purpose of the service auditor's engagement; a disclaimer of opinion on the operating effectiveness of the policies
and procedures; the service auditor's opinion on whether the policies and procedures are suitably designed to
provide reasonable assurance that stated control objectives would be achieved if the control policies and procedures
were complied with satisfactorily; a statement of inherent limitations; and identification of the parties for whom the
report is intended. Answers (b), (c) and (d) are incorrect because the service auditor's report expressing an opinion
on a description of policies and procedures placed in operation at a service organization does not indicate that
management of the user service organization disclosed design deficiencies to the service auditor; does not give an
opinion on operating effectiveness, which is a different type of report that a service auditor can provide; and does
not indicate the basis for the service auditor's assessment of control risk.
27. (a) Generalized audit software packages can be used to access client data, perform tests on those data, and
produce audit workpapers. Because generalized audit software contains preprogrammed routines, limited additional
programming is required. Accordingly, the auditor does not need an in-depth understanding of the client's hardware
and software features in order to use generalized audit software packages. Answer (b) is incorrect because the
choice between tests of transactions and analytical procedures is based on which substantive test is more effective
and efficient, not on the use of audit software. Answer (c) is incorrect because self-checking digits and hash totals
are input controls that the client uses, which are unrelated to audit procedures performed with audit software.
Answer (d) is incorrect because the extent of tests of controls depends on planned assessment of control risk and
other related factors, not the use of audit software.

7S-4

Chapter Seven - Solutions to Problems

Auditing with Technology
NUMBER 1
a.
The nature of a general purpose computer audit software package is to provide computer programs that can process
a variety of file media and record formats to perform a number of functions.
There are several types of general purpose computer audit software packages. A package may contain programs that
create or generate other programs, programs that modify themselves to perform requested functions, or skeletal
frameworks of programs that must be completed by the user.
A package can be used to perform or verify mathematical calculations; to include, exclude, or summarize items
having specified characteristics; to provide subtotals and final totals; to compute, select, and evaluate statistical
samples for audit tests; to print results in a form specified by the auditor; to arrange detailed items in a format or
sequence that will facilitate an audit step; to compare, merge, or match the contents of two or more files, and to
produce machine-readable files in a format specified by the auditor.
b.
Ways in which a general purpose computer audit software package can be used to assist in the audit of inventory of
Boos & Baumkirchner, Inc., include the following:
1. Compare data on the CPA's set of prepunched inventory count cards to data on the disc inventory master
file and list all differences. This will assure that the set of count cards furnished to the CPA is complete.
2. Determine which items and parts are to be test-counted by making a random selection of a sample from the
audit deck of count cards or the disc inventory master file. Exclude from the population items with a high
unit cost or total value that have already been selected for test counting.
3. Read the client's disc inventory master file and list all items or parts for which the date of last sale or usage
indicates a lack of recent transactions. This list provides basic data for determining possible obsolescence.
4. Read the client's disc inventory master file and list all items or parts of which the quantity on hand seems
excessive in relation to quantity used or sold during the year. This list provides basic data for determining
over-stocked or slow-moving items or parts.
5. Read the client's disc inventory master file and list all items or parts of which the quantity on hand seems
excessive in relation to economic order quantity. This list should be reviewed for possible slow-moving or
obsolete items.
6. Keypunch the audit test-count quantities into the cards. Match these cards against the client's adjusted disc
inventory master file comparing the quantities on the cards to the quantities on the disc file and list any
differences. This will indicate whether the client's year-end inventory counts and the master file are
substantially in agreement.
7. Use the adjusted disc inventory master file and independently extend and total the year-end inventory and
print the grand total on an output report. When compared to the balance determined by the client, this will
verify the calculations performed by the client.
8. Use the client's disc inventory master file and list all items with a significant cost per unit. The list should
show cost per unit and both major and secondary vendor codes. This list can be used to verify the cost per
unit.
9. Use the costs per unit on the client's disc inventory master file, and extend and total the dollar value of the
counts on the audit text count cards. When compared to the total dollar value of the inventory, this will
permit evaluation of audit coverage.

7S-5

NUMBER 2
2.

Organization and management of the data processing function

The auditor should understand the typical duties and different structural arrangements of organization,
supervision, and division of EDP duties. The auditor should understand the application of management
principles to the data processing function.

3.

Characteristics of computer based systems.

The auditor should have a broad knowledge of file organization, process flow, and system design and should
also understand the various methods for safeguarding computer files and the problems of including audit trails.
The auditor should have the ability to analyze and design an information system of modest complexity. The
auditor should be familiar with accounting control procedures that relate to all EDP activities (general controls)
and those that relate to specific accounting tasks (application controls).

4.

Fundamentals of computer programming

The auditor should understand what programming entails and should have the ability to prepare specifications
for and supervise preparation of a computer program.

5.

Computer center operations

The auditor should understand the use of software in the operation of the computer. The auditor should
understand the role of the computer operator and should be able to supervise the running of the computer audit
programs.

7S-6

NUMBER 3

1.

How General Purpose Computer Software

Package and Tape of Inventory File
Data Might Be Helpful
Determining which items are to be test
counted by making a random sample of a
representative number of items from the
inventory file as of the date of the physical
count.

Basic Inventory Auditing Procedures

Observe the physical count, making and
recording test counts where applicable.

2.

Test the mathematical accuracy of the

inventory compilation (summary).

Mathematically computing the dollar value of

each inventory item counted by multiplying
the quantity on hand by the cost per unit and
verifying the addition of the extended dollar
values.

3.

Compare the auditor's test counts to the

inventory records.

Arranging test counts in a tape-format

identical to the inventory file and matching
the tapes.

4.

Compare physical count data to inventory

records.

Comparing the total extended values of all

inventory items counted and the extended
values of each inventory item counted to the
inventory records.

5.

Test the pricing of the inventory by obtaining a list of costs per item from
buyers, vendors, or other sources.

Preparing a tape in a format identical to the

tape of the inventory file and matching
the tapes.

6.

Examine purchase and sale cutoff.

Listing a sample of items on the inventory file

for which the date of last purchase and date of
the last sale are on or immediately prior to the
date of the physical count.

7.

Ascertain the propriety of items of inventory located in public warehouses.

Listing items located in public warehouses.

8.

Analyze inventory for evidence of

possible obsolescence.

Listing items on the inventory file for which

the date of last sale indicates a lack of recent
transactions.

9.

Analyze inventory for evidence of

possible overstocking or slow-moving
items.

Listing items on the inventory file for which

the quantity on hand is excessive in relation to
the quantity sold during the year.

10. Perform overall test for accuracy of

inventory master file.

Listing items, if any, with negative quantities

or costs.

7S-7

NUMBER 4
1.

Testing Extensions and Footings: The computer can be used to perform simple summations and other
computations to test the correctness of extensions and footings. The auditor may choose to perform tests on all
records instead of just on samples, since the speed and low cost per computation of the computer enable this at
only a small extra amount of time and expense.

2.

Selecting and Printing Confirmation Requests: The computer can select and print out confirmation requests on
the basis of quantifiable selection criteria. The program can be written to select the accounts according to any
set of criteria desired and using any sampling plan.

3.

Examining Records for Quality (Completeness, Consistency, Valid Conditions, etc.): The quality of visible
records is readily apparent to the auditor. Sloppy recordkeeping, lack of completeness, and so on, are observed
by the auditor in the normal course of the audit. If machine-readable records, however, are evaluated manually,
a complete printout is needed to examine their quality. The auditor may choose to use the computer for
examining these records for quality. If the computer is to be used for the examination, a program is written
which examines the record for completeness, consistency between different items, valid conditions, reasonable
amounts, etc. For instance, customer file records might be examined to determine those for which no credit
limit is specified, those for which account balances exceed credit limit and those for which credit limits exceed
a stipulated amount.

4.

Summarizing Data and Performing Analyses Useful to the Auditor: The auditor frequently needs to have the
client's data analyzed and/or summarized. Such procedures as aging accounts receivable or listing all credit
balances in accounts receivable can be accomplished with a computer program.

5.

Selecting and Printing Audit Samples: The computer may be programmed to select audit samples by the use of
random numbers or by systematic selection techniques. The sample selection procedure may be programmed to
use multiple criteria, such as the selection of a random sample of items under a certain dollar amount plus the
selection of all items over a certain dollar amount. Other considerations can be included, such as unusual
transactions, dormant accounts, etc.

6.

Comparing Duplicate Data (Maintained in Separate Files) for Correctness and Consistency: Where there are
two or more separate records having identical data fields, the computer can be used in testing for consistency;
for instance, comparing catalogue prices with invoice prices.

7.

Comparing confirmation information with company records. For example, the computer can be used to
compare payment dates per customer confirmations with client cash receipts records.

8.

The computer may be programmed to print a workpaper listing of each account selected, with relevant data
inserted in applicable columns.

9.

The computer may be programmed to compare the customer's account balance with the customer's history of
purchases or to determine whether credit limits have been exceeded.

7S-8

NUMBER 5
a.

Based upon the information given, the computer may be used by Hastings to do the following:

Test extensions and footings of computerized sales records that serve as a basis for the preparation of the
invoices and sales journal.
Verify the mathematical accuracy of postings from the sales journal to appropriate ledger accounts.
Determine that all sales invoices and other related documents have been accounted for (for example, by
accounting for the integrity of the numerical sequence).
Select sales transactions for review (based upon predetermined criteria) through a review of the sales
journal or the accounts receivable subsidiary ledger.
Print a workpaper that lists each item selected, with relevant data inserted in applicable columns.
Select all debits posted to the sales account and all postings to the sales account from a source other than
the sales journal.
Analytically review recorded sales by use of predetermined criteria (percentage relationships, gross
margin, trends, and so forth, on a periodic or annual basis).
Compare duplicate data maintained in separate files for correctness. For example, the computer may be
used to compare the client's records of quantities sold with the client's record of quantities shipped.
Examine records for quality (completeness, consistency, and so forth). [The quality of visible records is
readily apparent to the auditor. Sloppy recordkeeping, lack of completeness, and so on, are observed by the
auditor in the normal course of the audit. If machine-readable records are evaluated manually, a complete
printout is needed to examine their quality. Hastings may choose to use the computer to examine these
records for quality.]

b. In addition to the procedures outlined above, Hastings should do the following:

Trace postings from the sales journal to invoice copies.

Trace data from sales invoices to the sales journal.
Compare dates of recorded sales transactions with dates on shipping records.
Determine that all shipping documents have been accounted for (for example, by accounting for the
integrity of the numerical sequence).
Examine documents for appropriate approval (for example, grant of credit, shipment of goods, and
determination of price and billing).
Determine the extent and nature of business transactions with major customers (for indications of
previously undisclosed relationshipsrelated partiesand for determination of applicability of disclosure
requirements required by generally accepted accounting principles).
Verify the sales cutoff at the beginning and end of the period to determine whether the recorded sales
represent revenues of the period.
Test pricing by comparing invoices to daily price list.

7S-9

Chapter Eight
Professional Responsibility
CODE OF PROFESSIONAL CONDUCT
INTRODUCTION TO THE CODE OF CONDUCT
1.

The Code derives its authority from the bylaws of AICPA

2.

The Code is needed because a distinguishing mark of a profession is its acceptance of responsibility to the
public

3.

The Code contains four parts:

a.
Principles of Conduct (aspirational in nature, not mandatory)
b.
Rules (mandatory compliance is required)
c.
Interpretations of Rules of Conduct
d.
Ethics Rulings

4.

Compliance with the Code of Professional Conduct depends

a.
primarily on members' understanding and voluntary actions
b.
secondarily on reinforcement by peers and public opinion
c.
ultimately on disciplinary proceedings against members who fail to comply with the Rules.

PRINCIPLES OF CONDUCT
1.

Article I. Responsibilities: Mem bers should exercise sensitive professional and moral judgments in all
their professional activities

2.

Article II. The Public Interest: Members should act in a w ay that serves the public interest, honors the
public trust, and demonstrates a commitment to professionalism

3.

Article III. Integrity: To maintain and broaden public confidence, members should perform all
professional responsibilities with the highest sense of integrity

4.

Article IV. Objectivity and Independence:

a.
a member should maintain objectivity and be free of con flicts of interest in discharging professional
responsibilities
b.
a member in public practice should be independent in fact and appearance when providing auditing
and other attestation services

5.

Article V. Due Care: A member should observe the profession's technical and ethical standards, strive to
continually improve competence and quality of services, and discharge professional responsibilities to
the best of the members ability

6.

Article VI. Scope and Nature of Services: Members in public practice should observe the Principles of the
Code in determining the nature and the scope of services

8-1

RULES OF CONDUCT, INTERPRETATIONS & RULINGS

1.

There are currently 11 Rules of Conduct that members must adhere to:
a.
Rule 101 Independence
b.
Rule 102 Integrity and Objectivity
c.
Rule 201 General Standards
d.
Rule 202 Compliance with Standards
e.
Rule 203 Accounting Principles
f.
Rule 301 Confidential Client Information
g.
Rule 302 Contingent Fees
h.
Rule 501 Acts Discreditable
i.
Rule 502 Advertising and Other Forms of Solicitation
j.
Rule 503 Commissions and Referral Fees
k.
Rule 505 Form of Organization and Name

2.

Interpretations of Rules of Conduct have been adopted by the professional ethics division to provide
guidelines as to the scope and application of the Rules

3.

Ethics Rulings are formal rulings by the professional ethics division that apply the Rules to specific factual
circumstances

101 INDEPENDENCE

101: A member in public practice shall be independent in the performance of professional services as required by
standards promulgated by bodies designated by Council
1.

Those in public practice should be i ndependent in fact and appeara nce in auditing a nd in other attest ation
services
a.
e.g. independence is required for audits and reviews, but is not required for compilations, consulting
services or tax services (not attestation services)
b.
independence in appearance is needed for auditors to maintain public confidence in the profession

2.

Independence is i mpaired with an attestation client if there is a d irect financial interest regardless of
materiality or if there is a material indirect interest
a.
e.g. independence is impaired if audit fees remain unpaid for more than one year prior to the date the
current year's report is issued (considered a loan)
b.
e.g. impaired if th e auditor had a jo int, closely held investment with the client that had a m aterial
effect on the CPA or the CPAs firm
c.
e.g. not impaired in a financial institution client if an auditor has:
1).
a checking account that is fully insured by the government
2).
a fully collateralized automobile loan
3).
loans fully collateralized by an insurance policy or by cash deposits
4).
credit card or cash advances where the aggregate outstanding balance is $5,000 or less by the
payment due date
d.
e.g. payments made to former members of the firm will not impair independence if evidenced by a
written agreement and are for an amount fixed by formula
1).
the amounts must not be material to the firm
2).
the former member cannot participate or appear to participate in firm business
Independence is impaired if the practitioner had a management position or was an employee of an audit or
attestation service client
a.
auditor can perform other services for a client (e.g. consulting services) and still be independent as
long as the auditor doesnt perform management functions
1).
i.e. auditor could advise the client, but could not make management decisions
2).
specifically the auditor could not negotiate for a client, have custody of clients assets or report
to the board of directors on behalf of management

3.

8-2

b.

c.

d.
e.

4.

examples of an auditor's independence being impaired

1).
signing a client's checks in an emergency situation
2).
performing payroll preparation services for clients
3).
contracting to supervise a client's office personnel
4).
being officially appointed stock transfer agent or registrar of a client
5).
auditor serves as an executor or trustee of a client
a spouse or dependent person of the auditor may be an accountant of the client
1).
they may not have a position with the client that has a significant influence over the clients
operating, financial or accounting policies
2).
they may be a bo okkeeper, but they may not have a position involving activities subject to
significant internal accounting controls (e.g. cashier; internal auditor; accounting supervisor;
purchasing agent)
independence is not impaired by an auditor being a member of or an honorary trustee for a not-forprofit group as lo ng as th e position is clearly h onorary and the auditor does not participate in any
management functions (e.g. could not serve on the board)
employment of personnel for an audit or attestation client
1).
a CPA may not hire employees for an audit client (a management function)
2).
the CPA may recommend a job description, screen and recommend qualified candidates, so
long as the ultimate hiring decision is made by the client

Actual or threatened litigation may impair independence

a.
independence is impaired if the auditor sues present management for fraud
b.
independence is impaired if the auditor is sued for audit deficiencies by the c lient or there is a th reat
of suit with a strong possibility of the suit occurring
c.
independence is not impaired if the suit involves immaterial dollar amounts and is not related to audit
work (e.g. a billing dispute for an immaterial amount)

102 INTEGRITY AND OBJECTIVITY

102:

In the performance of any professional service, a member shall maintain objectivity and integrity, shall be
free of conflicts of i nterest, and s hall not knowingly misrepresent facts or su bordinate his or her
judgment to others

1.

A member may not knowingly make, permit, sign or direct another to make false and misleading entries on
financial statements or records

2.

A conflict of i nterest may occur i f a m ember has a si gnificant relationship with a cl ient or em ployer that
could be viewed as impairing the member's objectivity
a.
the service may still be performed if th e relationship is d isclosed and the consent of the client is
obtained
b.
disclosure and consent cannot eliminate the requirement of independence

3.

If a member and his/her supervisor disagree regarding financial statements or recording of transactions, the
supervisor's position may be followed if it is an acce ptable alternative and does not result in material
misrepresentations
a.
if material misrepresentations would result, the member should discuss this with higher management
officials and document the details of the disagreement
b.
if discussions with higher management are fr uitless, CPA sh ould consider quitting, seeking legal
counsel and reporting the misrepresentations to appropriate parties

4.

Members engaged in educational services (e.g. teachers) and client advocacy must act with integri ty and
objectivity

8-3

201 GENERAL STANDARDS

201:

A member shall comply with the following standards and with any interpretations thereof by bodies
designated by Council
A.
Professional Competence. Undertake only those professional services that the member or the
member's firm can reasonably expect to be completed with professional competence
B.
Due Professional Care. Exercise due professional care in the performance of professional services
C.
Planning and Supervision. Adequately plan and supervise the performance of professional services
D.
Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions
and recommendations in relation to any professional services performed

1.

Professional Competence includes all of the following:

a.
the technical qualifications of the CPA and of the CPA's staff
b.
the ability to supervise and evaluate work
c.
the knowledge of techn ical subject matter OR ab ility to obtain it b y research or by consulting with
others

2.

If a CPA begins an engagement and then discovers (s)he lacks sufficient competence:
a.
the CPA should inform client, withdraw and recommend another CPA
b.
the CPA may still collect a fee for the work done

202 COMPLIANCE WITH STANDARDS

202:

A member who performs auditing, review, compilation, management, consulting, tax or other professional
services shall comply with standards designated by Council

1.

The standards and the issuing bodies are as follows

ENGAGEMENT
AUDIT
GOVERNMENT
AUDITS
REVIEWS AND
COMPILATIONS
TAX
CONSULTING
SERVICES

2.

STANDARD

ISSUING AGENCY

Generally Accepted Auditing

Standards - GAAS
Generally Accepted Gov't
Auditing Standards - GAGAS
Statements on Standards for
Accounting and Review Services
SSARS
Statements on Responsibilities
in Tax Practice
Statements on Standards for
Consulting Services - SSCS

AICPA Auditing
Standards Board
Government Accounting
Standards Board
Accounting and Review
Services Committee of AICPA
Federal Taxation Committee of
AICPA
Management Consulting Services
Committee of the AICPA

Note: as pertains to Generally Accepted Auditing Standards (GAAS)

a.
GAAS are measures of quality of an auditor's performance
b.
elements of materiality and relative risk underlie application of GAAS

8-4

203 ACCOUNTING PRINCIPLES

203:

(paraphrased) A member shall not expre ss an opinion or state affirmatively or negatively that financial
statements or other financial data are presented in conformity with generally accepted accounting
principles, if there is any depart ure from an accounting princi ple that has a material effect on the
statements or data.
If, due to unusual circumstances, compliance with generally accepted accounting principles would cause the
financial statement or data to be misleading, the member can comply with the rule by describing the
departure, its approximate effects and the reason why compliance would result in a misleading
statement

1.

The body des ignated to establish ge nerally accepted accounting principles is the Financial Acc ounting
Standards Board (FASB)

2.

Four sources of generally accepted accounting principles (GAAP)

a.
Statements Of Financial Accounting Standards.(SFAS not FASB's)
b.
AICPA Accounting Research Bulletins (ARB's)
c.
AICPA Accounting Principle Bd. Releases (APB's)
d.
Interpretations of the above th ree issued by Financial Accounting Standards Board
Interpretations)

3.

(FASB

Unusual circumstances may justify a departure from GAAP if compliance would cause the financial
statements to be misleading
a.
e.g. new legislation or the evolution of a new form of business transaction would justify a
departure from GAAP
b.
e.g. an unusual degree of materiality or the ex istence of conflicting industry practices would not
justify departure from GAAP
c.
the departure must be described and explained

301 CONFIDENTIAL CLIENT INFORMATION

301:

A member in public practice shall not disclose any confidential client information without the specific
consent of the client

1.

A member cannot reveal confidential client information without the client's consent
a.
in a sale or merger of a member's professional practice, a member:
1).
may allow a pu rchaser to review confidential information without the client's consent, but
should obtain a written confidentiality agreement from purchaser
2).
a member cannot give turn confidential information over to the purchaser without the client's
consent
b.
a member must disclose confidential client information if it is subpoenaed and relevant to a court case
(unless in a jurisdiction that recognizes the accountant client privilege)
c.
a member must reveal confidential client information to a state CPA quality control panel, even in a
jurisdiction recognizing the accountant-client privilege

2.

A CPA may use a reco rds-retention agency to store clients' records and working papers, so l ong as the
confidential nature of the records is maintained

3.

A CPA may disclose the name of a client without the client's consent, so long as the disclosure of the client's
name does not constitute the release of confidential information.

8-5

302 CONTINGENT FEES

302:

A member in public practice shall not

1)
Perform for a contingent fee any professional services for, or receive such a fee from a client for
whom the member or the member's firm performs
a) an audit or review of a financial statement; or
b) a compilation of a financial statement when the member expects, or reasonably might expect, that a
third party will use the financial statement and the member's compilation report does not disclose a
lack of independence; or
c) an examination of prospective financial information or
2)
Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client

1.

A contingent fee is a fee established for performing services where

a.
no fee will be charged unless a specific finding or result is obtained or
b.
the amount of the fee is dependent upon the finding or result obtained
c.
solely in the context of Rule 302, fees are not contingent if:
1).
fixed by courts or public authorities
2).
in tax m atters, if dete rmined based on the results of judicial proceedi ngs or the findings of
governmental agencies

2.

A contingent fee is specifically prohibited for audits or reviews of financial statements

3.

A contingent fee is specifically prohibited for preparing an original or amended tax return or for a claim for a
tax refund

4.

Contingent fees are permitted

a.
to sell a practice for a price based on fees the purchaser gains from clients
b.
for compilations only if you add the statement you are not independent
c.
for representing a client in an examination of a tax return by a revenue agent

501 ACTS DISCREDITABLE

501:

A member shall not commit an act discreditable to the profession

1.

Acts that are discreditable to the profession:

a.
retaining a client's records after the client has demanded them is discreditable
1).
e.g. cannot use retention of records for collection of past due fees
2).
a member may retain working papers until past due fees are paid
3).
a discreditable act even if there is a state statute permitting retention
b.
determination by a court or administrative agency of discrimination or harassment in public practice
based on race, color, sex, age, religion or national origin in employment is discreditable
c.
failing to follow applicable standards or procedures in governmental audits is discreditable unless:
1).
the CPA discloses in the report that such requirements were not followed
2).
the CPA states the reasons for not complying with the standards
d.
negligently making false or misleading journal entries or pe rmitting another to make false or
misleading journal entries is discreditable
e.
failing to follow GAAS and the applicable requirem ents of government bodies, commissions or
regulatory agencies is discreditable unless:
1).
the CPA discloses in the report that such requirements were not followed
2).
the CPA states the reasons for not complying with the standards
f.
soliciting or disclosing CPA examination questions is discreditable
g.
failure to timely file a personal or firm tax return or to timely remit payroll or other taxes collected on
behalf of others is discreditable

2.

A CPA firm may make arrangements with a bank to collect notes issued by a client in payment for audit fees
due without violating any provision of the Code

8-6

502 ADVERTISING & OTHER FORMS OF SOLICITATION

502:

A member in public practice shall not seek to obtain clients by advertising or other forms of solicitation in
a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, overreaching, or
harassing conduct is prohibited

1.

Advertisements and solicitations that are false, misleading or deceptive include

a.
creating false or unjustified expectations
b.
implying the ability to influence a court, tribunal, regulatory agency or official
c.
intentionally underestimating fees
d.
any representations that would mislead or deceive a reasonable person

503 COMMISSIONS AND REFERRAL FEES

503:
A.

B.

C.

Prohibited Commissions (pa raphrased)

A member in public practice shall not for a co mmission
recommend or refer to a client any product or service, when the m ember or the member's firm also
performs for that client
a)
an audit or review of a financial statement; or
b)
a compilation of a financial statement when the member expects, or reasonably might expect, t hat a
third party will u se the financial statement and the member's compilation report does not disclose a
lack of independence; or
c)
an examination of prospective financial information
Disclosure of Permitted Commissions A member in public practice who is not prohibited from performing
services for or receiving a commi ssion and who e xpects to be paid a commission shall disclose that
fact to the applicable parties
Referral Fees Any member who accepts a referral fee for recommending or referring any service of a CPA
to any person or who pays a referral fee to obtain a client shall disclose such acceptance or payment to
the client

1.

A CPA cannot receive a commission for recommending or referring to a client a product or service if the
CPA or firm provides any of the following services:
a.
audits or reviews of financial statements
b.
compilations if th e CPA reason ably believes the client will u se the financial statement and the
compilation does not disclose a lack of independence
c.
examination of prospective financial information

2.

A CPA performing other services not prohibited above may receive a commission but must disclose this to
the client

3.

A CPA who receives a referral fee for recommending another CPA or pays a referral fee to obtain a client
must disclose this to the client

505 FORM OF ORGANIZATION AND NAME

505:

A member may practice public accounting only in a form of organization permitted by state law or regulation
whose characteristics conform to resolutions of Council
A member shall not practice public accounting under a firm name that is misleading. Names of one or more
past owners may be included in the firm name of a successor organization.
A firm may not designate itself as "Me mbers of th e American Institute of Certified Public Accountants"
unless all of its owners are members of the Institute.

8-7

1.

Appendix B to the Code of Conduct specifies that a firm which designates itself "certified public
accountant(s)" or uses the designation "C PA" in c onnection with its name, must comply with the
following:
a.
a majority of the ownership of the firm must be CPAs
1).
non-CPA owners must be actively engaged in providing firm services
2).
ownership by investors not providing services to firm clients is prohibited
b.
a CPA must have ultimate authority for all services provided by the firm
c.
non-CPA owners must have a baccalaureate degree, attain 150 semester hours of education by 2010
and complete the same CPE requirements as CPAs
d.
non-CPA owners must abide by the Code of Conduct
e.
non-CPA owners may use the title of principal, owner, officer, member or shareholder but may not
hold themselves out as being CPA's

2.

A CPA in public practice must not have a misleading firm name

a.
a firm may not designate itself as a "m ember of the AICPA" unless all ow ners are members of the
AICPA
b.
a CPA who is an attorney or controller of bank may indicate this on their letterhead
c.
a former partner's name may be used for 2 years. if all other partners have died or withdrawn
d.
CPA in partnership with non-CPAs may sign his name as a CPA if it is made clear that the firm is not
being held out as all being CPA's

3.

A CPA in public practice may operate a separate business that performs accounting services for clients
a.
the CPA is also considered to be in public practice for the separate business
b.
the CPA must comply with the Rules of Conduct in the separate business

RESPONSIBILITIES OF CPAs IN BUSINESS & INDUSTRY

1.
6 of the Rules of Conduct apply to CPAs in business, industry and in the public sector
a.
102: Integrity and Objectivity
b.
201: General Standards
c.
202: Compliance with Standards
d.
203: Accounting Principles
e.
501: Acts Discreditable
f.
503: Commissions and Referral Fees
2.

5 of the Rules of Conduct apply only to CPAs in public practice

a.
101: Independence
b.
301: Confidential Client Information
c.
302: Contingent Fees
d.
502: Advertising and Other Forms of Solicitation
e.
505: Form of Organization and Name

3.

Specific rules and rulings relating to those in business, industry and the public sector
a.
101: Independence
1).
a CPA not in pu blic practice may use the CPA designation in connection with fin ancial
statements and correspondence of the member's employer
2).
the CPA may also use the CPA designation along with employment title on business cards
3).
The CPA must not imply that he or she is independent of the employer
b.
102: Integrity and Objectivity
1).
members not in public practice h ave the responsibility to maintain objectivity in rendering
professional services
2).
in dealing wi th an em ployer's external accountant, a member must be candid a nd not
knowingly misrepresent facts or knowingly fail to disclose material facts (e.g. responding to
specific inquiries for which the employer's external accountant requests written representation)
3).
members not in public practice may have a conflict of interest with an employer, if the conflict
is disclosed and the employer's consent is obtained

8-8

c.

d.
e.

203: Accounting Principles

1).
if a member not in public practice states affirmatively that a financial statement is presented in
conformity with generally accepted accounting principles, the member is subject to rule 203
2).
representations regarding GAAP conformity of t he client's financial statements included in
communications from a client to its auditor or others are subject to rule 203 for members who
signed the communication (e.g. signing reports to regulatory authorities, creditors and auditors)
501: Acts Discreditable - in dealing with an em ployer's external accountant, a m ember must be
candid and not knowingly misrepresent facts or k nowingly fail to disclose material facts (to do so
would be a discreditable act)
502: Advertising and Other Forms of Solicitation
1).
a member not in public practice who is a controller of a bank may permit the bank to use his
CPA title on bank stationery and in paid advertisements listing the officers and directors of the
bank
2).
a member who is also an attorney m ay represent himself on his letterhead as both an attorney
and a CPA

PROFICIENCY, INDEPENDENCE & DUE CARE

3 GENERAL STANDARDS IN AUDITS

1.

First general standard: T he audit is to be performed by a pe rson or persons having a dequate technical
training and proficiency as auditors
a.
this requires both proper education and experience in auditing
b.
experience is needed for an auditor to have seasoned judgment

2.

Second general standard: In all matters relating to the assignment, an independence in mental attitude is to
be maintained by the auditor or auditors

3.

Third general standard: Due professi onal care is to be exercised in the performance of the audit and the
preparation of the report
a.
the auditor must possess the same degree of skill commonly possessed by others in the field
b.
the auditor must act as a reasonably prudent accountant would under similar circumstances
c.
the auditor must critically review work done and judgment exercised by those assisting in the audit at
every level of supervision

STATEMENTS ON STANDARDS FOR CONSULTING SERVICES

1.

Statements on Standards for Consulting Services (SSCS) apply to CPAs performing consulting services
a.
consulting services are tho se that employ the practitioner's technical skill, education, observations,
experience and knowledge of the consulting process
b.
SSCS lists six types of consulting services (CPA SIT)

Consultations - give advise over a short per iod of time based on the consultant's personal knowledge of client
(e.g. reviewing a client's business plan)
Product Services - consultant supplies the client with a specific product and support necessary to use and maintain
the product (e.g. sale and implementation of computer software)
Advisory Services - development of findings, recommendations and conclusions for a client's consideration and
decision making (e.g. analysis of an accounting system or strategic planning)
Staff and Other Support Services - providing the staff and support to accomplish tasks assigned by the client
(e.g. computer programming or providing the trustee for a bankruptcy)
Implementation Services - put ting into effect a p lan of acti on (e.g. installing a new com puter system (should
insure that client's personnel will be able to maintain and operate the system)
Transaction Services - consultant provides services r elating to a spec ific client transaction ( e.g. preparing
information to assist the client in obtaining financing)

P
A
S
I
T

8-9

2.

The nature and scope of the consulting services to be performed is determined solely by the agreement
between the practitioner and the client
a.
the agreement may be written or oral
b.
any significant limitations or reservations concerning the engagement should be communicated to the
client
c.
significant engagement findings should also be communicated to the client

3.

The principal role of a CPA providing consulting services is that of an objective advisor
a.
the CPA cannot take positions that would impair objectivity or integrity
b.
the CPA can have a con flict of interest and still p erform a co nsulting engagement if th e conflict is
disclosed to the client and client consents
c.
consulting services do not require independence
d.
attainment of objectives cannot be guaranteed by a CPA

4.

Rule 201 of the Code of Conduct (General Standards) applies to all professional services performed by
CPAs and therefore are required for consulting services
a.
Professional Competence
b.
Due Professional Care
c.
Planning & Supervision
d.
Sufficient Relevant Data

STATEMENTS ON RESPONSIBILITIES IN PERSONAL FINANCIAL

PLANNING PRACTICE

Statements on Responsibilities in Personal Financial Planning (PFP) are not enforceable standards under Rule 202
of the Code of Professional Conduct - guidelines only

PFP 100:

BASIC PFP ENGAGEMENT FUNCTIONS

1.

PFP engagements involve developing strategies and m aking recommendations to assist clients in defining
and achieving personal financial goals - to include
a.
defining engagement objectives
b.
planning specific procedures appropriate for the engagement
c.
developing recommendations and communicating them to the client
d.
identifying tasks for taking action on planning decisions

2.

Other engagements may also include

a.
assisting client to take action on planning decisions (i.e. implementation engagements)
b.
monitoring a client's progress in achieving goals (i.e. monitoring engagements)
c.
updating recommendations and helping the client revise planning decisions (i.e.
engagements)

updating

3.

PFP does not include services that are limited to

a.
compiling personal financial statements
b.
projecting future taxes or tax compliance (e.g. preparing tax returns, tax advise or tax consultations
are not PFP engagements)

4.

A PFP engagement requires compliance with the Code of Conduct, to include:

a.
Rule 102 Integrity and Objectivity: main tain objectivity and integrity, be free of con flicts of
interest, and not knowingly misrepresent facts
b.
Rule 201 General Standards: performance of PFP e ngagements requires professional competence,
due professional care, adequate planning and supervision and obtaining sufficient relevant data
c.
Rule 301 Confidential Information
d.
Rule 302 Contingency Fees

8-10

5.

A CPA should define the objectives of t he PFP engagement based on an understanding of the client' s goals
and resources

6.

Document the overall scope of the engagement by an engagement letter or file memos that document oral
understandings with the client to include:
a.
the objectives of the engagement
b.
the scope of services to be provided, including limitations and constraints
c.
the fee arrangements

7.

PFP engagements should be adequately planned based on engagement objectives, materiality and cost-benefit
considerations

8.

Recommendations should be communicated in writin g and based on sufficient relevant information to

include:
a.
the client's goals and financial resources available to achieve the goals
b.
external factors (e.g. inflation and taxes)
c.
nonfinancial factors (e.g. client's risk tolerance and investment preference)

9.

Unless specifically agreed to, a PFP engagement does not require the CPA to:
a.
assist a client in taking action on planning decisions (implementation engagement)
b.
monitoring progress in achieving goals (monitoring engagement)
c.
updating recommendations or revising planning decisions (updating engagement)

PFP 200:

WORKING WITH OTHER ADVISORS

1.

If a CPA doesn't provide a service needed for a PFP engagement

a.
an advisor who provides such services should be recommended
b.
if the client declines to engage another advisor the CPA may still proceed with the engagement but
should document this in writing

2.

A CPA should communicate in writing to the client

a.
the nature of the work to be done by the advisor
b.
the extent to which the CPA will evaluate their work

PFP 300: IMPLEMENTATION ENGAGEMENTS

1.

Implementation engagements involve assisting a cl ient in taking action on planning decisions developed
during a PFP engagement (e.g. sel ecting investment advisors, restructuring debt, preparing budgets
and selecting investments products)

2.

Implementation decisions are made by the client, not the CPA

3.

Communication of information and recommendations should be in writing

8-11

PFP 400: MONITORING & UPDATING ENGAGEMENTS

1.

Monitoring engagements involve monitoring progress in achieving PFP goals

a.
nature, extent and frequency of monitoring services should be agreed upon
b.
monitoring may result in a recommendation that an updating of the financial plan and financial
planning recommendations be done

2.

Updating engagements involve revising the client's existing financial plan and financial planning
recommendations based on current circumstances

DISCIPLINARY SYSTEMS WITHIN THE PROFESSION

AICPA DISCIPLINARY MEASURES
1.

AICPA provisions for termination of membership and disciplinary sanctions are s pecified in the AICPA
Bylaws Section 700 and are listed below
a.
the AICPA only has the authority to sanction its members
b.
the AICPA does not have authority to suspend or revoke a CPA license

2.

BL 710 Resignation of Membership: A member may not resign if charges are pending before Professional
Ethics Division or Trial Board without approval

3.

BL 720 Termination for Nonpayment of Financial Obligation or Co mpliance With Membership-Retention

Requirements: membership may be terminated for
a.
failure to pay dues or other obligations to the Institute within 5 months
b.
failure to comply with the practice-m onitoring or co ntinuing education membership retention
requirements

4.

BL 730 Disciplinary Suspension and Termination of Membership Without Hearing - Me mbership shall be
suspended or terminated without hearing
a.
upon filing with the Institute a judgment of conviction for
1).
a crime punishable by imprisonment for more than one year
2).
willful failure to file a tax return or filing a fraudulent return
3).
willful aiding in the preparation of a fraudulent tax return of a client
b.
if a member's license to practice public accounting has been suspended or revoked as a disciplinary
action by any government authority
c.
the Trial Board may postpone the suspension or termination upon written request and refer the matter
to the Professional Ethics Division for action

5.

BL 740 Disciplining of Member by Trial Board:

a.
Trial Board may expel a member by two-thirds vote
b.
Trial Board may suspend a member for up to two years or impose lesser sanctions by a majority vote
c.
sanctions may be imposed for:
1).
violation of the bylaws or any rule of the Code of Conduct
2).
court ruling of fraud, conviction of a crime discrediting the profession, or declared by a court
to be insane or incompetent
3).
acts discreditable to the profession
4).
suspension or revocation of a member's license to practice public accounting as a disci plinary
action by government authority
5).
failure to c ooperate with Professional Ethics Division's disciplinary investigation of t he
member, partner or employee of the firm
6).
not complying with educati onal and remedial or c orrective action deemed necessary by
Professional Ethics Division within 30 days

8-12

6.

BL 750 Reinstatement:
a.
Trial Board may rescind or modify a disciplinary decision by 2/3 vote.
b.
if based upon a criminal conviction or the member's license was suspended or revoked by government
authority the member is reinstated upon an order reversing or setting aside the conviction, suspension
or termination
c.
suspension based on court ruling or order of a government authority that is reversed or set aside may
be rescinded by majority vote of Trial Board
d.
a member expelled or term inated may request re instatement after 3 years an d the Trial Bo ard may
reinstate by majority vote

7.

BL 760 Publication of Disciplinary Action: No tice of disciplinary action taken is pub lished in a
membership periodical (CPA Newsletter)

STATE BOARDS OF ACCOUNTANCY SANCTIONS

1.

State legislatures vest in state boards of acco untancy the authority to license CPAs an d to discipline those
engaged in the practice of public accounting
a.
only a state board has the authority to suspend or revoke a CPA's license
b.
the board's purpose is to protect the public welfare and preserve public confidence in the accounting
profession

2.

A state board may impose one or more of the following penalties for misconduct:
a.
suspension or revocation of the license to practice public accounting
b.
a fine
c.
a reprimand or probation
d.
require additional CPE courses as a condition of reinstatement

3.

States differ as to what constitutes professional misconduct but state boards may usually issue sanctions for
three broad types of misconduct
a.
criminal convictions (e.g. usually specified are felonies, those involving fraud or dishonesty, crimes
relating to the practice of accounting and failing to file one's own income tax return)
b.
misconduct while performing accounting services (e.g. incompetency, fraud, gross negligence,
dishonesty or violations of rules of conduct)
c.
misconduct outside the scope of performing accounting services (e.g. use of d rugs or alcohol to
the extent it impairs the ability to practice accounting or any acts determined to be discreditable to the
profession)

4.

Before a state board can take disciplinary action, it must conduct an investigation
a.
the accountant has the opportunity to request a hearing
b.
the test for guilt: is it more likely than not th at the accountant's actions constituted misconduct (not
proof beyond a reasonable doubt)
c.
the hearing panel's decision including possible sanctions are sent to the accountant and the board of
accountancy, which renders the final decision

5.

All disciplinary orders of boards of accountancy are subject to judicial review

AUTHORITY
BOARD
1.

OF

PUBLIC

COMPANY

ACCOUNTING

OVERSIGHT

The Sarbanes-Oxley Act created the PCAOB to promulgate and enforce standards for accountants and
accounting firms
a.
all accountants and firms must register with the PCAOB if it plays any substantial role in preparing an
audit report for a company registered with the SEC

8-13

b.
c.
d.

the PCAOB does not have authority to affect state licenses, and does not replace state authority to
make investigations and take disciplinary actions
the PCAOB does have authority to bar accountants and firms from providing audit services to publicly
traded companies
in general, the PCAOB has wide authority over 1) all auditing practice related to public companies and
2) all practice of registered accounting firms

2.

The PCAOB established its own Rules of the Board under authority of the Sarbanes-Oxley Act
a.
rules of the Board are subject to the approval of the SEC
b.
although PCAOB was set up to regulate accounting firms that audit public companies (only companies
under the jurisdiction of the SEC), once a firm is registered with the PCAOB the Rules may reach
some non-audit activities (e.g., firms cannot be responsible for a public companys audit report if i t
also does appraisal, actuarial or other work for the same company)
c.
audit reports prepared by registered firms must be reviewed and approved by more than one partner
d.
registered firms must report on its internal compliance procedures

3.

As of the end of 2010, the rules in the Professional Standards section of the Rules of the Board are mostly in
interim status
a.
until all Rules of the Board are finalized, its Rule 3200T (Interim Auditing Standards) specifies that all
accountants subject to PCAOB authority shall comply with generally accepted auditing standards
b.
as a general principle, the PCAOBs Professional Standards rules are largely modeled on or expressly
refer to guidelines and standards promulgated by the AICPA

4.

The PCAOB conducts inspections of registered accounting firms

a.
inspections for firms that audit between 1 and 100 public companies are inspected once e very three
years, while firms that audit over 100 public companies are inspected every year
b.
the PCAOB may conduct more inspections on its own initiative
c.
inspections may lead to informal or formal investigations

5.

The PCAOB may conduct informal or formal investigations of registered accounting firms
a.
investigations may concern suspected violations of, Sarbanes-Oxley violations, Rules of the PCAOB
Board, securities law or SEC regulations, or simply professional standards
b.
even in context of an informal investigation, the PCAOBs Director of Enforcement is en titled to
inspect work papers and may require interviews or testimony of any person
c.
the Director of Enforcem ent may determine that a form al hearing is necessary, assigning a heari ng
officer
d.
the PCAOB is empowered to bar individual accountants from working with any registered firm, or to
bar firms from e mploying individual accountants in any capacity (i.e. may prevent firm from
employing accountant found to have engaged in wrongdoing)
e.
the five-person PCAOB itself may review disciplinary decisions, on its own initiative or if accountant
or firm appeals
f.
because the PCAOB ope rates under the authority of the SEC, final PCAO B disciplinary proceedings
must be made by filing a petition with the SEC for review before it may then become reviewable by an
appellate court

8-14

Chapter Eight: Professional Responsibility

Multiple Choice Questions
5. According to the standards of the profession,
which of the following activities wou ld most likely
not impair a CPAs independence?
a. Providing extensive advisory services for a client.
b. Contracting with a client to supervise the clients
office personnel.
c. Signing a clients checks in emergency situations.
d. Accepting a luxurious gift from a client.

1. Which of t he following statements best explains

why the CPA profession has found it essential to
promulgate ethical standards and to establish means
for ensuring their observance?
a. A distinguishing mark of a profession is its
acceptance of responsibility to the public.
b. A requirement for a profession is to est ablish
ethical standards that stress primary responsibility
to clients and colleagues.
c. Ethical standards that em phasize excellence in
performance over material rewards establish a
reputation for competence and character.
d. Vigorous enforcement of an est ablished code of
ethics is the best way to prevent unscrupulous
acts.

6. The concept of m ateriality would be least

important to an auditor when considering the
a. Adequacy of disclosure of a client's illegal act.
b. Discovery of weaknesse s in a clien t's internal
control structure.
c. Effects of a di rect financial interest in t he client
on the CPA's independence.
d. Decision whether to use positive or negative
confirmations of accounts receivable.

2. Must a CPA in public practice be independent in

fact and a ppearance when providing the following
services?

a.
b.
c.
d.

Compilation
of personal
financial
statements
Yes
No
No
No

Preparation
of a
tax return
No
Yes
No
No

7. A violation of the profession's ethical standards

most likely would have occurred when a CPA
a. Issued an unqualified opinion on the 1992
financial statements when fees for the 1991 audit
were unpaid.
b. Recommended a co ntroller's position description
with candidate specifications to an audit client.
c. Purchased a CPA firm's practice of m onthly
write-ups for a percentage of fees to be rec eived
over a three-year period.
d. Made arrangements with a financial institution to
collect notes issued by a client in paym ent of fees
due for the current year's audit.

Compilation
of a
financial
forecast
No
No
Yes
No

3. Which of the following reports may be issued only

by an accountant who is independent of a client?
a. Standard report on a n examination of a financial
forecast.
b. Report on consulting services.
c. Compilation report on historical financial
statements.
d. Compilation report on a financial projection.

8. In which of the following situations would a CPA's

independence be considered to be impaired?
I. The CPA m aintains a ch ecking account that is
fully insured by a gove rnment deposit insurance
agency at an audit-client financial institution.
II. The CPA has a direct financial interest in an audit
client, but the interest is maintained in a b lind
trust.
III. The CPA owns a commercial building and leases
it to an audit client. The rental income is material
to the CPA.
a. I and II.
b. II and III.
c. I and III.
d. I, II, and III.

4. An auditor strives to achieve independence in

appearance in order to
a. Maintain public confidence in the profession.
b. Become independent in fact.
c. Comply with the generally accepted a uditing
standards of field work.
d. Maintain an unbiased mental attitude.

8Q-1

9. According to the standards of the profession,

which of the following circumstances will p revent a
CPA performing audit engagements from being
independent?
a. Obtaining a collateralized automobile loan from a
financial institution client.
b. Litigation with a clien t relating to billing for
consulting services for which the amount is
immaterial.
c. Employment of the CPA's spouse as a client's
internal auditor.
d. Acting as an honorary trustee for a not-for-profit
organization client.

12. Which of the following best describes what is

generally accepted auditing
meant by the term
standards?
a. Rules acknowledged by the accounting profession
because of their universal application.
b. Pronouncements issued by the Auditing Standards
Board.
c. Measures of th e quality of the auditor's
performance.
d. Procedures to be used to gather evi
dence to
support financial statements.
13. Which of th e following is the authoritative body
designated to promulgate attestation standards?
a. Auditing Standards Board.
b. Governmental Accounting Standards Board.
c. Financial Accounting Standards Board.
d. General Accounting Office.

10. According to the profession's ethical standards, an

auditor would be considered independent in which of
the following instances?
a. The auditor is the officially appointed stock
transfer agent of a client.
b. The auditor's checking account that is fu lly
insured by a fede ral agency is held at a client
financial institution.
c. The client owes the a uditor fees for more than
two years prior to the issuance of the audit report.
d. The client is the only tena nt in a commercial
building owned by the auditor.

14. The authoritative body designated to promulgate

standards concerning an accountant's association with
unaudited financial statements of an entity that is not
required to fil e financial statements with an agency
regulating the issuance of the entity's securities is the
a. Financial Accounting Standards Board.
b. General Accounting Office.
c. Accounting and Review Services Committee.
d. Auditing Standards Board.

11. After beginning an audit of a new client, Larkin,

CPA, discovers that the professional competence
necessary for the enga gement is lacking. Larkin
informs management of the situation and
recommends another CPA, and management engages
the other CPA. Under these circumstances
a. Larkin's lack of com petence should be construed
to be a violation of generally accepted auditing
standards.
b. Larkin may request compensation from the client
for any professional services rendered to it in
connection with the audit.
c. Larkin's request for a commission from the other
CPA is permitted because a more competent audit
can now be performed.
d. Larkin may be i ndebted to the other CPA since
the other CPA can collect from the client only the
amount the client originally agreed to pay Larkin.

15. According to the profession's ethical standards,

which of the following events may justify a departure
from a Statement of Financial Accounting Standards?

a.
b.
c.
d.

8Q-2

New legislation
No
Yes
Yes
No

Evolution of a new form

of business transaction
Yes
No
Yes
No

16. Eagle Company's financial statements contain a

departure from generally accepted a
ccounting
principles because, due to unusual circumstances, the
statements would otherwise be misleading. The
auditor should express an opinion that is
a. Unqualified but not mention the departure in the
auditor's report.
b. Unqualified and describe the departure in a
separate paragraph.
c. Qualified and describe the departure in a separate
paragraph.
d. Qualified or a dverse, depending on materiality,
and describe the departure in a separate
paragraph.

20. The profession's ethical standards most likely

would be considered to have been violated when a
CPA represents that specific consulting services will
be performed for a stated fee and it is apparent at the
time of the representation that the
a. Actual fee would be substantially higher.
b. Actual fee wou ld be substantially lower than the
fees charged by other CPA's for comparable
services.
c. CPA would not be independent.
d. Fee was a competitive bid.
21. Acco rding to the ethical standards of t he
profession, which of the following acts is generally
prohibited?
a. Purchasing a product from a t hird party and
reselling it to a client.
b. Writing a fi nancial management newsletter
promoted and sold by a publishing company.
c. Accepting a commission for recommending a
product to an audit client.
d. Accepting engagements obtained through the
efforts of third parties.

17. A CPA is permitted to disclose confidential client

information without the consent of the client to
I. Another CPA firm if the inf ormation concerns
suspected tax return irregularities.
II. A state CPA society vo luntary control review
board.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.

22. The first general standard recognizes that

regardless of how capable an individual may be i n
other fields, the individual can not meet the
requirements of t he auditing standards without the
proper
a. Business and finance courses.
b. Quality control and peer review.
c. Education and experience in auditing.
d. Supervision and review skills.

18. Which of the following actions by a C PA most

likely violates the profession's ethical standards?
a. Arranging with a financial institution to collect
notes issued by a client in payment of fees due.
b. Compiling the financial statements of a client that
employed the CPA's spouse as a bookkeeper.
c. Retaining client records after th e client has
demanded their return.
d. Purchasing a segment of an insura nce company's
business that performs actuarial servic es for
employee benefit plans.

23. The first general standard requires that an audit of

financial statements is to be performed by a person or
persons having
a. Seasoned judgment in varying degrees of
supervision and review.
b. Adequate technical training and proficiency.
c. Knowledge of the standards of field work and
reporting.
d. Independence with respect to the financial
statements and supplementary disclosures.

19. Acco rding to the ethical standards of t he

profession, which of the following acts is generally
prohibited?
a. Issuing a m odified report explaining a fail ure to
follow a gove rnment regulatory agencys
standards when conducting an attest service for a
client.
b. Revealing confidential client information during a
quality review of a professional practice by a
team from the state CPA society.
c. Accepting a continge nt fee for represe nting a
client in an examination of the clients federal tax
return by an IRS agent.
d. Retaining client records after an engagement is
terminated prior to completion and the client has
demanded their return.

24. Which of the following standards requires a

critical review of t he work done and the judgment
exercised by those assisting in an audit at e very level
of supervision?
a. Proficiency.
b. Audit risk.
c. Inspection.
d. Due care.

8Q-3

25. To exercise due professional care an auditor

should
a. Critically review the judgment exercised by those
assisting in the audit.
b. Examine all available corroborating e vidence
supporting management's assertions.
c. Design the audit to detect all instances of illegal
acts.
d. Attain the proper balance of pr ofessional
experience and formal education.

b. II only.
c. Both I and II.
d. Neither I nor II.
30. According to the profession's standards, which of
the following is not required of a C PA performing a
consulting engagement?
a. Complying with Statements on Standards for
Consulting Services.
b. Obtaining an understanding of the nature, scope,
and limitations of the engagement.
c. Supervising staff who are assigned to the
engagement.
d. Maintaining independence from the client.

26. The third general standard states that due care is

to be exercised in the performance of the
examination. This standa rd means that a CPA who
undertakes an engagement assumes a duty to perform
each audit
a. As a p rofessional possessing the degree of skill
commonly possessed by others in the field.
b. In conformity with generally accepted accounting
principles.
c. With reasonable diligence and without fault or
error.
d. To the satisfaction of governmental agencies and
investors who rely upon the audit.

31. According to the profession's standards, which of

the following would be considered consulting
services?

a.
b.
c.
d.

27. According to t he standards of the profession,

which of th e following activities may be required in
exercising due care?

a.
b.
c.
d.

Consulting with
experts
Yes
Yes
No
No

Advisory
services
Yes
Yes
Yes
No

Implementation
services
Yes
Yes
No
Yes

Product
services
Yes
No
Yes
Yes

32. Which of th e following services may a CPA

perform in carrying out a co nsulting service fo r a
client?

Obtaining specialty
accreditation
Yes
No
Yes
No

I. Review of the client-prepared business plan.

II. Preparation of information for obtaining
financing.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

28. A pervasive characteristic of a CPA' s role in a

Consulting Services engagement is th at of being
a(an)
a. Objective advisor.
b. Independent practitioner.
c. Computer specialist.
d. Confidential reviewer.

33. According to the standards of the profession,

which of the following would be considered a part of
a consulting services engagement?
I. Expressing a conclusion about the reliability of a
clients financial statements.
II. Reviewing and commenting on a client-prepared
business plan.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

29. According to the standards of the profession,

which of th e following events would require a CPA
performing a consulting services engagement for a
nonaudit client to withdraw from the engagement?
I. The CPA has a co nflict of interest that is
disclosed to the clien t and the clien t consents to
the CPA continuing the engagement.
II. The CPA fails to obtain a written understanding
from the client concerning the scope of the
engagement.
a. I only.

8Q-4

34. Nile, CPA, on completing an audit, was asked by

the client to provi de technical assi stance in
implementing a new ED P system. The set of
pronouncements designed to guide Nile in this
engagement is the Statement(s) on
a. Quality Control Standards.
b. Auditing Standards.
c. Standards for Accountants' EDP Services.
d. Standards for Consulting Services.
35. Which of the following general standards apply to
consulting service engagements?
Due
professional
care
a. No
b. No
c. Yes
d. Yes

Independence in
mental attitude
Yes
Yes
No
No

Planning and
supervision
No
Yes
Yes
No

36. Under the Statements on Sta

ndards for
Consulting Services, which of t he following
statements best reflects a CP As responsibility when
undertaking a consulting services engagement? Th e
CPA must
a. Not seek to modify any agreement made with the
client.
b. Not perform any attest services for the client.
c. Inform the client of sig
nificant reservations
concerning the benefits of the engagement.
d. Obtain a written understanding with the client
concerning the ti me for completion of th e
engagement.
37. Which of the following bodies ordinarily would
have the authority to suspend or revo ke a CPAs
license to practice public accounting?
a. The SEC
b. The AICPA
c. A state CPA society
d. A
state board of a
ccountancy

8Q-5

Chapter Eight: Professional Responsibility

Other Objective Questions
NUMBER 1
Dredge Corp. engaged Crew, a C PA licensed by a st ate board of accountancy, to perform an au dit of Dredges
financial statements so that Dredge could obtain a large capital improvement loan. During the audit, Bold, Dredges
CFO, asked Crew to accept a consulting engagement to assist Dredge with the installation of a new computerized
accounting system. Crew accepted the consulting engagement and performed it simultaneously with the audit.
While performing the audit, Crew discovered material misstatements in Dredges financial statements resulting from
management fraud committed by Bold. Crew notified Bold of the discovery and was told to disregard it or Crew
would lose the consulting engagement. Believing the consulting engagement would be lost, Crew intentionally did
not notify Dredges audit committee of t he fraud, and rendered an unqualified opinion on Dredges financial
statements.
Dredge submitted to Ocean Bank the materially misstated financial statements together with Crews auditors report.
Ocean relied on the opinion in agreeing to finance Dredges capital improvement.
While performing the consulting engagement, Crew failed to discover that Dredges new computerized accounting
system had insufficient control procedures because Crew omitted steps in order to complete the engagement on time.
The insufficient control procedures had allowed and were allowing employees to steal from the corporation.
As a result of Bolds fraud, Dredge defaulted on the Ocean loan and was petitioned into bankruptcy under Chapter
11 of the Federal Bankruptcy Code.
The following events resulted from the above situation:

Dredge Corp. reported Crews actions to the state board of accountancy that licensed Crew.
Dredge Corp. sued Crew for negligence in performing the consulting engagement.
Ocean Bank sued Crew for common law fraud for giving an unqualifi ed opinion on Dre dges financial
statements.

Required:
a.

1.

2.
b. 1.
2.

Determine whether or no t Crew v iolated the professions standa rds in the areas of indepe ndence (when
accepting the engagement), due ca re, and acts discreditable to the profession, an d give reasons for your
conclusions.
State the actions the state board of accountancy may take against Crew.
State the outcome of Dredge Corp.s su it against Crew fo r negligence in performing the consulting
engagement, and give the reasons for your conclusion.
State the outcome of Ocea n Banks suit against Crew for common law fraud for giving an unqualified
opinion on Dredges financial statements, and give the reasons for your conclusion.

Note: Only the (a) requirement relates to Professional Responsibility. The (b) requirement relates to
Accountants Legal Liability.

8Q-6

NUMBER 2
Wolf is an a udit client of Dunbar Associates, CPAs. Wolf is a re porting company under the provisions of the
Securities Exchange Act of 1934. In 1997, Wolfs audit committee engaged Dunbar to perform litigation support
services. The services were completed in January 1997, and Dunbar billed Wolf in February 1997.
In February 1998, Dunbar began its annual audit of Wolfs financial statements. D uring the course of the audit,
Dunbar discovered that Wolfs officers h ad committed management fraud. Th e officers fraud had resulted in
material misstatements in the financial statements that were to be submitted to the SEC with Wolfs annual report
(Form 10-K). In March 1998, Dunbar issued an auditors report containing an unqualified opinion on the financial
statements. As of that date, Wolf had not paid Dunbars outstanding February 1997 bill.

Required:
a.

State whether Dunbar c ommitted any vi olations of the standards of the professi on in the are as of
independence and due care. Explain your conclusions and indicate what, if any, additional actions Dunbar
should have taken.

b. State whether Dunbar committed any violations of th e Securities Exchange Act of 1934 and the Private
Securities Litigation Reform Act of 1995. Explain your conclusions.
Note:

Only the (a) requirement relates to Professional Responsibility. The (b) requirement relates to
Accountants Legal Liability.

8Q-7

Chapter Eight: Professional Responsibility

Multiple Choice Answers
1. (a) A Code of Professional Conduct is needed because a distinguishing mark of a profession is acceptance
of responsibility to the public. Answer (b) is incorrect because the ethical standards of the accounting profession
apply not only to clients and colleagues, but also to the public at large. Answer (c) is incorrect because the ethical
standards of the accounting profession emphasize more than excellence in performance. They also emphasize
integrity, objectivity, independence and overall moral judgment. Answer (d) is incorre ct because the best way to
prevent unscrupulous acts is through voluntary acceptance of ethical standards by those practicing in the profession.
Enforcement of standards would not be a better method than voluntary acceptance.
2. (d) Rule 101 of the Rules of Conduct requires that those in public practice should be independent in fact and
appearance when performing auditing and other attestation services. Therefore independence is required for
audits and reviews, but is not required for compilations, consulting services and tax services. Only answer (d)
states that independence is not required for a compilation of personal financial statements, preparation of a tax return
or compilation of a financial forecast.
3. (a) Rule 101 of the Rules of Conduct requires that those in public practice should be independent in fact and
appearance when performing auditing and other attestation services. Therefore independence is required for
audits and reviews, but is not required for compilations, consulting services and tax services. Since a report on
an examination of a financial forecast is an attestation service, independence is required. Answers (b), (c) and (d) are
incorrect because independence is not required for consulting services or compilations.
4. (a) Article IV of the Principles of Professional Ethics of the Code requires a member to be independent in fact and
appearance when providing auditing and other attestation services. This is because it is of the utmost importance
to the profession that the general public maintain confidence in the auditors independence. Answer (b) is
incorrect because independence in a ppearance does not necessarily make an auditor independent in fact. Equally,
independence in fact does not necessarily make an auditor appear to be independent. Both are required. Answer (c)
is incorrect because it is due care, not independence, which requires complying with GAAS. Answer (d) is incorrect
because it is objectivity, not independence, which requires an unbiased mental attitude.
5. (a) Rule 101 of the Rules of Conduct requires that those in public practice should be independent in fact and
appearance when performing auditing and other attestation services. Therefore independence is required for
audits and reviews, but is not required for consulting services. Answers (b) a nd (c) a re incorrect because
supervising a clients office personnel and signing checks for a client would be performing management functions
which impair independence. Answer (d) is incorrect beca use acceptance of a luxuri ous gift would obviously impair
independence.
6. (c) Under Rule 101 of the Rules of Conduct as in terpreted, independence is impaired if there is a direct
financial interest in an audit client regardless of materiality. Thus materiality would be irrelevant when
considering the effects of a direct financial interest in the audit client on independence. Answers (a), (b) and (d) are
incorrect because materiality would be important when considering the adequacy of disclosure of a client's illegal
act, discovery of a weakness in a client's internal control structure and decisions whether to use positive or negative
confirmations of accounts receivable.
7. (a) Under Rule 101 of the Rules of Conduct as interpreted, independence is impaired if there is a direct financial
interest in an audit client regardless of m ateriality. Specifically independence is impaired if audit fees remain
unpaid for more than one year prior to the date of the current years report. It is considered a loan. Answer
(b) is incorrect because independence is not impaired by merely recommending a job position including candidate
specifications. However, independence would be +impaired if the CPA actually did the hiring of the controller
because this would be management. Answer (c) is incorrect because there is no prohibition against purchase of a
CPA firms monthly write-ups for a pe rcentage of fees. Answer (d) is i ncorrect because a C PA may make
arrangements with a bank to collect notes issued by a client in payment for a fee that is due.

8S-1

8. (b) Under Rule 101 of the Rules of Conduct as interpreted, independence is impaired if there is a direct
financial interest in an audit client regardless of materiality. Thus any direct financial interest in an audit client
impairs independence. Independence is specifically impaired if the auditor owns a building and leases space to
the client. Independence is not impaired if the CPA maintains a checking account at a financial institution
audit client and the account is fully insured by a government agency. Only answer (b) st ates that II and III
impair independence, but I does not.
9. (c) Under Rule 101 of the Rules of Conduct as interpreted, employment of a CPAs spouse as an audit clients
internal auditor would impair independence. Answer (a) is i ncorrect because an auditor may obtain a
collateralized automobile loan from a fin ancial institution client without impairing independence. Answer (b) is
incorrect because independence is not impaired by litigation with an audit client if the amount is immaterial and not
related to the audit work. Answer (d) is incorrect because an auditor may act as an honorary trustee for a not-forprofit audit client.
10. (b) Under Rule 101 of the Rules of Conduct as interpreted, independence is impaired if there is a direct financial
interest in an audit client regardless of materiality. However, independence is not impaired if the CPA maintains
a checking account at a financial institution audit client and the account is fully insured by a government
agency. Answer (a) is incorrect because independence is impaired when the auditor has a management position or is
an employee of t he audit client, such as being appointed the official stock tra nsfer agent. Answer (c) is incorrect
because independence is impaired if audit fees remain unpaid for more than one year prior to the date of the current
years report. It is considered a loan. Answer (d) is i ncorrect because independence is specifically impaired if th e
auditor owns a building and leases space to the client.
11. (b) If a CPA begins an audit and then discovers that (s)he lacks the professional competence necessary to
successfully complete the engagement, the CPA should inform the client and recommend another CPA who
possesses the necessary competence. The withd rawing CPA may still collect a fee for the services provided.
Thus Larkin may request c ompensation from the client for services rendered. Answer (a) is inc orrect because no
violation of GAAS occurs when the CP A informs the client and withdraws. Answer (c) is incorrect because under
Rule 503 of the Rules of C onduct as interpreted, a CPA may not receive a comm ission for recommending a CPA
for audits or reviews. Answer (d) is incorrect because Larkin is not indebted to the other CPA.
12. (c) Generally accepted auditing standards (GAAS) are measures of quality of the auditors performance.
Answer (a) is incorrect because GAAS are not rules acknowledged by the accounting profession because of their
universal application, GAAS are m easures of the quality of an auditors performance. Answer (b) is in correct
because Pronouncements issued by the Audit Standa rds Board are not GAAS, they a re interpretations of GAAS.
Answer (d) is in correct because procedures relate to the specific acts to be performed, whereas standards a re
measures of the quality of the performance of those acts.
13. (a) The authoritative body designated to promulgate attestation standards is the Auditing Standards
Board, not the Governmental Accounting Standards Board, the Fi nancial Accounting Standards Board or the
General Accounting Office.
14. (c) An entity that is not required to file financial statements with an agency regulating the issuance of the entities
securities is a "non-public" company. The types of unaudited engagements that an accountant would issue for a nonpublic company would be reviews and compilations. The authoritative body for promulgating standards on
reviews and compilations is the Accounting and Review Services Committee, not the Financial Accounting
Standards Board, the General Accounting Office or the Auditing Standards Board.
15. (c) Under Rule 203 of the Rules of Conduct as interpreted, an accountant may issue an unqualified opinion on
financial statements that contain a departure from generally accepted accounting principles (GAAP) in
unusual circumstances when compliance with GAAP would cause the financial statements to be misleading.
Specifically, new legislation and a new form of business transaction have been interpreted as circumstances that
may justify departure from GAAP. Only answer (c) indicates that both may justify a departure from SFAS.

8S-2

16. (b) Under Rule 203 of the Rules of Conduct as interpreted, an accountant may issue an unqualified opinion
on financial statements that contain a departure from generally accepted accounting principles (GAAP) in
unusual circumstances when compliance with GAAP would cause the financial statements to be misleading.
Such a departure must be described in a separate paragraph in the report. Answer (a) is incorrect because the
departure must be described in a se parate paragraph in the auditors report. Answers (c) and (d) are incorrect
because an unqualified opinion may be given.
17. (b) Under Rule 301 of th e Rules of Conduct as in terpreted, an accountant may not reveal a clients
information to others without the clients consent. Thus, an acc ountant may not reveal confidential client
information to an other CPA firm concerning suspected tax irregularities. A CPA may reveal confidential client
information to a state CPA society quality review board. Only answer (b) states that disclosure to the state CPA
society quality control board is permissible, but disclosure of suspected tax return irregularities to another CPA firm
would not be permissible.
18. (c) Under Rule 501 of the Rules of Conduct as interpreted, a CPA may not retain a clients records after the
client has demanded them. Answer (a) is incorrect because the Rules of Conduct as interpreted specifically permit
a CPA to make arrangements with a bank t o collect notes issued by a client in payment of fees due. Answer (b) is
incorrect because independence would not be im paired by compiling the financial statements of a cl ient t hat
employed the CPAs spouse as a bookkeeper as long as management decisions were not made by the bookkeeper.
Answer (d) is incorrect beca use purchase of a segm ent of an insurance companys business that performs actuarial
services for employee benefit plans has been specifically interpreted as not impairing independence.
19. (d) Under Rule 501 of the Rules of Conduct as interpreted, a CPA may not retain a clients records after the
client has demanded them. Answer (a) is incorrect because although a CPA is generally required to follow GAAS
and the applicable standards of g overnmental regulatory agencies , there are rare occasions when complying with
applicable standards will cause a rep ort to be misleading. In such circumstances it is proper for a CPA to issue a
modified report that explains the reasons for failing to follow the applicable standard. Answer (b) is incorrect a CPA
is required to reveal confidential client information when requested to a s tate CPA quality review panel, even in a
jurisdiction that recognizes the accountant-client privilege. Answer (c) is incorrect because contingent fees, although
generally not permitted, are proper when representing a client in an examination of a tax return by a revenue agent.
20. (a) Under Rule 502 of the Ru les of Conduct as interpreted, a CPA is prohibited from soliciting business by
false, misleading or deceptive practices. This would specifically include representing a fee for any engagement
when the CPA knows that the actual fee would be substantially higher. Answer (b) is incorrect because it is no t
improper to charge a lower fe e than other CPAs. Answer (c) is incorrect because independence is not required of a
CPA performing consulting services. Answer (d) is incorrect because there is nothing improper with representing a
fee that is a competitive bid.
21. (c) Under Rule 503 of the Rules of Conduct as interpreted, a CPA is prohibited from receiving a commission
for recommending a product or service to an audit client. Answer (a) is incorrect because there is no prohibition
on reselling products obtained from others to clients. The Statements of Stan dards for Consulting Services
specifically lists product services (supplying a client with a specific product) as a type of consulting service that may
be provided for a fee. Answer (b) is incorrect because a C PA may write a financial management newsletter
promoted and sold by a publishing company. Answer (d) is incorrect because there is no prohibition on accepting an
engagement obtained through the efforts of others. Rule 503 prohibits paying a referral fee t o a t hird party for
obtaining a client without disclosing this to the client.
22. (c) The first general standard requires that audits be performed by persons having adequate technical
training and proficiency as auditors. Specifically this requires both proper education and experience in
auditing. Answer (a) is in correct because although education is requ ired in auditing, an auditor may possess
adequate technical training and proficiency as auditors without general business and finance courses. Answer (b) is
incorrect because quality control and peer review do not pertain to the first general standard. Answer (d) is incorrect
because supervision and review skills relate to the third general standard of due care, not the first general standard.

8S-3

23. (b) The first general standard requires that audits be performed by persons having adequate technical
training and proficiency as auditors. Answer (a) is incorrect because supervision and review skills relate to the
third standard of due care, not the first general standard. Answer (c) is incorrect because knowledge of the standards
of field work and t he standards of reporting are sepa rate standards from the general standards. Answer (d) is
incorrect because independence is required by the second general standard, not the first.
24. (d) The third general standard requires due care in audits. It requires auditors to possess the same degree of
skill commonly possessed of others in the field, act as r easonably prudent accountants would and requires auditors
to critically rev iew work done and the judgment exercised by those assisting in the aud it at ev ery level of
supervision. Answers (a), (b) and (c ) are incorrect because proficiency, aud it risk a nd inspection do not require
reviewing the judgment exercised by others in the audits, due care does.
25. (a) The third general standard requires due care in audits. It requires auditors to possess the same degree of
skill commonly possessed of others in the field, act as reasonably prudent accountants would and requires auditors
to critically review work done and the judgment exercised by those assisting in the audit at every level of
supervision. Answer (b) is incorrect beca use due care does not require examination of all available corroborating
evidence supporting m anagements assertions. Answer (c) is incorrect because an audit need not be designed to
detect all instances of illeg al acts. Au dits are designed to provide reasonable assurance o f detecting errors and
irregularities that are m aterial to the financial statements. Answer (d ) is in correct because it is th e first g eneral
standard that requires an auditor attain the proper balance of professional experience and formal education, not the
third general standard of due care.
26. (a) The third general standard requires due care in audits. It requires auditors to possess the same degree
of skill commonly possessed of others in the field, act as reas onably prudent acc ountants would and re quires
auditors to critically review work done and the judgment exercised by those assisting in the audit at every level of
supervision. Answer (b) is incorrect because the audit is to be performed in acc ordance with generally accepted
auditing standards; it is the fina ncial statements that must conform to generally accepted accounting principles.
Answer (c) is incorrect beca use due care does not require that the audit be performed without fault or error. An
accountant is not a guarantor or an insurer and need only act like a reasonably prudent accountant would in the same
or similar circumstances. Answer (d) is incorrect because the audit need not be performed to the satisfaction of third
parties that may rely u pon it. An accountant need only perform the audit in the same manner that a reason ably
prudent accountant would.
27. (b) Under Rule 201 of the Rules of Conduct as interpreted, a CPA must act with professional competence and
due professional care. Professional competence requires knowledge of technical subject matter or the ability to
obtain it by research or consulting with others. Due professional care requires that the CPA possess the same
degree of skill commonly possessed by others in the field and to act as reasonably prudent accountants would. If a
reasonably prudent CPA lacked knowledge of technical subject matter and did not obtain that knowledge through
research, they would consult with experts. Thus, due care may require consulting with experts. Due care only
requires the CPA possess the d egree of skill co mmonly possessed by others in the field and does not require
obtaining specialty accreditation. Only answer (b) states th at due care may require consulting with ex perts, but
does not require obtaining specialty accreditation.
28. (a) The pervasive character of a CPAs role in consulting service engagements is that of an objective
adviser. Answer (b) is incorrect because in dependence is not required in consulting service engagements. Answer
(c) is incorrect because the c onsulting service engagement may not involve com puter skills and therefore a CPA
would not need to be a computer specialist. Answer (d) is incorrect because a review is an attestation service, not a
consulting service.
29. (d) A CPA performing consulting services for a nonaudit client may have a conflict of interest if the
conflict is disclosed to the client and the client consents. A CPA performing consulting services for a nonaudit
client should obtain an understanding with the client concerning the nature, scope and limitations of the
engagement to include any reservations about the engagement. These communications may be written or oral.
Only answer (d ) indicates that with drawal is not mandated by a co nflict of interest or b y th e lack of a written
understanding of the scope of the engagement.

8S-4

30. (d) A CPA performing consulting services is not required to be independent. Independence is only
required when performing audits or other attestation services. Answers (a), (b) and (c) are incorre ct because a
CPA performing consulting services is required to comply with Statements of Standards for Consulting Services, is
required to obtain an understanding on the nature, scope and limitations of the engagement and is required to
supervise staff assigned to the engagement.
31. (a) Types of consulting services include Consultations (review a clients business plan), Product services
(supplying computer software), Advisory services (analysis of clients accounting system), Staff and other
support services (provide staff for computer programming), Implementation services (installing a new
computer system) and Transaction services (preparing information to obtain financing) (CPA SIT). Only
answer (a) states that advisory serv ices, implementation services and product services are consi dered types of
consulting services.
32. (c) Types of consulting services include Consultations (review a clients business plan), Product services
(supplying computer software), Advisory services (analysis of clients accounting system), Staff and other
support services (provide staff for computer programming), Implementation services (installing a new
computer system) and Transaction services (preparing information to obtain financing) (CPA SIT). Only
answer (c) indicates that review of a client-prepared business plan and preparing information for obtaining financing
are both types of consulting service engagements.
33. (b)
(CPA SIT). Expressing a conclusion about the reliability of a clients financial statements is an attestation service,
not a co nsulting service. Only answer (b) indicates that reviewing and commenting on a clien t-prepared business
plan would be a type of consulting service, but expressing a conclusion about the reliability of a clients financial
statements would not.
34. (d) Providing technical assistance in implementing a new EDP system is an implementation service which
is one of the types of consulting services. The set of pronouncem ents that a CPA m ust comply with when
performing consulting service engagements is the Statements on Standards for Consulting Services. Only answer (d)
so states.
35. (c) A CPA performing consulting service engagements must comply with the same general standards that
apply to all engagements under Rule 201 of the Rules of Conduct. These are professi onal competence, due
professional care, planning and supervision and sufficient relevant data to support conclusions. Independence is
not required of a C PA performing consulting services. Independence is only required when performing audit or
attestation services. Only answer (c) states that due professional care and planning and supervision are required, but
independence is not.
36. (c) The nature and scope of the consulting services to be performed is determined solely by the agreement
between the CPA and the client. Although the agreement may b e written or oral, any significant limitations or
reservations concerning the engagement must be communicated to the client. Thus, the CPA must inform the
client of significant reservations concerning the benefits of the engagement. Answer (a) is incorrect because the
agreement between the CPA an d the client for con sulting services may be modified. As with most contracts, any
agreement made between two parties can be modified by mutual agreement. Answer (b) is incorrect because a CPA
may perform both attest services and consulting services for a client if independence is maintained. Answer (d) is
incorrect because the agreement between the CPA and the client for consulting services , in cluding the time for
completion of the engagement, may be written or oral.
37. (d) State legislatures vest in state boa rds of accountancy the authority to license CPAs and to discipline those
engaged in the practice of public accounting. Only a state board of accountancy has the authority to suspend or
revoke a CPAs license. Answers (a), (b) and (c) are incorrect because neither the SEC, the AICPA nor a state CPA
society has this authority. Note, however, that the AICPA does have the power to impose disciplinary sanctions on
its members.

8S-5

Chapter Eight: Professional Responsibility Other

Objective Answers

ANSWER 1
a. 1. Crew did not violate the professions standards regarding independence when the engagements were accepted. A CPA
may perform consulting services simultaneously with an audit engagement.
Crew violated the professions standards in failing to perform the consulting engagement and the audit with due care.
Crew acted without due care by failing to disc over the insufficient cont rol procedures because of om itting steps in the
engagement and by issuing an unqualified opinion on the financial statements.
Crew committed acts d iscreditable to the profession by failing to notify Dredges audit committee of the material
misstatements contained in th e financial statements, failing to disclose Bolds fraudulent activities, an d profiting from
withholding the information.

a. 2. The state board of accountancy may permanently revoke Crews license to practice or may suspend or restrict it for a
period of time. If suspended or restricted, Crew may be required to take additional CPE courses as a condition of reinstatement.

b. 1. Dredge Corp. will be successful in its negligence suit against Crew. Crew owed a duty of care to Dredge to perform the
consulting engagement according to the standards of the profession. Crew breached that duty by failing to discover that there
were insufficient control procedures in Dredges new computerized accounting system. Dredge was damaged by Crews
breach of duty because the insufficient control procedures had allowed and were continuing to allow employees to steal.

b. 2. Ocean Bank will be successful in its common law fraud suit against Crew. Crew intentionally issued an unqualified
opinion on Dredges materially misstated financial statements. The financial statements and Crews accountants report were
submitted to Ocean. Ocean justifiably relied on Crews unqualified opinion in agreeing to finance Dredges capital
improvement. Ocean was damaged as a result of Dredges default on the loan, which was caused by the fraud.
8S-6

ANSWER 2
a. Dunbar did not violate the standards of the profession in the area of indepe ndence by accep ting the litigation support
services engagement. A CPA m ay perform litigation support services for an attest clien t at th e same time the CPA
performs the audit. However, when Dunbar did not receive payment of the bill for t he litigation support services within
one year and prior to issuing the audit report, Dunbars independence was impaired. Dunbar should not have issued the
report.
Dunbar violated the standards of the profession in the area of due care in two ways. First, Dunbar did this by knowingly
and intentionally giving an unqualified opinion on the materially misstated financial statements.
Second, Dunbar also violated due care by failing to comply with the standards of the profession regarding the discovery of
management fraud. Under the standards of the profession, Dunbar on discovering the fraud committed by Wolfs officers,
should have reported it directly to Wolfs audit committee. Dunbar should have insisted that the financial statements be
revised.
If the client did not revise the financial statements, Dunbar should have issued a nonstandard report or withdrawn from the
engagement. Dunbar should have reported its action (in either case) to the clients board of directors. If the client did not
advise the SEC of Dunbars findings and did not promptly notify Dunbar that the SEC had been advised, Dunbar should
have notified the SEC. By failing to take these steps, Dunbar violated due care.

b. Dunbar will lik ely be found to have violated the antifraud provisions of Section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934. Specifically, Dunbar contributed to the filing with the SEC of written material (Fo rm 10-K)
containing misstatements of material facts.
Dunbar will also likely be found to have violated the provisions of both the 1934 Act and the provisions of the Private
Securities Litigation Reform Act of 1995. Specifically, Dunbar will be found to have committed fraud because scienter
can be established. Dunbar knowingly and intentionally issued an opinion after discovering management fraud that caused
material misstatements in the financial statements.
Dunbar will also likely be found to have violated the provisions of the Private Securities Litigation Reform Act of 1995.
Specifically, Dunbar failed to withdraw from the engagement and notify the SEC of the material illegal acts committed by
Wolfs officers.
8S-7

SAS 115
COMMUNICATING INTERNAL CONTROL RELATED MATTERS
IDENTIFIED IN AN AUDIT
y

SAS 115 is effective for compliance audits for fiscal years completing on or after December 15,
2009.

It supersedes SAS 112, as it updated the definitions of the following:

y

Deficiency in internal control

Significant deficiency

Material weakness

It provides assistance on determining the level of deficiencies in internal control

discovered in a financial statement audit.

It obligates the auditor to write to management and governance personnel significant deficiencies
and material weaknesses discovered in a financial statement (financial statements) audit.

It is not applicable if the auditor is required to report on internal control effectiveness combined
with an audit of an organizations financial statements under Statement on Standards for
Attestation Engagements No. 15, an examination of an entitys internal control over financial
reporting that is integrated with an audit of its financial statements.

Internal control is a process created by all members of an organization to bring about efficient and
effective operations, and among other factors, safeguarding assets, which is related to financial
reporting controls. These controls are most applicable to financial statements audits.

An auditor is not responsible to perform activities that indicate deficiencies in internal controls or
state an opinion concerning internal control effectiveness. During an audit, an auditor may
become aware of internal control deficiencies while performing activities to attain knowledge of
an organization and its internal control.
SAS 115 (DEFINITIONS)

Financial reporting: creating trustworthy financial statements that are reasonably presented in
order to adhere with generally accepted accounting principles or if appropriate, other
comprehensive basis of accounting.

Deficiency in internal control: a condition that exists when the design or operation of a control
prohibits an organizations employees from timely preventing, detecting and correcting
misstatements.

1 of 36

Design deficiency is a condition where

y

A required control is missing to meet a control objective.

A control that is operating that is so poorly designed; it does not meet a control objective.

Operating deficiency is a condition where.

A properly designed control does not work as intended.

An individual executing the control is not capable or authorized to

properly execute the control.

Material Weakness: At least one deficiency in internal control to the extent that it is at least
reasonably expected that a material misstatement of the financial statements will not be timely
prevented, detected or corrected.

Significant Deficiency: at least one deficiency in internal control less grave than a material
weakness yet requires governance personnel attention.

SAS 115- (DEFICIENCIES FOUND DURING AN AUDIT)

y

An auditor must determine the gravity of all internal control deficiencies found during an audit to
categorize whether they are significant deficiencies or material weaknesses.

An internal control deficiencys gravity is determined by

The size of the possible misstatement of the financial statements due to the deficiency
and (see below)

A reasonable expectation that an organizations controls will not prevent, detect or

correct a misstatement of an account amount or disclosure.

It is not determined by whether an actual deficiency occurred in the past.

The size of a misstatement is determined by factors that include

y

The dollar amounts or transactions vulnerable due to the deficiency.

The amount of activity in an account during a time period vulnerable to the deficiency.

Overstated dollar amounts have expressed limits while understated dollar amounts have
unexpressed larger limits.

2 of 36

SAS 115 contd (DEFICIENCIES FOUND DURING AN AUDIT)

y

Risk factors determining whether a reasonable expectation that deficiencies in internal control
will result in financial statements misstatements include
y

Categories of transactions, disclosures and assertions affected.

Vulnerability to fraud of the assets and liabilities related to the transaction.

Judgment needed to arrive at account amounts.

The level the control or the control deficiency interacts with other controls and control
deficiencies.

The aftermath scenario if a deficiency occurs.

The size of a misstatement has no direct correlation to the possibility that it might occur.

Many deficiencies small in nature when individually viewed may add up to one material
weakness or significant deficiency.

An organizations compensating controls may limit the gravity of a deficiency but it does not
eradicate it.

Symptoms of a material weakness include

y

Identifying executive management fraud.

Reissuing correctly stated financial statements that were previously issued with a fraud
related misstatement.

Material misstatements of financial statements discoveries by an auditor that the

organizations internal control would not have caught.

Governance personnel ineffectiveness in monitoring an organizations financial

reporting.

y
SAS 115 (COMMUNICATION)
y

Deficiencies found during an audit by the auditor should be addressed to management and
governance personnel in writing, including prior year deficiencies not yet mitigated.

All deficiency communications may be made most appropriately by the audit report release date,
but it must be made no later than 60 days following the audit report release date.

3 of 36

Urgent items should be communicated during the audit, and can be done orally at first, then
written at a later time. It should be done even if the urgent items have been remediated.

Even though management and governance personnel incur the responsibility for the risk of
significant deficiencies and internal weaknesses, the auditor must communicate them to
management and governance personnel.

Positive recommendations for improved efficiencies and non-significant deficiencies may also be
communicated.

All oral communication must be written at some point in time (to indicate that it did in fact
occur).

Written communication involving significant deficiencies and material weaknesses discovered

during a financial statements audit should contain
y

A declaration identifying the reason for an auditors consideration of internal control was
to state an opinion on the financial statements, not to express an opinion on internal
control effectiveness.

A declaration identifying the auditors interest in internal control was to identify all
internal control deficiencies that potentially are significant deficiencies or material
weaknesses.

A material weakness definition and if required, one for a significant deficiency as well.

Matters identified that were found to be significant deficiencies and material weaknesses.

A declaration that the communication is for organization management, governance

personnel (and other organization personnel, if appropriate) and no one else. (except by
governmental or legal authority).

The auditor should not issue a report stating that the auditor did not discover any
significant deficiencies but the auditor may issue a report stating that the auditor did not
discover any material weaknesses

4 of 36

SAS 116
INTERIM FINANCIAL INFORMATION
y

SAS 116 is effective for reviews of interim financial information (IFI) for interims beginning
after December 15, 2009.
SAS 116 (DEFINITIONS)

Applicable financial reporting framework: the criteria adopted by entity management, and if
required, by governance personnel in preparing the f/s (financial statements) amenable to an
entitys environment. (GAAP, IFRS, OCBOA).

IFI is deemed so because it covers a period of less than a year or for a years worth of
information ending on a date other than a normal fiscal year end date of an organization.

Accountant: someone who performs a review of IFI. This distinguishment is made because the
person is not performing an audit, thus for this particular SAS will not be called an auditor.
SAS 116 (APPLICATIONS)

This SAS provides parameters on applying field work and reporting standards as far as they can
be applied to reviewing IFI.

General standards are covered in SAS 1 that has since been superseded by SAS 113 Omnibus
2006.

An accountants review report should be issued with IFI, if the organization being reviewed
writes in a document, e-mail or report that the IFI has been reviewed by an independent public
accountant, or a public accounting firm.

An accountant may deem it appropriate to write and issue a report to state that IFI has been
reviewed in order to distinguish that the IFI was not audited.

SAS 84 applies to an engagement to review IFI in communication between a prior auditor and
successor auditor before an initial review of IFI takes place.

An accountant may conduct, to comply with this SAS, a review if:

y

The latest annual financial statements have been audited by the accountant or another
auditor.

The accountant will also audit the organizations current year financial statements, or has
done so in the past and has no reason to believe that this will not continue.

Management uses the same reporting framework guidelines to IFI as it does to the
audited financial statements.

5 of 36

SAS 116 contd (APPLICATIONS)

y

If IFI is presented in summary it must:

y

Adhere to an appropriate reporting framework.

State that it is not the same as a complete set of financial statements.

Be made accessible by the organization (website) along with the audited financial
statements.
y

Objectives of a review of IFI are to:

y

Provide a means to the accountant for expressing whether there is

knowledge of any material modification required to be made to the IFI.

Distinguish a review from an audit (refer to Lambers CPA Review Audit

book chapter 5 for a discussion of review requirements).

Establishing agreement with an organizations management:

y

Should be made in writing.

Should include engagement objectives, limitations and

responsibilities of the accountant and management.

Should indicate the type of final communication regarding the

outcome of the engagement (oral or written).

The accountant should have already obtained a reasonable expectation that management
can create proper IFI, otherwise the engagement should not be accepted. (refer to
Lambers CPA Review Audit book chapter 5 for a discussion of review requirements).

SAS 116 KNOWLEDGE OF AN ORGANIZATION AND ITS INTERNAL CONTROL

y

To conduct a review of IFI, the accountant should have enough information on the organization
and its internal control as they pertain to creating annual financial information and IFI to
y

Indicate the types of possible material misstatement in IFI and to contemplate the
possibility of those mistakes occurring.

Choose appropriate inquiries and analytical activities that will give an accountant
information to communicate that (s)he is cognizant of any significant changes that need
to be made to the IFI for it conform with GAAP, IFRS, etc.

In planning a review of IFI, the accountant should act to make current his/her knowledge of the
organization and its internal control to
y

Assist in deciding the type of inquisitive and analytical procedures to execute, and (see
below)
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Indicate specific occurrences, transactions or declarations where questioning can be

steered or analytical activities performed.

The procedures executed in a review should be to

y

Read prior year written reports on audits and interim period reviews as well as those
reviews of the present year to allow the accountant to judge what items in them would
affect current year IFI.

During the reading, the accountant should contemplate the details of

y

Corrected material misstatements.

Matters regarding uncorrected material misstatements.

Risks regarding material misstatement as a result of fraud or management

superseding internal controls.

Matters important to the financial statements going forward (significant

deficiencies and material weaknesses).

Read the most current annual and comparative prior year IFI.

Decide if any of the current year auditing outcomes would affect current year financial
statements.

Ask management if any alterations to business procedures have occurred.

Ask management if any internal control procedures pertaining to IFI have changed after the prior
year audit or prior review of IFI.

If there is any communication required between a predecessor and successor accountant, the
successor accountant should if allowed, review predecessor accountant documentation. If the
successor accountant is issuing a review report on IFI, (s)he should not make reference to the
activities of the predecessor accountant.

If a predecessor accountant does not allow a successor accountant to review documentation, the
successor accountant should use other methods to satisfy the review objectives pertaining to IFI.

If an accountant has not audited an organizations financial statements prior to performing a

review of IFI, (s)he should perform activities to acquire knowledge of the organization and its
internal control. To assist in deciding what types of activities to conduct, the auditor should refer
to SAS 109, regarding understanding an organization and its environment.

A scope limitation on the review of IFI if the accountant is unable to conduct enough review
procedures to provide a foundation for the results that would be discussed in the accountants
report.

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SAS 116 ANALYTICAL ACTIVITIES AND RELATED INQUIRIES

y

An accountant should tailor analytical activities and related inquiries to the situation specific to
each review of IFI performed.

An accountant should lookout for peculiar appearing relationships among accounts that may
identify material misstatement while performing analytical activities. These activities should
encompass
y

Comparing IFI with similar data for the preceding interim period if applicable, and for
the same time period for the preceding year, giving thought to the organizations
activities and selected transactions.

Contemplating possible relationships within financial data and between financial and
non-financial data. This includes organization generated data.

Comparing general ledger account amounts, ratios from those amounts to anticipated
results developed by the accountant. The accountant should use knowledge acquired in
the past as a basis to look for an anticipated result.

Comparing dispersed information on revenue (i.e., comparing current revenue by city or

product for the reviewed period to that of similar prior periods). An accountant may also
refer to SAS 56 on analytical activities.

Anticipated amounts applicable to a review are usually less precise than those done in an audit.
Inquiries should still elicit consistent information to that obtained during analytical activities and
to knowledge acquired of the organization by the accountant.

The accountant should conduct the following inquiries and review procedures during a review of
IFI:
y

Read minutes of stockholder, board of directors meetings, etc. And other non- disclosed
meetings to indicate items possibly affecting IFI.

Gather other accountants reports who have performed a review of IFI for other
considerable sections of the organization.

Ask management responsible for finance and accounting about:

y

Whether IFI has been prepared to adhere to the appropriate reporting framework.

Gathering reports from other accountants who have previously performed a

review of IFI for considerable sections of the organization.

Abnormal or intricate situations or journal entries that could affect IFI.

Large transaction amounts recorded right before the end of the interim period.

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The disposition of uncorrected misstatements identified in previous audits and

reviews.

Matters that have come into question during the review.

Subsequent events to the reviewed period that can materially affect reporting IFI
in the current period.

Managements knowledge of any fraud, actual or possible with regard to

management, employees and financial statements effect.

Data communicated to and from regulatory industries.

Any deficiencies in internal control, significant deficiencies and material

weaknesses.

If the accountant believes there to be legal issues that would prevent IFI from being reported
adequately under the applicable reporting framework guidelines, (s)he should obtain the
necessary information from the organizations attorneys.

If the accountant is unsure whether the organization has the ability to remain a going concern, it
should consult management and based upon this determine whether further reporting should be
done on this matter.

The accountant can combine review and audit procedures to efficiently complete both
engagements if (s)he is performing them.

SAS 116 WRITTEN REPRESENTATIONS FROM MANAGEMENT

Written representations from management should be obtained on the following matters:

y

Its responsibility regarding both IFI and presentation of information to adhere to the appropriate
reporting framework.

Its responsibility for the creation and maintenance of internal control procedures.

Its responsibility to allow the accountant access to financial records and appropriate related data.

Its acknowledgement that there are no unrecorded transactions.

Its assertion that any uncorrected financial statements misstatements gathered by the accountant
are not material individually and combined to the IFI.

Its assertion that all related party transactions have been disclosed.

Its assertion that it has disclosed all significant estimates and material concentrations of financial
information in accordance with AICPA Statement of Position 94-6.

Its assertion that it has revealed appropriate information regarding subsequent events.

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SAS 116 EVALUATING RESULTS OF INTERIM REVIEW PROCEDURES

y

The accountant may set a ceiling to transaction amount misstatemements considered to be

immaterial, taking into consideration that accumulating misstatements could possibly affect IFI.

The accountant should contemplate whether significant adjustments be made to IFI to conform to
the appropriate reporting framework regarding:
y

Description, reason and amount of misstatements.

Whether the misstatements are from prior year or current interim periods.

Materiality evaluations made with regard to current or prior year audits.

Effects of misstatements on future IFI and audits.

SAS 116 COMMUNICATIONS

After reviewing IFI, if the accountant discovers items that lead to a circumstance where there should have
been either a material adjustment to the IFI for it adhere to the appropriate reporting framework or the
organization reported IFI before the review was finished when a review is mandatory, the accountant
should inform the appropriate management as soon as possible.
y

Regarding material misstatements, if management does not inform the accountant in an

appropriate period of time from the accountants perspective, the accountant should
inform governance personnel (board of directors, audit committee, etc.) orally or in
writing. The accountant should document all communication.

If governance personnel do not inform the accountant in an appropriate period of time

regarding material misstatement matters from the accountants perspective, the accountant
should consider resigning from the review engagement and if necessary, from the audit
engagement.

In cases of fraud or illegal acts discovered during a review of IFI, the accountant should
report the matter to the appropriate level of management in accordance with SAS 99,
consideration of fraud in a financial statement audit.

During a review of IFI, the accountant may discover significant deficiencies and/or
material weaknesses in internal control relating to preparing annual information and IFI
(refer to SAS 115 for definitions). If it is discovered, it should be addressed with
management and governance personnel.

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SAS 116 REPORTING

The accountants review report that will be presented along with the IFI should have in it:
y

A title that contains the word independent.

A declaration that the IFI in the report was reviewed.

A declaration stating IFI is managements responsibility.

A declaration that the review of IFI was performed appropriately with AICPA standards.

An explanation of IFI review procedures.

A declaration that a review is of lesser scope than that of an audit in accordance with generally
accepted auditing standards.

A declaration regarding whether the accountant is aware of material modification that is required
to be made to the IFI for it to be in adherence with an applicable financial reporting framework.

The accountant or the accountants firm signature.

The review report date.

Each page of the IFI should have the word unaudited clearly displayed.

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SAS 117
COMPLIANCE AUDITS
SAS 117(UPDATES SAS 74)
This SAS replaces SAS 74, compliance auditing considerations in audits of governmental entities and
recipients of governmental financial assistance. SAS 74 had the following provisions for auditors to:
y

Apply the provisions of SAS 54, illegal acts by clients pertaining to detecting misstatements
affecting government entity financial statements.
y

Prepare an audit in compliance with government auditing standards issued by the U.S.
Comptroller General.

Prepare a single or entity-wide audit or a program-specific audit in compliance with

federal audit regulations.

Communicate with management if an auditor discovers that the organization needs to

comply with audit regulations that are not already covered in the current audit scope.

In addition, the auditor should determine if management has indicated laws and requirements that have a
direct and significant effect on the decision as to the amounts disclosed in an organizations financial
statements and how those laws and requirements influence the financial statements.
SAS 117-(REQUIREMENTS)
SAS 117 is effective for compliance audits for fiscal years completing on or after June 15, 2010.
SAS 117 increases the requirements set forth in SAS 74 to include not only SAS 54, but many other
(although not all) of the auditing standards for financial statements audits to compliance audits. The new
requirements are listed below.
y

Unless otherwise directed in this SAS, generally accepted auditing standards (GAAS) should be
applied when an auditor uses professional judgment.

The auditor should use materiality levels the applicable government audit regulations prescribe.

Based upon the stipulation that management must identify its organizations government
programs and comply with the program regulations, the auditor should decide which programs to
test for compliance with government audit regulations. This would include:
y

Reading compliance enhancements issued by the government (i.e., OMB A-133).

Reading specific program audit guides (i.e., HUD section 8).

Asking questions about regulations and posing them to entity management, prior auditors
and governing boards.

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Reading governing board meeting minutes.

A risk assessment should be performed for all government programs tested to acquire
knowledge of the appropriate compliance regulations. To do this the auditor should be
aware of the following influences:
y

The age and degree of complexity of the compliance regulation.

The auditors awareness of the organizations internal control over complying

with regulations.

The services provided by the organization.

The type of appropriate government regulation.

A grantors level of supervision over the organization and managements

perspective of audit findings.

Among the influences an auditor may contemplate relating to significant noncompliance are:
y

The complexity of the compliance regulations.

The risk that the regulation will not be adhered to.

How long a period has the entity been required to adhere to the
regulation.

How diligently has the entity adhered to the regulation in the past?

The effect on the entity due to regulatory non-compliance.

The amount of judgment required to adhere to the regulation.

The auditors estimate of material non-compliance risk in the financial

statements.

After assessing non-compliance risk, the auditor should develop a procedural plan to address it.
This can be done by performing:
y

Sampling when testing internal controls (attributes).

Test of transactions for the following:

y

Grant payments for expenses.

Eligibility requirements.

Cost allocation determinations.

Periodic reports given to grantor entities.

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If there are government audit requirements that enhance GAAS requirements, the auditor should
determine a plan to consider them.

The auditor should request written assertions from management that address, among other items
regarding the audit:

Understanding and following government requirement regulations.

Accountability in creating and the upkeep of internal controls.

The auditor should perform the audit up to the audit report date to obtain sufficient evidence
related to subsequent events. In addition the auditor should inquire of management regarding the
subsequent time frame about
y

Appropriate audit reports.

Reports from pass through grantors.

Information about the organizations non-compliance discovered through other work

performed for the organization.

The auditor should also discuss with management and if necessary, governance personnel
regarding anything occurring in the subsequent time frame that could alter the understanding of
the auditors report by users. If the auditor does become aware of this type of occurrence, the
auditors report should also include an explanatory paragraph on the situation.

In order to decide as to whether an organization has materially adhered to the appropriate compliance
regulations, the auditor should contemplate:
y

The rate of non-compliance with regulations discovered during a compliance audit.

The specific types of non-compliance with regulation discovered.

The capability of the organizations monitoring process to ascertain adherence to regulations and
effects of non-compliance.

Whether there were any significant costs to the organizations program that were or will be
questioned as a result of non-compliance discovered during the audit.

ALL OF THESE FACTORS SHOULD BE CONSIDERED BY THE AUDITOR EVEN THOUGH THE
ORGANIZATION MAY HAVE CORRECTED THE NON-COMPLIANCE FOLLOWING THE
AUDITORS DISCOVERY OF IT.

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SAS 117 REPORTING

Among the items required in a compliance report are:

An introductory paragraph stating the appropriate responsibilities of management and the

auditor.

A scope paragraph stating the audit standards applied and audit procedures taken.

Any non-compliance results that require an opinion modification.

An opinion paragraph determining whether the organizational material adhered to the

appropriate government regulatory requirements.

If the auditor issues a combined report on compliance and internal control monitoring of the
compliance, the auditor in addition to the compliance requirements should also include:
y

A statement that the auditor is not expressing an opinion on internal control.

Management is responsible for creating and maintaining an internal control framework to

adhere to government regulations.

SAS 117 DOCUMENTATION

The auditor should document risk assessment steps that were performed including those used to
acquire knowledge of the organizations internal control over adherence to government
regulations.

The auditor should document how the materiality levels of the organization were determined.

Representation letters from management should also be obtained.

The auditor should also document communication of material weakness and significant
deficiencies in internal control to management as well as managements response to those
findings communicated by the auditor.

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SAS 118
OTHER INFORMATION IN DOCUMENTS CONTAINING AUDITED
FINANCIAL STATEMENTS
y

SAS 118 replaces SAS 8 other information in documents containing audited financial statements
and parts of SAS 29, 52 and 98.

Establishes compulsory requirements for audit performance pertaining to additional client

information included in a presentation of financial statements.

Effective for audits of financial statements for periods starting on or after December 15, 2010.
DEFINITIONS
y

Other information financial and non-financial information not already included in the
financial statements or the auditors report that accompanies those two items. Other
information does not include required supplementary information.

Inconsistency other information that disagrees with the audited financial statements.
If it is material, an inconsistency may create doubt about audit conclusions taken from
prior audit evidence and about the basis of an auditors opinion on the financial
statements.

Misstatement of fact other information unrelated to audited financial statement

subjects that is incorrectly asserted or represented. If it is material, the reliability of
the document containing audited financial statements is weakened.

FAS 118 (REQUIREMENTS)

y

The auditor should read other information that (s)he is made aware of to determine if any
inconsistencies exist. If they exist, a determination is to be made on whether a revision is
required on audited financial statements or the other information.

Other information should be obtained from management or governance personnel before an audit
report is released. If it is not obtainable by that time, it should be read as soon as possible.

The auditor should communicate responsibilities, procedures and results regarding other
information to governance personnel.
SAS 118 (INCONSISTENCIES RECOGNIZED BEFORE RELEASE DATE)

If a revision to the financial statements is required and management refuses to provide one, a
modification of audit opinion is to be made.

If it is a material inconsistency that requires other information revision that management refuses
to perform, the auditor should communicate it to governance personnel and include an

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explanation in the auditors report, withhold the report or possibly withdraw from the
engagement.
SAS 118 (IDENTIFICATION OF MATERIAL INCONSISTENCIES)
y

Actions to take when material inconsistencies are identified in other information after an audit
report date release:
y

If revision of financial statements is required, the auditor should perform steps discussed
in SAS 1 and/or 98.

If revision of other information is required and the client makes the revision, the auditor
should perform as required in the circumstances.

If revision of other information is required and the client does not make the revision,
governance personnel should be notified by the auditor about the auditors concerns
regarding the other information.

SAS 118 (MATERIAL MISTATEMENT OF FACT)

y

If the auditor discovers a material misstatement of fact in other information, it should be

discussed with client management.

After the discussion, if there is still a material misstatement of fact, the auditor must request the
client to discuss the matter with legal counsel.

Upon receiving legal counsel guidance, if management refuses to correct the material misstatement of
fact, the auditor should notify governance personnel and apply appropriate procedures.

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SAS 119
SUPPLEMENTARY INFORMATION IN RELATION TO THE
FINANCIAL STATEMENTS AS A WHOLE
y

SAS 119: Supplementary information pertains to data presented in addition to the financial
statements and is not necessary for financial statements to be fairly stated in accordance with
GAAP/IFRS. It may be presented with the financial statements or in a separate document.
Supplementary information in some cases may be required to accompany the financial
statements.

SAS 119 pertains to auditor responsibility in an engagement regarding whether supplementary

information is fairly stated in all material aspects in regards to the financial statements taken in
their entirety.

SAS 119 is effective for audits of financial statements for periods starting on or after December
15, 2010.

Auditor objectives are to

y

Evaluate the supplementary information presentation in regards to the financial

statements taken in their entirety.

Report on whether the supplementary information is materially fairly stated regarding the
financial statements in their entirety.
SAS 119 (Requirements)

In order to opine on the fair statement of supplementary information, relating to the financial statements
taken together, the following must have occurred or will occur:

The supplementary information was derived from and relates to the accounting and records
utilized to prepare the financial statements.

The supplementary information is for the same time period as the financial statements.

The financial statements were audited and the auditor was the primary auditor on that
engagement.

No adverse or disclaimer of opinion was rendered on the financial statements.

The supplementary information will accompany the financial statements or the audited financial
statements will be made accessible by the audited entity.

The auditor should get an affirmation from management stating that is knowledgeable and comprehends
responsibility for:

18 of 36

Preparing supplementary information to appropriate criteria.

Providing the auditor with written representations.

Including the auditors report on the supplementary information in all documents containing the
supplementary information and indicates the auditor has reported on the supplementary
information.

Presenting supplementary information with audited financial statements or, if supplementary

information is presented separately, that the financial statements be available for use by the
supplementary information and the financial statements issuance dates.

In addition to auditing procedures performed on the financial statements, the auditor is to perform these
procedures on supplementary information using the same materiality level used on the financial
statements:
y

Management inquiries about the reason to have supplementary information and the criteria used
in preparing it (financial, regulatory, etc.).

Determine whether the supplementary information is comparable to the criteria used to prepare it.

Understand methods used to prepare supplementary information and determine if any changes to
the methods have occurred from prior years and if there any changes, the reasons for the change.

Compare the information in the supplementary information to that of the financial statements, or
the accounting used to prepare the financial statements. Reconcile if necessary.

Determine from management if any assumption/interpretations underlying measurement or

presentation of the supplementary information were used.

Determine the relevancy and completeness of the supplementary information based upon the
audit procedures of the financial statements and other knowledge obtained during the audit.

Obtain written representations from management that

y

It is aware of its responsibility for presenting supplementary information in accordance

with appropriate criteria.

It believes the supplementary information in display and substance is fairly presented in

accordance with appropriate criteria.

No changes have been made to current measurement procedures compared to those

occurring in the prior period, or reasons for change if they in fact, have changed.

It has disclosed any material assumptions and interpretations used as a base in presenting
supplementary information.

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When the supplementary information is not presented with the audited financial
statements, it will make available the financial statements by the issuance date of the
supplementary information and related financial statements.

The auditor has no responsibility for considering subsequent events related to the supplementary
information. If information is obtained by the auditor before the financial statements release date
regarding supplementary information, the auditor should follow the requirements of the
subsequent event (AU 560) audit standard. If information is obtained after the financial
statements release date regarding supplementary information, the auditor should follow the
requirements of the subsequent discovery of facts existing at auditors report date (AU 561) audit
standard. Both of these requirements are found in SAS 1.
SAS 119 (contd) REPORTING

The auditor can report on the supplementary information in a paragraph explaining the supplementary
information after the opinion paragraph in the auditors report of the financial statements or in a
completely separate report on the supplementary information.
The paragraph or report must contain the following:
y

The audit was performed to form an opinion on the financial statements in their entirety.

The supplementary information is not required as part of the financial statements, but presented
as additional analysis.

Management is responsible for the supplementary information and the information in it was taken
from the same sources as that used to prepare the financial statements.

An explanation that the supplementary information is subject to audit procedures that were
applied to the financial statements.

Reconciliations, comparisons and other methods were performed on the accounting data that
underlies the financial statements or directly to the financial statements in accordance with U.S.
Accepted Auditing Standards (GAAS).

If an unqualified opinion is given on the financial statements and the supplementary information is fairly
stated relating to the financial statements according to the auditor, the auditor must state this fact.
If a qualified opinion is given regarding the financial statements and its effects on the supplementary
information, an except for opinion (stating the departure reason from the unqualified opinion) is
expressed in addition to noting that the remainder of the supplementary information is fairly stated.
When audited financial statements are not presented with the supplementary information, a separate
report should be given on the supplementary information that refers to the financial statements report
stating the date, opinion and any modifications to the auditors financial statements report.
No opinion on the supplementary information is given by auditor if a disclaimer or adverse opinion is
given on the related financial statements.

20 of 36

If allowed by law or regulation, an auditor can withdraw from a supplementary information engagement if
one of the above two opinions is rendered on the financial statements.
If a report is given in this situation, the auditor is required to express that under the circumstances, no
opinion will be given on the supplementary information.
The report date on the supplementary information should be on or following the last day of procedures
performed on the supplementary information.
If the auditor determines that the supplementary information is misstated, and management does not
rectify the situation the auditor must

Modify the report opinion on the supplementary information and describe the misstatement or

If a separate report on the supplementary information is to be given, withhold the report.

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SAS 120
REQUIRED SUPPLEMENTARY INFORMATION
y

SAS 120: When an audit standard setter (setter) needs information to go along with an
organizations financial statements, the goal of the auditor is to perform the following tasks to be
able to:
y

Explain in the auditors report if required supplementary information is displayed and

Reveal in the auditors report in the event when only some or none of the required
supplementary information has been presented in accordance with a setters guidelines, or
the auditor indicates that material adjustments to the required supplementary information
should be made for it comply with the setters guidelines.

SAS 120 is effective for audits of financial statements for periods starting on or after December 15, 2010.
DEFINITIONS:
y

Required supplementary information: data that a setter obliges to accompany the financial
statements. It is not a piece of the financial statements, but a setter deems it vital to financial
reporting to place the financial statements in proper perspective. Guidelines on presentation have
been given in financial accounting standards issued by the financial accounting standards board.

DESIGNATED ACCOUNTING STANDARD SETTER (SETTER): An entity appointed by the

AICPA council to establish generally accepted auditing standards (GAAS) to comply with AICPA
professional standards. The entities are the:
y

FINANCIAL ACCOUNTING STANDARDS BOARD

INTERNATIONAL ACCOUNTING STANDARDS BOARD

GOVERNMENTAL ACCOUNTING STANDARDS BOARD

FEDERAL ACCOUNTING STANDARDS ADVISORY BOARD

Basic financial statements: documentation presented in accordance with an appropriate financial

reporting framework created by a setter that does not include required supplementary
information.

Applicable financial reporting framework: the criteria adopted by entity management, and if
required, by governance personnel in preparing financial statements amenable to an entitys
environment and the purpose of the financial statements or if applicable, legal or regulatory
requirements (GAAP, IFRS, other comprehensive basis of accounting (OCBOA)).

Prescribed guidelines: mandatory rules determined by the setter measurement standards and
display of required supplementary information.

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SAS 120 (REQUIREMENTS)

The auditor should perform the following as it relates to required supplementary information:
y

Ask management about their procedures to create required supplementary information that
answers questions as to whether
y

Required supplementary information is presented properly and within appropriate

guidelines.

There have been any changes to procedures used to create required supplementary
information and explanations for those changes.

There were any material assumptions or interpretations supporting the required

supplementary information reporting.

Compare required supplementary information for consistency with management

statements related to auditor inquiries, financial statements and other information
garnered during the financial statements audit.

Obtain expressed assertion from management:

That it is aware of its responsibility regarding required supplementary

information.

About whether the required supplementary information is gauged and displayed

according to appropriate guidelines.

About whether the required supplementary informations means of gauging are different from
those performed in prior years and the reasons for the differences, if any.
y

About whether there were any material assumptions or interpretations supporting the
required supplementary information reporting.

If the auditor cannot perform any of the aforementioned requirements, the auditor should contemplate
whether management may have been responsible for this inability. Upon contemplation, if the auditor
believes this to be the case, the auditor should contact governance personnel.
SAS 120 REPORTING
The auditor can report on the required supplementary information in a paragraph explaining the required
supplementary information after the opinion paragraph in the auditors report of the financial statements.
If applicable, the paragraph must contain the following:
y

An indication that the required supplementary information is included and the procedures
previously mentioned have been used.

That required supplementary information was not included.

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Part of the required supplementary information is included and part is not included according to
applicable guidance.

The auditor has indicated material differences from appropriate guidance.

The auditor is not able to finish previously discussed procedures in this SAS.

The auditor is dubious as to whether required supplementary information is displayed according

to appropriate guidance.

If an organization has revealed all or part of the required supplementary information, the explanatory
paragraph previously noted should contain:
y

A declaration that (GAAP, IFRS, etc.) Mandates that the required supplementary information be
displayed to enhance the financial statements.

A declaration that the data, despite it not being a part of the basic financial statements, is
mandated by an indicated setter, who deems it to be a required part of financial reporting to
properly frame the appropriate financial statements in operational, economic or historic
perspective.

If the auditor is capable of performing the previously mentioned required actions the must make:

A declaration that the auditor used limited procedures to the required supplementary
information in applicability with GAAS, that includes management inquisition about
procedures used to prepare data to be comparable with managements answers to the
auditors questions, the financial statements and other information obtained during the
financial statements audit by the auditor.

A declaration that the auditor does not state an opinion or any guarantee on the data due
to the fact that limited procedures do not give an auditor enough evidence to state an
opinion or guarantee.

If the auditor is not capable of performing the previously mentioned required actions:
y

A declaration that the auditor could not use certain limited procedures to the
required supplementary information in accordance with GAAS including reasons
as to why this is.

A declaration that the auditor does not state an opinion or guarantee about the
data.

If part of the required supplementary information is not included:

y

A declaration that management has not included (describe the required supplementary
information left out) that (GAAP, IFRS, etc.) Mandate to be displayed to enhance the
financial statements.

24 of 36

A declaration that data left out, despite not being a part of basic financial statements, is
mandated by a setter to be required in order to frame the basic financial statements in a
proper operational, economic, or historical perspective.

A declaration that the auditors opinion on the financial statements is not influenced by
the data left out.

If the gauging or display of the required supplementary information is significantly changed from
mandated guidance, a declaration that despite the auditors opinion on the basic financial
statements is not changed, these changes from mandated guidance are still there (also include a
description of the changes from the mandated guidance).

If the auditor remains dubious of whether the required supplementary information is gauged or
displayed in accordance with mandated guidance, a declaration that despite the auditors opinion
is not changed, the results of the limited procedures have caused the auditor to be dubious of
whether significant changes should be included to the required supplementary information for it
to be displayed to comply with the setter.

If the entire required supplementary information data is left out, the explanatory paragraph must
have the following items:
y

A declaration that management has left out (describe the required supplementary
information) that (GAAP, IFRS, etc.) Mandates to be displayed to enhance the basic
financial statements.

A declaration that the omitted data, despite not being part of the basic financial
statements, is mandated by the setter, who deems it a required part of financial reporting
to put the basic financial statements in proper operational, economic or historical
perspective.

A declaration that the auditors opinion on the basic financial statements is not changed
by the data left out.

25 of 36

INTERNATIONAL AUDITING
STANDARDS
International Auditing Standards- Background
y

International auditing standards (IAS) are developed by the international auditing and assurance
standards board (IAASB) located in New York City and established in 1978.

The IAASB is an independent board within the International Federation of Accountants (IFAC).
The IFAC is the organization that has developed International Financial Reporting Standards.

At the time the IAASB was first formed, guidelines were established to govern audits. They were
formalized into standards beginning in 1991.

The Public Interest Oversight Board (PIOB) oversees the work of the IAASB as it does for other
IFAC public interest activity committees (PIAC) related to ethics, compliance and accounting
education.

Before international auditing concepts, policies and procedures become a standard, they must first
pass through due diligence overseen by the PIOB. The steps that comprise this due diligence are
performed by the PIAC.

Members of the IAASB are nominated by IFAC member groups, the Transnational Auditors
Committee, other organizations and citizens.

The IAASB consists of 18 members that represent 28 countries including the United States. The
United Kingdom, United States, Canada, Germany, Mexico and Australia have in the past been
the countries most represented on the IAASB.

The IAASB clarified its standards beginning in 2004 and five years later completed this project.
As a result, the clarified standards became effective for fiscal years beginning on or after
December 15, 2009. There will be no new standards that will be issued and in effect at the
present time.
.

There are 36 IASS and one International Standard On Quality Control (ISQC)
y

One standard addresses communication of internal control deficiencies.

Sixteen new and upgraded standards.

Twenty standards rewritten for clarity (including the ISQC).

Each IAS is structured in the following manner:

y

Introduction

26 of 36

Objective

Definition

Requirements

Application and other explanatory material

IAS 200 - OVERVIEW

Overall objectives of the independent auditor and the conduct of an audit in accordance with
International Standards of Auditing.
OBJECTIVES:
y

To acquire reasonable assurance entailing whether financial statements do not contain material
misstatement due to fraud or error. In doing so, the auditor can then express an opinion on the
financial statements to state that they were created appropriately with an applicable reporting
framework and to report on the financial statements, and communicate the findings of the audit, if
any, under IAS requirements.

If reasonable assurance cannot be acquired, the auditor is required under IAS to disclaim an
opinion or withdraw from the engagement.

Similar in topic to SASS 1, 107, and 115, which have a far more detailed discussion.
IAS 240 - Overview

The auditors responsibilities relating to fraud in audit of financial statements

Objectives:
y

To identify and assess the risks of material misstatement of the financial statements due to fraud.

To obtain sufficient appropriate evidence regarding the assessed risks of material misstatement as
a result of fraud through developing and executing adequate responses.

To respond adequately to fraud or suspected fraud identified during an audit.

Similar in topic to SAS 99, consideration of fraud in a financial statement audit.

Listing of International Accounting Standards (IASs)

200 Overall objectives of the independent auditor and the conduct of an audit in accordance
with international standards of auditing.

210 Agreeing the terms of audit engagements.

220 Quality control for an audit of financial statements.

230 Audit documentation.

27 of 36

240 The auditors responsibilities relating to fraud in an audit of financial statements.

250 Consideration of laws and regulations in an audit of financial statements.

260 Communication with those charged with governance.

265 Communicating deficiencies in internal control to those charged with governance and
management.

300 Planning an audit of financial statements.

315 Identifying and assessing the risks of material misstatement through understanding the
entity and its environment.

320 Materiality in planning and performing an audit.

330 - The auditors responses to assessed risks.

402 Audit considerations relating to an entity using a service organization.

450 Evaluation of misstatements identified during an audit.

500 Audit evidence.

501 Audit evidence specific considerations for selected items.

505 External confirmations.

510 Initial audit engagements opening balances.

520 Analytical procedures.

530 Audit sampling.

540 Auditing accounting estimates, including fair value accounting estimates, and related
disclosures.

550 Related parties.

560 Subsequent events.

570 Going concern.

580 Written representations.

600 Special considerations audits of group financial statements (including the work of
component auditors).

610 Using the work of internal auditors.

620 Using the work of an auditors expert.

28 of 36

700 Forming an opinion and reporting on financial statements.

705 Modifications to the opinion in the independent auditors report.

706 Emphasis of matter paragraphs and other matter paragraphs in the independent auditors
report.

710 Comparative information, corresponding figures and comparative financial statements.

720 The auditors responsibilities relating to other information in documents containing audited
financial statements.

800 Special considerations audits of financial statements prepared in accordance with special
purpose frameworks.

805 Special considerations audits of single financial statements and specific elements,
accounts or items of a financial statement.

810 engagements to report on summary financial statements

ISQC 1 -International Standard on Quality Control quality control for firms that perform audits,
and reviews of financial statements, and other assurance or related services engagements. This is
the U.S. equivalent to Statement on Quality Control Standards issues by the Auditing Standards
Board. (SQCS 7)
General comments regarding IASs

IASs are principles based and not rules based.

IASs are less detailed than statements on auditing standards (sass).

IASs do not cover as many topics or specialized areas as sass. Cover such as
y

Government audits

Litigation claims

IASs tend to have more detailed statements related to fraud and illegal acts.

29 of 36

SSAE 16
ATTESTATION ENGAGEMENTS
REPORTING ON CONTROLS AT A SERVICE ORGANIZATION
y

SSAE 116: This Statement On Standards For Attestation Engagements (SSAE) is the reporting
required for a service auditor to disclose on controls at a organization providing service to a user
organization that would be pertinent the user organizations internal control.

Examples of a service organization include:

y

Medical claims coders and processors.

Credit card transaction processors.

Brokerage firm equity instrument transaction processors.

Actuarial services to determine pension accounting related valuations and obligations to

plan members.

A service auditor is the auditor who reports on the controls of a service, but not a user
organization.

This SSAE is effective for Service Auditors Reports for periods ending on or after June 15,
2011.

User auditor requirements regarding organizations that use a service organization will be
forthcoming in a new statement of auditing standard that will be effective for periods ending on
or after December 15, 2012. For those obligations SAS 70 still applies regarding service
organizations.

A user auditor may visit a service organization to inquire about its internal controls, but most
service organizations have large client basis, so it would be infeasible for a service organization
to invite all of the interested user auditors to inquire about its internal controls.

As a result of this, a service organization will hire a CPA to perform an attestation on its internal
controls. This is known as a service auditors engagement and the CPA would be the service
auditor.

Service auditor management must provide the service auditor documentation regarding the
business operation of the service (who are the customers, how does it work, what are the controls
regarding the service and the reasons for the controls).

30 of 36

SSAE 16 provides for a service auditor to issue two kinds of reports:

y

Type 1 reports are those where a service auditor would state an opinion on whether the
documentation presented by management on the service organizations operations is
justly stated and the related internal controls are reasonably designed. If so, objectives of
the internal controls would have the ability to perform as they should.

Type 2 reports are those where a service auditor would state an opinion exactly as it
would appear in a Type 1 report and it would also indicate if the controls are working
effectively. This report would also describe the test the service auditor used to test the
service organizations internal controls. A user auditor can than can decide how the test
results affect the user organizations financial statements.

A service auditor must also receive from service organization management written
representations about its description of the business operations and in the case of a Type 2 report,
about its internal control effectiveness. These representations should address the reasonableness
of the presentation of the operations and the appropriateness of the related internal control
structure.

In addition to the these representations other matters regarding this type of engagement include:
y

No prior reliance on previous period testing or reporting on service organization internal

controls. A new engagement must cover all aspects of testing.

Any internal audit work performed by service organization auditors must be addressed by
a service auditor with regard to the procedures performed.

A specified period of time regarding internal control design must be stated by a service
auditor regarding its coverage rather than a specific date. (Applicable in Type 2 report
attestation procedures).

All the applicable language in the report must be present in accordance with SSAE 10,
attest engagements. It should be tailored to service organizations.

SSAE 16 only applies to financial statement matters.

31 of 36

SSARS 19
COMPILATION AND REVIEW ENGAGEMENTS
FRAMEWORK FOR PERFORMING AND REPORTING
y

SSARS 19: This Statement on Standards for Accounting and Review Services (SSARS)
supersedes three previous SSARS (1, 11 and 16) will become effective For compilations and
reviews of financial statements for year endings on or after December 15, 2010.

This revision covers

y

Professional and communication requirements when an accountant reports on unaudited

financial statements of a non-issuer to the non-issuers clients and vendors.

Standards for accounting and review services.

Professional requirements in SSARS.

SSARS 19 DEFINITIONS

FINANCIAL REPORTING FRAMEWORK (FRF) A benchmark utilized to

decipher gauging, recognizing, displaying and expressing material items. There are 2
types:
y

Applicable financial framework - the criteria adopted by entity

management, and if required, by governance personnel in preparing the
financial statements amenable to an entitys environment, usually
generally accepted accounting principles (Gaap) or international
financial reporting standards (IFRS).

Other comprehensive basis of accounting (OCBOA) the criteria that is

not GAAP or IFRS but has other another fact set that supports the
creation of financial statements in accordance with that basis. The most
common are cash, tax and liquidation basis accounting.

ASSURANCE ENGAGEMENT Work performed when an accountant states a conclusion to

affirm positively to an organizations clients and management about the results of an assessment
or gauging of the financial statements (condition) against an appropriate financial reporting
framework (benchmark).

ATTEST ENGAGEMENT Work performed where the AICPA professional standards

mandates an accountants independence of thought and form.

REVIEW EVIDENCE Data used by an accountant to give an adequate basis of acquiring

limited assurance.

32 of 36

SSARS 19 OBJECTIVES AND LIMITATIONS OF A COMPILATION AND REVIEW

y

A compilation is a service to aid management in giving financial information as financial

statements without any further effort to gather or declare any assurance that there are no
significant adjustments to the financial statements required for the statements to conform with an
appropriate financial reporting framework.

A compilation is distinguished from a review or audit of financial statements in that it

y

Does not consider conducting an inquiry, analytical activities or other review related
tasks.

Does not consider gathering knowledge of an organizations

y

Internal control

Risk for fraud

Accounting records

SSARS 19 objectives and limitations of a compilation and review

As a result of the lack of consideration to gather information, an accountant would not test
accounting entries through inspection, observation, confirmation, or examination of original
documentation (invoices, cancelled checks, bills of lading) or other activities usually performed
during an audit. If this work is not performed, there can be no assurance given regarding the
financial statements.

As a result of these factors, no requirement exists that an accountant be independent of the

organization to issue a compilation.

A review is a service to gather limited assurance that there are no significant adjustments to the
financial statements that are necessary in order for them to adhere to an applicable financial
reporting framework.

During a review, an accountant should gather evidence to acquire the limited assurance. As a
result, a review is an assurance engagement.

An accountant must be independent in order to perform a review, thus it is an attestation

engagement.

A review differs from an audit of financial statements, where the auditor gathers a greater
assurance level (reasonable or adequate vs. limited in a review) to state that the financial
statements do not contain material misstatement.

A Review:
y

Does consider conducting an inquiry and analytical activities.

33 of 36

Does not consider gathering knowledge of an organizations

y

Internal control

Risk for fraud

Accounting records

As a result of the lack of consideration of these matters, the accountant does not gather assurance
to become cognizant of material matters that would be reported in an audit.

A review is performed to gather limited assurance that there are no material adjustments that
should be made to the financial statements in order for them to be adhere to an applicable
financial framework.
SSARS 19 - REQUIREMENTS

SSARS issued professional guidance contains different categories of responsibilities required of

accountants:
y

Unconditional obligations mandate an accountant adhere in every matter applicable to the

requirement. Must is the term used to describe these circumstances.

Presumptively mandatory obligations oblige an accountant to adhere in every matter

applicable to the presumed requirement. In some cases, an accountant may use another
application if in any way the accountant can defend the use of that application that would
adequately carry out the requirements of the presumptively mandatory obligations. These
obligations are noted with the word should and not must.

SSARS 19 EXPLANATORY MATERIAL

y

Explanatory material provides additional background information to aid an accountant in

deploying a particular procedure or delving deeper into a professional requirement. It is not
imperative information.
SSARS 19 HIERARCHY AND PUBLICATIONS

SSARS 19 is the guiding issuance to perform compilations and reviews except when reviewing
interim financial information that is discussed in SAS 116.

If the guidance is SSARS 19 is not used, an accountant should explain how alternate procedures
are more applicable in a particular situation.

Professional publications may help an accountant in applying SSARS.

SSARS 19 ETHICS AND QUALITY CONTROL

Along with SSARS, other guidance should be followed by an accountant:

34 of 36

The AICPA code of professional conduct which discusses commitment to ethical

behavior and

Statements on quality control standards.

These two governing issuances are intertwined in that an accountant should develop
sound and ethical principles in the practice of public accounting that include an internal
control over accounting procedures and work product.

SSARS 19 ELEMENTS OF COMPILATIONS AND REVIEWS

In compilations and reviews, there are three party relationships:

y

Management or appropriate individuals

Accountant in public accounting practice

Users of financial statements or information.

Management is responsible for preparing financial statements in adherence to an

appropriate reporting framework (GAAP, IFRS, or another comprehensive basis of
accounting such as tax basis) and designing and maintaining internal control systems.

Due to the fact that an attest service and not an audit service is conducted by an accountant in a
compilation or review, an accountant cannot issue a report without expressing a departure of
managements financial statement preparation and internal control responsibilities if management
does not comply in performing those duties.

Accountants may use experts to carry out the responsibilities of preparing a compilation or
review.

SSARS 19 Elements of compilations and reviews

Users of financial statements and information may also request additional work be performed
along with a review or compilation (agreed upon procedures such as an inventory observation).
As long as an accountant complies with professional standards, the additional work can be
performed.

SSARS 19 Financial statement v. Financial information

An engagement may involve a compilation or review of a set of financial statements or just a

single financial statement (e.g. Income statement) for any length period.

Depending on the appropriate accounting framework, a financial statement may be only one of
what would be known as a complete set of financial statements under generally accepted
accounting principles.

35 of 36

If only one of a set of financial statements is compiled or reviewed, it is termed financial

information if under the appropriate framework that a complete set of financial statements is more
than one statement.
SSARS 19 - EVIDENCE

As discussed in Auditing chapter 5, the accountant should not obtain evidence to base any level
of assurance on the financial statements when performing a compilation.

In a review engagement, limited assurance on the financial statements that no material

misstatements are in the financial statements under review engagement.

Analytical procedures and questioning management are the general steps followed in a review
engagement.
SSARS 19 - MATERIALITY

Regardless of the reporting framework applied to a compilation or review engagement the

following guidelines generally apply:
y

Misstatements and omissions are deemed material if they would persuade a practical
persons (users) decision when relying on the financial statements.

Materiality rulings are made when looking at all of the encompassing situational matter
around the financial statements.

Financial statements users as a group and not individual financial statement users guide
rulings on materiality. Specific situations of users do not apply.

Rulings on materiality are a subjective matter that the accountant performs based upon an
accountants view of the financial information being presented by management. The accountant
can then presume that users:
y

Have practical business knowledge and are willing to perform additional due diligence on
their own.

Are aware of materiality levels in the financial statements.

Are cognizant that management has made assumptions, estimations and taken future
considerations into bear when dealing with uncertainty.

Make practical decisions based upon the financial statements.

36 of 36

INTERNATIONAL AUDITING
STANDARDS
International Auditing Standards- Background
y

International auditing standards (IAS) are developed by the international auditing and assurance
standards board (IAASB) located in New York City and established in 1978.

The IAASB is an independent board within the International Federation of Accountants (IFAC).
The IFAC is the organization that has developed International Financial Reporting Standards.

At the time the IAASB was first formed, guidelines were established to govern audits. They were
formalized into standards beginning in 1991.

The Public Interest Oversight Board (PIOB) oversees the work of the IAASB as it does for other
IFAC public interest activity committees (PIAC) related to ethics, compliance and accounting
education.

Before international auditing concepts, policies and procedures become a standard, they must first
pass through due diligence overseen by the PIOB. The steps that comprise this due diligence are
performed by the PIAC.

Members of the IAASB are nominated by IFAC member groups, the Transnational Auditors
Committee, other organizations and citizens.

The IAASB consists of 18 members that represent 28 countries including the United States. The
United Kingdom, United States, Canada, Germany, Mexico and Australia have in the past been
the countries most represented on the IAASB.

The IAASB clarified its standards beginning in 2004 and five years later completed this project.
As a result, the clarified standards became effective for fiscal years beginning on or after
December 15, 2009. There will be no new standards that will be issued and in effect in at the
present time.
.

There are 36 IASS and one International Standard On Quality Control (ISQC)
y

One standard addresses communication of internal control deficiencies.

Sixteen new and upgraded standards.

Twenty standards rewritten for clarity (including the ISQC).

Each IAS is structured in the following manner:

y

Introduction

Objective

Definition

Requirements

Application and other explanatory material

IAS 200 - OVERVIEW

Overall objectives of the independent auditor and the conduct of an audit in accordance with
International Standards of Auditing.
OBJECTIVES:
y

To acquire reasonable assurance entailing whether financial statements do not contain material
misstatement due to fraud or error. In doing so, the auditor can then express an opinion on the
financial statements to state that they were created appropriately with an applicable reporting
framework and to report on the financial statements, and communicate the findings of the audit, if
any, under IAS requirements.

If reasonable assurance cannot be acquired, the auditor is required under IAS to disclaim an
opinion or withdraw from the engagement.

Similar in topic to SASS 1, 107, and 115, which have a far more detailed discussion.
IAS 240 - Overview

The auditors responsibilities relating to fraud in audit of financial statements

Objectives:
y

To identify and assess the risks of material misstatement of the financial statements due to fraud.

To obtain sufficient appropriate evidence regarding the assessed risks of material misstatement as
a result of fraud through developing and executing adequate responses.

To respond adequately to fraud or suspected fraud identified during an audit.

Similar in topic to SAS 99, consideration of fraud in a financial statement audit.

Listing of International Accounting Standards (IASs)

200 Overall objectives of the independent auditor and the conduct of an audit in accordance
with international standards of auditing.

210 Agreeing the terms of audit engagements.

220 Quality control for an audit of financial statements.

230 Audit documentation.

240 The auditors responsibilities relating to fraud in an audit of financial statements.

250 Consideration of laws and regulations in an audit of financial statements.

260 Communication with those charged with governance.

265 Communicating deficiencies in internal control to those charged with governance and
management.

300 Planning an audit of financial statements.

315 Identifying and assessing the risks of material misstatement through understanding the
entity and its environment.

320 Materiality in planning and performing an audit.

330 - The auditors responses to assessed risks.

402 Audit considerations relating to an entity using a service organization.

450 Evaluation of misstatements identified during an audit.

500 Audit evidence.

501 Audit evidence specific considerations for selected items.

505 External confirmations.

510 Initial audit engagements opening balances.

520 Analytical procedures.

530 Audit sampling.

540 Auditing accounting estimates, including fair value accounting estimates, and related
disclosures.

550 Related parties.

560 Subsequent events.

570 Going concern.

580 Written representations.

600 Special considerations audits of group financial statements (including the work of
component auditors).

610 Using the work of internal auditors.

620 Using the work of an auditors expert.

700 Forming an opinion and reporting on financial statements.

705 Modifications to the opinion in the independent auditors report.

706 Emphasis of matter paragraphs and other matter paragraphs in the independent auditors
report.

710 Comparative information, corresponding figures and comparative financial statements.

720 The auditors responsibilities relating to other information in documents containing audited
financial statements.

800 Special considerations audits of financial statements prepared in accordance with special
purpose frameworks.

805 Special considerations audits of single financial statements and specific elements,
accounts or items of a financial statement.

810 engagements to report on summary financial statements

ISQC 1 -International Standard on Quality Control quality control for firms that perform audits,
and reviews of financial statements, and other assurance or related services engagements. This is
the U.S. equivalent to Statement on Quality Control Standards issues by the Auditing Standards
Board. (SQCS 7)
General comments regarding IASs

IASs are principles based and not rules based.

IASs are less detailed than statements on auditing standards (sass).

IASs do not cover as many topics or specialized areas as sass. Cover such as
y

Government audits

Litigation claims

IASs tend to have more detailed statements related to fraud and illegal acts.

SAS 115
COMMUNICATING INTERNAL CONTROL RELATED MATTERS
IDENTIFIED IN AN AUDIT
y

SAS 115 is effective for compliance audits for fiscal years completing on or after December 15,
2009.

It supersedes SAS 112, as it updated the definitions of the following:

y

Deficiency in internal control

Significant deficiency

Material weakness

It provides assistance on determining the level of deficiencies in internal control

discovered in a financial statement audit.

It obligates the auditor to write to management and governance personnel significant deficiencies
and material weaknesses discovered in a financial statement (financial statements) audit.

It is not applicable if the auditor is required to report on internal control effectiveness combined
with an audit of an organizations financial statements under Statement on Standards for
Attestation Engagements No. 15, an examination of an entitys internal control over financial
reporting that is integrated with an audit of its financial statements.

Internal control is a process created by all members of an organization to bring about efficient and
effective operations, and among other factors, safeguarding assets, which is related to financial
reporting controls. These controls are most applicable to financial statements audits.

An auditor is not responsible to perform activities that indicate deficiencies in internal controls or
state an opinion concerning internal control effectiveness. During an audit, an auditor may
become aware of internal control deficiencies while performing activities to attain knowledge of
an organization and its internal control.
SAS 115 (DEFINITIONS)

Financial reporting: creating trustworthy financial statements that are reasonably presented in
order to adhere with generally accepted accounting principles or if appropriate, other
comprehensive basis of accounting.

Deficiency in internal control: a condition that exists when the design or operation of a control
prohibits an organizations employees from timely preventing, detecting and correcting
misstatements.

Design deficiency is a condition where

y

A required control is missing to meet a control objective.

A control that is operating that is so poorly designed; it does not meet a control objective.

Operating deficiency is a condition where.

A properly designed control does not work as intended.

An individual executing the control is not capable or authorized to

properly execute the control.

Material Weakness: At least one deficiency in internal control to the extent that it is at least
reasonably expected that a material misstatement of the financial statements will not be timely
prevented, detected or corrected.

Significant Deficiency: at least one deficiency in internal control less grave than a material
weakness yet requires governance personnel attention.

SAS 115- (DEFICIENCIES FOUND DURING AN AUDIT)

y

An auditor must determine the gravity of all internal control deficiencies found during an audit to
categorize whether they are significant deficiencies or material weaknesses.

An internal control deficiencys gravity is determined by

The size of the possible misstatement of the financial statements due to the deficiency
and (see below)

A reasonable expectation that an organizations controls will not prevent, detect or

correct a misstatement of an account amount or disclosure.

It is not determined by whether an actual deficiency occurred in the past.

The size of a misstatement is determined by factors that include

y

The dollar amounts or transactions vulnerable due to the deficiency.

The amount of activity in an account during a time period vulnerable to the deficiency.

Overstated dollar amounts have expressed limits while understated dollar amounts have
unexpressed larger limits.

SAS 115 contd (DEFICIENCIES FOUND DURING AN AUDIT)

y

Risk factors determining whether a reasonable expectation that deficiencies in internal control
will result in financial statements misstatements include
y

Categories of transactions, disclosures and assertions affected.

Vulnerability to fraud of the assets and liabilities related to the transaction.

Judgment needed to arrive at account amounts.

The level the control or the control deficiency interacts with other controls and control
deficiencies.

The aftermath scenario if a deficiency occurs.

The size of a misstatement has no direct correlation to the possibility that it might occur.

Many deficiencies small in nature when individually viewed may add up to one material
weakness or significant deficiency.

An organizations compensating controls may limit the gravity of a deficiency but it does not
eradicate it.

Symptoms of a material weakness include

y

Identifying executive management fraud.

Reissuing correctly stated financial statements that were previously issued with a fraud
related misstatement.

Material misstatements of financial statements discoveries by an auditor that the

organizations internal control would not have caught.

Governance personnel ineffectiveness in monitoring an organizations financial

reporting.

y
SAS 115 (COMMUNICATION)
y

Deficiencies found during an audit by the auditor should be addressed to management and
governance personnel in writing, including prior year deficiencies not yet mitigated.

All deficiency communications may be made most appropriately by the audit report release date,
but it must be made no later than 60 days following the audit report release date.

Urgent items should be communicated during the audit, and can be done orally at first, then
written at a later time. It should be done even if the urgent items have been remediated.

Even though management and governance personnel incur the responsibility for the risk of
significant deficiencies and internal weaknesses, the auditor must communicate them to
management and governance personnel.

Positive recommendations for improved efficiencies and non-significant deficiencies may also be
communicated.

All oral communication must be written at some point in time (to indicate that it did in fact
occur).

Written communication involving significant deficiencies and material weaknesses discovered

during a financial statements audit should contain
y

A declaration identifying the reason for an auditors consideration of internal control was
to state an opinion on the financial statements, not to express an opinion on internal
control effectiveness.

A declaration identifying the auditors interest in internal control was to identify all
internal control deficiencies that potentially are significant deficiencies or material
weaknesses.

A material weakness definition and if required, one for a significant deficiency as well.

Matters identified that were found to be significant deficiencies and material weaknesses.

A declaration that the communication is for organization management, governance

personnel (and other organization personnel, if appropriate) and no one else. (except by
governmental or legal authority).

The auditor should not issue a report stating that the auditor did not discover any
significant deficiencies but the auditor may issue a report stating that the auditor did not
discover any material weaknesses

SAS 116
INTERIM FINANCIAL INFORMATION
y

SAS 116 is effective for reviews of interim financial information (IFI) for interims beginning
after December 15, 2009.
SAS 116 (DEFINITIONS)

Applicable financial reporting framework: the criteria adopted by entity management, and if
required, by governance personnel in preparing the f/s (financial statements) amenable to an
entitys environment. (GAAP, IFRS, OCBOA).

IFI is deemed so because it covers a period of less than a year or for a years worth of
information ending on a date other than a normal fiscal year end date of an organization.

Accountant: someone who performs a review of IFI. This distinguishment is made because the
person is not performing an audit, thus for this particular SAS will not be called an auditor.
SAS 116 (APPLICATIONS)

This SAS provides parameters on applying field work and reporting standards as far as they can
be applied to reviewing IFI.

General standards are covered in SAS 1 that has since been superseded by SAS 113 Omnibus
2006.

An accountants review report should be issued with IFI, if the organization being reviewed
writes in a document, e-mail or report that the IFI has been reviewed by an independent public
accountant, or a public accounting firm.

An accountant may deem it appropriate to write and issue a report to state that IFI has been
reviewed in order to distinguish that the IFI was not audited.

SAS 84 applies to an engagement to review IFI in communication between a prior auditor and
successor auditor before an initial review of IFI takes place.

An accountant may conduct, to comply with this SAS, a review if:

y

The latest annual financial statements have been audited by the accountant or another
auditor.

The accountant will also audit the organizations current year financial statements, or has
done so in the past and has no reason to believe that this will not continue.

Management uses the same reporting framework guidelines to IFI as it does to the
audited financial statements.

SAS 116 contd (APPLICATIONS)

y

If IFI is presented in summary it must:

y

Adhere to an appropriate reporting framework.

State that it is not the same as a complete set of financial statements.

Be made accessible by the organization (website) along with the audited financial
statements.
y

Objectives of a review of IFI are to:

y

Provide a means to the accountant for expressing whether there is

knowledge of any material modification required to be made to the IFI.

Distinguish a review from an audit (refer to Lambers CPA Review Audit

book chapter 5 for a discussion of review requirements).

Establishing agreement with an organizations management:

y

Should be made in writing.

Should include engagement objectives, limitations and

responsibilities of the accountant and management.

Should indicate the type of final communication regarding the

outcome of the engagement (oral or written).

The accountant should have already obtained a reasonable expectation that management
can create proper IFI, otherwise the engagement should not be accepted. (refer to
Lambers CPA Review Audit book chapter 5 for a discussion of review requirements).

SAS 116 KNOWLEDGE OF AN ORGANIZATION AND ITS INTERNAL CONTROL

y

To conduct a review of IFI, the accountant should have enough information on the organization
and its internal control as they pertain to creating annual financial information and IFI to
y

Indicate the types of possible material misstatement in IFI and to contemplate the
possibility of those mistakes occurring.

Choose appropriate inquiries and analytical activities that will give an accountant
information to communicate that (s)he is cognizant of any significant changes that need
to be made to the IFI for it conform with GAAP, IFRS, etc.

In planning a review of IFI, the accountant should act to make current his/her knowledge of the
organization and its internal control to
y

Assist in deciding the type of inquisitive and analytical procedures to execute, and (see
below)

Indicate specific occurrences, transactions or declarations where questioning can be

steered or analytical activities performed.

The procedures executed in a review should be to

y

Read prior year written reports on audits and interim period reviews as well as those
reviews of the present year to allow the accountant to judge what items in them would
affect current year IFI.

During the reading, the accountant should contemplate the details of

y

Corrected material misstatements.

Matters regarding uncorrected material misstatements.

Risks regarding material misstatement as a result of fraud or management

superseding internal controls.

Matters important to the financial statements going forward (significant

deficiencies and material weaknesses).

Read the most current annual and comparative prior year IFI.

Decide if any of the current year auditing outcomes would affect current year financial
statements.

Ask management if any alterations to business procedures have occurred.

Ask management if any internal control procedures pertaining to IFI have changed after the prior
year audit or prior review of IFI.

If there is any communication required between a predecessor and successor accountant, the
successor accountant should if allowed, review predecessor accountant documentation. If the
successor accountant is issuing a review report on IFI, (s)he should not make reference to the
activities of the predecessor accountant.

If a predecessor accountant does not allow a successor accountant to review documentation, the
successor accountant should use other methods to satisfy the review objectives pertaining to IFI.

If an accountant has not audited an organizations financial statements prior to performing a

review of IFI, (s)he should perform activities to acquire knowledge of the organization and its
internal control. To assist in deciding what types of activities to conduct, the auditor should refer
to SAS 109, regarding understanding an organization and its environment.

A scope limitation on the review of IFI if the accountant is unable to conduct enough review
procedures to provide a foundation for the results that would be discussed in the accountants
report.

SAS 116 ANALYTICAL ACTIVITIES AND RELATED INQUIRIES

y

An accountant should tailor analytical activities and related inquiries to the situation specific to
each review of IFI performed.

An accountant should lookout for peculiar appearing relationships among accounts that may
identify material misstatement while performing analytical activities. These activities should
encompass
y

Comparing IFI with similar data for the preceding interim period if applicable, and for
the same time period for the preceding year, giving thought to the organizations
activities and selected transactions.

Contemplating possible relationships within financial data and between financial and
non-financial data. This includes organization generated data.

Comparing general ledger account amounts, ratios from those amounts to anticipated
results developed by the accountant. The accountant should use knowledge acquired in
the past as a basis to look for an anticipated result.

Comparing dispersed information on revenue (i.e., comparing current revenue by city or

product for the reviewed period to that of similar prior periods). An accountant may also
refer to SAS 56 on analytical activities.

Anticipated amounts applicable to a review are usually less precise than those done in an audit.
Inquiries should still elicit consistent information to that obtained during analytical activities and
to knowledge acquired of the organization by the accountant.

The accountant should conduct the following inquiries and review procedures during a review of
IFI:
y

Read minutes of stockholder, board of directors meetings, etc. And other non- disclosed
meetings to indicate items possibly affecting IFI.

Gather other accountants reports who have performed a review of IFI for other
considerable sections of the organization.

Ask management responsible for finance and accounting about:

y

Whether IFI has been prepared to adhere to the appropriate reporting framework.

Gathering reports from other accountants who have previously performed a

review of IFI for considerable sections of the organization.

Abnormal or intricate situations or journal entries that could affect IFI.

Large transaction amounts recorded right before the end of the interim period.

The disposition of uncorrected misstatements identified in previous audits and

reviews.

Matters that have come into question during the review.

Subsequent events to the reviewed period that can materially affect reporting IFI
in the current period.

Managements knowledge of any fraud, actual or possible with regard to

management, employees and financial statements effect.

Data communicated to and from regulatory industries.

Any deficiencies in internal control, significant deficiencies and material

weaknesses.

If the accountant believes there to be legal issues that would prevent IFI from being reported
adequately under the applicable reporting framework guidelines, (s)he should obtain the
necessary information from the organizations attorneys.

If the accountant is unsure whether the organization has the ability to remain a going concern, it
should consult management and based upon this determine whether further reporting should be
done on this matter.

The accountant can combine review and audit procedures to efficiently complete both
engagements if (s)he is performing them.

SAS 116 WRITTEN REPRESENTATIONS FROM MANAGEMENT

Written representations from management should be obtained on the following matters:

y

Its responsibility regarding both IFI and presentation of information to adhere to the appropriate
reporting framework.

Its responsibility for the creation and maintenance of internal control procedures.

Its responsibility to allow the accountant access to financial records and appropriate related data.

Its acknowledgement that there are no unrecorded transactions.

Its assertion that any uncorrected financial statements misstatements gathered by the accountant
are not material individually and combined to the IFI.

Its assertion that all related party transactions have been disclosed.

Its assertion that it has disclosed all significant estimates and material concentrations of financial
information in accordance with AICPA Statement of Position 94-6.

Its assertion that it has revealed appropriate information regarding subsequent events.

SAS 116 EVALUATING RESULTS OF INTERIM REVIEW PROCEDURES

y

The accountant may set a ceiling to transaction amount misstatemements considered to be

immaterial, taking into consideration that accumulating misstatements could possibly affect IFI.

The accountant should contemplate whether significant adjustments be made to IFI to conform to
the appropriate reporting framework regarding:
y

Description, reason and amount of misstatements.

Whether the misstatements are from prior year or current interim periods.

Materiality evaluations made with regard to current or prior year audits.

Effects of misstatements on future IFI and audits.

SAS 116 COMMUNICATIONS

After reviewing IFI, if the accountant discovers items that lead to a circumstance where there should have
been either a material adjustment to the IFI for it adhere to the appropriate reporting framework or the
organization reported IFI before the review was finished when a review is mandatory, the accountant
should inform the appropriate management as soon as possible.
y

Regarding material misstatements, if management does not inform the accountant in an

appropriate period of time from the accountants perspective, the accountant should
inform governance personnel (board of directors, audit committee, etc.) orally or in
writing. The accountant should document all communication.

If governance personnel do not inform the accountant in an appropriate period of time

regarding material misstatement matters from the accountants perspective, the accountant
should consider resigning from the review engagement and if necessary, from the audit
engagement.

In cases of fraud or illegal acts discovered during a review of IFI, the accountant should
report the matter to the appropriate level of management in accordance with SAS 99,
consideration of fraud in a financial statement audit.

During a review of IFI, the accountant may discover significant deficiencies and/or
material weaknesses in internal control relating to preparing annual information and IFI
(refer to SAS 115 for definitions). If it is discovered, it should be addressed with
management and governance personnel.

SAS 116 REPORTING

The accountants review report that will be presented along with the IFI should have in it:

A title that contains the word independent.

A declaration that the IFI in the report was reviewed.

A declaration stating IFI is managements responsibility.

A declaration that the review of IFI was performed appropriately with AICPA standards.

An explanation of IFI review procedures.

A declaration that a review is of lesser scope than that of an audit in accordance with generally
accepted auditing standards.

A declaration regarding whether the accountant is aware of material modification that is required
to be made to the IFI for it to be in adherence with an applicable financial reporting framework.

The accountant or the accountants firm signature.

The review report date.

Each page of the IFI should have the word unaudited clearly displayed.

SAS 117
COMPLIANCE AUDITS
SAS 117(UPDATES SAS 74)
This SAS replaces SAS 74, compliance auditing considerations in audits of governmental entities and
recipients of governmental financial assistance. SAS 74 had the following provisions for auditors to:
y

Apply the provisions of SAS 54, illegal acts by clients pertaining to detecting misstatements
affecting government entity financial statements.
y

Prepare an audit in compliance with government auditing standards issued by the U.S.
Comptroller General.

Prepare a single or entity-wide audit or a program-specific audit in compliance with

federal audit regulations.

Communicate with management if an auditor discovers that the organization needs to

comply with audit regulations that are not already covered in the current audit scope.

In addition, the auditor should determine if management has indicated laws and requirements that have a
direct and significant effect on the decision as to the amounts disclosed in an organizations financial
statements and how those laws and requirements influence the financial statements.
SAS 117-(REQUIREMENTS)
SAS 117 is effective for compliance audits for fiscal years completing on or after June 15, 2010.
SAS 117 increases the requirements set forth in SAS 74 to include not only SAS 54, but many other
(although not all) of the auditing standards for financial statements audits to compliance audits. The new
requirements are listed below.
y

Unless otherwise directed in this SAS, generally accepted auditing standards (GAAS) should be
applied when an auditor uses professional judgment.

The auditor should use materiality levels the applicable government audit regulations prescribe.

Based upon the stipulation that management must identify its organizations government
programs and comply with the program regulations, the auditor should decide which programs to
test for compliance with government audit regulations. This would include:
y

Reading compliance enhancements issued by the government (i.e., OMB A-133).

Reading specific program audit guides (i.e., HUD section 8).

Asking questions about regulations and posing them to entity management, prior auditors
and governing boards.

Reading governing board meeting minutes.

A risk assessment should be performed for all government programs tested to acquire
knowledge of the appropriate compliance regulations. To do this the auditor should be
aware of the following influences:
y

The age and degree of complexity of the compliance regulation.

The auditors awareness of the organizations internal control over complying

with regulations.

The services provided by the organization.

The type of appropriate government regulation.

A grantors level of supervision over the organization and managements

perspective of audit findings.

Among the influences an auditor may contemplate relating to significant noncompliance are:
y

The complexity of the compliance regulations.

The risk that the regulation will not be adhered to.

How long a period has the entity been required to adhere to the
regulation.

How diligently has the entity adhered to the regulation in the past?

The effect on the entity due to regulatory non-compliance.

The amount of judgment required to adhere to the regulation.

The auditors estimate of material non-compliance risk in the financial

statements.

After assessing non-compliance risk, the auditor should develop a procedural plan to address it.
This can be done by performing:
y

Sampling when testing internal controls (attributes).

Test of transactions for the following:

y

Grant payments for expenses.

Eligibility requirements.

Cost allocation determinations.

Periodic reports given to grantor entities.

If there are government audit requirements that enhance GAAS requirements, the auditor should
determine a plan to consider them.

The auditor should request written assertions from management that address, among other items
regarding the audit:

Understanding and following government requirement regulations.

Accountability in creating and the upkeep of internal controls.

The auditor should perform the audit up to the audit report date to obtain sufficient evidence
related to subsequent events. In addition the auditor should inquire of management regarding the
subsequent time frame about
y

Appropriate audit reports.

Reports from pass through grantors.

Information about the organizations non-compliance discovered through other work

performed for the organization.

The auditor should also discuss with management and if necessary, governance personnel
regarding anything occurring in the subsequent time frame that could alter the understanding of
the auditors report by users. If the auditor does become aware of this type of occurrence, the
auditors report should also include an explanatory paragraph on the situation.

In order to decide as to whether an organization has materially adhered to the appropriate compliance
regulations, the auditor should contemplate:
y

The rate of non-compliance with regulations discovered during a compliance audit.

The specific types of non-compliance with regulation discovered.

The capability of the organizations monitoring process to ascertain adherence to regulations and
effects of non-compliance.

Whether there were any significant costs to the organizations program that were or will be
questioned as a result of non-compliance discovered during the audit.

ALL OF THESE FACTORS SHOULD BE CONSIDERED BY THE AUDITOR EVEN THOUGH THE
ORGANIZATION MAY HAVE CORRECTED THE NON-COMPLIANCE FOLLOWING THE
AUDITORS DISCOVERY OF IT.

SAS 117 REPORTING

Among the items required in a compliance report are:

An introductory paragraph stating the appropriate responsibilities of management and the

auditor.

A scope paragraph stating the audit standards applied and audit procedures taken.

Any non-compliance results that require an opinion modification.

An opinion paragraph determining whether the organizational material adhered to the

appropriate government regulatory requirements.

If the auditor issues a combined report on compliance and internal control monitoring of the
compliance, the auditor in addition to the compliance requirements should also include:
y

A statement that the auditor is not expressing an opinion on internal control.

Management is responsible for creating and maintaining an internal control framework to

adhere to government regulations.

SAS 117 DOCUMENTATION

The auditor should document risk assessment steps that were performed including those used to
acquire knowledge of the organizations internal control over adherence to government
regulations.

The auditor should document how the materiality levels of the organization were determined.

Representation letters from management should also be obtained.

The auditor should also document communication of material weakness and significant
deficiencies in internal control to management as well as managements response to those
findings communicated by the auditor.

SAS 118
OTHER INFORMATION IN DOCUMENTS CONTAINING AUDITED
FINANCIAL STATEMENTS
y

SAS 118 replaces SAS 8 other information in documents containing audited financial statements
and parts of SAS 29, 52 and 98.

Establishes compulsory requirements for audit performance pertaining to additional client

information included in a presentation of financial statements.

Effective for audits of financial statements for periods starting on or after December 15, 2010.
DEFINITIONS
y

Other information financial and non-financial information not already included in the
financial statements or the auditors report that accompanies those two items. Other
information does not include required supplementary information.

Inconsistency other information that disagrees with the audited financial statements.
If it is material, an inconsistency may create doubt about audit conclusions taken from
prior audit evidence and about the basis of an auditors opinion on the financial
statements.

Misstatement of fact other information unrelated to audited financial statement

subjects that is incorrectly asserted or represented. If it is material, the reliability of
the document containing audited financial statements is weakened.

FAS 118 (REQUIREMENTS)

y

The auditor should read other information that (s)he is made aware of to determine if any
inconsistencies exist. If they exist, a determination is to be made on whether a revision is
required on audited financial statements or the other information.

Other information should be obtained from management or governance personnel before an audit
report is released. If it is not obtainable by that time, it should be read as soon as possible.

The auditor should communicate responsibilities, procedures and results regarding other
information to governance personnel.
SAS 118 (INCONSISTENCIES RECOGNIZED BEFORE RELEASE DATE)

If a revision to the financial statements is required and management refuses to provide one, a
modification of audit opinion is to be made.

If it is a material inconsistency that requires other information revision that management refuses
to perform, the auditor should communicate it to governance personnel and include an

explanation in the auditors report, withhold the report or possibly withdraw from the
engagement.
SAS 118 (IDENTIFICATION OF MATERIAL INCONSISTENCIES)
y

Actions to take when material inconsistencies are identified in other information after an audit
report date release:
y

If revision of financial statements is required, the auditor should perform steps discussed
in SAS 1 and/or 98.

If revision of other information is required and the client makes the revision, the auditor
should perform as required in the circumstances.

If revision of other information is required and the client does not make the revision,
governance personnel should be notified by the auditor about the auditors concerns
regarding the other information.

SAS 118 (MATERIAL MISTATEMENT OF FACT)

y

If the auditor discovers a material misstatement of fact in other information, it should be

discussed with client management.

After the discussion, if there is still a material misstatement of fact, the auditor must request the
client to discuss the matter with legal counsel.

Upon receiving legal counsel guidance, if management refuses to correct the material misstatement of
fact, the auditor should notify governance personnel and apply appropriate procedures.

SAS 119
SUPPLEMENTARY INFORMATION IN RELATION TO THE
FINANCIAL STATEMENTS AS A WHOLE
y

SAS 119: Supplementary information pertains to data presented in addition to the financial
statements and is not necessary for financial statements to be fairly stated in accordance with
GAAP/IFRS. It may be presented with the financial statements or in a separate document.
Supplementary information in some cases may be required to accompany the financial
statements.

SAS 119 pertains to auditor responsibility in an engagement regarding whether supplementary

information is fairly stated in all material aspects in regards to the financial statements taken in
their entirety.

SAS 119 is effective for audits of financial statements for periods starting on or after December
15, 2010.

Auditor objectives are to

y

Evaluate the supplementary information presentation in regards to the financial

statements taken in their entirety.

Report on whether the supplementary information is materially fairly stated regarding the
financial statements in their entirety.
SAS 119 (Requirements)

In order to opine on the fair statement of supplementary information, relating to the financial statements
taken together, the following must have occurred or will occur:

The supplementary information was derived from and relates to the accounting and records
utilized to prepare the financial statements.

The supplementary information is for the same time period as the financial statements.

The financial statements were audited and the auditor was the primary auditor on that
engagement.

No adverse or disclaimer of opinion was rendered on the financial statements.

The supplementary information will accompany the financial statements or the audited financial
statements will be made accessible by the audited entity.

The auditor should get an affirmation from management stating that is knowledgeable and comprehends
responsibility for:

Preparing supplementary information to appropriate criteria.

Providing the auditor with written representations.

Including the auditors report on the supplementary information in all documents containing the
supplementary information and indicates the auditor has reported on the supplementary
information.

Presenting supplementary information with audited financial statements or, if supplementary

information is presented separately, that the financial statements be available for use by the
supplementary information and the financial statements issuance dates.

In addition to auditing procedures performed on the financial statements, the auditor is to perform these
procedures on supplementary information using the same materiality level used on the financial
statements:
y

Management inquiries about the reason to have supplementary information and the criteria used
in preparing it (financial, regulatory, etc.).

Determine whether the supplementary information is comparable to the criteria used to prepare it.

Understand methods used to prepare supplementary information and determine if any changes to
the methods have occurred from prior years and if there any changes, the reasons for the change.

Compare the information in the supplementary information to that of the financial statements, or
the accounting used to prepare the financial statements. Reconcile if necessary.

Determine from management if any assumption/interpretations underlying measurement or

presentation of the supplementary information were used.

Determine the relevancy and completeness of the supplementary information based upon the
audit procedures of the financial statements and other knowledge obtained during the audit.

Obtain written representations from management that

y

It is aware of its responsibility for presenting supplementary information in accordance

with appropriate criteria.

It believes the supplementary information in display and substance is fairly presented in

accordance with appropriate criteria.

No changes have been made to current measurement procedures compared to those

occurring in the prior period, or reasons for change if they in fact, have changed.

It has disclosed any material assumptions and interpretations used as a base in presenting
supplementary information.

When the supplementary information is not presented with the audited financial
statements, it will make available the financial statements by the issuance date of the
supplementary information and related financial statements.

The auditor has no responsibility for considering subsequent events related to the supplementary
information. If information is obtained by the auditor before the financial statements release date
regarding supplementary information, the auditor should follow the requirements of the
subsequent event (AU 560) audit standard. If information is obtained after the financial
statements release date regarding supplementary information, the auditor should follow the
requirements of the subsequent discovery of facts existing at auditors report date (AU 561) audit
standard. Both of these requirements are found in SAS 1.
SAS 119 (contd) REPORTING

The auditor can report on the supplementary information in a paragraph explaining the supplementary
information after the opinion paragraph in the auditors report of the financial statements or in a
completely separate report on the supplementary information.
The paragraph or report must contain the following:
y

The audit was performed to form an opinion on the financial statements in their entirety.

The supplementary information is not required as part of the financial statements, but presented
as additional analysis.

Management is responsible for the supplementary information and the information in it was taken
from the same sources as that used to prepare the financial statements.

An explanation that the supplementary information is subject to audit procedures that were
applied to the financial statements.

Reconciliations, comparisons and other methods were performed on the accounting data that
underlies the financial statements or directly to the financial statements in accordance with U.S.
Accepted Auditing Standards (GAAS).

If an unqualified opinion is given on the financial statements and the supplementary information is fairly
stated relating to the financial statements according to the auditor, the auditor must state this fact.
If a qualified opinion is given regarding the financial statements and its effects on the supplementary
information, an except for opinion (stating the departure reason from the unqualified opinion) is
expressed in addition to noting that the remainder of the supplementary information is fairly stated.
When audited financial statements are not presented with the supplementary information, a separate
report should be given on the supplementary information that refers to the financial statements report
stating the date, opinion and any modifications to the auditors financial statements report.
No opinion on the supplementary information is given by auditor if a disclaimer or adverse opinion is
given on the related financial statements.

If allowed by law or regulation, an auditor can withdraw from a supplementary information engagement if
one of the above two opinions is rendered on the financial statements.
If a report is given in this situation, the auditor is required to express that under the circumstances, no
opinion will be given on the supplementary information.
The report date on the supplementary information should be on or following the last day of procedures
performed on the supplementary information.
If the auditor determines that the supplementary information is misstated, and management does not
rectify the situation the auditor must

Modify the report opinion on the supplementary information and describe the misstatement or

If a separate report on the supplementary information is to be given, withhold the report.

SAS 120
REQUIRED SUPPLEMENTARY INFORMATION
y

SAS 120: When an audit standard setter (setter) needs information to go along with an
organizations financial statements, the goal of the auditor is to perform the following tasks to be
able to:
y

Explain in the auditors report if required supplementary information is displayed and

Reveal in the auditors report in the event when only some or none of the required
supplementary information has been presented in accordance with a setters guidelines, or
the auditor indicates that material adjustments to the required supplementary information
should be made for it comply with the setters guidelines.

SAS 120 is effective for audits of financial statements for periods starting on or after December 15, 2010.
DEFINITIONS:
y

Required supplementary information: data that a setter obliges to accompany the financial
statements. It is not a piece of the financial statements, but a setter deems it vital to financial
reporting to place the financial statements in proper perspective. Guidelines on presentation have
been given in financial accounting standards issued by the financial accounting standards board.

DESIGNATED ACCOUNTING STANDARD SETTER (SETTER): An entity appointed by the

AICPA council to establish generally accepted auditing standards (GAAS) to comply with AICPA
professional standards. The entities are the:
y

FINANCIAL ACCOUNTING STANDARDS BOARD

INTERNATIONAL ACCOUNTING STANDARDS BOARD

GOVERNMENTAL ACCOUNTING STANDARDS BOARD

FEDERAL ACCOUNTING STANDARDS ADVISORY BOARD

Basic financial statements: documentation presented in accordance with an appropriate financial

reporting framework created by a setter that does not include required supplementary
information.

Applicable financial reporting framework: the criteria adopted by entity management, and if
required, by governance personnel in preparing financial statements amenable to an entitys
environment and the purpose of the financial statements or if applicable, legal or regulatory
requirements (GAAP, IFRS, other comprehensive basis of accounting (OCBOA)).

Prescribed guidelines: mandatory rules determined by the setter measurement standards and
display of required supplementary information.

SAS 120 (REQUIREMENTS)

The auditor should perform the following as it relates to required supplementary information:
y

Ask management about their procedures to create required supplementary information that
answers questions as to whether
y

Required supplementary information is presented properly and within appropriate

guidelines.

There have been any changes to procedures used to create required supplementary
information and explanations for those changes.

There were any material assumptions or interpretations supporting the required

supplementary information reporting.

Compare required supplementary information for consistency with management

statements related to auditor inquiries, financial statements and other information
garnered during the financial statements audit.

Obtain expressed assertion from management:

That it is aware of its responsibility regarding required supplementary

information.

About whether the required supplementary information is gauged and displayed

according to appropriate guidelines.

About whether the required supplementary informations means of gauging are different from
those performed in prior years and the reasons for the differences, if any.
y

About whether there were any material assumptions or interpretations supporting the
required supplementary information reporting.

If the auditor cannot perform any of the aforementioned requirements, the auditor should contemplate
whether management may have been responsible for this inability. Upon contemplation, if the auditor
believes this to be the case, the auditor should contact governance personnel.
SAS 120 REPORTING
The auditor can report on the required supplementary information in a paragraph explaining the required
supplementary information after the opinion paragraph in the auditors report of the financial statements.
If applicable, the paragraph must contain the following:
y

An indication that the required supplementary information is included and the procedures
previously mentioned have been used.

That required supplementary information was not included.

Part of the required supplementary information is included and part is not included according to
applicable guidance.

The auditor has indicated material differences from appropriate guidance.

The auditor is not able to finish previously discussed procedures in this SAS.

The auditor is dubious as to whether required supplementary information is displayed according

to appropriate guidance.

If an organization has revealed all or part of the required supplementary information, the explanatory
paragraph previously noted should contain:
y

A declaration that (GAAP, IFRS, etc.) Mandates that the required supplementary information be
displayed to enhance the financial statements.

A declaration that the data, despite it not being a part of the basic financial statements, is
mandated by an indicated setter, who deems it to be a required part of financial reporting to
properly frame the appropriate financial statements in operational, economic or historic
perspective.

If the auditor is capable of performing the previously mentioned required actions the must make:

A declaration that the auditor used limited procedures to the required supplementary
information in applicability with GAAS, that includes management inquisition about
procedures used to prepare data to be comparable with managements answers to the
auditors questions, the financial statements and other information obtained during the
financial statements audit by the auditor.

A declaration that the auditor does not state an opinion or any guarantee on the data due
to the fact that limited procedures do not give an auditor enough evidence to state an
opinion or guarantee.

If the auditor is not capable of performing the previously mentioned required actions:
y

A declaration that the auditor could not use certain limited procedures to the
required supplementary information in accordance with GAAS including reasons
as to why this is.

A declaration that the auditor does not state an opinion or guarantee about the
data.

If part of the required supplementary information is not included:

y

A declaration that management has not included (describe the required supplementary
information left out) that (GAAP, IFRS, etc.) Mandate to be displayed to enhance the
financial statements.

A declaration that data left out, despite not being a part of basic financial statements, is
mandated by a setter to be required in order to frame the basic financial statements in a
proper operational, economic, or historical perspective.

A declaration that the auditors opinion on the financial statements is not influenced by
the data left out.

If the gauging or display of the required supplementary information is significantly changed from
mandated guidance, a declaration that despite the auditors opinion on the basic financial
statements is not changed, these changes from mandated guidance are still there (also include a
description of the changes from the mandated guidance).

If the auditor remains dubious of whether the required supplementary information is gauged or
displayed in accordance with mandated guidance, a declaration that despite the auditors opinion
is not changed, the results of the limited procedures have caused the auditor to be dubious of
whether significant changes should be included to the required supplementary information for it
to be displayed to comply with the setter.

If the entire required supplementary information data is left out, the explanatory paragraph must
have the following items:
y

A declaration that management has left out (describe the required supplementary
information) that (GAAP, IFRS, etc.) Mandates to be displayed to enhance the basic
financial statements.

A declaration that the omitted data, despite not being part of the basic financial
statements, is mandated by the setter, who deems it a required part of financial reporting
to put the basic financial statements in proper operational, economic or historical
perspective.

A declaration that the auditors opinion on the basic financial statements is not changed
by the data left out.

SSAE 16
ATTESTATION ENGAGEMENTS
REPORTING ON CONTROLS AT A SERVICE ORGANIZATION
y

SSAE 116: This Statement On Standards For Attestation Engagements (SSAE) is the reporting
required for a service auditor to disclose on controls at a organization providing service to a user
organization that would be pertinent the user organizations internal control.

Examples of a service organization include:

y

Medical claims coders and processors.

Credit card transaction processors.

Brokerage firm equity instrument transaction processors.

Actuarial services to determine pension accounting related valuations and obligations to

plan members.

A service auditor is the auditor who reports on the controls of a service, but not a user
organization.

This SSAE is effective for Service Auditors Reports for periods ending on or after June 15,
2011.

User auditor requirements regarding organizations that use a service organization will be
forthcoming in a new statement of auditing standard that will be effective for periods ending on
or after December 15, 2012. For those obligations SAS 70 still applies regarding service
organizations.

A user auditor may visit a service organization to inquire about its internal controls, but most
service organizations have large client basis, so it would be infeasible for a service organization
to invite all of the interested user auditors to inquire about its internal controls.

As a result of this, a service organization will hire a CPA to perform an attestation on its internal
controls. This is known as a service auditors engagement and the CPA would be the service
auditor.

Service auditor management must provide the service auditor documentation regarding the
business operation of the service (who are the customers, how does it work, what are the controls
regarding the service and the reasons for the controls).

SSAE 16 provides for a service auditor to issue two kinds of reports:

y

Type 1 reports are those where a service auditor would state an opinion on whether the
documentation presented by management on the service organizations operations is
justly stated and the related internal controls are reasonably designed. If so, objectives of
the internal controls would have the ability to perform as they should.

Type 2 reports are those where a service auditor would state an opinion exactly as it
would appear in a Type 1 report and it would also indicate if the controls are working
effectively. This report would also describe the test the service auditor used to test the
service organizations internal controls. A user auditor can than can decide how the test
results affect the user organizations financial statements.

A service auditor must also receive from service organization management written
representations about its description of the business operations and in the case of a Type 2 report,
about its internal control effectiveness. These representations should address the reasonableness
of the presentation of the operations and the appropriateness of the related internal control
structure.

In addition to the these representations other matters regarding this type of engagement include:
y

No prior reliance on previous period testing or reporting on service organization internal

controls. A new engagement must cover all aspects of testing.

Any internal audit work performed by service organization auditors must be addressed by
a service auditor with regard to the procedures performed.

A specified period of time regarding internal control design must be stated by a service
auditor regarding its coverage rather than a specific date. (Applicable in Type 2 report
attestation procedures).

All the applicable language in the report must be present in accordance with SSAE 10,
attest engagements. It should be tailored to service organizations.

SSAE 16 only applies to financial statement matters.

SSARS 19
COMPILATION AND REVIEW ENGAGEMENTS
FRAMEWORK FOR PERFORMING AND REPORTING
y

SSARS 19: This Statement on Standards for Accounting and Review Services (SSARS)
supersedes three previous SSARS (1, 11 and 16) will become effective For compilations and
reviews of financial statements for year endings on or after December 15, 2010.

This revision covers

y

Professional and communication requirements when an accountant reports on unaudited

financial statements of a non-issuer to the non-issuers clients and vendors.

Standards for accounting and review services.

Professional requirements in SSARS.

SSARS 19 DEFINITIONS

FINANCIAL REPORTING FRAMEWORK (FRF) A benchmark utilized to

decipher gauging, recognizing, displaying and expressing material items. There are 2
types:
y

Applicable financial framework - the criteria adopted by entity

management, and if required, by governance personnel in preparing the
financial statements amenable to an entitys environment, usually
generally accepted accounting principles (Gaap) or international
financial reporting standards (IFRS).

Other comprehensive basis of accounting (OCBOA) the criteria that is

not GAAP or IFRS but has other another fact set that supports the
creation of financial statements in accordance with that basis. The most
common are cash, tax and liquidation basis accounting.

ASSURANCE ENGAGEMENT Work performed when an accountant states a conclusion to

affirm positively to an organizations clients and management about the results of an assessment
or gauging of the financial statements (condition) against an appropriate financial reporting
framework (benchmark).

ATTEST ENGAGEMENT Work performed where the AICPA professional standards

mandates an accountants independence of thought and form.

REVIEW EVIDENCE Data used by an accountant to give an adequate basis of acquiring

limited assurance.

SSARS 19 OBJECTIVES AND LIMITATIONS OF A COMPILATION AND REVIEW

y

A compilation is a service to aid management in giving financial information as financial

statements without any further effort to gather or declare any assurance that there are no
significant adjustments to the financial statements required for the statements to conform with an
appropriate financial reporting framework.

A compilation is distinguished from a review or audit of financial statements in that it

y

Does not consider conducting an inquiry, analytical activities or other review related
tasks.

Does not consider gathering knowledge of an organizations

y

Internal control

Risk for fraud

Accounting records

SSARS 19 objectives and limitations of a compilation and review

As a result of the lack of consideration to gather information, an accountant would not test
accounting entries through inspection, observation, confirmation, or examination of original
documentation (invoices, cancelled checks, bills of lading) or other activities usually performed
during an audit. If this work is not performed, there can be no assurance given regarding the
financial statements.

As a result of these factors, no requirement exists that an accountant be independent of the

organization to issue a compilation.

A review is a service to gather limited assurance that there are no significant adjustments to the
financial statements that are necessary in order for them to adhere to an applicable financial
reporting framework.

During a review, an accountant should gather evidence to acquire the limited assurance. As a
result, a review is an assurance engagement.

An accountant must be independent in order to perform a review, thus it is an attestation

engagement.

A review differs from an audit of financial statements, where the auditor gathers a greater
assurance level (reasonable or adequate vs. limited in a review) to state that the financial
statements do not contain material misstatement.

A Review:
y

Does consider conducting an inquiry and analytical activities.

Does not consider gathering knowledge of an organizations

y

Internal control

Risk for fraud

Accounting records

As a result of the lack of consideration of these matters, the accountant does not gather assurance
to become cognizant of material matters that would be reported in an audit.

A review is performed to gather limited assurance that there are no material adjustments that
should be made to the financial statements in order for them to be adhere to an applicable
financial framework.
SSARS 19 - REQUIREMENTS

SSARS issued professional guidance contains different categories of responsibilities required of

accountants:
y

Unconditional obligations mandate an accountant adhere in every matter applicable to the

requirement. Must is the term used to describe these circumstances.

Presumptively mandatory obligations oblige an accountant to adhere in every matter

applicable to the presumed requirement. In some cases, an accountant may use another
application if in any way the accountant can defend the use of that application that would
adequately carry out the requirements of the presumptively mandatory obligations. These
obligations are noted with the word should and not must.

SSARS 19 EXPLANATORY MATERIAL

y

Explanatory material provides additional background information to aid an accountant in

deploying a particular procedure or delving deeper into a professional requirement. It is not
imperative information.
SSARS 19 HIERARCHY AND PUBLICATIONS

SSARS 19 is the guiding issuance to perform compilations and reviews except when reviewing
interim financial information that is discussed in SAS 116.

If the guidance is SSARS 19 is not used, an accountant should explain how alternate procedures
are more applicable in a particular situation.

Professional publications may help an accountant in applying SSARS.

SSARS 19 ETHICS AND QUALITY CONTROL

Along with SSARS, other guidance should be followed by an accountant:

The AICPA code of professional conduct which discusses commitment to ethical

behavior and

Statements on quality control standards.

These two governing issuances are intertwined in that an accountant should develop
sound and ethical principles in the practice of public accounting that include an internal
control over accounting procedures and work product.

SSARS 19 ELEMENTS OF COMPILATIONS AND REVIEWS

In compilations and reviews, there are three party relationships:

y

Management or appropriate individuals

Accountant in public accounting practice

Users of financial statements or information.

Management is responsible for preparing financial statements in adherence to an

appropriate reporting framework (GAAP, IFRS, or another comprehensive basis of
accounting such as tax basis) and designing and maintaining internal control systems.

Due to the fact that an attest service and not an audit service is conducted by an accountant in a
compilation or review, an accountant cannot issue a report without expressing a departure of
managements financial statement preparation and internal control responsibilities if management
does not comply in performing those duties.

Accountants may use experts to carry out the responsibilities of preparing a compilation or
review.

SSARS 19 Elements of compilations and reviews

Users of financial statements and information may also request additional work be performed
along with a review or compilation (agreed upon procedures such as an inventory observation).
As long as an accountant complies with professional standards, the additional work can be
performed.

SSARS 19 Financial statement v. Financial information

An engagement may involve a compilation or review of a set of financial statements or just a

single financial statement (e.g. Income statement) for any length period.

Depending on the appropriate accounting framework, a financial statement may be only one of
what would be known as a complete set of financial statements under generally accepted
accounting principles.

If only one of a set of financial statements is compiled or reviewed, it is termed financial

information if under the appropriate framework that a complete set of financial statements is more
than one statement.
SSARS 19 - EVIDENCE

As discussed in Auditing chapter 5, the accountant should not obtain evidence to base any level
of assurance on the financial statements when performing a compilation.

In a review engagement, limited assurance on the financial statements that no material

misstatements are in the financial statements under review engagement.

Analytical procedures and questioning management are the general steps followed in a review
engagement.
SSARS 19 - MATERIALITY

Regardless of the reporting framework applied to a compilation or review engagement the

following guidelines generally apply:
y

Misstatements and omissions are deemed material if they would persuade a practical
persons (users) decision when relying on the financial statements.

Materiality rulings are made when looking at all of the encompassing situational matter
around the financial statements.

Financial statements users as a group and not individual financial statement users guide
rulings on materiality. Specific situations of users do not apply.

Rulings on materiality are a subjective matter that the accountant performs based upon an
accountants view of the financial information being presented by management. The accountant
can then presume that users:
y

Have practical business knowledge and are willing to perform additional due diligence on
their own.

Are aware of materiality levels in the financial statements.

Are cognizant that management has made assumptions, estimations and taken future
considerations into bear when dealing with uncertainty.

Make practical decisions based upon the financial statements.