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Multiple Choice (20%)

1 An independent audit aids in the communication of economic data because the audit
a. Confirms the accuracy of managements financial representations.
b. Lends credibility to the financial statements.
c. Guarantees that financial data are fairly presented
d. Assures the readers of financial statements that any fraudulent activity has been corrected.
2 Which of the following, if material, would be fraud?
a. Mistakes in the application of accounting data underlying the financial statements.
b. Clerical mistakes in the accounting data underlying the financial statement.
c. Misappropriation of an asset or groups of assets.
d. Misinterpretations of facts that existed when the financial statements were prepared.
3 When is a duty to disclose fraud to parties other than the clients senior management and its audit
committee most likely to exist?
a. When the amount is material.
b. When the fraud results from misappropriation of assets rather than fraudulent financial
reporting.
c. In response to inquiries from a successor auditor.
d. When a line manager rather than a lower-level employee commits the fraudulent act.
4 Which of the following statements about internal control is correct?
a. A properly maintained internal control system reasonably ensures that collusion among
employees cannot occur.
b. The establishment and maintenance of internal control is an important responsibility of the
internal auditor.
c. An exceptionally strong internal control system is enough for the auditor to eliminate
substantive tests on a significant account balance.
d. The cost-benefit relationship is a primary criterion that should be considered in designing
an internal control system.
5 As a result of sampling procedures applied as tests of controls, an auditor incorrectly assesses
control risk lower than appropriate. The most likely explanation for this situation is that
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a. The deviation rates of both the auditors sample and the population exceed the tolerable
deviation rate.
b. The deviation rates of both the auditors sample and the population are less than the
tolerable deviation rate.
c. The deviation rate in the auditors sample is less than the tolerable deviation rate, but the
deviation rate in the population exceeds the tolerable deviation rate.
d. The deviation rate in the auditors sample exceeds the tolerable deviation rate, but the
deviation rate in the population is less than the tolerable deviation rate.
6 Which of the following statements concerning the auditors use of statistical sampling is correct?
a. An auditor needs to estimate the dollar amount of the standard deviation of the population
in order to use classical variables sampling.
b. An assumption of monetary-unit sampling is that the underlying accounting population is
normally distributed.
c. A classical variables sample needs to be designed with special considerations to include
negative balances in the sample.
d. The selection of zero balances usually does not require special sample design considerations
when using monetary-unit sampling.

7 Which of the following events occurring after the issuance of an auditors report would be most
likely to cause the auditor to make further inquiries about the previously issued financial
statements?
a. A technological development that could affect the entitys future ability to continue as a
going concern.
b. The discovery of information regarding a contingency that existed before the financial
statements were issued.
c. The entitys sale of a subsidiary that accounts for 30 percent of the entitys consolidated
sales.
d. The final resolution of a lawsuit explained in a separate paragraph of the auditors report.
8 Cable Corporation orally engaged Drake & Company, CPAs, to audit its financial statements.
Cables management informed Drake that it suspected the accounts receivable were materially
overstated. Though the financial statements Drake audited included a materially overstated
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accounts receivable balance, Drake issued an unqualified opinion. Cable used the financial
statements to obtain a loan to expand its operations. Cable defaulted on the loan and incurred a
substantial loss.
If Cable sues Drake for negligence in failing to discover the overstatement, Drakes best defense
would be that Drake did not
a. Have privity of contract with Cable
b. Sign an engagement letter.
c. Perform the audit recklessly or with an intent to deceive.
d. Violate generally accepted auditing standards in performing the audit.
Items 9 and 10 are based on the following:
The information below was taken from the bank transfer schedule prepared during the audit of Fox
Co.s financial statements for the year ended December 31, 2004. Assume all checks are dated and
issued on December 30, 2004.

Check no.
101
202
303
404

Bank Accounts
From
To
National
Federal
County
State
Federal
American
State
Republic

Disbursement Date
Per books
Per bank
Dec. 30
Jan. 4
Jan. 3
Jan. 2
Dec.31
Jan. 3
Jan. 2
Jan. 2

Receipt Date
Per books
Per bank
Dec. 30
Jan. 3
Dec. 30
Dec. 31
Jan. 2
Jan. 2
Jan. 2
Dec. 31

9. Which of the following checks might indicate kiting?

a. #101 and #303.
b. #101 and #404.
c. #202 and #404.
d. #202 and #303.
10. Which of the following checks illustrate deposits/transfers in transit at December 31, 2004?
a. #101 and #202.
b. #101 and #303.
c. #202 and #404.
d. #303 and #404.

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Problem 1 (20%)
When planning a financial statement audit a CPA must understand audit risk and its components.

Required
For each illustration, select the component of audit risk that is most directly illustrated.
Components of audit risk may be used once, more than once, or not at all.
Illustration
1. A client fails to discover employee fraud on a timely basis because bank
accounts are not reconciled monthly.
2. Cash is more susceptible to theft than an inventory of coal.
3. Confirmation of receivables by an auditor fails to detect a material
misstatement.
4. Disbursements have occurred without proper approval.
5. Inadequate segregation of duties.
6. Omission of a necessary substantive audit procedure.
7. Susceptibility of notes receivable to material misstatement, assuming
there are no related controls.
8. Technological developments make a major product obsolete.
9. The merchandise inventory risk of incorrect acceptance is high.
10. XYZ company, a client, lacks sufficient working capital to continue
operations.

Type of Risk
A. Business risk
B. Control risk
C. Detection risk
D. Inherent risk
E. Related risk
F. Relevant risk

Problem 2 (20%)
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 10 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.

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Items to be answered
For Investments
Audit objectives
1. Investments are properly described and
classified in the financial statements.
2. Recorded investments represent investments
actually owned at the balance sheet date.
3. Trading investments are properly valued at fair
market value at the balance sheet date.

Audit procedures
A. Trace opening balances in the subsidiary ledger
to prior years audit working papers.
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.

For Accounts Receivable

Audit objectives
Audit procedures
4. Accounts receivable represent all amounts owed A. Analyze the relationship of accounts receivable
to the entity at the balance sheet date.
and sales and compare it with relationships for
5. The entity has legal right to all accounts
preceding periods.
receivable at the balance sheet date.
B. Perform sales cutoff tests to obtain assurance
6. Accounts receivable are stated at net realizable
that sales transactions and corresponding entries
value.
for inventories and cost of goods sold are
7. Accounts receivable are properly described and
recorded in the same and proper period.
presented in the financial statements.
C. Review the aged trial balance for significant
past due accounts.
D. Obtain an understanding of the business

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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.
For Property & Equipment

Audit objectives
8. The entity has legal right to property and
equipment acquired during the year.
9. Recorded property and equipment represent
assets that actually exist at the balance sheet
date.
10. Net property and equipment are properly
valued at the balance sheet date.

Audit procedures
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 and title insurance certificates.
E. Perform cutoff 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.

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Problem 3 (20%)
Items 1 through 5 represent an auditors observed changes in certain financial statement ratios or
amounts from the prior years ratios or amounts. For each observed change, select the most likely
explanation or explanations from List A. Select only the number of explanations as indicated. The
observed changes are independent of each other. Answers on the list may be selected once, more than
once, or not at all.
1. Inventory turnover increased substantially from the prior year. (Select 3 explanations)
2. Accounts receivable turnover decreased substantially from the prior year. (Select 3 explanations)
3. Long-term debt increased from the prior year, but interest expense increased a larger-thanproportionate amount than long-term debt. (Select one explanation)
4. Operating income increased from the prior year although the entity was less profitable than in the
prior year. (Select two explanations)
5. Gross margin percentage was unchanged from the prior year although gross margin increased from
the prior year. (Select one explanation)
List A: Explanations
A. Items shipped on consignment during the last month of the year were recorded as sales.
B. A significant number of credit memos for returned merchandise that were issued during the
last month of the year were not recorded.
C. Year-end purchases of inventory were overstated by incorrectly including items received in
the first month of the subsequent year.
D. Year-end purchases of inventory were understated by incorrectly excluding items received
before the year-end.
E. A larger percentage of sales occurred during the last month of the year, as compared to the
prior year.
F. A smaller percentage of sales occurred during the last month of the year, as compared to the
prior year.
G. The same percentage of sales occurred during the last month of the year, as compared to the
prior year.
H. Sales increased at the same percentage as cost of goods sold, as compared to the prior year.
I. Sales increased at a greater percentage than cost of goods sold increased, as compared to the
prior year.
J. Sales increased at a lower percentage than cost of goods sold increased, as compared to the

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prior year.
K. Interest expense decreased, as compared to the prior year.
L. The effective income tax rate increased, as compared to the prior year.
M. The effective income tax rate decreased, as compared to the prior year.
N. Short-term borrowing was refinanced on a long-term basis at the same interest rate.
O. Short-term borrowing was refinanced on a long-term basis at lower interest rates.
P. Short-term borrowing was refinanced on a long-term basis at higher interest rates.

Problem 4 (20%)
Brown & Brown, CPAs, was engaged by the board of directors of Cook Industries, Inc. to audit
Cooks calendar year 2004 financial statements. The following report was drafted by an audit assistant
at the completion of the engagement. It was submitted to Brown, the partner with client responsibility
for review on March 7, 2005, the date of the completion of fieldwork. Brown has reviewed matters
thoroughly and properly concluded that an adverse opinion was appropriate.
Brown also became aware of a March 14, 2005 subsequent event that the client has properly
disclosed in the notes to the financial statement. Brown wants responsibility for subsequent events to
be limited to the specific event referred to in the applicable note to the clients financial statements.
The financial statements of Cook Industries, Inc. for the calendar year 2003 were examined by
predecessor auditors who also expressed an adverse opinion and have not reissued their report. The
financial statements for 2003 and 2004 are presented in comparative form.
Independent Auditors Report
To the President of Cook Industries, Inc.
We have audited the financial statements of Cook Industries, Inc. for the year ended December 31,
2004. These financial statements, in which, as discussed in Note K, the Company has properly
disclosed a subsequent event dated March 14, 2005, are the responsibility of the companys
management. Our responsibility is to express an opinion on these financial statements based on our
audits.
We conducted our audits in accordance with standards that require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are in conformity with US
generally accepted accounting principles. 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

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opinion.
As discussed in Note G to the financial statements, the Company carries its property and
equipment at appraisal values, and provides depreciation on the basis of such values. Further, the
company does not provide for income taxes with respect to differences between financial income and
taxable income arising because of the use, for income tax purposes, of the installment method of
reporting gross profit from certain types of sales.
In our opinion, subject to the effects as discussed in the preceding paragraph, the financial
statements referred to above do not present fairly, in all material respects, the financial position of
Cook Industries, Inc. as of December 31, 2003 and 2004, and the results of its operations and its cash
flows for the years then ended, applied on a basis consistent with that of the preceding year.
Brown & Brown, CPAs
March 7, 2005*
*Except for Note K, as to which the date is March 14, 2005.

Required
Items 1 through 10 represent deficiencies noted by Brown. For each deficiency, (1) indicate
whether Brown is correct or incorrect in the criticism of the assistants draft, and (2) briefly explain
why Brown is incorrect.
Items to be answered
1. The report should not be addressed to the President of Cook Industries, but instead to the
management of Cook Industries.
2. There should be no statement that the financial statements are the responsibility of the companys
management.
3. There should be no reference to Note K in the introductory paragraph.
4. There should be a reference to the predecessor auditor and to the type of report that the predecessor
issued in the introductory paragraph.
5. There should be a reference that the audit was conducted in accordance with US generally accepted
auditing standard.
6. There should be no statement that the audit includes assessing the significant estimates of
management.
7. There should be a statement that the audit is conducted to obtain reasonable assurance about whether
the financial statements are free of material misstatement, not that they are in conformity with US
generally accepted accounting principles.
8. There should be no reference to the consistency of the accounting principles used by the client.
9. The phrase subject to should not be used in the opinion.
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10. The report should be dated March 14, 2005.

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