lOMoARcPSD|9924941

NAME: DOAN PHAM PHUONG ANH

ID: 18071280

Chapter 14 Audit of the Sales and Collection Cycle: Tests of Controls

and Substantive Tests of Transactions

14.1 Learning Objective 14-1

1) Which of the following is an account that is not affected by the sales and collection cycle?
A) cash
B) accounts receivable
C) allowance for doubtful accounts
D) accounts payable

2) The auditor's objectives for the sales and cash collections activities when the client is
primarily an e-commerce business as compared to a "brick and mortar" business are
A) unchanged.
B) expanded.
C) mitigated.
D) decreased.

True false questions

3) The overall objective in the audit of the sales and collection cycle is to evaluate whether the
account balances affected by the cycle are fairly presented in accordance with accounting
standards.
true

4) The sales and collection cycle applies to businesses that sell goods to customers or provide
services to customers.
true

14.2 Learning Objective 14-2

1) Which of the following is not one of the five classes of transactions included in the sales and
collection cycle?
A) sales returns and allowances
B) write-off of uncollectible accounts
C) bad debt expense
D) interest income

2) What event initiates a transaction in the sales and collection cycle?

A) receipt of cash
B) delivery of product to a customer
C) identification of a new customer
D) customer request for goods or services

3) A ________ is a document that indicates a request for merchandise by a customer.

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A) sales invoice
B) vendor invoice
C) customer order
D) sales order

4) A ________ is a document for communicating the description, quantity, and related

information for goods ordered by a customer.
A) sales order
B) customer order
C) vendor invoice
D) sales invoice

5) What critical event must take place before goods can be shipped in order to assure payment
can be reasonably expected?
A) determination of correct delivery address
B) credit approval
C) matching of shipping document with sales invoice
D) receipt of sales order from the customer

6) Before goods are shipped on account, a properly authorized person must

A) prepare the sales invoice.
B) approve the journal entry.
C) approve the customer's credit.
D) verify that the unit price is accurate.

7) One type of shipping document is the ________, which is a written contract between the
carrier and the seller of the receipt and shipment of goods.
A) sales order
B) bill of lading
C) sales invoice
D) customer order

8) The document used to indicate to the customer the amount of a sale and payment due date is
the
A) sales invoice.
B) bill of lading.
C) purchase order.
D) sales order.
9) Which of the following is not an important aspect of billing?
A) All shipments made have been billed.
B) No shipment has been billed more than once.
C) Each customer is billed for the proper amount.
D) Credit is approved to customers for sales on account.

10) Most companies recognize sales revenue when

A) sales are invoiced.
B) payment is received from the customer.
C) goods are shipped.
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D) the customer's order is received.

11) Which of the following is not a business function within the "Sales" class of transactions?
A) processing customer orders
B) granting credit
C) processing and recording sales returns and allowances
D) shipping goods

12) The total of the individual account balances in the accounts receivable master file should
equal the
A) total sales for the period.
B) balance of the sales account in the general ledger.
C) total sales less the total cash received for the period.
D) balance of the accounts receivable account in the general ledger.
13) In the accounts receivable master file, the length of time the account has been due can be
useful to the client and the auditor in preparing the
A) trial balance.
B) working trial balance.
C) accounts receivable trial balance.
D) aged accounts receivable trial balance.

14) A document sent to each customer showing his or her beginning accounts receivable balance
and the amount and date of each sale, cash payment received, any debit or credit memo issued,
and the ending balance is the
A) accounts receivable subsidiary ledger.
B) monthly statement.
C) remittance advice.
D) sales invoice.

15) The document that accompanies the customer's payment is the

A) credit memo.
B) remittance advice.
C) vendor invoice.
D) monthly statement.

16) A ________ indicates a reduction in the amount due from a customer because of returned
goods or an allowance.
A) bill of lading
B) sales invoice
C) credit memo
D) monthly statement

17) A ________ is a list prepared when cash is received by someone who has no responsibility
for recording sales, accounts receivable, or cash, and who has no access to the accounting
records.
A) prelisting of cash receipts.
B) sales invoice.
C) packing ticket.
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D) vendor invoice.

18) When dealing with the processing and recording of cash receipts,
A) the most important concern is the theft of cash.
B) theft can only occur before the receipts are entered into the records.
C) cash receipts should be deposited at least monthly.
D) the monthly statement is used to prepare the cash receipts journal.

19) Some companies have customers send payments directly to an address maintained by a bank.
This is called a(n) ________ system.
A) direct deposit
B) funds transfer
C) lockbox
D) interbank transfer

20) Which of the following is a business function related to sales returns and allowances?
A) processing customer orders
B) writing off uncollectible accounts
C) processing and recording credit memos
D) granting credit

21) For a firm that practices good internal controls in the sales and collections cycle, the function
of indicating credit approval should be recorded on which of the following documents?
A) sales order
B) sales invoice
C) customer order
D) remittance advice
22) When posting items sold on account from the sales journal
A)
Details of the journal are posted to Journal totals are posted to
The sales account The general ledger

B)
Details of the journal are posted to Journal totals are posted to
The sales account The accounts receivable subsidiary ledger

C)
Details of the journal are posted to Journal totals are posted to
The accounts receivable master file The general ledger

D)
Details of the journal are posted to Journal totals are posted to
The accounts receivable account in the The sales account in the general ledger
general ledger

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23) Which document or record is used in the write-off of uncollectible accounts classes of
transactions?
A) general journal
B) remittance advice
C) sales transaction file
D) sales order
24) Who is generally responsible for opening receipts when a company uses a lockbox to speed
the handling of cash receipts?
A) company personnel
B) temporary employees in the town where the lockbox is located
C) bank employees
D) company controller

25) Which of the following is a correct statement regarding the shipment of goods?
A) The shipping document must be in paper form.
B) The shipping document is used to update the perpetual inventory records.
C) Only one copy of the shipping document is needed.
D) All of the above are correct statements.

26) Which accounts are involved in the sales class of transactions?

A) accounts receivable and sales returns and allowances
B) cash and allowance for uncollectible accounts
C) sales allowances and accounts receivable
D) accounts receivable and sales

27) Explain each of the following types of documents and indicate the class of transactions in
which they are commonly used.
1. customer order
2. shipping document
3. remittance advice
4. sales returns and allowance journal
5. uncollectible account authorization form
Answer:
1. Customer order — request for merchandise by a customer. Appears in the sales class of
transactions.
2. Shipping document — document prepared to initiate shipment of goods, indicating the
description of the merchandise, the quantity shipped, and other relevant data. Appears in
the sales class of transactions.
3. Remittance advice — document that is mailed to the customer and typically returned to
the seller with payment. Appears in the cash receipts class of transactions.
4. Sales returns and allowance journal — journal used to record all sales returns and
allowances. It performs the same function as the sales journal. Appears in the sales
returns and allowance class of transactions.
5. Uncollectible account authorization form — document used internally to indicate
authority to write off an account receivable. Appears in the write-off of uncollectible
accounts class of transactions.

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28) You are an audit manager for Rodgers & Co. and have recently taken on a new client,
Manufacturing Company. You are in the initial stages of planning the audit and have decided to
start gathering information about the sales/collection cycle of the business. List below the classes
of transactions that you need to gather audit evidence for in designing your audit procedures.
Answer:
• sales
• cash receipts
• sales returns and allowances
• write-off of uncollectible accounts
• bad debt expense

29) Customer billing is a critical process which auditors must understand. What are the most
important aspects of billing and what are the related objectives?
Answer:
• to make sure that all shipments made have been billed (completeness)
• that no shipment has been billed more than once (occurrence)
• that each shipment is billed for the proper amount (accuracy)

30) Discuss the four business functions that result in sales transactions in a typical sales and
collection cycle and, for each function, state the key documents and records involved.
Answer:
• Processing customer orders. Key documents include customer order and sales order
• Granting credit. Customer order or sales order
• Shipping goods. Shipping document (bill of lading)
• Billing customers and recording sales. Sales invoice, sales transaction file, sales journal or
listing, accounts receivable master file, accounts receivable trial balance, and monthly statements

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31) Match seven of the terms for documents and records (a-k) with the descriptions provided
below (1-7):

a. customer order form

b. sales order
c. bill of lading
d. sales invoice
e. summary sales report
f. accounts receivable master file
g. monthly statement
h. remittance advice
i. prelisting of cash receipts
j. credit memo
k. uncollectible account authorization form

prelisting________
of cash1. A list prepared when cash is received by someone who has no responsibility for
receipts recording sales, accounts receivable, or cash, and has no access to the accounting records. It is
used to verify whether cash received was recorded and deposited at the correct amounts and on a
timely basis.

________ 2. A document indicating a reduction in the amount due from a customer because of
credit memo
returned goods or an allowance.

bill of ________
lading 3. A document prepared to initiate shipment of goods, indicating the description of the
merchandise, the quantity shipped, and other relevant data. It is a written contract between the
carrier and seller of the receipt and shipment of goods.

sales________
order 4. A document for communicating the description, quantity, and related information
for goods ordered by a customer. This is frequently used to indicate credit approval and
authorization for shipment.

remittance________
advice 5. A document mailed to the customer and typically returned to the seller with the cash
payment.

________ 6. A document used internally to indicate authority to write-off an account receivable

as uncollectible. uncollectible account
authorization form
sales invoice
________ 7. A document or electronic record indicating the description and quantity of goods
sold, the price, freight charges, insurance, terms, and other relevant data.

Answer:
1. i, 2. j, 3. c, 4. b, 5. h, 6. k, 7. D

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True false questions

32) A sales invoice is a document that usually indicates credit approval.
False

33) Credit should be approved before a customer's order is received.

False

34) Credit should be approved before goods are shipped to a customer.

True

35) The receipt of a customer order from a customer is the starting point for the entire sales and
collection cycle.
True

36) The preparation of a sales invoice is the final step in the sales and collection cycle.
False

37) A bill of lading is a special type of sales invoice used when goods are shipped interstate.
False

38) The shipping point is critical because it is the first point at which company assets are released
to another party.
True

39) A bill of lading is a written contract between the seller and the buyer.
False

40) In a lockbox system, bank employees are responsible for opening cash receipts and
maintaining records of all payments made by customers at the lockbox address.
True

41) Sales transactions are the result of the following five functions in the sales and collection
cycle: processing customer orders, granting credit, shipping goods, billing customers, and
recording sales.
True

42) The prelisting of cash receipts should be prepared by the individual who has primary
responsibility for the recording of cash receipts.
False

43) A credit memo is a document used internally that indicates authority to write-off an account
receivable as uncollectible.
False

44) If a company uses a periodic inventory system, the shipping records are used to update the
inventory quantities.
False

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45) The sales journal is generated from the sales transaction file.
True

46) When customers purchase goods by credit card, the issuer of the credit card uses EFT to
transfer funds into the company's bank account.
True

47) The theft of cash can occur before receipts are entered in the records or after they are entered
in the records.
True

14.3 Learning Objective 14-3

1) When designing audit procedures, tracing of source documents to the customers subsidiary
ledger and subsequently to the general ledger is done to satisfy what assertion?
A) valuation
B) cutoff
C) completeness
D) classification

2) When assessing risk control, the auditor must do all of the following except
A) assess control risk for each objective by evaluating the controls and deficiencies for each
objective.
B) perform the detailed test of balances.
C) identify the key internal controls and deficiencies.
D) associate the key controls and deficiencies with the objectives.
3) When sales invoices are automatically calculated and posted by a computer, the auditor may
be able to reduce substantive tests of transactions for which, if any, assertion?
A) accuracy
B) existence
C) completeness
D) none of the above

4) In many audits, no substantive tests of transactions are made for the ________ assertion on the
grounds that understatement of sales is not a concern.
A) accuracy
B) existence
C) completeness
D) none of the above

5) Which one the following procedures performed for the billing function provides evidence for
the completeness assertion?
A) making sure that all shipments have been billed
B) making sure that no shipment has been billed more than twice
C) making sure that each shipment is billed at the correct amount
D) making sure that each shipment is billed to the proper customer
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6) When assessing planned control risk for sales,

A) the key internal controls and deficiencies for sales will be the same for every company.
B) the audit objectives for sales will differ from company to company.
C) a flowchart is required to help assess control risk for sales.
D) assessing control risk for sales is a highly subjective decision.
7) Which of the following is an accurate statement relating to separation of duties?
A) Management should deny cash access to anyone responsible for entering sales and cash
receipts transaction information into the computer.
B) All disagreements on the monthly statements should be directed to a designated person who
has no responsibility for handling cash or recording sales or accounts receivable.
C) The credit granting function should be separate from the sales function.
D) All of the above are accurate statements.

8) Which of the following is not a key control for sales and cash receipts?
A) active board of directors
B) adequate separation of duties
C) internal verification procedures
D) adequate documents and records

9) Which one of the following statements is true? In deciding on substantive tests of transactions
A) some procedures are commonly employed on every audit regardless of the
circumstances.
B) all procedures are dependent on the adequacy of the controls and the results of the tests of
controls.
C) results obtained in the prior year's audit will not affect the procedures used this year.
D) the materiality of the item will not influence the choice of procedures used.

10) To test for recorded sales for which there were no actual shipments, the auditor vouches from
the
A) bill of lading to the sales journal.
B) sales journal to the shipping documents.
C) sales journal to the accounts receivable subsidiary ledger.
D) bill of lading to the supporting customer order and sales order.
11) An effective procedure to test for unfilled shipments is to trace from the
A) sales journal to the shipping documents.
B) shipping documents to the sales journal.
C) sales journal to the accounts receivable ledger.
D) sales journal to the general ledger sales account.

12) The auditor traces items from the source documents to the journals in order to accumulate
audit evidence that will satisfy the
A) existence objective.
B) completeness objective.
C) ownership objective.
D) valuation objective.
13) In many audits of sales transactions substantive tests of transactions can be reduced in
determining the completeness objective because
A) understatements of assets and income are a greater concern than overstatements.
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B) overstatements of assets and income are a greater concern than understatements.

C) it doesn't matter if income is understated because the savings on income tax offsets the
reduced revenue and net income is correct.
D) the unrecorded sales cause a reduction of accounts receivable; therefore, the ratios of the two
financial statements will not be misleading.

14) To determine that sales are accurately recorded, the unit prices on the duplicate sales invoices
are normally compared with
A) the original invoices.
B) an approved master price list.
C) the amounts recorded in the sales journal for that transaction.
D) the amounts posted to the customer's account in the accounts receivable master file.

15) Prenumbered documents are intended to help

A)
Prevent the failure to bill or Prevent duplicate billings
record sales or recordings of sales
Yes Yes

B)
Prevent the failure to bill or Prevent duplicate billings or
record sales recordings of sales
No No

C)
Prevent the failure to bill or Prevent duplicate billings or
record sales recordings of sales
Yes No

D)
Prevent the failure to bill or Prevent duplicate billings or
record sales recordings of sales
No Yes

16) Prenumbered documents will only be useful for control purposes if

A) a different numerical sequence is used for each company.
B) the sequence is accounted for periodically.
C) employees are allowed to use documents out of numerical sequence.
D) the same numerical sequence is used each accounting period.
17) ________ tests are for omitted transactions, while ________ tests are for nonexistent
transactions.
A) Tracing; vouching
B) Vouching; tracing
C) Verifying; tracking
D) Tracking; verifying
18) Which one of the following best describes the auditors responsibilities regarding appropriate
authorizations in the sales/collections cycle?
A) Credit must be authorized before the sale.
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B) Goods must be shipped after the authorization

C) Prices must be authorized.
D) All of the above should be of concern to the auditor.

19) Which type of misstatement is always a fraud?

A) sales included in the journals for which no shipment was made
B) sales to related parties, such as officers and subsidiaries
C) shipments made to nonexistent customers and recorded as sales
D) sales recorded more than once.

20) An auditor needs to determine whether all customers of an electric utility company are being
billed. The auditor should test from the
A) sales register to the accounts receivable ledger.
B) sales register to the meter department records.
C) accounts receivable ledger to the sales register.
D) meter department records to the sales register.
21) Which one of the following would the auditor consider to be an incompatible operation if the
cashier receives remittances from the mail room?
A) The cashier prepares the daily deposit.
B) The cashier makes the daily deposit at a local bank.
C) The cashier posts the receipts to the accounts receivable subsidiary ledger cards.
D) The cashier endorses the checks.
22) Which of the following is the appropriate point at which the auditor deems authorization to
be critical?
A)
Credit granting Price authorization Shipment of goods
Yes Yes Yes

B)
Credit granting Price authorization Shipment of goods
Yes No Yes

C)
Credit granting Price authorization Shipment of goods
No Yes No

D)
Credit granting Price authorization Shipment of goods
Yes No No

23) Which of the following would least concern an auditor regarding the lack of a specific
authorization to conduct the sales transaction?
A) granting of credit
B) shipment of goods
C) determination of discounts
D) selling of goods for cash

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24) As a test of control, the auditor examines sales invoices for supporting documents. The
relevant transaction-related audit objective is
A) accuracy.
B) occurrence.
C) classification.
D) timing.
25) The accurate recording of sales transactions concerns all of the following except for
A) proper credit authorization.
B) shipping the amount of goods ordered.
C) accurately billing for the amount of goods shipped.
D) accurately recording the amount billed in the accounting records.

26) In designing substantive audit procedures for tests of transactions for sales, the auditor needs
to test for evidence of misstatements due to errors or fraud. Describe two potential errors
(unintentional) and one intentional (fraud).
Answer

1. Unintentional-sales included in the journals for which no shipment was made and sales that
were recorded more than once.
2. Intentional (fraud)-shipments made to nonexistent customers and recorded as sales.27) For
each of the following potential misstatements, provide one potential audit test that could be used
to detect the misstatement.
• sales included in the journals for which there was no shipment
• sale recorded more than once
• shipments made to nonexistent customers and recorded as sales

28) The auditor is concerned about authorization at three key points. What are the key points?
Answer
1. Credit must be properly authorized before a sale takes place.
2. Goods should be shipped only after proper authorization.
3. Prices including base terms, freight, and discounts must be authorized.

True false questions

29) Separation of duties in the sales and collection cycle should mandate that the credit-granting
function be separate from the sales function.
True

30) Tracing from source documents to the journal is useful for testing the existence objective.
False

31) The extent of tests of controls in audits of nonpublic companies depends on the effectiveness
of the controls and the extent to which the auditor believes they can be relied on to reduce
control risk.
True

32) For each key control, one or more tests of controls must be designed to verify its
effectiveness.
True
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33) Misstatements involving the completeness objective for sales lead to overstatements of assets
and income.
False

34) Violations of the occurrence/existence objective for sales are of greater concern to the auditor
than violations of the completeness objective.
True

35) An effective procedure to test the occurrence/existence objective for sales is to vouch sales
journal entries to copies of sales orders, shipping documents, and sales invoices.
True

36) For each significant internal control deficiency identified by the auditor, he or she should
design one or more tests of controls to assess the extent of the deficiency and its effect on the
financial statements.
True

37) The appropriate tests of controls for separation of duties are ordinarily restricted to the
auditor's observations of activities and discussions with personnel.
True

38) Auditing standard indicate that if the auditor identifies a significant risk at the assertion level,
the auditor is not required to perform substantive procedures.
False

14.4 Learning Objective 14-4

1) Except for two key differences, the transaction-related audit objectives are essentially the
same for the processing of credit memos as they are for sales. Which of the following are the two
key differences?
A) risk and emphasis on the completeness objective
B) materiality and emphasis on the accuracy objective
C) risk and emphasis on the classification objective
D) materiality and emphasis on the occurrence objective
2) Smith Manufacturing Company's accounts receivable clerk has a friend who is also a customer
of Smith Manufacturing. The accounts receivable clerk has issued fictitious credit memos to his
friend for goods supposedly returned. The most effective procedure for preventing this activity is
to
A) prenumber and account for all credit memorandums.
B) require receiving reports that provide evidence of returned inventory items to support
all credit memorandums before they are approved.
C) have independent sales and accounts receivable departments.
D) mail monthly statements to customers.

3) The transaction-related audit objectives and the client's methods of controlling misstatements
are essentially the same for credit memos as for sales with the exception of two differences.
What are the two differences from the auditor's perspective?
Answer:
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Lapping, which is a common type of embezzlement, is the postponement of entries for the
collection of receivables to conceal an existing cash shortage. The embezzlement is perpetrated
by a person who handles cash receipts and then enters them into the computer system. He or she
defers recording the cash receipts from one customer and covers the shortages with subsequent
receipts from another. These in turn are covered from the receipts of a third customer a few days
later. The employee must continue to cover the shortage through repeated lapping, replace the
stolen money, or find another way to conceal the shortage. The embezzlement can be easily
prevented by segregation of duties and a mandatory vacation policy for employees who hand
cash and enter cash receipts into the system. It can be detected by comparing the name, amount,
and dates shown on remittance advices with cash receipts, journal entries and related duplicate
deposit slips. Because this procedure is relatively time-consuming, it is ordinarily performed
only when specific concerns with embezzlement exist because of a deficiency in internal control.

True false questions

4) When auditors evaluate sales returns and allowances, a primary emphasis is on the objective
of occurrence.
True

5) Sales returns and allowances are often ignored by auditors because they are often immaterial.
True

6) When auditing sales returns and allowances, the emphasis is normally on testing the
completeness objective.
False

14.5 Learning Objective 14-5

1) When an employee who is authorized to make customer entries in the accounts receivable
subsidiary ledger purposefully enters cash received into the wrong customer's account that
employee may be suspected of
A) kiting.
B) lapping.
C) floating.
D) shorting.

2) An audit procedure that compares the name, amount, and dates shown on remittance advices
with cash receipts journal entries and with related duplicate deposit slips would be effective in
detecting
A) kiting.
B) lapping.
C) unauthorized write-offs of customers as uncollectible accounts.
D) sales without proper credit authorization.

3) Which of the following tests of controls is useful to test the transaction-related audit objective
of posting and summarization?
A) Observe whether monthly statements are sent.
B) Observe unrecorded cash at a point in time.
C) Observe whether the accountant reconciles the bank account.
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D) Observe endorsement of incoming checks.

4) The audit procedure referred to as proof of cash receipts is particularly useful to test
A) time lags in making deposits.
B) whether all recorded cash receipts have been deposited in the bank.
C) whether there are cash receipts that have not been recorded in the journals.
D) the client's reconciliation between cash receipts and bank deposits.
5) Which of the following test of controls is useful to test the completeness objective for cash
receipts?
A) Compare shipping documents with sales records.
B) Observe endorsement of incoming checks.
C) Examine evidence that the receivable master file is reconciled to the general ledger.
D) Observe if the client reconciles the bank account.

6) When designing tests of controls and substantive tests of transactions for cash receipts, it is
important to remember that
A) the test of controls are designed to test for monetary misstatements.
B) auditors use the same methodology for designing tests of controls and substantive tests
of transactions for cash receipts as they use for sales.
C) the tests of controls are not dependent on the controls the auditor identifies.
D) the tests of controls is not dependent on whether the company being audited is publicly
traded.
7) Cash receipts from sales on account have been misappropriated. Which of the following acts
would conceal this fraud and be least likely to be detected by an auditor?
A) understating the sales journal by not recording cash sales
B) overstating the accounts receivable control account by intentionally misstating prices charged
for goods sold
C) overstating the accounts receivable subsidiary ledger by not recording payments made by
customers
D) understating the cash receipts journal by purposely recording incorrect amounts
8) Which of the following would offer the best protection for a company that wishes to prevent a
reoccurrence of a previously detected "lapping" problem with trade accounts receivable?
A) Separate duties so that the bookkeeper in charge of the general ledger has no access to
incoming mail.
B) Separate duties so that no employee has access to both checks from customers and currency
from daily cash receipts.
C) Have a mandatory vacation policy for employees who both handle cash and enter cash
receipts into the system.
D) Request that customer's payment checks be made payable to the company and addressed to
the treasurer.

9) The most difficult type of cash embezzlement for auditors to detect is when it occurs
A) after the merchandise has been shipped.
B) before the merchandise has been shipped.
C) before the cash is recorded in the cash receipts journal or other cash listing.
D) after the cash is recorded in the cash receipts journal or other cash listing.

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10) The completeness transaction-related audit objective must be considered when determining
key controls for sales. List three of the key controls that must be considered when cash received
is recorded in the cash receipts journal.
Answer
1) Is a prelisting of cash receipts prepared?
(2) Are checks restrictively endorsed?
(3) Are the batch totals of cash receipts compared with the computer summary?
(4) Are statements sent to customers each month?

11) Explain what lapping means, and discuss the internal control deficiency that allows it to
occur. Also discuss the procedures the auditor can perform to detect lapping.
Answer:
Lapping, which is a common type of embezzlement, is the postponement of entries for the
collection of receivables to conceal an existing cash shortage. The embezzlement is perpetrated
by a person who handles cash receipts and then enters them into the computer system. He or she
defers recording the cash receipts from one customer and covers the shortages with subsequent
receipts of another. These in turn are covered from the receipts of a third customer a few days
later. The employee must continue to cover the shortage through repeated lapping, replace the
stolen money, or find another way to conceal the shortage.

12) You are part of the audit team that is auditing Hillsburg Hardware Co. and you have been
assigned to the sales and collection cycle. You are testing whether the cash receipts are deposited
and recorded at the amounts received (accuracy objective). List two tests of controls and one test
of transactions that you would do to satisfy yourself regarding the accuracy objective.
Answer:
Control Tests:
1. Observe whether the accountant reconciles the bank account.
2. Examine file of batch totals for initials of data control clerk.
3. Observe whether monthly statements are sent.

Transaction Tests:
1. Obtain prelisting of cash receipts and trace amounts to the cash receipts journal, testing for
names, amounts, and dates.
2. Prepare proof of cash receipts.

13) In planning the audit, an auditor takes three basic steps in determining the audit procedures
to be performed for any business cycle or class of transactions in order to gather audit evidence
concerning possible misstatement due to error or fraud. List those three basic steps below.
Answer:
• Determine key internal controls for each audit objective.
• Design tests of controls for each control used to support a reduced control risk.
• Design substantive tests of transactions to test for monetary misstatements for each objective

True false questions

14) The most difficult type of cash embezzlement for the auditor to detect is when the cash is
stolen before it can be recorded in the cash receipts journal.
True

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15) An essential part of the auditor's responsibility in auditing cash receipts is to identify
deficiencies in internal control that increase the likelihood of fraud.
True

14.6 Learning Objective 14-6

1) The auditor's primary concern in performing audit procedures of the write-off of uncollectible
accounts relates to the risk that the client writes off customer accounts that have already been
collected. The primary control for preventing this fraud is
A) examining authorized credit memos.
B) examining the uncollectible account authorization form.
C) examining debit memos.
D) examining the vouchers payable register.

True false questions

2) The estimation of bad debts expense relates to the write-off of uncollectible accounts.
True

3) There should generally be correspondence in the client's file establishing the uncollectibility
of their account.
True

4) Realizable value is an essential balance-related audit objective for accounts receivable.

14.7 Learning Objective 14-7

1) The most significant effect of the results of the tests of controls and substantive tests of
transactions in the sales and collection cycle is on
A) bad debt expense.
B) the analytical tests to be performed.
C) the confirmation of accounts receivable.
D) the impact of processing cash receipts.

2) At the completion of the tests of controls and substantive tests of transactions, auditors must
analyze each exception to determine its cause and the implication of the exception on assessed
control risk.
True

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Auditing and Assurance Services, 17e (Arens/Elder/Beasley)

Chapter 21 Audit of the Inventory and Warehousing Cycle

21.1 Learning Objective 21-1

1) Receipt of ordered materials by the receiving department will generate the completion of a
form called the
A) bill of lading.
B) receiving report.
C) materials requisition.
D) inventory acquisition summary.
Answer: B
Terms: Receipt of ordered materials generates completion of form
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

2) ________ is normally characterized as a difficult and complex account to audit.

A) Property, plant and equipment
B) Cash
C) Inventory
D) Prepaid insurance
Answer: C
Terms: Complex and difficult account to audit
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

3) Inventory is a complex area to audit for all except which of the following reasons?
A) Inventory is often in different locations.
B) There are several acceptable valuation methods and some entities use different methods for
different types of inventory.
C) Inventory is often the largest account on the balance sheet.
D) Inventory valuation includes few estimates.
Answer: D
Terms: Reasons inventory is complex to audit
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

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4) In most manufacturing companies, the inventory and warehousing cycle begins with the
A) receipt of a customer's order.
B) completion of production of a customer's order.
C) initiation of production of a customer's order.
D) acquisition of raw materials for production.
Answer: D
Terms: Inventory and warehousing cycle begins with
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

5) ________ accumulate costs by individual jobs as material is issued into production and labor
costs are incurred.
A) Just-in-time production systems
B) Job cost systems
C) Process cost systems
D) Manufacturing systems
Answer: B
Terms: Accumulate costs by individual jobs
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

6) Master files, spreadsheets, and reports that accumulate material, labor, and overhead as the
costs are incurred are
A) accounting systems.
B) storeroom documents.
C) cost accounting records.
D) finished goods inventory records.
Answer: C
Terms: Master files, worksheets, and reports that accumulate material, labor and overhead as
costs
Difficulty: Moderate
Objective: LO 21-1
AACSB: Reflective thinking

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7) The main difference between job order and process costing systems is that
A) one accumulates costs by materials issued and the other by labor incurred.
B) one accumulates costs by individual jobs and the other by particular processes.
C) one emphasizes costs accumulated in completed products and the other emphasizes costs
associated with work-in-process.
D) one emphasizes costs adding value to the product and the other emphasizes costs incurred
because of waste, scrap, and obsolescence.
Answer: B
Terms: Main difference between job order and process costing systems
Difficulty: Moderate
Objective: LO 21-1
AACSB: Reflective thinking

8) The inventory and warehousing cycle can be thought of as having two separate but closely
related systems, one involving the actual physical flow of goods, and the other the
A) related costs.
B) storage of the goods.
C) internal control over those goods.
D) prevention of waste, obsolescence, and theft.
Answer: A
Terms: Inventory and warehousing cycle; Separate but closely related systems
Difficulty: Moderate
Objective: LO 21-1
AACSB: Reflective thinking

9) Auditors test the quantity of materials charged to work-in-process by tracing these quantities
to
A) cost ledgers.
B) perpetual inventory records.
C) receiving reports.
D) material requisitions.
Answer: D
Terms: Test quantity of materials charged to work-in-process by tracing to
Difficulty: Moderate
Objective: LO 21-1
AACSB: Reflective thinking

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10) Which of the following is a continuously updated computerized record of inventory items
purchased, used, sold, and on hand for merchandise, raw materials, and finished goods?
A) job cost system
B) standard cost records
C) cost accounting records
D) perpetual inventory master file
Answer: D
Terms: Perpetual inventory master file
Difficulty: Moderate
Objective: LO 21-1
AACSB: Reflective thinking

11) In the flow of inventory and costs, when work-in-progress is credited, ________ is (are)
debited.
A) raw materials
B) cost of goods sold
C) finished goods
D) direct labor
Answer: C
Terms: Flow of inventory and costs
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

12) Separate perpetual records are likely to be kept only for raw materials inventory.
Answer: FALSE
Terms: Perpetual inventory records for inventories
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

13) In process cost systems, costs are accumulated by individual jobs.

Answer: FALSE
Terms: Process cost system
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

14) In job cost systems, costs are accumulated by individual jobs.

Answer: TRUE
Terms: Job cost systems
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

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15) In some inventory systems, raw materials can be requisitioned by automated computer
software when raw materials reach a predetermined level.
Answer: TRUE
Terms: Raw materials requisitions
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

16) The inventory and warehousing cycle is unique because of its close relationship to other
transaction cycles.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

17) The inventory and warehousing cycle ends with the sale of goods in the sales and collection
cycle.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

18) Inventory items such as jewels, chemicals, and electronic parts are easy for auditors to
observe and to value.
Answer: FALSE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

19) It is not allowed under accounting standards to use different inventory valuation methods for
different parts of the inventory.
Answer: FALSE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

20) Inventory valuation issues include the estimation of inventory obsolescence and the
allocation of manufacturing costs to inventory.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking
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21) Purchase requisitions are often initiated by stockroom personnel as raw materials are needed.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

22) The receiving department prepares a receiving report which often is electronic notification of
the receipt of goods that become part of the document before payment is made to the vendor.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

23) An adequate cost accounting system is an important part of the processing of goods function
for all manufacturing companies.
Answer: TRUE
Terms: Inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

24) What are two factors affecting the complexity of the audit of inventory?
Answer:
• Inventory is often the largest account on the balance sheet.
• Inventory is often in different locations, making physical control and counting difficult.
• Diverse inventory items (jewels, chemicals) are often difficult for auditors to observe and
value.
• Inventory valuation is difficult when estimation of inventory obsolescence is necessary and
when manufacturing costs must be allocated to inventory.
• There are several acceptable inventory valuation methods and some organizations use
different valuation methods for different parts of the inventory, which is acceptable under
accounting standards.
Terms: Factors affecting complexity of audit of inventory
Difficulty: Easy
Objective: LO 21-1
AACSB: Reflective thinking

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21.2 Learning Objective 21-2

1) The audit tests to verify that the client is using an inventory method which is generally
accepted and to verify that physical counts were correctly summarized are performed during the
audit of the
A) acquisition and payments cycle.
B) payroll and personnel cycle.
C) inventory and warehousing cycle.
D) sales and collection cycle.
Answer: C
Terms: Audit tests to verify client is using inventory method which is generally accepted
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

2) Handling the receipt of ordered goods is a part of the ________ cycle.

A) purchasing
B) acquisition and payment
C) inventory
D) inventory and warehousing
Answer: B
Terms: Handling receipt of ordered goods
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

3) Which of the following is not a function within the inventory and warehousing cycle?
A) process the goods
B) store raw materials
C) ship finished goods
D) process invoices for shipped goods
Answer: D
Terms: Functions within inventory and warehousing cycle
Difficulty: Easy
Objective: LO 21-2 and LO 21-1
AACSB: Reflective thinking

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4) Inventory is often a significant part of a company's current assets. Because of its importance,
A) auditors are required by auditing standards to observe the client taking a physical inventory
count.
B) price tests must be performed to verify whether the physical counts were correctly
summarized.
C) companies are required to use perpetual inventory systems.
D) auditors are required by auditing standards to take the physical inventory for the client.
Answer: A
Terms: Physical inventory
Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

5) Inventory compilation tests are used to verify that the inventory is recorded at the lower of
cost or market.
Answer: FALSE
Terms: Inventory compilation tests
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

6) An approved purchase requisition form authorizes shipment of goods to customers.

Answer: FALSE
Terms: Approved purchase requisition authorizes shipment of goods
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

7) The receipt of raw materials is a part of the acquisition and payment cycle.
Answer: TRUE
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

8) The physical observation of the inventory and the acquisition of raw materials are part of the
inventory and warehousing cycle.
Answer: FALSE
Terms: Inventory and warehousing cycles
Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

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9) Physical examination is an essential type of evidence used to verify the existence and count of
inventory.
Answer: TRUE
Terms: Physical counting of inventory
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

10) Costs used to value inventory must be tested by the auditor only to determine whether the
client has followed an inventory method which is in accordance with generally accepted
accounting principles.
Answer: FALSE
Terms: Inventory pricing and compilation tests
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

11) Audit procedures verifying the costs used to value inventories are called compilation tests.
Answer: FALSE
Terms: Inventory pricing and compilation tests
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

12) The pricing and compilation of inventory are audited using substantive analytical procedures
and test of details of the balances.
Answer: TRUE
Terms: Inventory pricing and compilation tests
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

13) As part of the risk assessment process, the auditor will consider whether any of the identified
risks of material misstatement found during the audit of the inventory and warehousing cycle are
considered a significant risk.
Answer: TRUE
Terms: Inventory pricing and compilation tests
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

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14) It is acceptable practice for CPA firms to use drones to evaluate inventories and other assets
such as mineral deposits during audits.
Answer: TRUE
Terms: Inventory drone revolution
Difficulty: Easy
Objective: LO 21-2
AACSB: Reflective thinking

15) The audit of the inventory and warehousing cycle will be affected by the results from other
business processes. Identify the "other" business cycles and how they impact the audit of
inventory.
Answer: Acquisition and payment, and payroll and personnel: Acquire and record raw materials,
labor, and overhead.
Sale and collection: Ship goods and record revenue and costs.
Terms: Audit of inventory and warehousing cycle affected by other business cycles
Difficulty: Moderate
Objective: LO 21-2
AACSB: Reflective thinking

16) The audit of the inventory and warehousing cycle consists of five parts. State the five parts
and, for each part, identify the cycle in which that part is tested by the auditor.
Answer: The five parts are:
• Acquire and record raw materials, labor, and overhead. This is tested during the audits of the
acquisition and payment cycle, and the payroll and personnel cycle.
• Internally transfer assets and costs. This is tested in the inventory and warehousing cycle.
• Ship goods, and record revenue and costs. This is tested during the audit of the sales and
collection cycle.
• Physically observe inventory. This is tested in the inventory and warehousing cycle.
• Price and compile inventory. This is tested in the inventory and warehousing cycle.
Terms: Parts of inventory and warehousing cycle and cycle in which tested by auditor
Difficulty: Challenging
Objective: LO 21-2
AACSB: Reflective thinking

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17) State the six functions that make up the inventory and warehousing cycle and, for each
function, identify the related documents that would be used by a manufacturing company.
Answer: The six functions are:
• Process purchase orders. Related documents are the purchase requisition and the purchase
order.
• Receive raw materials. Related documents are the receiving report and vendor's invoice.
• Store raw materials. Related document is the raw materials perpetual inventory master file.
• Process the goods. Related documents are the raw materials requisition and the cost
accounting records.
• Store finished goods. Related documents are the finished goods perpetual inventory master
file and the cost accounting records.
• Ship finished goods. Related documents are the shipping document, the finished goods
perpetual inventory master file, and the cost accounting records.
Terms: Functions that make up the inventory and warehousing cycle and related
documents/records
Difficulty: Challenging
Objective: LO 21-2
AACSB: Reflective thinking

21.3 Learning Objective 21-3

1) Auditor tests of the physical controls over raw materials, work in process, and finished goods
are generally limited to
A) observation and confirmation.
B) observation and inquiry.
C) inquiry and reconciliation.
D) observation and reconciliation.
Answer: B
Terms: Auditor tests of physical controls over inventory limited
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

2) Almost all companies need physical controls over their assets to prevent loss. Which of the
following is not an example of such a control?
A) perpetual inventory master files
B) segregated, limited-access storage areas
C) custody of assets assigned to specific responsible individuals
D) approved prenumbered documents for authorizing movement of inventory
Answer: A
Terms: Physical controls over assets to prevent loss
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

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3) The reliability of perpetual inventory master files affects the timing and ________ of the
auditor's physical examination of inventory.
A) cutoff
B) accuracy
C) nature
D) extent
Answer: D
Terms: Perpetual inventory master file
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

4) When auditing inventory cost accounting, the auditor is concerned with all of the following
except for
A) net realizable value.
B) unit cost records.
C) physical controls over inventory.
D) documents and records for transferring inventory.
Answer: A
Terms: Tests of inventory cost accounting
Difficulty: Easy
Objective: LO 21-3
AACSB: Analytic thinking

5) Auditors usually test cost accounting records as part of the

A) acquisition tests.
B) payroll tests.
C) sales tests.
D) All of the above are correct.
Answer: D
Terms: Cost accounting controls related to physical inventory and costs
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

6) To ensure proper segregation of duties, who should maintain the perpetual inventory master
files?
A) production personnel
B) inventory storeroom personnel
C) inventory receiving personnel
D) accounting department personnel
Answer: D
Terms: Segregation of duties; Maintain perpetual inventory master files
Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

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7) Which of the following statements is correct regarding the audit of inventory cost accounting?
A) Cost accounting systems and controls are the same for all manufacturing companies.
B) All companies that have work-in-process must use a perpetual inventory system.
C) Auditors test perpetual inventory master files by examining documentation that supports
additions and reductions of inventory amounts in the master files.
D) Manufacturing companies keep their cost accounting records separate from the production
and other accounting records.
Answer: C
Terms: Audit of cost accounting for inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

8) Which of the following is an accurate statement regarding perpetual inventory master files?
A) When perpetual inventory master files are accurate, auditors can test the physical inventory
after the balance sheet date.
B) It is a difficult procedure for the auditor to test the accuracy of the perpetual inventory master
files.
C) Auditors test the perpetual records for reductions in finished goods for sale as part of the sales
and collection cycle.
D) All of the above are accurate statements.
Answer: C
Terms: Perpetual inventory master file
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

9) Which of the following is a significant audit concern related to the transfer of inventory from
one location to another?
A) Recorded transfers occurred.
B) Transfers were properly transported.
C) Transfers were properly planned.
D) Transfers represent efficient movement of assets.
Answer: A
Terms: Significant audit concern related to transfer of inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

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10) When auditing manufacturing overhead costs assigned to inventory, auditors should keep in
mind that
A) GAAP has strict procedures that must be followed when assigning overhead to work-in-
process inventory.
B) overhead costs must be allocated to raw materials, work-in-process, and finished goods
inventory.
C) management typically allocates overhead using total direct labor dollars as the basis for the
allocation.
D) determining the reasonableness of the allocation method is relatively simple for work-in-
process inventory.
Answer: C
Terms: Audit of cost accounting for inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

11) A major difficulty in the verification of inventory cost records for the purpose of inventory
valuation is in determining the reasonableness of the
A) direct labor costs.
B) raw material costs.
C) manufacturing overhead costs.
D) period costs.
Answer: C
Terms: Difficulty in verification of inventory cost records for valuation
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

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12) Auditor tests of physical controls over raw materials, work-in-process, and finished goods
are performed by
A)
Examination Observation Inquiry
Yes No Yes

B)
Examination Observation Inquiry
No Yes No

C)
Examination Observation Inquiry
Yes Yes No

D)
Examination Observation Inquiry
No Yes Yes

Answer: D
Terms: Auditor tests of physical controls over inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

13) If the perpetual inventory master files show lower quantities of inventory than the physical
count, an explanation of the difference might be unrecorded
A) sales.
B) sales discounts.
C) purchases.
D) purchase discounts.
Answer: C
Terms: Perpetual inventory master file shows lower quantities of inventory than physical count
Difficulty: Challenging
Objective: LO 21-3
AACSB: Analytic thinking

14) Cost accounting controls are those related to the physical inventory and the consequent costs
from the point at which
A) materials are ordered for purchase until the finished product is sold.
B) the customer's order is received until the finished product is shipped.
C) raw materials are requisitioned until the finished product is sent to storage.
D) raw materials are requisitioned until the finished product is completely manufactured.
Answer: C
Terms: Cost accounting controls related to physical inventory and costs
Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking
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15) In order to strengthen controls over cost accounting information, a company should consider
implementing
A) perpetual inventory master files.
B) a job order cost accounting system.
C) an accounting system that keeps separate the records of the accounting department from the
records of the production department.
D) an economic quantity order system.
Answer: A
Terms: Strengthen internal controls over accounting for materials used in production
Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

16) The auditor is concerned with four aspects of cost accounting, including
A) documents and records for transferring inventory.
B) perpetual inventory master files.
C) unit cost records.
D) all of the above.
Answer: D
Terms: Tests of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

17) One of the auditor's primary concerns in verifying the transfer of inventory from one location
to another is that
A) recorded transfers exist.
B) all actual transfers are recorded.
C) the quantity, date, and description of all recorded transfers are accurate.
D) all of the above.
Answer: D
Terms: Audit tests of cost accounting system
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

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18) The audit of cost accounting begins with the internal transfer of assets from raw materials to
work-in-process to
A) manufacturing overhead.
B) finished goods inventory.
C) the perpetual inventory master files.
D) retail sales.
Answer: B
Terms: Audit of cost accounting for inventory
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

19) Management typically allocates overhead using total raw materials as the basis for the
allocation.
Answer: FALSE
Terms: Audit of cost accounting for inventory
Difficulty: Easy
Objective: LO 21-3
AACSB: Reflective thinking

20) When verifying the transfer of inventory from one location to another, the audit objectives
with which the auditor is primarily concerned are occurrence of recorded transfers, completeness
of recorded transfers, and accuracy of recorded transfers.
Answer: TRUE
Terms: Transfer of inventory; Occurrence, completeness, and accuracy
Difficulty: Challenging
Objective: LO 21-3
AACSB: Reflective thinking

21) Cost accounting systems and controls are the same for all manufacturing companies.
Answer: FALSE
Terms: Cost accounting controls related to physical inventory and costs
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

22) The extent and timing of an auditor's physical examination of inventory is significantly
influenced by the adequacy of the client's perpetual inventory records.
Answer: TRUE
Terms: Extent and timing of auditor's physical examination of inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

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23) In evaluating management's overhead cost allocations, the auditor must simply consider the
reasonableness of the allocation method and determine if the valuation method complies with
generally accepted accounting principles.
Answer: FALSE
Terms: Tests of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

24) Management may decide to allocate manufacturing overhead based upon machine hours. In
this situation, the auditor must test and verify the reasonableness of the use of machine hours to
allocate overhead.
Answer: TRUE
Terms: Tests of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

25) Internal controls over cost accounting records are very similar among companies.
Answer: FALSE
Terms: Tests of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

26) Auditors should design appropriate tests of internal controls over cost accounting records
based upon their understanding of those records and the extent they will be relied upon for
reducing substantive tests.
Answer: TRUE
Terms: Tests of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

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27) Discuss the four aspects of the audit of cost accounting with which the auditor is most
concerned.
Answer: The auditor is most concerned with:
• Physical controls over inventory. Generally limited to observation and inquiry to determine if
inventory is protected from theft and misuse.
• Documents and records for transferring inventory. The auditor's primary concerns in
verifying the transfer of inventory from one location to another are that the recorded transfers
exist, all actual transfers are recorded, and the quantity, description, and date of all recorded
transfers are accurate.
• Perpetual inventory master files. The adequacy of perpetual inventory master files has a major
effect on the timing and extent of the auditor's physical examination of inventory.
• Unit cost records. To maintain accurate cost data, clients must integrate their cost accounting
records with production and other accounting records. The auditor is concerned that there is
accurate cost data for raw materials, direct labor, and manufacturing overhead to ensure that raw
materials, work-in-process, and finished goods inventories are fairly stated.
Terms: Four aspects of audit of cost accounting
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

28) What are the auditor's primary concerns in verifying the transfer of inventory from one
location to another?
Answer:
1. Recorded transfers exist.
2. All actual transfers are recorded.
3. The quantity, description, and date of all recorded transfer are accurate.
Terms: Methodology for designing tests of details of balances for inventory
Difficulty: Moderate
Objective: LO 21-3
AACSB: Reflective thinking

21.4 Learning Objective 21-4

1) Which one of the following substantive analytical procedures would be most useful in alerting
the auditor to the possibility of obsolete inventory?
A) Compare gross margin percentage with that of previous years.
B) Compare unit costs of inventory with previous years.
C) Compare inventory turnover ratio with previous years.
D) Compare current year manufacturing costs with previous years.
Answer: C
Terms: Analytical procedure useful in alerting for obsolete inventory
Difficulty: Moderate
Objective: LO 21-4
AACSB: Reflective thinking

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2) Which one of the following substantive analytical procedures would be most useful in alerting
the auditor to the possibility inventory and cost of goods sold being overstated or understated?
A) Compare extended inventory value with that of previous years.
B) Compare unit costs of inventory with previous years.
C) Compare inventory turnover ratio with previous years.
D) Compare current year manufacturing costs with previous years.
Answer: C
Terms: Analytical procedure useful in alerting for obsolete inventory
Difficulty: Moderate
Objective: LO 21-4
AACSB: Reflective thinking

3) A comparison of the current year's inventory turnover ratio with previous years' may indicate
the presence of obsolete inventory.
Answer: TRUE
Terms: Comparison of inventory turnover ratios
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

4) Ratios such as the gross margin percentage calculated as part of risk assessment procedures
may be performed using aggregate data.
Answer: TRUE
Terms: Comparison of inventory turnover ratios
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

5) Significant improvements in audit effectiveness and efficiency may be achieved by the use of
audit data analytics in the inventory and warehousing cycle.
Answer: TRUE
Terms: Use of audit data analytics in audit of inventory
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

6) It is permissible for an auditor to test the entire inventory population for certain types of audit
tests in order to eliminate the need for more costly tests involving sampling.
Answer: TRUE
Terms: Use of audit data analytics in audit of inventory
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

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7) Many of the internal controls over inventory and the details of the entire inventory population
can be tested using audit software.
Answer: TRUE
Terms: Use of audit data analytics in audit of inventory
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

8) In addition to performing analytical procedures that examine the relationship of inventory

account balances with related financial statement accounts, auditor's will often use nonfinancial
measures in determining the reasonableness of inventory balances. List below at least two
nonfinancial measures that may be useful to auditors.
Answer: size and weight of inventory products
methods of storage
capacity of storage facilities
Terms: Nonfinancial measures to determine reasonableness of inventory
Difficulty: Easy
Objective: LO 21-4
AACSB: Reflective thinking

9) Given the following information about your audit client, perform analytical procedures and
comment on your findings.

2015 2016 Industry Average

Inventory $20,000 $32,000 $25,000
Cost of Sales $240,000 $320,000 $400,000

Answer: Inventory turnover for 2015 is 12, and for 2016 is 10, industry average is 16. (Basic
accounting information that should be known applied to the inventory chapter)

Inventory is increasing with lower inventory turnover, and a turnover that is well below the
industry average. Principal audit concern would be that inventory is overvalued on the balance
sheet. Another concern will be the realizable value of the inventory.
Terms: Analytical procedures
Difficulty: Challenging
Objective: LO 21-4
AACSB: Analytic thinking

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21.5 Learning Objective 21-5

1) You are auditing the inventory account and are concerned about the possibility of an inventory
overstatement. What is the best audit procedure to detect damaged inventory?
A) Observe the condition of inventory during the client's physical count.
B) Compare the condition of inventory from the previous year's count to the current year.
C) Compare inventory turnover from the previous year's inventory to the current year's
inventory.
D) Reconcile the inventory counts to the cost accounting records.
Answer: A
Terms: Best audit procedure to detect damaged inventory
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

2) When determining the sample size for the number of items the auditor should count during the
physical inventory,
A) it is easy to quantify the number of items based on a formula developed by the AICPA.
B) one of the key determinants that must be considered is internal control over the physical
count.
C) one of the key determinants that must be considered is the cost involved.
D) generally accepted auditing standards require that at least 80% of the dollar value of the
inventory should be included in the sample.
Answer: B
Terms: Audit procedure observe client taking physical inventory count
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

3) There must be a periodic physical count by the client of the inventory items on hand
A) only if the client uses the LIFO method.
B) only if the client uses a lower-of-cost-or-market method.
C) regardless of the client's inventory valuation method.
D) only if the client uses either the LIFO or FIFO method.
Answer: C
Terms: Periodic physical count on inventory on hand
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

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4) If the auditor concludes that physical controls over inventory are so inadequate that the
inventory will be difficult to count, the auditor should ordinarily
A) withdraw from the engagement.
B) issue a qualified audit report.
C) conduct expanded observation tests of physical inventory.
D) hire a specialist to assist the auditor.
Answer: C
Terms: Auditor concludes physical controls over inventory are so inadequate
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

5) From which of the following evidence-gathering audit procedures would an auditor obtain
most assurance concerning the existence of inventories?
A) observation of physical inventory counts
B) written inventory representations from management
C) confirmation of inventories in a public warehouse
D) auditor's recomputation of inventory extensions
Answer: A
Terms: Evidence-gathering audit procedures for auditor to obtain most assurance concerning
existence of inventories
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

6) When auditors observe the client counting inventory, they should be careful to do all of the
following except
A) inquire about items that are likely to be obsolete or damaged.
B) calculate the unit cost of the inventory items.
C) discuss with management the reasons for excluding any material items.
D) observe the counting of the most significant items.
Answer: B
Terms: Physical counting of inventory
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

7) It is frequently possible to test the physical inventory prior to the balance sheet date when
A) the perpetual inventory records are accurate and related controls operate effectively.
B) year-end sales are small.
C) the internal control system is no better at year-end than at an earlier point in time.
D) the client counts inventory at interim dates.
Answer: A
Terms: Test of physical inventory prior to balance sheet date
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking
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8) Comparing the physical counts with the perpetual inventory master files satisfies the balance-
related audit objective of
A) classification.
B) observation.
C) completeness.
D) accuracy.
Answer: D
Terms: Tests of perpetual inventory master files
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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9) Which of the following statements is correct regarding the auditor's responsibility with respect
to the year-end inventory procedures of an audit client?
A)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
Yes No No

B)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
No No Yes

C)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
Yes No Yes

D)
The auditor is responsible The auditor is responsible The auditor is responsible
for setting up the for taking and compiling for observing the physical
procedures for taking an the inventory. counting of inventory.
accurate physical
inventory.
No Yes No

Answer: B
Terms: Auditor's responsibility for year-end inventory procedures
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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10) McKesson & Robbins Company is a well-known audit case involving auditor responsibility.
What occurred at the McKesson & Robbins Company to change the way in which auditors audit
inventory?
A) The company recorded nonexistent inventory.
B) The auditor did not perform any audit tests of the inventory.
C) The auditor and company colluded to overstate inventory balances.
D) The company counted inventory three months prior to year-end.
Answer: A
Terms: McKesson & Robbins Company audit case; Auditor responsibility in auditing inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

11) When a physical count of inventory is performed at an interim date, the auditor observes it at
that time and tests the perpetual records for transactions
A) throughout the year.
B) which are a representative sample of the period under audit.
C) from the date of the count to year-end.
D) from the date of the count to the end of the audit field work.
Answer: C
Terms: Count of inventory performed at interim date
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

12) When there are no perpetual inventory files and inventory is material,
A) an audit cannot be performed, so the auditor must issue a disclaimer.
B) a physical inventory should be taken by the client near the end of the accounting period.
C) the auditor will have to perform the inventory count and determine valuation.
D) the auditor need not observe inventory counts but must do test counts.
Answer: B
Terms: No perpetual inventory files and inventory is material
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

13) The most important part of the observation of inventory is to determine whether
A) all counts are accurate.
B) the inventory-takers are qualified.
C) obsolete inventory has been identified.
D) the physical count is being taken in accordance with the client's instructions.
Answer: D
Terms: Most important part of observation of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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14) A useful starting point for becoming familiar with the client's inventory is for the auditor to
A) read the AICPA's Industry Audit Guide.
B) review accounting theory covering special inventory problems.
C) read the client's accounting manual.
D) tour the client's facility.
Answer: D
Terms: Starting point for becoming familiar with client's inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

15) A common inventory observation procedure is to select a random sample of tag numbers and
identify the tag with that number attached to the actual inventory item. The audit objective being
achieved by this procedure is
A) inventory as recorded on tags actually exists (existence).
B) existing inventory is counted and tagged (completeness).
C) inventory is counted accurately (accuracy).
D) inventory is classified correctly (classification).
Answer: A
Terms: Audit objective of procedure to select random sample
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

16) If a client intends to count inventory at an interim date, the auditor should expect there to be
all of the following except
A) controls over the preparation and maintenance of perpetual inventory records.
B) competent personnel assigned to count the inventory.
C) third-party inventory counting specialists.
D) an adequately designed plan to count the inventory.
Answer: C
Terms: Inventory count at interim date
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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17) A common inventory observation procedure is to be alert for items that are damaged, rust- or
dust-covered, or located in inappropriate places. The balance-related audit objective being
achieved by this procedure is
A) classification.
B) cutoff.
C) realizable value.
D) rights.
Answer: C
Terms: Balance-related audit objective for alert for items that are damaged
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

18) The test of details of balance procedure which requires the auditor to account for unused
inventory tag numbers to make sure none have been deleted is associated with the audit objective
of
A) accuracy.
B) existence.
C) detail tie-in.
D) completeness.
Answer: D
Terms: Audit objective related to test of details of balances procedure to account for unused
inventory tag numbers
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

19) Which of the following is an accurate statement regarding inventory and risk?
A) Inventory with a high business risk includes products with potential obsolescence.
B) Auditors often have a greater concern for misstatements when inventory is stored in one
warehouse.
C) Inherent risk is generally set at low for manufacturing companies.
D) Performance materiality for inventory is determined before assessing client business risk.
Answer: A
Terms: Inventory and risk
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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20) The auditor's tour of the client's inventory facilities should be led by
A) a member of the audit committee.
B) the CFO.
C) a plant supervisor.
D) the company president.
Answer: C
Terms: Physical counting of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Analytic thinking

21) The physical counting of inventory may be performed at which of the following times?
A)
Interim dates On a cycle basis during the year
Yes Yes

B)
Interim dates On a cycle basis during the year
No No

C)
Interim dates On a cycle basis during the year
Yes No

D)
Interim dates On a cycle basis during the year
No Yes

Answer: A
Terms: Physical counting of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

22) When an auditor observes that personnel who are responsible for physically counting
inventory are not following the inventory instructions, the auditor should
A) contact a client's supervisor to correct the problem.
B) modify the client's physical inventory instructions.
C) not discuss the problem with client's supervisor in order to maintain independence.
D) assign audit staff to the inventory count.
Answer: A
Terms: Observation of personnel taking inventory not following instructions
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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23) Auditors need to understand the client's physical inventory count controls before the count of
the inventory begins so that
A) the auditors can accurately count and tag the inventory for the client.
B) the auditors can make constructive suggestions as to the adequacy of the procedures.
C) the client will be informed on exactly what items the auditor intends to test count.
D) the auditor can communicate any weaknesses directly to the audit committee.
Answer: B
Terms: Auditor's objective during observation of physical inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

24) The audit of year-end physical inventories should include steps to verify that the client's
purchases and sales cutoffs were adequate. The audit steps should be designed to detect whether
merchandise included in the physical count at year-end was not recorded as a
A) sale in the current period.
B) sale in the subsequent period.
C) purchase in the current period.
D) purchase return in the subsequent period.
Answer: A
Terms: Audit of year-end physical inventories
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

25) 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
Answer: B
Terms: Procedures not appropriate for auditor in discharging responsibilities concerning
physical inventories
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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26) The auditor generally decides whether the inventory count can be taken before year-end
primarily on the basis of
A) audit efficiency.
B) accuracy of the perpetual inventory master files.
C) client convenience.
D) audit staff availability.
Answer: B
Terms: Basis that auditor decides whether inventory count can be taken before year-end
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

27) An auditor selects a random sampling of tag numbers and identifies the tag with that number
attached to the actual inventory. The purpose of the procedure is to
A) obtain proper cutoff information.
B) uncover the inclusion of nonexistent items as inventory.
C) determine if the client has adequately priced the inventory item.
D) verify that the client has not changed the recorded counts after the auditor left the premises.
Answer: B
Terms: Physical counting of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

28) An auditor must inquire about consigned or customer inventory included on the client's
premises to satisfy the balance-related audit objective of
A) cutoff.
B) classification.
C) rights.
D) completeness.
Answer: C
Terms: Audit of year-end physical inventories
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

29) 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 cutoff procedures.
C) contractual commitments made by the purchasing department.
D) purchase invoices received on or around year-end.
Answer: B
Terms: Auditor should review and test for proper inclusion of merchandise in ending inventory
Difficulty: Challenging
Objective: LO 21-5
AACSB: Reflective thinking
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30) Boxes or other containers holding inventory should also be opened during test counts to
determine the ________ of the inventory.
A) classification
B) detail tie-in
C) existence
D) realizable value
Answer: C
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

31) When may auditors observe the physical inventory count?

A)
At an interim date At year-end
Yes Yes

B)
At an interim date At year-end
No No

C)
At an interim date At year-end
Yes No

D)
At an interim date At year-end
No Yes

Answer: A
Terms: Auditors observe physical inventory count
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

32) Auditing standards recommend that auditors observe physical inventory counts by the client.
Answer: FALSE
Terms: Audit standards; Auditors observe physical inventory
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

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33) In the audit of inventory, the auditor and client are jointly responsible for making and
recording the count of physical inventory, while the auditor is responsible for drawing
conclusions about the adequacy of the physical inventory.
Answer: FALSE
Terms: Responsibility for making and recording count of physical inventory count
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

34) A common source of business risk for inventory is the reliance on a few key suppliers.
Answer: TRUE
Terms: Inventory and risk
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

35) To test for proper sales cutoff, an auditor would obtain the number of the last bill of lading
issued during the period under audit and verify that the item shipped had been excluded from the
inventory listing.
Answer: TRUE
Terms: Test for proper sales cutoff
Difficulty: Easy
Objective: LO 21-5
AACSB: Reflective thinking

36) When the client's perpetual inventory master files are inadequate, the auditor will probably
choose to test the physical inventory prior to the balance sheet date.
Answer: FALSE
Terms: Client's perpetual inventory master files are inadequate
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

37) When part of the client's inventory is in a public warehouse or in the possession of other
outside custodians, the auditor does not need to observe a physical count of the inventory if a
written confirmation is obtained directly from the inventory custodians.
Answer: TRUE
Terms: Client's inventory in pubic warehouse
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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38) The adequacy of internal controls over the physical count of inventory is one of the key
determinants of the amount of time needed to test inventory.
Answer: TRUE
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

39) Inherent risk is typically assessed at a low level for inventory due to the nature of the asset.
Answer: FALSE
Terms: Inherent risk for inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

40) Discuss the auditor's responsibilities for inventory maintained in public warehouses or with
other outside custodians.
Answer: An auditor's physical examination of inventory is not required if inventory is housed in
a public warehouse or overseen by outside custodians. In these situations, auditors verify
inventory by confirmation with the custodian. However, the auditor may perform additional
procedures if the amounts involved are significant. These additional procedures may include: an
investigation of the custodian's inventory procedures, obtaining an independent accountant's
report on the custodian's control procedures over the custody of goods, or observing the physical
count of goods held by the custodian, if practical.
Terms: Auditor responsibilities for inventory maintained in public warehouses
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

41) Discuss the key control procedures relating to the client's physical count of inventory.
Answer: The key control procedures relating to the client's physical count of inventory include:
1. proper client instructions for the physical count
2. supervision by responsible company personnel
3. independent internal verification of the counts by other client personnel
4. independent reconciliations of the physical counts with perpetual inventory master files
5. adequate client control over count sheets or tags used to record inventory counts
Terms: Control procedures related to physical count of inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

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42) Auditing standards require that auditors satisfy themselves about the effectiveness of the
client's methods of counting inventory and the reliance they can place on the client's
representations about the quantities and physical condition of the inventories. To meet this
requirement, auditors must perform four activities. List them below.
Answer:
• be present at the time the client counts the inventory for determining year-end balances
• observe the client's counting procedures
• make inquiries of client personnel about their counting procedures
• make their own independent tests of the physical count
Terms: Effectiveness of client's method of counting inventory
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

43) When auditors observe the client counting inventory, the auditor should take special care in
three areas with regards to selection of inventory items. What action should be taken in these
areas?
Answer:
• Observe the counting of the most significant items and a representative sample of typical
inventory items.
• Inquire about items likely to be damaged or obsolete.
• Discuss with management reasons for excluding any material items from the inventory count.
Terms: Selection of inventory items for the auditor to audit
Difficulty: Moderate
Objective: LO 21-5
AACSB: Reflective thinking

21.6 Learning Objective 21-6

1) If an auditor were concerned with obtaining evidence about the appropriateness of the value of
inventory, which of the following tests would be most appropriate?
A) compilation tests
B) price tests
C) confirmation of inventory held by outside parties
D) physical examination of the inventory
Answer: B
Terms: Tests of evidence about appropriateness of value of inventory
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

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2) The first step in verifying the valuation of purchased inventory is in determining the valuation
method used by the client. The next step is
A) determining that all inventory that is purchased is expensed through cost of goods sold.
B) determining which costs should be included in the valuation of an item of inventory.
C) determining that all inventory on hand reconciles to the perpetual inventory records.
D) determining that cut-off procedures have been adhered to prior to counting inventory.
Answer: B
Terms: Second step in verifying the valuation of purchased inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

3) You are gathering evidence for the audit objective that existing inventory items are included
in the inventory listing schedule. The audit procedure that would provide you with the best
evidence to confirm this objective is
A) trace from inventory tags to the inventory listing schedule and make sure the inventory on the
tags is included.
B) trace the inventory totals to the general ledger.
C) perform tests of lower-of-cost-or-market.
D) account for unused tags shown in the auditor's documentation to make sure no tags have been
added.
Answer: A
Terms: Audit procedure that provides evidence to confirm audit objective of existence of
inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

4) The test of details of balance procedure which requires the auditor to perform tests of lower of
cost or market, selling price, and obsolescence is an attempt to satisfy the objective of
A) existence.
B) completeness.
C) accuracy.
D) realizable value.
Answer: D
Terms: Objective for tests of details of balance procedure to perform lower-of-cost-or-market,
selling price, and obsolescence
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

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5) A major source of cutoff information for sales and purchases of inventory is

A) confirmations from outside parties.
B) the test of details of balances.
C) physical observation.
D) the performance of analytical procedures.
Answer: C
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

6) Pricing manufactured inventory is difficult. Auditors must evaluate the method of allocating
manufacturing overhead for all but which of the following?
A) reasonableness
B) computational correctness
C) compliance with generally accepted auditing standards
D) consistency
Answer: C
Terms: Auditors must evaluate method of allocating manufacturing overhead
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

7) Controls which provide a means of ensuring that the physical counts are properly summarized,
priced at the same amount as the unit records, correctly extended and totaled, and included in the
general ledger at the proper amount are known as
A) standard cost controls.
B) pricing internal controls.
C) compilation internal controls.
D) count quantity internal controls.
Answer: C
Terms: Controls which provide means of ensuring physical counts are properly summarized
Difficulty: Challenging
Objective: LO 21-6
AACSB: Reflective thinking

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8) Assume that the client's valuation of an inventory item is $10 per unit for 1,000 units, using
first-in, first-out (FIFO). If the most recent acquisition of inventory was for 600 units at $10 per
unit and the immediately preceding acquisition was for 700 units at $9 per unit, the inventory
item is in error and it is
A) understated $400.
B) understated $300.
C) overstated $400.
D) overstated $700.
Answer: C
Terms: Inventory errors—First-in, first-out (FIFO)
Difficulty: Challenging
Objective: LO 21-6
AACSB: Analytic thinking

9) The auditor traces inventory tags identified as non-owned during the physical observation to
the inventory listing schedule to make sure these have not been included. This test satisfies the
balance-related audit objective of
A) cutoff.
B) rights.
C) accuracy.
D) existence.
Answer: B
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Analytic thinking

10) Which of the following is an accurate statement regarding the audit of pricing and
compilation of inventory?
A) Inventory compilation tests include all of the tests of the client's unit prices to determine
whether they are correct.
B) The review for obsolete inventory should be performed by the accounting department.
C) The most important internal control for accurate unit costs is external verification by an
outside consultant.
D) Inventory compilation internal controls are needed to ensure that the physical counts are
correctly summarized and priced.
Answer: D
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

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11) In valuing inventory, the auditor must consider all but which of the following factors?
A) The valuation method must be in accordance with GAAP.
B) The valuation method must be applied on a consistent basis.
C) The inventory must be valued at the lower of cost or market.
D) LIFO must be used for work-in-process inventory.
Answer: D
Terms: Factors considered in valuing inventory
Difficulty: Challenging
Objective: LO 21-6
AACSB: Reflective thinking

12) In pricing raw materials in manufactured products, auditors must consider both the unit cost
of the raw materials and the number of units required to manufacture a unit of output.
Answer: TRUE
Terms: Pricing manufactured inventory
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

13) The audit procedure "Perform tests of lower-of-cost-or-market, selling price, and
obsolescence" provides assurance mainly for the realizable value objective for inventory pricing
and compilation.
Answer: TRUE
Terms: Assurance for realizable value objective for inventory pricing and compilation
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

14) When performing price tests for purchased inventory, the auditor would not be concerned
with the most recent vendors' invoices if the client uses the FIFO valuation method.
Answer: FALSE
Terms: Performing price tests for purchased inventory; FIFO valuation method
Difficulty: Easy
Objective: LO 21-6
AACSB: Reflective thinking

15) When a client has standard cost records, an efficient and useful method of determining
valuation is to review and analyze variances.
Answer: TRUE
Terms: Audit of inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

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16) Inventory price tests include testing the client's summarization of the inventory counts.
Answer: FALSE
Terms: Inventory price tests and inventory compilation tests
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

17) The audit procedure "Foot the inventory listing schedules for raw materials, work-in-process,
and finished goods" provides assurance mainly for the accuracy objective for inventory pricing
and compilation.
Answer: FALSE
Terms: Accuracy objective for inventory pricing and compilation
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

18) The auditor need not be concerned about inventory being classified and disclosed, properly,
into finished goods, work-in-process and raw materials (separately) in the financial statements;
this is management's responsibility, only.
Answer: FALSE
Terms: Balance-related audit objective
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

19) When performing inventory valuation tests, the auditor must be concerned that the method is
in accordance with accounting standards.
Answer: TRUE
Terms: Valuation of inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

20) Explain why the audit of work in process and finished goods inventory is generally more
complex than the audit of purchased inventory.
Answer: The need to verify the cost of raw materials, direct labor, and manufacturing overhead
in pricing work in process and finished goods has the effect of making the audit of work in
process and finished goods inventory more complex than the audit of purchased inventory.
Terms: Audit of work-in-process and finished goods inventory
Difficulty: Moderate
Objective: LO 21-6
AACSB: Reflective thinking

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21.7 Learning Objective 21-7

1) When labor is a significant part of inventory, verifying the proper accounting of these costs
should be tested in the
A) inventory and warehousing cycle.
B) payroll and personnel cycle.
C) acquisitions and payments cycle.
D) cash cycle.
Answer: B
Terms: Labor a significant part of inventory
Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

2) Accounting standards require disclosure of inventory valuation methods.

Answer: TRUE
Terms: Disclosures for inventory
Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

3) Cost of goods sold is generally a residual of beginning inventory less acquisitions plus ending
inventory.
Answer: FALSE
Terms: Cost of goods sold as a residual
Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

4) Cost of goods sold is generally one of the largest accounts on the income statement.
Answer: TRUE
Terms: Cost of goods sold as a residual
Difficulty: Easy
Objective: LO 21-7
AACSB: Reflective thinking

5) The design of tests of details of balances for inventory is affected by audit results from
multiple cycles. Identify the cycles, other than the inventory and warehousing cycle that affect
the audit of inventory.
Answer: Tests of details of balances for inventory are also affected by the results of tests of
controls and substantive tests of transactions in the sales and collection cycle, acquisition and
payment cycle, and the payroll and personnel cycle.
Terms: Cycles that affect inventory
Difficulty: Moderate
Objective: LO 21-7
AACSB: Reflective thinking

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Auditing and Assurance Services, 17e (Arens/Elder/Beasley)

Chapter 19 Completing the Tests in the Acquisition and Payment Cycle:
Verification of Selected Accounts

19.1 Learning Objective 19-1

1) Which of the following accounts is not associated with the acquisition and payment cycle?
A) common stock
B) property, plant and equipment
C) accrued property taxes
D) income tax expense
Answer: A
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-1
AACSB: Reflective thinking

2) Which of the following expenses is not typically evaluated as part of the audit of the
acquisition and payment cycle?
A) depreciation expense
B) insurance expense
C) estimated liability for warranties
D) property tax expense
Answer: C
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-1
AACSB: Reflective thinking

3) Other accrued expenses are normally considered to be associated with the acquisition and
payment cycle.
Answer: TRUE
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-1
AACSB: Reflective thinking

4) The types of assets, expenses, and liabilities associated with the acquisition and payment cycle
will differ by company.
Answer: TRUE
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-1
AACSB: Reflective thinking

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5) The billing of customers and collection of the related accounts receivable are normally
considered to be associated with the acquisition and payment cycle.
Answer: FALSE
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-1
AACSB: Reflective thinking

19.2 Learning Objective 19-2

1) You are auditing the acquisition and payment cycle and note the presence of excessive
recurring losses on retired assets. You may conclude that
A) insured values are greater than book values.
B) there are a large number of fully depreciated assets.
C) depreciation charges may by insufficient.
D) the company has a policy of selling relatively new assets.
Answer: C
Terms: Acquisition and payment cycle; Excessive recurring losses on retired assets
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

2) Which of the following would generally not be a component of the audit of the acquisition
and payment cycle?
A) adequacy of controls over acquisitions of long-lived assets
B) tracing disposals of long-lived assets to the fixed asset master file
C) determining the adequacy of the funds available for capital expenditures
D) reperformance of recorded depreciation expense
Answer: C
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

3) Normally it may be unnecessary to examine supporting documentation for each addition to

property, plant, and equipment, but it would be customary to verify
A) all large transactions.
B) all unusual transactions.
C) a representative sample of typical additions.
D) all of the above.
Answer: D
Terms: Property, plant, and equipment documentation
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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4) The auditor must know the client's capitalization policies to determine whether acquisitions
are
A)
Recorded at historical Treated consistently with Necessary
cost those of the preceding
year
Yes Yes Yes

B)
Recorded at historical Treated consistently with Necessary
cost those of the preceding
year
Yes No No

C)
Recorded at historical Treated consistently with Necessary
cost those of the preceding
year
No No No

D)
Recorded at historical Treated consistently with Necessary
cost those of the preceding
year
No Yes No

Answer: D
Terms: Acquisitions; Capitalization policy
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

5) Which is not one of the tests that would be used in the audit of equipment, depreciation
expense, and accumulated depreciation?
A) Verify the ending balance in the asset account.
B) Send confirmations to the sales personnel who sold the equipment to the company.
C) Perform substantive analytical procedures.
D) Verify current year acquisitions.
Answer: B
Terms: Property, plant, and equipment; Capitalized
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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6) The primary accounting record for manufacturing equipment and other fixed assets is the
A) depreciation ledger.
B) fixed asset master file.
C) asset inventory.
D) equipment roster.
Answer: B
Terms: Primary accounting record for equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

7) Which of the following statements about the audit of fixed assets is the least correct?
A) The primary accounting record for manufacturing equipment and other property, plant and
equipment is generally a fixed asset master file.
B) Manufacturing equipment and current assets are normally audited in the same fashion
regardless of the activity within a particular account.
C) The emphasis on auditing fixed assets is on verification of current-period acquisitions.
D) Failure to record the acquisition of a fixed asset affects the income statement until the assets
are fully depreciated.
Answer: B
Terms: Audit of fixed assets
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

8) You are the in-charge auditor for a company who has been an audit client for several years.
Which of the following is not a category of tests commonly associated with the audit of
manufacturing equipment?
A) verification of depreciation expense
B) analytical procedures
C) verification of current-period disposals
D) verification of the beginning balance in the equipment account
Answer: D
Terms: Audit of manufacturing equipment; Category of tests
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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9) The audit procedure that requires an auditor to "foot the acquisition schedule" relates to which
balance-related audit objective?
A) classification
B) detail tie-in
C) existence
D) cut-off
Answer: B
Terms: Audit procedure; Balance-related audit objective; Foot acquisition schedule
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

10) You are auditing Manufacturing Company and testing the audit related objective of
completeness for the equipment accounts. Which of the following audit procedures is most likely
to achieve your objective?
A) Examine vendor invoices and receiving reports.
B) Physically examine assets.
C) Examine vendor invoices of closely related accounts such as repairs and maintenance.
D) Trace individual acquisitions to the fixed asset master file.
Answer: C
Terms: Testing audit related objective of completeness for equipment accounts
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

11) Which of the following audit procedures would be the most correct in determining the audit
objective of existence for the equipment account in the fixed asset master file?
A) Examine vendor invoices and receiving reports.
B) Review transactions near the balance sheet date.
C) Recalculate vendor invoices.
D) Examine vendor invoices for correct accounting treatment.
Answer: A
Terms: Audit objective of existence for equipment account
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

12) The source of debits in the equipment account is the

A) sales schedule.
B) cash disbursements journal.
C) cash receipts journal.
D) acquisitions schedule.
Answer: D
Terms: Acquisitions schedule and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking
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13) Failure to capitalize a fixed asset at the correct amount would impact which financial
statements?
A) the balance sheet
B) the income statement
C) the cash flow statement only
D) both the income statement and the balance sheet
Answer: D
Terms: Failure to capitalize a fixed asset; Financial statements
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

14) Which of the following tests are typically not necessary when auditing a client's schedule of
recorded disposals?
A) footing the schedule
B) tracing the totals on the schedule to the recorded disposals in the general ledger
C) tracing cost and accumulated depreciation of the disposals to the property master file
D) All of the above are necessary.
Answer: D
Terms: Tests when auditing schedule of recorded disposals
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

15) Which of the following is a substantive analytical procedure to determine if there is idle
equipment or equipment that was disposed of but not written off?
A) Compare depreciation expense divided by gross equipment cost with previous years.
B) Compare gross manufacturing cost divided by some measure of production with previous
years.
C) Compare accumulated depreciation divided by gross equipment cost with previous years.
D) Compare annual repairs and maintenance accounts with previous years.
Answer: B
Terms: Equipment; analytical procedures
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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16) A set of records for each piece of equipment that includes descriptive information, date of
acquisition, original cost, current year depreciation, and accumulated depreciation is the
A) acquisitions schedule.
B) depreciation schedule.
C) fixed asset master file.
D) file of purchase requisitions.
Answer: C
Terms: Set of records for each piece of equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

17) In testing acquisitions the auditor needs to understand the appropriate accounting guidance
related to acquisition accounting. Which of the following is not an accounting consideration for
the auditor as regards to acquisition cost?
A) inclusion of material transportation and installation costs
B) recording of trade-in costs
C) allocating costs when building and equipment are purchased at one price
D) verifying that purchased equipment amounts correspond to the budgeted amount
Answer: D
Terms: Appropriate accounting guidance related to acquisition accounting
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

18) Methods used to determine if there are legal encumbrances related to fixed assets include all
but which of the following?
A) Read the terms of loan and credit agreements.
B) Send loan confirmation requests to banks and other lending institutions.
C) Have discussions with the client or send letters to legal counsel.
D) All of the above may be used to identify legal encumbrances.
Answer: D
Terms: Methods to determine legal encumbrances related to fixed assets
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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19) When performing the test of details of balances, the balance-related audit objective of
classifications is closely related to the objective of
A) accuracy.
B) detail tie-in.
C) existence.
D) completeness.
Answer: D
Terms: Tests of details of balances
Difficulty: Moderate
Objective: LO 19-2
AACSB: Analytic thinking

20) The test of details of balances procedure to "examine vendors' invoices of closely related
accounts such as repairs to uncover items that should be property, plant, and equipment" satisfies
the audit objective of
A) completeness.
B) detail tie-in.
C) cutoff.
D) existence.
Answer: A
Terms: Test of details of balances; Audit objective
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

21) The auditor's starting point for verifying disposals of property, plant, and equipment is the
A) equipment account in the general ledger.
B) file of shipping documents.
C) client's schedule of recorded disposals.
D) equipment subsidiary ledger.
Answer: C
Terms: Disposals of property, plant, and equipment
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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22) Improperly classifying a fixed asset by recording the amount in the repairs and maintenance
expense account will have an effect on which of the following financial statements until the asset
would normally have been depreciated?
A) the balance sheet
B) the income statement
C) the cash flow statement
D) both the income statement and the balance sheet
Answer: D
Terms: Failure to capitalize a fixed asset
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

23) Because the failure to record disposals of property, plant, and equipment can significantly
affect the financial statements, the search for unrecorded disposals is essential. Which of the
following is not a procedure used to verify disposals?
A) Make inquiries of management and production personnel about the possibility of the disposal
of assets.
B) Review whether newly acquired assets replace existing assets.
C) Test the valuation of fixed assets recorded in prior periods.
D) Review plant modifications and changes in product line, property taxes, or insurance
coverage.
Answer: C
Terms: Unrecorded disposals of property, plant, and equipment
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

24) When the auditor is determining whether the client followed a consistent depreciation policy
from period to period, and the client's depreciation calculations are correct, the balance-related
audit objective of ________ is being determined for depreciation expense.
A) completeness
B) existence
C) classification
D) accuracy
Answer: D
Terms: Determining appropriate depreciation calculations; Testing audit objective
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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25) A major consideration in verifying the ending balance in fixed assets is the possibility of
existing legal encumbrances. Tests to identify possible legal encumbrances would satisfy the
audit objective of
A) existence.
B) presentation and disclosure.
C) detail tie-in.
D) classification.
Answer: B
Terms: Tests to identify legal encumbrances
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

26) When auditing depreciation expense, the two major concerns related to the accuracy audit
objective are
A) consistent application of depreciation method and useful lives.
B) consistent application of depreciation method and classification of assets.
C) correctness of calculations and consistent application of depreciation policies.
D) cost of the fixed asset and useful lives.
Answer: C
Terms: Auditing depreciation expense
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

27) The auditor needs to gain reasonable assurance that the equipment accounts in the fixed asset
master file are not understated. Which of the following accounts would most likely be reviewed
in making that determination?
A) depreciation expense
B) repairs and maintenance expense
C) gains/losses on sales and retirements
D) cash
Answer: B
Terms: Reasonable assurance that equipment accounts in the fixed asset master file are not
understated
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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28) Changing circumstances may require a change in the useful life of an asset. When this
occurs, it involves a change in
A) accounting estimate rather than a change in accounting principle.
B) accounting principle rather than a change in accounting estimate.
C) both accounting principle and accounting estimate.
D) neither accounting principle nor accounting estimate.
Answer: A
Terms: Change in useful life of an asset
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

29) The auditor normally does not need to test the accuracy or classification of fixed assets
recorded in prior periods if they are the continuing auditor because
A) they are rarely material to the audit.
B) they rarely contain misstatements.
C) they are verified in previous audits.
D) they don't affect the balance sheet.
Answer: C
Terms: Test accuracy or classification of fixed assets recorded in prior periods
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

30) The auditor is examining the accounting entries made to the accumulated depreciation
account during the year and notices a significant number and amounts of debits to the account.
Which of the following provides the most logical explanation?
A) large number of asset retirements
B) salvage values were revised downward
C) useful lives were revised downward
D) allocation of fixed overhead was revised
Answer: A
Terms: Accounting entries (debits) made to accumulated depreciation account
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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31) In determining the reasonableness of the client's amount for depreciation expense the auditor
is primarily concerned that the client has followed a consistent policy and the calculations are
correct. Which of the following audit objectives best addresses the above concerns?
A) existence
B) accuracy
C) valuation
D) allocation
Answer: B
Terms: Depreciation expense; Consistency policy and calculations are correct
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

32) Which of the following audit procedures would be least likely to lead the auditor to find an
unrecorded fixed asset disposal?
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
Answer: B
Terms: Unrecorded fixed asset disposal
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

33) The most common audit test to verify equipment additions is to

A) examine vendors' invoices.
B) perform an inventory of the fixed assets.
C) confirm the additions with the vendors.
D) trace the vendor invoices to the cash disbursements journal.
Answer: A
Terms: Equipment additions; audit procedures
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

34) The auditor is testing for unrecorded retirements/disposals of equipment. Which of the
following audit procedures would the auditor most likely use?
A) Select items from the fixed asset master file and then physically locate them.
B) Examine the repairs and maintenance amount for large debits.
C) Compare current year's depreciation expense with the previous year's depreciation expense.
D) Trace acquisition documents to the fixed asset master file.
Answer: A
Terms: Testing for unrecorded retirements/disposals of equipment
Difficulty: Challenging
Objective: LO 19-2
AACSB: Analytic thinking
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35) The failure to capitalize a permanent asset, or the recording of an asset acquisition at the
improper amount, affects the balance sheet
A) forever.
B) for the current period.
C) for the depreciable life of the asset.
D) until the firm disposes of the asset.
Answer: D
Terms: Failure to capitalize a permanent asset; Recording of an asset acquisition at improper
amount
Difficulty: Moderate
Objective: LO 19-2
AACSB: Analytic thinking

36) One of the primary objectives in examining the repairs and maintenance accounts is to obtain
evidence that
A) expenditures of equipment have not been charged to expense.
B) the actual amount recorded is the same as the budgeted amount.
C) expenditures for equipment have been recorded in the proper period.
D) revenue expenditures made on behalf of equipment have been recorded in the proper period.
Answer: A
Terms: Primary objective in examining repairs and maintenance accounts
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

37) The auditor's main objectives in the verification of the sale, trade-in, or abandonment of
equipment are to gather sufficient appropriate evidence that all disposals are ________ and at the
________.
A) verified; historical cost
B) recorded; correct amounts
C) accurate; proper gain or loss amount
D) classified properly; net realizable value
Answer: B
Terms: Equipment disposals; audit procedures
Difficulty: Moderate
Objective: LO 19-2
AACSB: Analytic thinking

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38) Which of the following explanations might satisfy an auditor who discovers significant
debits to an accumulated depreciation account?
A) Extraordinary repairs have lengthened the life of an asset.
B) Prior years' depreciation charges were erroneously understated.
C) A reserve for possible loss on retirement has been recorded.
D) An asset has been recorded at its fair value.
Answer: A
Terms: Significant debits to accumulated depreciation account
Difficulty: Challenging
Objective: LO 19-2
AACSB: Analytic thinking

39) Which of the following is not one of the reasons auditors verify equipment differently from
current asset accounts?
A) There are usually fewer current period acquisitions of equipment.
B) The amount of any given acquisition is often material.
C) The equipment is likely to be kept and maintained in the accounting records for several years.
D) Current assets are subject to liens and encumbrances while equipment is not.
Answer: D
Terms: Acquisition and payment cycle; Current assets and equipment
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

40) Which of the following information would not be included, generally, in a fixed asset master
file for a piece of equipment?
A) disposal of the equipment during the year
B) copy of the supplier's sales proposal for the equipment
C) date of acquisition of the equipment
D) accumulated depreciation for the equipment
Answer: B
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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41) Auditors verify and emphasize current additions of equipment. Which of the following is not
a reason for this verification and emphasis?
A) The amount of any given acquisition is often material.
B) The equipment is likely to be kept and maintained in the accounting records for several years.
C) There are usually fewer current period acquisitions of equipment, especially large equipment
used in manufacturing.
D) The balance carried forward in the equipment account from the previous year is important.
Answer: D
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

42) One of the auditor's primary objectives when auditing manufacturing equipment is
completeness.
Answer: TRUE
Terms: Primary objective in auditing equipment; Completeness
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

43) Completeness and existence are the auditor's primary objectives in auditing manufacturing
equipment.
Answer: TRUE
Terms: Completeness and existence; Primary objectives in auditing equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

44) The primary characteristic that distinguishes property, plant, and equipment from inventory,
prepaid expenses, and investments is the intention to use property, plant, and equipment as a part
of the operations of the client's business over their expected life.
Answer: TRUE
Terms: Primary characteristic of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

45) The emphasis in auditing manufacturing equipment is on the verification of current-period

disposals and acquisitions.
Answer: TRUE
Terms: Auditing equipment; Current-period disposals and acquisitions
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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46) The starting point for the verification of current-year acquisitions of property, plant, and
equipment is normally a client-prepared schedule of all acquisitions recorded in the general
ledger during the year.
Answer: TRUE
Terms: Verification of acquisitions; Client-prepared schedule of acquisitions
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

47) Depreciation amounts are determined by exchange transactions with outside parties.
Answer: FALSE
Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests
of transactions
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

48) Depreciation expense is normally verified as a part of tests of details of balances rather than
as part of tests of controls or substantive tests of transactions.
Answer: TRUE
Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests
of transactions
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

49) The most important audit objective for depreciation expense is detail tie-in.
Answer: FALSE
Terms: Audit objective for depreciation expense
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

50) One of the reasons that auditors verify equipment differently from current assets is the
amount of any given equipment acquisition is often material.
Answer: TRUE
Terms: Auditing current year acquisitions
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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51) The transportation and installation costs for a piece of equipment should be charged to an
expense account.
Answer: FALSE
Terms: Equipment additions; audit procedures
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

52) The auditor's tests for proper cutoff of current year acquisitions of property, plant, and
equipment are usually done as part of accounts payable cutoff tests.
Answer: TRUE
Terms: Cutoff of acquisitions; Accounts payable cutoff tests
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

53) The company's choices for determining the fixed asset's useful life and residual value impact
the amount of depreciation recorded.
Answer: TRUE
Terms: Asset's useful life and residual value; Impact depreciation recorded
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

54) The audit procedure "foot the schedule of fixed assets acquisitions and trace the total to the
general ledger" relates most closely to the completeness objective for fixed assets acquisitions.
Answer: FALSE
Terms: Audit procedure for completeness objective
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

55) Confirmations are commonly used to verify additions of property, plant, and equipment.
Answer: FALSE
Terms: Confirmations to verify additions
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

56) One very useful method of auditing depreciation is to use an analytical procedure to test for
reasonableness.
Answer: TRUE
Terms: Auditing depreciation; Analytical procedures to test for reasonableness
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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57) The approach to auditing patents and copyrights is similar to that used for property, plant,
and equipment accounts.
Answer: TRUE
Terms: Auditing patents and copyrights
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

58) Recording an acquisition of a fixed asset at an improper amount affects the balance sheet
until the company disposes of the asset, but the income statement is not affected.
Answer: FALSE
Terms: Recording acquisition at improper amount
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

59) Ordinarily, if you are auditing a continuing client, it is unnecessary to test the accuracy
objective or the classification objective for fixed assets acquired in prior years.
Answer: TRUE
Terms: Accuracy objective; Classification objective; Fixed assets in prior years
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

60) When auditing acquisitions of property, plant, and equipment, the auditor's review of lease
and rental agreements most closely relate to the cutoff objective.
Answer: FALSE
Terms: Auditing acquisitions; Lease and rental agreements; Cutoff objective
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

61) Performance materiality is important for verifying current year additions because these
transactions have consistent dollar amounts from year to year.
Answer: FALSE
Terms: Performance materiality
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

62) Property, plant, and equipment are assets that have expected lives of less than one year, are
used in the business, and are not acquired for resale.
Answer: FALSE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking
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63) The intent to use property, plant, and equipment as part of the operations of a client's
business is a significant characteristic that differentiates these assets from other assets like
inventory and prepaid expenses.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

64) Generally, in most situations, the audits of property, plant, and equipment accounts are
similar.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

65) Equipment additions which are infrequent in occurrence and large in dollar amounts, which
were included as part of the tests of the acquisition and payment cycle, allow the auditor to rely
heavily on the results of such tests.
Answer: FALSE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

66) In the audit of equipment and related accounts, verifying that the ending balances are
properly classified and are adequately disclosed in the financial statements is one of the tests the
auditor must perform.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

67) A balance-related audit objective in property, plant, and equipment includes the proper
classification of these assets on the balance sheets. The auditor should therefore examine
vendors' invoices in various property, plant, and equipment accounts to ensure that such invoices
are classified, properly, as building, manufacturing, office equipment, or repairs.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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68) In the audit of property, plant, and equipment, auditors need to examine if the client has the
right to record these assets as assets on the balance sheet. The auditor needs to examine any lease
agreements associated with these assets to determine if the lease qualifies as a finance or an
operating lease.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

69) Auditors needs to examine purchase and/or lease contracts entered into related to property,
plant, and equipment, to determine if capitalization of the property, plant, and equipment is
appropriate or not.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

70) Using audit software to foot the equipment master file and agreeing the master file total to
the general ledger is generally sufficient when verifying the ending balance of the equipment
account.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

71) Equipment on hand which is no longer used in operations but which the auditor has
physically verified as being in existence does not need to be evaluated for potential impairment.
Answer: FALSE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

72) A long-lived asset that is classified as held for sale is measured at the lower of the carrying
value or fair value less the cost to sell, and should be presented, separately, in the financial
statements if material.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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73) The auditor's knowledge of the client's business is important when auditing management's
judgements in evaluating whether a long-lived asset is impaired or not, including estimating fair
value of these assets.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

74) If management hires a specialist to estimate the fair value of a long-lived asset, the auditor
should take appropriate steps as required by auditing standards in evaluating the work of the
specialist
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

75) The auditor can rely on the combination of management's estimates of fair value estimates
and any associated impairment write downs that result to long-lived assets, when required,
combined with the opinion of the specialist hired by management in auditing management's
estimates and write downs.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

76) It is important that the auditor use various data analytics techniques in testing the entire
population of fixed assets and related depreciation.
Answer: TRUE
Terms: Audit of property, plant, and equipment
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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77) The primary accounting record for property, plant, and equipment accounts is the fixed asset
master file. What is included for each fixed asset in the master file?
Answer:
• description of the asset
• date of acquisition
• original cost
• current year depreciation
• accumulated depreciation for the asset
Terms: Included for each fixed asset in the master file
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

78) The auditor receives the client's schedule of recorded disposals and then performs detail tie-
in tests of the recorded disposals schedule. What procedures does the auditor perform on the
client's schedule of recorded disposals?
Answer:
• footing the schedule
• tracing the totals on the schedule to the recorded disposals in the general ledger
• tracing the cost and accumulated depreciation of the disposals to the property master file
Terms: Procedures performed on client's schedule of recorded disposals
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

79) In auditing depreciation expense, one of the auditor's concerns is determining that the client's
calculations are correct. In making this determination, the auditor must weigh four
considerations. List these four considerations.
Answer:
1. the useful life of current period acquisitions
2. the method of depreciation
3. the estimated salvage value
4. the policy of depreciating assets in the year of acquisition and disposition
Terms: Auditing depreciation expense; Determining client calculations are correct
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

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80) In testing acquisitions, the auditor must understand the relevant accounting standards to
insure the client adheres to accepted accounting practices for property, plant, and equipment.
Describe three of the auditor's concerns in this area.
Answer: (Answers may vary.)
• inclusion of material transportation and installation costs as part of the asset's acquisition cost
• failure to properly record the trade-in of existing equipment
• client's capitalization policy to determine whether acquisitions are treated consistently with
those of the preceding year
• examine whether the client has the right to record the equipment as an asset (Capitalization of
leased equipment or classification of the equipment as an operating lease)
• Correct classification among various equipment accounts
• Improper inclusion of transactions that should be recorded as assets in repairs and
maintenance expense, lease expense, supplies, small tools, and similar accounts
Terms: Acquisition and payment cycle
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

81) Property, plant, and equipment is normally audited in a different manner than current asset
accounts. State three reasons why this is so, and discuss the differences in how property, plant,
and equipment is audited compared to current assets.
Answer:
• There are usually fewer current period acquisitions of property, plant, and equipment than
current assets.
• The amount of any given acquisition is often material.
• The equipment is likely to be kept and maintained in the accounting records for several years.

Because of these three differences, the emphasis in auditing property, plant, and equipment is on
the verification of current period acquisitions rather than on the balance in the account carried
forward from the preceding year. In addition, the expected life of assets over one year requires
depreciation expense and accumulated depreciation accounts, which are verified as a part of the
audit of the assets.
Terms: Audit of property, plant, and equipment
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

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82) State four of the seven specific balance-related audit objectives for property, plant, and
equipment additions and, for each objective, describe one common test of details of balances.
Answer:
• Current-year acquisitions in the acquisitions schedule agree with related master file amounts,
and the total agrees with the general ledger (detail tie-in). (1) Foot the acquisitions schedule, (2)
trace the individual acquisitions to the master file for amounts and descriptions, and (3) trace the
total to the general ledger.
• Current-year acquisitions as listed exist (existence). (1) Examine vendors' invoices and
receiving reports and (2) physically examine assets.
• Existing acquisitions are recorded (completeness). (1) Examine vendors' invoices of closely
related accounts such as repairs and maintenance to uncover items that should be recorded as
equipment, and (2) review lease and rental agreements.
• Current-year acquisitions as listed are accurate (accuracy). Examine vendors' invoices.
• Current-year acquisitions as listed are correctly classified (classification). (1) Examine
vendors' invoices in various equipment accounts to uncover items that should be classified as
manufacturing or office equipment, part of buildings, or repairs, (2) examine vendors' invoices of
closely related accounts such as repairs to uncover items that should be recorded as equipment,
and (3) examine rent and lease expense for capitalizable leases.
• Current-year acquisitions are recorded in the correct period (cutoff). Review transactions
near the balance sheet date for correct period.
• The client has rights to current-year acquisitions (rights). Examine vendors' invoices.
Terms: Balance-related audit objectives for property, plant, and equipment; Test of details of
balances
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

83) When auditing disposals of property, plant, and equipment, the search for unrecorded
disposals is essential. State the four audit procedures frequently used for verifying disposals.
Answer:
• Review whether newly acquired assets replace existing assets.
• Analyze gains and losses on the disposal of assets and miscellaneous income for receipts from
the disposal of assets.
• Review plant modifications and changes in product lines, changes in major costly computer-
related equipment, property taxes, or insurance coverage for indications of deletions of
equipment.
• Make inquiries of management and production personnel about the possibility of the disposal
of assets.
Terms: Audit procedures for verifying disposals
Difficulty: Challenging
Objective: LO 19-2
AACSB: Reflective thinking

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84) Discuss the key internal controls related to the disposal of property, plant, and equipment.
Answer: The most important internal control over the disposal of property, plant, and equipment
is the existence of a formal method to inform management of the sale, trade-in, abandonment, or
theft of recorded machinery and equipment. Formal methods of tracking disposals and provisions
for proper authorization of the sale or other disposal of equipment help reduce the risk of
misstatement. There should also be adequate internal verification of recorded disposals to make
sure that assets are correctly removed from the accounting records. The client should periodically
take an inventory of fixed assets to identify assets that have been lost or stolen.
Terms: Equipment disposals; audit procedures
Difficulty: Easy
Objective: LO 19-2
AACSB: Reflective thinking

85) State four of the seven specific balance-related audit objectives which the auditor should use
as a frame of reference for tests of property, plant, and equipment acquisitions.
Answer: Existence; Completeness; Accuracy; Cutoff; Detail Tie-In; Rights and Obligations; and
Classification
Terms: Audit of property, plant, and equipment
Difficulty: Moderate
Objective: LO 19-2
AACSB: Reflective thinking

19.3 Learning Objective 19-3

1) Which of the following accounts would normally not be a part of the acquisition and payment
cycle of prepaid insurance?
A) cash
B) insurance payable
C) insurance expense
D) prepaid insurance
Answer: B
Terms: Acquisition and payment cycle; Current assets and equipment
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

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2) Which type of audit procedure would normally be sufficient for purposes of auditing prepaid
expenses and deferred charges?
A) tests of controls
B) tests of transactions
C) tests of details of balances
D) substantive analytical procedures
Answer: D
Terms: Audit procedure for auditing prepaid expenses and deferred charges
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

3) When an auditor recomputes the unexpired portion of prepaid insurance, they are satisfying
which audit objective?
A) completeness
B) existence
C) accuracy and detail tie-in
D) rights
Answer: C
Terms: Audit objective; Recompute unexpired portion of prepaid insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

4) A record of insurance policies in force and the due date of each policy is contained in the
A) voucher register.
B) insurance register.
C) insurance expense account.
D) prepaid insurance account.
Answer: B
Terms: Record of insurance policies
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

5) Insurance expense for the period is a function of which of the following?

A) the beginning prepaid balance, current premium payments and the ending prepaid balance
B) the beginning prepaid balance and the current period premium payments
C) the current period premium payments
D) the current period premium payments and the ending prepaid balance
Answer: A
Terms: Insurance expense if a function of
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

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6) In connection with a review of the prepaid insurance account, which of the following audit
procedures would you be least likely to use?
A) Recompute the portion of the premium that expired during the year.
B) Prepare excerpts of insurance policies for audit working papers.
C) Confirm premium rates with an independent insurance broker.
D) Examine support for premium payments.
Answer: C
Terms: Prepaid insurance; Audit procedures
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

7) Controls over the acquisition and recording of insurance are a part of which of the following
transaction cycles?
A) inventory and warehousing cycle
B) capitalization cycle
C) treasury cycle
D) acquisition and payment cycle
Answer: D
Terms: Acquisition and recording of insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

8) Which balance-related audit objective is not relevant to an audit of prepaid expenses?

A) rights
B) accuracy
C) detail tie-in
D) realizable value
Answer: D
Terms: Balance-related audit objective for audit of prepaid expenses
Difficulty: Challenging
Objective: LO 19-3
AACSB: Reflective thinking

9) When auditing prepaid insurance,

A) for many audits, significant substantive procedures are needed if the control risk is low.
B) companies often have a standard monthly journal entry to reclassify prepaid insurance as
insurance expense.
C) the emphasis in the tests of details of balances is on insurance expense.
D) the auditor must prepare the insurance register.
Answer: B
Terms: Audit of prepaid insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

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10) The realizable value audit objective is not applicable when auditing prepaid insurance or
insurance expense.
Answer: TRUE
Terms: Auditing prepaid insurance and insurance expense; Realizable value
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

11) Problems commonly encountered in the audit of prepaid insurance are not typical of the
problems found in other prepaid assets.
Answer: FALSE
Terms: Audit of prepaid insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

12) Cutoff for acquisitions of insurance is normally not a significant problem for the auditors.
Answer: TRUE
Terms: Tests of cutoff objective for prepaid insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

13) When auditing insurance expense, auditors normally rely on analytical procedures and
limited testing of the debits to ensure that they arose from credits to prepaid insurance.
Answer: TRUE
Terms: Auditing insurance expense; Analytical procedures
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

14) The auditor should keep in mind that the amount in insurance expense is a residual amount.
Answer: TRUE
Terms: Acquisition and payment cycle
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

15) In determining whether goodwill should be tested for impairment, companies and their
management consider qualitative factors second, after performing a quantitative test for
impairment.
Answer: FALSE
Terms: Goodwill impairment testing
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

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16) Goodwill is often identified as a significant audit risk area by auditors and is likely to be a
critical audit matter disclosed in audit reports for companies with goodwill impairment(s).
Answer: TRUE
Terms: Goodwill impairment testing
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

17) The accounting rules related to goodwill impairment testing were recently changed by the
Financial Accounting Standards Board (FASB) simplifying, for auditor's, the process of auditing
management's estimates related to potential goodwill impairment.
Answer: FALSE
Terms: Goodwill impairment testing
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

18) For auditors, there is a significant amount of objectivity management must follow under
generally accepted accounting principles in preparing the analysis required for goodwill
impairment testing.
Answer: FALSE
Terms: Goodwill impairment testing
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

19) Describe the two tests auditors can perform to test for the existence and completeness of
insurance policies in force.
Answer: The verification of existence and tests for completeness of the insurance policies can be
tested in one of two ways: by examining a sample of insurance invoices and policies in force for
comparison to the schedule, or by obtaining a confirmation of insurance information from the
company's insurance agent.
Terms: Verification of existence and tests for omissions of insurance policies
Difficulty: Easy
Objective: LO 19-3
AACSB: Reflective thinking

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20) What are several substantive analytical procedures used in the audit of prepaid insurance and
insurance expense?
Answer:
1. Compare total prepaid insurance and insurance expense with previous years.
2. Compute the ratio of prepaid insurance to insurance expense and compare it with previous
years.
3. Compare the individual insurance policy coverage on the schedule of insurance obtained
from the client with the preceding year's schedule as a test of elimination of certain policies or a
change in insurance coverage.
4. Compare the computed prepaid insurance balance for the current year on a policy-by-policy
basis with that of the preceding year as a test of an error in the calculation.
5. Review the insurance coverage listed on the prepaid insurance schedule with an appropriate
client official or insurance broker for adequacy of coverage.
Terms: Analytical procedures in the audit of prepaid insurance and insurance expense
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

21) Describe the audit procedures used to verify the accuracy and detail tie-in objectives for
prepaid insurance.
Answer: The accuracy objective is tested by verifying the amount of the insurance premium, the
length of the policy period, and the allocation of the premium to unexpired insurance. The
amount of the premium for a given policy and its time period can be verified at the same time by
examining the premium invoice or the confirmation from an insurance agent. After these two
have been verified, the client's calculations of unexpired insurance can be tested by recalculation.
The schedule of prepaid insurance can then be footed and the totals traced to the general ledger
to complete the detail tie-in tests.
Terms: Audit procedures to verify accuracy and detail tie-in objectives for prepaid insurance
Difficulty: Moderate
Objective: LO 19-3
AACSB: Reflective thinking

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22) Discuss the key internal controls for prepaid insurance that affect the auditor's extent of
testing of the prepaid insurance account.
Answer: Internal controls for prepaid insurance and insurance expense can be conveniently
divided into three categories: controls over the acquisition and recording of insurance, controls
over the insurance register, and controls over the charge-off of insurance expense. Controls over
the acquisition and recording of insurance are a part of the acquisition and payment cycle and
include proper authorization for new insurance policies and payment of insurance premiums.

An insurance register, which is a record of insurance policies in force and the expiration date of
each policy, is an essential control which auditors use to identify policies in force related to
prepaid insurance accounts. Because the terms and amounts contained in the register provide the
basis for determining prepaid insurance amounts, the auditor independently verifies these terms
and amounts to the underlying insurance policies or contracts.

Companies often have a closely related control which is to have a standard monthly journal entry
to reclassify prepaid insurance as insurance expense.
Terms: Key internal controls for prepaid insurance
Difficulty: Challenging
Objective: LO 19-3
AACSB: Reflective thinking

19.4 Learning Objective 19-4

1) When auditing accrued property taxes,

A) the source for the debits to the liability account is the acquisitions journal.
B) realizable value is an important balance-related audit objective.
C) the ending balance in the account should be confirmed with the applicable taxing authority.
D) the most important consideration for the auditor is that the same portion of each tax payment
for the accrual that was used in the preceding year is used in the current year.
Answer: D
Terms: Audit of accrued liabilities
Difficulty: Moderate
Objective: LO 19-4
AACSB: Reflective thinking

2) The estimated unpaid obligations for services or benefits that have been received before the
balance sheet date are
A) accounts payable.
B) accounts receivable.
C) unearned liabilities.
D) accrued liabilities.
Answer: D
Terms: Audit of accrued liabilities
Difficulty: Moderate
Objective: LO 19-4
AACSB: Reflective thinking

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3) When auditors verify accrued property taxes, two audit objectives are especially significant.
These are
A) completeness and accuracy.
B) completeness and net realizable value.
C) detail tie-in and completeness.
D) accuracy and classification.
Answer: A
Terms: Accrued property taxes; Audit objectives
Difficulty: Moderate
Objective: LO 19-4
AACSB: Reflective thinking

4) When auditing accrued property taxes,

A) the auditors will generally only verify the larger payments since there are usually many
property tax payments.
B) property taxes should only be charged to one expense account.
C) the auditor begins by obtaining a schedule of property tax payments from the client.
D) the auditor must generally spend a considerable amount of time in this area.
Answer: C
Terms: Property tax expense
Difficulty: Moderate
Objective: LO 19-4
AACSB: Reflective thinking

5) Auditors verify the accruals before they verify the current year property tax payments.
Answer: FALSE
Terms: Audit of accrued property taxes
Difficulty: Easy
Objective: LO 19-4
AACSB: Reflective thinking

6) After the accrual and property tax expense for each piece of property has been recalculated,
the totals are added and compared with the general ledger.
Answer: TRUE
Terms: Audit of accrued property taxes
Difficulty: Moderate
Objective: LO 19-4
AACSB: Reflective thinking

7) In the audit of accrued property taxes, the two most important balance-related audit objectives
are completeness and accuracy.
Answer: TRUE
Terms: Audit of accrued property taxes
Difficulty: Challenging
Objective: LO 19-4
AACSB: Reflective thinking

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19.5 Learning Objective 19-5

1) Which of the following audit tests both have the effect of simultaneously verifying balance
sheet and income statement accounts?
A) analytical procedures and substantive tests of transactions
B) tests of controls and substantive tests of transactions
C) tests of details of balances and substantive tests of transactions
D) tests of controls and analytical procedures
Answer: B
Terms: Audit tests that have effect simultaneously verifying balance sheet and income statement
accounts
Difficulty: Challenging
Objective: LO 19-5
AACSB: Analytic thinking

2) The most effective and efficient audit approach in the examination of the income statement
would be which of the following?
A) Examine income statement accounts concurrently with the related balance sheet accounts.
B) Compare company's components of net income to other businesses in the same industry.
C) Compare company's components of net income to the previous two years.
D) Examine changes in all balance sheet accounts.
Answer: A
Terms: Effective and efficient audit approach in examination of the income statement
Difficulty: Challenging
Objective: LO 19-5
AACSB: Reflective thinking

3) The auditor needs to be aware that most users of financial statements rely most heavily on the
________ for making decisions.
A) balance sheet
B) income statement
C) statement of cash flows
D) statement of stockholders' equity
Answer: B
Terms: Audit of income and expense accounts
Difficulty: Moderate
Objective: LO 19-5
AACSB: Analytic thinking

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4) ________ expense is rarely analyzed unless analytical procedures indicate high potential for
material misstatement.
A) Repairs and maintenance
B) Legal
C) Utilities
D) Rent and lease
Answer: C
Terms: Audit of income and expense accounts
Difficulty: Moderate
Objective: LO 19-5
AACSB: Reflective thinking

5) In the analysis of expense accounts, the auditor verifies transactions in specific accounts to
determine whether the transactions are properly classified and accurately recorded.
Answer: TRUE
Terms: Audit of income and expense accounts
Difficulty: Moderate
Objective: LO 19-5
AACSB: Reflective thinking

6) Depreciation expense results from the allocation of accounting data rather than discrete
transactions.
Answer: TRUE
Terms: Tests of details of balances; allocation
Difficulty: Moderate
Objective: LO 19-5
AACSB: Reflective thinking

7) Tests of controls provide an indication of the likelihood of misstatements in both the income
statement and the balance sheet, simultaneously.
Answer: TRUE
Terms: Tests of controls; Misstatements in income statement and balance sheet
Difficulty: Moderate
Objective: LO 19-5
AACSB: Reflective thinking

8) Typically, analytical procedures are the primary means of verifying income statement
accounts resulting from allocations.
Answer: TRUE
Terms: Analytical procedures; Verifying income statement accounts resulting from allocations
Difficulty: Challenging
Objective: LO 19-5
AACSB: Reflective thinking

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9) Explain the audit objective allocation and why it is important to have accurate allocation
within the financial statements, particularly for property, plant, and equipment.
Answer: Several expense accounts result from the allocation of accounting data rather than
discrete transactions. Such expenses include depreciation, depletion, and the amortization of
copyrights and trademark costs. The allocation of manufacturing overhead between inventory
and cost of goods sold is an example of another type of allocation that affects expenses.

Allocations are important because they determine whether an expenditure is an asset or current
period expense. If the client fails to follow accounting standards or fails to calculate the
allocation correctly, then financial statements can be materially misstated.
Terms: Allocation within financial statements
Difficulty: Moderate
Objective: LO 19-5
AACSB: Reflective thinking

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Auditing and Assurance Services, 17e (Arens/Elder/Beasley)

Chapter 23 Audit of Cash and Financial Instruments

23.1 Learning Objective 23-1

1) Which of the following is not a "cash equivalent"?

A) time deposits
B) certificates of deposit
C) money market funds
D) marketable securities
Answer: D
Terms: Cash equivalent
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

2) An imprest petty cash fund would least likely be used to pay for which of the following
items?
A) minor office supplies
B) monthly interest expense
C) stamps for small mailings
D) small contributions to a local charity
Answer: B
Terms: Imprest petty cash fund
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

3) An imprest petty cash fund

A) is a bank account.
B) is used for large, unusual purchases.
C) is usually reimbursed at least once a week for good internal control.
D) is being replaced by pre-approved purchase cards in many companies.
Answer: D
Terms: Examination of imprest petty cash fund
Difficulty: Moderate
Objective: LO 23-1
AACSB: Analytic thinking

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4) Financial instruments
A) include debt securities and money market funds.
B) such as derivatives can be used as a way of hedging.
C) must be classified as held-to-maturity securities.
D) All of the above are correct.
Answer: B
Terms: Financial instruments
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

5) Companies may purchase marketable securities as a way to temporarily invest excess cash.
Answer: TRUE
Terms: Financial instruments
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

6) Examples of cash equivalents include time deposits, certificates of deposit, and marketable
securities.
Answer: FALSE
Terms: Cash equivalent
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

7) Branch bank accounts are useful for building banking relations in local communities.
Answer: TRUE
Terms: Types of cash accounts
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

8) Cash is the only account included in every cycle except inventory and warehousing.
Answer: TRUE
Terms: Cash accounts
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

9) The evidence accumulated for cash balances depends heavily on the results of tests performed
in the other major transaction cycles.
Answer: TRUE
Terms: Cash accounts
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking
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10) Cash is important because of its susceptibility to theft, and cash can be significantly
misstated as illustrated in the China Media Express case.
Answer: TRUE
Terms: Cash accounts
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

11) Financial instruments, which include investments in debt and equity securities as well as
derivative instruments, vary in significance across audit clients.
Answer: TRUE
Terms: Types of cash accounts
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

12) A growing number of organizations, especially larger organizations, use pre-approved V-

cards to make miscellaneous purchases instead of maintaining a petty cash fund.
Answer: FALSE
Terms: P-cards (purchasing cards) usage
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

13) Consistent with financial accounting standards, equity investments are normally recorded at
cost until they are disposed of in the future.
Answer: FALSE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

14) Debt instruments can be classified as trading securities, available-for-sale securities, or held-
to-maturity securities; auditors should ensure that such debt instruments are classified, properly,
in the financial statements consistent with accounting standards.
Answer: TRUE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-1
AACSB: Reflective thinking

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15) Describe each of the major types of cash accounts maintained by business entities.
Answer:
• General cash account. This is the focal point of cash for most organizations because virtually
all cash receipts and disbursements flow through this account.
• Imprest payroll account. As a means of improving internal control, many companies establish
a separate imprest bank account for making payroll payments to employees. In such an account,
a fixed balance, such as $1,000, is maintained. Immediately before each pay period, one check or
electronic transfer is drawn on the general cash account to deposit the total amount of the net
payroll in the imprest payroll account.
• Branch bank account. For a company operating in multiple locations or having different
company branches, it is often desirable to have a separate bank balance at each location. Branch
bank accounts are useful for building public relations in local communities and permitting the
centralization of operations at the branch level.
• Imprest petty cash fund. This fund is used for small cash acquisitions that can be paid more
conveniently and quickly by cash than by check, or for the convenience of employees in cashing
personal or payroll checks.
• Cash equivalents. Excess cash accumulated during certain parts of the operating cycle that
will be needed in the reasonably near future is often invested in short-term, highly liquid cash
equivalents such as time deposits, certificates of deposit, and money market funds.
Terms: Major types of cash accounts
Difficulty: Moderate
Objective: LO 23-1
AACSB: Reflective thinking

23.2 Learning Objective 23-2

1) Which of the following misstatements is most likely to be uncovered during an audit of a

client's bank reconciliation?
A) duplicate payment of a vendor's invoice
B) billing a customer at a lower price than indicated by company policy
C) failure to record a collection of a note receivable by the bank on the client's behalf
D) payment to an employee for more than the hours actually worked
Answer: C
Terms: Bank reconciliation
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

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2) Which of the following is likely to be detected as part of the audit of the bank reconciliation?
A) failure to bill a customer
B) duplicate payment of a vendor invoice
C) cash received by the client after year-end, but included in cash receipts in the current year
D) an embezzlement of cash by intercepting cash receipts from customers before they are
recorded
Answer: C
Terms: Bank reconciliation
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

3) Which of the following would normally be discovered as part of the audit of the bank
reconciliation?
A) failure to bill a customer
B) failure to include a deposit in transit on the bank reconciliation
C) duplicate payment of a vendor's invoice
D) payment to an employee for more hours than she or he worked
Answer: B
Terms: Bank reconciliation
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

4) The general cash account is considered a significant account in almost all audits
A) where the ending balance is material.
B) even when the ending balance is immaterial.
C) except those of not-for-profit organizations.
D) where either the beginning or ending balance is material.
Answer: B
Terms: General cash account
Difficulty: Moderate
Objective: LO 23-2
AACSB: Reflective thinking

5) Which of the following is an accurate statement regarding cash?

A) The amount of cash flowing into and out of the cash account is often larger than that for any
other account in the financial statements.
B) The susceptibility of cash to embezzlement is greater than that for other types of assets.
C) Auditors must verify whether recorded cash in the general ledger correctly reflects all cash
transactions that took place during the year.
D) All of the above are accurate statements.
Answer: D
Terms: Cash in bank
Difficulty: Moderate
Objective: LO 23-2
AACSB: Reflective thinking
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6) Which of the following cycles does not affect cash in bank?

A) capital acquisitions cycle
B) inventory and warehousing
C) payroll and personnel cycle
D) acquisitions and disbursements
Answer: B
Terms: Cash in bank
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

7) The general cash account will not be audited if the ending balance is immaterial.
Answer: FALSE
Terms: Cash in bank
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

8) List at least three misstatements that are designed to be detected by a bank reconciliation.
Answer:
1. Failure to include a check that has not cleared the bank on the outstanding checklist, even
though it has been recorded on the cash disbursement journal
2. Cash received by the client subsequent to the balance sheet date, but recorded as cash
receipts in the current year
3. Deposits recorded as cash receipts near the end of the year, deposited in the bank in the same
month, and included in the bank reconciliation as a deposit in transit
4. Payments on notes payable debited directly to the bank balance by the bank but not entered
in the client's records
Terms: Bank reconciliation audit tests; Detected misstatements
Difficulty: Easy
Objective: LO 23-2
AACSB: Reflective thinking

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9) "Failure to bill a customer" is an example of an error that results in the failure to receive cash,
but would not be discovered as part of the audit of the bank reconciliation. State three other
examples of errors or irregularities that result in the improper payment of, or failure to receive,
cash, but that would not be discovered during the audit of the bank reconciliation. How are these
types of misstatements normally uncovered in the audit?
Answer:
• An embezzlement of cash by intercepting cash receipts from customers before they are
recorded with the account charged off as a bad debt
• Duplicate payment of a vendor's invoice
• Improper payments of officers' personal expenditures
• Payment for raw materials that were not received
• Payment to an employee for more hours than he or she worked
• Payment of interest to a related party for an amount in excess of the going rate

If these misstatements are to be uncovered in the audit, their discovery must occur through tests
of controls and substantive tests of transactions.
Terms: Improper payment or failure to receive cash but not discovered during audit of bank
reconciliation
Difficulty: Challenging
Objective: LO 23-2
AACSB: Reflective thinking

23.3 Learning Objective 23-3

1) The test of details of balances procedure that requires the auditor to foot the outstanding check
and electronic payment list and deposits in transit is an attempt to satisfy which audit objective?
A) cutoff
B) presentation and disclosure
C) detail tie-in
D) completeness
Answer: C
Terms: Test of details of balances procedure
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

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2) The audit objective of determining that cash in bank, as stated on the reconciliation, foots
correctly and agrees with the general ledger can be tested by which of the following procedures?
A) performing tests for kiting
B) receiving and testing a cutoff bank statement
C) proving the bank reconciliation as to additions and subtractions, including all reconciling
items
D) examining the minutes of the board of directors for restrictions on the use of cash
Answer: C
Terms: Audit objective; Cash in bank; Reconciliation
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

3) The test of details of balances procedure that requires the auditor to trace the book balance on
the reconciliation to the general ledger is an attempt to satisfy the audit objective of
A) detail tie-in.
B) existence.
C) completeness.
D) accuracy.
Answer: A
Terms: Test details of balances procedure; Reconciliation
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

4) Which of the following statements is correct?

A) Auditors must obtain bank confirmations for audits of nonpublic entities.
B) Auditors are required to obtain bank confirmations under international auditing standards.
C) Auditing standards do not address specific requirements regarding bank confirmations.
D) Auditing standards do not require bank confirmations.
Answer: D
Terms: Bank confirmation
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

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5) A partial-period bank statement and the related copies of or digital access to cancelled checks,
duplicate deposit slips, and other documents included in bank statements, mailed by the bank
directly to the CPA firm's office, is called
A) a four-column proof of cash.
B) a year-end bank statement.
C) a cutoff bank statement.
D) a short-period bank statement.
Answer: C
Terms: Partial-period bank statement
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

6) Which of the following statements is correct?

A) Bank personnel are responsible for providing reasonable assurance that a response to a bank
confirmation is accurate.
B) Bank personnel are responsible for providing complete assurance that a bank confirmation is
complete.
C) Bank personnel are not responsible for searching their records for bank balances or loans
beyond those included on the bank confirmation.
D) Bank personnel are not responsible for providing information related to interest on the bank
confirmation.
Answer: C
Terms: Bank confirmation
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

7) In addition to confirming bank balances of your audit client, a bank confirmation would
normally contain
A) the client's bank loans with due date, interest rate, and collateral requested.
B) the client's credit history as regards to paying back loans.
C) the client's managements bank account information.
D) the client's business prospects.
Answer: A
Terms: Bank confirmation
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

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8) Which of the following balance-related audit objectives typically is assessed as having high
inherent risk for cash?
A) existence
B) cutoff
C) detail tie-in
D) presentation and disclosure
Answer: A
Terms: Balance-related audit objectives; High inherent risk for cash
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

9) Because cash is the most desirable asset for people to steal, it has a higher
A) control risk.
B) inherent risk.
C) detection risk.
D) liquidity risk.
Answer: B
Terms: Cash; Risk
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

10) The starting point for the verification of the balance in the general bank account is to obtain
A) a bank reconciliation from the client.
B) the client's cash account from the general ledger.
C) a cutoff bank statement directly from the bank.
D) the client's year-end bank statement.
Answer: A
Terms: Verification of balance in the general bank account
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

11) In an effort to satisfy the completeness objective, the auditor could perform which of the
following test of details of balance procedures?
A) Trace the book balance on the reconciliation to the general ledger.
B) Trace outstanding checks to subsequent period bank statements.
C) Perform a four-column proof of cash.
D) Review financial statements to make sure that material savings accounts and certificates of
deposit are disclosed separately.
Answer: C
Terms: Completeness objective; Test of details of balance procedures
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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12) The audit procedure which requires the auditor to record the last check number used on the
last day of the year and subsequently trace to the outstanding checks and the cash disbursements
records is performed to satisfy the audit objective of
A) detail tie-in.
B) existence.
C) completeness.
D) cutoff.
Answer: D
Terms: Audit procedure to record last check number used
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

13) The direct receipt of a confirmation from every bank with which the client does business is
A) required by auditing standards for every audit.
B) not necessary unless material fraud is suspected.
C) recommended but not required by auditing standards.
D) necessary for every audit except when there are an unusually large number of active accounts.
Answer: C
Terms: Direct receipt of confirmation from every bank
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

14) The reason for testing the client's bank reconciliation is to verify whether the client's
recorded bank balance is the same amount as the actual cash in bank, except for deposits in
transit, checks outstanding, and other reconciling items. The information needed to complete the
tests of the reconciliation is provided by the
A) client's records and ledgers for the year under audit.
B) cutoff bank statement.
C) client's records and ledgers for the subsequent year.
D) canceled checks for the year under audit.
Answer: B
Terms: Bank reconciliation; Deposits in transit; Outstanding checks
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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15) Which of the following items would not normally appear on bank reconciliations?
A) balance per bank
B) list of deposits in transit
C) outstanding deposits
D) outstanding checks
Answer: C
Terms: Bank reconciliation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

16) If a bank does not respond to a bank confirmation request, the auditor would most likely
A)
Perform alternative Send a second Ask the client to
procedures request communicate with the bank
to ask them to complete and
return the confirmation
No Yes Yes

B)
Perform alternative Send a second Ask the client to
procedures request communicate with the bank
to ask them to complete and
return the confirmation
No No Yes

C)
Perform alternative Send a second Ask the client to
procedures request communicate with the bank
to ask them to complete and
return the confirmation
Yes No Yes

D)
Perform alternative Send a second Ask the client to
procedures request communicate with the bank
to ask them to complete and
return the confirmation
Yes Yes No

Answer: A
Terms: Bank confirmation request
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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17) The most important balance-related audit objectives in the audit of cash include all except
which of the following?
A) existence
B) accuracy
C) completeness
D) occurrence
Answer: D
Terms: Balance-related audit objectives in the audit of cash
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

18) The bank reconciliation

A) must be done on a daily basis if the client uses electronic banking.
B) should be performed by someone independent of the handling or recording of cash receipts.
C) should be performed by someone who handles cash disbursements.
D) ensures that no cash has been embezzled.
Answer: B
Terms: Bank fraud protection tools
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

19) ________ is an automated fraud detection tool offered by most banks.

A) Positive pay
B) A bank confirmation
C) Fraud buster
D) Check matching
Answer: A
Terms: Bank reconciliation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Analytic thinking

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20) Which of the following balance-related objectives applies to auditing the general cash
account?
A)
Rights Classification Realizable value
Yes No Yes

B)
Rights Classification Realizable value
No Yes No

C)
Rights Classification Realizable value
Yes Yes Yes

D)
Rights Classification Realizable value
No No No

Answer: D
Terms: Balance-related objective applied to auditing the general cash account
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

21) The standard bank confirmation form has been agreed upon by the
A) SEC and FASB.
B) AICPA and the SEC.
C) SEC and the American Bankers' Association.
D) AICPA and the American Bankers' Association.
Answer: D
Terms: Standard bank confirmation
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

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22) The auditors test the client's monthly bank reconciliation to verify whether the client's
recorded bank balance is the same amount as the actual cash in the bank. Which of the following
would not explain a difference between the company's cash balance and the bank's balance for
the client?
A) deposits in transit
B) Checks are written by the client in the same month the checks clear the bank.
C) other reconciling items
D) outstanding checks
Answer: B
Terms: Bank reconciliation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

23) If an auditor waits until the subsequent period bank statement is available to verify
reconciling items, it is primarily a test for
A) errors.
B) omissions.
C) kiting.
D) intentional misstatements.
Answer: D
Terms: Auditor proves the bank statement
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

24) Which of the following verifications would generally not be performed by the auditor in the
month subsequent to the balance sheet date?
A) Foot the lists of all canceled checks, debit memos, deposits, and credit memos.
B) Verify the bank statement balances when the footed totals are used.
C) Verify the book statement balances tie to the cash receipts and disbursements journals for the
year under audit.
D) Review the items included in the footings to make sure that they were cancelled by the bank.
Answer: C
Terms: Verifications performed in the month subsequent to balance sheet date
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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25) When assessing risks affecting cash,

A) if a business defers preparing bank reconciliations for long periods, the value of the control is
reduced and may affect the auditor's assessment of control risk for cash.
B) most companies are likely to have significant client business risks affecting their cash
balances.
C) there is a low inherent risk for the existence and completeness objectives for cash.
D) all of the above are accurate statements.
Answer: A
Terms: Cash; Risk
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

26) Which of the following is not included in Phase I of the auditing of year-end general cash
balances?
A) Identify client business risks affecting cash.
B) Design and perform tests of controls and substantive tests of transactions.
C) Set performance materiality and assess inherent risk.
D) Assess control risk.
Answer: B
Terms: Methodology for auditing year-end cash
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

27) The bank reconciliation control is enhanced when a qualified employee reviews the monthly
reconciliation as soon as possible after its completion.
Answer: TRUE
Terms: Bank reconciliation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

28) Many of the auditor's audit procedures in the audit of cash center around the client's bank
confirmations.
Answer: FALSE
Terms: Audit of cash; Bank confirmations
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

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29) Tracing outstanding checks to subsequent period bank statements tests the cutoff audit
objective.
Answer: TRUE
Terms: Tracing outstanding checks; Cutoff audit objective
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

30) When auditing the year-end cash balance, one of the areas of focus is on the accuracy
objective.
Answer: TRUE
Terms: Auditing year-end cash balance; Accuracy objective
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

31) The three most important audit objectives for cash are accuracy, existence, and classification.
Answer: FALSE
Terms: Audit objectives for cash
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

32) The starting point for the verification of the balance in the general bank account is to obtain a
bank cut-off statement.
Answer: FALSE
Terms: General bank account; Bank cut-off statement
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

33) When auditing the general cash account, receipt of a standard bank confirmation is the
starting point for verifying the company's general cash account balance.
Answer: FALSE
Terms: General cash account; Standard bank confirmation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

34) To test the client's list of outstanding checks on the bank reconciliation for completeness, the
auditor should trace from the list to the checks included with the cutoff bank statement.
Answer: FALSE
Terms: Outstanding checks on bank reconciliation for completeness; Cutoff bank statement
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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35) The client may mail the bank confirmation requests if the auditor believes doing so will
increase the likelihood that the confirmation will be returned promptly.
Answer: FALSE
Terms: Bank confirmation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

36) Auditors usually design bank confirmations that address the client's specific circumstances.
Answer: FALSE
Terms: Bank confirmation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

37) Ordinarily, all deposits-in-transit listed on the year-end bank reconciliation should appear as
deposits on the cutoff bank statement.
Answer: TRUE
Terms: Deposits-in-transit; Year-end bank reconciliation; Cutoff bank statement
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

38) Auditors are not always required to obtain bank confirmations.

Answer: TRUE
Terms: Bank confirmation
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

39) The auditor is generally concerned about the realizable value and the rights to cash.
Answer: FALSE
Terms: Audit of cash
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

40) A statement near the bottom of the standard bank confirmation form requires the bank to
inform auditors of open lines of credit and compensating balance requirements.
Answer: FALSE
Terms: Bank confirmation
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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41) The methodology for auditing year-end cash is generally the same as the auditing for all
other balance sheet accounts.
Answer: TRUE
Terms: Audit objectives of the general cash account
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

42) A monthly bank reconciliation of the general bank account on a timely basis by someone
involved in either the handling or the recording of cash receipts and disbursements is an essential
control over the ending cash balance.
Answer: FALSE
Terms: Importance of monthly bank reconciliation and separation of duties
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

43) Positive pay reduces potential check fraud by matching account number, check number, and
dollar amounts of each check presented for payment against the electronic records of checks
provided by the company.
Answer: TRUE
Terms: Positive pay reducing check fraud
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

44) The presentation of cash in the financial statements is normal straight-forward unless
restrictions on cash or compensating balance agreements with a bank exist.
Answer: TRUE
Terms: Presentation of cash in the financial statements
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

45) A common test of details the auditor should perform with regards to determining if cash is
appropriately described and presented in the financial statements is to review the Board of
Director minutes and loan agreements for any restrictions on cash.
Answer: TRUE
Terms: Positive pay reducing check fraud
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

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46) Internal controls over year-end cash balances in the general account can be divided into two
categories. List the two below.
Answer:
1. controls over the transaction cycles affecting the recording of cash receipts and cash
disbursements
2. independent bank reconciliations
Terms: Internal controls over year-end cash balances
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

47) Explain what is meant by a cutoff bank statement, and discuss the purpose of the cutoff bank
statement in the audit of cash.
Answer: A cutoff bank statement is a partial-period bank statement and the related copies of or
digital access to cancelled checks, duplicate deposit slips, and other documents included in bank
statements, mailed by the bank directly to the CPA firm's office or through online access to the
bank's electronic records of the client's bank account information. The purpose of the cutoff bank
statement or electronic access to account information on the bank's system is to verify the
reconciling items on the client's year-end bank reconciliation with evidence that is maintained by
the bank, not the client.
Terms: Cutoff bank statement; Audit of cash
Difficulty: Easy
Objective: LO 23-3
AACSB: Reflective thinking

48) Explain the purpose of testing the client's bank reconciliation, and discuss the major audit
procedures involved.
Answer: Auditors test the bank reconciliation to determine whether client personnel have
carefully prepared the bank reconciliation and to verify whether the client's recorded bank
balance is the same amount as the actual cash in the bank except for deposits in transit,
outstanding checks, and other reconciling items. Procedures include:
• Verify that the client's bank reconciliation is mathematically accurate.
• Trace the balance on the bank confirmation and/or the beginning balance shown in online
client banking records or in the cutoff statement to the balance per bank on the bank
reconciliation to ensure they are the same.
• Trace checks written and recorded before year-end and included with the cutoff bank
statement to the list of outstanding checks on the bank reconciliation and to the cash
disbursements journal in the period or periods prior to the balance sheet date.
• Investigate all significant checks included on the outstanding check list that have not cleared
the bank on the cutoff statement.
• Trace deposits in transit to the cutoff bank statement.
• Account for other reconciling items on the bank statement and bank reconciliation.
Terms: Testing client's bank reconciliation and major audit procedures
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

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49) Instead of receiving a cutoff bank statement or if online access to client bank account
information is not available to the auditor, auditors can wait until the subsequent period bank
statement is available to verify reconciling items. Discuss the purpose of reviewing the
subsequent period bank statement and list the verifications the auditor performs on this bank
statement.
Answer: The purpose of such a proof is to test whether the client's employees have omitted,
added, or altered any of the documents accompanying the statement. Obviously, this tests for
intentional misstatements. The audit procedures include footing the lists of all the cancelled
checks, debit memos, deposits, and credit memos; verifying that the bank statement balances
when the footed totals are used; and reviewing the items included in the footings to make sure
that they were cancelled by the bank in the proper period and do not include any erasures or
alterations.
Terms: Prove subsequent period bank statement and audit procedures
Difficulty: Challenging
Objective: LO 23-3
AACSB: Reflective thinking

50) In testing the year-end balance in the general cash account, the auditor must accumulate
sufficient appropriate evidence to evaluate whether cash, as stated on the balance sheet, is fairly
stated and properly disclosed in accordance with six of the nine balance-related audit objectives
used for all tests of details of balances. Name those six audit objectives.
Answer: Existence; completeness; accuracy; cutoff; detail tie-in; and presentation
Terms: Audit objectives of the general cash account
Difficulty: Moderate
Objective: LO 23-3
AACSB: Reflective thinking

23.4 Learning Objective 23-4

1) Auditors are likely to prepare a proof of cash when the client has
A) material internal control weaknesses in cash.
B) material internal control weaknesses in accounts receivable and revenue.
C) material internal control weaknesses in accounts payable and inventory.
D) material internal control weaknesses in payroll.
Answer: A
Terms: Proof of cash
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

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2) The auditor uses a proof of cash to determine whether

A)
All recorded cash disbursements All amounts that were paid by the
were paid by the bank. bank were recorded.
Yes Yes

B)
All recorded cash disbursements All amounts that were paid by the
were paid by the bank. bank were recorded.
No No

C)
All recorded cash disbursements All amounts that were paid by the
were paid by the bank. bank were recorded.
Yes No

D)
All recorded cash disbursements All amounts that were paid by the
were paid by the bank. bank were recorded.
No Yes

Answer: A
Terms: Proof of cash
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

3) A proof of cash represents

A) a test of controls and substantive test of transactions.
B) a substantive test of transactions.
C) a substantive test of transactions and test of details of balances.
D) a test of details of balances.
Answer: C
Terms: Proof of cash
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

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4) A major consideration in the audit of the general cash balance is the possibility of fraud. The
auditor must extend his or her procedures in the audit of year-end cash to determine the
possibility of a material fraud when there are
A) large cash balances at the end of the year.
B) large cash receipts and disbursements during the year.
C) no imprest accounts used for payroll.
D) inadequate internal controls.
Answer: D
Terms: Material fraud; Extend procedures in audit of year-end cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

5) The audit and accounting concern addressed in a monthly proof of cash is with
A) adjusting account balances.
B) reconciling the amounts recorded in the books with the amounts included in the bank
statement.
C) determining the month-end balance.
D) identifying cash transfers.
Answer: B
Terms: Monthly proof of cash
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

6) A proof of cash is effective at identifying which of the following misstatements?

A) checks written for an improper amount
B) checks issued to invalid vendors
C) fraudulent checks
D) checks recorded in the books for an amount different from that on the check
Answer: D
Terms: Proof of cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

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7) The process of transferring money from one bank account to another and improperly
recording the transaction is referred to as
A) kiting.
B) lapping.
C) scamming.
D) embezzling.
Answer: A
Terms: Transferring money from one bank account to another and improperly recording the
transaction
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

8) Which of the following is a correct statement?

A) The proof of cash receipts is a test of the balance in the cash account at a point in time.
B) The proof of cash disbursements is effective for discovering a check written for the incorrect
amount for which the dollar amount in cash disbursements is also incorrect.
C) It is extremely difficult for an auditor to detect thefts of cash, especially omitted transactions
and account balances.
D) Segregation of duties is not an important control procedure for cash in a small business.
Answer: C
Terms: Audit of cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

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The following information applies to the questions below.

Listed below are four interbank cash transfers, indicated by the numbers 1, 2, 3, and 4, of a client
for late December 2015 and early January 2016:

Bank Account One Bank Account Two

Disbursing Date Receiving Date
(Month/Day) (Month/Day)
Per Bank Per Books Per Bank Per Books
1. 12/31 12/30 12/31 12/30
2. 1/2 12/30 12/31 12/31
3. 1/3 12/31 1/2 1/2
4. 1/3 12/31 1/2 12/31

9) Based on the schedule of interbank transfers above, which of the cash transfers indicates an
error in cash cutoff at December 31, 2015?
A) 1
B) 2
C) 3
D) 4
Answer: C
Terms: Interbank cash transfers
Difficulty: Challenging
Objective: LO 23-4
AACSB: Analytic thinking

10) Based on the schedule of interbank transfers above, which of the cash transfers would appear
as a deposit in transit on the December 31, 2015 bank reconciliation?
A) 1
B) 2
C) 3
D) 4
Answer: D
Terms: Interbank cash transfers
Difficulty: Challenging
Objective: LO 23-4
AACSB: Analytic thinking

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11) Based on the schedule of interbank transfers above, which of the cash transfers would not
appear as an outstanding check on the December 31, 2015 bank reconciliation?
A) 1
B) 2
C) 3
D) 4
Answer: A
Terms: Interbank cash transfers
Difficulty: Challenging
Objective: LO 23-4
AACSB: Analytic thinking

12) A proof of cash is not an effective procedure for identifying which of the following types of
misstatements?
A) All recorded disbursements were paid by the bank.
B) All recorded cash receipts were deposited.
C) All amounts that were paid by the bank were recorded.
D) Some checks were written for incorrect amounts.
Answer: D
Terms: Proof of cash; Misstatements
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

13) Listing all bank transfers made a few days before and after the balance sheet date and tracing
each to the accounting records for proper recording is a useful approach to test for
A) kiting.
B) lapping.
C) income smoothing.
D) channel stuffing.
Answer: A
Terms: Bank transfers
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

14) Procedures that may uncover fraud in the cash receipts area include
A) confirmation of accounts payable.
B) comparison of purchase orders to invoices.
C) tests performed to detect lapping.
D) all of the above.
Answer: C
Terms: Fraud; Cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

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15) Which of the following should be audited on the interbank transfer schedule?
A) Receipts on the interbank transfer schedule should be correctly included in or excluded from
year-end bank reconciliations as deposits in transit.
B) Disbursements on the interbank transfer schedule must always be shown as outstanding
checks.
C) The interbank transfers cannot be recorded in both the receiving and disbursing banks.
D) All transfers that occurred for the month before and the month after the year-end must be
included on the interbank transfer schedule.
Answer: A
Terms: Interbank cash transfers
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

16) On the last day of the fiscal year, the cash disbursements clerk drew a company check on
bank A and deposited the check in the company account in bank B to cover a previous theft of
cash. The disbursement has not been recorded. The auditor will best detect this form of kiting by
A) examining the composition of deposits in both bank A and bank B subsequent to year-end.
B) examining paid checks returned with the bank statement of the next account period after year-
end.
C) preparing, from the cash disbursements records, a summary of bank transfers for one week
prior to and subsequent to year-end.
D) comparing the detail of cash receipts as shown by the client's cash receipts records with the
detail on the confirmed duplicate deposit tickets for three days prior to and subsequent to year-
end.
Answer: B
Terms: Cash disbursements; Kiting
Difficulty: Challenging
Objective: LO 23-4
AACSB: Analytic thinking

17) When the auditor believes the year-end bank reconciliation may be intentionally misstated, it
is appropriate to perform extended tests of the year-end bank reconciliation. Assuming the client
has an October 31 year-end, these extended tests would not include
A) comparing all September 30 reconciling items with canceled checks and other documents in
the October bank statement.
B) comparing all canceled checks and deposit slips in the October bank statement with the
October cash disbursements and receipts records.
C) carrying out all proper procedures subsequent to the end of the year with the use of the bank
cutoff statement.
D) determining that all outstanding checks had cleared by the date of the bank cutoff statement.
Answer: D
Terms: Bank reconciliation; Extended tests
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

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18) A proof of cash involves a combination of substantive tests of transactions and tests of
details of balances.
Answer: TRUE
Terms: Proof of cash; Substantive tests of transactions and tests of details of balances
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

19) A proof of cash includes a reconciliation of cash receipts deposited in the bank with the cash
disbursements records for a given period.
Answer: FALSE
Terms: Proof of cash; Reconciliation of cash receipts deposited in the bank with cash
disbursements
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

20) The transfer of money from one bank account to another and improperly recording the
transfer so that the amount is recorded as an asset in both banks is referred to as kiting.
Answer: TRUE
Terms: Kiting
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

21) Tests for kiting are performed using only a schedule of intrabank transfers.
Answer: FALSE
Terms: Tests for kiting
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

22) A proof of cash helps the auditor determine whether all recorded cash receipts were
deposited in the bank and whether all recorded cash disbursements were paid by the bank.
Answer: TRUE
Terms: Proof of cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

23) A proof of cash receipts is not useful for uncovering the theft of cash receipts or the
recording and deposit of an improper amount of cash.
Answer: TRUE
Terms: Proof of cash receipts; Theft of cash receipts
Difficulty: Challenging
Objective: LO 23-4
AACSB: Reflective thinking
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24) A proof of cash disbursements is not effective for discovering checks written for an
improper amount, fraudulent checks, or misstatements in which the dollar amount appearing in
the cash disbursements records is incorrect.
Answer: TRUE
Terms: Proof of cash disbursements
Difficulty: Challenging
Objective: LO 23-4
AACSB: Reflective thinking

25) The auditor must extend the audit procedures in the audit of year-end cash when there are
inadequate internal controls.
Answer: TRUE
Terms: Audit procedures; Inadequate internal controls
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

26) Only tests of details of cash balances are useful when auditors are specifically testing for
fraud.
Answer: FALSE
Terms: Fraud; Cash
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

27) Auditors will often prepare a proof of cash when the client has material internal control
weaknesses in cash receipts and cash disbursements. The purpose of the proof of cash is to
determine the client's accounting records for cash are reliable. List below the four requirements
the proof of cash is designed to provide for the auditor.
Answer:
1. All recorded cash receipts were deposited.
2. All deposits in the bank were recorded in the accounting records.
3. All recorded cash disbursements were paid by the bank.
4. All amounts that were paid by the bank were recorded.
Terms: Proof of cash requirements
Difficulty: Easy
Objective: LO 23-4
AACSB: Reflective thinking

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28) A proof of cash includes four reconciliation tasks. List below two of those tasks.
Answer:
1. Reconcile the balance on the bank statement with the general ledger balance at the beginning
of the proof-of-cash period.
2. Reconcile cash receipts deposited per the bank with the receipts recorded in the cash receipts
journal for a given period.
3. Reconcile electronic payments and cancelled checks clearing the bank with those recorded in
the cash disbursements journal for a given period.
4. Reconcile the balance on the bank statement with the general ledger balance at the end of the
proof-of-cash period.
Terms: Proof of cash requirements
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

29) What should be audited on an interbank transfer schedule?

Answer:
1. The accuracy of the information on the interbank transfer schedule should be verified.
2. The interbank transfers must be recorded in both the receiving and disbursing banks.
3. The date of the recording of the disbursements and receipts for each transfer must be in the
same fiscal year.
4. Disbursements on the interbank transfer schedule should be correctly included in or excluded
from year-end bank reconciliations as outstanding checks.
5. Receipts on the interbank transfer schedule should be correctly included in or excluded from
year-end bank reconciliations as deposits in transit.
Terms: Audit of interbank transfer schedule
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

30) Explain kiting, and discuss how it is performed.

Answer: Kiting is the transfer of money from one bank to another and incorrectly recording the
transaction to cover a theft of cash. Near the balance sheet date, a check is drawn on one bank
account and immediately deposited in a second account for credit before the end of the
accounting period. In making this transfer, the embezzler is careful to make sure that the check is
deposited at a late enough date so that it does not clear the first bank until after the end of the
period. If the interbank transfer is not recorded until after the balance sheet date, the amount of
the transfer is recorded as an asset in both banks.
Terms: Kiting
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

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31) Match six of the terms (a-k) with the descriptions/definitions provided below (1-6).

a. bank reconciliation
b. branch cash account
c. cash equivalents
d. cutoff bank statement
e. general cash account
f. imprest payroll account
g. imprest petty cash fund
h. kiting
i. proof of cash
j. standard bank confirmation form
k. lapping

________ 1. a fund of cash maintained within the company for small cash acquisitions,
expenses, or to cash employees' checks

________ 2. a form approved by the AICPA and American Bankers' Association through which
the bank responds to the auditor about bank balance and loan information

________ 3. excess cash invested in short-term, highly liquid investments such as time deposits,
certificates of deposit, and money market funds

________ 4. the primary bank account for most organizations

________ 5. the transfer of money from one bank account to another and improperly recording
the transfer so that the amount is recorded as an asset in both accounts

________ 6. the document usually prepared by client personnel of the differences between the
cash balance recorded in the general ledger and the amount in the bank account

Answer:
1. g
2. j
3. c
4. e
5. h
6. a
Terms: Bank reconciliation; Cash equivalents; General cash account; Imprest petty cash fund;
Kiting; Standard bank confirmation form
Difficulty: Moderate
Objective: LO 23-4
AACSB: Reflective thinking

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23.5 Learning Objective 23-5

1) Which of the following is not a correct statement regarding business risk and financial
instruments?
A) Business risks associated with financial instruments will vary depending of the
aggressiveness of a company's investing activity.
B) Business risk will be higher for companies investing in less liquid securities.
C) Financial services firms are exposed to very little risk with their financial instruments.
D) Business risk for a company will be higher when investments represent a greater proportion
of total assets.
Answer: C
Terms: Audit of financial instruments accounts; risk
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

2) Factors that impact inherent risk of financial instruments do not include

A) management's objectives related to investment activity.
B) the complexity of the securities.
C) the cost of the securities.
D) the company's prior experience with certain investments.
Answer: C
Terms: Audit of financial instruments accounts; risk
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

3) The use of unobservable inputs such as a pricing model or discounted cash flow is an example
of a level ________ estimate.
A) 1
B) 2
C) 3
D) 1 and 3
Answer: C
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

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4) The majority of financial instruments are valued using

A) cost.
B) fair value estimates.
C) lower of cost or market.
D) realizable value.
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

5) When an audit client uses a service organization to manage their investment activity,
A) the auditor can always rely on the internal controls of the service organization.
B) the auditor must state in their audit opinion that the client uses a service organization.
C) the auditor can rely on the internal controls of the service organization if the service
organization's auditor issues a report on their internal control.
D) the auditor must rely on the service organization to determine the fair level 1, 2, and 3
estimates.
Answer: C
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

6) As part of their internal control procedures, management needs to have procedures in place to
properly classify financial instruments as trading, available-for-sale, or held-to-maturity, based
on
A) cost.
B) intent.
C) maturity.
D) probable future gain or loss.
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

7) Prices in an active market for identical assets is a level ________ fair value estimate.
A) 1
B) 2
C) 3
D) 4
Answer: A
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking
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8) When auditing financial instruments,

A) the auditor usually performs more extensive substantive testing to reduce reliance on controls.
B) analytical procedures are critical in assessing the year-end balances for financial instruments.
C) the auditor relies on statements and broker's advices from investment managers to test
purchases and sales as long as controls were deemed effective.
D) tests of transactions are generally not performed.
Answer: C
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

9) When auditing financial instruments, analytical procedures can be used to

A) test the reasonableness of interest and dividend income.
B) test the year-end balance.
C) determine if the financial instruments were properly valued.
D) determine if the gain or loss on the sales were properly computed.
Answer: A
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

10) Which is not an important objective for financial instruments?

A) existence
B) cutoff
C) accuracy
D) realizable value
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

11) Level ________ estimates use observable inputs other than quoted prices.
A) 1
B) 2
C) 3
D) 4
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

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12) A schedule of investment activity will include all of the following except
A) the purchases and sales.
B) ending balances.
C) the gains and losses.
D) the opinion of management as to the suitability of the investment to the company.
Answer: D
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

13) When auditing financial instruments, a confirmation is sent to the broker-dealer

A) only if the client has poor internal controls.
B) to confirm interest and dividends.
C) to provide assurance on realizable value.
D) to confirm year-end holdings.
Answer: D
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

14) The auditor is testing for the balance-related audit objective of detail tie-in when they
A) prove the schedule of investment activity as to additions and subtractions.
B) perform a physical inspection of the security.
C) verify the quoted market prices.
D) test management's assumptions related to valuation.
Answer: A
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

15) When the auditor sends a confirmation to the broker-dealer, they are testing the balance-
related audit objective of
A) detail tie-in.
B) existence.
C) cutoff.
D) rights.
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

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16) When dealing with financial instruments, the most difficult balance-related audit objective to
test is
A) existence.
B) accuracy.
C) rights.
D) realizable value.
Answer: D
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

17) An auditor is reviewing the minutes of board meetings to determine whether any securities
are pledged as collateral. This test of the detail of balances relates to the audit objective of
A) rights.
B) cutoff.
C) realizable value.
D) classification.
Answer: A
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

18) Determining if the financial instruments included in the schedule of investment activity at
year-end are stated at appropriate amounts in accordance with accounting standards is the
balance-related audit objective of
A) materiality.
B) realizable value.
C) consistency.
D) classification.
Answer: B
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

19) The majority of financial instruments are valued at the lower of cost or market.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

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20) Business risks associated with financial instruments are the same for all companies.
Answer: FALSE
Terms: Audit of financial instruments accounts; risk
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

21) The starting point for testing the ending balance of financial instruments accounts is to obtain
a gain or loss schedule for the year.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

22) The auditor needs to have an understanding of the client's internal controls over determining
fair value estimates.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

23) A factor that increases inherent risk for financial instruments is the complexity of the
relevant accounting standards.
Answer: TRUE
Terms: Audit of financial instruments accounts; risk
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

24) Level 1 estimates require more management judgment than level 2 or level 3 estimates.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

25) There is significant potential for misstatements and misclassification of financial

instruments.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

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26) Assessing internal controls related to financial instruments may be necessary in order to
reduce audit risk to an acceptable level.
Answer: TRUE
Terms: Audit of financial instruments accounts; risk
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

27) When auditing financial instruments, interest income and dividends can be recomputed and
compared to a public source.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

28) Analytical procedures may be used to assess the year-end balances for financial instruments.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

29) Completeness is an important objective for derivative financial instruments.

Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

30) The most important objectives for financial instruments are existence and consistency.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

31) Presentation and disclosure objectives are important when auditing financial instruments.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

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32) Tests related to realizable value will vary according to the type of security and the associated
accounting standard.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

33) Auditing guidance is provided for auditing accounting estimates specifically for fair values
estimates as considerable auditor judgment is involved.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

34) Cutoff is more important in testing transactions as a client may want to record a gain or a
loss on the sale at the end of the year.
Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

35) When an auditor is verifying quoted market prices, they are concerned about the balance-
related audit objective of accuracy.
Answer: FALSE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

36) Securities and contracts will typically be held by the broker-dealer.

Answer: TRUE
Terms: Audit of financial instruments accounts
Difficulty: Moderate
Objective: LO 23-5
AACSB: Reflective thinking

37) When auditing financial instruments, the most difficult objective to test is existence.
Answer: FALSE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

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38) The auditor should test for the proper classification of debt instruments as either trading
securities, available-for-sale securities, or held-to-maturity securities in the financial statements.
Answer: TRUE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

39) The proper classification of debt instruments in the financial statements is based solely on
the nature of the debt instrument.
Answer: FALSE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

40) The majority of financial instruments are valued using fair value estimates.
Answer: TRUE
Terms: Financial instruments
Difficulty: Easy
Objective: LO 23-5
AACSB: Reflective thinking

41) List two common tests of details of balances procedures the auditor would perform when
testing for the balance-related audit objective of realizable value.
Answer:
1. Verify quoted market prices.
2. Test management classifications.
3. Test management's assumptions related to valuation.
4. Consider using a specialist for testing fair value estimates.
5. Consider whether an impairment loss is required.
Terms: Audit of financial instruments accounts
Difficulty: Challenging
Objective: LO 23-5
AACSB: Reflective thinking

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