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Senior Auditing Class Study Guide

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Multiple Choice

REQUIRED: Indicate the best answer choice for each of the following.

1. Which of the following would most likely be audited in conjunction with the examination of the client's interest notes payable?
a. Interest income.
b. Interest expense.
c. Amortization of goodwill.
d. Royalty revenue.

2. The main purpose of management representations is to
a. Shift responsibility for financial statements from the management to the auditor.
b. Provide a substitute source of audit evidence for substantive procedures that auditors would otherwise perform.
c. Provide management a place to make assertions about the quantity and valuation of the physical inventory.
d. Impress on management its ultimate responsibility for the financial statements and disclosures.

3. Which of these substantive procedures or sources is not obtain evidence about contingencies?
a. Scan expense accounts for credit entries.
b. Obtain a letter from the client's attorney.
c. Read the minutes of the board of directors' meetings.
d. Examine terms of sale in sales contracts.

4. A Type I subsequent event involves subsequent information about a condition that existed at the balance sheet date. Subsequent knowledge of which of the following would company to adjust its December 31 financial statements?
a. Sale of an issue of new stock for $500,000 on January 30.
b. Settlement of a damage lawsuit for a customer's injury sustained February 15 for
$10,000.
c. Settlement of litigation in February for $100,000 that had been estimated at $12,000
in the December 31 financial statements?
d. Storm damage of $1 million to the company's buildings on March 1.

5. Griffin audited the financial statements of Dodger Magnificat Corporation for the year ended December 31, 2006. She completed the audit fieldwork on January 30 and later learned of a stock split voted by the board of directors on February 5. The financial statements were changed to reflect the split, and shenow needs to dual date the report on the company's financial statements before sending it to the company. Which of the following is the proper form?
a. December 31, 2006, except as to Note X, which is dated January 30, 2007.
b. January 30, 2007, except as to note X, which is dated February 5, 2007.
c. December 31, 2006, except as to Note X, which is dated February 5, 2007.
d. February 5, 2007, except for completion of fieldwork for which the date is January 30, 2007.

6. In connection with a company's filing a registration statement under the 1933 Securities Act, auditors have a responsibility to perform substantive procedures to find subsequent events until
a. The year-a. end balance sheet date.
b. The audit report date.
c. The date the registration statement and audit reports are delivered to the U.S.
Securities and Exchange Commission.
d. The â??effective dateâ? of the registration statement, when the securities can be
offered for sale.

7. The Auditing Standards regarding â??subsequent discovery of facts that existed at the balance sheet dateâ? refers to knowledge obtained after
a. The date the audit reports are delivered to the client.
b. The audit report date.
c. The company's year-end balance sheet date.
d. The date interim audit work was complete.

8. Which of the following is not required by generally accepted Auditing Standards?
a. Management representations.
b. Attorney letter.
c. Management letter.
d. Engagement letter.

9. Which of these persons generally does not participate in writing the management letter (client advisory comments)?
a. Client's outside attorneys.
b. Client's accounting and production managers.
c. Audit firm's audit team on the engagement.
d. and tax experts.

10. Which of the following is ordinarily performed last in the examination?
a. Securing a signed engagement letter from the client.
b. Performing tests of controls.
c. Performing a review for subsequent events.
d. Obtaining signed management representations.
11. A CPA found that the company has not capitalized a material amount of leases in the financial statements. When considering the materiality of this departure from GAAP, the CPA would choose between which reporting options?
a. Unqualified opinion or a. disclaimer of opinion.
b. Unqualified opinion or qualified opinion.
c. Emphasis paragraph with unqualified opinion or an adverse opinion.
d. Qualified opinion or adverse opinion.

12. An auditor determined that the company is suffering financial difficulty and the goingconcern status is seriously in doubt. Even though the company has placed adequate disclosures in the financial statements, the auditor must choose between which of the following audit report alternatives?
a. Unqualified report with a going-concern explanatory paragraph or disclaimer of
opinion.
b. Standard unqualified report or a disclaimer of opinion.
c. Qualified opinion or adverse opinion.
d. Standard unqualified report or adverse opinion.

13. A company accomplished an early extinguishment of debt, and the auditors believe that literal application of SFAS No.98 cause recognition of a loss that would materially distort the financial statements and cause them to be misleading. Given these facts, the auditor would probably choose which reporting option?
a. Explain the situation and give an adverse opinion.
b. Explain the situation and give a disclaimer of opinion.
c. Explain the situation and give an unqualified opinion, relying on Rule 203 of the
AICPA Code of Professional Conduct.
d. Give the standard unqualified audit report.

14. Which of these situations would require an auditor to append an explanatory paragraph about consistency to an otherwise unqualified audit report?
a. Company changed its estimated allowance for uncollectible accounts receivable.
b. Company corrected a prior mistake in accounting for interest capitalization.
c. Company sold one of its subsidiaries and consolidated six subsidiaries this year
compared to seven last year.
d. Company changed its inventory costing method from FIFO to LIFO.

15. Wolfe became the new auditor for Royal Corporation, succeeding Mason, who audited the financial statements last year. Wolfe needs to report on Royal's comparative financial statements should write in his report an explanation about another auditor having audited the prior year
a. Only if Mason's opinion last a. year was qualified.
b. Describing the prior audit and the opinion but not naming Mason as the predecessor auditor.
c. Describing the audit but not revealing the type of opinion Mason gave.
d. Describing the audit and the opinion and naming Mason as the predecessor auditor.

16. When other independent auditors are involved in the current audit of parts of the company's business, the principal auditor can write an audit report that (two answers)
a. Mentions the other auditor, describes the extent of the other auditor's work, and gives an unqualified opinion.
b. Does not mention the other auditor and gives an unqualified opinion in a standard unqualified report
c. Places primary responsibility for the audit report on the other auditors.
d. Names the other auditors, describes their work, and presents only the principal auditor's report.

17. An â??emphasis-of-a-matterâ? paragraph inserted in a standard audit report causes the report to be characterized as a(n)
a. Unqualified opinion report.
b. Divided responsibility report.
c. Adverse opinion report.
d. Disclaimer of opinion.

18. Under which of the following conditions can a disclaimer of opinion never be given?
a. Going-concern problems are highly material and significant.
b. The company does not let the auditor have access to evidence about important accounts.
c. The auditor owns stock in the company.
d. The auditor has found that the company has used the NIFO (next-in, first-out) inventory costing method.

19. Where will you find an auditor's own responsibility for the opinion on financial statements?
a. Stated explicitly in the introductory paragraph of the standard unqualified report.
b. Unstated but understood in the introductory paragraph of standard unqualified
report.
c. Stated explicitly in the opinion paragraph of the standard unqualified report.
d. Stated explicitly in the scope paragraph of the standard unqualified report.

20. Company A hired Sampson & Delila, CPAs, to audit the financial statements of Company B and deliver the audit report to Megabank. Which is the client?
a. Megabank.
b. Sampson & Delila.
c. Company A.
d. Company B.

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Solution Preview

1. a - Interest notes payable involves income, not expence.
2. c - This is the major participation from management other than those in financial departments.
3. d - Terms of sale allow for any contingencies.
4. c - A, b, and d are on the current year. Only c must be corrected in the estimated amount in the previous year's financial statement.
5. b - dates of completion and date of split
6. a - Only events in the remainder of the fiscal year will affect the company's audit.
7. c - Again, only facts found after year end date, occuring in the previous year but not found in the ...

Solution Summary

A twenty Q/A, multiple-choice, formatted study guide for fourth year auditing class with explanations for answers.

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Auditing Case Study: Case 2.1 (Doughtie's Foods, Inc.) Q1 and 2

Case 2.1 (Doughtie's Foods, Inc.)
In the late 1970s, William Nashwinter accepted a position as a salesman with Doughtie's Foods, Inc., a publicly owned food products company headquartered in Portsmouth, Virginia.1 The ambitious young salesman impressed his superiors with his hard work and dedication and was soon promoted to general manager of the Gravins Division of Doughtie's, a promotion that nearly doubled his salary. The Gravins Division was essentially a large warehouse that wholesaled frozen-food products to retail outlets on the East Coast.
Nashwinter quickly discovered that managing a large wholesale operation was much more complicated and stressful than working a sales route. Within a short time after accepting the promotion, Nashwinter found himself being maligned by corporate headquarters for his division's poor performance. After several rounds of scathing criticism for failing to meet what he perceived to be unrealistic profit goals, Nashwinter decided to take matters into his own hands. The young manager began fabricating fictitious inventory on his monthly performance reports to headquarters. By inflating his monthly inventory balance, Nashwinter lowered his division's cost of goods sold and thus increased its gross profit.
Several years later, Nashwinter insisted that he had never intended to continue his scheme indefinitely. Instead, he saw his actions simply as a solution to a short-term problem: "I always had in the back of my mind that the division would make enough legitimate profit one day to justify the fake numbers."2 Unfortunately for Nashwinter, his division's actual operating results continued to be disappointing. With each passing year, Nashwinter had to fabricate larger amounts of fictitious inventory to reach his profit goals. Finally, in 1982, Nashwinter admitted to a superior that he had been filing false inventory reports to corporate headquarters for several years. Doughtie's management immediately fired Nashwinter and retained Price Waterhouse to determine the magnitude of the inventory errors in Gravins' accounting records and their impact on the company's consolidated financial statements. Price Waterhouse's study revealed that Nashwinter's scheme had overstated Doughtie's 1980 consolidated net income by 15 percent, while the company's 1981 net income had been overstated by 39 percent.3
Nashwinter used simple methods to misrepresent his division's inventory. In 1980, he inflated Gravins' inventory by including three pages of fictitious inventory items in the count sheets that summarized the results of the division's annual physical inventory. Nashwinter also changed the unit of measure of many inventory items. Rather than reporting 15 single boxes of a given product, for example, Nashwinter changed the inventory sheet so that it reported 15 cases of the product. In 1981, after Doughtie's acquired a computerized inventory system, Nashwinter simply input fictitious inventory items into his division's computerized inventory ledger.
In 1980 and 1981, the CPA firm of Goodman & Company audited Doughtie's. Thomas Wilson of Goodman & Company served as the audit manager on the 1980 audit and as the audit engagement partner the next year, after having been promoted to partner. In both years, Frank Pollard was the audit supervisor assigned to the Doughtie's engagement. Following the disclosure of Nashwinter's scheme to the Securities and Exchange Commission (SEC) by Doughtie's executives, the federal agency began investigating the 1980 and 1981 audits of the food distribution company. The SEC subsequently criticized Wilson and Pollard for their roles in those audits, particularly for their failure to rigorously audit Doughtie's inventory account.
The SEC maintained that Doughtie's inventory should have been considered a high-risk account and thus subject to a higher-than-normal degree of scrutiny by Wilson and Pollard during the 1980 and 1981 audits. First, inventory was the largest line item on the Doughtie's balance sheet, accounting for approximately 40 percent of the company's total assets. Second, Wilson and Pollard were aware of several weaknesses in Doughtie's internal controls for inventory, particularly within the Gravins Division. These weaknesses increased the likelihood of inventory errors. Finally, the SEC noted that Gravins' inventory increased rapidly during 1980 and 1981. The federal agency maintained that Wilson and Pollard should have considered the audit implications of this high growth rate and the closely related implications of the division's abnormally low inventory turnover.
The SEC also criticized Wilson and Pollard for failing to pursue problems that they or their subordinates uncovered during the 1980 and 1981 audits of Gravins' inventory. Following the completion of the physical inventory for Gravins in 1980, Nashwinter forwarded the three fictitious inventory count sheets to Wilson and Pollard. Nashwinter claimed that the Goodman & Company auditors had overlooked the three count sheets. After briefly reviewing these count sheets, Wilson and Pollard added the items on them to Gravins' inventory. Following the division's 1981 physical inventory, the audit senior on the Doughtie's engagement could not reconcile the quantities for numerous items listed on the inventory count sheets with the quantities shown on the computer printout that summarized the details of Gravins' year-end inventory balance. The senior notified Wilson of the problem and wrote Nashwinter a memo asking for an explanation. Wilson failed to follow up on the problem, and Nashwinter never responded to the memo. In his review of the senior's workpapers, Pollard either did not notice the numerous differences between the count sheets and the computer listing of Gravins' inventory or chose not to investigate those differences.
Nashwinter's testimony to the SEC was not complimentary of Goodman & Company's annual audits. Nashwinter testified that he often made up excuses to account for missing or misplaced inventory and that the auditors apparently never double-checked his explanations. He also testified that the auditors were lax when it came time to test count inventory items in Gravins' blast freezer: "A lot of times the auditors didn't want to stay in the freezer. It was too cold."4
EPILOGUE
For their roles in the Doughtie's case, the SEC required Wilson and Pollard to complete several professional education courses. The SEC also required that selected audits supervised by the two men in the future be subjected to peer reviews to determine that the appropriate audit procedures had been performed. Goodman & Company was not sanctioned by the SEC, since Wilson and Pollard had failed to comply with the firm's quality control standards. In 1983, Doughtie's dismissed Goodman & Company and retained Price Waterhouse as its audit firm.
To settle the charges filed against him by the SEC, William Nashwinter signed a consent decree in which he neither admitted nor denied the charges but agreed not to violate federal securities laws in the future. At last report, Nashwinter still worked in the food distribution industry.5
QUESTIONS
1. What are the auditor's primary objectives when he or she observes the client's annual physical inventory? Identify the key audit procedures that an auditor would typically perform during and after the client's physical inventory.
2. What audit procedure or procedures might have prevented Nashwinter from successfully overstating the 1980 year-end inventory of the Gravins Division? What audit procedure or procedures might have prevented Nashwinter from overstating the division's 1981 year-end inventory?

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