GRATIS EXAM - Convert VCE to PDF, download for all

Certkiller.CPA.1687.QA

Number: CPAPassing Score: 800Time Limit: 120 minFile Version: 11.1

http://www.gratisexam.com/

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Sections1. Business Environment and Concepts (Volume A)2. Business Environment and Concepts (Volume B)3. Business Environment and Concepts (Volume C)4. Business Environment and Concepts (Volume D)5. Auditing and Attestation (I) (Volume A) Audited Financial Statements - The Basics6. Auditing and Attestation (I) (Volume B)7. Auditing and Attestation (I) (Volume C)8. Auditing and Attestation (II) (Volume D)9. Auditing and Attestation (II) (Volume E)

Regulation

QUESTION 1In a tax year where the taxpayer pays qualified education expenses, interest income on the redemption of qualified U.S. Series EE Bonds may be excluded fromgross income. The exclusion is subject to a modified gross income limitation and a limit of aggregate bond proceeds in excess of qualified higher educationexpenses. Which of the following is (are) true?

A. The exclusion applies for education expenses incurred by the taxpayer, the taxpayer's spouse, or any person whom the taxpayer may claim as a dependent forthe year.II. "Otherwise qualified higher education expenses" must be reduced by qualified scholarships not includible in gross income.

B. I only.C. II only.D. Both I and II.E. Neither I nor II.

Correct Answer: CSection: (none)Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Interest earned on Series EE bonds issued after 1989 may qualify for exclusion. One requirement is that the interest is used to pay tuition andfees for the taxpayer, spouse, or dependent enrolled in higher education. The interest exclusion is reduced by qualified scholarships that are exempt from tax andother nontaxable payments received for educational expenses (other than gifts and inheritances).

QUESTION 2During 1993 Kay received interest income as follows:

On U.S. Treasury certificates $4,000On refund of 1991 federal income tax 500The total amount of interest subject to tax in Kay's 1993 tax return is:

A. $4,500B. $4,000C. $500D. $0

Correct Answer: ASection: (none)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Interest income from U.S. obligations is generally taxable. Interest income on a federal tax refund is taxable, even though the refund itself isnot taxed. Choice "b" is incorrect. Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.Choice "c" is incorrect. Interest income from U.S. obligations is generally taxable. Choice "d" is incorrect. Interest income from U.S. obligations is generally taxable.Interest income on a federal tax refund is taxable, even though the refund itself is not taxed.

QUESTION 3Rich is a cash basis self-employed air-conditioning repairman with 1993 gross business receipts of $20,000. Rich's cash disbursements were as follows:

What amount should Rich report as net self-employment income?

A. $15,100B. $14,900C. $14,100D. $13,900

Correct Answer: ASection: (none)Explanation

Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Deductions to arrive at net self-employed income include all necessary and ordinary expenses connected with the business. Estimated federalincome tax payments are not an expense. Charitable contributions by an individual are only deductible as an itemized deduction on Schedule A. This assumes thecontribution was not made with the "expectation of commensurate financial return."

Choice "b" is incorrect. Charitable contributions are an itemized deduction unless there is an expectation of commensurate financial return.Choice "c" is incorrect. Federal income taxes paid are not a deductible expense. Choice "d" is incorrect. Charitable contributions are an itemized deduction unlessthere is an expectation of commensurate financial return. Federal income taxes paid are not a deductible expense.

QUESTION 4On December 1, 1992, Michaels, a self-employed cash basis taxpayer, borrowed $100,000 to use in her business. The loan was to be repaid on November 30,1993. Michaels paid the entire interest of $12,000 on December 1, 1992. What amount of interest was deductible on Michaels' 1993 income tax return?

A. $12,000B. $11,000C. $1,000D. $0

Correct Answer: BSection: (none)Explanation

Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Prepaid interest must be prorated over the time for which payment is made. This is true for both cash and accrual basis taxpayers. The loan isfor 1 month in 1992 and 11 months in 1993. Therefore, 1/12 of the interest is deductible in 1992 and 11/12, or $11,000 is deductible in 1993. Choices "a", "c", and"d" are incorrect. Prepaid interest must be prorated over the time for which payment is made. This is true for both cash and accrual basis taxpayers.

QUESTION 5DAC Foundation awarded Kent $75,000 in recognition of lifelong literary achievement. Kent was not required to render future services as a condition to receive the$75,000. What condition(s) must have been met for the award to be excluded from Kent's gross income?


A. Kent was selected for the award by DAC without any action on Kent's part.II. Pursuant to Kent's designation, DAC paid the amount of the award either to a governmental unit or to a charitable organization.



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Generally, the fair market value of prizes and awards is taxable income. However, an exclusion from income for certain prizes and awardsapplies where the winner is selected for the award without entering into a contest (i.e., without any action on their part) and then assigns the award directly to agovernmental unit or charitable organization. Therefore, conditions "I" and "II" must be met in order for Ken to exclude the award from his gross income. Choice "a"is incorrect. "II" is a necessary condition as well. See explanation above. Choice "b" is incorrect. "I" is a necessary condition as well. See explanation above. Choice"d" is incorrect. "I" and "II" are both necessary conditions. See explanation above.

QUESTION 6Mosh, a sole proprietor, uses the cash basis of accounting. At the beginning of the current year, accounts receivable were $25,000. During the year, Mosh collected$100,000 from customers. At the end of the year, accounts receivable were $15,000. What was Mosh's gross taxable income for the current year?

A. $75,000B. $90,000C. $100,000D. $110,000

Correct Answer: C

Section: (none)Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The facts state that cash collections from customers were $100,000 and as a cash basis taxpayer this is the amount of Mosh's gross taxableincome for the year. Note that according to the formula BASE - we can determine the amount of sales = $90,000, but that would give us accrual, not cash basis,income.

Choice "a" is incorrect. See explanation above.Choice "b" is incorrect. $90,000 is the amount of sales that would be Mosh's taxable income if Mosh were an accrual basis taxpayer.Choice "d" is incorrect. See explanation above.

QUESTION 7Porter was unemployed for part of the year. Porter received $35,000 of wages, $4,000 from a state unemployment compensation plan, and $2,000 from his formeremployer's company-paid supplemental unemployment benefit plan. What is the amount of Porter's gross income?

A. $35,000B. $37,000C. $39,000D. $41,000

Correct Answer: DSection: (none)Explanation

Explanation/Reference:Explanation:ExplanationRULE: Gross income includes all income unless it is specifically excluded in the tax code. Choice "d" is correct. Wages and all unemployment compensation are notexcluded from being taxable; therefore, there are included in the taxpayer's gross income for tax purposes.

Choice "a" is incorrect. All forms of unemployment compensation are included as part of gross income. Choice "b" is incorrect. The $4,000 of state unemploymentcompensation received is included as part of gross income.Choice "c" is incorrect. The $2,000 of his former employer's company-paid supplemental unemployment benefit plan is included as part of gross income.

QUESTION 8Which one of the following will result in an accruable expense for an accrual-basis taxpayer?

A. An invoice dated prior to year end but the repair completed after year end.B. A repair completed prior to year end but not invoiced.C. A repair completed prior to year end and paid upon completion.D. A signed contract for repair work to be done and the work is to be completed at a later date.


Explanation/Reference:Explanation:ExplanationRULE: An accruable expense is one is which the services have been received/performed but have not been paid for by the end of the reporting period.

Choice "b" is correct. The facts indicate that a repair was completed prior to year end but not yet invoiced. If it has not yet been invoiced, it is assumed that it hasalso not yet been paid for. Therefore, this is a situation in which the repair expense would be accrued at year end. Services have been performed, but they have notbeen paid for, as they have not even been invoiced yet. Choice "a" is incorrect. If the repair was completed after year end, then the expense is not accruable, as thebenefit of the services hasn't been received as of year end. The fact that the repair was invoiced prior to year end does not impact the situation.Choice "c" is incorrect. If a repair was completed and paid for prior to year end, no accrual is appropriate. On the accrual basis, the expense is taken in the year therepair is completed and the benefit is received. In this case, the account payable was also paid in the same year, but this has no effect on the expense.Choice "d" is incorrect. The facts indicate that the work is to be completed at a date later than year end. Therefore, the expense is not accruable at year end, as thebenefit of the repair hasn't been received as of year end. It is reasonable that a signed contract for the repair work exists, but this has no effect on the accrual.

QUESTION 9In the current year Jensen had the following items:

What is Jensen's AGI for the current year?

A. $44,000B. $59,000C. $62,000D. $84,000


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The question asks for AGI, but all of the items in the list are items of potential gross income. There are no adjustments included in the list;therefore, in this case, AGI is the same as gross income. The calculation is as follows:

Choices "a", "c", and "d" are incorrect, per the above calculation.

QUESTION 10Which of the following is subject to the Uniform Capitalization Rules of Code Sec. 263A?

A. Editorial costs incurred by a freelance writer.B. Research and experimental expenditures.C. Mine development and exploration costs.D. Warehousing costs incurred by a manufacturing company with $12 million in annual gross receipts.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Uniform capitalization rules apply to the following: (1) real or tangible personal property produced by the taxpayer for use in his or her trade orbusiness; (2) real or tangible personal property produced by the taxpayer for sale to his or her customers; and (3) real or tangible personal property acquired by thetaxpayer for resale, provided the taxpayer's annual average gross receipts for the preceding three years exceeds $10,000,000. Warehousing costs incurred by amanufacturing company (making inventory for sale to its customers) are subject to the Uniform Capitalization Rules. Further, they are the only item on the list that isreal or tangible personal property. In this case, the inventory is not acquired for resale (it is produced by the taxpayer for sale to his or her customers), so the factthat the annual sales are $12,000,000 does not matter in this case. The sales could have been less than $10,000,000 annually, and the Uniform CapitalizationRules would still have applied. Choices "a", "b", and "c" are incorrect, based on the above discussion.

QUESTION 11Under the uniform capitalization rules applicable to taxpayers with property acquired for resale, which of the following costs should be capitalized with respect toinventory if no exceptions have been met?

A. Option AB. Option BC. Option CD. Option D


Explanation

Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Direct material, direct labor, and factory overhead (applicable indirect costs) are capitalized with respect to inventory under the uniformcapitalization rules for property acquired for resale. Applicable indirect costs include depreciation and amortization, insurance, supervisory wages, utilities, spoilageand scrap, design expenses, repair and maintenance and rental of equipment and facilities (including offsite storage), some administrative costs, costs of bonusand other incentive plans, and indirect supplies and other materials (including repackaging costs). Choices "b", "c", and "d" are incorrect, per the above discussion.Individual Taxation - Capital Gains and Losses

QUESTION 12Smith made a gift of property to Thompson. Smith's basis in the property was $1,200. The fair market value at the time of the gift was $1,400. Thompson sold theproperty for $2,500. What was the amount of Thompson's gain on the disposition?

A. $0B. $1,100C. $1,300D. $2,500


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The general rule for the basis on gifted property is that the donee receives the property with a rollover cost basis (equal to the donor's basis).An exception exists where the fair market value of the property at the time of the gift is less than the donor's basis. That is not the case in this question; thus, thecalculation of the gain on the disposition of the property is:

Choice "a" is incorrect. This choice could be correct if the facts of the question met the exception whereby no gain or loss is recognized when a donee sells giftedproperty for an amount between the donor's basis and the fair market value at the date of the gift. Choice "b" is incorrect. This choice uses the basis as the fairmarket value of the property. Fair market value of property at date of death is used as the basis for inherited property, not gifted property. Choice "d" is incorrect.This choice assumes that Thompson's basis is zero. His basis is $1,200 as indicated above.

QUESTION 13Leker exchanged a van that was used exclusively for business and had an adjusted tax basis of $20,000 for a new van. The new van had a fair market value of$10,000, and Leker also received $3,000 in cash.What was Leker's tax basis in the acquired van?

A. $20,000B. $17,000C. $13,000D. $7,000


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. $17,000 is the tax basis in the van. The basis for like-kind exchanges is computed as follows:

The general rule is the gain is recognized to the extent boot is received. As the transaction results in a loss to Leker (he received an asset worth $10,000 plus$3,000 cash less a $20,000 tax basis equals $7,000 loss) no gain is recognized and the $3,000 received reduces his basis in the new asset. Choice "a" is incorrect.Basis must be reduced by non-like-kind assets (boot) received. Choice "c" is incorrect. For non-like-kind exchanges, the basis would be the FMV of the assetsreceived ($10,000 FMV plus $3,000 Boot). However, because both assets have similar use, this is a like-kind exchange, which follows the rule above.Choice "d" is incorrect. The basis of the old property is used to calculate the basis of the new property, less any boot received.

QUESTION 14Capital assets include:

A. A corporation's accounts receivable from the sale of its inventory.B. Seven-year MACRS property used in a corporation's trade or business.C. A manufacturing company's investment in U.S. Treasury bonds.D. A corporate real estate developer's unimproved land that is to be subdivided to build homes, which will be sold to customers.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Investment assets of a taxpayer that are not inventory are capital assets. The manufacturing company would have capital assets including aninvestment in U.S. Treasury bonds. Choice "a" is incorrect. Accounts receivable generated from the sale of inventory are excluded from the statutory definition ofcapital assets.Choice "b" is incorrect. Depreciable property used in a trade or business is excluded from the statutory definition of capital assets.Choice "d" is incorrect. Land is usually a capital asset, but when it is effectively inventory, as when it is used by a developer to be subdivided, it is excluded from thestatutory definition of capital assets.

QUESTION 15Conner purchased 300 shares of Zinco stock for $30,000 in 1980. On May 23, 1994, Conner sold all the stock to his daughter Alice for $20,000, its then fair marketvalue. Conner realized no other gain or loss during 1994. On July 26, 1994, Alice sold the 300 shares of Zinco for $25,000. What amount of the loss from the sale ofZinco stock can Conner deduct in 1994?

A. $0B. $3,000C. $5,000D. $10,000


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Even though Conner has a realized loss of $10,000 on this transaction he cannot deduct the loss since it was incurred in a transaction with hisdaughter, a related party. Choice "b" is incorrect. $3,000 is the limit on deductible net capital losses. However, Conner cannot deduct this loss, since it was incurredin a transaction with his daughter, a related party. Choice "c" is incorrect. Conner's realized loss on the sale is $10,000 ($20,000 proceeds less $30,000 basis).However, Conner cannot deduct this loss, since it was incurred in a transaction with his daughter, a related party.Choice "d" is incorrect. $10,000 is Conner's realized loss on the sale. However, Conner cannot deduct this loss, since it was incurred in a transaction with hisdaughter, a related party.

QUESTION 16Conner purchased 300 shares of Zinco stock for $30,000 in 1980. On May 23, 1994, Conner sold all the stock to his daughter Alice for $20,000, its then fair marketvalue. Conner realized no other gain or loss during 1994. On July 26, 1994, Alice sold the 300 shares of Zinco for $25,000.

What was Alice's recognized gain or loss on her sale?


A. $0B. $5,000 long-term gain.C. $5,000 short-term loss.D. $5,000 long-term loss.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Alice has a realized gain of $5,000 on the transaction: $25,000 sales price less $20,000 purchase price. However, she can reduce the gain,but not below zero, by the amount of loss her father could not deduct on the sale to her. Thus, Alice can reduce her gain by up to $10,000, but not below zero. Here,the gain is $5,000, so it is reduced to zero. Conner should have sold the stock in the open market so that he could deduct the entire loss. Alice could then havepurchased the stock in the open market.Choice "b" is incorrect. $5,000 is Alice's realized long-term gain on the sale. However, she can reduce the gain, but not below zero, by the amount of loss her fathercould not deduct on the sale to her. Choice "c" is incorrect. Alice has a realized gain of $5,000 on the sale. However, since she is related to Conner, her holdingperiod includes his holding period. Therefore, her realized gain is long-term. In addition, she can reduce the gain, but not below zero, by the amount of loss herfather could not deduct on the sale to her.Choice "d" is incorrect. Alice can reduce the gain by the amount of loss her father could not deduct on the sale to her. However, she cannot reduce the gain belowzero.

QUESTION 17Smith, an individual calendar-year taxpayer, purchased 100 shares of Core Co. common stock for $15,000 on December 15, 1992, and an additional 100 shares for$13,000 on December 30, 1992. On January 3, 1993, Smith sold the shares purchased on December 15, 1992, for $13,000. What amount of loss from the sale ofCore's stock is deductible on Smith's 1992 and 1993 income tax returns?



Explanation/Reference:Explanation:ExplanationChoice "a" is correct. In 1992, no sale of stock occurred so there would be no loss. In 1993, there is a $2,000 loss realized ($15,000 basis less $13,000 received),but it is not deductible because it is a wash sale. A wash sale occurs when a taxpayer sells stock at a loss and invests in substantially identical stock within 30 daysbefore or after the sale. In this case, Smith reinvested in an additional 100 shares four days prior to selling 100 shares of the same stock at a loss. The $2,000disallowed loss would, however, increase the basis of the new shares by $2,000.Choice "b" is incorrect. The $2,000 loss realized in 1993 is disallowed under the wash sale rules. Choice "c" is incorrect. In 1992, there is no loss since no shareswere sold. In 1993, the $2,000 loss is disallowed under the wash sale rules.Choice "d" is incorrect. In 1992, there is no possible loss since no shares were sold.

QUESTION 18Greller owns 100 shares of Arden Corp., a publicly-traded company, which Greller purchased on January 1, 2001, for $10,000. On January 1, 2003, Arden declareda 2-for-1 stock split when the fair market value (FMV) of the stock was $120 per share. Immediately following the split, the FMV of Arden stock was $62 per share.On February 1, 2003, Greller had his broker specifically sell the 100 shares of Arden stock received in the split when the FMV of the stock was $65 per share. Whatis the basis of the 100 shares of Arden sold?

A. $5,000B. $6,000C. $6,200D. $6,500

Correct Answer: A


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The receipt of a nontaxable stock dividend will require the shareholder to spread the basis of his original share over both the original sharesand the new shares received resulting in the same total basis, but a lower basis per share of stock held. Therefore, Greller total basis remains the same, $10,000,but is now split between 200 shares (a 2-for-1 split and he originally owned 100 shares).Therefore, his basis per share goes from $100/share ($10,000/100) to $50/share ($10,000/200). Consequently, his basis in 100 share is 100 x $50 = $5,000.Choices "b", "c", and "d" are incorrect per the above explanation.

QUESTION 19Farr made a gift of stock to her child, Pat. At the date of gift, Farr's stock basis was $10,000 and the stock's fair market value was $15,000. No gift taxes were paid.What is Pat's basis in the stock for computing gain?

A. $0B. $5,000C. $10,000D. $15,000


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Property acquired as a gift generally retains the rollover cost basis as it had in the hands of the donor at the time of the gift. Basis is increasedby any gift tax paid that is attributable to the net appreciation in the value of the gift. Since there were no gift taxes paid, Pat's basis for computing a gain is therollover cost (basis), $10,000. Choices "a", "b", and "d" are incorrect, per the explanation above.

QUESTION 20Allen owns 100 shares of Prime Corp., a publicly-traded company, which Allen purchased on January 1, 2001, for $10,000. On January 1, 2003, Prime declared a2-for-1 stock split when the fair market value (FMV) of the stock was $120 per share. Immediately following the split, the FMV of Prime stock was $62 per share. OnFebruary 1, 2003, Allen had his broker specifically sell the 100 shares of Prime stock received in the split when the FMV of the stock was $65 per share. Whatamount should Allen recognize as long-term capital gain income on his Form 1040, U.S. Individual Income Tax Return, for 2003?

A. $300B. $750

C. $1,500D. $2,000


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The receipt of a nontaxable stock dividend will require the shareholder to spread the basis of his original shares over both the original sharesand the new shares received, resulting in the same total basis but a lower basis per share of stock helD. Therefore, Allen's total basis remains the same, $10,000,but is now split between 200 shares (a 2-for-1 split and he originally owned 100 shares).Therefore, his basis per share goes from $100/share ($10,000/100) to $50/share ($10,000/200). Consequently, his basis in the 100 shares sold is 100 x $50 =$5,000. Calculate his gain as follows:

Choices "a", "b", and "d" are incorrect.

QUESTION 21Dale received $1,000 in 1990 for jury duty. In exchange for regular compensation from her employer during the period of jury service, Dale was required to remit theentire $1,000 to her employer in 1990. In Dale's 1990 income tax return, the $1,000 jury duty fee should be:

A. Claimed in full as an itemized deduction.B. Claimed as an itemized deduction to the extent exceeding 2% of adjusted gross income.C. Deducted from gross income in arriving at adjusted gross income.D. Included in taxable income without a corresponding offset against other income.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The $1,000 jury duty fee that was required to be remitted to the employer may be deducted from gross income in arriving at adjusted gross

income. This, in effect, washes out the $1,000 income she will have to report as part of gross income for the jury duty fees paid to her. Choices "a" and "b" areincorrect. The amount remitted is allowed as an adjustment in arriving at AGI, not as an itemized deduction.Choice "d" is incorrect. A corresponding offset is allowed against other income as an adjustment in arriving at AGI.

QUESTION 22Clark bought Series EE U.S. Savings Bonds after 1989. Redemption proceeds will be used for payment of college tuition for Clark's dependent child. One of theconditions that must be met for tax exemption of accumulated interest on these bonds is that the:

A. Purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse).B. Bonds must be bought by a parent (or both parents) and put in the name of the dependent child.C. Bonds must be bought by the owner of the bonds before the owner reaches the age of 24.D. Bonds must be transferred to the college for redemption by the college rather than by the owner of the bonds.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. One of the conditions that must be met for tax exemption of accumulated interest on the bonds is that the purchaser of the bonds must be thesole owner of the bonds (or joint owner with his or her spouse).Choice "b" is incorrect. The bonds must be bought and put in the name of the owner or co-owner, not in the name of the dependent child.Choice "c" is incorrect. The owner must be at least 24 years old before the bonds issue date. Choice "d" is incorrect. There is no requirement that the bonds mustbe transferred to the college for redemption by the college rather than by the owner of the bonds.

QUESTION 23Doris and Lydia are equal partners in the capital and profits of Agee & Nolan, but are otherwise unrelated. The following information pertains to 300 shares of MastCorp. stock sold by Lydia to Agee & Nolan:

The amount of long-term capital loss that Lydia realized in 1988 on the sale of this stock was:

A. $5,000B. $3,000

C. $2,500D. $0


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. $5,000 long term capital loss "realized" in 1988 by Lydia. Be careful, and always check the question being asked. In this case, the question ishow much of a capital loss Lydia realized in 1988.

Choice "b" is incorrect. $3,000 represents the portion of the $5,000 realized loss that would currently be recognized unless there were additional capital transactionsresulting in gains. Remember that the deduction for capital losses for an individual is limited to $3,000 each year. Choice "c" is incorrect. $2,500 represents the pre-1986 portion of the $5,000 realized loss that would have given rise to a recognized loss. Pre-1986 law required $2 of net long term loss to give the benefit of $1 oftax deduction. Current law gives a dollar-for-dollar deduction limited to $3,000 in any year. Choice "d" is incorrect. $0 would have been the amount of lossrecognized if Lydia owned more than a 50% interest in the partnership. Losses realized on transactions between a partnership and a partner owning more than a50% interest are not deductible as the parties would be considered related and any realized loss would be disallowed.

QUESTION 24On December 31, 1989, a building owned by Pine Corp. was totally destroyed by fire. The building had fire insurance coverage up to $500,000. Other pertinentinformation as of December 31, 1989 follows:

During January 1990, before the 1989 financial statements were issued, Pine received insurance proceeds of $500,000. On what amount should Pine base thedetermination of its loss on involuntary conversion?

A. $520,000B. $530,000C. $550,000

D. $560,000


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. $530,000 basis of involuntary converted building.

QUESTION 25Fred Berk bought a plot of land with a cash payment of $40,000 and a mortgage of $50,000. In addition, Berk paid $200 for a title insurance policy. Berk's basis inthis land is:

A. $40,000B. $40,200C. $90,000D. $90,200


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. $90,200 is Berk's basis in the land. Rule: The basis of the property acquired will be the property's cost consisting of the amount of cash paidplus any amount of related debt assumed. Cost will be adjusted to reflect any additional costs incurred in purchasing the property.

Choices "a", "b", and "c" are incorrect, per the above rule.

QUESTION 26For a cash basis taxpayer, gain or loss on a year-end sale of listed stock arises on the:

A. Trade date.B. Settlement date.C. Date of receipt of cash proceeds.D. Date of delivery of stock certificate.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Trade date.Gain or loss on a year-end sale of listed stock arises on the trade date. Rule: Whether on the cash or accrual method of accounting taxpayers who sell stock orsecurities on an established securities market must recognize gains and losses on the trade date, rather than on the settlement date.Choices "b", "c", and "d" are incorrect, per the above rule.

QUESTION 27Hall, a divorced person and custodian of her 12-year old child, filed her 1990 federal income tax return as head of a household. She submitted the followinginformation to the CPA who prepared her 1990 return:

· In 1990, Hall sold an antique that she bought in 1980 to display in her home. Hall paid $800 for the antique and sold it for $1,400, using the proceeds to pay acourt ordered judgment. The $600 gain that Hall realized on the sale of the antique should be treated as:

A. Ordinary income.B. Long-term capital gain.

C. An involuntary conversion.D. A nontaxable antiquities transaction.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The gain should be treated as a long-term capital gain because the property was held for more than one year and was sold for more than itcost. Choice "a" is incorrect. Because Hall was not in the business of selling antiques, the profit from the sale will be treated as a gain from the disposition of acapital asset, not ordinary income. Choice "c" is incorrect. This transaction does not qualify as an involuntary conversion. In order to be treated as an involuntaryconversion, the transaction must result from a condemnation of property or a destruction or loss from theft or casualty.Choice "d" is incorrect. An obvious distracter.

QUESTION 28Ryan, age 57, is single with no dependents. On July 1, 1997, Ryan's principal residence was sold for the net amount of $500,000 after all selling expenses. Ryanbought the house in 1963 and occupied it until sold. On the date of sale, the house had a basis of $180,000. Ryan does not intend to buy another residence. Whatis the maximum exclusion of gain on sale of the residence that may be claimed in Ryan's 1997 income tax return?

A. $320,000B. $250,000C. $125,000D. $0


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. $250,000 maximum exclusion from taxable income. Rule: An individual may exclude from income up to $250,000 gain provided that theproperty was the taxpayer's primary residence for 2 of the last 5 years. Married taxpayers may exclude gains up to $500,000.Choice "a" is incorrect. $320,000. Ryan, age 57, was not married. Thus, his exclusion was limited to $250,000.Choice "c" is incorrect. The $125,000 exclusion was old law and eliminated for sales after 5/6/97.Choice "d" is incorrect, per the above rule.

QUESTION 29

Among which of the following related parties are losses from sales and exchanges not recognized for tax purposes?

A. Father-in-law and son-in-law.B. Brother-in-law and sister-in-law.C. Grandfather and granddaughter.D. Ancestors, lineal descendants, and all in-laws.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Losses from sales and exchanges are not recognized for tax purposes between grandfather and granddaughter.Rule: Losses are disallowed on sales between related parties. "Related" includes brothers and sisters, husband-wife, lineal descendants (father, son, grandfather),and entities that are more than 50% owned by individuals, corporations, trusts and/or partnerships. Choices "a", "b", and "d" are incorrect, because losses fromsales and exchanges are recognized for all "in-laws."

QUESTION 30The uniform capitalization method must be used by:

A. Manufacturers of tangible personal property.II. Retailers of personal property with $2 million dollars in average annual gross receipts for the 3 preceding years.



Explanation/Reference:Explanation:ExplanationChoice "a" is correct. I only.Rule: The uniform capitalization rules apply to the following:1. Real or tangible personal property produced by the taxpayer for use in a trade or business.

2. Real or tangible personal property produced by the taxpayer for sale to customers.3. Real or personal property acquired by the taxpayer for resale.4. However, the uniform capitalization rules do not apply to property acquired for resale if the taxpayer's annual gross receipts for the preceding three tax years donot exceed $10,000,000 (not $2 million).

QUESTION 31Elm Corp. is an accrual-basis calendar-year C corporation with 100,000 shares of voting common stock issued and outstanding as of December 28, 1996. OnFriday, December 29, 1996, Hall surrendered 2,000 shares of Elm stock to Elm in exchange for $33,000 cash. Hall had no direct or indirect interest in Elm after thestock surrender. Additional information follows:

What amount of income did Hall recognize from the stock surrender?

A. $33,000 dividend.B. $25,000 dividend.C. $18,000 capital gain.D. $17,000 capital gain.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. $17,000 capital gain.Amount realized:

Choices "a" and "b" are incorrect. Dividends are distributions of earnings. These proceeds are from the sale of stock.Choice "c" is incorrect, per above. Accumulated earnings and profits do not effect the gain calculation, they only affect the taxability of dividends paid to

shareholders.

QUESTION 32Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.Tom's 1994 wages were $53,000. In addition, Tom's employer provided group-term life insurance on Tom's life in excess of $50,000. The value of such excesscoverage was $2,000.

A. $0B. $500C. $900D. $1,000E. $1,250F. $1,300G. $1,500H. $2,000I. $2,500J. $3,000K. $10,000L. $25,000M. $50,000N. $55,000O. $75,000


Explanation/Reference:Explanation:Explanation"N" is correct. $55,000. The value of employer-provided group term life insurance for which the face amount exceeds $50,000 is taxable income to the insuredemployee and the $53,000 in wages would both be included on page one, Form 1040.

QUESTION 33Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.

Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.During 1994, the Moores received a $2,500 federal tax refund and a $1,250 state tax refund for 1993 overpayments. In 1993, the Moores were not subject to thealternative minimum tax and were not entitled to any credit against income tax. The Moores' 1993 adjusted gross income was $80,000 and itemized deductionswere $1,450 in excess of the standard deduction. The state tax deduction for 1993 was $2,000.


Correct Answer: ESection: (none)Explanation

Explanation/Reference:Explanation:Explanation"E" is correct. $1,250. The Moores itemized deductions in 1993 because such deductions were $1,450 in excess of the standard deduction. The amount of statetaxes deducted in 1993 was $2,000, which (along with the fact that the Moores were not subject to alternative minimum tax, which may have reduced their taxbenefit) indicates that the Moores received a tax benefit in 1993 from deducting the $1,250 state tax refund they received in 1994. The $1,250 is taxable in 1994.

QUESTION 34Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.In 1994, Joan received $1,300 in unemployment compensation benefits. Her employer made a $100 contribution to the unemployment insurance fund on herbehalf.


Correct Answer: FSection: (none)Explanation

Explanation/Reference:Explanation:Explanation"F" is correct. $1,300. Unemployment compensation benefits are fully taxable (when received by the employee), but contributions made by the employer to theinsurance fund are not taxable.

QUESTION 35Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.The Moores received $8,400 in gross receipts from their rental property during 1994. The expenses for the residential rental property were:

A. $0B. $500C. $900D. $1,000

E. $1,250F. $1,300G. $1,500H. $2,000I. $2,500J. $3,000K. $10,000L. $25,000M. $50,000N. $55,000O. $75,000

Correct Answer: ISection: (none)Explanation

Explanation/Reference:Explanation:Explanation"I" is correct. $2,500. Rental activity net income is reported on page one; the gross income ($8,400) is fully reportable; and all deductions listed (total = $5,900) arefully deductible for a net of $2,500.

QUESTION 36Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.The Moores received a stock dividend in 1994 from Ace Corp. They had the option to receive either cash or Ace stock with a fair market value of $900 as of thedate of distribution. The par value of the stock was $500.

A. $0B. $500C. $900D. $1,000E. $1,250F. $1,300G. $1,500H. $2,000

I. $2,500J. $3,000K. $10,000L. $25,000M. $50,000N. $55,000O. $75,000


Explanation/Reference:Explanation:Explanation"C" is correct. $900. If a taxpayer has the option of taking a dividend either in stock or in other property (e.g., cash), the dividend is taxable regardless of the optionthe taxpayer selects.

QUESTION 37Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.In 1994, Joan received $3,500 as beneficiary of the death benefit, which was provided by her brother's employer. Joan's brother did not have a nonforfeitable rightto receive the money while living.

A. $0B. $500C. $900D. $1,000E. $1,250F. $1,300G. $1,500H. $2,000I. $2,500J. $3,000K. $10,000L. $25,000

M. $50,000N. $55,000O. $75,000


Explanation/Reference:Explanation:Explanation"A" is correct. $0. Life insurance proceeds received by reason of the death of the insured are not taxable income to the recipient.

QUESTION 38Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.Tom received $10,000, consisting of $5,000 each of principal and interest, when he redeemed a Series EE savings bond in 1994. The bond was issued in his namein 1990 and the proceeds were used to pay for Laura's college tuition. Tom had not elected to report the yearly increases in the value of the bond.


Correct Answer: A


Explanation/Reference:Explanation:Explanation"A" is correct. $0. Generally, if a taxpayer does not make an election to accrue interest income from Series EE bonds, the interest is taxable at the time the bondsare cashed. However, an exception applies in this case because Tom Moore meets the criteria (assume he was 24 years or older in 1990). Savings bonds is tax-exempt when:

(1) It is used to pay for qualified higher-education expenses for the taxpayer, spouse, or dependents; (2) There is taxpayer or joint ownership with spouse;(3) The taxpayer is age 24 (or over) when the bonds are issued; and (4) The bonds are acquired after 1989.

QUESTION 39Parker, whose spouse died during the preceding year, has not remarried. Parker maintains a home for a dependent child. What is Parker's most advantageousfiling status?

A. Single.B. Head of household.C. Married filing separately.D. Qualifying widow(er) with dependent child.


Explanation/Reference:ExplanationChoice "d" is correct. A qualifying widow (er) is a taxpayer who may use the joint tax return standard deduction and rates (but not the exemption for the deceasedspouse) for each of two taxable years following the year of death of his or her spouse, unless he or she remarries. The surviving spouse must maintain a householdthat, for the whole entire taxable year, was the principal place of abode of a son, stepson, daughter, or stepdaughter (whether by blood or adoption). The survivingspouse must also be entitled to a dependency exemption for such individual. Parker may file as a qualifying widow (er) since her spouse died in the previous taxyear, she did not remarry and she maintained a home for a dependent child. Since, qualifying widow (er) is the most advantageous status and Parker qualifies,Parker would file as a qualifying widow (er).Choice "a" is incorrect. Even though Parker would qualify as single, filing single would give Parker a high tax liability than the qualifying widow (er) status andtherefore is not most advantageous. Choice "b" is incorrect. Parker would not qualify as head of household for the first two years after the death of Parker's spousebecause one of the requirements for Head of Household status is that the taxpayer is NOT a surviving spouse. (Also, note that the likely reason for this requirementis that filing as Head of Household status would give the qualifying surviving spouse taxpayer a higher tax liability than the Qualifying Widow(er) status, which wouldbe less advantageous.) Choice "c" is incorrect. Parker would not qualify to file married filing separately.

QUESTION 40

In which of the following situations may taxpayers file as married filing jointly?

A. Taxpayers who were married but lived apart during the year.B. Taxpayers who were married but lived under a legal separation agreement at the end of the year.C. Taxpayers who were divorced during the year.D. Taxpayers who were legally separated but lived together for the entire year.


Explanation/Reference:ExplanationRULE: In order to file a joint return, the parties must be MARRIED at the end of the year. Exception:If the parties are married but are LEGALLY SEPARATED under the laws of the state in which they reside, they cannot file a joint return (they will file either under thesingle or head of household filing status).

Choice "a" is correct. Per the above rule, taxpayers who are married but lived apart during the year are allowed to file a joint return for the year. The fact that theydid not live together during the year has no bearing on the issue.Choice "b" is incorrect. Per the above rule, taxpayers who are married but lived under a legal separation agreement at the end of the year may not file a joint return.They will generally file either under the single or head of household filing status.Choice "c" is incorrect. Per the above rule, taxpayers who were divorced during the year may not file a joint return together, as they are not married at the end of theyear. [Note, however, that they may become married again in the year and file a joint return with the new spouse.] Choice "d" is incorrect. Per the above rule,taxpayers who were legally separated but lived together for the entire year may not file a joint return. They will generally file either under the single or head ofhousehold filing status.

QUESTION 41Barkley owns a vacation cabin that was rented to unrelated parties for 10 days during the year for $2,500. The cabin was used personally by Barkley for threemonths and left vacant for the rest of the year. Expenses for the cabin were as follows:

Real estate taxes $1,000Maintenance and utilities $2,000

How much rental income (loss) is included in Barkley's adjusted gross income?

A. $0B. $500C. $(500)D. $(1,500)


Explanation/Reference:ExplanationRULE: If a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rental income is excluded from income, andmortgage interest (first or second home) and real estate taxes are allowed as itemized deductions. Depreciation, utilities, and repairs are not deductible.

Choice "a" is correct. Applying the rule above, if a vacation residence is rented for less than 15 days per year, it is treated as a personal residence. The rentalincome ($2,500 in this case) is excluded from income. A Schedule E is not filed for this property (i.e., no income is reported, the taxes are reported as itemizeddeductions, and the maintenance and utilities are not deductible), so the effect on AGI is zero. Choice "b" is incorrect. This assumes that the property taxes arereported as itemized deductions but that the rental income ($2,500) less the maintenance and utilities ($2,000) are reported net on Schedule E.Per the above RULE, the rental income is excluded from income, and the maintenance and utilities are not deductible.Choice "c" is incorrect. This assumes that all of the items shown are reported net on the Schedule E- $2,500 - $1,000 - $2,000 = ($500). Per the above RULE, therental income is excluded from income, the maintenance and utilities are not deductible, and the property taxes are reported on Schedule A as an itemizeddeduction.Choice "d" is incorrect, per the above rule and discussion.

QUESTION 42Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.The Moores had no capital loss carryovers from prior years. During 1994, the Moores had the following stock transactions, which resulted in a net capital loss:

A. $0B. $500C. $900D. $1,000E. $1,250F. $1,300G. $1,500

H. $2,000I. $2,500J. $3,000K. $10,000L. $25,000M. $50,000N. $55,000O. $75,000

Correct Answer: JSection: (none)Explanation

Explanation/Reference:Explanation:Explanation"J" is correct. $3,000. The capital loss on Revco ($10,000 loss) is added to the capital gain on Abbco ($4,000) to produce a net capital loss of ($6,000). The Moorescan claim $3,000 of the loss on their 1994 income tax return and carry the balance forward to 1995.

QUESTION 43Tom and Joan Moore, both CPAs, filed a joint 1994 federal income tax return showing $70,000 in taxable income. During 1994, Tom's daughter Laura, age 16,resided with Tom. Laura had no income of her own and was Tom's dependent.Determine the amount of income or loss, if any that should be included on page one of the Moores' 1994 Form 1040.In 1992, Joan received an acre of land as an inter-vivos gift from her grandfather. At the time of the gift, the land had a fair market value of $50,000. Thegrandfather's adjusted basis was $60,000. Joan sold the land in 1994 to an unrelated third party for $56,000.

A. $0B. $500C. $900D. $1,000E. $1,250F. $1,300G. $1,500H. $2,000I. $2,500J. $3,000K. $10,000

L. $25,000M. $50,000N. $55,000O. $75,000


Explanation/Reference:Explanation:Explanation"A" is correct. $0. Property received by gift has two bases: one for computing gain and another for computing loss. Joan's basis for gain is the grandfather'sadjusted basis ($60,000). Using this basis for gain, Joan has a loss of: $56,000 - $60,000 = ($4,000 loss). Joan's basis for loss is the fair market value of theproperty on the date of the gift ($50,000). Using this basis for loss, Joan has a gain of: $56,000 - $50,000 = $6,000 gain. In this unusual situation, Joan has neither again nor a loss, although the transaction must be reported.

QUESTION 44Freeman, a single individual, reported the following income in the current year:

Guaranteed payment from services rendered to a partnership $50,000 Ordinary income from a S corporation $20,000

What amount of Freeman's income is subject to self-employment tax?

A. $0B. $20,000C. $50,000D. $70,000


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Guaranteed payments are reasonable compensation paid to a partner for services rendered (or use of capital) without regard to his ratio ofincome. Earned compensation is subject to selfemployment tax. Payments not guaranteed are merely another way to distribute partnership profits. The ordinaryincome reported from an S corporation are taxable income to the individual or their own individual tax return but is not subject to self-employment tax. The ordinaryincome reported from a partnership may be subject to self-employment tax (if to a general partner).

Financial Accounting and Reporting

QUESTION 1In the hierarchy of generally accepted accounting principles, APB Opinions have the same authority as AICPA:

A. Statements of Position.B. Industry Audit and Accounting Guides.C. Issues Papers.D. Accounting Research Bulletins.


Explanation/Reference:Explanation:

Choice "d" is correct. AICPA Accounting Research Bulletins, FASB Standards, FASB Interpretations, FASB Staff Positions, FASB Statement 133 ImplementationIssues, and APB Opinions and Interpretations are the most authoritative sources of generally accepted accounting principles. Choice "a" is incorrect. AICPAStatements of Position, AICPA Accounting and Auditing Guides, and FASB Technical Bulletins are secondary sources of generally accepted accounting principles.Choice "b" is incorrect. AICPA Statements of Position, AICPA Accounting and Auditing Guides, and FASB Technical Bulletins are secondary sources of generallyaccepted accounting principles. Choice "c" is incorrect. AICPA Issues Papers and Practice Bulletins, FASB Concepts Statements, and other authoritativepronouncements are tertiary sources for generally accepted accounting principles.

QUESTION 2What is the underlying concept that supports the immediate recognition of a contingent loss?

A. Substance over form.B. Consistency.C. Matching.D. Conservatism.



Choice "d" is correct. Conservatism is a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately

considereD. Recognition of a contingent loss is the recording of an amount representing uncertainty and risk in a business situation. SFAC 2, SFAS 5 para. 82Choice "a" is incorrect. The substance over form concept presumes that the transaction form may not dictate the accounting treatment.Choice "b" is incorrect. Consistency is conformity from period to period with unchanging policies and procedures. SFAC 2Choice "c" is incorrect. The matching principle dictates that expenses be matched with the related revenues generated or the time period in which the expense isincurred and known. SFAS #5 cites matching as the one concept supporting the immediate recognition of a contingent loss, but it is not the primary underlyingconcept. SFAS 5 para. 76

QUESTION 3According to the FASB conceptual framework, the process of reporting an item in the financial statements of an entity is:

A. Allocation.B. Matching.C. Realization.D. Recognition.


Explanation/Reference:Explanation:Choice "d" is correct. Recognition is the process of recording an item in the financial statements of an entity. SFAC 5 para. 6Choice "a" is incorrect. Allocation is the accounting process of assigning or distributing an amount according to a plan or a formulA. SFAC 6 para. 142Choice "b" is incorrect. Matching of costs and revenues is simultaneous or combined recognition of the revenues and expenses that result directly and jointly fromthe same transactions or other events. SFAC 6 para. 146Choice "c" is incorrect. Realization is the process of converting noncash resources and rights into money. SFAC 6 para. 143

QUESTION 4Which of the following statements best describes an operating procedure for issuing a new Financial Accounting Standards Board (FASB) statement?

A. The emerging issues task force must approve a discussion memorandum before it is disseminated to the public.B. The exposure draft is modified per public opinion before issuing the discussion memorandum.C. A new statement is issued only after a majority vote by the members of the FASB.D. A new FASB statement can be rescinded by a majority vote of the AICPA membership.


Explanation/Reference:

Explanation:

Choice "c" is correct. A new statement from the FASB is issued only after a majority vote of the members of the FASB.

Choice "a" is incorrect. There is no necessity for the EITF to approve a discussion memorandum (presumably the question means a discussion memorandum ofthe FASB statement itself and not an EITF statement) before it is disseminated to the public.

Choice "b" is incorrect. There is no necessity for an exposure draft to be modified per public opinion before issuing the discussion memorandum (a question can beraised here as to "what" discussion memorandum"). Exposure drafts are quite/most often modified before they are issued as FASB statements, but they do nothave to be. Whether they are or are not modified is a function of whether the FASB thinks they should be modified, partly due to the public comments that havebeen received. Choice "d" is incorrect. There is no way to rescind a new FASB statement, although, in reality, a FASB statement can be rescinded by the issuanceof a new statement on the same subject. However, even if there was a way to rescind a new FASB statement, it would not be by a majority vote of the AICPAmembership, but by a majority vote of the members of the FASB.Reporting Net Income

QUESTION 5Income tax-basis financial statements differ from those prepared under GAAP in that income tax-basis financial statements:

A. Do not include nontaxable revenues and nondeductible expenses in determining income.B. Include detailed information about current and deferred income tax liabilities.C. Contain no disclosures about capital and operating lease transactions.D. Recognize certain revenues and expenses in different reporting periods.



Choice "d" is correct. Income tax-basis financial statements recognize events when taxable income or deductible expenses are recognized on the entity's tax return.Non-taxable income and non-deductible expenses are shown on the financial statement and included in the determination of income (and become M-1 adjustmentsto arrive at taxable income).Please Note: This question appeared in the releases for 1999 in FARE; however, it may also apply to OCBOA financial statements discussed in the Auditingtextbook. The question did not apply well to any FARE CSO line item, so we included it here so that you could read the Explanation: and learn from it.

QUESTION 6An extraordinary gain should be reported as a direct increase to which of the following?

A. Net income.

B. Comprehensive income.C. Income from continuing operations, net of tax.D. Income from discontinued operations, net of tax.


Explanation/Reference:Explanation:Choice "a" is correct. Extraordinary items are reported as a component of net income, after income from continuing operations and discontinued operations. Choice"b" is incorrect. An extraordinary gain (or loss) only indirectly affects comprehensive income as a component of net income.Choice "c" is incorrect. Extraordinary items are reported net of tax after income from continuing operations and discontinued operations.Choice "d" is incorrect. Extraordinary items are reported net of tax after income from continuing operations and discontinued operations.

Income Statement

QUESTION 7On December 2, 20X1, Flint Corp.'s board of directors voted to discontinue operations of its frozen food division and to sell the division's assets on the open marketas soon as possible. The division reported net operating losses of $20,000 in December and $30,000 in January. On February 26, 20X2, sale of the division'sassets resulted in a gain of $90,000. Assuming that the frozen foods division qualifies as a component of the business and ignoring income taxes, what amount ofgain/loss from discontinued operations should Flint recognize in its income statement for 20X2?

A. $0B. $40,000C. $60,000D. $90,000



Choice "c" is correct. The $60,000 gain from discontinued operations would be reported in Flint's 20X2 income statement. The operating loss for January wouldoffset the gain from disposal in February, and the net amount would be reported as a gain (in this case) from discontinued operations. The operating losses forDecember would have been reported in Flint's 20X1 income statement. Choice "a" is incorrect per the above. It would be correct if all of the gains and losses wereincluded in 20X1 instead of 20X2. However, gains and losses from discontinued operations are included in the year they occur.Choice "b" is incorrect. It includes the operating loss for December, 20X1 in with the 20X2 amounts. Choice "d" is incorrect. It ignores the January operating loss.

Operating losses are included in gain/loss from discontinued operations, along with impairment losses and gains/losses on disposal.

QUESTION 8Lore Co. changed from the cash basis of accounting to the accrual basis of accounting during 1994. The cumulative effect of this change should be reported inLore's 1994 financial statements as a:

A. Prior period adjustment resulting from the correction of an error.B. Prior period adjustment resulting from the change in accounting principle.C. Component of income before extraordinary item.D. Component of income after extraordinary item.


Explanation/Reference:Explanation:Choice "a" is correct. The cash basis for financial reporting is not a generally accepted accounting basis of accounting (GAAP); therefore, it is an error. Correction ofan error from a prior period is a reported as prior period adjustment to retained earnings.Choice "b" is incorrect. Cash basis reporting is not an accounting principle under accrual accounting principles. Thus, the change from cash basis is not reported asa change in accounting principle. In addition, changes in accounting principle are not prior period adjustments; instead, they are treated retrospectively.Choices "c" and "d" are incorrect. Correction of prior period errors has no effect on the current year's income statement.

QUESTION 9A material loss should be presented separately as a component of income from continuing operations when it is:

A. An extraordinary item.B. A cumulative effect type change in accounting principle.C. Unusual in nature and infrequent in occurrence.D. Not unusual in nature but infrequent in occurrence.



Choice "d" is correct. Gains or losses that are unusual in nature or occur infrequently but not both, are presented as a component of income from continuingoperations. Choice "a" is incorrect. Extraordinary items are shown net of tax in a separate section of the income statement after income from continuing operations.

Choice "b" is incorrect. Cumulative effects of changes in accounting principle are now shown net of tax as an adjustment to the opening balance of retainedearnings in the retained earnings statement. This treatment is called retrospective application. There really are no longer any cumulative effect types of changes inaccounting principle. The cumulative effect is merely how the amount of the change is measured.Choice "c" is incorrect. This is the definition of an extraordinary item.

QUESTION 10During 1994, Orca Corp. decided to change from the FIFO method of inventory valuation to the weightedaverage method. Inventory balances under each methodwere as follows:

Orca's income tax rate is 30%.Orca should report the cumulative effect of this accounting change as a(n):

A. Adjustment to beginning retained earnings.B. Component of income from continuing operations.C. Extraordinary item.D. Component of income after extraordinary items.



Choice "a" is correct. The cumulative effect of a change in accounting principle is shown as an adjustment to beginning retained earnings.Choice "b" is incorrect. The cumulative effect of a change in accounting principle is now presented as a separate category on the retained earnings statement and isnot a component of net income. Choice "c" is incorrect. Extraordinary items are unusual and infrequent in nature. Extraordinary items have nothing to do withchanges in accounting principle. Choice "d" is incorrect. A change in accounting principle affects retained earnings, not the income statement, under SFAS No. 154.

QUESTION 11A transaction that is unusual in nature and infrequent in occurrence should be reported separately as a component of income:

A. After cumulative effect of accounting changes and before discontinued operations of a segment of a business.B. After cumulative effect of accounting changes and after discontinued operations of a segment of a business.

C. Before cumulative effect of accounting changes and before discontinued operations of a segment of a business.D. After discontinued operations of a segment of a business.


Explanation/Reference:Explanation:Choice "d" is correct. An extraordinary item (a transaction that is both "unusual in nature" and "infrequent in occurrence") should be reported separately as acomponent of income after discontinued operations of a segment of a business.The cumulative effect of a change in accounting principle is shown on the retained earnings statement. This is why memorizing the mnemonic "idea" is soimportant.

QUESTION 12How should the effect of a change in accounting estimate be accounted for?

A. By restating amounts reported in financial statements of prior periods.B. By reporting pro forma amounts for prior periods.C. As a prior period adjustment to beginning retained earnings.D. In the period of change and future periods if the change affects both.



Choice "d" is correct, a "change in accounting estimate" affects only the current and subsequent (future) periods, if the change affects both. It does not affect "priorperiods," nor "retained earnings." Choice "a" is incorrect. Restating prior years' financial statements is required when comparative financial statements are shownfor prior period adjustments of "corrections of errors," "changes in entities," and changes in accounting principle.Choices "b" and "c" are incorrect. A "change in accounting estimate" does not affect prior periods.

QUESTION 13Foy Corp. failed to accrue warranty costs of $50,000 in its December 31, 1992, financial statements. In addition, a $30,000 change from straight-line to accelerateddepreciation was made at the beginning of 1993. Both the $50,000 and the $30,000 are net of related income taxes. What amount should Foy report as prior periodadjustments in 1993?

A. $0

B. $30,000C. $50,000D. $80,000


Explanation/Reference:Explanation:Choice "c" is correct. $50,000.The cumulative effect of a change in accounting principle is now shown on the retained earnings statement as an adjustment to the beginning balance of retainedearnings, assuming that the cumulative effect can be calculated.An exception is made however, for a change in depreciation method, since a change in depreciation method is no longer considered to be a change in accountingprinciple. A change in depreciation method is now considered to be both a change in method and a change in estimate. These changes should now be accountedfor as a change in estimate and handled prospectively. The new depreciation method should be used as of the beginning of the year of change and should start withthe current book value of the underlying asset. No retroactive or retrospective calculations should be made, and no adjustment should be made to retainedearnings.The correction of the failure to accrue warranty costs is treated as a correction of an error and thus as a prior period adjustment.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 14The following question is based on the following:Vane Co.'s trial balance of income statement accounts for the year ended December 31, 2002, included the following:

Vane's income tax rate is 30%.In Vane's 2002 multiple-step income statement, what amount should Vane report as income from continuing operations?

A. $126,000B. $129,500C. $140,000D. $147,000



Choice "c" is correct, $140,000.

QUESTION 15The effect of a material transaction that is infrequent in occurrence but not unusual in nature should be presented separately as a component of income fromcontinuing operations when the transaction results in a:



Explanation/Reference:Explanation:Choice "a" is correct, Yes - Yes. A material transaction that is "infrequent in occurrence" but not "unusual in nature" should be presented separately as a componentof "income from continuing operations" when the transaction results in a gain or loss.

QUESTION 16An extraordinary item should be reported separately on the income statement as a component of income:




Choice "b" is correct, Yes - No. An extraordinary item should be reported separately on the income statement as a component of income:Yes - net of income taxes.No - after (not before) "discontinued operations of a segment of a business."

QUESTION 17On January 2, 20X5, to better reflect the variable use of its only machine, Holly, Inc. elected to change its method of depreciation from the straight-line method tothe units of production method. The original cost of the machine on January 2, 20X3, was $50,000, and its estimated life was 10 years. Holly estimates that themachine's total life is 50,000 machine hours. Machine hours usage was 8,500 during 20X4 and 3,500 during 20X3.Holly's income tax rate is 30%. Holly should report the accounting change in its 20X5 financial statements as a(n):

A. Cumulative effect of a change in accounting principle of $2,000 in its income statement.B. Adjustment to beginning retained earnings of $2,000.C. Cumulative effect of a change in accounting principle of $1,400 in its income statement.D. None of the above.



Choice "d" is correct. A change in the method of depreciation is now considered to be both a change in method and a change in estimate. These changes should beaccounted for as changes in estimate and handled prospectively. The new depreciation method should be used as of the beginning of the year of change andshould start with the current book value of the underlying asset. No retroactive or retrospective calculations should be made, and no adjustment should be made toretained earnings. The cumulative effect treatment on the income statement was the treatment of most changes in accounting principle prior to SFAS No. 154. Theadjustment to beginning retained earnings is the treatment now given to changes in accounting principle by SFAS No. 154. However a change in depreciationmethod is no longer accounted for as a change in accounting principle. Choices "a", "b", and "c" are incorrect, per the above Explanation: .

QUESTION 18On November 1, 20X2, Smith Co. contracted to dispose of an industry segment. Throughout 20X2 the segment had operating losses. These losses were expectedto continue until the segment's disposition. If a loss is projected on final disposition, how much of the operating losses should be included in the loss fromdiscontinued operations reported in Smith's 20X2 income statement?

A. Operating losses for the period January 1 to October 31, 20X2.II. Operating losses for the period November 1 to December 31, 20X2.III. Estimated operating losses for the period January 1 to February 28, 20X3.

B. II only.C. II and III only.D. I and III only.E. I and II only.


Explanation/Reference:Explanation:Choice "d" is correct. The operating losses to be included in Smith's 20X2 income statement would be the total 20X2 operating losses, regardless of whether thoselosses occurred before or after the date the decision to dispose of the component was made, and not any 20X3 operating losses. Projected operating losses are notanticipated and accrued.Choice "a" is incorrect. The operating losses to be included in Smith's 20X2 income statement would be the total 20X2 operating losses, regardless of whetherthose losses occurred before or after the date the decision to dispose of the component was made, and not any 20X3 operating losses. Choice "b" is incorrect. Theoperating losses to be included in Smith's 20X2 income statement would be the total 20X2 operating losses, regardless of whether those losses occurred before orafter the date the decision to dispose of the component was made, and not any 20X3 operating losses. Choice "c" is incorrect. The operating losses to be includedin Smith's 20X2 income statement would be the total 20X2 operating losses, regardless of whether those losses occurred before or after the date the decision todispose of the component was made, and not any 20X3 operating losses.

QUESTION 19

If a company is not presenting comparative financial statements, the correction of an error in the financial statements of a prior period should be reported, net ofapplicable income taxes, in the current:

A. Retained earnings statement after net income but before dividends.B. Retained earnings statement as an adjustment of the opening balance.C. Income statement after income from continuing operations and before extraordinary items.D. Income statement after income from continuing operations and after extraordinary items.



Choice "b" is correct. The correction of an error in the financial statements of a prior period should be reported, net of tax, in the current statement of retainedearnings as an adjustment of the opening balance.Choice "a" is incorrect. The adjustment is before net income, not after net income. Choices "c" and "d" are incorrect. Corrections of errors of prior periods go toretained earnings and do not affect the income statement.

QUESTION 20The cumulative effect of a change in accounting estimate should be shown separately:

A. On the income statement above income from continuing operations.B. On the income statement after income from continuing operations and before extraordinary items.C. On the retained earnings statement as an adjustment to the beginning balance.D. It should not be recorded separately on any financial statement.



Choice "d" is correct. A change in estimate is handled prospectively. No cumulative effect adjustment is made and no separate line item presentation is made onany financial statement. If a material change is being made, appropriate footnote disclosure is necessary. Choices "a", "b", and "c" are incorrect, per the aboveExplanation: .

QUESTION 21

The following costs were incurred by Griff Co., a manufacturer, during 1992:

What amount of these costs should be reported as general and administrative expenses for 1992?

A. $260,000B. $550,000C. $635,000D. $810,000



Choice "a" is correct. General and administrative expenses include:

Freight-in is part of cost of sales; freight-out is a selling expense; and sales salaries are selling expenses.Choice "b" is incorrect. Freight-in is part of cost of inventory; freight-out is a selling expense; and sales salaries are selling expenses.Choice "c" is incorrect. Freight-in is part of cost of inventory; freight-out is a selling expense; and sales salaries are selling expenses.Choice "d" is incorrect. Freight-in is part of cost of inventory; freight-out is a selling expense; and sales salaries are selling expenses.

QUESTION 22On January 2, 1989, Union Co. purchased a machine for $264,000 and depreciated it by the straight- line method using an estimated useful life of eight years with

no salvage value. On January 2, 1992, Union determined that the machine had a useful life of six years from the date of acquisition and will have a salvage value of$24,000. An accounting change was made in 1992 to reflect the additional data. The accumulated depreciation for this machine should have a balance atDecember 31, 1992, of:

A. $176,000B. $160,000C. $154,000D. $146,000



Choice "d" is correct, $146,000 accumulated depreciation balance at DeC. 31, 1992.

QUESTION 23During 1992, Krey Co. increased the estimated quantity of copper recoverable from its mine. Krey uses the units of production depletion method. As a result of thechange, which of the following should be reported in Krey's 1992 financial statements?




Choice "c" is correct, No - No. This is a change in "accounting estimate," which affects only the current and subsequent periods (not prior periods and not retainedearnings). "Cumulative effect of a change in accounting principle" is only used for changes in "accounting principle."

QUESTION 24On August 31, 1992, Harvey Co. decided to change from the FIFO periodic inventory system to the weighted average periodic inventory system. Harvey is on acalendar year basis. The cumulative effect of the change is determined:

A. As of January 1, 1992.B. As of August 31, 1992.C. During the eight months ending August 31, 1992, by a weighted average of the purchases.D. During 1992 by a weighted average of the purchases.


Explanation/Reference:Explanation:Choice "a" is correct, as of January 1, 1992, the beginning of the year. Rule: The cumulative effect of a change in accounting principle equals the differencebetween retained earnings at the beginning of period of the change and what retained earnings would have been if the change was applied to all affected priorperiods, assuming comparative financial statements are not presented. If comparative statements are presented, then beginning retained earnings of the earliestyear presented is adjusted for the cumulative effect of the change. We are assuming, based on the answer options given, that Harvey is not presenting comparativefinancial statements. Choice "b" is incorrect. The cumulative effect of the change is not determined as of the date the decision is made.Choices "c" and "d" are incorrect. The cumulative effect of the change is not determined by a weighted average.

QUESTION 25In 1992, hail damaged several of Toncan Co.'s vans. Hailstorms had frequently inflicted similar damage to Toncan's vans. Over the years, Toncan had savedmoney by not buying hail insurance and either paying for repairs, or selling damaged vans and then replacing them. In 1992, the damaged vans were sold for lessthan their carrying amount. How should the hail damage cost be reported in Toncan's 1992 financial statements?

A. The actual 1992 hail damage loss as an extraordinary loss, net of income taxes.B. The actual 1992 hail damage loss in continuing operations, with no separate disclosure.C. The expected average hail damage loss in continuing operations, with no separate disclosure.D. The expected average hail damage loss in continuing operations, with separate disclosure.



Choice "b" is correct. Actual hail damage must be reported. Since the hailstorms are frequent, the damage is not considered an extraordinary gain/loss. Thus, thedamages would be shown in continuing operations. No separate disclosure is necessary since hail damage is a common occurrence. Choice "a" is incorrect.Hailstorms are not unusual and infrequent so the loss could not be classified as extraordinary. APB 30 para. 20Choice "c" is incorrect. Actual hail damage must be reported. Estimated hail damage may be probable but is not estimable; so it should not be included in incomecalculations. Choice "d" is incorrect. Estimated hail damage may be probable but is not estimable; so it should not be included in income calculations.

QUESTION 26In which of the following situations should a company report a prior-period adjustment?

A. A change in the estimated useful lives of fixed assets purchased in prior years.B. The correction of a mathematical error in the calculation of prior years' depreciation.C. A switch from the straight-line to double-declining balance method of depreciation.D. The scrapping of an asset prior to the end of its expected useful life.



Choice "b" is correct. Prior period adjustments consist of: corrections of errors in the financial statements of prior periods, retroactive restatements required by newGAAP pronouncements, and changes from a non-GAAP method of accounting to a GAAP method of accounting (which are corrections of errors).Choice "a" is incorrect. This change is a change in accounting estimate. Choice "c" is incorrect. This change is a change for one GAAP method of depreciation toanother GAAP method of depreciation. Under SFAS No. 154, it is treated as a change in accounting estimate effected by a change in accounting principle and ishandled prospectively, and not as a prior-period adjustment.Choice "d" is incorrect. This is a business activity ordinary in nature.

QUESTION 27Mellow Co. depreciated a $12,000 asset over five years, using the straight-line method with no salvage value. At the beginning of the fifth year, it was determinedthat the asset will last another four years. What amount should Mellow report as depreciation expense for year 5?

A. $600B. $900C. $1,500D. $2,400



Choice "a" is correct. Over the first 4 years, the asset would be depreciated down to $2,400. Once it was determined that the asset would last for another 4 years,$600 would be depreciated each year of that 4 year period. This change is a change in accounting estimate (the estimate being the life of the asset).Changes is accounting estimate are accounted for in the current year and future years if the change affects both.Choice "b" is incorrect. This answer is the annual difference between the depreciation expense IF depreciation expense had been retroactively restated ($24,000 / 8= $1,500) and the correct depreciation expense. Retroactive restatement is not appropriate for changes in accounting estimate. Choice "c" is incorrect. This answeris the depreciation expense IF depreciation had been retroactively restated ($24,000 / 8 = $1,500). Retroactive restatement is not appropriate for changes inaccounting estimate.Choice "d" is incorrect. This answer is the undepreciated amount at the beginning of the fifth year or the amount of the annual depreciation expense for each of thefirst 4 years. Either way, it certainly is not going to be the depreciation expense for that year because the remaining cost will depreciated over the remaining period.

QUESTION 28Envoy Co. manufactures and sells household products. Envoy experienced losses associated with its small appliance group. Operations and cash flows for thisgroup can be clearly distinguished from the rest of Envoy's operations. Envoy plans to sell the small appliance group with its operations. What is the earliest point atwhich Envoy should report the small appliance group as a discontinued operation?

A. When Envoy classifies it as held for sale.B. When Envoy receives an offer for the segment.C. When Envoy first sells any of the assets of the segment.D. When Envoy sells the majority of the assets of the segment.



Choice "a" is correct. The earliest period that a component of an entity can be reported in discontinued operations is when the component meets the following "heldfor sale" criteria:

1. Management commits to a plan to sell the component.2. The component is available for immediate sale in its present condition.3. An active program to locate a buyer has been initiated.4. The sale of the component is probable and the sale is expected to be completed within one year.5. The sale of the component is being actively marketed.6. It is unlikely that significant change to the plan to sell will be made or that the plan will be withdrawn.Choices "b", "c", and "d" are incorrect, per the Explanation: above.

QUESTION 29Belle Co. determined after four years that the estimated useful life of its labeling machine should be 10 years rather than 12 years. The machine originally cost$46,000 and had an estimated salvage value of $1,000. Belle uses straight-line depreciation. What amount should Belle report as depreciation expense for thecurrent year?

A. $3,200B. $3,750C. $4,500D. $5,000

Correct Answer: DSection: (none)

Explanation


Choice "d" is correct. A change in estimated useful life is a change in accounting estimate, and is therefore accounted for prospectively. The revised useful lifeshould be used as of the beginning of the year of the change and should be applied to the current book value of the fixed asset. The first step in determining thedepreciation expense in the year of the change in estimate is to determine the book value of the labeling machine at the time of the change:

Original cost $46,000- Accumulated depreciation 15,000 = [(46,000 - 1,000) / 12] *4 Current book value $31,000This book value is then depreciated over the remaining life of the fixed asset based on the new estimated life. In this problem, the new estimated life is 10 years,four of which have already passed, so the asset must be depreciated over the remaining 6 years:($31,000 - 1,000) / 6 = $5,000Choice "a" is incorrect. This answer is incorrectly calculated by adding the salvage value to the current book value, and by using the entire 10 year revisedestimated life. Salvage value should always be subtracted and the asset should only be depreciated over the remaining life of the asset. Choice "b" is incorrect. Thisis the annual depreciation before the change in estimated life ($46,000 - $1,000) / 12 = $3,750]. The depreciation after the change in estimate should be calculatedas described above.Choice "c" is incorrect. This would have been the annual straight-line depreciation if the original useful life of the asset had been 10 years rather than 12 years. Thechange in estimated life is applied prospectively, as described above, not retrospectively.

Comprehensive Income

QUESTION 30Rock Co.'s financial statements had the following balances at December 31:

What amount should Rock report as comprehensive income for the year ended December 31?

A. $400,000B. $420,000C. $520,000D. $570,000

Correct Answer: C



Choice "c" is correct. Comprehensive Income includes all items included in "Net Income" plus "Other Comprehensive Income" items. Since the $50,000extraordinary gain is already included in Net Income, Comprehensive Income is:

QUESTION 31According to the FASB conceptual framework, comprehensive income includes which of the following?




Explanation:

Choice "b" is correct. Comprehensive income is the change in equity of a business during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity except those resulting from investments by owners and distributions to owners. SFAC 6 para 70.

QUESTION 32Which of the following describes how comprehensive income should be reported?

A. Must be reported in a separate statement, as part of a complete set of financial statements.B. Should not be reported in the financial statements but should only be disclosed in the footnotes.C. May be reported in a separate statement, in a combined statement of income and comprehensive income, or within a statement of stockholders' equity.D. May be reported in a combined statement of income and comprehensive income or disclosed within a statement of stockholders' equity; separate statements of

comprehensive income are not permitted.



Choice "c" is correct.Comprehensive income must be presented in one of three formats:

1. In a combined statement of income and comprehensive income;2. In a separate statement of comprehensive income that begins with net income; or3. In a statement of changes in equity.Choices "a", "b", and "d" are incorrect, per the above.Balance Sheet and Disclosures Overview

QUESTION 33What is the purpose of information presented in notes to the financial statements?

A. To provide disclosures required by generally accepted accounting principles.B. To correct improper presentation in the financial statements.C. To provide recognition of amounts not included in the totals of the financial statements.D. To present management's responses to auditor comments.


Explanation


Choice "a" is correct. Information presented in notes to the financial statements have the purpose of providing disclosures required by generally acceptedaccounting principles. SFAC 5 para. 7

QUESTION 34Which of the following should be disclosed in a summary of significant accounting policies?

A. Basis of profit recognition on long-term construction contracts.B. Future minimum lease payments in the aggregate and for each of the five succeeding fiscal years.C. Depreciation expense.D. Composition of sales by segment.



Choice "a" is correct. The summary of significant accounting policies should disclose policies. The only policy in this question is the "basis" of profit recognition onlong-term construction contracts. The other disclosures are accounting details and would be disclosed in other footnotes, but not in the summary of significantaccounting policies.Choice "b" is incorrect. The future minimum lease payments should be disclosed, but not in the summary of significant accounting policies.Choice "c" is incorrect. Depreciation expense should certainly be disclosed, but not in the summary of significant accounting policies.Choice "d" is incorrect. The composition of sales by segment should be disclosed, but not in the summary of significant accounting policies.

QUESTION 35Which of the following must be included in a company's summary of significant accounting policies in the notes to the financial statements?

A. Description of current year equity transactions.B. Summary of long-term debt outstanding.C. Schedule of fixed assets.D. Revenue recognition policies.

Correct Answer: DSection: (none)

Explanation


Choice "d" is correct. The summary of significant accounting policies should include "policies." The only policy in the choices listed is the revenue recognitionpolicies. Choice "a" is incorrect. A description of current year equity transactions is not a policy. It should be disclosed somewhere in the footnotes but not in thesummary of significant accounting policies. Choice "b" is incorrect. A summary of long-term debt outstanding is not a policy. It should be disclosed somewhere inthe footnotes but not in the summary of significant accounting policies. Choice "c" is incorrect. A schedule of fixed assets is not a policy. It should be disclosedsomewhere in the footnotes but not in the summary of significant accounting policies.

QUESTION 36Which of the following is correct concerning financial statement disclosure of accounting policies?

A. Disclosures should be limited to principles and methods peculiar to the industry in which the company operates.B. Disclosure of accounting policies is an integral part of the financial statements.C. The format and location of accounting policy disclosures are fixed by generally accepted accounting principles.D. Disclosures should duplicate details disclosed elsewhere in the financial statements.



Choice "b" is correct. Disclosure of accounting policies (and all other disclosure also) is an integral part of the financial statements.Choice "a" is incorrect. For disclosure of accounting policies, disclosure should not be limited to principles and methods peculiar to the industry in which thecompany operates. All material accounting policies should be disclosed.Choice "c" is incorrect. For disclosure of accounting policies, the format and location of accounting policies are not fixed by GAAP. Accounting policy disclosures arenormally Note 1, but that is a (reasonable and very general) practice and not a "rule." It does make sense to disclose the "why" before the "what."Choice "d" is incorrect. Disclosure of accounting policies should not duplicate details disclosed elsewhere in the financial statements.Interim Financial Reporting

QUESTION 37Due to a decline in market price in the second quarter, Petal Co. incurred an inventory loss. The market price is expected to return to previous levels by the end ofthe year. At the end of the year the decline had not reversed. When should the loss be reported in Petal's interim income statements?

A. Ratably over the second, third, and forth [sic] quarters.B. Ratably over the third and fourth quarters.

C. In the second quarter only.D. In the fourth quarter only.



Choice "d" is correct. When the loss is probable and estimable, the expected loss must be recorded in full. This loss becomes such at the end of the fourth quarter.Therefore, the inventory must be valued on the year-end at the lower of cost or market, recognizing the loss at that time. Choice "a" is incorrect. Expected lossesmust be recorded in full when the loss is probable and estimable and not ratably over several quarters.Choice "b" is incorrect. Expected losses must be recorded in full when the loss is probable and estimable and not ratably over several quarters.Choice "c" is incorrect. Since the loss is not probable at the end of the second quarter, no amount should be recognized at that time.

QUESTION 38In general, an enterprise preparing interim financial statements should:

A. Defer recognition of seasonal revenue.B. Disregard permanent decreases in the market value of its inventory.C. Allocate revenues and expenses evenly over the quarters, regardless of when they actually occurred.D. Use the same accounting principles followed in preparing its latest annual financial statements.



Choice "d" is correct. Generally accepted accounting principles that were used in the most recent annual report of an enterprise should be applied to interimfinancial statements of the current year, unless a change in accounting principle is adopted in the current year.Choices "a", "b", and "c" are incorrect, per above.

QUESTION 39During the first quarter of the calendar year, Worth Co. had income before taxes of $100,000, and its effective income tax rate was 15%. Worth's effective annualincome tax rate for the previous year was 30%. Worth expects that its effective annual income tax rate for the current year will be 25%. The statutory tax rate for thecurrent year is 35%. In its first quarter interim income statement, what amount of income tax expense should Worth report?

A. $15,000B. $25,000C. $30,000D. $35,000



Choice "b" is correct. When preparing interim financial statements, income tax expense is estimated each quarter using the effective tax rate expected to apply tothe entire year. Choice "a" is incorrect. Worth should use the effective annual tax rate, not the effective tax rate for the quarter only.Choice "c" is incorrect. Worth should use the effective annual tax rate expected to apply to the current year, not the prior year's effective tax rate.Choice "d" is incorrect. Worth should use the effective annual tax rate, not the statutory tax rate.

Segment Reporting

QUESTION 40Terra Co.'s total revenues from its three operating segments were as follows:

Which operating segment(s) is (are) deemed to be reportable segments?

A. None.B. Lion only.C. Lion and Monk only.

D. Lion, Monk, and Nevi.



Choice "d" is correct. A reportable operating segment is one having 10% of all revenue, including revenue from unaffiliated sales and from intersegment sales:

Lion's revenue percentage is 66.7% [$100,000/150,000].Monk's revenue percentage is 17.3% [$26,000/150,000].Nevi's revenue percentage is 16% [$24,000/150,000].Thus, all three segments meet the 10% of total revenues test and are reportable as operating segments.SFAS 14 para. 10 and 15 as amended by SFAS 131Choice "a" is incorrect. All segments with revenue percentages exceeding 10% of total revenues are reportable operating segments.Choice "b" is incorrect. Lion is not the only segment with revenue percentages exceeding 10% of total revenues.Choice "c" is incorrect. Nevi has a revenue percentage exceeding 10% of total revenues.

QUESTION 41What information should a public company present about revenues from its reporting segments?

A. Disclose separately the amount of sales to unaffiliated customers and the amount of intracompany sales.B. Disclose as a combined amount sales to unaffiliated customers and intracompany sales between geographic areas.C. Disclose separately the amount of sales to unaffiliated customers but not the amount of intracompany sales between geographic areas.D. No disclosure of revenues from foreign operations need be reported.


Explanation/Reference:Explanation:Choice "a" is correct. Unaffiliated customers sales and intracompany sales must be disclosed separately.

QUESTION 42Taft Corp. discloses supplemental industry segment information. The following information is available for 1992:

Additional 1992 expenses, not included above, are as follows:

Indirect operating expenses $7,200General corporate expenses 4,800

Segment C's 1992 operating profit was:

A. $5,000B. $3,200C. $2,600D. $2,000



Choice "a" is correct. $5,000 operating profit for Segment C. Rule: Operating profit by segments is based on the measure of profit reported to the "Chief OperatingDecision Maker."Interest expense, income taxes, and general corporate expenses are not allocated to the divisions solely for the purposes of segment disclosures; they may beallocated if that is how the segments report to the "Chief Operating Decision Maker."

QUESTION 43In financial reporting of segment data, which of the following items is always used in determining a segment's operating income?

A. Income tax expense.B. Sales to other segments.C. General corporate expense.D. Gain or loss on discontinued operations.



Choice "b" is correct. Sales to other segments would be used in determining a segment's operating income.Rule: Equity in net income of another company, general corporate expenses, interest, income tax expense, and gains or losses on discontinued operations are allnot included in segment profit unless they are included in the determination of segment profit reported to the "Chief Operating Decision Maker."

QUESTION 44Opto Co. is a publicly-traded, consolidated enterprise reporting segment information. Which of the following items is a required enterprise-wide disclosure regardingexternal customers?

A. The fact that transactions with a particular external customer constitute more than 10% of the total enterprise revenues.B. The identity of any external customer providing 10% or more of a particular operating segment's revenue.C. The identity of any external customer considered to be "major" by management.D. Information on major customers is not required in segment reporting.


Explanation/Reference:Explanation:Choice "a" is correct. In order to conform to GAAP, financial statements for public business enterprises must report segment information about a company's majorcustomers if that customer provides 10% or more of the combined revenue, internal and external, of all operating segments. Choice "b" is incorrect. Revenue is10% of ALL operating segments not "a particular" segment. Choice "c" is incorrect. Disclosure is not at management's discretion.Choice "d" is incorrect. Disclosure is required.

QUESTION 45Which of the following qualifies as an operating segment?

A. Corporate headquarters, which oversees $1 billion in sales for the entire company.B. North American segment, whose assets are 12% of the company's assets of all segments, and management reports to the chief operating officer.C. South American segment, whose results of operations are reported directly to the chief operating officer, and has 5% of the company's assets, 9% of revenues,

and 8% of the profits.D. Eastern Europe segment, which reports its results directly to the manager of the European division, and has 20% of the company's assets, 12% of revenues,

and 11% of profits.



Choice "b" is correct. Assets of the North American segment exceed 10% combined assets of all operating segments.Choice "a" is incorrect. Corporate headquarters in not considered a segment. Choice "c" is incorrect. The South American segment does not meet any of the 10%minimums (Revenue, P&L or Assets).Choice "d" is incorrect. Eastern Europe segment does not report to the chief operating officer.

QUESTION 46Which of the following should be disclosed for each reportable operating segment of an enterprise?




Explanation:

Choice "a" is correct. For each reportable segment of an enterprise, both profit or loss and total assets should be disclosed. In disclosure questions, if you are notsure, disclose the most rather than the least. Choice "b" is incorrect. For each reportable segment of an enterprise, both profit or loss and total assets should bedisclosed.Choice "c" is incorrect. For each reportable segment of an enterprise, both profit or loss and total assets should be disclosed.Choice "d" is incorrect. For each reportable segment of an enterprise, both profit or loss and total assets should be disclosed.

QUESTION 47Which of the following factors determines whether an identified segment of an enterprise should be reported in the enterprise's financial statements under SFASNo. 131, Disclosures about Segments of an Enterprise and Related Information?

A. The segment's assets constitute more than 10% of the combined assets of all operating segments.II. The segment's liabilities constitute more than 10% of the combined liabilities of all operating segments.




Choice "a" is correct. For segment reporting, if an identified segment's assets constitute more than 10% of the combined assets of all operating segments, thesegment should be reported. The same rule does not apply for the segment's liabilities. The candidate does have to remember the 10% and also the 10% of "what."Choice "b" is incorrect. For segment reporting, if an identified segment's assets constitute more than 10% of the combined assets of all operating segments, thesegment should be reported. The same rule does not apply for the segment's liabilities.Choice "c" is incorrect. For segment reporting, if an identified segment's assets constitute more than 10% of the combined assets of all operating segments, thesegment should be reported. The same rule does not apply for the segment's liabilities, so the correct answer cannot be "Both." Choice "d" is incorrect. Forsegment reporting, if an identified segment's assets constitute more than 10% of the combined assets of all operating segments, the segment should be reported.The correct answer cannot be "Neither."

QUESTION 48Which of the following types of entities are required to report on business segments?

A. Nonpublic business enterprises.B. Publicly-traded enterprises.

C. Not-for-profit enterprises.D. Joint ventures.



Choice "b" is correct. Only publicly-traded enterprises are required to report on business segments. Choices "a", "c", and "d" are incorrect, per the Explanation:above.

QUESTION 49In financial reporting of segment data, which of the following must be considered in determining if an industry segment is a reportable segment?

A. Option A


B. Option BC. Option CD. Option D



Choice "a" is correct. A segment is considered reportable if its reported revenue, including sales to unaffiliated customers and intersegment sales, is 10% or moreof the combined revenue (unaffiliated and intersegment) of all operating segments.Choices "b", "c", and "d" are incorrect, per the above Explanation: .

Development-Stage Enterprises

QUESTION 50A development stage enterprise should use the same generally accepted accounting principles that apply to established operating enterprises for:




Choice "a" is correct. Development stage enterprises must use all the same principles as established enterprises including those of revenue recognition anddeferral of expenses. The primary difference is that development stage enterprises must provide additional disclosures not required of established operating

enterprises. SFAS #7, para. 10

QUESTION 51Tanker Oil Co., a development stage enterprise, incurred the following costs during its first year of operations:

Tanker had no revenue during its first year of operation. What amount may Tanker capitalize as organizational costs?

A. $115,000B. $95,000C. $55,000D. $0



Choice "d" is correct. $0.

All organizational costs (start-up costs) should be expensed when incurred (per SOP 98-5).Fair Value Measurements

QUESTION 52Which of the following statements regarding fair value is/are correct?

A. The fair value of an asset or liability is specific to the entity making the fair value measurement.II. Fair value is the price to acquire an asset or assume a liability.III. Fair value includes transportation costs, but not transaction costs.IV. The price in the principal market for an asset or liability will be the fair value measurement.

B. I & IIC. I & IVD. II & IIIE. III & IV



Choice "d" is correct. Statements III and IV are correct. Statement I is incorrect because fair value is a market-specific measure, not an entity-specific measure.Statement II is incorrect because fair value is an exit price (the price to sell an asset or transfer a liability), not an entrance price. Choices "a", "b" and "c" areincorrect, per the above Explanation: .

QUESTION 53Which of the following is not a valuation technique that can be used to measure the fair value of an asset or liability?

A. The market approach.B. The impairment approach.C. The income approach.D. The cost approach.



Explanation:

Choice "b" is correct. The impairment approach is not used to measure the fair value of an asset or liability. Instead, when an entity is determining whether an assethas been impaired, the entity will use the market approach, the income approach or the cost approach to determine the fair value of the asset. Choice "a" isincorrect. The market approach is an accepted method of fair value measurement in which price and other market information from identical or comparable assetsor liabilities is used to measure fair value.Choice "c" is incorrect. The income approach is an accepted method of fair value measurement in which future cash flows or earnings are discounted to determinefair value. Choice "d" is incorrect. The cost approach is an accepted method of fair value measurement in which current replacement cost is used to determine thefair value of an asset.

QUESTION 54Which of the following statements is incorrect regarding the inputs that can be used to measure fair value?

A. Level I inputs are the most reliable fair value measurements and Level III inputs are the least reliable.II. Level I measurements are quoted prices in active markets for identical or similar assets or liabilities.III. A fair value measurement based on management assumptions only (no market data) would not be acceptable per GAAP.IV. The level in the fair value hierarchy of a fair value measurement is determined by the level of the highest level significant input.

B. I only.C. I, II, IV.D. II, III, IV.E. I, II, III, IV.



Choice "c" is correct. Statement I is correct and statements II, III, and IV are incorrect. Statement II is incorrect because Level I measurements are quoted prices inactive markets for identical assets or liabilities only. Quoted prices in active markets for similar assets or liabilities are Level II inputs. Statement III is incorrectbecause a fair value measurement based on management assumptions only is aLevel III measurement and is acceptable when there are no Level I or Level II inputs or when undo cost or effort is required to obtain Level I or Level II inputs.Statement IV is incorrect because the level in the fair value hierarchy of a fair value measurement is determined by the level of the lowest level significant input.

QUESTION 55There are multiple active markets for a financial asset with different observable market prices:

There is no principal market for the financial asset. What is the fair value of the asset?

A. $71B. $72C. $74D. $76



Choice "c" is correct. When there is no principal market, the price in the most advantageous market is the fair value measurement. Although transaction costs arenot included in the fair value measurement, they are used to determine the most advantageous market, as follows:

Market A: Net Price = Quoted Price - Transaction Costs = $76 - 5 = $71 Market B: Net Price = Quoted Price - Transaction Costs = $74 - 2 = $72 Because the netprice in Market B is higher than the net price in Market A, Market B is the most advantageous market and the quoted price in Market B ($74) is the fair value of theasset. Choice "a" is incorrect. This is the net price in Market A. Fair value does not include transaction costs. Choice "b" is incorrect. This is the net price in MarketB. This net price indicates that Market B is the most advantageous market, but the net price is not the fair value because fair value does not include transactioncosts.Choice "d" is incorrect. If Market A were the principal market for the asset, then this would be the fair value of the asset. However, because there is no principalmarket, the price in the most advantageous market (Market B) is the price of the asset.

QUESTION 56A change from the cost approach to the market approach of measuring fair value is considered to be what type of accounting change?

A. Change in accounting estimate.B. Change in accounting principle.C. Change in valuation technique.

D. Error correction.



Choice "a" is correct. A change in the valuation technique used to measure fair value is a change in accounting estimate.Choice "b" is incorrect. Per SFAS No. 157, a change in valuation technique is a change in accounting estimate, not a change in accounting principal.Choice "c" is incorrect. Although a change from the cost approach to the market approach is a change in valuation technique, a change in valuation technique is notdefined as a type of accounting change, but instead falls into the category of changes in accounting estimate. Choice "d" is incorrect. Both the market approach andthe cost approach are acceptable methods of measuring fair value per SFAS No. 157; therefore, switching between these methods is not the correction of an error.Additionally, an error correction is not a type of accounting change.

QUESTION 57According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on:

A. The need for conservatism.B. Reporting on management's stewardship.C. Generally accepted accounting principles.D. The needs of the users of the information.



Choice "d" is correct. The FASB conceptual framework states that the objectives of financial reporting stem from the informational needs of the external users of theinformation. SFAC 1 para. 28 Choice "a" is incorrect. Conservatism is an underlying concept for financial accounting but is not the basis for the objectives. SFAC 2para. 91-97Choice "b" is incorrect. Information concerning management's stewardship is only one aspect of the information financial statements are intended to provide. SFAC1 para. 50 Choice "c" is incorrect. Generally accepted accounting principles (GAAP) are derived from and based on the objectives of financial reporting, not theother way around.

QUESTION 58According to the FASB conceptual framework, predictive value is an ingredient of:




Choice "d" is correct. Yes - No. Predictive value is an ingredient of relevance but not of reliability.Memorize:Bud's relevance to "PFT."Bud's reliability to "VRN."

QUESTION 59According to the FASB's conceptual framework, the process of reporting an item in the financial statements of an entity is:

A. Recognition.B. Realization.C. Allocation.D. Matching.



Choice "a" is correct. Recognition.According to the FASB's conceptual framework, the process of reporting an item in the financial statements of an entity is recognition.

QUESTION 60Under FASB Statement of Financial Accounting Concepts #5, which of the following items would cause earnings to differ from comprehensive income for anenterprise in an industry not having specialized accounting principles?

A. Unrealized loss on investments in noncurrent marketable equity securities available for sale.B. Unrealized loss on investments in current marketable equity securities held for trading.C. Loss on exchange of nonmonetary assets without commercial substance.D. Loss on exchange of nonmonetary assets with commercial substance.



Choice "a" is correct. Unrealized loss on investments in marketable equity securities available for sale would cause earnings to differ from comprehensive incomefor an enterprise in an industry not having specialized accounting principles.Rule: FAC 5 defines "earnings" for a period to exclude certain cumulative accounting adjustments and other non-owner changes in equity (such as changes inmarket value of marketable securities available for sale) that are included in comprehensive income for a period.

QUESTION 61FASB's conceptual framework explains both financial and physical capital maintenance concepts. Which capital maintenance concept is applied to currentlyreported net income, and which is applied to comprehensive income?




Choice "c" is correct. Financial capital - Financial capital. Financial capital maintenance is considered to be an element of both "currently reported net income" and"comprehensive income." This was a rare instance in which this type of information was asked on the exam.

QUESTION 62According to the FASB conceptual framework, which of the following is an essential characteristic of an asset?

A. The claims to an asset's benefits are legally enforceable.B. An asset is tangible.C. An asset is obtained at a cost.D. An asset provides future benefits.



Choice "d" is correct. An asset provides future benefits. Rule: According to the FASB conceptual framework, assets are probable future economic benefits obtainedor controlled by a particular entity as a result of past transactions or events.

QUESTION 63According to the FASB conceptual framework, an entity's revenue may result from:

A. A decrease in an asset from primary operations.B. An increase in an asset from incidental transactions.C. An increase in a liability from incidental transactions.

D. A decrease in a liability from primary operations.



Rule: Revenues are inflows or other enhancements of assets and/or settlements (decreases) in liabilities resulting from the entity's ongoing major operations, notfrom "incidental" operations. Choice "d" is correct. An entity's revenue may result from a decrease in a liability from primary operations.

QUESTION 64Which of the following facts concerning fixed assets should be included in the summary of significant accounting policies?




Choice "c" is correct. Yes - No.Yes - "Depreciation methods" should be disclosed in the "summary of significant accounting policies." No - Composition of fixed assets (or any other account)should not be disclosed in the "summary of significant accounting policies."

QUESTION 65

Brock Corp. reports operating expenses in two categories: (1) selling and (2) general and administrative.The adjusted trial balance at December 31, 1989 included the following expense and loss accounts:

One-half of the rented premises is occupied by the sales department. Brock's total selling expenses for 1989 are:

A. $480,000B. $400,000C. $370,000D. $360,000



Note: Only one-half of rent for office space was used for sales office.Choice "a" is correct. $480,000.

QUESTION 66The following items were among those that were reported on Lee Co.'s income statement for the year ended December 31, 1989:

The office space is used equally by Lee's sales and accounting departments. What amount of the abovelisted items should be classified as general andadministrative expenses in Lee's multiple-step income statement?

A. $290,000B. $325,000C. $410,000D. $500,000



Note: 1/2 of the office space of $240,000 was used by the sales department, which should be allocated to "selling expenses" (not general and administrative).Choice "a" is correct. $290,000.

QUESTION 67In Baer Food Co.'s 1990 single-step income statement, the section titled "Revenues" consisted of the following:

In the revenues section of its 1990 income statement, Baer Food should have reported total revenues of:

A. $216,300B. $215,400C. $203,700D. $201,900



Choice "d" is correct. $201,900.

The various amounts from discontinued operations should be included in discontinued operations, not in revenues.

QUESTION 68

FASB Interpretations of Statements of Financial Accounting Standards have the same authority as the FASB:

A. Statements of Financial Accounting Concepts.B. Emerging Issues Task Force Consensus.C. Technical Bulletins.D. Statements of Financial Accounting Standards.



Choice "d" is correct. FASB interpretations of the "statements of financial accounting standards" (SFAS) have the same authority as the FASB statements offinancial accounting standards (SFAS), which by themselves determine GAAP.Choice "a" is incorrect. Statements of financial accounting concepts (FAC's) have much less authority (fifth floor) and do not by themselves determine GAAP as isthe case with SFASs and interpretations of SFASs.Choice "b" is incorrect. Emerging issues task force (EITF) consensus is in the nature of a "third floor" authority. The EITF was established in 1984 to aid the FASBin identifying and implementing emerging issues before they become widespread and ultimately require action by the FASB. After discussing the issues and therelevant accounting pronouncements, the group can sometimes reach a consensus on an issue, in which case no action by the FASB is usually needed. Choice "c"is incorrect. Technical bulletins of the FASB (second floor) do not by themselves determine GAAP.

QUESTION 69On January 1, 1991, Brecon Co. installed cabinets to display its merchandise in customers' stores. Brecon expects to use these cabinets for five years. Brecon's1991 multi-step income statement should include:

A. One-fifth of the cabinet costs in cost of goods sold.B. One-fifth of the cabinet costs in selling, general, and administrative expenses.C. All of the cabinet costs in cost of goods sold.D. All of the cabinet costs in selling, general, and administrative expenses.



Choice "b" is correct. One-fifth of the cabinet costs (depreciation expense) should be included in selling, general, and administrative expenses for 1991. Choice "a"

is incorrect. Merchandise display cabinets in stores relate to selling activities, not to the purchase cost of goods sold.Choices "c" and "d" are incorrect. Merchandise display cabinets are fixed assets whose cost should be allocated systematically over their five-year useful life.

QUESTION 70Which of the following accounting pronouncements is the most authoritative?

A. FASB Statement of Financial Accounting Concepts.B. FASB Technical Bulletin.C. AICPA Accounting Principles Board Opinion.D. AICPA Statement of Position.



Choice "c" is correct. The AICPA accounting principal board opinion (APBO) is a first floor (category A) of established accounting principle pronouncements. Choice"a" is incorrect. FASB statement of financial accounting concepts (SFAC or FACs) is a fifth floor (other accounting literature) category.Choice "b" is incorrect. FASB technical bulletins are a second floor (category B) accounting pronouncement.Choice "d" is incorrect. AICPA statement of position is a second floor (category B) accounting pronouncement.

QUESTION 71Which of the following should be disclosed in a summary of significant accounting policies?

A. Management's intention to maintain or vary the dividend payout ratio.II. Criteria for determining which investments are treated as cash equivalents.III. Composition of the sales order backlog by segment.

B. I only.C. I and III.D. II only.E. II and III.



Explanation:

Choice "c" is correct. Il only.The criteria for determining which investments are treated as "cash equivalents" is a method of accounting policies that needs to be disclosed in the summary ofsignificant accounting policies. Choice "a" is incorrect. Management's intention to maintain or vary the "dividend payout ratio" is not an "accounting policy."Choices "b" and "d" are incorrect. Composition of the sales order backlog by segment is not an "accounting policy."

QUESTION 72The summary of significant accounting policies should disclose the:

A. Maturity dates of noncurrent debts.B. Terms for convertible debt to be exchanged for common stock.C. Concentration of credit risk of all financial instruments by geographical region.D. Criteria for determining which investments are treated as cash equivalents.



Choice "d" is correct. The criteria for determining which investments are treated as cash equivalents would be part of the summary of significant accounting policies.Choice "a" is incorrect. The maturity dates of noncurrent debts are required disclosures, but are not a part of the summary of significant accounting policies. Choice"b" is incorrect. The terms for convertible debt to be exchanged for common stock are not accounting policies; they would be disclosed separately. Choice "c" isincorrect. The concentration of credit risk of all financial instruments by geographic region may be a required segment disclosure, especially for financial institutions.However, it would not be a part of the summary of significant accounting policies.

QUESTION 73The following costs were incurred by Griff Co., a manufacturer, during 1992:

What amount of these costs should be reported as general and administrative expenses for 1992?

A. $260,000B. $550,000C. $635,000D. $810,000



Choice "a" is correct. $260,000.General and administrative

"Freight-in" is part of "cost of goods sold.""Freight-out" is a "selling" expense.Sales representative salaries is a selling expense.

QUESTION 74Which of the following information should be included in Melay, Inc.'s 1992 summary of significant accounting policies?

A. Property, plant, and equipment is recorded at cost with depreciation computed principally by the straight-line method.B. During 1992, the Delay component was sold.C. Business segment 1992 sales are Alay $1M, Belay $2M, and Celay $3M.D. Future common share dividends are expected to approximate 60% of earnings.



Explanation:

Choice "a" is correct. Computing depreciation principally by the straight-line method is a GAAP method of depreciation that should be described in the "summary ofsignificant accounting policies." Choice "b" is incorrect. Disclosing the sale of a component of a business is required (and is covered in the lecture on "discontinuedoperations" in the F1 class) but is not a "significant accounting policy." Choice "c" is incorrect. Disclosing "sales" of segments is required, but is not a "significantaccounting policy."Choice "d" is incorrect. "Estimates of future common share dividends" are not appropriate disclosures for the financial statements. They might be appropriate for the"presidents letter to shareholders."

QUESTION 75Several sources of GAAP consulted by an auditor are in conflict as to the application of an accounting principle. Which of the following should the auditor considerthe most authoritative?

A. FASB Technical Bulletins.B. AICPA Accounting Interpretations.C. FASB Statements of Financial Accounting Concepts.D. AICPA Technical Practice Aids.



Choice "a" is correct. The most authoritative pronouncements (first floor) are FASB Statements, FASB Staff Positions, FASB Statement 133 Implementation Issues,FASB Interpretations, AICPA APB opinions, and AICPA Accounting Research Bulletins. When these pronouncements do not provide appropriate guidance, the nextlevel of pronouncements (second floor) are AICPA Industry Audit and Accounting Guides, AICPA Statements of Position, and FASB Technical Bulletins. Choice "b"is incorrect. AICPA Accounting Interpretations are not as authoritative as FASB Technical Bulletins, since they are on the fourth floor.Choices "c" and "d" are incorrect. FASB Concepts Statements and AICPA Technical Practice Aids are among the least authoritative of accounting literature (fifthfloor).

QUESTION 76Coffey Corp.'s trial balance of Income Statement Accounts for the year ended December 31, 1988 as follows:

Coffey's income tax rate is 30%. The gain on debt extinguishment is considered a usual and recurring part of Coffey's operations. Coffey prepares a multiple-stepincome statement for 1988.Income from operations before income tax is:

A. $190,000B. $200,000C. $230,000D. $240,000



Choice "d" is correct. $240,000The gain on debt extinguishment does not meet the unusual and infrequent criteria of APB 30 to be treated as an extraordinary item (per SFAS No. 145,extinguishments of debt are no longer automatically extraordinary), so it is included as part of income from continuing operations.

QUESTION 77Coffey Corp.'s trial balance of Income Statement Accounts for the year ended December 31, 1988 as follows:

Coffey's income tax rate is 30%. The gain on debt extinguishment is considered a usual and recurring part of Coffey's operations. The hurricane is considered anunusual and infrequent event. Coffey prepares a multiple-step income statement for 1988.

Net income is:

A. $140,000B. $161,000C. $168,000D. $200,000



Choice "a" is correct. $140,000.Net income is the "bottom line" amount after all has been considered on the income statement. Without showing all the line items as required for the incomestatement, the "bottom line" amount of $140,000 is derived as follows:

QUESTION 78Gown, Inc. sold a warehouse and used the proceeds to acquire a new warehouse. The excess of the proceeds over the carrying amount of the warehouse soldshould be reported as a(an):

A. Extraordinary gain, net of income taxes.B. Part of continuing operations.C. Gain from discontinued operations, net of income taxes.D. Reduction of the cost of the new warehouse.



Choice "b" is correct. Part of continuing operations.Rule: When a fixed asset is sold, gain or loss is recognized as part of income from continuing operations. The amount of the gain or loss is equal to the differencebetween the proceeds from the sale and the carrying amount (FMV) of the fixed asset sold. Choice "a" is incorrect. The gain is not extraordinary and is shown gross- not net of tax. Choice "c" is incorrect. The gain is part of continuing operations - not discontinued operations. Choice "d" is incorrect. The gain is not reported as areduction of the cost of the new warehouse.

QUESTION 79Adam Corp. had the following infrequent transactions during 1989:

· A $190,000 gain on reacquisition and retirement of bonds. This material event is also considered unusual for Adam Corp.· A $260,000 gain on the disposal of a component of a business. Adam continues similar operations at another location.· A $90,000 loss on the abandonment of equipment.

In its 1989 income statement, what amount should Adam report as total infrequent net gains that are not considered extraordinary?

A. $100,000B. $170,000C. $360,000D. $450,000



Infrequent net gains not considered extraordinary include:

Choice "b" is correct. $170,000.

QUESTION 80Thorpe Co.'s income statement for the year ended December 31, 1990, reported net income of $74,100. The auditor raised questions about the following amountsthat had been included in net income:

The loss from the fire was an infrequent but not unusual occurrence in Thorpe's line of business. Thorpe's December 31, 1990, income statement should report netincome of:

A. $65,000B. $66,100C. $81,600D. $87,000



Net income before adjustments

Rule: Unrealized losses (or gains) resulting from changes in market value of available-for-sale investments should be reported as a component of othercomprehensive income in shareholders' equity. Unrealized gains and losses on investments held for trading would be included in net income. Correction of errors ofprior periods should be reported as an adjustment to beginning retained earnings, not as an item of net income.Choice "d" is correct. $87,000.

QUESTION 81A transaction that is unusual, but not infrequent, should be reported separately as a(an):

A. Extraordinary item, net of applicable income taxes.B. Extraordinary item, but not net of applicable income taxes.C. Component of income from continuing operations, net of applicable income taxes.D. Component of income from continuing operations, but not net of applicable income taxes.



Choice "d" is correct. A transaction that is unusual, but not "infrequent" should be reported separately as a component of continuing operations, (gross) but not netof applicable income taxes. Choices "a" and "b" are incorrect. An extraordinary item has to be both "unusual" and "infrequent." Choice "c" is incorrect, per "d" above.

QUESTION 82During 1990, Fuqua Steel Co. had the following unusual financial events occur:

· Bonds payable were retired five years before their scheduled maturity, resulting in a $260,000 gain. Fuqua has frequently retired bonds early when interest ratesdeclined significantly. · A steel forming segment suffered $255,000 in losses due to hurricane damage. This was the fourth similar loss sustained in a 5-year periodat that location. · A component of Fuqua's operations, steel transportation, was sold at a net loss of $350,000.

This was Fuqua's first divestiture of one of its operating segments. Before income taxes, what amount of gain (loss) should be reported separately as a componentof income from continuing operations in 1990?

A. $260,000

B. $5,000C. $(255,000)D. $(350,000)


Explanation/Reference:Explanation:Choice "b" is correct. $5,000.The steel forming segment's hurricane damage (4th in 5 years) of $255,000 is only "unusual in nature" and does not occur infrequently, therefore, it is not an"extraordinary item," and should be reported separately as a component of "income from continuing operations." The retirement of debt, although unusual, is notinfrequent for the company; therefore, the gain does not qualify for classification as an extraordinary item per APBO No. 30 (and SFAS No. 145).

QUESTION 83During 1990, Fuqua Steel Co. had the following unusual financial events occur:

· Bonds payable were retired five years before their scheduled maturity, resulting in a $260,000 gain. Fuqua has frequently retired bonds early when interest ratesdeclined significantly. · A steel forming segment suffered $255,000 in losses due to hurricane damage. This was the fourth similar loss sustained in a 5-year periodat that location. · A component of Fuqua's operations, steel transportation, was sold at a net loss of $350,000.

This was Fuqua's first divestiture of one of its operating segments. Before income taxes, what amount should be disclosed as the gain (loss) from extraordinaryitems in 1990?

A. $0B. $5,000C. $(90,000)D. $(350,000)



Choice "a" is correct. $0.Note: The sale of the steel transportation component resulted in a loss from discontinued operations and is reported after "income from continuing operations." Thesteel forming segment's hurricane damage (4th in 5 years) of $255,000 is only "unusual in nature" and does not occur infrequently, therefore, it is not an

"extraordinary item," and should be reported separately as a component of "income from continuing operations." The retirement of debt, although unusual, is notinfrequent for the company; therefore, the gain does not qualify for classification as an extraordinary item per APBO No. 30 (and SFAS No. 145).

QUESTION 84On January 2, 1991, Air, Inc. agreed to pay its former president $300,000 under a deferred compensation arrangement. Air should have recorded this expense in1990 but did not do so. Air's reported income tax expense would have been $70,000 lower in 1990 had it properly accrued this deferred compensation in itsDecember 31,1991, financial statements, Air should adjust the beginning balance of its retained earnings by a:

A. $230,000 credit.B. $230,000 debit.C. $300,000 credit.D. $370,000 debit.



Choice "b" is correct. $230,000 debit.

QUESTION 85On August 31, 1992, Harvey Co. decided to change from the FIFO periodic inventory system to the weighted average periodic inventory system. Harvey is on acalendar year basis. The cumulative effect of the change is determined:

A. As of January 1, 1992.B. As of August 31, 1992.C. During the eight months ending August 31, 1992, by a weighted average of the purchases.D. During 1992 by a weighted average of the purchases.


Explanation


Rule: The cumulative effect of a change in accounting principle equals the difference between retained earnings at the beginning of period of the change and whatretained earnings would have been if the change was applied to all affected prior periods.Choice "a" is correct. As of January 1, 1992, the beginning of the year. This assumes that the company is not presenting comparative financial statements. Ifcomparative financial statements are presented, then the adjustment is made to the beginning retained earnings of the earliest year presented. Choice "b" isincorrect. The cumulative effect of the change is not determined as of the date the decision is made.Choices "c" and "d" are incorrect. The cumulative effect of the change is not determined by a weighted average. (A far out distractor.)

QUESTION 86Conn Co. reported a retained earnings balance of $400,000 at December 31, 1991. In August 1992, Conn determined that insurance premiums of $60,000 for thethree-year period beginning January 1, 1991, had been paid and fully expensed in 1991. Conn has a 30% income tax rate. What amount should Conn report asadjusted beginning retained earnings in its 1992 statement of retained earnings?

A. $420,000B. $428,000C. $440,000D. $442,000



Choice "b" is correct. $428,000 net of tax.

QUESTION 87Which of the following is true regarding the presentation of "comprehensive income."




Choice "c" is correct. No - Yes.Comprehensive income may be shown on the face of a combined "statement of income and comprehensive income" a separate section below net income, or in:

1. Separate "statement of comprehensive income," or as a2. Component of the "statement of changes of owners' equity." The income tax expense or benefit allocated to components must be disclosed, either on the face ofthe statement or in notes to the statement.Choices "a", "b", and "d" are incorrect, per the above rules.

QUESTION 88Reclassification adjustments must be shown in the financial statement that discloses comprehensive income:

A. To show what portion of comprehensive income is from the realization of current assets.B. To show the tax effect of items of comprehensive income.C. To avoid double counting in comprehensive income items, which are currently displayed in net income.

D. To avoid including transactions with shareholders in items of comprehensive income.


Explanation/Reference:Explanation:Choice "c" is correct. Reclassification entries may be necessary to avoid double counting an item previously reported as comprehensive income (i.e., unrealizedgain), which are now reported as part of net income (i.e., realized gain).Choice "a" is incorrect. The classification of assets as current or non-current has no bearing on reporting comprehensive income.Choice "b" is incorrect. All items of comprehensive income must be shown net of the related tax effects, but it is not done with reclassification adjustments. Choice"d" is incorrect. Transactions with shareholders such as paying dividends and issuing capital stock are not included in comprehensive income, thus, reclassificationadjustments are not necessary to exclude them.

QUESTION 89Dean Co. acquired 100% of Morey Corp. prior to 1989. During 1989, the individual companies included in their financial statements the following:

What amount should be reported as related party disclosures in the notes to Dean's 1989 consolidated financial statements?

A. $150,000B. $155,000C. $175,000D. $330,000



Choice "c" is correct. The only related party transaction that would require disclosure (assuming that all amounts are material to the financial statements) would be

the loans to officers since they are outside of the ordinary course of business.Choices "a", "b", and "d" are incorrect. Officers' salaries, officers' expenses and intercompany sales (between entities included in a consolidated set of financialstatements) are all transactions in the ordinary course of business and generally would not require disclosure.

QUESTION 90Wilson Corp. experienced a $50,000 decline in the market value of its inventory in the first quarter of its fiscal year. Wilson had expected this decline to reverse inthe third quarter, and in fact, the third quarter recovery exceeded the previous decline by $10,000. Wilson's inventory did not experience any other declines inmarket value during the fiscal year. What amounts of loss and/or gain should Wilson report in its interim financial statements for the first and third quarters?




Choice "a" is correct. Temporary market declines in inventory need not be recognized at interim when a turn-around can reasonably be expected to occur before theend of the fiscal year.

QUESTION 91During the second quarter of 1988, Buzz Company sold a piece of equipment at a $12,000 gain. What portion of the gain should Buzz report in its income statementfor the second quarter of 1988?

A. $12,000B. $6,000C. $4,000

D. $0



Choice "a" is correct. $12,000.Rule: The entire amount of an "extraordinary gain or loss" or an "unusual or infrequently occurring item," e.g., a gain or loss from sale of fixed assets, should bereported during the period (quarter) incurred.Choices "b", "c", and "d" are incorrect. The full gain should be reported in the second quarter when it occurred.

QUESTION 92For interim financial reporting, the computation of a company's second quarter provision for income taxes uses an effective tax rate expected to be applicable forthe full fiscal year. The effective tax rate should reflect anticipated:




Choice "d" is correct. Yes - Yes.

The effective income tax rates for operations for the full year should reflect anticipated foreign tax rates and available tax planning alternatives. In addition, the effectof other anticipated tax credits, capital gains rates, and foreign tax credits should be included.

QUESTION 93An inventory loss from a permanent market decline of $360,000 occurred in May 1989. Cox Co. appropriately recorded this loss in May 1989 after its March 31,1989 quarterly report was issued. What amount of inventory loss should be reported in Cox's quarterly income statement for the three months ended June 30,1989?

A. $0B. $90,000C. $180,000D. $360,000



Choice "d" is correct. $360,000 inventory loss reported for the quarter ended 6-30-89. Rule: Inventory losses from "permanent market declines" are recognized inthe interim period, incurred and later, if they "turn-around," are recognized as gains in a subsequent interim period only to the extent of previously reported losses.Rule: "Temporary" market declines need not be recognized at interim when a "turn-around" can reasonably be expected to occur before the end of the fiscal year.Facts: This $360,000 inventory decline is permanent and the entire loss would be recognized in the quarter interim period incurred (6-30-89).

QUESTION 94Advertising costs may be accrued or deferred to provide an appropriate expense in each period for:

A. Option AB. Option BC. Option C

D. Option D


Explanation/Reference:Explanation:Choice "b" is correct. Yes - Yes.Advertising costs may be accrued or deferred to provide an appropriate expense in each period for both "interim" and "year-end" financial reporting.

QUESTION 95A planned volume variance in the first quarter, which is expected to be absorbed by the end of the fiscal period, ordinarily should be deferred at the end of the firstquarter if it is:




Choice "d" is correct. Yes - Yes.Rule: Volume variances that are planned or expected to be absorbed by the end of the year should be deferred at interim whether favorable or unfavorable.

QUESTION 96An inventory loss from a market price decline occurred in the first quarter, and the decline was not expected to reverse during the fiscal year. However, in the thirdquarter the inventory's market price recovery exceeded the market decline that occurred in the first quarter. For interim financial reporting, the dollar amount of net

inventory should:

A. Decrease in the first quarter by the amount of the market price decline and increase in the third quarter by the amount of the decrease in the first quarter.B. Decrease in the first quarter by the amount of the market price decline and increase in the third quarter by the amount of the market price recovery.C. Decrease in the first quarter by the amount of the market price decline and not be affected in the third quarter.D. Not be affected in either the first quarter or the third quarter.



Choice "a" is correct. Market price declines should be recognized in the interim period in which decline is judged permanent and later, if they "turn around," arerecognized as gains in subsequent periods only to the extent of previously reported losses.Choice "b" is incorrect. Recovery should not cause an increase in inventory value above original cost. Choice "c" is incorrect. The recovery should be recognized tothe extent of the first quarter write down.Choice "d" is incorrect.

QUESTION 97The following information pertains to Aria Corp. and its divisions for the year ended December 31, 1988:

Aria and all of its divisions are engaged solely in manufacturing operations. Aria has a reportable segment if that segment's revenue exceeds:

A. $264,000B. $260,000C. $204,000D. $200,000



Choice "b" is correct. $260,000 represents a reportable segment (10% of total sales):

Rule: To be significant enough to report on, a segment must be at least 10% of:

1. Combined revenues (whether intersegment or unaffiliated customers), or2. Operating income, or3. Identifiable assets.

QUESTION 98Hyde Corp. has three manufacturing divisions, each of which has been determined to be a reportable segment. In 1989, Clay division had sales of $3,000,000,which was 25% of Hyde's total sales, and had operating costs of $1,900,000, as reported to the CFO. In 1989, Hyde incurred operating costs of $500,000 that werenot directly traceable to any of the divisions. In addition, Hyde incurred corporate interest expense of $300,000 in 1989. In reporting segment information, whatamount should be shown as Clay's operating profit for 1989?

A. $875,000B. $900,000C. $975,000D. $1,100,000



Choice "d" is correct. $1,100,000 operating profit for clay. Rule: Operating profit by segments is based on the measure of profit reported to the "chief operatingdecision maker."Allocations for general operating costs and interest, etc., should not be made solely for purposes of segment disclosures.

QUESTION 99YIV, Inc. is a multidivisional corporation, which has both intersegment sales and sales to unaffiliated customers. YIV should report segment financial information foreach division meeting which of the following criteria?

A. Segment operating profit or loss is 10% or more of consolidated profit or loss.B. Segment operating profit or loss is 10% or more of combined operating profit or loss of all company segments.C. Segment revenue is 10% or more of combined revenue of all the company segments.D. Segment revenue is 10% or more of consolidated revenue.



Choice "c" is correct. Segment revenue is 10% or more of combined revenue of all the company segments.Rule: To be significant enough to report on, a segment must be at least 10% of:

1. Combined revenues (whether intersegment or affiliated customers) or2. Operating profit (of all segments not having an operating loss), or3. Identifiable assets.

Choice "a" is incorrect. Rule is 10% of "operating profit," not "consolidated profit." Choice "b" is incorrect. Segments with "operating losses" are not combined withthose having "operating profits" in determining a segment.Choice "d" is incorrect. "Consolidated revenue" would not include "intersegment revenue." Rule is "combined revenue," not "consolidated revenue."

QUESTION 100Grum Corp., a publicly-owned corporation, is subject to the requirements for segment reporting. In its income statement for the year ended December 31, 1991,Grum reported revenues of $50,000,000, operating expenses of $47,000,000, and net income of $3,000,000. Operating expenses include payroll costs of $15,000,000. Grum's combined identifiable assets of all industry segments at December 31, 1991, were $40,000,000.In its 1991 financial statements, Grum should disclose major customer data if sales to any single customer amount to at least:

A. $300,000B. $1,500,000C. $4,000,000D. $5,000,000



Choice "d" is correct. $5,000,000 (10% x $50,000,000 revenue). If revenue from a single external customer is 10% or more of total revenue, then the companyshould disclose this fact, the total amount of revenue from the customer, and the segment or segments reporting the revenues. The identity of the customer neednot be disclosed.

QUESTION 101Grum Corp., a publicly-owned corporation, is subject to the requirements for segment reporting. In its income statement for the year ended December 31, 1991,Grum reported revenues of $50,000,000, operating expenses of $47,000,000, and net income of $3,000,000. Operating expenses include payroll costs of $15,000,000. Grum's combined identifiable assets of all industry segments at December 31, 1991, were $40,000,000.Cott Co.'s four business segments have revenues and identifiable assets expressed as percentages of Cott's total revenues and total assets as follows:

Which of these business segments are deemed to be reportable segments?

A. Ebon only.B. Ebon and Fair only.C. Ebon, Fair, and Gel only.D. Ebon, Fair, Gel, and Hak.

Correct Answer: D



Rule: A segment must be at least 10% of:

1. Combined revenues (whether intersegment or unaffiliated customers), or2. Operating income (of all segments not having an operating loss), or3. Identifiable assets.

Choice "d" is correct. Ebon, Fair, Gel, and Hak, since all four companies meet at least one of the criteria.

QUESTION 102Chester Corp. was a development stage enterprise from its inception on September 1, 1987 to December 31, 1988. The following information was taken fromChester's accounting records for the above period:

For the period September 1, 1987 to December 31, 1988, what amount should Chester report as net loss?

A. $ 50,000B. $150,000C. $350,000D. $450,000



Choice "d" is correct. $450,000 net loss for the period Sept. 1, 1987 to DeC. 31, 1988. Rule: "Development stage enterprises" present their FS in accordance with

GAAP and make additional disclosures such as: cumulative net losses, cumulative deficit, cumulative sales and expenses.

QUESTION 103Deficits accumulated during the development stage of a company should be:

A. Reported as organization costs.B. Reported as a part of stockholders' equity.C. Capitalized and written off in the first year of principal operations.D. Capitalized and amortized over a five year period beginning when principal operations commence.



Choice "b" is correct. Deficits accumulated during the development stage of a company should be reported as a part of stockholders' equity.Rule: Development stage enterprises should present FS in accordance with GAAP and make additional disclosures such as: cumulative net losses, cumulativedeficit (as part of equity), cumulative sales & expenses (part of I/S), cumulative statement of cash flows and supplementary "shareholders equity." Choices "a", "c",and "d" are incorrect, per the rule above.

QUESTION 104Financial reporting by a development stage enterprise differs from financial reporting for an established operating enterprise in regard to footnote disclosures:

A. Only.B. And expense recognition principles only.C. And revenue recognition principles only.D. And revenue and expense recognition principles.


Explanation/Reference:Explanation:Choice "a" is correct. Financial reporting by a development stage enterprise differs from financial reporting for an established operating enterprise in regard to (moreextensive) footnote disclosures only.Choices "b", "c", and "d" are incorrect. Revenue and expense recognition principles are the same. Rule: Development stage enterprises should present financialstatements in accordance with GAAP and make additional disclosures such as: cumulative net losses, cumulative deficit (as part of equity), cumulative sales andexpenses (as part of the income statement), cumulative statement of cash flows and supplementary "shareholders equity."

QUESTION 105A statement of cash flows for a development stage enterprise:

A. Is the same as that of an established operating enterprise and, in addition, shows cumulative amounts from the enterprise's inception.B. Shows only cumulative amounts from the enterprise's inception.C. Is the same as that of an established operating enterprise, but does not show cumulative amounts from the enterprise's inception.D. Is not presented.



Rule: Development stage enterprises should present financial statements in accordance with GAAP and make additional disclosures such as cumulative amountsfrom inception for: net losses, deficits, sales, expenses, and cash flows and supplementary data.Choice "a" is correct, per the rule shown above.Choice "b" is incorrect. Current amounts are shown as well as cumulative amounts. Choice "c" is incorrect. Cumulative amounts from inception are shown. Choice"d" is incorrect. A statement of cash flows is required.

QUESTION 106On January 2, 1993, Quo, Inc. hired Reed to be its controller. During the year, Reed, working closely with Quo's president and outside accountants, made changesin accounting policies, corrected several errors dating from 1992 and before, and instituted new accounting policies. Quo's 1993 financial statements will bepresented in comparative form with its 1992 financial statements.This question represents one of Quo's transactions. List A represents possible clarifications of these transactions as: a change in accounting principle, a change inaccounting estimate, a correction of an error in previously presented financial statements, or neither an accounting change nor an accounting error.

Item to Be Answered

Quo manufactures heavy equipment to customer specifications on a contract basis. On the basis that it is preferable, accounting for these long-term contracts wasswitched from the completed-contract method to the percentage-of-completion method.

List A (Select one)

A. Change in accounting principal.B. Change in accounting estimate.C. Correction of an error in previously presented financial statements.D. Neither an accounting change nor an accounting error.



Choice "a" is correct. Switching from the completed-contract method of accounting to the percentage- ofcompletion method is a "change in accounting principle."

QUESTION 107On January 2, 1993, Quo, Inc. hired Reed to be its controller. During the year, Reed, working closely with Quo's president and outside accountants, made changesin accounting policies, corrected several errors dating from 1992 and before, and instituted new accounting policies. Quo's 1993 financial statements will bepresented in comparative form with its 1992 financial statements.This question represents one of Quo's transactions. List B represents the general accounting treatment required for these transactions. These treatments are:

· Cumulative effect approach - Include the cumulative effect of the adjustment resulting from the accounting change or error correction in the 1993 financialstatements, and do not restate the 1992 financial statements.· Retroactive or retrospective restatement approach - Restate the 1992 financial statements and adjust 1992 beginning retained earnings if the error or changeaffects a period prior to 1992. · Prospective approach - Report 1993 and future financial statements on the new basis but do not restate 1992 financial statements.

Item to Be AnsweredQuo manufactures heavy equipment to customer specifications on a contract basis. On the basis that it is preferable, accounting for these long-term contracts wasswitched from the completed-contract method to the percentage-of-completion method.

List B (Select one)

A. Cumulative effect approach.B. Retroactive or retrospective restatement approach.C. Prospective approach.



Choice "B" is correct. Changes in accounting principle are handled "retrospectively." Beginning retained earnings of the earliest year presented is adjusted for thecumulative effect of the change and all prior year financial statements are restated.


Item to Be AnsweredAs a result of a production breakthrough, Quo determined that manufacturing equipment previously depreciated over 15 years should be depreciated over 20 years.

List A (Select one)




Choice "b" is correct. Change in lives of fixed assets is a change in accounting estimate.



Item to Be AnsweredAs a result of a production breakthrough, Quo determined that manufacturing equipment previously depreciated over 15 years should be depreciated over 20 years.

List B (Select one)




Choice "C" is correct. This affects only the prospective (current and subsequent) periods - not prior periods, not retained earnings.


Item to Be AnsweredThe equipment that Quo manufactures is sold with a five-year warranty. Because of a production breakthrough, Quo reduced its computation of warranty costs from3% of sales to 1% of sales.

List A (Select one)

A. Change in accounting principal.B. Change in accounting estimate.C. Correction of an error in previously presented financial statements.

D. Neither an accounting change nor an accounting error.



Choice "b" is correct. Change in the computation of warranty costs from 3% of sales to 1% of sales is a change in accounting estimate.



Item to Be AnsweredThe equipment that Quo manufactures is sold with a five-year warranty. Because of a production breakthrough, Quo reduced its computation of warranty costs from3% of sales to 1% of sales.

List B (Select one)




Choice "C" is correct. This affects only the prospective (current and subsequent) periods - not prior periods, not retained earnings.


Item to Be AnsweredQuo changed from LIFO to FIFO to account for its finished goods inventory.

List A (Select one)




Choice "a" is correct. Change from LIFO to FIFO is a change in accounting principle.



Item to Be AnsweredQuo changed from LIFO to FIFO to account for its finished goods inventory.

List B (Select one)




Choice "B" is correct. A change in accounting principle should be shown in the retained earnings statement of the earliest year presented as an adjustment of thebeginning balance. All prior year financial statements are recast.



Item to Be AnsweredQuo sells extended service contracts on its products. Because related services are performed over several years, in 1993 Quo changed from the cash method tothe accrual method of recognizing income from these service contracts.

List B (Select one)




Choice "B" is correct. If comparative FS are issued, restate prior year's FS. If comparative FS are not issued, restate prior year-end's retained earnings account by"adjusting" (net of tax) the opening balance of the current retained earnings statement. Note that when an error is corrected, retroactive restatement is used, andwhen there is a change in accounting principle, retrospective restatement is done.However, this is only a difference in terminology.


Item to Be AnsweredDuring 1993, Quo determined that an insurance premium paid and entirely expensed in 1992 was for the period January 1, 1992, through January 1, 1994.

List A (Select one)




Choice "c" is correct. Expensing insurance premiums when paid (rather than allocating them to the periods benefited) is a correction of an error in previouslypresented financial statements.



Item to Be AnsweredDuring 1993, Quo determined that an insurance premium paid and entirely expensed in 1992 was for the period January 1, 1992, through January 1, 1994.

List B (Select one)




Choice "B" is correct. If comparative FS are issued, restate prior year's FS. If comparative FS are not issued, restate prior year-end's retained earnings account by"adjusting" (net of tax) the opening balance of the current retained earnings statement.

QUESTION 117On January 2, 1993, Quo, Inc. hired Reed to be its controller. During the year, Reed, working closely with Quo's president and outside accountants, made changesin accounting policies, corrected several errors dating from 1992 and before, and instituted new accounting policies. Quo's 1993 financial statements will bepresented in comparative form with its 1992 financial statements.This question represents one of Quo's transactions. List A represents possible clarifications of these transactions as: a change in accounting principle, a change inaccounting estimate, a correction of an error in previously presented financial statements, or neither an accounting change nor an accounting error.During 1993, Quo increased its investment in Worth, Inc. from a 10% interest, purchased in 1992, to 30%, and acquired a seat on Worth's board of directors. As aresult of its increased investment, Quo changed its method of accounting for investment in Worth, Inc. from the cost method to the equity method.

List A

A. Change in accounting principle.B. Change in accounting estimate.C. Correction of an error in previously presented financial statements.D. Neither an accounting change nor an accounting error.



Choice "d" is correct. A change from the cost method (less than 20% ownership) to the equity method (20% or more ownership or a Board seat or other significantinfluence) of accounting for investment in an investee is neither an accounting change nor an accounting error. If it is not an accounting change, it cannot be achange in accounting principle or a change in accounting estimate since those two types of changes are both accounting changes.

There is a considerable amount of controversy on this particular answer. Some people think that this change is a change in accounting principle (somethingcertainly changed, but was it the accounting principle?), and others think it is a change in accounting entity (which is not one of the available answers; anyway, didthe accounting entity actually change or is it the same entity accounted for differently?). Under SFAS No. 154, a change in accounting principle is treatedretrospectively and a change in accounting entity is treated retrospectively.

This kind of change (cost to equity) has never been specifically identified in any accounting literature as either a change in accounting principle or a change inaccounting entity. The words "cost method" were never mentioned in APB 20 (other than the full cost method for oil & gas companies, which is an entirely differentsubject), nor was it mentioned in SFAS No. 154. It was, however, discussed in APB 18 (the pronouncement for the equity method) in Paragraph 19m (bold added):"An investment in common stock of an investee that was previously accounted for on other than the equity method may become qualified for use of the equitymethod by an increase in the level of ownership described in paragraph 17 (i.e., acquisition of additional voting stock by the investor, acquisition or retirement ofvoting stock by the investee, or other transactions). When an investment qualifies for use of the equity method, the investor should adopt the equity method ofaccounting. The investment, results of operations (current and priorperiods presented), and retained earnings of the investor should be adjusted retroactively in a manner consistent with the accounting for a step-by-step acquisitionof a subsidiary."

What does all this mean? It means that, when there is a change in the percentage of ownership that changes accounting from the cost method to the equitymethod, the change is treated retroactively (just like changes in accounting entity used to be treated, although they are now treated retrospectively). It does not saythat the change is a change in accounting principle or anything else. Nothing in SFAS No.154 changed this treatment. So all this still makes Choice "d" correct. Thiswhole issue might easily be considered to be splitting hairs, at the very least. Some questions on the CPA exam are just that way.Most are not.



During 1993, Quo increased its investment in Worth, Inc. from a 10% interest, purchased in 1992, to 30%, and acquired a seat on Worth's board of directors. As aresult of its increased investment, Quo changed its method of accounting for investment in Worth, Inc. from the cost method to the equity method.

List B




Choice "B" is correct. The equity method of accounting is applied retroactively when the investor has acquired 20% ownership. Prior to acquiring the ability toinfluence the investee, the cost method is proper. The retroactive restatement approach does not mean that this change is the correction of an error (which is nowtreated retroactively), a change in accounting principle (which is now treated retrospectively), or a change in accounting entity (which is now treated retrospectively).It just means that retroactive restatement is the proper treatment.

QUESTION 119According to the FASB conceptual framework, what does the concept of reliability in financial reporting include?

A. Effectiveness.B. Certainty.C. Precision.D. Neutrality.



Choice "d" is correct. The concept of reliability in financial reporting includes; neutrality, representational faithfulness and verifiability.Choices "a", "b", and "c" are incorrect, per the above.

QUESTION 120

According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on:

A. Generally accepted accounting principles.B. Reporting on management's stewardship.C. The need for conservatism.D. The needs of the users of the information.



Choice "d" is correct. The FASB conceptual framework states that the objectives of financial reporting stem from the informational needs of the external users of theinformation. SFAC 1 para. 28 Choice "a" is incorrect. Generally accepted accounting principles (GAAP) are derived from and based on the objectives of financialreporting, not the other way around. Choice "b" is incorrect. Information concerning management's stewardship is only one aspect of the information financialstatements are intended to provide. SFAC 1 para. 50 Choice "c" is incorrect. Conservatism is an underlying concept for financial accounting but is not the basis forthe objectives. SFAC 2 para. 91-97

QUESTION 121According to the FASB conceptual framework, the usefulness of providing information in financial statements is subject to the constraint of:

A. Consistency.B. Cost-benefit.C. Reliability.D. Representational faithfulness.


Explanation/Reference:Explanation:Choice "b" is correct. The pervasive constraint on providing information in financial statements is that the cost should be outweighed by the benefit to be derivedfrom providing the information. SFAC 1 para. 23, SFAC 2 para. 133Choice "a" is incorrect. Consistency is an underlying concept for financial statements (and a secondary quality of accounting information), but it is not a constrainton providing information. SFAC 2 para. 120 Choice "c" is incorrect. Reliability is a primary quality of accounting information and an underlying concept for financialstatements, but it is not a constraint on providing information. SFAC 2 para. 58 Choice "d" is incorrect. Representational faithfulness is an underlying concept forfinancial statements (as an element of reliability), but it is not a constraint on providing information. SFAC 2 para.

QUESTION 122Conceptually, interim financial statements can be described as emphasizing:

A. Timeliness over reliability.B. Reliability over relevance.C. Relevance over comparability.D. Comparability over neutrality.



Choice "a" is correct. Interim financial statements emphasize timeliness (an element of relevance) by providing financial information based on actual performance todate and estimates prior to year end. Information must be available when it is needed to be useful. Reliability is impeded by the extensive use of estimates;however, the lag until verifiability is obtained detracts from usefulness. SFAC 2 para. Choice "b" is incorrect. Relevance (particularly timeliness) of information ininterim financial statements is emphasized more than reliability. Reliability is impeded by the extensive use of estimates in interim data.Choice "c" is incorrect. Since comparability is a secondary quality of information, there should be no need to trade off comparability for relevance (a primary quality).Choice "d" is incorrect. Neutrality is an element of reliability (a primary quality of information. There should be NO need for a trade-off for comparability overneutrality.

QUESTION 123APB Opinion No. 28, Interim Financial Reporting, concluded that interim financial reporting should be viewed primarily in which of the following ways?

A. As useful only if activity is spread evenly throughout the year.B. As if the interim period were an annual accounting period.C. As reporting for an integral part of an annual period.D. As reporting under a comprehensive basis of accounting other than GAAP.



Choice "c" is correct. Interim financial reporting should be viewed as reporting for an integral part of an annual period.

Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 124During the first quarter of 1993, Tech Co. had income before taxes of $200,000, and its effective income tax rate was 15%. Tech's 1992 effective annual income taxrate was 30%, but Tech expects its 1993 effective annual income tax rate to be 25%. In its first quarter interim income statement, what amount of income taxexpense should Tech report?

A. $0B. $30,000C. $50,000D. $60,000



Choice "c" is correct. Interim period tax expense is the estimated annual effective tax rate (25% in this case) applied to the year-to-date income before taxes minusthe tax expense recognized in previous interim periods. Since this question involves the first quarter, there are no previous interim periods.25% × $200,000 = $50,000. FIN 18, para. 16Choice "a" is incorrect. Income tax expense is reported in interim income statements. Choice "b" is incorrect. The 1993 annual estimated tax rate, not the firstquarter effective tax rate, is used to calculate income tax expense for interim statements. Choice "d" is incorrect. The 1993 annual estimated tax rate, not the 1992annual effective tax rate, is used to calculate income tax expense for interim statements.

QUESTION 125A segment of Ace Inc. was discontinued during 1992. Ace's loss from discontinued operations should not:

A. Include employee relocation costs associated with the decision to dispose.B. Exclude operating losses from the date the decision to dispose of the segment was made until the end of 1992.C. Include additional pension costs associated with the decision to dispose.D. Include operating losses of the current period up to the date the decision to dispose of the segment was made.



Choice "b" is correct. Ace's loss on discontinued operations should not exclude operating losses from the date the decision to dispose of the segment was madeuntil the end of 1992. All 1992 operating losses should be included.Choice "a" is incorrect. Employee relocation costs associated with the decision to dispose should be included in the loss from discontinued operations.Choice "c" is incorrect. Additional pension costs associated with the decision to dispose should be included in the loss from discontinued operations.Choice "d" is incorrect. Ace's loss on discontinued operations should include operating losses of the current period up to the date the decision to dispose of thesegment was made and also after that date.All 1992 operating losses should be included.

QUESTION 126On December 31, 20X2, the Board of Directors of Maxy Manufacturing, Inc. committed to a plan to discontinue the operations of its Alpha division. Maxy estimatedthat Alpha's 20X3 operating loss would be $500,000 and that the fair value of Alpha's facilities was $300,000 less than their carrying amounts.

Alpha's 20X2 operating loss was $1,400,000, and the division was actually sold for $400,000 less than its carrying amount in 20X3. Maxy's effective tax rate is 30%.In its 20X2 income statement, what amount should Maxy report as loss from discontinued operations?

A. $980,000B. $1,190,000C. $1,400,000D. $1,700,000



Choice "b" is correct. Since the fair value of Alpha's facilities was $300,000 less than its carrying value, there has been an impairment loss, and that loss should berecognized in 20X2. That $300,000 impairment loss plus the $1,400,000 20X2 operating loss would be recognized in 20X2 net of tax. The total loss would be$1,700,000 × 70% (100% - 30%) or $1,190,000. Choice "a" is incorrect. It includes the 20X2 operating loss of $1,400,000 but not the $300,000 impairment loss butdoes report the 20X2 operating loss net of tax. Choice "c" is incorrect. It includes the 20X2 operating loss of $1,400,000, but not the $300,000 impairment loss, andreports the 20X2 operating loss gross of tax and not net of tax. Choice "d" is incorrect. It reports the 20X2 loss from discontinued operations gross of tax and not netof tax.

QUESTION 127On December 31, 20X2, the Board of Directors of Maxy Manufacturing, Inc. committed to a plan to discontinue the operations of its Alpha division. Maxy estimatedthat Alpha's 20X3 operating loss would be $500,000 and that the fair value of Alpha's facilities was $300,000 less than their carrying amounts.The estimate for 20X3 turned out to be correct. Alpha's 20X2 operating loss was $1,400,000, and the division was actually sold for $400,000 less than its carryingamount. Maxy's effective tax rate is 30%. In its 20X3 income statement, what amount should Maxy report as loss from discontinued operations?

A. $350,000B. $500,000C. $420,000D. $600,000



Choice "c" is correct. The 20X3 loss from discontinued operations would include both the 20X3 operating loss of $500,000 (which turned out to be a correctestimate) and the "additional" loss (on disposal) of $100,000, net of tax, for a total of $600,000 x .70 or $420,000. Choice "a" is incorrect. It includes the 20X3operating loss of $500,000 but not the $300,000 impairment loss but does report the 20X3 operating loss net of tax. Choice "b" is incorrect. It includes the 20X3operating loss of $500,000, but not the $100,000 loss on disposal, and reports the 20X3 operating loss gross of tax and not net of tax. Choice "d" is incorrect. Itreports the 20X3 loss from discontinued operations gross of tax and not net of tax. The 20X3 loss from discontinued operations should include both the 20X3operating loss of $500,000 and the loss on disposal of $100,000, net of tax, for a total of $600,000 x .70 or $420,000.

QUESTION 128Kell Corp.'s $95,000 net income for the quarter ended September 30, 1990, included the following aftertax items:

· A $60,000 extraordinary gain, realized on April 30, 1990, was allocated equally to the second, third, and fourth quarters of 1990.· A $16,000 cumulative-effect loss resulting from a change in inventory valuation method was recognized on August 2, 1990.In addition, Kell paid $48,000 on February 1, 1990, for 1990 calendar-year property taxes. Of this amount, $12,000 was allocated to the third quarter of 1990. Forthe quarter ended September 30, 1990, Kell should report net income of:

A. $91,000B. $103,000C. $111,000D. $115,000



Choice "a" is correct. $91,000 net income for the third quarter ended 9-30-90. Rules: The entire amount of an "extraordinary" item should be reported during the

period incurred. A "cumulative effect" type accounting change is not included in the net income of the period of change; instead, the beginning of the year retainedearnings is restated. Expenses, which benefit more than one interim period, such as property taxes, are allocated among the periods benefited.

QUESTION 129On June 30, 1991, Mill Corp. incurred a $100,000 net loss from disposal of a component of a business. Also, on June 30, 1991, Mill paid $40,000 for property taxesassessed for the calendar year 1991. What amount of the foregoing items should be included in the determination of Mill's net income or loss for the six-monthinterim period ended June 30, 1991?

A. $140,000B. $120,000C. $90,000D. $70,000


Explanation/Reference:Explanation:Choice "b" is correct. $120,000 expense included in the determination of net income or loss for the sixmonth interim period ended June 30, 1991.

QUESTION 130On March 15, 1992, Krol Co. paid property taxes of $90,000 on its office building for the calendar year 1992. On April 1, 1992, Krol paid $150,000 for unanticipatedrepairs to its office equipment. The repairs will benefit operations for the remainder of 1992. What is the total amount of these expenses that Krol should include inits quarterly income statement for the three months ended June 30, 1992?

A. $172,500B. $97,500C. $72,500D. $37,500



Rule: Actual and estimated expenditures benefiting all interim periods equally should be expensed ratably throughout the year.

Choice "c" is correct. $72,500 total expense for the three months ended June 30, 1992.

QUESTION 131During 20X5, Dale Corp. made the following accounting changes:

What amount should be shown in the 20X5 retained earnings statement as an adjustment to the beginning balance?

A. $0B. $30,000C. $98,000

D. $128,000



Choice "c" is correct. $98,000.The cumulative effect of a change in accounting principle is now shown on the retained earnings statement as an adjustment to the beginning balance of retainedearnings, assuming that the cumulative effect can be calculated. A change from LIFO to FIFO for inventory valuation (costing) is a change in accounting principle.An exception is made however, for a change in depreciation method, since a change in depreciation method is no longer considered to be a change in accountingprinciple. A change in depreciation method is now considered to be both a change in principle and a change in estimate. These changes should now be accountedfor as a change in estimate and handled prospectively. The new depreciation method should be used as of the beginning of the year of change and should start withthe current book value of the underlying asset. No retroactive or retrospective calculations should be made, and no adjustment should be made to retainedearnings.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 132Earnings per share data should be reported on the income statement for:




Explanation:

Choice "b" is correct. Yes - Yes.Both the "extraordinary items" and "income before extraordinary items" should be shown with an earnings per share number on the income statement.

QUESTION 133The effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate should be reported:

A. By restating the financial statements of all prior periods presented.B. As a correction of an error.C. As a component of income from continuing operations, in the period of change and future periods if the change affects both.D. As a separate disclosure after income from continuing operations, in the period of change and future periods if the change affects both.



Choice "c" is correct. A change in accounting principle that is inseparable from a change in accounting estimate should now be reported as a change in estimateand thus as a component of income from continuing operations, in the period of change and future periods if the change affects both. Distinguishing between achange in accounting principle and a change in accounting estimate is sometimes difficult. For example, a company may change from deferring and amortizing acost to recording it as an expense when incurred because future benefits of the cost have become doubtful. The new accounting method is adopted, therefore, inpartial or complete recognition of the change in estimated future benefits. The effect of the change in principle is inseparable from the effect of the change inestimate. Changes of this type are often related to the continuing process of obtaining additional information and revising estimates and are therefore considered aschanges in estimates. Choice "a" is incorrect. Restating the financial statements of all prior periods would be done in the case of prior period adjustments(corrections of errors), changes in accounting principle (retrospective application), and changes in accounting entity (retrospective application). Choice "b" isincorrect. Correction of an error would be treated as a prior period adjustment. Choice "d" is incorrect. Separate disclosure after income from continuing operationswould be done in the case of extraordinary items or discontinued operations. However, this disclosure would not be made "in the period of change and futureperiods if the change affects both" but only in the period of the extraordinary item or discontinued operation.

QUESTION 134At December 31, 1998, Off-Line Co. changed its method of accounting for demo costs from writing off the costs over two years to expensing the costs immediately.Off-Line made the change in recognition of an increasing number of demos placed with customers that did not result in sales. Off-Line had deferred demo costs of$500,000 at December 31, 1997, $300,000 of which were to be written off in 1998 and the remainder in 1999. Off-Line's income tax rate is 30%. In its 1998 financialstatements, what amount should Off-Line report as cumulative effect of change in accounting principle?

A. $0B. $200,000

C. $350,000D. $500,000



Choice "a" is correct. When a change in accounting principle is considered inseparable from a change in estimate, the change is handled as a change in estimate -prospectively. No cumulative effect adjustment is made.Choices "b", "c", and "d" are incorrect since no cumulative effect adjustment is made.

QUESTION 135How should the effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate be reported?

A. As a component of income from continuing operations.B. By restating the financial statements of all prior periods presented.C. As a correction of an error.D. By footnote disclosure only.



Choice "a" is correct. When the effect of a change in accounting principle is inseparable from the effect of a change in accounting estimate, the reporting treatmentfor the overall effect is as a change in estimate.Thus, the effect is reported prospectively as a component of income from continuing operations. Under SFAS No. 154, this type of change is now called a change inaccounting estimate affected by a change in accounting principle.Choice "b" is incorrect. Restatement of all prior periods is the retroactive accounting treatment that is applied to the correction of an error and the retrospectiveaccounting treatment given to changes in accounting principle. However, a change in accounting principle that is inseparable from the effect of a change inaccounting estimate is now treated as a change in accounting estimate. Choice "c" is incorrect. Correction of an error is given retroactive treatment as a prior periodadjustment to retained earnings with restatement of prior periods. This is not the treatment appropriate for the effect of a change in accounting principle that isinseparable from the effect of a change in accounting estimate.Choice "d" is incorrect. While footnote disclosure is always appropriate for an accounting change, such disclosure alone is never the appropriate accountingtreatment.

QUESTION 136In September 1996, Koff Co.'s operating plant was destroyed by an earthquake. Earthquakes are rare in the area in which the plant was located. The portion of theresultant loss not covered by insurance was $700,000. Koff's income tax rate for 1996 was 40%. In its 1996 income statement, what amount should Koff report asextraordinary loss?

A. $0B. $280,000C. $420,000D. $700,000



Choice "c" is correct. For a loss to be reported as an extraordinary loss, the event causing the loss must be both unusual in nature and infrequent in occurrence.The earthquake in this case does meet these criteria so the loss is reported net of income tax effect as an extraordinary loss of $420,000 (60% of the total $700,000loss). APB 30.11, .19-.26Choice "a" is incorrect. Review the criteria for reporting an extraordinary loss. Choice "b" is incorrect. This is the tax effect of the loss. Review your calculations.Choice "d" is incorrect. It is not appropriate to report the full loss as an extraordinary loss.

QUESTION 137In April 30, 20X4, Deer Corp. approved a plan to dispose of a component of its business. For the period January 1 through April 30, 20X4, the component hadrevenues of $500,000 and expenses of $800,000.The assets of the component were sold on October 15, 20X4 at a loss. In its income statement for the year ended December 31, 20X4, how should Deer report thecomponent's operations from January 1 to April 30, 20X4?

A. $500,000 and $800,000 should be included with revenues and expenses, respectively, as part of continuing operations.B. $300,000 should be reported as part of the loss on disposal of a component and included as part of continuing operations.C. $300,000 should be reported as an extraordinary loss.D. $300,000 should be reported as a loss from operations of a component and included in loss from discontinued operations.



Explanation:

Choice "d" is correct. Once the decision has been made to dispose of a component of a business and that component meets the criteria to be classified as held forsale, the operating results of the component for the period reported on, and any gain or loss from the disposal, should be reported separately from continuingoperations, net of tax. In this question, the component was classified as held for sale and was sold in the same year.

Thus, in 20X4, the results of operations, the $300,000 ($500,000-$800,000) loss, are reported as a loss from discontinued operations. The loss on disposal wouldbe reported as part of that loss from discontinued operations also.

Choice "a" is incorrect. The results of operations prior to the decision date, and also after the decision date, are reported separately from the results of continuingoperations as a part of discontinued operations.Choice "b" is incorrect. The results of operations prior to the decision date, and also after the decision date, are reported separately from the results of continuingoperations as a loss from operations of a component and included in loss from discontinued operations. Choice "c" is incorrect. The results of discontinuedoperations are not reported as an extraordinary item.

QUESTION 138In open market transactions, Gold Corp. simultaneously sold its long-term investment in Iron Corp. bonds and purchased its own outstanding bonds. The brokerremitted the net cash from the two transactions.Gold's gain on the purchase of its own bonds exceeded its loss on the sale of the Iron bonds. Assume the transaction to purchase its own outstanding bonds isunusual in nature and has occurred infrequently.Gold should report the:


A. Net effect of the two transactions as an extraordinary gain.B. Net effect of the two transactions in income before extraordinary items.C. Effect of its own bond transaction gain in income before extraordinary items, and report the Iron bond transaction as an extraordinary loss.D. Effect of its own bond transaction as an extraordinary gain, and report the Iron bond transaction loss in income before extraordinary items.



Explanation:

Choice "d" is correct, these are two separate transactions because Gold Corp. (1) sold Iron Corp. bonds (an investment) for a loss, and, (2) bought back its own(Gold) Corp. bonds (a debt) for a gain. This is not a "refinancing" (where one would sell new bond debt to buy back old bond debt outstanding). The gain from thepurchase of its own bonds is an "extraordinary gain" because it is both unusual in nature and infrequently occurring (per APB Opinion No. 30 and SFAS No. 145).The Iron Corp. transaction is a loss in "income before extraordinary items." Choices "a" and "b" are incorrect. The two transactions are separate and cannot benetted. Choice "c" is incorrect. Just the opposite. The sale of the investment is a loss in "income before extraordinary items," while the purchase of its bond debt isan "extraordinary gain" according to the provisions of APB Opinion No. 30.

Business Environment and Concepts

QUESTION 1Heather, Erika, and Shelby are members in HES LLC. Heather works 40 hours per week and Erika and Shelby work 20 hours per week. Heather contributed$30,000 to the LLC and Erika and Shelby contributed $60,000 each. Erika and Shelby have each originated 45% of the LLC's business and Heather has originatedthe other 10%.If HES were a general partnership, who controls management?

A. Heather, because she works the most.B. Erika and Shelby equally because they contributed the most.C. Heather, Erika, and Shelby equally because of state law.D. Erika and Shelby, because they originate most of the work.

Correct Answer: CSection: Business Environment and Concepts (Volume A)Explanation

Explanation/Reference:Explanation:Choice "c" is correct.Rule: Absent an agreement to the contrary, partners have equal management authority. Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 2Rivers and Lee want to form a partnership. For the partnership agreement to be enforceable, it must be in writing if:

A. Rivers and Lee reside in different states.B. The agreement cannot be completed within one year from the date on which it will be entered into.C. Either Rivers or Lee is to contribute more than $500 in capital.D. The partnership intends to buy and sell real estate.

Correct Answer: BSection: Business Environment and Concepts (Volume A)Explanation


Choice "b" is correct. A transaction which cannot be completed within a year must be in writing to be enforceable.Choice "a" is incorrect. Residence of the prospective partners is not relevant. Choice "c" is incorrect. The statute of frauds $500 threshold applies to the sale ofgoods only. Choice "d" is incorrect. Transactions in land are within the statute of frauds, but the possibility that a partnership may engage in a real estate transaction

is not a transaction in land.

QUESTION 3Which of the following statements is correct regarding the division of profits in a general partnership when the written partnership agreement only provides thatlosses be divided equally among the partners?

Profits are to be divided:

A. Based on the partners' ratio of contribution to the partnership.B. Based on the partners' participation in day-to-day management.C. Equally among the partners.D. Proportionately among the partners.


Explanation/Reference:Explanation:Choice "c" is correct.Rule: When the partnership agreement is silent as to how profits are to be divided, they are divided equally. Note also that when the agreement is silent, losses aretreated similar to profits, there is no reverse rule that profits are treated like losses.Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 4Downs, Frey, and Vick formed the DFV general partnership to act as manufacturers' representatives. The partners agreed Downs would receive 40% of anypartnership profits and Frey and Vick would each receive 30% of such profits. It was also agreed that the partnership would not terminate for five years.After the fourth year, the partners agreed to terminate the partnership. At that time, the partners' capital accounts were as follows: Downs, $20,000; Frey, $15,000;and Vick, $10,000. There also were undistributed losses of $30,000.Which of the following statements about the form of the DFV partnership agreement is correct?

A. It must be in writing because the partnership was to last for longer than one year.B. It must be in writing because partnership profits would not be equally divided.C. It could be oral because the partners had explicitly agreed to do business together.D. It could be oral because the partnership did not deal in real estate.

Correct Answer: ASection: Business Environment and Concepts (Volume A)Explanation


Choice "a" is correct. Under the statute of frauds, an agreement, which by its terms cannot be performed within a year, must be evidenced by a writing containingthe material terms and signed by the parties to be charged. Absent a writing, the partnership will be treated as a partnership at will. Choice "b" is incorrect. There isno requirement that partnership agreements be in writing merely because profits will be divided unequally.Choice "c" is incorrect. The statute of frauds requires contracts that cannot by their terms be performed within one year to be evidenced by a writing containing thematerial terms and signed by the parties to be charged.Choice "d" is incorrect. Whether or not a partnership is to deal in real estate is irrelevant to whether the partnership agreement must be in writing.

QUESTION 5Downs, Frey, and Vick formed the DFV general partnership to act as manufacturers' representatives. The partners agreed Downs would receive 40% of anypartnership profits and Frey and Vick would each receive 30% of such profits. It was also agreed that the partnership would not terminate for five years.After the fourth year, the partners agreed to terminate the partnership. At that time, the partners' capital accounts were as follows: Downs, $20,000; Frey, $15,000;and Vick, $10,000. There also were undistributed losses of $30,000.Vick's share of the undistributed losses will be:

A. $0B. $1,000C. $9,000D. $10,000



Rule: Where the partnership agreement is silent, losses are shared in the same proportion as profits. Choice "c" is correct. Vick was entitled to 30% of the profitsand so will be responsible for 30% of the undistributed $30,000 loss, or $9,000.Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 6Lewis, Clark, and Beal entered into a written agreement to form a partnership. The agreement required that the partners make the following capital contributions:Lewis, $40,000, Clark, $30,000, and Beal, $10,000. It was also agreed that in the event the partnership experienced losses in excess of available capital, Bealwould contribute additional capital to the extent of the losses. The partnership agreement was otherwise silent about division of profits and losses. Which of thefollowing statements is correct?

A. Profits are to be divided among the partners in proportion to their relative capital contributions.

B. Profits are to be divided equally among the partners.C. Losses will be allocated in a manner different from the allocation of profits because the partners contributed different amounts of capital.D. Beal's obligation to contribute additional capital would have an effect on the allocation of profit or loss to Beal.



Choice "b" is correct.Rule: Regardless of the contributions and obligations of the partners, unless the partnership agreement specifically states otherwise, all partners are entitled to anequal share of the profits. Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 7Gillie, Taft, and Dall are partners in an architectural firm. The partnership agreement is silent about the payment of salaries and the division of profits and losses.Gillie works full-time in the firm, and Taft and Dall each work half time. Taft invested $120,000 in the firm, and Gillie and Dall invested $60,000 each. Dall isresponsible for bringing in 50% of the business, and Gillie and Taft 25% each. How should profits of $120,000 for the year be divided?

A. Gillie $60,000, Taft $30,000, Dall $30,000.B. Gillie $40,000, Taft $40,000, Dall $40,000.C. Gillie $30,000, Taft $60,000, Dall $30,000.D. Gillie $30,000, Taft $30,000, Dall $60,000.



Choice "b" is correct. $40,000 - $40,000 - $40,000 (equally). Rule: In the absence of an agreement to the contrary, the profits will be shared equally regardless ofinvestment of money or time.Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 8With respect to the following matters, which is correct if a general partnership agreement is silent?

A. A partnership will continue indefinitely unless a majority of the partners votes to dissolve the partnership.

B. Partnership losses are allocated in the same proportion as partnership profits.C. A partner may assign his interest in the partnership but only with the consent of the other partners.D. A partner may sell the goodwill of the partnership without the consent of the other partners when the sale is in the best interest of the partnership.


Explanation/Reference:Explanation:Choice "b" is correct. As a general principle of partnership law, as well as under the Revised Uniform Partnership Act, in the absence of an agreement otherwisepartnership losses are allocated among partners in the same proportion as partnership profits.Choice "a" is incorrect. A partnership will dissolve on the death, bankruptcy, incapacity, or other withdrawal of a partner, unless the partners vote to continue. Choice"c" is incorrect. A partner may assign his interest in the partnership at any time without consent of the partners since such an assignment does not make theassignee a partner; instead it merely gives the assignee the assignor's rights to distributions from the partnership. Choice "d" is incorrect. A sale of partnership goodwill is an extraordinary transaction that requires consent of the partners. A single partner has no authority to make such a sale on his own accord.

QUESTION 9Which of the following statements is correct concerning liability when a partner in a general partnership commits a tort while engaged in partnership business?

A. The partner committing the tort is the only party liable.B. The partnership is the only party liable.C. Each partner is jointly and severally liable.D. Each partner is liable to pay an equal share of any judgment.



Choice "c" is correct. Each partner is jointly and severally liable for torts committed by any partner while in the course of partnership business.Choice "a" is incorrect. All partners may be held liable for a tort committed by a partner in the course of partnership business.Choice "b" is incorrect. Each partner is liable for torts committed by any partner while in the course of partnership business.Choice "d" is incorrect. Each partner is liable for the full amount of damages incurred as a result of a partner's tort; the partners are not liable only for their pro ratashare.

QUESTION 10Lark, a partner in DSJ, a general partnership, wishes to withdraw from the partnership and sell Lark's interest to Ward. All of the other partners in DSJ have agreed

to admit Ward as a partner and to hold Lark harmless for the past, present, and future liabilities of DSJ. As a result of Lark's withdrawal and Ward's admission tothe partnership, Ward:

A. Acquired only the right to receive Ward's share of DSJ profits.B. Has the right to participate in DSJ's management.C. Is personally liable for partnership liabilities arising before and after being admitted as a partner.D. Must contribute cash or property to DSJ to be admitted with the same rights as the other partners.



Choice "b" is correct. The general rule is that the mere assignment of a partner's interest does not make the assignee a partner. One may become a partner onlywith the consent of all other partners. Here, all other partner's consented to Ward's becoming a partner. Thus, Ward is a partner with full rights to participate inmanagement.Choice "a" is incorrect. The general rule is that the mere assignment of a partner's interest does not make the assignee a partner. One may become a partner onlywith the consent of all other partners. Here, all other partner's consented to Ward's becoming a partner. Thus, Ward is a partner with full partner rights.Choice "c" is incorrect. An incoming partner is not liable for debts that the partnership incurred before admission beyond the incoming partner's contribution, but isfully liable for debts incurred after becoming a partner.Choice "d" is incorrect. A partnership is a consensual relationship; there is no requirement of a contribution to become a partner.

QUESTION 11Unless the partnership agreement prohibits it, a partner in a general partnership may validly assign rights to:




Choice "c" is correct.Rules: A partner has no right to assign an interest in partnership property because a partner's rights in partnership property are limited to using the property forpartnership purposes. However, a partner does have a right to assign her interest in partnership distributions. The assignee does not become a partner, but merelyhas a right to receive whatever distributions the assignor would have received. Choices "a", "b", and "d" are incorrect, per the above rules.

QUESTION 12Cobb, Inc., a partner in TLC Partnership, assigns its partnership interest to Bean, who is not made a partner. After the assignment, Bean asserts the rights to:

A. Participate in the management of TLC.II. Cobb's share of TLC's partnership profits.Bean is correct as to which of these rights?

B. I only.C. II only.D. I and II.E. Neither I nor II.



Choice "b" is correct.Rule: The assignee of a partner's interest in the partnership does not thereby become a partner absent the unanimous consent of the other partners. Thus, theassignee has no right to participate in the management of the partnership and has only a right to receive the assignor's share of the partnership profits.Choices "a", "c", and "d" are incorrect, per the above rules.

QUESTION 13A partner's interest in specific partnership property is:


Correct Answer: DSection: Business Environment and Concepts (Volume A)Explanation


Choice "d" is correct. No - No.Rule: A partner's interest in specific partnership property is neither assignable to the partner's individual creditors nor is it subject to attachment by the partner'sindividual creditors. Choices "a", "b", and "c" are incorrect, per the above rule.

QUESTION 14If no provisions are made in an agreement, a general partnership allocates profits and losses based on the:

A. Value of actual contributions made by each partner.B. Number of partners.C. Number of hours each partner worked in the partnership during the year.D. Number of years each partner belonged to the partnership.



Explanation:

Choice "b" is correct. Absent an agreement to the contrary, all partners have equal rights to share in the profits of the partnership.Choices "a", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 15Under the Uniform Partnership Act, which of the following statements is(are) correct regarding the effect of the assignment of an interest in a general partnership?

A. The assignee is personally responsible for the assigning partner's share of past and future partnership debts.II. The assignee is entitled to the assigning partner's interest in partnership profits and surplus on dissolution of the partnership.




Choice "b" is correct. A partner may assign his or her interest in the partnership. The effect of such an assignment is to transfer the partner's right to receive thepartner's share of profits or surplus only. Such an assignment does not cause dissolution or make the assignee a new partner. The assignor is still regarded as apartner and is liable for past and future partnership debts. The assignee, since he is not a partner, is not liable for past and future partnership debts. Choice "a" isincorrect. The assignee of an interest in a general partnership is not personally responsible for the assigning partner's share of past and future partnership debts butis entitled to the assigning partner's interest in partnership profits and surplus on dissolution of the partnership. Choice "c" is incorrect. The assignee of an interest ina general partnership is entitled to the assigning partner's interest in partnership profits and surplus on dissolution of the partnership but is not personallyresponsible for the assigning partner's share of past and future partnership debts. Choice "d" is incorrect. The assignee of an interest in a general partnership isentitled to the assigning partner's interest in partnership profits and surplus on dissolution of the partnership but is not personally responsible for the assigningpartner's share of past and future partnership debts.

QUESTION 16Smith and James were partners in S and J Partnership. The partnership agreement stated that all profits and losses were allocated 60 percent to Smith and 40percent to James. The partners decided to terminate and wind up the partnership. The following was the balance sheet for S and J on the day of the windup:

Of the total accounts receivable, $10,000 was collected and the remainder was written off as bad debt. All liabilities of S and J were paid by the partnership. Theproperty and equipment are sold for $32,000. Under the Uniform Partnership Act, what amount of cash was distributed to Smith?

A. $25,200B. $26,000C. $30,000D. $34,800



Choice "a" is correct. Upon termination of the partnership creditors are paid first. After payment of creditors, each partner is deemed to have an account that ischarged or credited an amount equal to the partner's contribution plus or minus the partner's share of any profits or losses. The agreement between Smith andJames was that profits and losses would be allocated 60% to Smith and 40% to James. The partnership had $82,000 in assets ($40,000 in cash, $10,000 fromaccounts receivable, and $32,000 from property and equipment). The partnership had $90,000 in liabilities and capital. Of the $82,000 in assets, $24,000 is paidfirst to creditors. This leaves a balance of $58,000. Smith contributed $30,000 in capital and James contributed $36,000 in capital. With $66,000 owed in capital andonly $58,000 available, there is a deficit of $8,000. By agreement, Smith is responsible for 60% of the $8,000 deficit or $4,800.Smith would be credited an amount equal to his capital ($30,000) minus his share of the loss ($4,800) or $25,200. Only choice "a" reflects this amount.Choices "b", "c", and "d" are incorrect, per the above calculation.

QUESTION 17Leslie, Kelly, and Blair wanted to form a business. Which of the following business entities does not require the filing of organization documents with the state?

A. Limited partnership.

B. Joint venture.C. Limited liability company.D. Subchapter S corporation.



Choice "b" is correct. A joint venture is like a partnership. A partnership or joint venture can be formed without filing any documents with the state.Choice "a" is incorrect. Formation of a limited partnership requires the filing of a certificate of limited partnership with the state.Choice "c" is incorrect. A limited liability company may be formed only by filing articles of organization with the state.Choice "d" is incorrect. A corporation, including a Subchapter S corporation, may be formed only by filing articles of incorporation with the state.

QUESTION 18Under the Revised Uniform Partnership Act, which of the following have the right to inspect partnership books and records?

A. Employees.B. Former partners.C. Inactive partners.D. Transferees of partners' interests.



Choice "c" is correct. Every partner in a partnership - whether active or inactive - has the right to inspect the partnership's books and records.Choice "a" is incorrect. Only a partner has a right to inspect the partnership's books and records; an employee of the partnership has no such right.Choice "b" is incorrect. Only current partners have a right to inspect the partnership's books and records; former partners do not have such a right.Choice "d" is incorrect. Only partners have a right to inspect a partnership's books and records. A transferee of a partner's interest has only the partner's right todistributions.

QUESTION 19Berry, Drake, and Flanigan are partners in a general partnership. The partners made capital contributions as follows: Berry, $150,000; Drake, $100,000; andFlanigan, $50,000. Drake made a loan of $50,000 to the partnership. The partnership agreement specifies that Flanigan will receive a 50% share of profits, and

Drake and Berry each will receive a 25% share of profits. Under the Revised Uniform Partnership Act and in the absence of any partnership agreement to thecontrary, which of the following statements is correct regarding the sharing of losses?

A. The partners will share equally in any partnership losses.B. The partners will share in losses on a pro rata basis according to the capital contributions.C. The partners will share in losses on a pro rata basis according to the capital contributions and loans made to the partnership.D. The partners will share in losses according to the allocation of profits specified in the partnership agreement.



Choice "d" is correct. Under the Revised Uniform Partnership Act, unless agreed otherwise, partners share losses in the same manner that they share profits.Choice "a" is incorrect. Under the Revised Uniform Partnership Act, unless agreed otherwise, partners share losses in the same manner that they share profits.Here, the partners agreed to share profits in a2:1:1 ratio. Thus, losses will be shared in that manner rather than equally. Choice "b" is incorrect. Under the Revised Uniform Partnership Act, unless agreedotherwise, partners share losses in the same manner that they share profits. They are not shared in accordance with the partners' capital contributions.Choice "c" is incorrect. Under the Revised Uniform Partnership Act, unless agreed otherwise, partners share losses in the same manner that they share profits.They are not shared in accordance with the partners' capital contributions or loans.

QUESTION 20Fil and Breed are 50% partners in F&B Cars, a used-car dealership. F&B maintains an average used- car inventory worth $150,000. On January 5, National Bankobtained a $30,000 judgement against Fil and Fil's child on a loan that Fil had cosigned and on which Fil's child had defaulted. National sued F&B to be allowed toattach $30,000 worth of cars as part of Fil's interest in F&B's inventory. Will National prevail in its suit?

A. No, because the judgement was not against the partnership.B. No, because attachment of the cars would dissolve the partnership by operation of law.C. Yes, because National had a valid judgement against Fil.D. Yes, because Fil's interest in the partnership inventory is an asset owned by Fil.



Choice "a" is correct. A partner has no right to possess partnership property except for partnership purposes. Thus, a personal creditor of a partner has no right toattach items of partnership property to satisfy a partner's personal debt.Choice "b" is incorrect. There is no such rule. If the partnership were liable for the individual partner's debt, the cars could be attached and the partnership would notbe dissolved. Choice "c" is incorrect. A partner has no right to possess partnership property except for partnership purposes. Thus, a personal creditor of a partnerhas no right to attach items of partnership property to satisfy a partner's personal debt.Choice "d" is incorrect. A partner has no right to possess partnership property except for partnership purposes. Thus, a personal creditor of a partner has no right toattach items of partnership property to satisfy a partner's personal debt.

Limited Liability Partnership

QUESTION 21Which of the following partners of a limited liability partnership (LLP) may avoid personal liability when a partner commits a negligent act?

A. All the partners.B. The supervisor of the negligent partner.C. All the partners other than the negligent partner.D. All the partners other than the supervisor of, and, the negligent partner.



Choice "d" is correct. LLP partners are liable only for their own negligence and the negligence of anyone who commits a wrongful act under the partner's directcontrol.Choices "a", "b", and "c" are incorrect, per the above.

Limited Partnership

QUESTION 22Green Trees, LP is a limited partnership. Dave is a limited partner. Seeds Today, InC. is a creditor of the limited partnership. Upon dissolution of the partnership, theassets of Green Trees, LP will be distributed to pay:

A. Seeds Today, Inc., first.B. Dave first.C. Seeds Today, Inc. and Dave.D. The general partners first.



Choice "a" is correct.Rule: Upon dissolution, the assets of a limited partnership are first used to pay off the outside creditors.Limited partners such as Dave are next in line.Choices "b", "c", and "d" are incorrect, per the above rule.

QUESTION 23A limited partnership must have:

A. One general partner and two limited partners.B. All must be general partners and one limited partner.C. One general partner and one limited partner.D. All limited partners.



Choice "c" is correct.Rule: A limited partnership must have at least one general partner and one limited partner. Choices "a", "b", and "d" are incorrect, per the above rule. Be careful ofanswers that include the word "all."

QUESTION 24Juan is a limited partner in Pet Food and Fun, Limited Partnership. Juan visited Chow, Inc., a local supplier of dog food claiming to be a "partner" in the partnershipand negotiated a distribution contract between the supplier and limited partnership on behalf of the partnership.As a result of these actions, Juan:

A. Has limited liability as a limited partner in reference to all creditors.B. Has limited liability as a limited partner to all creditors except Chow, Inc.C. Has full personal liability to all creditors.D. None of the above.


Explanation/Reference:Explanation:Choice "b" is correct.Rule: A limited partner will be considered a general partner with full personal liability only to those that the limited partner transacts with as if he were a generalpartner. Limited partners have no right to participate in management, such as negotiating contracts on behalf of the limited partnership. The limited partner willretain his status and limited liability to all others that the limited partner has not transacted with on behalf of the partnership.Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 25Doug was the sole general partner in Heavy Foot, Limited Partnership. While driving to work one morning, Doug died in a car accident. The limited partnership:

A. Continues to exist as it was before Doug's death.B. Dissolves by operation of law as a result of Doug's death.C. Dissolves only by attaining a judicial decree.D. Converts to a general partnership and all former limited partners become general partners.



Choice "b" is correct.Rule: The death of a general partner will by operation of law, dissolve the limited partnership. Because the dissolution is by operation of law, there is no requirementto attain a judicial decree. Remaining limited partners do not automatically become general partners as a result of the death of the general partner.Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 26Which of the following statements is correct with respect to the differences and similarities between a corporation and a limited partnership?

A. Stockholders may be entitled to vote on corporate matters but limited partners are prohibited from voting on any partnership matters.B. Stock of a corporation may be subject to the registration requirements of the federal securities laws but limited partnership interests are automatically exempt

from those requirements.C. Directors owe fiduciary duties to the corporation and limited partners owe such duties to the partnership.

D. A corporation and a limited partnership may be created only under a state statute and each must file a copy of its organizational document with the propergovernmental body.



Choice "d" is correct. Both a limited partnership and a corporation:1. Can only be created by statute, and2. Each must file a copy of its certificate with the proper state agency. Choice "a" is incorrect. There are instances in which limited partners do vote on certainpartnership matters (e.g., approve new general or limited partners). Choice "b" is incorrect. Limited partnership interests are not automatically exempt from thefederal securities laws.Choice "c" is incorrect. Limited partners do not owe a fiduciary duty to the limited partnership.

QUESTION 27Aarons Group, Limited Partnership, was formed by three brothers, Aaron, Barry, and Sam. Aaron is the general partner and devotes more than 60 hours per weekto the business. Barry and Sam are limited partners who work for different companies having no relationship to the limited partnership. The partners' capitalcontributions are as follows: Aaron invested 20%. Barry and Sam invested 40% each. During the formation of the limited partnership, the brothers signed anagreement that addresses how the brothers will split profits and losses. At year-end, the limited partnership enjoyed large profits due to high demand for thebusiness' product line.The profits will be divided:

A. In proportion to each partner's capital contribution.B. According to the agreement.C. Equally.D. By determining by the amount of time and labor each partner devoted to the operation of the partnership.



Choice "b" is correct.Rule: Partners in a limited partnership can agree as to how they will split profits and losses, with losses shared up to the amount of the limited partners' capital.Profits and losses are shared on the basis of percentages of capital contributions only in the absence of an agreement otherwise. Choices "a", "c", and "d" areincorrect, per the above rule.

QUESTION 28Lisa is a limited partner in a limited partnership. Jen, one of the other limited partners, is seeking to sell her interest in the partnership to Karen and allow Karen tobecome a new limited partner. Which of the following statements is true?

A. Lisa may engage in the management of the limited partnership without losing her limited liability.B. Jen may transfer her interest and make Karen a new limited partner without the approval of the other partners.C. Jen may withdraw from the limited partnership without giving notice to the partnership.D. Lisa has a right to vote on the transferring of interest to and admission of Karen as a limited partner.



Choice "d" is correct. Limited partners have the right to vote on the transfer of interest and admission of a new partner. Admission of a new partner requiresunanimous consent. Choice "a" is incorrect. A limited partner who acts as a general partner loses her limited liability status to those she acted as a general partnertowards.Choice "b" is incorrect. Partners can freely transfer their interests in profits and losses to third parties, but the third party cannot become a limited partner without theunanimous consent of the other partners.Choice "c" is incorrect. Limited partners must give 6 months notice of withdrawal in absence of an agreement to the contrary.

QUESTION 29Which of the following statements is correct with respect to a limited partnership?

A. A limited partner may not be an unsecured creditor of the limited partnership.B. A general partner may not also be a limited partner at the same time.C. A general partner may be a secured creditor of the limited partnership.D. A limited partnership can be formed with limited liability for all partners.



Choice "c" is correct. In a limited partnership, a general partner may be a secured creditor of the limited partnership.

Choice "a" is incorrect. In a limited partnership, a limited partner may be an unsecured creditor of the limited partnership.Choice "b" is incorrect. In a limited partnership, a general partner may also be a limited partner at the same time.Choice "d" is incorrect. In a limited partnership, only the limited partners will have limited liability. A limited partnership must have at least one general partner andgeneral partners have unlimited liability.(The word "all" makes this option wrong.)

QUESTION 30In general, which of the following statements is correct with respect to a limited partnership?

A. A limited partner has the right to obtain from the general partner(s) financial information and tax returns of the limited partnership.B. A limited partnership can be formed with limited liability for all partners.C. A limited partner may not also be a general partner at the same time.D. A limited partner may hire employees on behalf of the partnership.



Choice "a" is correct. A limited partner has rights similar to those of a corporate shareholder; he must be allowed to review financial and tax information of thelimited partnership. Choice "b" is incorrect. A limited partnership must have one or more general partners, whose liability is unlimited.Choice "c" is incorrect. One may be both a general and a limited partner simultaneously. Such a person has all of the rights and liabilities of both a limited partnerand a general partner. Choice "d" is incorrect. A limited partner has no management authority, rather he is a passive investor, like a corporate shareholder.

QUESTION 31In general, which of the following statements is correct with respect to a limited partnership?

A. A limited partner will be personally liable for partnership debts incurred in the ordinary course of the partnership's business.B. A limited partner is unable to participate in the management of the partnership in the same manner as general partners and still retain limited liability.C. A limited partner's death or incompetency will cause the partnership to dissolve.D. A limited partner is an agent of the partnership and has the authority to bind the partnership to contracts.



Choice "b" is correct. While the general rule is that a limited partner has no liability on partnership debts except to the extent of his agreed-upon contribution, thelimited partner will lose this limited liability if he takes part in control of the business, which generally means a limited partner may not manage the business on aday-to-day basis as a general partner could. Choice "a" is incorrect. Limited partners are not personally liable for partnership debts; their liability generally is limitedto their contributions.Choice "c" is incorrect. Death or incapacity of a general partner will cause a dissolution, but the same is not true of a limited partner.Choice "d" is incorrect. A limited partner is more like a shareholder in a corporation than like a general partner. Limited partners are not agents of their partnershipsand have no authority to bind their partnership on contracts.

QUESTION 32White, Grey, and Fox formed a limited partnership. White is the general partner and Grey and Fox are the limited partners. Each agreed to contribute $200,000.Grey and Fox each contributed $200,000 in cash while White contributed $150,000 in cash and $50,000 worth of services already rendered. After two years, thepartnership is insolvent. The fair market value of the assets of the partnership is $150,000 and the liabilities total $275,000. The partners have made nowithdrawals. If Fox is insolvent and White and Grey each has a net worth in excess of $300,000, what is White's maximum potential liability in the event of adissolution of the partnership?

A. $62,500B. $112,500C. $125,000D. $175,000



Rule: The liability of a limited partner for partnership debts is limited to the extent of the capital, which he has contributed or has agreed to contribute. A generalpartner, however, is liable for all partnership debts and liabilities.Choice "c" is correct. In this case, both Grey and Fox are limited partners and, thus, their respective maximum liability for partnership debts may not exceed theircontributions ($200,000 each). Because White is a general partner, however, he will be personally liable for the excess of any debt remaining after assets havebeen applied upon a dissolution. Therefore, White will be liable for $125,000 (the difference between the fair market value of assets ($150,000) and partnershipliabilities ($275,000) at dissolution).Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 33Harry, Betty, and Jim decide to form a hair salon business. Betty and Jim agree to equally manage the business and have agreed to accept full personal liability forobligations of the business. Harry contributes money to help them get started. Harry does not want any personal liability but does want access to the books andrecords and to share in the profits. They have all agreed that unanimous consent is needed to transfer their ownership interests. Assume any necessary filings havebeen made. What type of business entity best reflects the terms of their agreement? The three have formed:

A. A limited partnership.B. A limited liability company.C. A general partnership.D. A corporation.



Choice "a" is correct. A limited partnership best reflects the terms of the parties' agreement. A limited partnership has one or more general partners and one ormore limited partners. The general partners are personally liable for partnership obligations and run the business (such as Betty and Jim agreed). A limited partnerdoes not have personal liability for partnership obligations and does not take part in management; however, limited partners have a right to inspect partnershipbooks and records relevant to their interest. Thus, a limited partnership has the attributes that Harry agreed to. Finally, all partners must unanimously consent to atransfer of an ownership interest in a limited partnership, as the parties agreed here. Thus, a limited partnership best reflects the agreement of the parties. Choice"b" is incorrect. Members of a limited liability company are not personally liable for the company's debt. (They may agree otherwise, but this is not a general attributeof a limited liability company.) Because the facts say Betty and Jim each agreed to have full personal liability, a limited liability company does not best reflect theparties' agreement. Choice "c" is incorrect. All partners are personally liable for all obligations of a general partnership. Because the facts say Harry did not acceptpersonal liability, the agreement does not reflect a general partnership.Choice "d" is incorrect. Corporate shareholders generally are not liable for the corporation's obligations. (They may agree otherwise, but this is not a basic attributeof a corporation.) As the facts say Betty and Jim share full personal liability, the agreement does not reflect a corporation.

QUESTION 34White, Grey, and Fox formed a limited partnership. White is the general partner and Grey and Fox are the limited partners. Each agreed to contribute $200,000.Grey and Fox each contributed $200,000 in cash while White contributed $150,000 in cash and $50,000 worth of services already rendered. After two years, thepartnership is insolvent. The fair market value of the assets of the partnership is $150,000 and the liabilities total $275,000. The partners have made nowithdrawals. Unless otherwise provided in the certificate of limited partnership, which of the following is correct if Fox assigns her interest in the partnership to Barrand only White consents to Barr's admission as a limited partner?

A. Barr will not become a substituted limited partner unless Grey also consents.B. Barr will have the right to inspect the partnership's books.C. The partnership will be dissolved.D. Barr will become a substituted limited partner because White, as general partner, consented.



Choice "a" is correct. In the absence of an agreement between all partners, the assignment of a partner's interest does not make the assignee a substitute partner;it merely transfers the assignor's rights to distributions to the assignee.Choice "b" is incorrect. Absent an agreement among the partners otherwise, an assignment of an interest in a partnership is merely an assignment of the assignor'srights to receive distributions from the partnership and does not give the assignee any right to inspect the partnership's books. Choice "c" is incorrect. Absent anagreement among the partners otherwise, an assignment of an interest in a partnership is merely an assignment of the assignor's rights to receive distributionsfrom the partnership; it does not make the assignee a new partner. Since there is no change in who is a partner, there is no dissolution.Choice "d" is incorrect. All partners must agree to make someone a partner, not just the general partner.

QUESTION 35Under the Revised Uniform Limited Partnership Act and in the absence of a contrary agreement by the partners, which of the following events is most likely todissolve a limited partnership?

A. A majority vote in favor by the partners.B. A two-thirds vote in favor by the partners.C. A withdrawal of a majority of the limited partners.D. Withdrawal of the only general partner.



Choice "d" is correct. Absent a contrary agreement of the partners, a limited partnership can be dissolved by written consent of all the general partners, withdrawalor death of a general partner, or judicial decree.Thus, withdrawal of the only general partner would cause dissolution. (There has to be at least one general partner in a limited partnership.)Choice "a" is incorrect. It takes unanimous written consent of all general partners to dissolve the limited partnership, not majority vote.Choice "b" is incorrect. It takes unanimous written consent of all general partners to dissolve the limited partnership, not two-thirds vote.Choice "c" is incorrect. Death or withdrawal of a limited partner does not cause dissolution. Only death or withdrawal of a general partner causes dissolution.

Limited Liability Company

QUESTION 36Eller, Fort and Owens are members of Venture Associates, LLC. Trent Corp. brought a breach of contract suit against Venture for a contract executed by Eller asan agent of the LLC. If Trent prevails, Trent will generally be able to collect the judgment from:

A. The LLC's assets only.B. The personal assets of Eller, Fort and Owens jointly.C. Eller's personal assets only after LLC assets are exhausted.D. Eller's personal assets only.



Choice "a" is correct.Rule: Members of an LLC are not personally liable for the LLC's obligations. Moreover, an agent is not liable on a contract the agent enters into on behalf of adisclosed principal. Here, the contract was entered into by Eller on behalf of Venture, an LLC, and Eller disclosed that he was acting only as an agent of Venture.Thus, Trent Corp. can collect from the LLC'S assets only. Choices "b", "c", and "d" are incorrect, per the above rule.

QUESTION 37Tim, Peter, and Rick want to form a limited liability company. What document must they file with the state?

A. Operating Agreement.B. Articles of Incorporation.C. Bylaws.D. Articles of Organization.



Choice "d" is correct. The Articles of Organization must be filed with the secretary of state. Choice "a" is incorrect. An operating agreement is an agreementbetween the members containing provisions relating to management, profit sharing, transferring interests, etC. and does not need to be filed with the state.Choices "b" and "c" are incorrect. Articles of incorporation and bylaws are documents relating to corporations, and they are not required to be filed with the state.

QUESTION 38The articles of organization for a limited liability company must contain everything, except the following:

A. The name of the entity that includes some indication it is a LLC.B. The name and address of the registered agent.C. Number of shares authorized and issued.D. If the company is to be manager managed, a statement to that effect.



Choice "c" is correct. Limited liability companies do not issue "shares" held by shareholders like in a corporation. Instead, members (the owners) are said to have"interests" in the LLC. Choices "a", "b", and "d" are incorrect. These are all required to be included in the articles of organization.

QUESTION 39Unless there is an agreement to the contrary, the voting power of members in a limited liability company is determined by:

A. Each member's salary.B. Each member's share of profits.C. When the member was admitted to the company.D. Each member's capital contribution.



Choice "d" is correct.Rule: Absent an agreement otherwise, all members generally participate in management, and their voting strength is determined in proportion to ownership interest.This is calculated by comparing each member's capital contribution to that of the other members. Choices "a", "b", and "c" are incorrect, per the above rule.

QUESTION 40Heather, Erika, and Shelby are members in HES LLC. Heather works 40 hours per week and Erika and Shelby work 20 hours per week. Heather contributed$30,000 to the LLC and Erika and Shelby contributed $60,000 each. Erika and Shelby have each originated 45% of the LLC's business and Heather has originatedthe other 10%. Absent an agreement to the contrary among the owners, who controls the management of the HES LLC?

A. Heather, because she works the most.B. Erika and Shelby equally because they contributed the most.C. Heather, Erika, and Shelby in proportion to their ownership interests.D. Erika and Shelby, because they originate most of the work.



Choice "c" is correct.Rule: Absent an agreement to the contrary, the members' voting strength is proportionate to their contributions.Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 41Heather, Erika, and Shelby are members in HES LLC. Heather dies. Absent an agreement to the contrary, what is the result?

A. The LLC must dissolve.B. The LLC ceases to exist.C. The LLC is dissolved unless the other members consent to continue.D. The LLC continues as though nothing happened.



Choice "c" is correct. Absent an agreement to the contrary, if a member of an LLC dies, the LLC is dissolved unless the other members consent to continue.Choice "a" is incorrect, because the LLC does not have to dissolve upon the death of a member. Choice "b" is incorrect, because the LLC does not cease to existimmediately. Choice "d" is incorrect, because the LLC does not continue unless the members consent to continue.

QUESTION 42Heather, Erika, and Shelby are members in HES LLC. Heather works 40 hours per week and Erika and Shelby work 20 hours per week. Heather contributed$30,000 to the LLC and Erika and Shelby contributed $60,000 each. Erika and Shelby have each originated 45% of the LLC's business and Heather has originatedthe other 10%. Absent an agreement to the contrary, how will the LLC's $120,000 profits be divided among the members?




Rule: Absent an agreement to the contrary, the LLC's profits will be divided among the members in proportion to their contributions. Here, Heather's, Erika's andShelby's contributions were $30,000, $60,000, and $60,000, respectively. Thus, the profits will be divided in a 1:2:2 ratio (20% of $120,000 to Heather; 40% of$120,000 to Erika; and $120,000 to Shelby).Choice "d" is correct.

Heather Erika ShelbyD. $24,000 $48,000 $48,000

Choices "a", "b", and "c" are incorrect, per the above rule.

QUESTION 43A member of a limited liability company may generally do all of the following, except:

A. Transfer his membership in the company without the consent of the other members.B. Participate in the management of the company absent an agreement to the contrary.C. Have limited liability.D. Order office supplies for the company.

Correct Answer: ASection: Business Environment and Concepts (Volume A)

Explanation


Choice "a" is correct. The transfer of a member interest requires the consent of the other members. Members may not assign their interest without the othermembers' consent. Choice "b" is incorrect. Unless the members have agreed to operate as a manager managed limited liability company, all members have thepower to participate in management. Choice "c" is incorrect. Members in a limited liability company all have limited personal liability. Choice "d" is incorrect. Unlessotherwise agreed, members have the right to manage the every day operations of a limited liability company. This can include the ordering of office supplies.

QUESTION 44Jeb, a member in J & S LLC, sold his interest in the LLC to Chris without obtaining the other members' consent. Absent an agreement to the contrary, Chris:

A. May participate in the management of J & S.II. May receive Jeb's share of J & S's profits.III. Is not entitled to anything since Jeb did not obtain the other members' consent.

B. I only.C. I and II only.D. II only.E. III only.



Choice "c" is correct. Absent an agreement to the contrary, if a member in the LLC sells his interest in an LLC without obtaining the other members' consent, theassignee is only entitled to receive the assignor's share of profits.Choices "a", "b", and "d" are incorrect, because, absent an agreement to the contrary, although a member of an LLC is allowed to assign his interest in profits andlosses, an assignee of a membership interest may not participate in the management of the LLC.

QUESTION 45Which of the following parties generally has the most management rights?

A. Minority shareholder in a corporation listed on a national stock exchange.B. Limited partner in a general partnership.C. Member of a limited liability company.D. Limited partner in a limited partnership.



Choice "c" is correct. Unless the articles or operating agreement provides otherwise, all members of the LLC have a right to participate in management. A memberof a limited liability company has the most management rights of any of the parties listed. A minority shareholder in a corporation has no management rights (andneither does a majority shareholder). A limited partner has no day-to-day management rights but may have some rights in extraordinary circumstances. It is unclearwhat a limited partner in a general partnership would even be; the existence of a limited partner would make a partnership a limited partnership and not a generalpartnership. Choice "a" is incorrect. Stockholders have very limited rights to run the corporation. They generally only have the right to elect directors and to vote onfundamental changes in the corporation. Such fundamental changes would include dissolutions, amendments to the articles, mergers, consolidations, compulsoryshare exchanges, and sale of substantially all of the corporation's assets. Choice "b" is incorrect. There are no limited partners in a general partnership. There areonly general partners. Since there are no limited partners, there are no management rights for limited partners. Choice "d" is incorrect. Limited partners in a limitedpartnership have very limited rights to participate in the management of the business. In fact, if they do participate in management, they face potential liability tothose who thought they were a general partner (i.e., if a limited partner becomes involved in day-to-day management is some way (participating in control), she maybe treated as a general partner and lose her limited liability).

Corporation

QUESTION 46Case Corp. is incorporated in State A. Under the Revised Model Business Corporation Act, which of the following activities engaged in by Case requires that Caseobtain a certificate of authority to do business in State B?

A. Maintaining bank accounts in State B.B. Collecting corporate debts in State B.C. Hiring employees who are residents of state B.D. Maintaining an office in State B to conduct intrastate business.



Choice "d" is correct. A domestic corporation is one created under the laws of a given state. A foreign corporation is a corporation created under the laws of anotherstate. A foreign corporation must obtain a certificate of authority from each state in which it does intrastate business. Choices "a", "b", and "c" are incorrect becausemaintaining a bank account, collecting debts, and hiring employees who live within a state are not considered to be "doing business" within the state.

QUESTION 47Which of the following statements is(are) correct regarding the methods a target corporation may use to ward off a takeover attempt?

A. The target corporation may make an offer ("self-tender") to acquire stock from its own shareholders.II. The target corporation may seek an injunction against the acquiring corporation on the grounds that the attempted takeover violates federal antitrust law.




Choice "c" is correct.Rule: A tender offer is a general invitation by a bidder to the shareholders of a target company to tender their shares to the bidder at a specified price during aspecified time. A target of a takeover may ward off a tender offer by offering to repurchase shares from its shareholders. If a takeover will violate federal antitrustlaw, a court will enjoin the takeover. Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 48Acorn Corp. wants to acquire the entire business of Trend Corp. Which of the following methods of business combination will best satisfy Acorn's objectives withoutrequiring the approval of the shareholders of either corporation?

A. A merger of Trend into Acorn, whereby Trend shareholders receive cash or Acorn shares.B. A sale of all the assets of Trend, outside the regular course of business, to Acorn, for cash.C. An acquisition of all the shares of Trend through a compulsory share exchange for Acorn shares.D. A cash tender offer, whereby Acorn acquires at least 90% of Trend's shares, followed by a short- form merger of Trend into Acorn.



Choice "d" is correct. A parent corporation owning 90% or more of a subsidiary may merge the subsidiary (short form merger) into the parent without the approval ofthe shareholders of either corporation or the approval of the subsidiary's board.Choices "a", "b", and "c" all require at least one of the corporations to follow the general procedure for fundamental corporate changes (i.e., board resolution notice,approval by majority shares, and filing).

QUESTION 49Under the Revised Model Business Corporation Act, which of the following statements regarding a corporation's bylaws is(are) correct?

A. A corporation's initial bylaws shall be adopted by either the incorporators or the board of directors.II. A corporation's bylaws are contained in the articles of incorporation.




Choice "a" is correct. Under the Revised Model Business Corporation act, a corporation's initial bylaws may be adopted by either the incorporators or the board ofdirectors. Choices "b" and "c" are incorrect, because the corporation's bylaws are a separate document not included in the corporation's articles of incorporation.Choice "d" is incorrect, because under the Revised Model Business Corporation Act, a corporation's initial bylaws may be adopted by either the incorporators or theboard of directors.

QUESTION 50Under the Revised Model Business Corporation Act, which of the following must be contained in a corporation's articles of incorporation?

A. Quorum voting requirements.B. Names of stockholders.C. Provisions for issuance of par and nonpar shares.D. The number of shares the corporation is authorized to issue.



Choice "d" is correct. The articles must set out the corporation's authorized shares. Choice "a" is incorrect. Quorum requirements, if stated at all, usually are in thebylaws; they need not be included in the articles of incorporation.Choice "b" is incorrect. The articles need not include the names of stockholders. Choice "c" is incorrect. The RMBCA has eliminated the concept of par value andso does not have a requirement that par value be established in the articles.

QUESTION 51Under the Revised Model Business Corporation Act, a merger of two public corporations usually requires all of the following, except:

A. A formal plan of merger.B. An affirmative vote by the holders of a majority of each corporation's voting shares.C. Receipt of voting stock by all stockholders of the original corporations.D. Approval by the board of directors of each corporation.



Choice "c" is correct. A merger can be effected by giving some parties cash or property; not everyone need receive voting shares.Choice "a" is incorrect. The merger must be pursuant to a formal plan. Choice "b" is incorrect. The majority of each corporation generally must approve a merger.Choice "d" is incorrect. A plan of merger must be approved by the boards of the merging corporations.

QUESTION 52Which of the following provisions must a for-profit corporation include in its articles of incorporation to obtain a corporate charter?

A. Provision for the authorization of voting stock.II. Name of the corporation.


Correct Answer: CSection: Business Environment and Concepts (Volume A)

Explanation


Choice "c" is correct. Both I and II.Rule: In order to obtain a corporate charter, a for-profit corporation must include in its articles of incorporation the name of the corporation and a provision for theauthorization of voting stock. In addition, the articles of incorporation must include the names of the incorporators and the name and address of the registeredagent.Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 53The corporate veil is most likely to be pierced and the shareholders held personally liable if:

A. The corporation has elected S corporation status under the Internal Revenue Code.B. The shareholders have commingled their personal funds with those of the corporation.C. An ultra vires act has been committed.D. A partnership incorporates its business solely to limit the liability of its partners.



Choice "b" is correct. Generally, a corporation is treated as an entity distinct from its shareholders and shareholders are not liable for the corporation's debts.However, where the shareholders do not treat the corporation as a distinct entity, such as where they commingle their personal funds with the corporation's funds,courts are likely to ignore the corporate form as well. Choice "a" is incorrect. An election to be taxed like a partnership under Subchapter S is not grounds to piercethe corporate veil.Choice "c" is incorrect. An ultra vires act is one beyond the corporation's powers. The persons who authorized the ultra vires act can be held personally liable fordamages caused, but it is not a ground for piercing the corporate veil.Choice "d" is incorrect. Limiting personal liability is the main reason to incorporate. It is a ground for piercing the corporate veil only if it is done fraudulently (i.e., toavoid paying present creditors).

QUESTION 54Generally, a corporation's articles of incorporation must include all of the following, except the:

A. Name of the corporation's registered agent.B. Name of each incorporator.

C. Number of authorized shares.D. Quorum requirements.



Choice "d" is correct. A corporation's articles of incorporation need not contain any information regarding quorum requirements.Choices "a", "b", and "c" are incorrect because under the Revised Model Business Corporations Act a corporation's articles of incorporation must include:(1) The name of the corporation,(2) The name and address of the corporation's registered agent, (3) The names and addresses of each of the incorporators, and (4) The number of sharesauthorized to be issued.

QUESTION 55Which of the following actions may a corporation take without its stockholders' consent?

A. Consolidate with one or more corporations.B. Merge with one or more corporations.C. Dissolve voluntarily.D. Purchase 55% of another corporation's stock.



Choice "d" is correct. Directors are free to make most corporate decisions unilaterally. However, decisions that might fundamentally change the nature of thecorporation require the consent of the shareholders. The purchase of 55% of another corporation's stock can be quite insignificant to the purchaser and is not afundamental corporate change.Choice "a" is incorrect because a consolidation is a fundamental corporate change. Choice "b" is incorrect because a merger is a fundamental corporate change.Choice "c" is incorrect because a dissolution is a fundamental corporate change.

QUESTION 56Absent a specific provision in its articles of incorporation, a corporation's board of directors has the unilateral power to do all of the following, except:

A. Repeal the bylaws.B. Declare dividends.C. Fix compensation of directors.D. Amend the articles of incorporation.



Choice "d" is correct. Amendment of the articles of incorporation, albeit proposed by the directors, cannot usually be effected without the affirmative vote of theshareholders. Choice "a" is incorrect. The directors ordinarily have the power to repeal bylaws unless the articles or the specific bylaw to be repealed providesotherwise.Choice "b" is incorrect. The directors have the power to declare dividends at their discretion as long as the dividends do not violate any statute, article provision,bylaw, or contract with a creditor. Choice "c" is incorrect. Although it seems like there would be a conflict of interest, directors do have the power to set their owncompensation, limited only by the fiduciary duties owed to the corporation (e.g., the directors cannot set salaries so high as to constitute waste).

QUESTION 57Carr Corp. declared a 7% stock dividend on its common stock. The dividend:

A. Must be registered with the SEC pursuant to the Securities Act of 1933.B. Is includable in the gross income of the recipient taxpayers in the year of receipt.C. Has no effect on Carr's earnings and profits for federal income tax purposes.D. Requires a vote of Carr's stockholders.



Choice "c" is correct. A stock dividend means that the corporation issues its existing shareholders more stock. In essence, the corporation is merely diluting theproportional ownership interest of existing shares. This has no effect on the corporation's earnings and profits for federal income tax purposes. Choice "a" isincorrect. There is no requirement that stock dividends be registered with the SEC because no "sale" is involved.Choice "b" is incorrect. The receipt of a stock dividend is not the recognition of income. It merely divides the stockholders' current ownership interests into morepieces; it does not increase proportional ownership interest in the corporation.Choice "d" is incorrect. The issuance of dividends, including stock dividends, is at the directors' discretion; shareholders do not vote on dividends.

QUESTION 58Which of the following rights is a holder of a public corporation's cumulative preferred stock always entitled to?

A. Conversion of the preferred stock into common stock.B. Voting rights.C. Dividend carryovers from years in which dividends were not paid, to future years.D. Guaranteed dividends.



Choice "c" is correct. Cumulative preferred dividends are dividends that must be paid before any dividend can be paid to holders of non-preferred shares. The rightto the dividend accumulates if it is not paid in a particular year.Choice "a" is incorrect. There is no right to convert preferred shares into common stock unless that right is specifically granted.Choice "b" is incorrect. Preferred stock need not have voting rights. Choice "d" is incorrect. Preferred dividends are not guaranteed. They must be paid before anycommon shareholder can be paid a dividend, but no dividend might ever be paid.

QUESTION 59Which of the following securities are corporate debt securities?


Correct Answer: C

Section: Business Environment and Concepts (Volume A)Explanation


Choice "c" is correct.Rules: Bonds are debt securities. Thus, convertible bonds and debenture bonds are debt securities. A warrant is a contractual right to purchase stock, whichconstitutes a share of corporate equity. Choices "a", "b", and "d" are incorrect, per the above rules.

QUESTION 60Under the Revised Model Business Corporation Act, a dissenting stockholder's appraisal right generally applies to which of the following corporate actions?




Choice "a" is correct. "Yes-Yes."Rule: Shareholders who are dissatisfied with the terms of a merger, consolidation or sale of assets are permitted to compel the corporation to buy their shares atfair market value. This is known as the right of appraisal or the dissenting right.Rule: A short-form merger is when a parent mergers a 90% or more owned subsidiary into the parent. In this case, only the shareholders of the subsidiary havedissenting rights. Choices "b", "c", and "d" are incorrect, per the above rules.

QUESTION 61

Which of the following actions may be taken by a corporation's board of directors without stockholder approval?

A. Purchasing substantially all of the assets of another corporation.B. Selling substantially all of the corporation's assets.C. Dissolving the corporation.D. Amending the articles of incorporation.



Choice "a" is correct. Purchasing substantially all the assets of another corporation does not require approval of the buyer's stockholders. Such a transaction wouldbe relatively insignificant if a large corporation purchased substantially all the assets of a much smaller corporation. Choice "b" is incorrect. Selling substantially all ofthe corporation's assets is considered to be a fundamental change to the corporation's structure that requires approval by a majority of the shareholders followingthe board of directors' approval. Choice "c" is incorrect. Dissolving the corporation is considered to be a fundamental change to the corporation's structure thatrequires approval by a majority of the shareholders following the board of directors' approval.Choice "d" is incorrect. Amending the articles of incorporation is considered to be a fundamental change to the corporation's structure that requires approval by amajority of the shareholders following the board of directors' approval.

QUESTION 62To which of the following rights is a stockholder of a public corporation entitled?

A. The right to have annual dividends declared and paid.B. The right to vote for the election of officers.C. The right to a reasonable inspection of corporate records.D. The right to have the corporation issue a new class of stock.



Choice "c" is correct. Stockholders have a right to inspect certain corporate records. Choice "a" is incorrect. Declaration of dividends is within the directors'discretion. There is no absolute right of shareholders to receive annual dividends.Choice "b" is incorrect. Officers are appointed by the directors; they are not elected by the shareholders.

Choice "d" is incorrect. Shareholders do not have a right to force the corporation to issue a new class of stock.

QUESTION 63A parent corporation owned more than 90% of each class of the outstanding stock issued by a subsidiary corporation and decided to merge that subsidiary intoitself. Under the Revised Model Business Corporation Act, which of the following actions must be taken?

A. The subsidiary corporation's board of directors must pass a merger resolution.B. The subsidiary corporation's dissenting stockholders must be given an appraisal remedy.C. The parent corporation's stockholders must approve the merger.D. The parent corporation's dissenting stockholders must be given an appraisal remedy.



Choice "b" is correct. In a short form merger (one between a parent and a subsidiary 90% of which is owned by the parent), the subsidiary's shareholders have aright to dissent and take advantage of the appraisal remedy.Choice "a" is incorrect. The subsidiary's board is not required to take any action in a short-form merger. Choice "c" is incorrect. The parent corporation'sshareholders have no right to approve or disapprove a short-form merger.Choice "d" is incorrect. The parent corporation's shareholders have no right to dissent to a short-form merger.

QUESTION 64Davis, a director of Active Corp., is entitled to:

A. Serve on the board of a competing business.B. Take sole advantage of a business opportunity that would benefit Active.C. Rely on information provided by a corporate officer.D. Unilaterally grant a corporate loan to one of Active's shareholders.



Choice "c" is correct. As a director of the corporation Davis may rely on information provided to him/her by a corporate officer. A corporate director is under no

obligation to verify information given to him by management (corporate officers).Choice "a" is incorrect. A director is not entitled to serve on the board of a competing business. Doing so would be a breach of fiduciary duty.Choice "b" is incorrect. A director may not take sole advantage of a business opportunity that would benefit the corporation. Doing so would be a breach of fiduciaryduty. Choice "d" is incorrect. A director may not unilaterally grant a corporate loan to one of the corporation's shareholders. Directors generally must act through amajority vote at a directors' meeting.

QUESTION 65Knox, president of Quick Corp., contracted with Tine Office Supplies, InC. to supply Quick's stationery on customary terms and at a cost less than that charged byany other supplier. Knox later informed Quick's board of directors that Knox was a majority stockholder in Tine. Quick's contract with Tine is:

A. Void because of Knox's self-dealing.B. Void because the disclosure was made after execution of the contract.C. Valid because of Knox's full disclosure.D. Valid because the contract is fair to Quick.



Choice "d" is correct. If a corporation enters into a contract and a director has a conflict of interest in the transaction, the contract is voidable unless the directormakes full disclosure of all of the facts to the disinterested directors or the shareholders, who then approve the transaction, or the director can prove that thetransaction was fair to the corporation. The stationery purchase was fair to Quick, since it was purchased at a below-market price. Thus, the contract is valid.Choice "a" is incorrect. A director's self-dealing does not automatically make a contract voiD. The contract can be upheld if it was fair.Choice "b" is incorrect. A director's self-dealing does not automatically make a contract voiD. The contract can be upheld if it was fair.Choice "c" is incorrect. If a corporation enters into a contract and a director has a conflict of interest in the transaction, the contract is voidable unless the directormakes full disclosure of all of the facts to the disinterested directors or shareholders, who then approve the transaction, or the director can prove that the transactionwas fair. Mere disclosure after the contract was adopted does not automatically render the contract valid.

QUESTION 66A stockholder's right to inspect books and records of a corporation will be properly denied if the purpose of the inspection is to:

A. Commence a stockholder's derivative suit.B. Obtain stockholder names for a retail mailing list.C. Solicit stockholders to vote for a change in the board of directors.D. Investigate possible management misconduct.

Correct Answer: B



Choice "b" is correct. In general, a shareholder has a right to inspect the books and records of a corporation for purposes related to the stockholder's interest in thecorporation. This right will be denied where the purpose is not reasonably related to their status as a shareholder. Obtaining stockholder names to create a retailmailing list is a personal purpose. Choices "a", "c", and "d" are incorrect. The following reasons for shareholders to inspect the books of the corporation arereasonably related to their status as shareholders:

A. To commence a stockholder's derivative suit.C. To solicit stockholders to vote for a change in the board of directors.D. To investigate possible management misconduct.

QUESTION 67Following the formation of a corporation, which of the following terms best describes the process by which the promoter is released from, and the corporation ismade liable for, pre-incorporation contractual obligations?

A. Assignment.B. Novation.C. Delegation.D. Accord and satisfaction.



Choice "b" is correct. A promoter is personally liable for the contracts he or she enters into prior to incorporation. A corporation may become liable by adoption ofthe contract, and through the process of novation (an agreement among all of the parties), the promoter may be released from contractual obligations.Choice "a" is incorrect. An assignment is a transfer of a contractual duty to perform. After the transfer, both the assignor and assignee may be held liable forperformance. The assignor is not, thereby, released from liability.Choice "c" is incorrect. A delegation is a transfer of a contractual duty to perform. Both the delegor and delegee are liable to perform after the assignment; it doesnot release the promoter from liability. Choice "d" is incorrect. An accord is an agreement to change the performance due under a contract. Once the new terms areperformed or satisfied, the original contract terms are terminated. Such an agreement does not automatically result in release of a promoter.

QUESTION 68Which of the following parties is liable to repay an illegal distribution to a corporation?

A. A director not breaching his or her duty in approving the distribution and the corporation is solvent.B. A director not breaching his or her duty in approving the distribution and the corporation is insolvent.C. A shareholder not knowing of the illegality of the distribution and the corporation is solvent.D. A shareholder knowing of the illegality of the distribution and the corporation is insolvent.



Choice "d" is correct. Illegal dividends from an insolvent company must be repaid to the corporation for the benefit of the creditors. A shareholder who knowinglyaccepts an illegal dividend is liable to return it.Choices "a" and "b" are incorrect. If a director does not breach any duties in approving a distribution, the director is protected by the business judgment rule and isnot liable for the distribution whether the corporation is solvent or insolvent.Choice "c" is incorrect. A shareholder of a solvent corporation who unknowingly accepts an illegal distribution is not obligated to repay the distribution.

QUESTION 69Which of the following may not own shares in an S corporation?

A. Individuals.B. Estates.C. Trusts.D. Corporations.



Choice "d" is correct. Shareholders must be individuals, estates, or certain trusts. Corporations are not permitted to be shareholders of an S corporation.Choices "a", "b", and "c" are incorrect, per the above Explanation: .

QUESTION 70Which of the following decreases stockholder equity?

A. Investments by owners.B. Distributions to owners.C. Issuance of stock.D. Acquisition of assets in a cash transaction.



Choice "b" is correct. Distributions to owners, typically in the form of dividends, will serve to reduce stockholders' equity.Choice "a" is incorrect. Investments by owners, typically in the form of stock purchases or contributions, will serve to increase shareholders' equity. Choice "c" isincorrect. Issuance of stock by sale will increase shareholders' equity, while issuance of stock dividends will have no effect on total shareholders' equity. Stockdividends will reduce the book value of each share outstanding.Choice "d" is incorrect. Acquisition of assets with cash will have no effect on total stockholders' equity. The acquisition of assets with cash will effectively reclassifyassets from one type to another without impacting liabilities or equity.

QUESTION 71Food Corp. owned a restaurant called The Ambers. The corporation president, T.J. Jones, hired a contractor to make repairs at the restaurant, signing the contract,"T.J. Jones for The Ambers." Two invoices for restaurant repairs were paid by Food Corp. with corporate checks. Upon presenting the final invoice, the contractorwas told that it would not be paiD. The contractor sued Food Corp. Which of the following statements is correct regarding the liability of Food Corp.?

A. It is not liable because Jones is liable.B. It is not liable because the corporation was an undisclosed principal.C. It is liable because Jones is not liable.D. It is liable because Jones had authority to make the contract.



Choice "d" is correct. Where an agent enters into a contract on behalf of a principal and discloses the existence and identity of the principal and acts with authority,the principal is liable and the agent is not liable. Here, Jones signed the contract with an indication that he was signing for the corporation. The president of acorporation is an agent of the corporation and has apparent authority to enter contracts that appear to be within the ordinary scope of the corporation's business.The restaurant repairs here appear to be with the scope of Food Corp.'s business. Therefore, Food Corp. will be bound because Jones had at least apparent

authority.Choice "a" is incorrect, per the rule stated above.Choice "b" is incorrect. The president signed as acting on behalf of the corporation, thus disclosing the principal.Choice "c" is incorrect, per the rule stated above.

QUESTION 72Which of the following statements describes the same characteristic for both an S corporation and a C corporation?

A. Both corporations can have more than 100 shareholders.B. Both corporations have the disadvantage of double taxation.C. Shareholders can contribute property into a corporation without being taxed.D. Shareholders can be either citizens of the United States or foreign countries.



Choice "c" is correct. Either entity's shareholders may contribute property to the corporations without being taxed and may contribute such property as an exchangefor stock as appraised by the directors. Choice "a" is incorrect. An S corporation may not have more than 100 shareholders, although a C corporation may have asmany shareholders as desired.Choice "b" is incorrect. Only the C corporation is subject to the double taxation disadvantage. Choice "d" is incorrect. Only an S corporation is prohibited from havingforeign country shareholders.

QUESTION 73Smith was an officer of CCC Corp. As an officer, the business judgment rule applies to Smith in which of the following ways?

A. Because Smith is not a director, the rule does not apply.B. If Smith makes, in good faith, a serious but honest mistake in judgment, Smith is generally not liable to CCC for damages caused.C. If Smith makes, in good faith, a serious but honest mistake in judgment, Smith is generally liable to CCC for damages caused, but CCC may elect to reimburse

Smith for any damages Smith paid.D. If Smith makes, in good faith, a serious but honest mistake in judgment, Smith is generally liable to CCC for damages caused, and CCC is prohibited from

reimbursing Smith for any damages Smith paid.


Explanation/Reference:Explanation:Choice "b" is correct. The business judgment rule applies to officers as well as directors, who in their capacity, act in a manner the officer believes to be in the bestinterest of the corporation, and with the care an ordinarily prudent person in a like position would exercise. If the standards of the business judgment rule are met,the officer is not liable to the company for resulting damages. Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 74In which type of business entity is the entire ownership interest most freely transferable?

A. General partnership.B. Limited partnership.C. Corporation.D. Limited liability company.



Choice "c" is correct. Among the business entities listed, entire ownership interests are most freely transferable in a corporation. Unless transferability is restrictedby contract (restricted shares or voting trusts or voting agreements), there are no restrictions on the sale of corporate stock (the common stock represents thestockholders' ownership interest). The right to transfer ownership interests freely is one of the advantages of the corporate form of business.Choice "a" is incorrect. A general partner in a general partnership may assign his or her right to receive profits or surplus. A general partner cannot assign hisinterest and confer partnership status on the assignee without unanimous consent of all other partners. Choice "b" is incorrect. Both general partners and limitedpartners in a limited partnership may assign the right to receive profits and surplus. Neither general nor limited partners can confer general or limited partnershipstatus on the assignee without the unanimous consent of all general and all limited partners.Choice "d" is incorrect. In most states, limited liability company (LLC) members may not sell and confer ownership interest without the consent of all LLC members.

QUESTION 75Which of the following statements is correct regarding both debt and common shares of a corporation?

A. Common shares represent an ownership interest in the corporation, but debt holders do not have an ownership interest.B. Common shareholders and debt holders have an ownership interest in the corporation.C. Common shares typically have a fixed maturity date, but debt does not.D. Common shares have a higher priority on liquidation than debt.

Correct Answer: ASection: Business Environment and Concepts (Volume A)

Explanation


Choice "a" is correct. Common shares represent an investment in the corporation whereby the common shareholder becomes a part owner of the corporation. Adebt holder is a creditor of the corporation. The corporation has borrowed money from the debt holder and promises to repay at a later date. A debt holder is not anowner of the corporation.Choice "b" is incorrect. Unlike a common shareholder, a debt holder does not have an ownership interest in the corporation.Choice "c" is incorrect. Common shares do not have a fixed maturity date, but debt securities do. This answer is backwards.Choice "d" is incorrect. Upon liquidation of a corporation, the creditors of the corporation are paid first. After the creditors are paid, the shareholders are paid on apro rata basis. Thus, debt holders (creditors) have a higher priority than stockholders.

QUESTION 76Which of the following is an advantage of forming a limited liability company (LLC) as opposed to a partnership?

A. The entity may avoid taxation.B. The entity may have any number of owners.C. The owner may participate in management while limiting personal liability.D. The entity may make disproportionate allocations and distributions to members.



Choice "c" is correct. A member in a limited liability company has limited liability and the ability to manage, while a partner in a general partnership has full liabilityand the ability to manage. Choice "a" is incorrect. Generally, both entities' profits are taxable at the ownership level, but a Limited Liability Company may be taxedas an entity if it so elects. Choice "b" is incorrect. Both entities may have any number of owners. Choice "d" is incorrect. Both entities may make disproportionateallocations and distributions to their owners.

QUESTION 77Under the Revised Model Business Corporation Act, following what type of corporate acquisition does the acquiring corporation automatically become liable for allobligations of the acquired corporation?

A. A leveraged buyout of assets.B. An acquisition of stock for debt securities.C. A cash tender offer.

D. A merger.


Explanation/Reference:Explanation:Choice "d" is correct. A merger involves one corporation joining with another corporation. The surviving corporation has all of the rights and liabilities of the mergedcorporation. Thus, the acquiring corporation automatically becomes liable for all obligations of the acquired corporation. Choice "a" is incorrect. A leveraged buyoutis a strategy involving the acquisition of another corporation using a significant amount of borrowed money (bonds or loans). Often, the assets of the corporationbeing acquired are used as collateral for the loans (in addition to the assets of the acquiring corporation).The acquiring corporation does not automatically become liable for all (or any) obligations of the acquired corporation if it merely acquires another corporation'sassets. Choice "b" is incorrect. An acquisition of stock for debt securities does not make the acquiring corporation liable for the obligations of the acquiredcorporation. The acquiring corporation has simply purchased stock. In an acquisition of stock for debt securities, the acquired corporation becomes a subsidiary ofthe acquiring corporation and the acquired corporation remains a separate entity liable for its own obligations.Choice "c" is incorrect. A cash tender offer is an offer to purchase a corporation's stock directly from its shareholders at a specified price for a specified period oftime. In a cash tender offer, the acquiring corporation does not automatically become liable for all obligations of the acquired corporation. In fact, if there is only anoffer, there is no transaction at all.

QUESTION 78Which of the following actions is required to ensure the validity of a contract between a corporation and a director of the corporation?

A. An independent appraiser must render to the board of directors a fairness opinion on the contract.B. The director must disclose the interest to the independent members of the board and refrain from voting.C. The shareholders must review and ratify the contract.D. The director must resign from the board of directors.



Choice "b" is clearly the best answer here, although it is not completely correct. Directors owe their corporation a duty of loyalty and must act solely in the bestinterests of the corporation. If a corporation enters into a contract and a director has a conflict of interest in the transaction, the contract is voidable unless thedirector makes full disclosure of all of the facts to the disinterested directors or the shareholders who then approve the transaction, or the transaction is fair. Thus,disclosing the interest to the independent members and refraining from voting is one way to ensure the validity of a contract between a director and his or hercorporation, but it technically is not required as disclosure to and approval by the shareholders also ensures validity, as does making sure the transaction is fair tothe corporation. Nevertheless, the other choices are clearly incorrect - making this the best choice. Choice "a" is incorrect. A transaction with an interested director

will be upheld if it is fair, but it is not necessary to hire an independent appraiser to prove fairness. Choice "c" is incorrect. One method of approving a contract withan interested director is to disclose all of the material facts to the shareholders and seek their approval. Merely allowing the shareholders to review the contract isnot sufficient.Choice "d" is incorrect. To ensure the validity of a contract between a corporation and a director of the corporation, it is not necessary for the director to resign fromthe board (i.e., a director is not required to resign because of a conflict of interest). The corporation can approve the conflict if it is disclosed and the director doesnot participate in the approval process.

QUESTION 79Which of the following statements is correct regarding the declaration of a stock dividend by a corporation having only one class of par value stock?

A. A stock dividend is prohibited in such a corporation.B. A stock dividend increases a stockholder's proportionate share of corporate ownership.C. A stock dividend causes a decrease in the assets of the corporation.D. A stock dividend is a corporation's ratable distribution of additional shares of stock to its stockholders.



Choice "d" is correct. Stock dividends are dividends in the corporation's own authorized but unissued shares given to existing shareholders on account of theirshares. Choice "a" is incorrect. Despite the fact that a stock dividend in a corporation with only one class of par value stock does not change a shareholder'sproportional ownership or affect capitalization of the corporation, nothing prohibits a corporation--even a corporation with only one class of par value stock--fromdeclaring a stock dividend.Choice "b" is incorrect. With a stock dividend, when there is only one class of stock, each shareholder receives a proportionate amount of stock, resulting in eachshareholder owning the same percentage of the corporation after the dividend is issued as he or she owned before the dividend was issued. Choice "c" is incorrect.When a stock dividend is issued in a corporation's own stock, no assets are distributed and the solvency of the corporation remains the same.

QUESTION 80Which of the following corporate actions is subject to shareholder approval?

A. Election of officers.B. Removal of officers.C. Declaration of cash dividends.D. Removal of directors.

Correct Answer: DSection: Business Environment and Concepts (Volume A)

Explanation


Choice "d" is correct. Shareholders have the right to elect and remove directors through the voting process.Choice "a" is incorrect. Officers are selected by the directors rather than by the shareholders. Choice "b" is incorrect. Because officers are selected by the directors,generally they may be removed only by the directors.Choice "c" is incorrect. Dividends generally can be declared only by the directors; shareholders usually do not have any right to declare or vote on a distribution.

QUESTION 81Which of the following is a requirement for a small business corporation to elect S corporation status?

A. It has only one class of stock.B. It has at least one partnership as a shareholder.C. It has international ownership.D. It has more than 75 shareholders.



Choice "a" is correct. A corporation may elect to be taxed like a partnership under Subchapter S only if it has only one class of stock.Choice "b" is incorrect. A corporation can elect S corporation status only if its shareholders are individuals, estates, or certain types of trusts.Choice "c" is incorrect. Foreign shareholders generally are prohibited in an S corporation. Choice "d" is incorrect. An S corporation can have up to 100 shareholders,but it may have fewer.

QUESTION 82The president of a company has signed a $10 million contract with a construction company to build a new corporate office. Which of the following corporatedocuments sets forth the scope of authority under which this transaction is governed?

A. Certificate of Incorporation.B. Charter.C. Bylaws.D. Proxy statement.

Correct Answer: C



Choice "c" is correct. The bylaws usually contain the rules for running the corporation. Choices "a" and "b" are incorrect. These are possible choices, but not asgood an answer as "c". A corporation's articles of incorporation (called a charter in a few states) must set out certain information relevant to formation of thecorporation, but it may include any other information that it is not illegal. However, usually details about intracorporate power are set out in bylaws rather than in thearticles or charter.Choice "d" is incorrect. A proxy statement is a request to shareholders to allow their shares to be voted by a specified person in a specified way. It has nothing to dowith a corporate president's authority.

Supplemental Questions

QUESTION 83A limited liability company taxed under subchapter K of the Internal Revenue Code (the partnership subchapter):

A. Must pay federal income tax.B. Is generally not considered a legal entity separate and apart from its owners.C. Must have written articles of organization.D. Must provide for apportionment of liability for the company's debts.



Choice "c" is correct. A limited liability company must have written articles of organization, which must be filed with the state.Choice "a" is incorrect. An LLC taxed under subchapter K of the Internal Revenue Code (the partnership subchapter) does not pay federal income tax; the membersare taxed on their share of the LLC's income.Choice "b" is incorrect. Unlike a general partnership, but like a corporation and a limited partnership, an LLC is considered a legal entity separate and apart from itsowners. Choice "d" is incorrect. An LLC does not have to provide for apportionment of liability for LLC debts; the members of an LLC have limited liability.

QUESTION 84A partnership agreement must be in writing if:

A. Any partner contributes more than $500 in capital.

B. The partners reside in different states.C. The partnership intends to own real estate.D. The partnership's purpose cannot be completed within one year of formation.



Choice "d" is correct. Under the statute of frauds, a partnership agreement must be in writing if by its terms the agreement cannot be completed within one year.Choice "a" is incorrect. No such rule. Although the statute of frauds requires a contract for the sale of goods for $500 or more to be evidenced by a writing, a writingis not required to contribute more than $500 in capital to a partnership.Choice "b" is incorrect. No such rule, a far out distracter. Choice "c" is incorrect. While a contract to buy or sell real estate will require a writing, a partnershipagreement to own/buy real estate need not be in writing.

QUESTION 85Unless prohibited by the organization documents, a stockholder in a publicly held corporation and the owner of a limited partnership interest both have the right to:

A. Ownership of the business' assets.B. Control management of the business.C. Assign their interest in the business.D. An investment that has perpetual life.


Explanation/Reference:Explanation:Choice "c" is correct. Both a shareholder in a publicly held corporation and the owner of a limited partnership interest have a right to assign (sell) their interest. Whilea shareholder is free to assign his whole ownership interest, a limited partner's assignable interest is limited to the limited partner's interest in profits and losses.Choice "a" is incorrect. Neither the stockholder of a publicly held corporation nor the owner of a limited partnership interest (or indeed, even a general partnershipinterest) has an ownership interest in any item of the business' assets--the assets belong to the business and not to the owners of the business. Choice "b" isincorrect. Stockholders and limited partners generally do not have the right to participate in the management of the business.Choice "d" is incorrect. A limited partnership interest dissolves upon death of the limited partner and so is not a perpetual investment.

QUESTION 86Price owns 2,000 shares of Universal Corp.'s $10 cumulative preferred stock. During its first year of operations, cash dividends of $5 per share were declared on

the preferred stock but were never paid. In the second year, dividends on the preferred stock were neither declared nor paiD. If Universal is dissolved, which of thefollowing statements is correct?

A. Universal will be liable to Price as an unsecured creditor for $10,000.B. Universal will be liable to Price as a secured creditor for $20,000.C. Price will have priority over the claims of Universal's bond owners.D. Price will have priority over the claims of Universal's unsecured judgment creditors.



Choice "a" is correct. After a dividend is declared but not paid on cumulative preferred stock, the unpaid dividend ranks with other "unsecured" debts.Choice "b" is incorrect. The unpaid dividend ranks as an "unsecured" not a "secured" debt and Price has no right to a dividend for the second year because nodividend was declared that year. Choice "c" is incorrect. As an "unsecured" creditor, Price does not have priority over the company's bondholders.Choice "d" is incorrect. The "unsecured" creditors will share in the "unsecured" category as a whole and not with any priority within the class.

QUESTION 87A stockholder's right to inspect books and records of a corporation will be properly denied if the stockholder:

A. Wants to use corporate stockholder records for a personal business.B. Employs an agent to inspect the books and records.C. Intends to commence a stockholder's derivative suit.D. Is investigating management misconduct.



Choice "a" is correct. In general, a shareholder has a right to inspect the books and records of a corporation for purposes reasonably related to his or her status asa shareholder. This right will be properly denied where the purpose is not reasonably related to their status as a shareholder. Choice "b" is incorrect. In general, ashareholder has a right to inspect the books and records of a corporation for purposes reasonably related to his or her status as a shareholder. A shareholder neednot conduct the inspection personally; a shareholder may send an agent such as an attorney or an accountant.Choices "c" and "d" are incorrect. In general, a shareholder has a right to inspect the books and records of a corporation for purposes reasonably related to his or

her status as a shareholder. Choices "c" and "d" are purposes reasonably related to the shareholder's status as a shareholder. Thus, the stockholder would have aright to inspect for those reasons.

QUESTION 88Generally, a merger of two corporations requires:

A. That a special meeting be held and that notice and copy of the merger plan be given to all stockholders of both corporations.B. Unanimous approval of the merger plan by the stockholders of both corporations.C. Unanimous approval of the merger plan by the boards of both corporations.D. That all liabilities owed by the absorbed corporation be paid before the merger.



Choice "a" is correct. The merger of two corporations requires that a special meeting be held and that notice and copy of the merger plan be given to allstockholders of both companies. A merger generally requires the approval of both the directors and stockholders. Choice "b" is incorrect. While the stockholders'approval is required, in most states a majority vote is required; no state requires a unanimous vote.Choice "c" is incorrect. While the board's approval is required, a majority vote and not a unanimous vote is required.Choice "d" is incorrect. There is no requirement that all liabilities owed by the absorbed corporation be paid before the merger because the merged corporationbecomes obligated to pay such liabilities upon the merger.

QUESTION 89In a member managed LLC, the apparent authority of a member to bind the LLC in dealing with third parties:

A. Would permit a member to submit a claim against the LLC to arbitration.B. Must be derived from the express powers and purposes contained in the operating agreement.C. Will be effectively limited by a formal resolution of the members of which third parties are aware.D. Will be effectively limited by a formal resolution of the members of which third parties are unaware.



Choice "c" is correct. This is really an agency question on apparent authority. Apparent authority is authority that a third party reasonably believes an agent has. Ifthe third party is aware of a restriction on the agent's authority, the third party cannot reasonably believe that the agent has the restricted authority.Choice "a" is incorrect. Submitting a claim to arbitration is an extraordinary act and so is not within a member's apparent authority.Choice "b" is incorrect. Apparent authority is derived from what the reasonable person believes is the authority of a member, not the express powers and purposescontained in the operating agreement. Choice "d" is incorrect. A formal resolution of the members will not be effective to destroy apparent authority if third partiesare unaware of the resolution.

QUESTION 90Unless otherwise provided in a general partnership agreement, which of the following statements is correct when a partner dies?




Choice "d" is correct. "No - No - No."Upon the death of a general partner:Rule: A partner's death is an event of dissociation. Where a partner dissociates, the partner's right to participate in the management ceases; the partner's executordoes not take the partner's place. Rule: The partner's estate remains liable for the partner's obligations to the partnership and has a right to the deceased partner's

share of distributions.Rule: Under the Revised Uniform Partnership Act, a partnership does not automatically dissolve on the death of a partner; rather it will dissolve only if 90 days passand the remaining partners do not wish to continue the partnership.Choices "a", "b", and "c" are incorrect, per the above rules.

QUESTION 91Under the Revised Model Business Corporation Act, which of the following actions by a corporation would entitle a stockholder to dissent from the action and obtainpayment of the fair value of his/her shares?

A. An amendment to the articles of incorporation that materially and adversely affects rights in respect of a dissenter's shares because it alters or abolishes apreferential right of the shares.II. Consummation of a plan of share exchange to which the corporation is a party as the corporation whose shares will be acquired, if the stockholder is entitledto vote on the plan.


Correct Answer: CSection: Business Environment and Concepts (Volume B)Explanation


Choice "c" is correct. "Both I and II."Rule: Shareholders who vote against a share exchange are entitled to payment for fair value of their shares.Rule: Preferred shareholders who dissent to having their preferential rights altered or abolished have dissenters' rights to be paid the fair value of their shares.Choices "a", "b", and "d" are incorrect, per the above rules.

QUESTION 92The apparent authority of a partner to bind the partnership in dealing with third parties:

A. Will be effectively limited by a formal resolution of the partners of which third parties are aware.B. Will be effectively limited by a formal resolution of the partners of which third parties are unaware.C. Would permit a partner to submit a claim against the partnership to arbitration.D. Must be derived from the express powers and purposes contained in the partnership agreement.

Correct Answer: ASection: Business Environment and Concepts (Volume B)

Explanation


Choice "a" is correct. This is really an agency question on apparent authority. Apparent authority is authority that a third party reasonably believes an agent has. Ifthe third party is aware of a restriction on the agent's authority, the third party cannot reasonably believe that the agent has the restricted authority.Choice "b" is incorrect. A formal resolution of the partners will not be effective to destroy authority if a third party is aware of the resolution, but not if the third party isunaware of the resolution. Choice "c" is incorrect. Submitting a claim to arbitration is an extraordinary act. A partner has apparent authority only to enter intotransactions apparently carrying on in the usual way the business of the partnership. There is no apparent authority to enter into an extraordinary transaction.Choice "d" is incorrect. Apparent authority is derived from what a reasonable person believes concerning the authority of a partner based on the partnership'sactions toward the third party; authority derived from the express powers and purposes contained in the partnership agreement is actual authority.

QUESTION 93Grey and Carr entered into a written partnership agreement to operate a hardware store. Their agreement was silent as to the duration of the partnership. Greywishes to withdraw from the partnership. Which of the following statements is correct?

A. Unless Carr consents to a withdrawal, Grey must apply to a court and obtain a decree allowing withdrawal.B. Grey may not withdraw unless Carr consents.C. Grey may withdraw only after notice of the proposed dissolution is given to all partnership creditors.D. Grey may withdraw from the partnership at any time.

Correct Answer: DSection: Business Environment and Concepts (Volume B)Explanation


Choice "d" is correct.Rule: Where a partnership agreement does not state the duration of the partnership, the partners may withdraw at any time. The partner need not obtain consent ofthe other partners or of the court.Choices "a" and "b" are incorrect, per the above rule.Choice "c" is incorrect. A partner has no duty to inform creditors of his intent to withdraw in order for the withdrawal to be effective (although notice is needed to limitthe partner's personal liability).

QUESTION 94The limited liability of the shareholders of a closely-held corporation will most likely be disregarded if the shareholders:

A. Lend money to the corporation.

B. Are also corporate officers, directors, or employees.C. Undercapitalized the corporation when it was formed.D. Formed the corporation solely to limit their personal liability.


Explanation/Reference:Explanation:Choice "c" is correct. The "corporate veil" can be pierced in situations in which the corporation was undercapitalized at formation, where it is the alter ego of theshareholders, or when it used to perpetrate a fraud.Choice "a" is incorrect. Shareholders may lend money to their corporation. This does not make such shareholders personally liable for the corporation's debt.Choice "b" is incorrect. Officers, directors, and employees are not personally liable for the corporation's debt, and there is no reason to change this role merelybecause such persons also own shares.Choice "d" is incorrect. The desire to limit liability is a valid reason to adopt the corporate form and will not, by itself, allow the "corporate veil" to be pierced.

QUESTION 95Acorn and Bean were general partners in a farm machinery business. Acorn contracted, on behalf of the partnership, to purchase 10 tractors from Cobb Corp.Unknown to Cobb, Acorn was not authorized by the partnership agreement to make such contracts. Bean refused to allow the partnership to accept delivery of thetractors and Cobb sought to enforce the contract. Cobb will:

A. Lose because Acorn's action was beyond the scope of Acorn's implied authority.B. Prevail because Acorn had implied authority to bind the partnership.C. Prevail because Acorn had apparent authority to bind the partnership.D. Lose because Acorn's express authority was restricted, in writing, by the partnership agreement.



Choice "c" is correct. A general partner has apparent authority to bind the partnership and other partners in respect to all ordinary transactions within the apparentscope of the partnership business. A farm machinery business probably regularly purchases tractors. Thus, there was apparent authority here.Choices "a" and "b" are incorrect. Implied authority is authority that an agent reasonably believes he or she was given by the principal along with any expressauthority. Because Acorn knew that he did not have express authority to make the contracts here, he could not reasonably believe that he had implied authority todo so.Choice "d" is incorrect. The seller was not aware of Acorn's lack of express authority. Therefore, Cobb relied on Acorn's apparent authority.

QUESTION 96In 1992, Anchor, Chain, and Hook created ACH Associates, a general partnership. The partners orally agreed that they would work full time for the partnership andwould distribute profits based on their capital contributions. Anchor contributed $5,000; Chain $10,000; and Hook $15,000. For the year ended December 31, 1993,ACH Associates had profits of $60,000 that were distributed to the partners. During 1994, ACH Associates was operating at a loss. In September 1994, thepartnership dissolved. In October 1994, Hook contracted in writing with Ace Automobile Co. to purchase a car for the partnership. Hook had previously purchasedcars from Ace Automobile Co. for use by ACH Associates partners. ACH Associates did not honor the contract with Ace Automobile Co. and Ace Automobile Co.sued the partnership and the individual partners.

A. The ACH Associates oral partnership agreement was valid.B. The ACH Associates oral partnership agreement was invalid because the partnership lasted for more than one year.

Correct Answer: ASection: Business Environment and Concepts (Volume B)Explanation


Choice "a" is correct. A partnership agreement does not have to be in writing to be valid. If the partners want to enforce an agreement to be partners for more thanone year, that agreement must be in writing, but merely having the partnership last for more than one year does not make an oral partnership agreement invalid.


A. Anchor, Chain, and Hook jointly owning and conducting a business for profit establishes a partnership relationship.B. Anchor, Chain, and Hook jointly owning income producing property establishes a partnership relationship.


Explanation/Reference:Explanation:Choice "a" is correct. A partnership is defined as an association of two or more persons who agree to carry on as co-owners a business for profit. Merely owningincome-producing property jointly is not sufficient.


A. Anchor's share of ACH Associates' 1993 profits was $20,000.B. Hook's share of ACH Associates' 1993 profits was $30,000.

Correct Answer: BSection: Business Environment and Concepts (Volume B)Explanation


Choice "b" is correct. Unless otherwise agreed, partners share profits equally. Here, the partners agreed to share profits on the basis of their contributions, whichwere in a ratio of 1:2:3 respectively for Anchor, Chain, and Hook. Thus, Anchor's share of the 1993 profits was $10,000, Chain's share was $20,000, and Hook'sshare was $30,000.

QUESTION 99In 1992, Anchor, Chain, and Hook created ACH Associates, a general partnership. The partners orally agreed that they would work full time for the partnership andwould distribute profits based on their capital contributions. Anchor contributed $5,000; Chain $10,000; and Hook $15,000. For the year ended December 31, 1993,ACH Associates had profits of $60,000 that were distributed to the partners. During 1994, ACH Associates was operating at a loss. In September 1994, thepartnership dissolved.In October 1994, Hook contracted in writing with Ace Automobile Co. to purchase a car for the partnership. Hook had previously purchased cars from AceAutomobile Co. for use by ACH Associates partners. ACH Associates did not honor the contract with Ace Automobile Co. and Ace Automobile Co. sued thepartnership and the individual partners.

A. Anchor's capital account would be reduced by 1/3 of any 1994 losses.B. Hook's capital account would be reduced by 1/2 of any 1994 losses.



Choice "b" is correct. If the partnership agreement is silent on how losses will be shared, they are shared in the same manner as profits. Here, the partners agreedto share profits on the basis of their contributions, which were in a ratio of 1:2:3 respectively for Anchor, Chain, and Hook. Thus, Anchor is liable for one-sixth of theloss, Chain is liable for 1/3 of the loss, and Hook is liable for 1/2 of the loss.


A. Ace Automobile Co. would lose a suit brought against ACH Associates because Hook, as a general partner, has no authority to bind the partnership.B. Ace Automobile Co. would win a suit brought against ACH Associates because Hook's authority continues during dissolution.



Choice "b" is correct. A partner's authority to bind the partnership continues after dissolution to persons who have extended credit to the partnership previously andwho are without notice of the dissolution. The facts state that Hook had previously purchased cars for the partnership from Ace, and presumably the purchaseswere on credit. Since nothing in the facts indicates that Ace was given notice of the dissolution, the partnership will be bound.

QUESTION 101In 1992, Anchor, Chain, and Hook created ACH Associates, a general partnership. The partners orally agreed that they would work full time for the partnership andwould distribute profits based on their capital contributions. Anchor contributed $5,000; Chain $10,000; and Hook $15,000. For the year ended December 31, 1993,ACH Associates had profits of $60,000 that were distributed to the partners. During 1994, ACH Associates was operating at a loss. In September 1994, thepartnership dissolved.In October 1994, Hook contracted in writing with Ace Automobile Co. to purchase a car for the partnership. Hook had previously purchased cars from AceAutomobile Co. for use by ACH Associates partners. ACH Associates did not honor the contract with Ace Automobile Co. and Ace Automobile Co. sued thepartnership and the individual partners.Determine whether (A) or (B) is correct. Select the answer that corresponds to the correct statement.

A. ACH Associates and Hook would be the only parties liable to pay any judgment recovered by Ace Automobile Co.B. Anchor, Chain, and Hook would be jointly and severally liable to pay any judgment recovered by Ace Automobile Co.

Correct Answer: B

Section: Business Environment and Concepts (Volume B)Explanation


Choice "b" is correct. Since Ace brought suit against both the partnership and the individual partners, if judgment is rendered against the partnership, all partnerscould be held jointly and severally liable.

QUESTION 102In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers.

A. Amber Corp. must be formed under a state's general corporation statute.B. Amber Corp.'s articles of incorporation must include the names of all stockholders.C. Amber Corp. must include its corporate bylaws in the incorporation documents filed with the state.



Choice "a" is correct. A corporation must be formed by compliance with the state's corporation statute. Choice "b" is incorrect. The articles need not contain thenames of the stockholders. Choice "c" is incorrect. Bylaws do not have to be in the articles; they are usually adopted at the first directors' meeting.

QUESTION 103In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers. Amber Corp.'s initial bylaws ordinarily would be adopted by its:

A. Stockholders.B. Officers.

C. Directors.



Choice "c" is correct. Bylaws usually are adopted by the initial directors.

QUESTION 104In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers. Amber Corp.'s officers ordinarily would be elected by its:

A. Stockholders.B. Directors.C. Outgoing officers.



Choice "b" is correct. Officers usually are selected by the directors.

QUESTION 105In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers. Amber Corp.'s day-to-day business ordinarily would be operated by its:

A. Directors.B. Stockholders.C. Officers.



Choice "c" is correct. Stockholders have no day-to-day control; management power of a corporation is vested in the directors, but they usually delegate day-to-daymanagement duties to the officers.

QUESTION 106An increase (shift right) in aggregate demand causes:

A. An increase in the price level and a decrease in real GDP.B. A decrease in the price level and an increase in real GDP.C. An increase in the price level and an increase in real GDP.D. A decrease in the price level and a decrease in real GDP.



Choice "c" is correct. As shown above, an increase in aggregate demand causes the equilibrium price level to rise and equilibrium output (real GDP) to increase.Choice "a" is incorrect. As shown above, equilibrium output increases, not decreases. Choice "b" is incorrect. As shown above, the equilibrium price level increases,not decreases. Choice "d" is incorrect. As shown above, the equilibrium price level increases, not decreases.

QUESTION 107The trough of a business cycle is generally characterized by:

A. Shortages of essential raw materials and rising costs.B. Increasing purchasing power and increasing capital investments.C. Unused productive capacity and an unwillingness to risk investments.D. Declining purchasing power and unused productive capacity.



Choice "c" is correct. The trough of a business cycle is an economic low point with no positive indicators for the future. It is characterized by unused productivecapacity and an unwillingness to risk new investments.Choice "a" is incorrect. Shortages may occur during a peak. Choice "b" is incorrect. Increasing purchasing power and increasing capital investments come with

recovery.Choice "d" is incorrect. Declining purchasing power comes with inflation; unlikely in a trough.

QUESTION 108During a recession:

A. Output (real GDP) will be increasing.B. The natural rate of unemployment will increase dramatically.C. Potential output will exceed actual output.D. Actual output will exceed potential output.



Choice "c" is correct. During a recession, potential output (real GDP) will exceed actual output (real GDP).Choice "a" is incorrect. Real GDP is falling during a recession. Choice "b" is incorrect. The natural rate of unemployment will not be affected by the various phasesof the business cycle. Actual unemployment will change with the cycle. Choice "d" is incorrect. Actual output will not exceed potential output except at the peak ofthe cycle, and perhaps not then.

QUESTION 109A recession can be caused by:

A. An increase in aggregate demand.B. A decrease in aggregate supply.C. A decrease in aggregate demand.D. Both "b" and "c".



Choice "d" is correct. Both choices "b" and "c" can cause a recession. A recession is defined as a period of falling GDP and rising unemployment. GDP will fall ifthere is a decrease in aggregate demand or a decrease in aggregate supply.

Choice "a" is incorrect. An increase in aggregate demand will cause GDP to increase NOT decrease.Choice "b" is incorrect, per the above Explanation: .Choice "c" is incorrect, per the above Explanation: .

QUESTION 110A period during which real GDP is rising and unemployment is falling is called a(n):

A. Recession.B. Peak.C. Expansion.D. Trough.



Choice "c" is correct. During an expansion, real GDP is rising and unemployment is falling. Choice "a" is incorrect. A recession is when real GDP is falling NOTrising. Choice "b" is incorrect. A peak is the highest point of economic activity. It is the point where real GDP is at its highest level in the cycle and unemployment isat its lowest level in the cycle. Choice "d" is incorrect. A trough is the lowest level of economic activity. It is the point where real GDP is at its lowest level in the cycleand unemployment is at its highest level in the cycle.

QUESTION 111Which of the following might be considered the most expansionary set of fiscal policies?

A. Increase government purchases, increase in taxes.B. Increase government purchases, decrease in taxes.C. Decrease in taxes, increase in the money supply.D. Increase in government purchases, increase in the money supply.



Choice "b" is correct. Expansionary fiscal policy involves increasing government purchases and/or decreasing taxes. Both increases in government spending and

decreases in taxes cause the aggregate demand curve to shift right and thus cause real GDP (output) to increase. Choice "a" is incorrect. An increase in taxes is anexample of contractionary fiscal policy. Choice "c" is incorrect. An increase in the money supply is expansionary monetary policy (not fiscal policy).Choice "d" is incorrect per above Explanation: .

QUESTION 112An increase in government spending will tend to cause:

A. Real GDP to fall and unemployment to rise.B. Real GDP to rise and unemployment to fall.C. Real GDP to rise and unemployment to rise.D. Real GDP to fall and unemployment to fall.



Choice "b" is correct. An increase in government spending causes an increase in aggregate demand (i.e., causes the aggregate demand curve to shift right). As aresult, an increase in government spending causes real GDP to rise and unemployment to fall.Choice "a" is incorrect. Real GDP will rise, not fall.Choice "c" is incorrect. Unemployment will fall, not rise.Choice "d" is incorrect. Real GDP will rise, not fall.

QUESTION 113An increase in the personal income tax will tend to cause:

A. Real GDP to fall and unemployment to rise.B. Real GDP to rise and unemployment to fall.C. Real GDP to rise and unemployment to rise.D. Real GDP to fall and unemployment to fall.



Choice "a" is correct. An increase in the personal income tax will cause a decrease in aggregate demand (i.e., causes the aggregate demand curve to shift left). Asa result, an increase in taxes causes real GDP to fall and unemployment to rise.Choice "b" is incorrect. Real GDP will fall, not rise.Choice "c" is incorrect. Real GDP will fall, not rise.Choice "d" is incorrect. Unemployment will rise, not fall.

QUESTION 114Which one of the following most accurately describes the normal sequence of a business cycle?

A. Expansion, contraction, trough, and peak.B. Expansion, peak, contraction, and trough.C. Peak, contraction, expansion, and trough.D. Trough, contraction, expansion, and peak.



Choice "b" is correct. The sequence of a typical business cycle includes an expansionary phase, a peak of economic activity, a contractionary phase, and a troughof economic activity. Choice "a" is incorrect. A peak does not follow a trough. Choice "c" is incorrect. A trough does not follow an expansion. Choice "d" is incorrect.A contraction does not follow a trough.

QUESTION 115Within the framework of the aggregate demand/aggregate supply model, an increase in short run aggregate supply will cause:

A. Real output to expand and the price level to fall.B. Real output to decline and the price level to rise.C. Real output to expand and the price level to rise.D. Real output to decline and the price level to fall.



Choice "a" is correct. A shift right in short run aggregate supply causes output to increase and the price level to fall.Choice "b" is incorrect. Real output would rise, not fall. Choice "c" is incorrect. The price level would fall, not rise. Choice "d" is incorrect. Real output would rise, notfall.

QUESTION 116Which one of the following is most likely to accompany a reduction in aggregate demand?

A. An increase in the price level.B. A decrease in employment.C. An increase in real GDP.D. A decrease in the unemployment rate.



Choice "b" is correct. As aggregate demand falls, the unemployment rate rises so employment would decrease.

Choice "a" is incorrect. The price level would fall, not rise.Choice "c" is incorrect. Real GDP would fall, not rise.Choice "d" is incorrect. The unemployment rate would rise, not fall.

QUESTION 117If an economy is currently experiencing both full employment and price stability, a major tax reduction will probably cause:

A. An increase in the unemployment rate.B. An acceleration in the inflation rate, unless government expenditures are also reduced.C. No change in real GDP or the price level.D. A decrease in consumption.



Choice "b" is correct. A tax cut shifts the aggregate demand curve to the right causing the price level and therefore the inflation rate to rise.

Choice "a" is incorrect. The unemployment rate would fall, not rise. Choice "c" is incorrect. The price level would rise, not remain unchanged. Choice "d" is incorrect.Consumption would rise as disposable income rises, not fall.

QUESTION 118A large increase in nominal wages, perhaps orchestrated by unions, would most likely result in:

A. An increase in real GDP and a decrease in the price level.B. A decrease in real GDP and an increase in the price level.C. A decrease in real GDP and a decrease in the price level.D. An increase in real GDP and an increase in the price level.



Choice "b" is correct. An increase in nominal wages represents an increase in input costs. This would shift the aggregate supply curve to the left resulting in adecrease in real GDP and an increase in the overall price level.Choice "a" is incorrect. Real GDP would decrease, not increase. Choice "c" is incorrect. The price level would increase, not decrease. Choice "d" is incorrect. RealGDP would decrease, not increase.

QUESTION 119Economic fluctuations (or business cycles) are best described as:

A. Long run increases in a nations standard of living.B. Changes in the profits of a given firm from one year to the next.C. Fluctuations of equal duration and equal severity in the level of economic activity over time.D. Fluctuations in the level of economic activity, relative to a long-term growth trend.



Choice "d" is correct. By the definition of business cycles.Choice "a" is incorrect. This is economic growth.

Choice "b" is incorrect. Business cycles refer to overall economic activity not the activity of one firm. Choice "c" is incorrect. Business cycles are not predictable andare not of equal duration nor of equal severity.

QUESTION 120Which of the following would most likely cause real GDP to increase the most:

A. A rise in interest rates and a rise in input costs.B. A fall in interest rates and a fall in input costs.C. A rise in wealth and a rise in interest rates.D. A rise in consumer confidence and a fall in government spending.



Choice "b" is correct. A decline in interest rates would cause the aggregate demand curve to shift right, which increases real GDP. Similarly, a decline in input costswould cause the aggregate supply curve to shift right, which also increases real GDP.Choice "a" is incorrect. Both of these events would cause real GDP to decline. Choice "c" is incorrect. A rise in interest rates would cause real GDP to decline, notincrease. Choice "d" is incorrect. A decline in government spending would cause real GDP to decline, not increase.

QUESTION 121At the peak of a business cycle:

A. Output (real GDP) tends to be below the potential level of output.B. There is likely to be an excess supply of labor and business inventories are likely to be high.C. The overall price level is likely to be falling.D. Capacity constraints and labor shortages are likely to put upward pressure on the overall price level.



Choice "d" is correct. The peak of a business cycle marks the highest point of economic activity. At that point, firms are likely to face capacity constraints and laborshortages, which will put upward pressure on the overall price level.

Choice "a" is incorrect. Real GDP is likely to be above, not below, its potential level. Choice "b" is incorrect. Business inventories are likely to be low, not high, andthere is likely to be excess demand for labor not an excess supply of labor.Choice "c" is incorrect. The overall price level is likely to be rising not falling.

QUESTION 122Which of the following segments of the economy will be least affected by the business cycle?

A. Commercial construction industry.B. Machinery and equipment industry.C. Residential construction industry.D. Healthcare industry.



Choice "d" is correct. The business cycle is the rise and fall of economic activity relative to its long- term growth trend. During a contraction or a recession, mostindustries experience a decline in sales and profits. Similarly, during an expansion, most industries experience an increase in sales and profits. However, healthcare services are typically not affected by business cycles. People need medical services regardless of whether or not the economy is doing well. Thus, the healthcare industry is the least affected by the business cycle.Choice "a" is incorrect. During a downturn in economic activity (recession or contraction), firm investment in new plants and equipment typically drops offsubstantially. Thus, the demand for commercial construction is typically low during a contraction and high during an expansion. Thus, the commercial constructionindustry is sensitive to the business cycle. Choice "b" is incorrect. During a downturn in economic activity (recession or contraction) firm investment in new plantsand equipment typically drops off substantially. Thus, the machinery and equipment industry is sensitive to business cycles. Sales grow during an expansion, butthey tend to decline during a contraction or recession.Choice "c" is incorrect. The residential construction industry is sensitive to interest rates, unemployment rates, and consumer wealth. All of these fluctuate with thebusiness cycle. As a result, the residential construction industry is sensitive to the business cycle.

QUESTION 123An auditor is required to obtain an understanding of the entity's business, including business cycles and reasons for business fluctuations. What is the audit purposemost directly served by obtaining this understanding?

A. To enable the auditor to accurately identify significant deficiencies.B. To assist the auditor to accurately interpret information obtained during an audit.C. To allow the auditor to more accurately perform tests of controls.D. To decide whether it will be necessary to perform analytical procedures.



Choice "b" is correct. As part of audit planning, the auditor should obtain an understanding of the entity's business. This understanding enables the auditor to betterunderstand events, transactions, and practices that may affect the financial statements, to plan and perform appropriate audit tests, and to properly understand andevaluate the results of those tests. Choice "a" is incorrect. Obtaining an understanding of the entity's business would not be particularly helpful in identifyingsignificant deficiencies. Significant deficiencies in internal control are typically identified during the fieldwork stage of the audit.Choice "c" is incorrect. Obtaining an understanding of the entity's business would not result in a more accurate performance of tests of controls. Accurateperformance of audit tests is dependent upon factors such as existence of an appropriate audit trail, client cooperation, training and supervision of audit staff, etc.Choice "d" is incorrect. Analytical procedures are always required in an audit during the planning and overall review stages.

QUESTION 124Which of the following statements is correct if there is an increase in the resources available within an economy?

A. More goods and services will be produced in the economy.B. The economy will be capable of producing more goods and services.C. The standard of living in the economy will rise.D. The technological efficiency of the economy will improve.



Choice "b" is correct. If there is an increase in the resources available in an economy, the economy will be capable of producing more goods and services. Thisincrease is really an increase in the long-run aggregate supply (potential GDP). On the aggregate supply and demand chart, the long-run aggregate supply line(LRAS) is the vertical line that represents the potential or equilibrium level of output. If that line shifts to the right, then the economy is capable of expanding, but itwill not automatically expand just because the line shifts to the right.Choice "a" is incorrect. Just because there is an increase in the resources available in an economy, it does not mean that more goods and services willautomatically be produceD. There would have to be increased demand (a shift upward in the aggregate demand line) for more goods and services to actually beproduced.Choice "c" is incorrect. If there is an increase in the resources available in an economy, the standard of living in the economy will not necessarily rise. It could rise,but it will not necessarily do that. Choice "d" is incorrect. If there is an increase in the resources available in an economy, the technological efficiency of the economywill not automatically improve. This statement is backwards. An increase in technological efficiency of an economy will normally increase the resources available inthe economy by increasing productivity.

Economic Measures and Reasons for Changes in the Economy

QUESTION 125A period of inflation:

A. Increases the price level, which benefits those who are entitled to receive specific amounts of money.B. Enhances the positive relationship between the price level and the purchasing power of money.C. Harms anyone who has an obligation to pay a specific amount and benefits anyone who is entitled to receive a specific amount.D. Increases the price level, which is negatively related to the purchasing power of money.



Choice "d" is correct. A period of inflation increases the price level, which is negatively related to the purchasing power of money (inflation erodes the value ofmoney). Choice "a" is incorrect. When price levels increase, those with fixed amounts of money are hurt. Choice "b" is incorrect. The relationship between pricelevels and the purchasing power of money is negative, or inverse.Choice "c" is incorrect. Inflation helps anyone with a fixed obligation since the debt can be repaid in inflated dollars. Those receiving a specific fixed amount areharmed.

QUESTION 126Which of the following is not consistent with full employment?

A. An unemployment rate greater than zero.B. Structural unemployment.C. Cyclical unemployment.D. Frictional unemployment.



Choice "c" is correct. When the economy is operating at full employment, there is no cyclical unemployment. When the economy is operating at full employment,there is still some unemployment known as the natural rate of unemployment, which does not include cyclical unemployment. Choice "a" is incorrect. There is still

some unemployment (frictional, structural, and seasonal) when the economy is operating at full employment.Choice "b" is incorrect, per the above Explanation: .Choice "d" is incorrect, per the above Explanation: .

QUESTION 127Cyclical unemployment results from:

A. Skills of workers not corresponding to jobs available.B. The time it takes to match qualified workers with available jobs.C. Seasonal decreases in demand for labor.D. A recession in the economy.



Choice "d" is correct. Cyclical Unemployment is caused by the business cycle. It tends to rise during a recession and fall during an expansion.Choice "a" is incorrect. This is an example of structural unemployment. Choice "b" is incorrect. This is an example of frictional unemployment. Choice "c" isincorrect. This is an example of seasonal unemployment.

QUESTION 128A sharp rise in the price of oil (a major input), would result in:

A. Cost (Push) inflation.B. Demand (Pull) inflation.C. An increase in aggregate demand.D. An increase in aggregate supply.



Choice "a" is correct. Cost (Push) inflation is inflation caused by a shift left in aggregate supply. An increase in input costs, such as a sharp increase in the price ofoil, will cause the aggregate supply curve to shift left and thus increase the aggregate price level causing inflation. Choice "b" is incorrect. Demand (Pull) inflation is

inflation caused by a shift right in aggregate demand.Choice "c" is incorrect. An increase in the price of oil causes the aggregate supply curve to shift, not the aggregate demand curve.Choice "d" is incorrect. An increase in the price of oil will cause aggregate supply to decrease (shift left), not increase.

QUESTION 129During a period of high inflation, which of the following groups in society would be most likely to gain?

A. Those with a fixed income.B. Those with a fixed amount of debt.C. Those holding a large amount of money.D. Workers under contract without a cost of living adjustment.



Choice "b" is correct. During a period of high inflation, those with a fixed amount of debt will repay their debt with inflated dollars and are thus likely to gain. Choice"a" is incorrect. Those with a fixed income will see the purchasing power of their income erode and are thus likely to be hurt.Choice "c" is incorrect. Those holding a large amount of money will see the purchasing power of their money erode and are thus likely to be hurt.Choice "d" is incorrect. Cost of living adjustments take inflation into account, thus these individuals are likely to be unaffected.

QUESTION 130Frictional unemployment refers to unemployment resulting from:

A. The skills of workers do not correspond to the skills demanded by employers.B. The time needed to match qualified job seekers with available jobs.C. Seasonal decreases in demand for labor.D. A recession in the economy.



Choice "b" is correct. Frictional unemployment is the unemployment that arises from workers routinely changing jobs or from workers being temporarily laid off. It

results from the time needed to match qualified job seekers with available jobs.Choice "a" is incorrect. This is structural unemployment.Choice "c" is incorrect. This is seasonal unemployment.Choice "d" is incorrect. This is cyclical unemployment.

QUESTION 131The measure most often used to compare standards of living across countries or across time is:

A. Government spending.B. Real GDP.C. Real consumption expenditures.D. Real GDP per capita.



Choice "d" is correct. Real GDP per capita is real GDP divided by population. Real GDP per capita is typically used to compare standards of living across countriesor across time. By dividing real GDP by population, this measure adjusts for differences in the size of countries and for differences in population over time.Choice "a" is incorrect. Government spending is not a measure of the standard of living of a country. Choice "b" is incorrect. Countries with larger populations tendto have higher levels of real GDP. This however does not mean they have a higher standard of living. To adjust for differences in population, real GDP per capita istypically used to compare standards of living, not real GDP. Choice "c" is incorrect. Real consumption expenditures are only a part of real GDP and thus do notmeasure all economic activity. Furthermore, real consumption expenditures do not adjust for differences in population. It is therefore not used as a measure of thestandard of living.

QUESTION 132The determination of gross domestic product (GDP) by the expenditure approach would include:

A. Net exports.B. Business profits.C. Compensation to employees.D. A capital consumption allowance.



Choice "a" is correct. The expenditure approach to computing GDP includes:ConsumptionNet exportsGovernment expendituresCapital investmentChoices "b", "c", and "d" are incorrect, per the Explanation: above.

QUESTION 133Under the expenditure approach, GDP can be calculated as the sum of:

A. Consumption, money supply, government purchases, and exports.B. Consumption, investment, transfer payments, and imports.C. Consumption, investment, government purchases, and net exports.D. Consumption, investment, government purchases, and foreign exchange.



Choice "c" is correct. Under the expenditure approach, GDP is calculated as the sum of: consumption expenditures + investment expenditures + governmentpurchases + net exports.Choice "a" is incorrect. See definition above.Choice "b" is incorrect. See definition above.Choice "d" is incorrect. See definition above.

QUESTION 134The discount rate set by the Federal Reserve is the:

A. Rate that commercial banks charge for loans to each other.B. Rate that commercial banks charge for loans to the general public.C. Rate that the central bank charges for loans to commercial banks.D. Ratio of a bank's reserves to its demand deposits.

Correct Answer: C

Section: Business Environment and Concepts (Volume B)Explanation


Choice "c" is correct. The discount rate refers to the rate established by the Federal Reserve for shortterm (often overnight) loans the Fed makes to member banks.Choice "a" is incorrect. The discount rate is the rate the Federal Reserve charges.Choice "b" is incorrect per above Explanation: .Choice "d" is incorrect. This would be the bank's reserve ratio - not the discount rate.

QUESTION 135All of the following actions are valid tools that the Federal Reserve Bank uses to control the supply of money, except:

A. Selling government securities.B. Changing the reserve ratio.C. Raising or lowering the discount rate.D. Printing money when the money supply appears low.



Choice "d" is correct. The treasury prints money. The Fed must increase the money supply through:

1. Federal open market committee (FOMC) purchasing or selling government securities,2. Raising or lowering the discount rate, or3. Changing the reserve ratio.Choices "a", "b", and "c" are incorrect because they are all valid tools to control the supply of money.

QUESTION 136If the Federal Reserve wanted to implement an expansionary monetary policy, which one of the following actions would the Federal Reserve take?

A. Raise the reserve requirement and the discount rate.B. Purchase additional U.S. government securities and lower the discount rate.C. Raise the discount rate and sell U.S. government securities.D. Lower the discount rate and raise the reserve requirement.



Choice "b" is correct. Fed purchases of government securities increase the money supply (putting money into circulation), and lowering the discount rateencourages borrowing by member banks and increases the money supply. Hence, these measures would help implement an expansionary monetary policy.Choice "a" is incorrect. Raising the reserve requirement and the discount rate would have the opposite effect of decreasing the money supply.Choice "c" is incorrect. Raising the discount rate and selling government securities would reduce the money supply.Choice "d" is incorrect. Raising the reserve requirement would decrease the money supply, but lowering the discount rate would increase the money supply.

QUESTION 137To decrease the money supply, the Fed might:

A. Sell government securities on the open market.B. Buy government securities on the open market.C. Decrease the required reserve ratio.D. Lower the discount rate.



Choice "a" is correct. To decrease the money supply, the Fed can: (1) sell government securities in the open market, (2) increase the discount rate, and (3)increase the required reserve ratio. Choice "b" is incorrect. The Fed should sell (not buy) securities on the open market. Choice "c" is incorrect. The Fed shouldincrease (not decrease) the required reserve ratio. Choice "d" is incorrect. The Fed should increase (not decrease) the discount rate.

QUESTION 138Which of the following correctly lists the three ways to increase the money supply?

A. Raise the required reserve ratio, increase the discount rate, sell bonds in the open market.B. Raise the required reserve ratio, increase the discount rate, buy bonds in the open market.C. Lower the required reserve ratio, increase the discount rate, buy bonds in the open market.D. Lower the required reserve ratio, decrease the discount rate, buy bonds in the open market.



Choice "d" is correct. The three ways the Fed can increase the money supply are: (1) buy (purchase) government securities in the open market, (2) lower thediscount rate, and (3) lower the required reserve ratio.Choice "a" is incorrect, per above Explanation: .Choice "b" is incorrect, per above Explanation: .Choice "c" is incorrect, per above Explanation: .

QUESTION 139An increase in the money supply leads to:

A. A decline in interest rates, an increase in investment and an increase in aggregate demand.B. A decline in interest rates, a decrease in investment and an increase in aggregate demand.C. An increase in interest rates, a decrease in investment and a decrease in aggregate demand.D. An increase in the money supply has no effect on interest rates or investment.



Choice "a" is correct. Expansionary monetary policy results when the Fed increases the money supply. Expansionary monetary policy affects the economy throughthe following chain of events: (1) an increase in the money supply causes interest rates to fall, (2) falling interest rates stimulate the desired levels of firm investmentand household consumption, (3) increases in desired investment and consumption cause an increase in aggregate demand, and (4) aggregate demand shifts to theright causing real GDP and the price level to rise.Choice "b" is incorrect. An increase in the money supply causes investment to increase, not decrease. Choice "c" is incorrect. An increase in the money supplycauses interest rates to decrease, not increase, investment to increase, not decrease and aggregate demand to increase, not decrease.Choice "d" is incorrect per above Explanation: .

QUESTION 140Which of the following is most likely to cause an increase in the amount of frictional unemployment in an economy?

A. An invention that renders an industry obsolete.B. A downturn in aggregate business activity.C. An increase in the average age of the work force.D. A reduction in the average age of the work force.



Choice "d" is correct. Younger workers tend to move between jobs more frequently. Choice "a" is incorrect. This would lead to structural unemployment. Choice "b"is incorrect. This would lead to cyclical unemployment. Choice "c" is incorrect. Older workers tend to be voluntarily between jobs less frequently than youngerworkers.

QUESTION 141Which of the following would lead to a reduction in inflation?

A. Increasing aggregate demand and increasing aggregate supply.B. Decreasing aggregate demand and increasing aggregate supply.C. Decreasing aggregate demand and decreasing aggregate supply.D. Increasing aggregate demand and decreasing aggregate supply.



Choice "b" is correct. Decreasing aggregate demand and increasing aggregate supply will reduce the inflationary pressures.Choice "a" is incorrect. Increasing aggregate demand causes the price level to rise. Choice "c" is incorrect. Decreasing aggregate supply causes the price level torise. Choice "d" is incorrect. Both of these would cause the price level to rise.

QUESTION 142Initially the nominal interest rate is 8 percent and the inflation rate is 6 percent. One year later, the nominal interest rate rises to 12 percent while the inflation raterises to 10 percent. It follows that the real rate of interest:

A. Has remained the same.B. Has fallen.C. Has risen.D. Insufficient information given for an answer.



Choice "a" is correct. The real interest rate equals the nominal interest rate minus the inflation rate. Thus, the real interest rate in the first year is: real interest rate =8 - 6 = 2 and the real interest rate in the next year is: real interest rate = 12 - 10 = 2.

QUESTION 143If consumption is $70b, investment $50b, government spending $20b, exports $7b, and imports $5b, what is GDP?

A. $152b.B. $138b.C. $140b.D. $142b.



Choice "d" is correct. By the expenditure approach to measuring GDP, GDP equals: Consumption + Investment + Government Spending + Exports - Imports. Thus,GDP = 70 + 50 + 20 + 7 - 5 = 142b.

QUESTION 144When a worker quits work to stay at home with the children, it is an example of:

A. Frictional unemployment.B. Structural unemployment.C. Cyclical unemployment.

D. Not counted in unemployment figures.



Choice "d" is correct. Unemployment only tallies workers actively seeking employment; it does not count retirees or stay-at-home parents.Choice "a" is incorrect. Frictional unemployment describes workers who leave work voluntarily to seek a better position.Choice "b" is incorrect. Structural unemployment describes workers whose skills are no longer needed. Choice "c" is incorrect. Cyclical unemployment describesworkers unemployed due to the business cycle.

QUESTION 145The CPI jumps from 131 in year 1 to 136.5 in year 2. What is annual inflation rate?

A. 4.2%B. 3%C. 1.38%D. 13.8%



Choice "a" is correct. The inflation rate is measured as:

QUESTION 146

The inflation rate measures:

A. The rate at which nominal GDP increases.B. How the price of a particular good changes over time.C. How nominal interest rate changes over time.D. The rate at which the overall price level increases.



Choice "d" is correct. The inflation rate measures the rate of increase in the overall price level in the economy.Choice "a" is incorrect. The inflation rate is associated with price level changes not changes in the nominal value of output.Choice "b" is incorrect. Inflation refers to a sustained increase in the overall price level. Not the price of a particular good.Choice "c" is incorrect. The inflation rate is associated with price level changes not interest rate changes.

QUESTION 147Stagflation refers to:

A. A combination of rising unemployment and rising real GDP.B. A combination of rising unemployment and a rising price level.C. High inflation rates.D. High unemployment rates.


Explanation/Reference:Explanation:Choice "b" is correct. Stagflation occurs when the economy suffers a recession that is characterized by falling output, rising unemployment, and a rising price level.Choice "a" is incorrect. Real GDP is falling during stagflation, not rising. Choice "c" is incorrect. High inflation rates is just one aspect of stagflation; the other isfalling output and rising unemployment.Choice "d" is incorrect. High unemployment rates are just one aspect of stagflation; the other is a rising overall price level (high inflation).

QUESTION 148When the overall price level is rising, nominal interest rates tend to be:

A. Unaffected by changes in the price level.B. Falling.C. Rising.D. None of the above.



Choice "c" is correct. The relationship between nominal interest rates and inflation can be seen by rearranging the equation for real interest rates as follows:Nominal Interest Rate = Real Interest Rate + InflationThus, if real interest rates do not change, a 1% increase in the inflation rate will lead to a 1% increase in nominal interest rates.

QUESTION 149Inflation can be caused by:

A. Increases in aggregate demand only.B. Increases in aggregate supply only.C. Decreases in aggregate demand and increases in aggregate supply.D. Increases in aggregate demand and decreases in aggregate supply.


Explanation/Reference:Explanation:Choice "d" is correct. Both an increase in aggregate demand and a decrease in aggregate supply can cause inflation.Choice "a" is incorrect. While an increase in aggregate demand can cause inflation, it is not the only cause of inflation.Choice "b" is incorrect. An increase in aggregate supply would lower the overall price level, not increase the overall price level.Choice "c" is incorrect. A decrease in aggregate demand would lower the overall price level, not increase the overall price level.

QUESTION 150To address the problem of a recession, the Federal Reserve Bank most likely would take which of the following actions?

A. Lower the discount rate it charges to banks for loans.B. Sell U.S. government bonds in open-market transactions.C. Increase the federal funds rate charged by banks when they borrow from one another.D. Increase the level of funds a bank is legally required to hold in reserve.



Choice "a" is correct. During a recession, real GDP has fallen and unemployment has risen. To stimulate the economy, the Fed can lower the discount rate. Thiscauses the money supply to increase, which, in turn, causes aggregate demand to shift right. As a result, real GDP would increase and unemployment woulddecrease.Choice "b" is incorrect. If the Fed sells U.S. government bonds in the open market, the money supply will decrease. This causes aggregate demand to shift left. Asa result, real GDP would decrease and unemployment would increase.Choice "c" is incorrect. Increasing the federal funds rate would increase interest rates. Higher interest rates cause the aggregate demand curve to shift left. As aresult, real GDP would decrease and unemployment would increase.Choice "d" is incorrect. An increase in the required reserve ratio causes the money supply to decrease. This causes aggregate demand to shift left. As a result, realGDP would decrease and unemployment would increase.

QUESTION 151Which of the following actions is the acknowledged preventive measure for a period of deflation?

A. Increasing interest rates.B. Increasing the money supply.C. Decreasing interest rates.D. Decreasing the money supply.



Choice "b" is correct. Deflation is a general decline in the overall price level (i.e., when the inflation rate is negative). Increasing the money supply causes the overallprice level to rise. As a result, it helps eliminate deflation.Choice "a" is incorrect. Increasing interest rates causes aggregate demand to shift left. As a result, the aggregate price level will fall even further. This will

exasperate deflation. Choice "c" is not wrong but it is not as good an answer as "b". A decrease in interest rates causes the aggregate demand curve to shift right.As a result, the aggregate price level will rise. This helps eliminate deflation. However, there are times when interest rates are already so low that lowering interestrates is not an option. Thus, the preferred or "acknowledged" preventative measure for deflation is increasing the money supply.Choice "d" is incorrect. Decreasing the money supply causes the overall price level to fall. This would obviously exasperate deflation.

QUESTION 152All of the following are components of the formula used to calculate gross domestic product, except:

A. Household income.B. Foreign net export spending.C. Government spending.D. Gross investment.



Choice "a" is correct. Gross domestic product (GDP) is calculated in two different ways. The first, which is the expenditure approach and can be used to answer thisquestion, is the mnemonic GICE, or government purchases plus private domestic investment plus personal consumption expenditures plus net exports. Householdincome is the only one of the answers that is not included in this mnemonic. Choice "b" is incorrect. Foreign net export spending is included in the mnemonic (E) forGDP; although, it is called simply net exports in the mnemonic and not foreign net export spending. Choice "c" is incorrect. Government spending is included in themnemonic (G) for GDP. Choice "d" is incorrect. Gross investment is included in the mnemonic (I) for GDP, although it is called private domestic investment in themnemonic.

QUESTION 153Gross domestic product includes which of the following measures?

A. The size of a population that must share a given output within one year.B. The negative externalities of the production process of a nation within one year.C. The total monetary value of all final goods and services produced within a nation in one year.D. The total monetary value of goods and services including barter transactions within a nation in one year.



Explanation:

Choice "c" is correct. Gross domestic product (GDP) is the total dollar (monetary) value of all new final products and services produced with the economy in a giventime perioD. The emphasis is on the final goods and services.Choice "a" is incorrect. The size of a population that must share a given output within one year is not a part of the GDP calculation.Choice "b" is incorrect. The negative (or positive) externalities of the production process of a nation within one year are not a part of the GDP calculation. Ineconomics, externalities are the effects that the acts of consumers or producers have on each other. Externalities range from technological changes to changes inthe range of options available to consumers. Externalities may also be regarded as the unanticipated side effects of courses of action.Choice "d" is incorrect. The total monetary value of goods and services, including barter transactions, is not a part of the GDP calculation. GDP includes onlymonetary value, not barter value.

QUESTION 154Which of the following is correct regarding the consumer price index (CPI) for measuring the estimated decrease in a company's buying power?

A. The CPI is measured only once every 10 years.B. The products a company buys should differ from what a consumer buys.C. The CPI measures what consumers will pay for items.D. The CPI is skewed by foreign currency translations.



Choice "b" is correct. The consumer price index measures the costs of a market basket of specific goods commonly purchased by consumers. It measuresconsumer buying power and is not distorted by items generally bought by industry.Choice "a" is incorrect. The Consumer Price Index (CPI) represents monthly data on changes in the prices paid by urban consumers for a representative basket ofgoods and services. Choice "c" is incorrect. The Consumer Price Index measures what has been paid for items, not what consumers will pay for items.Choice "d" is incorrect. The Consumer Price Index measures what has been paid by consumers in over eighty urban areas in the United States. The amounts paidare denominated in US dollars and would not be skewed by foreign currency translations.

QUESTION 155The following table contains Emerald Corp.'s quarterly revenues, in thousands, for the past three years. During that time, there were no major changes to Emerald'sselling strategies and total capital investment.

Which of the following statements best describes the likely cause of the fluctuations in Emerald's revenues and the best response to those fluctuations?

A. The fluctuations are from changes in the economy, and Emerald should examine its cost structure for potential changes.B. The fluctuations are from changes in the economy, and Emerald should manage its inventories and cash flow to match the cycle.C. The fluctuations are from the seasonal demand for Emerald's products, and Emerald should examine its cost structure for potential changes.D. The fluctuations are from the seasonal demand for Emerald's products, and Emerald should manage its inventories and cash flow to match the cycle.



Choice "d" is correct. Relatively stable demand over a three year period in each of the first three quarters of the year followed by an increase of between 40 and 50percent in the final quarter of the year over average sales in the first three quarters in each of the three years presented is indicative of seasonal fluctuations indemand for Emerald's product that would require appropriate inventory management.Choice "a" is incorrect. The consistent volume levels and fluctuation percentages displayed for the activity in each quarter for each year are indicative of changes inseasonal demand rather than changes in the economy generally.Choice "b" is incorrect. The consistent volume levels and fluctuation percentages displayed for the activity in each quarter for each year are indicative of changes inseasonal demand rather than changes in the economy generally.Choice "c" is incorrect. Relatively stable demand over a three year period in each of the first three quarters of the year followed by an increase of between 40 and50 percent in the final quarter of the year over average sales in the first three quarters in each of the three years presented is indicative of seasonal fluctuations indemand for Emerald's product. The company should be more attentive to the timing of inventory purchases to meet demand, however, rather than the company'soverall cost structure.Market Influences on Business Strategies

QUESTION 156When markets are perfectly competitive, consumers:

A. Have goods and services produced at the lowest cost in the long run.B. Must choose the brands they buy solely on the basis of informational advertising.C. Do not receive any consumer surplus unless producers choose to overproduce.

D. Must search for the lowest price for the products they buy.



Choice "a" is correct. Since price is barely sufficient to give a firm a normal profit and stay in business, the consumer obtains the product at as low a price as iseconomically feasible. In addition, every firm is forced to produce at the most efficient output rate.Choice "b" is incorrect. Brand differentiation is present in monopolistic competition, not perfect competition.Choice "c" is incorrect. This is a far-out distractor.Choice "d" is incorrect. Also far out. Individual consumers are also price takers at the market equilibrium price.

QUESTION 157Which one of the following is not a key assumption of perfect competition?

A. Customers are indifferent about which firm they buy from.B. The level of a firm's output is small relative to the industry's total output.C. Each firm can price its product above the industry price.D. There is freedom of entry into and exit out of the industry.



Choice "c" is correct. A key assumption of perfect competition is that the firm is a "price taker," that is, it cannot fix the price. Accordingly, it is not true that each firmcan price its product above the industry price.Key assumptions of perfect competition include:

A. Customers are indifferent about which firm they buy from. B. The level of a firm's output is small relative to the industry's total output. D. There is freedom of entryinto and exit out of the industry.

QUESTION 158In order to sell at the rate of output in markets controlled by monopolists, price is set where:

A. Price equals marginal cost.B. Marginal revenue equals marginal cost.C. Marginal revenue equals average total cost.D. Price equals average total cost.



Choice "b" is correct. In order to sell at the rate of output in markets controlled by monopolists, the price is set where marginal revenue equals marginal cost. Nomatter which model is representative of the industry in which the firm operates, the firm will maximize profits by producing at MR = MC. The monopolist's price willbe higher than MR.Choice "a" is incorrect. Price exceeds both MR and MC.Choices "c" and "d" are incorrect, which are far-out distractors.

QUESTION 159A natural monopoly exists because:

A. The firm owns natural resources.B. Economic and technical conditions permit only one efficient supplier.C. The government is the only supplier.D. Other firms are unable to enter the industry.



Choice "b" is correct. A natural monopoly exists when economic and technical conditions permit only one efficient supplier.Choice "a" is incorrect. Owning natural resources, even if they are unique, would not create a monopoly.Substitutes for the resource may be available.Choice "c" is incorrect. Government control may create a monopoly, but not a natural monopoly. This is a regulated monopoly.Choice "d" is incorrect. Barriers to entry help create a monopoly, but the product must be unique.

QUESTION 160

Karen Parker wants to establish an environmental testing company that would specialize in evaluating the quality of water found in rivers and streams. However,Parker has discovered that she needs either certification or approval from five separate local and state government agencies before she can commence business.Also, the necessary equipment to begin would cost several million dollars. However, Parker believes that if she is able to obtain capital resources, she can gainmarket share from the two major competitors.The large capital outlay necessary for the equipment is an example of a(n):

A. Entry barrier.B. Minimum efficiency scale.C. Created barrier.D. External cost.



Choice "a" is correct. Large capital (money) requirements are the basic example of barriers to entry. A barrier to entry effectively prevents firms from entering themarket to compete against existing firms. Choice "b" is incorrect. Minimum efficient scale is the output level at which long run average costs are minimized. Here,Parker has not even been able to enter the industry. Choice "c" is incorrect. A created barrier is made by firms already in the industry. Here, Parker's barrier was notcreated.Choice "d" is incorrect. An external cost is a cost that the company does not account for, but passes on to the detriment of society.

QUESTION 161Entry into monopolistic competition is:

A. Frequent, as no obstacles exist.B. Difficult, with significant obstacles.C. Rare, as significant capital is required.D. Relatively easy, with only a few obstacles.



Choice "d" is correct. The characteristics of monopolistic competition include:

· Numerous firms with differentiated products.· Ease of entry - few barriers.· Firms exact some influence over price and market.· Non-price competition is frequent and critical.Choice "a" is incorrect. Monopolistic competition has a few obstacles. A market with no obstacles is in perfect competition.Choice "b" is incorrect. Significant obstacles are characteristic of oligopoly. Choice "c" is incorrect. Significant capital requirements represent a significant barrier toentry, which is characteristic of oligopoly.

QUESTION 162Monopolistic competition is characterized by:

A. A relatively large group of sellers who produce differentiated products.B. A relatively small group of sellers who produce differentiated products.C. One or two companies producing similar products.D. A relatively large group of sellers who produce a homogeneous product.



Choice "a" is correct. Monopolistic competition is characterized by a relatively large number of sellers who produce differentiated products. There are few barriers toentry and firms exert some influence over the price and the market. Best examples are brand name consumer products. Choice "b" is incorrect. Relatively fewsellers with differentiated products would indicate an oligopoly. Choice "c" is incorrect. One company would be a monopoly, two an oligopoly. Choice "d" is incorrect.A relatively large number of sellers and a standardized product indicates perfect competition.

QUESTION 163An industry that is oligopolistic would be best characterized by:

A. One firm selling a product with no close substitutes.B. Significant barriers to entry.C. Horizontal or flat demand curves for the output of individual firms.D. The absence of significant economies of scale.



Choice "b" is correct. Oligopoly market conditions are characterized by:

· Few firms in the market· Significant barriers to entry· Differentiated products· Fixed (or semi fixed) prices· Kinked demand curves

Choice "a" is incorrect. This is an example of monopoly. Choice "c" is incorrect. Horizontal demand curves represent demand that is perfectly price elastic (buyerswill only pay one price for any quantity of a product). This occurs in perfectly competitive markets.Choice "d" is incorrect. This is characteristic of perfect competition, as there are no barriers to entry ("size doesn't matter") in perfect competition.

QUESTION 164The kinked demand curve is associated with:

A. The analysis of agricultural markets.B. The analysis of monopolistic competition.C. The analysis of pure competition.D. The analysis of oligopoly.



Choice "d" is correct. The demand curve for any individual oligopolist is kinked sharply downward. This occurs because, in oligopoly market conditions, the otherfirms in the market will match any price reduction so they do not lose market share but will not match any price increase of an individual firm. Therefore, for theindividual firm attempting to raise its prices beyond equilibrium, consumers will quickly buy from other firms in the market and demand will drop off sharply creatinga kinked demand curve.Choices "a", "b", and "c" are incorrect, per the above Explanation: .

QUESTION 165Karen Parker wants to establish an environmental testing company that would specialize in evaluating the quality of water found in rivers and streams. However,Parker has discovered that she needs either certification or approval from five separate local and state government agencies before she can commence business.Also, the necessary equipment to begin would cost several million dollars. However, Parker believes that if she is able to obtain capital resources, she can gainmarket share from the two major competitors.

The market structure Karen Parker is attempting to enter is best described as:

A. Pure competition.B. A natural monopoly.C. An oligopoly.D. Monopolistic competition.



Choice "c" is correct. Major competitors and substantial capital requirements (high barriers to entry) are oligopolistic market conditions.Choice "a" is incorrect. Pure competition has small barriers to entry and numerous suppliers. Choice "b" is incorrect. A natural monopoly suggests that economicconditions allow only one supplier for efficiency purposes.Choice "d" is incorrect. Monopolistic competition has easier barriers to entry and more firms competing to supply the market than oligopoly.

QUESTION 166Any business firm that has the ability to control the price of the product it sells:

A. Faces a downward-sloping demand curve.B. Does not have any entry or exit barriers in its industry.C. Has a supply curve that is horizontal.D. Has a demand curve that is horizontal.



Choice "a" is correct. Any business firm that has the ability to control the price of the product it sells faces a downward-sloping demand curve for the firm. Only thefirm in a competitive market is a price- taker facing a horizontal demand curve at the market equilibrium price. Choice "b" is incorrect. Firms in competitiveindustries have no entry or exit barriers and are price- takers.Choice "c" is incorrect, this is a far-out distractor.Choice "d" is incorrect. Only firms in perfectly competitive markets (price-takers) face horizontal demand curves.

QUESTION 167If a group of consumers decide to boycott a particular product, the expected result would be:

A. An increase in the product price to make up lost revenue.B. A decrease in the demand for the product.C. An increase in product supply because of increased availability.D. That companies in the industry would experience higher economic profits.



Choice "b" is correct. A consumer boycott will decrease demand for the product being boycotted. Choice "a" is incorrect. Increasing price will further reduce thequantity demanded. The effect on revenue is uncertain.Choice "c" is incorrect. Supply will be unaffected by a boycott. Choice "d" is incorrect. A boycott of a particular product will reduce the overall profits of the industry.

QUESTION 168In competitive markets, an increase in an effective minimum wage will:

A. Have a neutral effect on the demand for labor.B. Decrease the supply of labor.C. Decrease unemployment.D. Increase unemployment.



Choice "d" is correct. When the "minimum" wages are increased, employers may elect to hire fewer employees thereby increasing unemployment.Choice "a" is incorrect. An increase in the minimum wage will have an effect on the demand for labor. Choice "b" is incorrect. The supply of labor will likely go up asthe wage being paid increases. Choice "c" is incorrect. As the minimum wage increases, unemployment will increase.

QUESTION 169In a competitive market, an increase in the minimum wage will likely have the following effects:

A. Firms currently paying above the new minimum wage would generally raise their pay rates (although the new minimum wage creates a new floor for employeewage bargaining purposes).

B. Firms paying at the current minimum wage rate would generally be unaffected if the marginal revenue produced by the lowest paid workers does not exceed thenew higher cost of the worker. Many firms would thus be forced to work more efficiently.

C. Total employment will likely decrease in affected industries and generate unemployment.Employers will demand a smaller number of workers while a larger number of workers will be attracted by the higher wage.

D. If a marginally more expensive form of capital is available to substitute for labor (e.g., due to technological advances), firms will reduce their use of labor.


Explanation/Reference:Explanation:Choice "c" is correct. With an increase in the minimum wage, total employment will likely decrease in affected industries and generate unemployment. Employerswill demand a smaller number of workers while a larger number of workers will be attracted by the higher wage. Choice "a" is incorrect. Firms currently payingabove the new minimum wage would generally be unaffected, not raise their pay rates.Choice "b" is incorrect. Firms paying at the current minimum wage rate would attempt to reduce labor, not generally be unaffected.Choice "d" is incorrect. If a marginally cheaper, not more expensive.

QUESTION 170Suppose the equilibrium wage for low skilled workers in California is $6.00 an hour. If the government increases the minimum wage to $7.00 an hour, what wouldbe the effect on the market for low skilled labor?

A. An excess demand for labor would result.B. An excess supply of labor would result.C. The demand for labor would decrease.D. The supply of labor would increase.



Choice "b" is correct. A minimum wage that is set above the equilibrium wage will result in an excess supply (or surplus) of labor.

Choice "a" is incorrect, since the quantity demanded of labor at $7 is less than the quantity supplied, implying an excess supply not an excess demand.Choice "c" is incorrect. An increase in the minimum wage causes a decrease in quantity demanded of labor, not a decrease in the demand (shift in demand) forlabor.Choice "d" is incorrect, per the above Explanation: .

QUESTION 171In a competitive labor market, a minimum wage that is set above the equilibrium wage will result in which of the following:

A. A decrease in the quantity demanded of labor.B. An increase in the quantity supplied of labor.C. A decrease in total employment.D. All of the above.



Choice "d" is correct. As illustrated in the graph, a minimum wage that is set above the equilibrium wage results in a decrease in the quantity demanded of labor

(falls to LD), an increase in the quantity supplied of labor (increases to LS), and a decrease in total employment (total employment falls from L* to LD).

Choices "a", "b", and "c" are incorrect. All are true, making choice "d" the only right answer.

QUESTION 172The continual process of re-evaluating the strategic plans includes all of the following significant questions a firm should be concerned with, except:

A. Has the firm been able to attain or maintain competitive advantage?B. Is the firm able to be profitable under the current strategy?C. Does the current strategy continue to be aligned with the established goals of the firm?D. Has the firm been able to adapt to the preferences of its employees?



Choice "d" is correct. Although the firm needs to be flexible with respect to changes in many situations and then adapt to them, the ability to adapt to thepreferences of its employees is not nearly as significant to the process as the other three choices, which are crucial to the success of the strategic plan.Choices "a", "b", and "c" are incorrect because they are all significant questions a firm should be concerned with when re-evaluating the strategic plan.

QUESTION 173Under monopolistic competition, strategic plans focus on:

A. Profitability from production levels that maximize profits.B. Maintaining the market share and being responsive to market conditions related to sales price.C. Maintaining the market share and planning for enhanced product differentiation.D. Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.



Choice "c" is correct. Under monopolistic competition, strategic plans include maintaining the market share (as with pure competition), but they also likely includeplans for enhanced product differentiation and allocation of resources to advertising, product research, etc. Choices "a", "b", and "d" are incorrect because they arecharacteristics of other types of market structures.

QUESTION 174Under monopoly, strategic plans focus on:

A. Profitability from production levels that maximize profits.B. Maintaining the market share and being responsive to market conditions related to sales price.C. Maintaining the market share and planning for enhanced product differentiation.D. Maintaining the market share, ensuring product differentiation, and adapting to price changes or required changes in production volume.



Choice "a" is correct. Under monopoly, strategic plans ignore market share and focus on profitability from production levels that will maximize profits.Choices "b", "c", and "d" are incorrect because they are characteristics of other types of market structures.

QUESTION 175With respect to price elasticity of demand:

A. The shorter the time period, the more product demand becomes elastic because less choices are available.B. Product demand is more elastic when fewer substitutes are available.C. Product demand is more inelastic when more substitutes are available.D. Product demand is more elastic when more substitutes are available.



Choice "d" is correct. Product demand is more elastic when more substitutes are available. Choice "a" is incorrect. The longer the time period, the more productdemand becomes elastic because more choices are available.Choice "b" is incorrect. Product demand is more elastic when more substitutes are available, not fewer substitutes.Choice "c" is incorrect. Product demand is more inelastic when few substitutes are available.

QUESTION 176If demand is price inelastic:

A. An increase in price will result in a decrease in total revenue.B. An increase in price will result in an increase the quantity demanded that is more than the increase in price.C. An increase in price will result in an increase in total revenue.D. An increase in price will have no effect on total revenue.



Choice "c" is correct. If demand is price inelastic, an increase in price will result in an increase in total revenue (positive relationship).Choice "b" is incorrect. When demand is price inelastic, an increase in price results in a decrease in quantity demanded that is proportionately smaller than theincrease in price, thus having the result of an increase in total revenue (price multiplied by quantity). Choices "a" and "d" are incorrect, per the above statement.

QUESTION 177If demand is price elastic:

A. An increase in price will result in a decline in total revenue.B. An increase in price will result in a decline the quantity demanded that is less than the increase in price.C. An increase in price will result in an increase in total revenue.D. An increase in price will have no effect on total revenue.



Choice "a" is correct. If demand is price elastic, an increase in price will result in a decline in total revenue (negative relationship).Choice "b" is incorrect. When demand is price elastic, an increase in price results in a decline in quantity demanded that is proportionately larger than the increasein price, thus having the result of a decline in total revenue (price multiplied by quantity). Choices "c" and "d" are incorrect, per the above statement.

QUESTION 178If demand is unit elastic:

A. An increase in price will result in a decline in total revenue.B. An increase in price will result in a decline the quantity demanded that is less than the increase in price.C. An increase in price will result in an increase in total revenue.D. An increase in price will have no effect on total revenue.



Choice "d" is correct. If demand is unit elastic, a change in price will have no effect on total revenue. Choices "a", "b", and "c" are incorrect, per the abovestatement.

QUESTION 179Which of the following is incorrect with regard to government intervention in market operations?

A. Government intervention may create a price different from the market price, thus causing either a surplus or a shortage.B. A price ceiling is a price that is established above the equilibrium price, which causes a surplus to develop.

C. Price floors are minimum prices established by law, such as minimum wages and agricultural price supports.D. Rationing limits the availability of certain goods to a specified level, which lowers demand and prices for a given supply.



Choice "b" is an incorrect statement and the correct choice. A price ceiling is a price that is established below the equilibrium price, which causes a shortage todevelop. The statement in choice "b" defines a price floor.Choices "a", "c", and "d" are correct statements.

QUESTION 180Which of the following is incorrect with regard to value chain analysis?

A. Value chain analysis must be used in conjunction with the strategic plan of the organization.B. Value chain analysis is critical to assessing the competitive advantage of a firm.C. Value chain analysis is a strategic tool that assists the firm in determining how important the perceived value of the buyers is with respect to the market the firm

operates in.D. The value chain starts with the firm and goes all the way through to the end users of the product.



Choice "d" is an incorrect statement and the correct choice. The best description of a value chain is that value starts with the suppliers who provide the rawmaterials for a production process, continues with the firm and its strategic plan, continues with the value created by the customers, and then ends with the disposaland recycling of the materials.Choices "a", "b", and "c" are incorrect, as all are correct statements with regard to value chain analysis.

QUESTION 181According to Michael Porter, which of the following are the two major categories of business activities?

A. Demand activities and supply activities.B. Firm activities and customer activities.

C. Primary activities and support activities.D. Internal activities and external activities.



Choice "c" is correct. According to Michael Porter, the two major categories of business activities are primary activities and support activities.Choices "a", "b", and "d" are incorrect, per the above statement.

QUESTION 182Which of the following activities is considered a support activity?

A. Delivery of products.B. Procurement of materials.C. Product advertising.D. In-home warranty service.



Choice "b" is correct. Support activities are those activities that are performed by the support staff of an organization (e.g., purchasing of materials and supplies,development of the technology used, management of employees, accounting, finance, strategic planning, etc.). Choices "a", "c", and "d" are incorrect, as these areall considered primary activities. Primary activities are those that are involved with the direct manufacture of products, the delivery of products through distributionchannels, and the support of the product that exists after the sale is made (e.g., handling the raw materials, the manufacturing process, taking orders for theproduct, advertising the product, and servicing the product after it is sold).

QUESTION 183When applying value chain analysis, a firm sends its production manager to visit the operations of its major supplier in an attempt to determine if there are cost-savings capabilities that could be implemented at the supplier's warehouse. The firm is performing which form of value chain analysis?

A. Internal differentiation analysis.B. Internal costs analysis.

C. Vertical linkage analysis.D. None of the above.



Choice "c" is correct. Analyzing the vertical linkage of a firm means understanding the activities of the suppliers and buyers of the product and determining wherevalue can be created external to the firm's operations.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 184Which of the following is not a type of major strategic framework that has proven useful for value chain analysis?

A. Core competencies analysis.B. Customer preference analysis.C. Industry structure analysis.D. Segmentation analysis.



Choice "b" is correct. Customer preference analysis is not a major strategic framework that has been proven to be useful for value chain analysis.Choices "a", "c", and "d" are incorrect, as the three major types of strategic frameworks that have been proven to be useful for value chain analysis are industrystructure analysis, core competencies analysis, and segmentation analysis.

QUESTION 185Jordan Industries is the leader in its market for producing high-quality cat food for cats that require special diets. While it has been able to sustain competitiveadvantage for years, Jordan's management has implemented a strategic framework that focuses on why the firm has been so successful in its market.Jordan Industries has implemented which type of strategic framework?

A. Industry structure analysis.B. Core competencies analysis.

C. Segmentation analysis.D. None of the above.



Choice "b" is correct. Analysis of the core competencies of a firm help it to determine why it is able to create, attain, and sustain new types of competitive advantageand profits and reveal what it is within the firm that enables it to obtain competitive advantage. Choice "a" is incorrect. Industry structure analysis assists indetermining what it is that makes a firm more profitable compared to another firm, and it looks at five forces that influence profitability of an industry or market and,thus, the competitive environment. Choice "c" is incorrect. Segmentation analysis is a possibility when a firm is vertically integrated and when the industry structureand core competencies vary among activities in the value chain. Choice "d" is incorrect, as choice "b" is the answer to the question.

QUESTION 186If a nation has superior conditions in which to grow coffee beans and firms are able to grow them at very low costs, which of the four major factors that MichaelPorter has indicated impact the global competitive environment would allow this nation to fare better with respect to global competitive advantage?

A. Conditions of the factors of production.B. Conditions of domestic demand.C. Related and supporting industries.D. Firm strategy, structure, and rivalry.



Choice "a" is correct. If a nation has a strong set of factors of production (such as low cost, high quality raw material inputs), that are required in a given industry, itwill fare better with regard to competitive advantage.Choice "b" is incorrect. Conditions of domestic demand relate to the nation's domestic demand for the product, which is directly related to the ability of the nation tofare better with regard to competitive advantage.Choice "c" is incorrect. The factor of related and supporting industries deals with whether there are suppliers of material inputs that exist within a nation or whetherthere are rival firms who are competitive in the international environment, both of which would increase the nation's competitive advantage.Choice "d" is incorrect. The factor of firm strategy, structure, and rivalry relates to the practices of a nation with respect to how the companies are managed andorganized, long with the laws of the nation that regulate the formation of the companies, and how intense the rivalry is with respect to competing firms in the nation.

QUESTION 187Factors internal to the organization that impact strategy and are sources of strengths and weaknesses include all of the following, except:

A. Marketing effectiveness.B. Competence of management.C. Innovation of product lines.D. Regulations and laws.



Choice "d" is correct. Regulations and laws are external factors of opportunities and threats that affect the overall industry.Choices "a", "b", and "c" are incorrect, as all of these factors are examples of internal factors of an organization.

QUESTION 188When does competition not become an even stronger force impacting the profitability of a firm?

A. The market consists of several equal-sized firms.B. Customers do not have strong brand preferences.C. The market is fast-growing.D. The costs of exiting the market exceed the costs of continuing to operate.



Choice "c" is correct, as it is not a factor that would cause market competitiveness to be even stronger. Choices "a", "b", and "d" are incorrect because they are allreasons that competition becomes an even stronger force that impacts the firm's profitability. The following are situations that would cause competition to be aneven stronger force impacting the profitability of a firm:· The market is not growing fast.· There are several equal-sized firms in the market.· Customers do not have strong brand preferences.

· The costs of exiting the market exceed the costs of continuing to operate. · Some firms profit from making certain moves to increase market share. · The variousfirms in the market use different types of strategic plans.

QUESTION 189Which of the following statements regarding the existence of substitute products is correct?

A. The impact of substitutes will have more of an effect on the competitive environment of a firm if the substitutes are difficult for customers to obtain.B. When the cost of buyers switching to new products is high, the effect of substitutes on the competitive environment of a firm is high.C. If few substitutes exist, buyers have little choice of products and may be willing to pay a higher price for the products that are available.D. If few substitutes exist, buyers may have a limit on the maximum price that they are willing to pay and may choose to not purchase the firm's product if the price

is too high.



Choice "c" is correct. If few substitutes exist, buyers have little choice of products and may be willing to pay a higher price for the products that are available. Choice"a" is incorrect. The impact of substitutes will have more of an effect on the competitive environment of a firm if the substitutes are readily available to consumers(not difficult to obtain). Choice "b" is incorrect. When the cost of buyers switching to new products is low (not high), the effect of substitutes on the competitiveenvironment of a firm is high. Choice "d" is incorrect. If many (not few) substitutes exist, buyers may have a limit on the maximum price that they are willing to payand may choose to not purchase the firm's product if the price is too high.

QUESTION 190Which of the following is not considered a factor that increases the bargaining power of the customer?

A. Much information is available to the customer to compare and contrast features of all products on the market.B. One group of customers makes up a large volume of the firm's business.C. Buyers have low switching costs of changing products.D. The firm is unable to change suppliers easily.



Choice "d" is correct. When a firm is unable to change suppliers easily, that is a factor that increases the bargaining power of the suppliers.Choices "a", "b", and "c" are incorrect because they all are factors that increase the bargaining power of the customer, which are:

· Customers make up a large volume of a firm's business.· There is much information available to customers.· The buyers have low switching costs.· There are a high number of alternate suppliers.

QUESTION 191When do cost leadership strategies fail?

A. Buyers have large amounts of bargaining power in the market.B. Heavy price competition exists in the market.C. Buyers become less price sensitive and start to have brand loyalty.D. New entry firms are able to influence buyers to switch to their product by cutting the price of their product for a period of time in an effort to gain market share

and increase profits.

Correct Answer: CSection: Business Environment and Concepts (Volume C)Explanation


Choice "c" is correct. If firms overlook the fact that few customers care about the fact that a product is priced lower than others and care more about brand loyalty,cost leadership strategies will fail. Choices "a", "b", and "d" are incorrect, as these are all situations in which cost leadership strategies work well.

QUESTION 192Which of the following is not correct regarding best cost provider strategies?

A. The overall lowest cost in the industry is not a viable option in best cost strategies because the firm could not compete profit-wise with its differentiation strategycomponent.

B. When generic products are not acceptable to buyers, yet they still remain price sensitive to the value they are receiving for their money, the best cost strategymay work well.

C. The best cost strategy is a combination of the benefits of the cost leadership and differentiation strategies.D. The best cost strategy strives to have the firm evaluate and change its value chain such that it can achieve the highest cost among its closest competitors with a

quality differentiated product in an effort to obtain the highest profits.

Correct Answer: DSection: Business Environment and Concepts (Volume C)

Explanation


Choice "d" is correct because it is not a correct statement. The best cost strategy strives to have the firm evaluate and change its value chain such that it canachieve the lowest (not highest) cost among its closest competitors while matching them on the features desired by consumers. Choices "a", "b", and "c" areincorrect, as they are all true statements regarding best cost provider strategies.

QUESTION 193Considering the SCOR Model of supply chain operations, which of the following key management processes does assessing the ability of the suppliers to supplyresources fall into?

A. Plan.B. Source.C. Make.D. Deliver.

Correct Answer: ASection: Business Environment and Concepts (Volume C)Explanation


Choice "a" is correct. The process of planning consists of developing a way to properly balance aggregate demand and aggregate supply within the goals andobjectives of the firm and plan for the necessary infrastructure. Assessing the ability of the suppliers to supply resources is part of the "plan" process.Choices "b", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 194Considering the SCOR Model of supply chain operations, which of the following key management processes does implementing changes in engineering fall into?




Choice "c" is correct. The "make" process encompasses all the activities that turn the raw materials into finished products that are produced to meet a planneddemand. Implementing changes in the engineering process falls into the "make" process.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 195Considering the SCOR Model of supply chain operations, which of the following key management processes does collecting and processing vendor payments fallinto?


Correct Answer: BSection: Business Environment and Concepts (Volume C)Explanation


Choice "b" is correct. Once demand has been planned, it is necessary to procure the resources required to meet it and to manage the infrastructure that exists forthe sources. Collecting and processing vendor payments falls into the "source" process.Choices "a", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 196In which stage of supply chain management will management move away from simple consolidation of its operations to an internally-integrated supply chain, whichall work together towards the main business issue of the cost of customer service?

A. Cross-functional teams.B. Integrated enterprise.C. Extended supply chain.D. Supply chain communities.



Choice "b" is correct. In the integrated enterprise stage of supply chain management, the firm's management will move away from simple consolidation of itsoperations to an internally-integrated supply chain, which all work together towards the main business issue of the cost of customer service. Choice "a" is incorrect.In the cross-functional teams stage of supply chain management, the firm's management will turn its attention to consolidation of the various departments that makeup operations in order to solve the firm's problems, and the focus will be on customer service. Choice "c" is incorrect. In the extended supply chain stage of supplychain management, integration moves external to the firm to involve those outside the firm who are able to work as a unified team in an attempt to obtain slow,profitable growth.Choice "d" is incorrect. In the supply chain communities stage of supply chain management, the extended supply chain forms a single competitive entity with asynchronized supply chain and a complex system of networks.

QUESTION 197In which stage of supply chain management will integration move external to the firm to involve those outside the firm who are able to work as a unified team in anattempt to obtain slow, profitable growth?




Choice "c" is correct. In the extended supply chain stage of supply chain management, integration moves external to the firm to involve those outside the firm whoare able to work as a unified team in an attempt to obtain slow, profitable growth.Choice "a" is incorrect. In the cross-functional teams stage of supply chain management, the firm's management will turn its attention to consolidation of the variousdepartments that make up operations in order to solve the firm's problems, and the focus will be on customer service. Choice "b" is incorrect. In the integratedenterprise stage of supply chain management, the firm's management will move away from simple consolidation of its operations to an internally-integrated supplychain, which all work together towards the main business issue of the cost of customer service. Choice "d" is incorrect. In the supply chain communities stage ofsupply chain management, the extended supply chain forms a single competitive entity with a synchronized supply chain and a complex system of networks.

QUESTION 198An increase in the quantity demanded for a product would be associated with a(n):

A. Increase in the price of a complementary product.

B. Increase in average household income.C. Decrease in the price of that product.D. Decrease in the price of a substitute product.



Choice "c" is correct. The fundamental law of demand holds that there is an inverse relationship between price of the product and the quantity demanded. We movealong the demand curve D-D. Choice "a" is incorrect. An increase in complementary product prices would decrease the demand curve (e.g., if PC prices increase,the demand for printers and other peripherals decrease). Choice "b" is incorrect. Increases in consumers and consumer income shift the demand curve itself.Choice "d" is incorrect. A decrease in price for a substitute product (like Pepsi) decreases demand for the other product (Coke).

QUESTION 199An increase in the market supply of beef would result in a(n):

A. Decrease in the quantity of beef demanded.B. Increase in the price of beef.C. Decrease in the demand for beef.D. Increase in the quantity of beef demanded.

Correct Answer: DSection: Business Environment and Concepts (Volume C)Explanation


Choice "d" is correct. As illustrated above, a shift outward (increase) in supply, increases quantity demanded (Q2) at equilibrium, accompanied by a decline in price.Thus, an increase in the market supply of beef would result in an increase in the quantity of beef demanded. Choices "a" and "b" are incorrect, as seen in the graphabove. There is an increase in the quantity of beef demanded and a decrease in the price of beef.Choice "c" is incorrect, because there is no information in the question pertaining to any "shift" in the beef demand curve or in the demand for any complimentaryproducts (e.g., pork).

QUESTION 200In competitive markets, an increase in demand for a product causes a(n):

A. Increase in product supply.B. Reduction in purchases by consumers.C. Reduction in the number of buyers of the product.D. Increase in the price of the product.



Rule of economic reasoning: "Draw the graph!"

Choice "d" is correct. When demand increases and supply has not increased (as implied by the question), suppliers will raise the price of the product and moreproduct will be bought (but the supply curve does not change). Because consumers are demanding more product than is available, they are "willing" to pay a higherprice.Choice "a" is incorrect. Although buyers would pay higher prices and purchase more products, the supply "curve" has not changed. Therefore, the quantity suppliedremains the same. Choice "b" is incorrect. Because consumer demand has increased (not decreased). Choice "c" is incorrect. An increase in demand has anindeterminate (and irrelevant) impact on the number of buyers. For example, there could be the same number of buyers in the market, but that each demands ahigher quality.

QUESTION 201Which one of the following statements about supply and demand is true?

A. If supply increases and demand remains constant, equilibrium price will rise.B. If demand increases and supply increases, equilibrium quantity will fall.C. If demand increases and supply decreases, equilibrium price will increase.D. If demand increases and supply remains constant, equilibrium price will fall.



Choice "c" is correct. If quantity demanded for a product goes up, this drives price up. Additionally, if supply decreases, this will also drive prices up. Therefore, it isa certainty that price will be driven up, given an increase in demand and a decrease in supply.Choice "a" is incorrect. Increased supply will reduce (not increase) prices, assuming demand remains constant.Choice "b" is incorrect. Increased demand will increase price, and increased supply will reduce price. The net impact on price cannot be determined without morefacts. Choice "d" is incorrect. Increased demand will increase (not reduce) price, assuming supply remains constant.

QUESTION 202An increase in the price of crude oil will have what affect on the equilibrium price and quantity of gasoline?

A. Price will fall and quantity will rise.B. Price will rise and quantity will fall.C. Price will fall and quantity will fall.D. Price will rise and quantity will rise.



Choice "b" is correct. Crude oil is an input to the production of gasoline. When the price of an input increases, supply shifts left, causing equilibrium price to rise andequilibrium quantity to fall.

Choice "a" is incorrect, since price will rise and quantity will fall.Choice "c" is incorrect, since price will rise.Choice "d" is incorrect, since quantity will fall.

QUESTION 203When the supply of and demand for a good both increase:

A. Equilibrium price will increase.B. Equilibrium price will decrease.C. Equilibrium price may increase, decrease, or remain unchanged.D. Equilibrium quantity may increase, decrease, or remain unchanged.



Choice "c" is correct. When the supply of and demand for a good both increase, equilibrium quantity increases. However, the impact on price is indeterminate. Ifdemand and supply increase by the same amount, price will remain unchanged (as illustrated above). However, if demand increases by more than supply, price willincrease. Conversely, if supply increases by more than demand, price will decrease.Choices "a" and "b" are incorrect, since the impact on price is indeterminate. Choice "d" is incorrect, since equilibrium quantity will increase.

QUESTION 204A basic determinant of the elasticity of demand for a normal good is the:

A. Length of time producers have to respond to market changes.B. Number of substitutes available for the product.C. Number of sellers of the product.D. Number of complements available for the product.



Choice "b" is correct. The change in demand for a product, based upon a given change in that product's price, is dependent on whether or not other (presumablycheaper) goods can be substituted for the product.Choice "a" is incorrect. The elasticity of supply (not demand) would take into account the response time producers might have to market changes.

Choice "c" is incorrect. The number of sellers is irrelevant when calculating the elasticity of demand. Choice "d" is incorrect. A complement good's demand is thesame as the primary gooD. For example, an increase in the demand for a given food would cause the demand for its complement to also increase.The increased demand of the complement is irrelevant when calculating the elasticity of demand.

QUESTION 205If the elasticity of demand for a normal good is estimated to be 1.5, then a 10% reduction in its price would cause:

A. Total revenue to fall by 10%.B. Total revenue to fall by 15%.C. Quantity demanded to rise by 15%.D. Demand to decrease by 10%.



Choice "c" is correct. The elasticity of demand is calculated as:

% Change in demand% Change in price

If the elasticity of demand is 1.5 (assumed to be the absolute value, as the elasticity of demand for a normal good is always negative), then a 10% price reductionwould cause an increase in the quantity demanded by 15% (a ratio of 15 to 10 or 1.5).Choices "a", "b", and "d" are incorrect, per Explanation: above.

QUESTION 206If the demand for a normal good is inelastic, then the sales price of the product would increase following a(n):

A. Decrease in the price of a substitute good.B. Increase in the supply of the product.C. Decrease in the supply of the product.D. Increase in the number of suppliers of the product.



Choice "c" is correct. If demand is perfectly inelastic (or not price sensitive), there will be no change in quantity demanded for a change in price. This means thatconsumers of the product will demand a constant quantity, regardless of the price. If the quantity supplied is reduced (presumably below an equilibrium point wheresupply equals demand), there will be excess demand for the product and sales price will go up. The increase in sales price will have no impact on demand(because demand is assumed to be perfectly price inelastic).Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 207The Waymand family typically ate hamburger as a regular staple in their diet. In the last few years, the family income has doubled, and they have now replacedhamburger with steak as a regular staple in their diet. This is an example where the demand for hamburger:

A. Is relatively elastic.B. Is perfectly elastic.C. Responds as an inferior good.D. Is perfectly inelastic.



Choice "c" is correct. An inferior good is one for which the demand declines as income increases. A normal good would experience an increase in demand inresponse to an increase in income. Because the demand for hamburger went down as income increased, it is an inferior good. Choices "a", "b", and "d" areincorrect. The elasticity of demand for a good is calculated by measuring the change in quantity demanded over the change in price (not income). The questiondoes not have sufficient information to calculate the elasticity of the demand for hamburger.

QUESTION 208A perfectly inelastic supply curve in a competitive market:

A. Means the equilibrium price must be zero.B. Implies a vertical demand curve.C. Exists when firms cannot vary input usage.D. Says the market supply curve is horizontal.

Correct Answer: CSection: Business Environment and Concepts (Volume C)

Explanation


Choice "c" is correct. Price elasticity of supply is calculated the same way as demand except that quantity supplied is measured:

Perfectly inelastic supply curves are also vertical representing that supply is insensitive to changes in price; i.e., the quantity supplied will not change as pricechanges. Perfectly inelastic supply curves would exist if firms cannot vary input usage. Regardless of price, the firm has to use all inputs if it produces at all.Choices "a", "b", and "d" are incorrect, as they are far-out distractors.

QUESTION 209In the pharmaceutical industry where a diabetic must have insulin no matter what the cost and where there is no substitute, the diabetic's demand curve is bestdescribed as:

A. Perfectly elastic.B. Perfectly inelastic.C. Elastic.D. Indifferent.



Choice "b" is correct. When a good is demanded, no matter what the price, demand is described as perfectly inelastic. The demand "curve" is a vertical line at thequantity demanded with price making no difference.Choices "a" and "c" are incorrect. There is no such thing as perfect elasticity. However, the more elastic demand is, the greater the change in quantity demandedfor price changes. Choice "d" is incorrect. Diabetics are indifferent to changes in the price of insulin, and to economists, this is perfectly inelastic demand.

QUESTION 210Demand for a product tends to be price inelastic if:

A. The product is considered a luxury item.

B. Few good complements for the product are available.C. People spend a large share of their income on the product.D. Few good substitutes are available for the product.



Choice "d" is correct. Demand for a product tends to be price inelastic if few good substitutes are available for the product. Even if price increases, consumers arethen unable to switch to substitute goods, because there aren't any.Choice "a" is incorrect. Luxury items may have good substitutes available. Choice "b" is incorrect. Complementary goods are those whose demand fluctuates inunison; substitute goods are more relevant here.Choice "c" is incorrect. If consumers spend a large share of their income on the product, they will be very sensitive to any price changes and hence product demandwould be more "elastic."

QUESTION 211Long Lake Golf Course has raised green fees to a nine-hole game due to an increase in demand.

Which of the following is correct?

A. The regular weekday and weekend demand is inelastic.B. The regular weekday and weekend demand is elastic.C. The senior citizen and weekend demand is inelastic.D. The senior citizen demand is elastic and weekend demand is inelastic.


Explanation/Reference:Explanation:Choice "d" is correct. Demand is elastic if a decline in price (P) results in an increase in total revenue (TR); or if an increase in P results in a decline in TR. On theother hand, if demand is inelastic, a decline in P will result in a decline in TR or an increase in P will result in an increase in TR. First, the total revenues at both thenew and the previous rate must be computed. The (new or previous) rate* average games played (AGP) = the total revenue. As a result, TR at the previous rate(PR) is 800 for regular weekday (RW), 900 for senior citizen (SC), and 3315 for the weekend (WE). TR at the new rate (NR) is 770 for RW, 656 for SC, and 4460for WE.So, demand for RW and SC is elastic because the increase in P results in a decline in total revenue. The demand for WE is inelastic because the increase in Presults in an increase in TR.As a result, choices "a", "b", and "c" are incorrect.Note: if TR remains constant after a change in P, the demand is unit elastic.

QUESTION 212In the long run in a competitive market, a maximum or ceiling price set below the equilibrium price will:

A. Cause a surplus to be produced.B. Have no effect on the market.C. Cause a shortage to be created.D. Result in a decrease in price.



Choice "c" is correct. Setting a ceiling price below the price dictated by market forces (which is the equilibrium price set by the supply and demand curves) wouldcreate excess demand for the product (at its reduced price) and, consequently, a shortage.Choice "a" is incorrect. A surplus would be produced if a floor price (under which no supplier could sell) were set above the equilibrium price, because supplierswould supply excess product at the inflated price.Choices "b" and "d" are incorrect, per the above Explanation: .

QUESTION 213If the federal government were to regulate a product or service in a competitive market by setting a maximum price that is below the equilibrium price, then in thelong run this action will:

A. Result in a surplus.B. Result in a shortage.C. Cause a decrease in price.D. Have no effect on the market.



Choice "b" is correct. Setting a maximum or ceiling price, which is below the equilibrium price dictated by a competitive market, would result in a shortage as aresult of excess demand. Choices "a", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 214A government price support program will:

A. Lead to surpluses.B. Lead to shortages.C. Improve the rationing function of prices.D. Not influence the rationing function of prices.



Choice "a" is correct. A government price support program acts as a subsidy that will encourage suppliers to increase supply beyond an equilibrium point (the pointwhere supply and demand curves intersect). This excess of supply over demand will create surpluses in the market. Choices "b", "c", and "d" are incorrect, per theabove Explanation: .

QUESTION 215Strategic planning activities normally involve which of the following efforts:

A. Strategic Positioning.II. Value Chain Analysis.

III. Balance Scorecard Development.B. I.C. I and II.D. I and III.E. I, II, and III.



Choice "d" is correct. Strategic planning activities are normally acknowledged to include each of three operations including:

I. Strategic positioning. Strategic positioning includes the process of identifying mission, identifying overall strategy, identifying factors critical to succeeding giventhe assumed strategy and identifying internal and external factors that contribute or detract from achieving the strategy. II. Value chain analysis. Value chainanalysis includes the process of identifying the functional characteristics of an organization and the manner in which each one of those functions adds value to thefirm's customers.III. Balanced scorecard development. Development of a balanced scorecard identifies measurements of value that are both financial and non-financial to be used tomonitor and evaluate performance.

Choice "a" is incorrect. All three activities are integral to strategic planning. Choice "b" is incorrect. All three activities are integral to strategic planning. Choice "c" isincorrect. All three activities are integral to strategic planning.

QUESTION 216Economic theory identifies two basic types of goods: inferior goods and superior goods. As consumer income rises, a lower percentage of earnings are expendedon inferior goods while a higher percentage of earnings are spent on superior goods. Overall strategies for achieving organizational missions would most likelymatch with types of goods as follows:

A. Cost leadership strategies for superior goods, differentiation strategies for inferior goods.B. Cost leadership strategies for inferior goods, differentiation strategies for superior goods.C. Cost leadership strategies would most likely be used for both inferior and superior goods.D. Differentiation strategies would most likely be used for both inferior and superior goods.



Explanation:

Rule: Overall strategies are divided into two different types that are defined as follows:Cost leadership: Organization seeks to capture market share through maintaining the lowest cost. Differentiation: Organization seeks to capture market share bydemonstrating product value. Choice "b" is correct. Organizations that sell economically inferior goods (necessities such as cotton swabs, light bulbs, etc.) are morelikely to posture themselves as cost leaders than organizations that sell economically superior goods (luxuries such as cruise packages, fine china, jewelry, etc.)who will likely seek to differentiate the value of their product as part of their strategy. Choice "a" is incorrect. Economically inferior products would likely beassociated with cost leadership, not differentiation while economically superior products would likely be associated with differentiation.Choice "c" is incorrect. Economically inferior products would likely be associated with cost leadership, not differentiation while economically superior products wouldlikely be associated with differentiation.Choice "d" is incorrect. Economically inferior products would likely be associated with cost leadership, not differentiation while economically superior products wouldlikely be associated with differentiation.

QUESTION 217Having identified their mission, overall strategy, and critical success factors, organizations often review the internal and external factors that will contribute to theirsuccess. This analysis is often referred toas:

A. TOC evaluation.B. Brainstorming.C. Balanced scorecard review.D. SWOT analysis.



Choice "d" is correct. Evaluation of internal and external factors contributing to an organization's success is referred to as Strengths, Weaknesses, Opportunitiesand Threats (SWOT) analysis. Strengths and weaknesses focus on internal factors while opportunities and threats relate to external factors. Choice "a" is incorrect.The acronym TOC stands for Theory of Constraints, which is an evaluation technique for optimizing throughput time, it does not relate to overall strategy evaluation.Choice "b" is incorrect. Brainstorming is a meeting technique used to generate ideas. Although brainstorming could be used as part of an organization's approach toSWOT analysis, it is not, itself, the evaluation of internal and external factors.Choice "c" is incorrect. A review of the balanced scorecard, which summarizes measures of achievement of critical success factors, does not represent theobjective review of internal and external factors that may impact achievement of strategy.

QUESTION 218Under which of the following conditions is the supplier most able to influence or control buyers?

A. When the supplier's products are not differentiated.B. When the supplier does not face the threat of substitute products.C. When the industry is controlled by a large number of companies.D. When the purchasing industry is an important customer to the supplying industry.



Choice "b" is correct. When there are few good substitutes for a supplier's product, the supplier has market power (think of a monopoly). As a result, the supplier isbetter able to control buyers and act as a price setter rather than a price taker.Choice "a" is incorrect. When supplier's products are not differentiated, buyers will be indifferent about which supplier they purchase from. In other words, if firmssell identical products (think of perfect competition) the product of one firm is a perfect substitute for the product of another firm. In this case, firms are price takers,not price setters.Choice "c" is incorrect. When there are a large number of firms, no one firm has much market power. This is the case of either perfect competition (if all firms sellidentical products) or monopolistic competition (if all firms sell slightly differentiated products). Choice "d" is incorrect. If the purchasing industry is an importantcustomer of the supplier, the purchasing industry (i.e. the buyer) will have some market power. This will diminish the ability of the supplier to influence or control thebuyer.

QUESTION 219Which of the following inputs would be most beneficial to consider when management is developing the capital budget?

A. Supply/demand for the company's products.B. Current product sales prices and costs.C. Wage trends.D. Profit center equipment requests.



Choice "d" is correct. In developing its capital budget, management would find the employee input associated with equipment requests from various profit centersmost helpful. Departmental requests, appropriately justified, would provide key insights into the capital requirements of the business that are not otherwise known.Choice "a" is incorrect. Supply and demand for company products is a crucial strategic input in forecasting the future capital requirements. Current year capital

budgeting would not benefit as directly from this information, however, as profit center equipment requests. Choice "b" is incorrect. Current product sales prices andcosts represent operating data most relevant to operating rather than capital budgeting.Choice "c" is incorrect. Wage trends represent operating data most relevant to operating than capital budgeting.

Comments:Some people have questioned why the answer is not choice "a." However, the answer to the question is very clear.The question really is what are the best (most beneficial to consider) inputs to a capital budget. The "supply and demand for the company's products" is veryindirect. The demand for the company's products may or may not result in the company spending any capital money because the demand may be able to besatisfied with the current capital equipment. But, equipment requests, if approved, will most likely result in spending money (assuming that the money in the budgetis actually spent) and thus should go into the capital budget. The supply and demand might affect future capital budgets if the demand is not able to be satisfied withthe current capital equipment. But the question asks for the best inputs for presumably the current capital budget.

QUESTION 220A city ordinance that freezes rent prices may cause:

A. The demand curve for rental space to fall.B. The supply curve for rental space to rise.C. The quantity demanded of rental space exceeds the quantity supplied.D. The quantity supplied of rental space exceeds the quantity demanded.



Choice "c" is correct. A city ordinance that freezes rent prices (such as rent control and rent stabilization in New York City) may cause the quantity demanded forrental space to exceed the quantity supplied.This occurs if the rent controlled price is set below the market clearing price. At the controlled price, the quantity supplied will be constrained due to the low rentprices for the rent-controlled and rent- stabilized properties; builders will not want to build and rent properties for less than they are worth on the open market. Thequantity demanded for the rental space will still be artificially high due to the city ordinance, which sets the controlled price below the market price. Thus, the quantitydemanded will exceed the quantity supplied. New York City rent control is a perfect example of the effect of a price ceiling and the problems that it can cause.Choice "a" is incorrect. A city ordinance that freezes rent prices will not cause the demand curve for rental space to fall. Price changes cause movements along thedemand curve, not shifts in the demand curve.Choice "b" is incorrect. A city ordinance that freezes rent prices will not cause the supply curve for rental space to rise. Price changes cause movements along thesupply curve, not shifts in the supply curve.Choice "d" is incorrect. A city ordinance that freezes rent prices will not cause the quantity supplied to exceed the quantity demanded. This choice is backwards.

QUESTION 221What is strategic planning?

A. It establishes the general direction of the organization.B. It establishes the resources that the plan will require.C. It establishes the budget for the organization.D. It consists of decisions to use parts of the organization's resources in specified ways.



Choice "a" is correct. Strategic planning is the creation of an overall strategic plan for an organization to achieve its overall "business objectives." The strategic planwill establish the general direction of the organization.Choice "b" is incorrect. Strategic planning will not establish the resources that the plan will require. The resources that the plan will require are part of theimplementation of the strategic plan, not part of the plan itself.Choice "c" is incorrect. Strategic planning will not establish the budget for the organization. Budgets are even further down implementing the plan than are theresources that the plan will require. Choice "d" is incorrect. Strategic planning does not consist of decisions to use parts of the organization's resources in specifiedways. Again, these decisions are part of the implementation of the strategic plan, not part of the plan itself.

Implications of Dealing in Foreign Currencies

QUESTION 222Which of the following is not correct about the purchasing power parity theory of explaining changes in exchange rates?

A. Purchasing power of a common currency in different economies for similar products will remain the same.B. Inflationary forces on foreign and domestic currencies will cause the exchange rates to automatically adjust to ensure that a common currency will have identical

or similar purchasing power in each economy for similar goods.C. Interest rates include a premium or discount that ensures purchasing power parity.D. The purchasing power parity theory is presented in both absolute and relative form.



Choice "c" is correct. The purchasing power parity theory holds that inflation will cause exchange rates to automatically adjust to ensure that an equal amount of a

common currency will purchase similar goods in separate economies. The International Fischer effect considers the premium or discount on interest rates as anindicator of inflation.Choice "a" is incorrect. The basic idea underlying the purchasing power parity theory is that the purchasing power of a common currency in different economies forsimilar products will remain the same and that inflation in any particular economy will cause exchange rates to adjust until parity is consistently achieved.Choice "b" is incorrect. The purchasing power parity theory holds that inflationary forces on foreign and domestic currencies will cause the exchange rates toautomatically adjust to ensure that a common currency will have identical or similar purchasing power in each economy for similar goods. Choice "d" is incorrect.The purchasing power parity theory is presented as both an absolute theory of parity determination regardless of market imperfections and as a relative conceptthat considers market imperfections.

QUESTION 223Which of the following methods of measuring transaction exposure to exchange rate risk uses standard deviation, coefficient of correlation and other formalstatistical techniques?

A. Measurement of currency variability.II. Measurement of currency correlations.

B. I only.C. II only.D. Both I and II.E. Neither I and II.



Choice "c" is correct. The currency variability approach uses standard deviations as a means of predicting future exchange rates while the currency correlationapproach is often applied to circumstances involving multiple currencies and evaluates exposure in relation to the statistically computed degree of correlationbetween the movements of different currencies. Choices "a", "b", and "d" are incorrect, per above Explanation: .

QUESTION 224Which of the following methods is designed to measure transaction exposure in terms of the maximum one day loss related to holdings denominated in foreigncurrency?

A. Measurement of currency variability.II. Measurement of currency correlations.III. Value at risk.

B. I only.C. II only.

D. III only.E. I, II, and III.



Choice "c" is correct. The value at risk method seeks to quantify the exposure of business to a one day loss in the value of its positions in foreign currencies.Choices "a", "b", and "d" are incorrect, per above Explanation: .

QUESTION 225Atlas Worldwide Industries conducts business in a number of different countries and is trying to evaluate its economic exposure to exchange rate risk. Which of thefollowing statements is not correct?

A. Atlas will suffer an economic loss in the event it has net cash outflows of a foreign currency and the foreign currency appreciates.B. Atlas will enjoy an economic gain in the event it has net cash outflows of a foreign currency and the foreign currency depreciates.C. Atlas will suffer an economic loss in the event it has net cash inflows of a foreign currency and the foreign currency appreciates.D. Atlas will suffer an economic loss in the event it has net cash inflows of a foreign currency and the foreign currency depreciates.



Choice "c" is correct. Atlas will benefit from an economic gain in the event that it has net cash inflows of a foreign currency and the foreign currency appreciates (thedomestic currency depreciates). Atlas will collect a more valuable currency that can buy more of its domestic currency. Choices "a", "b", and "d" are incorrectbecause they are correct statements.

QUESTION 226

Universal Industries limits its operations to exports to foreign countries. What can be said about Universal's exposures to exchange rate risk?

A. Universal is subject to potential transaction, economic and translation exposures to exchange rate risk.B. Universal is subject to potential transaction and economic exposures to exchange rate risk.C. Universal is subject to economic and translation exposures to exchange rate risk.D. Universal is subject transaction and translation exposures to exchange rate risk.



Choice "b" is correct. Universal is subject to transaction risks associated with settlement of export transactions and is subject to economic risks associated with thesatisfaction of domestic expenses denominated in domestic currencies with imported revenues denominated in a foreign currency. No translation exposure existssince there is no foreign investment or subsidiary. Choices "a", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 227Hedgehog International owes 500,000 local currency units to its foreign supplier in 90 days. The current spot rate of the local currency unit is $.60. Hedgehogpurchases a call option to buy the local currency unit in 90 days for $.61 for a premium of $.005. The exchange rate for the local currency increases to $.63 in 90days. What will Hedgehog do on the payables' settlement date?

A. Hedgehog will exercise its option and settle the payables with proceeds from the option contract at a gain.B. Hedgehog will not exercise the option and settle the payables after purchase of the local currency unit at the spot rate.C. Hedgehog will be indifferent as to whether it exercises the option or not.D. Hedgehog will sell the option at the settlement date and use its proceeds along with local currency units purchased at the spot rate to satisfy the amount

payable.



Choice "a" is correct. Hedgehog will exercise its option and liquidate the payables associated with the proceeds. The exercise of the option represents a less costlyalternative than acquisition of proceeds at the spot rate at the time the payables are due. The net impact of exercise of the option is computed as follows:

The premium is a sunk cost and is irrelevant to the decision. Note that the premium is a factor in determining the net gain (loss) but not in deciding whether toexercise the option. Choices "b", "c", and "d" are incorrect, per computation above.

QUESTION 228Hedgehog International has a receivable valued at 500,000 local currency units from its foreign customer due in 90 days. The current spot rate of the local currencyunit is $.60. Hedgehog purchases a put option to sell the local currency unit in 90 days for $.61 for a premium of $.005. The exchange rate for the local currencyincreases to $.63 in 90 days. What will Hedgehog do on the receivable's settlement date?

A. Hedgehog will exercise its option and sell the proceeds of its accounts receivable collection under the provisions of the option contract at a gain.B. Hedgehog will not exercise the option and sell local currency units collected from its receivable at the spot rate.C. Hedgehog will be indifferent as to whether it exercises the option or not.D. Hedgehog will sell the option at the settlement date and combine its proceeds along with local currency units purchased at the spot rate to maximize its revenue.



Choice "b" is correct. Hedgehog will not exercise its option and will, instead convert the local currency units collected from the receivables to its domestic currencyby selling that currency at the spot rate at the time of collection. The exercise of the option represents a less profitable alternative than sale of the accountsreceivable proceeds at the spot rate at the time the receivables are collected. The exercise of the option in comparison to allowing the option to expire is computedas follows:

The premium is a sunk cost and is irrelevant to the Explanation: . Note that the premium is a factor in determining the net gain (loss) but not in deciding whether toexercise option. Choices "a", "c", and "d" are incorrect, per computation above.

QUESTION 229Hedgehog International has numerous foreign exchange transactions. Management has elected to hedge transactions as a means of mitigating transactionexposure to exchange rate risk. What is the most effective means that Hedgehog International can use to avoid overhedging?

A. Hedgehog should acquire parallel loans to provide a means for liquidating unneeded hedge securities.B. Hedgehog should acquire the maximum amount required to hedge known and projected transactions.C. Hedgehog should acquire the minimum amount required to hedge known transactions.D. Hedgehog should enter into a cross hedging agreement.



Choice "c" is correct. Hedgehog should only acquire the minimum amount of hedge contracts needed to offset the effect of known transactions.Choice "a" is incorrect. Parallel loans represent a swap contract for hedging long-term transaction exposure and are not specifically designed to mitigate the risk ofoverhedging. Choice "b" is incorrect. Acquisition of the maximum number of hedge contracts for known and projected transactions exposes the organization togreater risk of overhedging since projected transactions might not materialize.Choice "d" is incorrect. Cross hedging involves techniques related to currencies that do have hedge instruments available to mitigate risk and are not specificallydesigned to avoid overhedging.

QUESTION 230An American importer expects to pay a British supplier 500,000 British pounds in three months. Which of the following hedges is best for the importer to fix the pricein dollars?

A. Buying British pound call options.B. Buying British pound put options.C. Selling British pound put options.D. Selling British pound call options.



Explanation:

Choice "a" is correct. To fix a price in dollars to buy British pounds, British pound call options should be purchased. Call options would allow, but not require, thepurchaser of the call to acquire the currency (British pounds) for a specified price at or before a specified time in the future. If the price goes down, the purchaser(the importer) would exercise the options; if not, the purchaser (importer) would buy the British pounds in the market and let the options expire. British pound futurescould also be used, but that was not one of the choices listed.Choice "b" is incorrect. Buying British pound put options would allow, but not require, the purchaser of the put to sell the currency for a specified price at a specifiedtime in the future. Since the importer needs British pounds, buying put options would not work. The importer needs to end up with British pounds.Choice "c" is incorrect. Selling British pound put options would not work. The importer needs to end up with British pounds. Selling put options could work, but theoption would be exercised, or not, by the purchaser and not by the importer. If the options were not exercised, the importer could end up with nothing (other than theoption premium).Choice "d" is incorrect. Selling British pound call options would not work. The importer needs to end up with British pounds; if call options are sold, the other partycan exercise the options or let them expire, and if the options were exercised, the importer would have to supply the British pounds. This answer is backwards.

QUESTION 231What is the effect when a foreign competitor's currency becomes weaker compared to the U.S. dollar?

A. The foreign company will have an advantage in the U.S. market.B. The foreign company will be disadvantaged in the U.S. market.C. The fluctuation in the foreign currency's exchange rate has no effect on the U.S. company's sales or cost of goods sold.D. It is better for the U.S. company when the value of the U.S. dollar strengthens.



Choice "a" is correct. As a foreign competitor's currency becomes weaker compared to the U.S. dollar, the product becomes less expensive in U.S. dollars. Theless expensive product will have the advantage in the U.S. market.Choice "b" is incorrect. As a foreign competitor's currency becomes weaker compared to the U.S. dollar, the product becomes less expensive in U.S. dollars. Theless expensive product will have the advantage in the U.S. market, not a disadvantage.Choice "c" is incorrect. Foreign currency exchange rates impact both sales and possibly cost of goods sold of a competing domestic company. Sales within U.S.markets will deteriorate as the currency of foreign competitors deteriorates and makes the domestic company's goods more expensive. As a foreign competitor'scurrency appreciates, sales within U.S. markets by a domestic company should also increase as goods manufactured in the U.S. become less expensive. Cost ofgoods sold may fluctuate if foreign suppliers are used.Choice "d" is incorrect. It is better for a U.S. company when the value of the U.S. dollar weakens, not strengthens. A weak U.S. dollar makes domestic goodsrelatively less expensive that imported goods.


QUESTION 232Compared to firms in a perfectly competitive market, a monopolist tends to:

A. Produce substantially less but charge a higher price.B. Produce substantially more and charge a higher price.C. Produce the same output and charge a higher price.D. Produce substantially less and charge a lower price.



Choice "a" is correct. Compared to firms in a perfectly competitive market, a monopolist tends to produce substantially less but charge a higher price.Choices "b", "c", and "d" are incorrect, per above Explanation: .

QUESTION 233Patents are granted in order to encourage firms to invest in the research and development of new products. Patents are an example of:

A. Market concentration.B. Entry barriers.C. Exclusionary practices.D. Collusion.



Choice "b" is correct. Patents are an example of entry barriers. Patents prevent other rival firms (without patents) from entering the market and consequently, are aform of entry barriers. Patents can be "process-related" or "product-related."Choices "a", "c", and "d" are incorrect, per above Explanation: .

QUESTION 234An oligopolist faces a "kinked" demand curve. This terminology indicates that:

A. When an oligopolist lowers its price, the other firms in the oligopoly will match the price reduction, but if the oligopolist raises its price, the other firms will ignorethe price change.

B. An oligopolist faces a non-linear demand for its product, and price changes will have little effect on demand for that product.C. An oligopolist can sell its product at any price, but after the "saturation point," another oligopolist will lower its price and, therefore, shift the demand curve to the

left.D. An oligopolist is similar to a monopolist, and as the quantity demanded for its product increases, the demand curve for that firm shifts to the right.



Choice "a" is correct. In an oligopoly, each firm faces a "kinked" demand curve. Others will match price cuts, but ignore price increases. The "kink" is at theprevailing price. Best real world examples of oligopoly are the airline and auto industries.Choice "b" is incorrect. An oligopolist's demand curve is linear but "kinked." Above the "kink," demand is highly elastic. Below, very inelastic.Choice "c" is incorrect. An oligopolist cannot sell at any price. There is no "saturation point." Choice "d" is incorrect. A change in quantity demanded indicates amovement along the demand curve, not a shift in the curve.

QUESTION 235An increase in the minimum wage:

A. Will move employers down the labor demand curve, causing the quantity of labor demanded to fall.II. Is likely to increase the supply of labor, as more people will be willing to work for the higher wage.

B. Only I.C. Only II.D. Both I and II.E. Neither I nor II.



Choice "d" is correct; neither statement I nor statement II are correct. Statement I is incorrect, as an increase in the minimum wage will move employers up, not

down, the labor demand curve, causing the quantity of labor demanded to fall. Statement II is incorrect, as an increase in the minimum wage leads to a decrease inthe quantity demanded of labor and an increase in the quantity supplied of labor. It does not increase the supply of labor, only the quantity supplied of labor.Choices "a", "b", and "c" are incorrect, per the above.

QUESTION 236In a competitive market an increase in the minimum wage will likely have the following effects:

A. The general (or aggregate) demand for labor will increase; however, the quantity demanded will remain unchanged.B. The general (or aggregate) supply of labor will increase; however, the quantity supplied will remain unchanged.C. The general (or aggregate) demand for labor will remain unchanged; however, the quantity demanded will decrease.D. The general (or aggregate) supply of labor will remain unchanged; however, the quantity supplied will decrease.



Choice "c" is correct. The general (or aggregate) demand for labor will remain unchanged; however, the quantity demanded will decrease.Choice "a" is incorrect, per Explanation: for choice "c" above. Choices "b" and "d" are incorrect. The general (or aggregate) supply of labor will remain unchanged;however, the quantity supplied will increase.

QUESTION 237An increase in the minimum wage will benefit specific economic wage groups as outlined below:

A. Employees at the minimum wage rate who remain employed will benefit, since they will receive more money.II. Many of the unskilled could lose their jobs. There would be fewer jobs for the currently unemployed such as less educated and untrained personnel (e.g.,teenagers) who will have more difficulty finding work as firms reduce their labor force and pursue more efficiency.

B. Only I.C. Only II.D. Both I and II.E. Neither I nor II.



Explanation:

Choice "a" is correct. Only I.Choices "b", "c", and "d" are incorrect, since II is a disadvantage - not a benefit.

QUESTION 238The movement along the demand curve from one price-quantity combination to another is called a(n):

A. Change in demand.B. Shift in the demand curve.C. Change in the quantity demanded.D. Increase in demand.


Explanation/Reference:Explanation:Choice "c" is correct. References to the change in quantity demanded refer to a single demand curve, which is downward sloping to the right.

Changes in the quantity demanded result from changes in price. Choices "a", "b", and "d" are incorrect. All refer to changes in the demand curve itself, like anoutward shift from curve D - D to D1 - D1.

QUESTION 239Which one of the following would cause the demand curve for a commodity to shift to the left?

A. A rise in the price of a substitute product.B. A rise in average household income.C. A rise in the price of a complementary commodity.D. A rise in the population.



Choice "c" is correct. A rise in the price of a complementary commodity would cause a shift to the left in any demand curve (representing decrease in demand, at allprice levels, for that product). With respect to complementary goods, the demand for the primary product is directly impacted by the demand (and hence the pricechanges) for the complementary goods. For instance, if the price of gasoline goes up, the demand for cars will decrease, causing the demand curve for cars to shiftleft. Choice "a" is incorrect. A rise in the price of a substitute product will make the demand curve shift to the right.Choice "b" is incorrect. A rise in average household income would make the demand curve shift to the right, representing an increase in demand.Choice "d" is incorrect. A rise in population, or a change in consumers' tastes in favor of the commodity are also changes that may cause an increase in demand,making the demand curve shift to the right.

QUESTION 240In any competitive market, an equal increase in both demand and supply can be expected to always:

A. Increase both price and market-clearing quantity.B. Increase market-clearing quantity.C. Increase price.D. Decrease price.



Choice "b" is correct. As illustrated above, a shift outward (increase) in supply increases quantity supplied at equilibrium. As illustrated, this is true even whendemand increases. Choice "a" is incorrect. As illustrated, price may stay the same but quantity will increase. Draw the graph!Choices "c" and "d" are incorrect. Price may remain the same, but quantity will "always" increase.

QUESTION 241When the federal government imposes health and safety regulations on certain products, one of the most likely results is:

A. Greater consumption of the product.B. Lower prices for the product.C. Higher prices for the product.D. Increased supply of the product.



Choice "c" is correct. One of the consequences of greater government regulation of certain products is the resulting higher cost to the consumer when thegovernment imposes health and safety regulations on certain products it is likely that expenses will increase and that the added costs will be passed on toconsumers in terms of higher prices. The total output for the product may decrease. Choice "a" is incorrect. Since the price goes up, consumption will decrease.Choice "b" is incorrect. The price can be expected to increase (see choice "c" Explanation: above). Choice "d" is incorrect. Since the price goes up, supply goesdown.

QUESTION 242Tennis rackets and tennis balls are:

A. Substitute goods.B. Independent goods.

C. Inferior goods.D. Complementary goods.



Choice "d" is correct. Complementary goods are ones whose demand fluctuates together. If Good A and Good B are complements, then if the demand for Good Aincreases, the demand for Good B will also increase, tennis rackets and tennis balls are complements. Choice "a" is incorrect. For substitutive goods, as the priceof one of the goods increases, the other good experiences an increase in demand as it is substituted for the first good. An example of substitute goods is apple andorange juice.Choice "b" is incorrect. Independent goods have demand functions that are not interrelated. An example would be bread and vacuum cleaners.Choice "c" is incorrect. Inferior goods experience a decrease in demand when income levels rise. An example is hamburger, which experiences decrease indemand as incomes rise and buyers switch to higher priced meats.

QUESTION 243All of the following are complementary goods, except:

A. Margarine and butter.B. Gas and motor oil.C. Cameras and rolls of film.D. VCRs and video cassettes.



Choice "a" is correct. Margarine and butter are substitute goods. If the price of one goes up, demand for the substitute increases.Choices "b", "c", and "d" are incorrect. They are complements. Two goods are complements if they are used together or their demand curves move together(breakfast cereal and milk, e.g., or tennis balls and tennis racquets). Thus, if the price of one complement goes up, demand for the other good goes down.

QUESTION 244Utility companies can generally price their product, a good that establishes a comfortable life-style (i.e., electricity, gas for home heating) based on the fact that thedemand:

A. Is relatively elastic.B. Is perfectly elastic.C. Is relatively inelastic.D. Is perfectly inelastic.



Choice "c" is correct. Goods that are important for a comfortable life-style would be relatively price insensitive (i.e., inelastic). For example, demand for electricitywould only decrease if there were an enormous increase in price (people might then use other forms of energy - such as solar). Only goods that are absolutenecessities (a theoretical example is water) have perfectly inelastic demand curves. That is, no matter what price is charged, people will still buy the productbecause they need it to stay alive.Choices "a", "b", and "d" are incorrect, per Explanation: for choice "c" above.

QUESTION 245Product demands become more elastic the:

A. Greater the number of substitute products available.B. Greater the consumer income.C. Greater the elasticity of supply.D. Shorter the time period considered.



Choice "a" is correct. Product demands become more elastic the greater the number of substitutes available. With price increases, consumers will switch tosubstitute goods. Choice "b" is incorrect. Consumer income will not affect demand elasticity. Choice "c" is incorrect. Elasticity of supply and demand is unrelated.Choice "d" is incorrect. Product demand is more elastic the longer the time period, since more choices become available.

QUESTION 246If a product's demand is elastic and there is a decrease in price, the effect will be:

A. A decrease in total revenue.B. No change in total revenue.C. A decrease in total revenue and the demand curve shifts to the left.D. An increase in total revenue.



Choice "d" is correct. If demand is relatively elastic, then the reduction in price will, by definition, produce a proportionately greater increase in quantity demanded.Hence, total revenue will increase. Choices "a", "b", and "c" are incorrect, per Explanation: above.

QUESTION 247If a product has a price elasticity of demand of 2.0, the demand is said to be:

A. Perfectly elastic.B. Perfectly inelastic.C. Relatively elastic.D. Relatively inelastic.



Choice "c" is correct. A price elasticity of demand of 2.0 means demand will change by 2× (as a percentage) for any change in price. This is called elastic. Choice"a" is incorrect. Perfectly elastic demand does not exist. Choice "b" is incorrect. Perfectly inelastic demand means the quantity demanded will not change whenprice changes.Choice "d" is incorrect. Inelastic demand responds less than 1× (as a percentage) for a change in price.

QUESTION 248In the pharmaceutical industry where a diabetic must have insulin no matter what the cost, the diabetic's demand is considered to be:

A. Perfectly elastic.B. Perfectly inelastic.C. Relatively elastic.D. Relatively inelastic.



Choice "b" is correct. When a good is demanded, no matter the price, demand is described as perfectly inelastic. The demand "curve" is a vertical line at thequantity demand with price making no difference. Choices "a" and "c" are incorrect. There is no such thing as perfect elasticity. However, the more elastic demandis, the greater the change in quantity demand for price changes. Choice "d" is incorrect. Insulin is an example of perfectly inelastic.

QUESTION 249If, in a competitive market, a price ceiling is imposed establishing a maximum price below the market equilibrium price, this price ceiling would result in:

A. Shortages because the quantity demanded would exceed the quantity supplied.B. No effect on the quantity supplied or demanded.C. Surpluses because the quantity supplied would exceed the quantity demanded.D. Surpluses because the supply curve would shift to the right.


Explanation/Reference:Explanation:Choice "a" is correct. Setting a ceiling price below the price dictated by the market (as established by the equilibrium price) would create excess demand and ashortage. Choices "b", "c", and "d" are incorrect, per above Explanation: .

QUESTION 250Government price regulations in competitive markets that set maximum or ceiling prices below the equilibrium price will in the short run:

A. Cause demand to increase.B. Cause supply to increase.C. Create shortages of that product.

D. Produce a surplus of the product.



Choice "c" is correct. Government price regulations in competitive markets that set maximum or ceiling prices below the equilibrium price will create shortages ofthat product in the short run because quantity supplied will be less than quantity demanded at that price. Choice "a" is incorrect. Quantity demand will increase atthe lower price. Choice "b" is incorrect. Quantity supplied will decrease at the lower price. Choice "d" is incorrect. A price set below the market's equilibrium pricecauses shortages, not surpluses, per the graph above.

QUESTION 251Which of the following activities is considered a primary activity?

A. Delivery of products.B. Procurement of materials.C. Human resources.D. Accounting.



Choice "a" is correct. Primary activities are those that are involved with the direct manufacture of products, the delivery of products through distribution channels,and the support of the product that exists after the sale is made (e.g., handling the raw materials, the manufacturing process, taking orders for the product,

advertising the product, and servicing the product after it is sold). Choices "b", "c", and "d" are incorrect, as these are all considered support activities. Supportactivities are those activities that are performed by the support staff of an organization (e.g., purchasing of materials and supplies, development of the technologyused, management of employees, accounting, finance, strategic planning, etc.).

QUESTION 252When applying value chain analysis, a firm asks it accounting department to perform an analysis of the sources of profits and costs of activities that exist within thefirm. The firm is performing which form of value chain analysis?

A. Internal differentiation analysis.B. Internal costs analysis.C. Vertical linkage analysis.D. None of the above.



Choice "b" is correct. Internal costs analysis includes analyzing the internal value-creating ability of a firm, so the sources of profit and costs of the internal activitiesof the firm must be analyzed. Choices "a", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 253If a nation has many rival domestic firms which are all competitive in the global marketplace for a product, which of the four major factors that Michael Porter hasindicated impact the global competitive environment would allow this nation to fare better with respect to global competitive advantage?

A. Conditions of the factors of production.B. Conditions of domestic demand.C. Related and supporting industries.D. Firm strategy, structure, and rivalry.



Choice "c" is correct. The factor of related and supporting industries deals with whether there are suppliers of material inputs that exist within a nation or whether

there are rival firms who are competitive in the international environment, both of which would increase the nation's competitive advantage.Choice "a" is incorrect. If a nation has a strong set of factors of production (such as low-cost, high quality raw material inputs), that are required in a given industry, itwill fare better with regard to competitive advantage. However, this factor is different from the "many rival domestic firms which are all competitive in the globalmarketplace for a product" as stated in the question. Choice "b" is incorrect. The factor of conditions of domestic demand related to the nation's domestic demandfor the product, which is directly related to the ability of the nation to fare better with regard to competitive advantage. However, this factor is different from the"many rival domestic firms which are all competitive in the global marketplace for a product" as stated in the question. Choice "d" is incorrect. The factor of firmstrategy, structure, and rivalry relates to the practices of a nation with respect to how the companies are managed and organized, along with the laws of the nationthat regulate the formation of the companies, and how intense the rivalry is with respect to competing firms in the nation. However, this factor is different from the"many rival domestic firms which are all competitive in the global marketplace for a product" as stated in the question.

QUESTION 254Which of the following is not an external factor that directly affects the competitive environment of the firm?

A. Barriers to market entry.B. Bargaining power of suppliers.C. Political issues.D. Existence of substitute products.



Choice "c" is correct. Political issues are external factors that affect the overall industry, not simply the competitive environment of the firm.Choices "a", "b", and "d" are incorrect, as all of these factors directly affect the competitive environment of the firm.

QUESTION 255When does competition not become an even stronger force impacting the profitability of a firm?

A. Various firms use various types of strategic plans.B. Customers do not have strong brand preferences.C. The market is not growing fast.D. The costs of exiting the market are less than the costs of continuing to operate.



Choice "d" is the proper choice, as it is not a factor that would cause market competitiveness to be even stronger.Choices "a", "b", and "c" are incorrect because they are all reasons that competition becomes an even stronger force that impacts the firm's profitability. Followingare situations that would cause competition to be an even stronger force impacting the profitability of a firm:

· The market is not growing fast.· There are several equal-sized firms in the market.· Customers do not have strong brand preferences.· The costs of exiting the market exceed the costs of continuing to operate. · Some firms profit from making certain moves to increase market share. · The variousfirms in the market use different types of strategic plans.

QUESTION 256Which of the following statements regarding the existence of substitute products is true?

A. The impact of substitutes will have more of an effect on the competitive environment of a firm if the substitutes are readily available for customers to obtain.B. When the cost of buyers switching to new products is high, the effect of substitutes on the competitive environment of a firm is high.C. If many close substitutes exist, buyers have little choice of products and may be willing to pay a higher price for the products that are available.D. If substitutes have equal performance and are priced at or below the firm's product, the competitive force of substitutes with respect to the firm is weak.



Choice "a" is correct. The impact of substitutes will have more of an effect on the competitive environment of a firm if the substitutes are readily available toconsumers. Choice "b" is incorrect. When the cost of buyers switching to new products is low (not high), the effect of substitutes on the competitive environment ofa firm is high. Choice "c" is incorrect. If few (not many close) substitutes exist, buyers have little choice of products and may be willing to pay a higher price for theproducts that are available. Choice "d" is incorrect. If substitutes have equal performance and are priced at or below the firm's product, the competitive force ofsubstitutes with respect to the firm is strong (not weak).

QUESTION 257Which of the following is not considered a factor that increases the bargaining power of the customer?

A. Much information is available to the customer to compare and contrast features of all products on the market.B. One group of customers makes up a large volume of the firm's business.C. Strategic alliances have been formed with suppliers and other firms.

D. Several alternate suppliers (sellers) of the product exist.



Choice "c" is correct. When strategic alliances exist between a supplier and other firms that is a situation, which increases the bargaining power of the suppliers.Choices "a", "b", and "d" are incorrect because they all are factors that increase the bargaining power of the customer, which are:

· Customers make up a large volume of a firm's business.· There is much information available to customers.· The buyers have low switching costs.· There are a high number of alternate suppliers (sellers) of the product.

QUESTION 258Which of the following statements regarding competitive advantage is not true?

A. The two major forms of competitive advantage are product differentiation and cost leadership.B. If the manufacturing costs of a firm are less than those of close rivals, then the firm has a competitive market advantage.C. Cost leadership advantage may be the best be obtained by a firm when a firm builds market share or matches the price of its rivals.D. Differentiation advantage may best be obtained by a firm when a firm builds market share or increases its price.



Choice "b" is the proper choice, as it is not a true statement. Simply because the manufacturing costs of a firm are less than those of close rivals, this does notnecessarily mean that the firm has a competitive market advantage. Only if TOTAL costs to a firm are less than those of close rivals will a firm have a competitivemarket advantage.Choices "a", "c", and "d" are incorrect, as they are all true statements.

QUESTION 259In which stage of supply chain management will the firm's management turn its attention to consolidation of the various departments that make up operations inorder to solve the firm's problems, with a focus on customer service?




Choice "a" is correct. In the cross-functional teams stage of supply chain management, the firm's management will turn its attention to consolidation of the variousdepartments that make up operations in order to solve the firm's problems, and the focus will be on customer service. Choice "b" is incorrect. In the integratedenterprise stage of supply chain management, the firm's management will move away from simple consolidation of its operations to an internally-integrated supplychain, which all work together towards the main business issue of the cost of customer service. Choice "c" is incorrect. In the extended supply chain stage of supplychain management, integration moves external to the firm to involve those outside the firm who are able to work as a unified team in an attempt to obtain slow,profitable growth.Choice "d" is incorrect. In the supply chain communities stage of supply chain management, the extended supply chain forms a single competitive entity with asynchronized supply chain and a complex system of networks.

QUESTION 260Strategy is a broad term that usually means the selection of overall objectives. Strategic analysis would generally exclude the:

A. Trends that will affect the entity's markets.B. Target product mix and production schedule to be maintained during the year.C. Forms of organizational structure that would best serve the entity.D. Best ways to invest in research, design, production, distribution, marketing, and administrative activities.



Choice "b" is correct. Target product mix and production scheduling would be operational plans.Strategy is much more general and conceptual.Choices "a", "c", and "d" are incorrect, which are parts of strategy.

QUESTION 261Which one of the following management considerations is usually addressed first in strategic planning?

A. Overall goals of the firm.B. Organizational structure.C. Recent annual budgets.D. Being an industry leader.



Choice "a" is correct. Setting the overall goals of the firm is usually the starting point in strategic planning.Choice "b" is incorrect. The organizational structure will be partially determined by the goals of the firm.Choice "c" is incorrect. Recent annual budgets may be reviewed as an aid in planning, but they are not the first consideration in strategic planning. In fact, they oftenare ignored. Choice "d" is incorrect. Being an industry leader may be or become a goal of the firm, but that would be determined during the strategic planningprocess.

QUESTION 262All of the following are characteristics of the strategic planning process, except the:

A. Emphasis on both the short and long run.B. Review of the attributes and behavior of the organization's competition.C. Analysis and review of departmental budgets.D. Analysis of consumer demand.



Choice "c" is correct. Analysis and review of departmental budgets is not a part of the strategic planning process. Budgets are operational and much more specificthan the things that are part of strategic planning.Choices "a", "b", and "d" are incorrect. All of these are part of the strategic planning process:

A. Emphasis on both the short and long run.B. A review of competition.D. Analysis of consumer demand.

QUESTION 263Strategic planning, as practiced by most modern organizations, includes all of the following, except:

A. Top-level management participation.B. Strategies that will help in achieving long-range goals.C. Analysis of the current month's actual variances from budget.D. Identification of long-term key variables including external influences.



Choice "c" is correct. Analysis of the current month's actual variances from budget is not a part of strategic planning. It is too short-term and looks at the past.Strategic planning has a long-term focus and is forward-looking.Strategic planning includes:A. Top-level management participation.B. Strategies that will help in achieving long-range goals. D. Identification of long-term key variables including external influences.

QUESTION 264The key difference between strategic goals and tactical goals is that tactical goals are:

A. Usually attainable.B. Developed by top management.C. Concerned with issues other than profit.D. Short-term in nature.



Choice "d" is correct. Tactical goals are the means for attaining strategic goals and are short-term in nature. Strategic goals are overall objectives and relativelylong-term. Choice "a" is incorrect. Both strategic and tactical goals are usually attainable. Choice "b" is incorrect. Development of all goals are best accomplishedwith the involvement of employees at all levels.Choice "c" is incorrect. Tactical goals are the means for achieving strategic goals. Both are concerned with profit and other issues.

QUESTION 265Eugene Entrepreneur developed his waste collections and disposal business from one truck 20 years ago to a fleet of 2,000 trucks serving an entire region today.Gene is looking to retire and knows that he cannot find a suitable buyer for the entire business. Gene has developed a series of short range plans with his seniormanagement group that include generous bonuses, funded in part by deferred repair and maintenance expenses and prior earnings, sales of business segmentswhere possible or transfers of assets to the counties and municipalities that had engaged the waste collection and disposal service. Gene has frozen all new capitalinvestment. The mission that Eugene Entrepreneur has mapped out for his company can best be described as:

A. Build.B. Hold.C. Harvest.D. Sunset.



Choice "c" is correct. Eugene Entrepreneur has mapped out a harvest mission for his company. As Gene retires and pulls assets and value from the company, he isclearly taking a short-term view toward reaping immediate benefit.Choice "a" is incorrect. A "build" mission anticipates that the business is positioned to expand markets or market share and is characterized by a long-term view thatpromotes investment. Choice "b" is incorrect. A "hold" mission contemplates that the business is trying to hold on to current market share and is characterized byappropriate investment and competitive positioning. Choice "d" is incorrect. The term "sunset" mission is a distracter.

QUESTION 266Anson Industries, a vertically integrated producer and retailer of high end audio visual equipment has mapped out its overall business process as beginning withproduct development followed by product testing then raw materials purchasing then manufacturing and assembly, and, finally, sales and service. Finance staff atAnson Industries are trying to evaluate the efficiency and the effectiveness of each process and the relationship between each process. This evaluation is oftenreferred to as:

A. Process improvement.B. Continuous quality improvement.C. Value chain analysis.D. Benchmarking.



Choice "c" is correct. The process of developing macro level flow charts of business processes that produce products or services and then identifying the valueadded by each process is referred to as value chain analysis.Choice "a" is incorrect. Process improvement represents the results of total quality management efforts. Choice "b" is incorrect. Continuous quality improvementrepresents an unswerving focus on customer satisfaction and quality, not necessarily the specific steps associated with value chain analysis. Choice "d" is incorrect.Benchmarking relates to determining best practices and, often, using those practices as standards.

QUESTION 267A market with many independent firms, low barriers to entry, and product differentiation is best classified as:

A. A natural monopoly.B. Monopolistic competition.C. An oligopoly.D. Pure competition.



Choice "b" is correct. A market with many independent firms, low barriers to entry, and product differentiation is best classified as monopolistic competition. Thereare few barriers to entry and firms exert some influence over price in such a market. Best examples are brand name consumer products. Choice "a" is incorrect. Anatural monopoly exists when economic and technical conditions permit only one efficient supplier.Choice "c" is incorrect. The presence of only one company indicates a monopoly; the presence of a few companies would indicate an oligopoly.Choice "d" is incorrect. Market conditions characterizing pure competition include homogeneous, not differentiated, products.

Factors Affecting Financial Modeling and Decision Making

QUESTION 268Which tool would most likely be used to determine the best course of action under conditions of uncertainty?

A. Cost-volume-profit analysis.B. Expected value (EV).C. Program evaluation and review technique (PERT).D. Scattergraph method.



Choice "b" is correct. Probability and expected value formulate quantitative models to address the issue of appropriate course of action in an environment ofuncertainty. The expected value is a weighted average of all values and variables. The course of action with the highest expected monetary value should beselected.Choice "a" is incorrect. Cost-volume profit analysis is a method used to evaluate operating decisions. Choice "c" is incorrect. PERT is a technique used in projectmanagement that focuses on the time required to complete each step in a project. It allows a project manager to monitor a project's progress and identify potentialbottlenecks or delays that will postpone the completion date. Choice "d" is incorrect. The scattergraph method is used in statistical analysis toplot relationshipsbetween variables to determine a line function that best describes those relationships.

QUESTION 269In situations when management must decide on accepting or rejecting one-time-only special orders, where there is sufficient idle capacity, which one of thefollowing is not relevant to the decision?

A. Absorption costs.B. Direct costs.C. Variable costs.D. Incremental costs.



Choice "a" is correct. Absorption costs are not relevant in situations when management must decide on accepting or rejecting one-time-only special orders, andwhere there is sufficient idle capacity. All of the following costs are relevant in such situations:

B. Direct costs

C. Variable costsD. Incremental costs

QUESTION 270Dough Distributors has decided to increase its daily muffin purchases by 100 boxes. A box of muffins costs $2 and sells for $3 through regular stores. Any boxesnot sold through regular stores are sold through Dough's thrift store for $1. Dough assigns the following probabilities to selling additional boxes:

What is the expected value of Dough's decision to buy 100 additional boxes of muffins?

A. $28B. $40C. $52D. $68



Choice "c" is correct. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit. Each outcome is thenadded. There is a 60% probability that Dough will sell 60 of the 100 additional boxes through regular stores and that means that Dough would have a 60% chanceof making a profit of $20 (60 boxes at a $1 profit ($3 - $2) sold through the regular stores and 40 boxes at a $1 loss ($1 - $2) sold through the thrift stores).There is a 40% probability that Dough will have a profit of $40 (100 boxes at a $1 profit through the regular store sales and zero boxes sold at a loss through thethrift store).

Choice "a" is incorrect. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit.Choice "b" is incorrect. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit.

Choice "d" is incorrect. The expected value of a decision is computed by multiplying the probability of each outcome by its value or profit.

QUESTION 271A vendor offered Wyatt Co. $25,000 compensation for losses resulting from faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit againstthe vendor for a $12,000 retainer and 50% of any award over $35,000. Possible court awards with their associated probabilities are:

Compared to accepting the vendor's offer, the expected value for Wyatt to litigate the matter to verdict provides a:

A. $4,000 loss.B. $18,200 gain.C. $21,000 gain.D. $38,000 gain.



Choice "a" is correct.

Choices "b", "c", and "d" are incorrect based on the above Explanation:.

QUESTION 272Under frost-free conditions, Cal Cultivators expects its strawberry crop to have a $60,000 market value. An unprotected crop subject to frost has an expectedmarket value of $40,000. If Cal protects the strawberries against frost, then the market value of the crop is still expected to be $60,000 under frostfree conditionsand $90,000 if there is a frost. What must be the probability of a frost for Cal to be indifferent to spending $10,000 for frost protection?

A. .167B. .200C. .250D. .333



Choice "b" is correct. If there is no frost, then there is no difference between Cal's income with or without the insurance-the crop is worth $60,000 either way.However, if the insurance is purchased and a frost occurs, Cal earns $50,000 more with insurance ($90,000 - $40,000) than he would without the insurance.The expected value of having the insurance is therefore:Probability of frost x $50,000 + Probability of no frost x $0 Cal will be indifferent to spending $10,000 for frost protection when the expected value of the insuranceequals the cost of the insurance:Probability of frost x $50,000 = $10,000Probability = 20%Choices "a", "c", and "d" are incorrect based on the above Explanation:.

QUESTION 273During 1994, Deet Corp. experienced the following power outages:

Each power outage results in out-of-pocket costs of $400. For $500 per month, Deet can lease an auxiliary generator to provide power during outages. If Deetleases an auxiliary generator in 1995, the estimated savings (or additional expenditures) for 1995 would be:

A. ($3,600)B. ($1,200)C. $1,600D. $1,900



Choice "c" is correct.

Choice "a" is incorrect. The estimated savings is dependent on the number of outages and on the number of months, since there are two costs involved.Choice "b" is incorrect. The estimated savings is not the difference between the out-of-pocket costs and cost of generator, times 12 months.Choice "d" is incorrect. The cost of the generator is a monthly cost, not dependent on the number of power outages.

QUESTION 274What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

A. To cause the price of the company's stock to rise.B. To lower the company's bond rating.C. To reduce the risk for existing bondholders.D. To reduce the interest rate on the bonds being sold.



Note: The material tested in this question does not appear specifically on-point in our textbook, as the topic has rarely shown up on the CPA exam. The topics arecovered in general in parts of our textbook, so we believe that our students would have answered this question correctly given the information they had. However,we have expanded our Explanation: of this question to provide you with more detailed information.

Choice "d" is correct. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is to reduce the interest rate onNEW bonds being sold. A debt covenant is a provision in a bond indenture (contract between the bond issuer and the bond holders) that the bond issuer will eitherdo (affirmative covenants) or not do (negative covenants) certain things. In this question, the issuer would agree not to issue bonds in the future over a certainpercentage of its long-term debt.

Such a provision would be good for the potential bondholders and would probably reduce the interest rate on the bonds being sold.

Choice "a" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to cause the price of thecompany's stock to rise. Bond covenants affect bonds, not equity (at least not directly).

Choice "b" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to lower the company'sbond rating. Such a covenant might raise, not lower, a company's bond rating because there would be less risk. Besides, why would a bond covenant be signed if itwould lower the company's bond rating?

Choice "c" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to reduce the risk ofexisting bondholders, although a reduction in the risk of the existing bondholders certainly might result from such a covenant. As a general rule, more debt meansmore risk, less debt means less risk. So less debt would reduce the risk of all bondholders.This answer is a very close second.

QUESTION 275The capital budgeting model that is generally considered the best model for long-range decision making is the:

A. Payback model.B. Accounting rate of return model.C. Unadjusted rate of return model.D. Discounted cash flow model.



Choice "d" is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index.Choice "a" is incorrect. Payback and bailout payback do not consider the time value of money or the return after the initial investment is recovered. The differencebetween the two methods is that bailout payback takes salvage value into account in calculating cash flows. Choice "b" is incorrect. Accounting rate of return isbased on accrual income rather than cash flows. It does not consider the time value of money and is considered inferior to the discounted cash flow methods.Choice "c" is incorrect. There is no unadjusted rate of return model.

QUESTION 276Para Co. is reviewing the following data relating to an energy saving investment proposal:

What would be the annual savings needed to make the investment realize a 12% yield?

A. $8,189B. $11,111C. $12,306D. $13,889



Choice "c" is correct. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equals thepresent value of the net cash outflows. Use algebra to calculate the annual savings, as follows:

Choice "a" is incorrect. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equal thepresent value of the net cash outflows. Choice "b" is incorrect. Subtract the present value of $10,000 due in 5 years at 12%, or $10,000 × .57 = $5,700. Don'tsubtract the entire $10,000.Choice "d" is incorrect. Subtract the present value of the $10,000 residual value from the $50,000 cost.

QUESTION 277A project's net present value, ignoring income tax considerations, is normally affected by the:

A. Proceeds from the sale of the asset to be replaced.B. Carrying amount of the asset to be replaced by the project.

C. Amount of annual depreciation on the asset to be replaced.D. Amount of annual depreciation on fixed assets used directly on the project.



Choice "a" is correct. A project's net present value is a function of current and future cash flows, including proceeds from the sale of the old asset.Choice "b" is incorrect. A project's net present value is a function of current and future cash flows. The carrying amount of the asset does not affect cash flows.Choice "c" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.Choice "d" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.

QUESTION 278The profitability index is a variation on which of the following capital budgeting models?

A. Internal rate of return.B. Economic value-added.C. Net present value.D. Discounted payback.



Choice "c" is correct. The profitability index is a variation on the net present value capital budgeting model.RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is alsoreferred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the presentvalue of the inflows is greater than the present value of the outflows.

Choice "a" is incorrect. The profitability index is a companion computation to net present value, not internal rate of return, which measures percentage return.Choice "b" is incorrect. The profitability index is a companion computation to net present value, not economic value added.Choice "d" is incorrect. The profitability index is a companion computation to net present value, not the discounted payback method, which measures years topayback.

QUESTION 279A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000;divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%. What amount represents the manager's bonus?

A. $200,000B. $140,000C. $100,000D. $40,000



Choice "d" is correct as shown in the computation below:

Choice "a" is incorrect. The amount of the residual income itself is not the amount of the bonus. Choice "b" is incorrect. The difference between revenues (beforeconsideration of divisional expenses) and the hurdle amount is not residual income. The bonus would be improperly calculated if residual income were to be inflated

by divisional expenses as suggested by this answer. Choice "c" is incorrect. The difference between the hurdle amount and the residual income ($100,000) is notthe bonus amount.

QUESTION 280A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

A. Less than the company's weighted average cost of capital.B. Less than the project's internal rate of return.C. Greater than the company's weighted average cost of capital.D. Greater than the project's internal rate of return.



Choice "b" is correct. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment thatequates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to computethat NPV.Choice "a" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). Apositive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likelyequal.Choice "c" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). Apositive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likelyequal.Choice "d" is incorrect. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment thatequates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to computethat NPV.

QUESTION 281Which of the following statements is true regarding the payback method?

A. It does not consider the time value of money.B. It is the time required to recover the investment and earn a profit.C. It is a measure of how profitable one investment project is compared to another.D. The salvage value of old equipment is ignored in the event of equipment replacement.

Correct Answer: A

Section: Business Environment and Concepts (Volume C)Explanation


Choice "a" is correct. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. The paybackmethod does not consider the time value of money.Choice "b" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Althoughthe payback method focuses on liquidity and measures risk, project cash flows after the initial investment are not considered; thus, profitability is ignored.Choice "c" is incorrect. The payback method determines the number of years that it will take for a company to recoup or be paid back for its investment. Althoughthe payback method focuses on liquidity and measures risk, project cash flows after the initial investment are not considered; thus, profitability is ignored.Choice "d" is incorrect. Salvage value is specifically considered as part of payback computations because it contributes to the incoming cash flow when the asset issold.

QUESTION 282In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machineeffective January 1, 1997. The following information is being considered by Gunning Industries.

· The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.· The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unitin variable costs and total fixed costs of $40,000 per year.· The investment in the new machine will require an immediate increase in working capital of $35,000. · Gunning uses straight-line depreciation for financialreporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. · Gunning is subject to a 40 percentcorporate income tax rate. Gunning uses the net present value method to analyze investments and will employ the following factors and rates.

Gunning Industries' discounted annual depreciation tax shield for the year 1997 would be:

A. $13,817B. $15,200

C. $16,762D. $20,725



Choice "a" is correct. $13,817 discounted annual depreciation tax shield for the year 1997.

Choices "b", "c", and "d" are incorrect based on the above Explanation:.



The acquisition of the new production machine by Gunning Industries will contribute a discounted net- oftax contribution margin of:

A. $242,624B. $303,280C. $363,936D. $454,920



Choice "d" is correct. $454,920 discounted net-of-tax contribution margin.

Choices "a", "b", and "c" are incorrect based on the above Explanation:.

QUESTION 284RLF Corporation had income before taxes of $60,000 for the year 1991. Included in this amount was depreciation of $5,000, a charge of $6,000 for the amortizationof bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is:

A. $66,000B. $49,000C. $71,000D. $65,000


Explanation/Reference:Explanation:Choice "c" is correct. Cash flow is computed from net income by adding back non-cash expenses like depreciation and amortization. Presumably, interest expensehas been paid (i.e., is not "accrued" interest) and should not be added back.

Choices "a", "b", and "d" are incorrect, per above.

QUESTION 285A depreciation tax shield is:

A. An after-tax cash outflow.B. A reduction in income taxes.C. The expense caused by depreciation.D. Caused by the fact that depreciation does not affect cash flow.



Choice "b" is correct. Whenever depreciation protects income from taxation, it is known as a depreciation tax shield.Choice "a" is incorrect. A depreciation tax shield may result in after-tax cash inflow, but not outflow.Choice "c" is incorrect, per above.Choice "d" is incorrect. A depreciation tax shield is caused by the tax deductibility of the depreciation expense, not by the fact that depreciation does not affect cashflow.

QUESTION 286Wendy's Sandwich Shop purchased an asset for $100,000 that has no salvage value and a 10-year life. Wendy's effective income tax rate is 40 percent, and it usesthe straight-line depreciation method for income tax reporting purposes. Wendy's annual depreciation tax shield from the asset would be:

A. $10,000B. $6,000C. $4,000D. $2,000



Choice "c" is correct. $4,000 annual depreciation tax shield.

Choices "a", "b", and "d" are incorrect, per the above calculation.

QUESTION 287In considering the payback period for three projects, Fly Corp. gathered the following data about cash flows:

Which of the projects will achieve payback within three years?

A. Projects A, B, and C.B. Projects B and C.C. Project B only.D. Projects A and C.


Explanation/Reference:Explanation:Choice "b" is correct. Projects B and C achieve payback in three years. The payback period for Project A is somewhere between the end of Year 4 and Year 5. Forall three projects, Year 1 appears to be a combination of cash outflows (initial cost) and cash inflows (return of investment), but it really does not make anydifference. When the cumulative cash flow (both inflow and outflow) is zero, the project has paid back.

Choice "a" is incorrect. Project A does not pay back within 3 years even though Projects B and C do. Choice "c" is incorrect. Projects B and C, not just Project B,pay back within 3 years. Choice "d" is incorrect. Project A does not pay back within 3 years even though Project C does.

QUESTION 288Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:

If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:

A. 3.25 years.B. 2.67 years.C. 2.5 years.D. 2 years.



Choice "c" is correct. With even cash flows, payback period is calculated as initial cost / annual net cash inflows. That is, $500,000 / $200,000 = 2.5.Choice "a" is incorrect. We could not determine an obvious approach to obtain this answer. It is incorrect per the calculation above.Choice "b" is incorrect. This answer is calculated as follows: (initial cost - salvage value) / (annual net cash inflows - annual depreciation) or ($500,000 - $100,000) /($200,000 - $50,000) = $400,000 / $150,000 = 2.67. With the payback period, depreciation should only be considered to the extent that it represents a tax shield.Choice "d" is incorrect. This answer appears to be the initial cost less salvage value divided by the annual net cash inflows (($500,000 - $100,000) / $200,000 =2.0). Salvage value is not included in the correct calculation.

QUESTION 289Net present value as used in investment decision-making is stated in terms of which of the following options?

A. Net income.B. Earnings before interest, taxes, and depreciation.C. Earnings before interest and taxes.

D. Cash flow.



Choice "d" is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance thatisolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm hasavailable for operations and other activities. Choice "a" is incorrect. Net present value focuses on cash flows. Net income distorts financial results useful for capitalbudgeting decisions with non-cash items, such as depreciation, as well as with sunk costs.Choice "b" is incorrect. Net present value focuses on cash flows. Earnings before interest, taxes, and depreciation often approximates cash flow but still distortsfinancial results with earnings rather than the cash flow data most useful for capital budgeting.Choice "c" is incorrect. Net present value focuses on cash flows. Earnings before interest and taxes distort financial results with non-cash data (depreciation) aswell as earnings data rather than the cash flow data most useful for capital budgeting.

QUESTION 290A project has an initial outlay of $1,000. The projected cash inflows are:

What is the investment's payback period?

A. 4.0 years.B. 3.5 years.C. 3.4 years.D. 3.0 years.



Choice "b" is correct. The payback period is computed as the number of years required to fully recover the original investment with out respect to the time value ofmoney. With uneven cash flows, the payback period is computed by development of a cumulative payback balance converted to years as follows:

Choice "a" is incorrect. Although the payback occurs in the fourth year, only half the year is required.The payback period is 3.5, not 4.0 years.Choice "c" is incorrect. Although the payback occurs in the fourth year, half the year is required. The payback period is 3.5, not 3.4 years.Choice "d" is incorrect. The payback occurs in the fourth year. The payback period is 3.5, not 3.0 years.Strategies for Short-term and Long-term Financing

QUESTION 291If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be:

A. Risk indifferent.B. Risk averse.C. Risk seeking.D. Cautious.



Choice "c" is correct. If an investor's certainty equivalent, the point at which they are indifferent to risk, exceeds the expected return on an investment, then theinvestor is actually seeking lower return for higher risk. This behavior represents risk seeking behavior. Choice "a" is incorrect. Risk indifferent behavior occurswhen an investor's certainty equivalent is equal to the expected return on the investment.Choice "b" is incorrect. Risk averse behavior occurs when an investor's certainty equivalent is less than the expected rate of return. The investor seeks higherreturns for more risk. Choice "d" is incorrect. Cautious is not a technical term used in risk behavior classifications.

QUESTION 292Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by developmentof a portfolio. Risks that cannot be eliminated through a portfolio are called:

A. Non-market risks.B. Unsystematic risks.C. Firm-specific risks.D. Systematic risks.



Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced bydiversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get usDUNS.

DiversifiableUnsystematic (non market/firm-specific)Non-diversifiableSystematic (market)

Choice "d" is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as systematic risk.(DUNS) Choice "a" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-marketrisk. Choice "b" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed unsystematic risk.Choice "c" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed firm-specific risk.

QUESTION 293Residco, Inc. expects net income of $800,000 for the next fiscal year. Its targeted and current capital structure is 40 percent debt and 60 percent common equity.The director of capital budgeting has determined that the optimal capital spending for next year is $1.2 million. Residco does not plan to issue any new commonequity next year. If Residco follows a strict residual dividend policy, what is the expected dividend payout ratio for next year?

A. 90.0 percent.B. 66.7 percent.C. 40.0 percent.D. 10.0 percent.



Choice "d" is correct. A strict dividend policy guides a company's management to pay no more (and no less) in dividends from net income to generate a change inequity that produces or maintains a targeted capital structure. The dividend pay out ratio is the ratio of dividends to income. The call of the question requires thecalculation of the ratio of dividends to income assuming income, capital projects and capital structure amounts as follows:

Assuming the company is in compliance with the 40/60 Debt/Equity capital structure to begin with, 60% of the $1,200,000 in capital projects will be financed byadditions to equity the come from new earnings of $800,000. The equity funded portion of capital projects is $720,000 ($1,200,000 x 60%). Following a strictresidual dividend policy, the company will pay out the difference between is additions to equity ($800,000 in income) and the amounts reinvested in the business($720,000). The dividend will be $80,000. ($800,000 - $720,000).The dividend payout ratio is, therefore, 10% ($80,000 in dividends/ $800,000 in income). Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 294DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance theinvestment.

· Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par.· Use $35 million of funds generated from earnings.The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent.

The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40 percent.The Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the riskfree rate of return to the incremental yield of the expectedmarket return, which is adjusted by the company's beta. Compute DQZ's expected rate of return.




Choice "a" is correct. 9.20 percent expected rate of return. Choices "b", "c", and "d" are incorrect, per the above calculation.

QUESTION 295By using the discounted cash flow model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first yearof $3.00 per share, and an expected growth rate of 10 percent.


Correct Answer: DSection: Business Environment and Concepts (Volume C)

Explanation


Choice "d" is correct. 20.0 percent cost of equity capital by using the discounted cash flow model.

QUESTION 296Which one of the following factors might cause a firm to increase the debt in its financial structure?

A. An increase in the corporate income tax rate.B. Increased economic uncertainty.C. An increase in the price/earnings ratio.D. A decrease in the times interest earned ratio.



Choice "a" is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is taxdeductible, while dividends are paid after-tax. Choice "b" is incorrect. Increased economic uncertainty would cause a firm to decrease debt (and interest cost).Choice "c" is incorrect. An increase in the price/earnings ratio would encourage the issuance of equity rather than debt.Choice "d" is incorrect. A decrease in the times interest earned ratio indicates that earnings have declined compared with interest, and that more debt would beunwise (and more difficult to negotiate).

QUESTION 297If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?

A. Market interest rates have increased.B. Additional debt can be issued more cheaply that the original debt.

C. Interest is deductible for tax purposes.D. There is a mixture of old and new debt.



Choice "c" is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.Choice "a" is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. Thisdiscount would increase (not lower) Brewer's cost of debt.Choice "b" is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt.Choice "d" is incorrect. Presumably, the 8% yield already includes new and old debt.

QUESTION 298The theory underlying the cost of capital is primarily concerned with the cost of:

A. Long-term funds and old funds.B. Short-term funds and new funds.C. Long-term funds and new funds.D. Any combination of old or new, short-term or long-term funds.



Choice "d" is correct. The cost of capital considers the cost of all funds - whether they are short-term, long-term, new or old.Choices "a", "b", and "c" are incorrect, per above.

QUESTION 299Which one of a firm's sources of new capital usually has the lowest after tax cost?

A. Retained earnings.B. Bonds.

C. Preferred stock.D. Common stock.



Choice "b" is correct. Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuingbonds receives a tax deduction for interest paid. This further reduces the cost of bond financing.Choices "a", "c", and "d" are incorrect, per Explanation: above.

QUESTION 300Youngsten Electric is contemplating new projects for the next year that will require $30,000,000 of new financing. In keeping with its capital structure, Youngstenplans to use debt & equity financing as follows:

· Issue $10,000,000 of 20-year bonds at a price of 101.5, with a coupon of 10%, and flotation costs of 2.5% of par value.· Use internal funds generated from earnings of $20,000,000.

The equity market is expected to earn 15%. U.S. treasury bonds currently are yielding 9%. The beta coefficient for Youngsten's common stock is estimated to be .8.Youngsten is subject to a 40% corporate income tax rate. Youngsten has a price/earnings ratio of 10, a constant dividend payout ratio of 40%, and an expectedgrowth rate of 12%.

Assume Youngsten has an after-tax cost of debt of 9% and an after-tax cost of equity of 15%.Youngsten's weighted average cost of capital is:

A. 11.0%B. 13.0%C. 12.0%D. 11.8%



Choice "b" is correct. The WACC is computed by multiplying the required returns on equity and debt by the percentage of equity and debt used to finance thatparticular project. Youngsten will use 33% debt ($10 million of $30 million total project cost) and 67% equity ($20 million of $30 million total project cost).


QUESTION 301Sylvan Corporation has the following capital structure:

The financial leverage of Sylvan Corp. would increase as a result of:

A. Issuing common stock and using the proceeds to retire preferred stock.B. Issuing common stock and using the proceeds to retire debenture bonds.C. Financing its future investments with a higher percentage of bonds.D. Financing its future investments with a higher percentage of equity funds.



Choice "c" is correct. Financial leverage increases when the debt to equity ratio increases. Using a higher percentage of debt (bonds) for future investments wouldincrease financial leverage. Choice "a" is incorrect. This results in no change in total equity and, consequently, no change in financial leverage.Choice "b" is incorrect. This would result in increased equity and decreased debt, which would decrease financial leverage.Choice "d" is incorrect. This would increase equity, decrease the debt to equity ratio and decrease financial leverage.

QUESTION 302

Colt Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is8.5 percent, and the market return is estimated at 12.4%. If a new issue of common stock was used in this model, the flotation costs would be 7%. By using theCapital Asset Pricing Model equation C = R + B (M - R), the cost of using retained earnings to finance the capital expenditures is:




Choice "b" is correct. The capital asset pricing model (CAPM) is:

QUESTION 303Listed below is selected financial information for the Western Division of the Hinzel Company for last year.

If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment for last year?




Choice "d" is correct. 16.67% return on investment.

QUESTION 304James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing thefollowing forecasted information for his division for next year.

If the imputed interest charge is 15 percent and Webb wants to achieve a residual income target of $2 million, what will costs have to be in order to achieve thetarget?

A. $10,800,000B. $23,620,000C. $25,150,000D. $25,690,000



Choice "c" is correct. $25,150,000 costs to achieve residual income target of $2 million.


QUESTION 305The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:

A. Return on investment.B. Residual income.C. Operating income.D. Return on assets.



Explanation:

Choice "b" is correct. Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by theinvestment center. Choice "a" is incorrect. Return on investment is the ratio of income earned to the investment. Choice "c" is incorrect. Operating income is notwell defined, but is generally the income from operations for the entire organization, not a segment.Choice "d" is incorrect. Return on assets is the ratio of income produced to assets employed (not the amount invested).

QUESTION 306Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect?

A. When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate.B. ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation.C. The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models.D. The use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning around unprofitable

divisions.



Choice "b" is correct. ROI is no more and no less capable of being independently verified or manipulated than other performance measure.Choice "a" is incorrect. Old fixed assets may be undervalued and make comparison with a segment with newer assets inappropriate.Choice "c" is incorrect. Investment projects with positive present value may be rejected because ROI is too low.Choice "d" is incorrect. Turning around an unprofitable division would be good for the company but would probably lower a manager's ROI.

QUESTION 307The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:

A. Return on investment rate.B. Imputed interest rate charge.C. Cash flows in excess of a desired minimum amount.D. Income in excess of a desired minimum amount.



Choice "d" is correct. Residual income is defined as income in excess of a desired minimum return. Choices "a" and "b" are incorrect, as residual income is not a"rate" of return; it is a dollar amount. Choice "c" is incorrect, as residual income is an accrual method.

QUESTION 308Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income?




Choice "b" is correct. The addition of an asset at year end serves to reduce both return on investment and residual income. The addition of an asset increases thendenominator in the ROI computation and increases the threshold earnings required using the residual income approach. Both measures would suffer as a result ofaddition of assets. See illustration below:

The purchase of the additional asset reduces ROI from 10% to 8% and produces negative residual income.Choices "a", "c", and "d" are incorrect, per the above illustration.

QUESTION 309Vested, Inc. made some changes in operations and provided the following information:

What percentage represents the return on investment for year 3?

A. 28.57%B. 25%C. 20.31%D. 20%



Choice "b" is correct. Return on investment is the ratio of operating income to average operating assets and is computed as follows based on Year 2 and Year 3data:

Choice "a" is incorrect per the above computation.Choice "c is incorrect. The year 3 return on investment is not computed by combining revenues, expenses, and assets for all year's presented.Choice "d" is incorrect. The year 3 return on investment is based on the average assets (($1,200,000 + $2,000,000)/2 = $1,600,000), not simply on the total assetsat the end of year 3 ($2,000,000).

QUESTION 310The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm's netcost of debt?

A. 8.4%B. 9.8%C. 12.0%D. 14.0%



Choice "b" is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%. The question is trying to trick the candidate intousing the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are noflotation costs.Choice "a" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% x .70 = 8.4%.Choice "c" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% by itself. The costof debt is computed on an after-tax basis and uses the effective interest rate instead of the coupon rate. Choice "d" is incorrect. The net cost of debt is computed asthe effective interest rate net of tax, or 14% x .70 = 9.8%, not the effective interest rate of 14% by itself. The cost of debt is computed on an after- tax basis.

QUESTION 311What is the primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment centermanagers?

A. ROI is a percentage, while RI is a dollar amount.B. ROI may lead to rejecting projects that yield positive cash flows.C. ROI does not necessarily reflect the company's cost of capital.D. ROI does not reflect all economic gains.



Choice "b" is correct. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investmentcenter managers is that ROI may lead to rejecting projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest inprojects that might lower their ROI (especially if their bonuses are based only on their investment center's ROI), even though those projects might generate positivecash flows for the company as a whole.This characteristic is often known as the "disincentive to invest."

Choice "a" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investmentcenter managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI is a percentage and RI is a dollar amount.The fact that one is a percentage and one is a dollar amount might make them a little harder to interpret, but this interpretation difficulty would certainly not seem tobe the "primary" disadvantage.

Choice "c" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investmentcenter managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI does not necessarily reflect the cost of capital.

Choice "d" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investmentcenter managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI does not reflect all economic gains.

QUESTION 312The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

A. High marginal tax rates and few noninterest tax benefits.B. Low marginal tax rates and few noninterest tax benefits.C. High marginal tax rates and many noninterest tax benefits.D. Low marginal tax rates and many noninterest tax benefits.



Choice "a" is correct. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt isdeductible for tax purposes) and if there are few noninterest tax benefits (because there is little or no reason to depart from debt financing). Choice "b" is incorrect.The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt is deductible for taxpurposes), and if there are few noninterest tax benefits.Choice "c" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt isdeductible for tax purposes) and if there are few, not many, noninterest tax benefits.Choice "d" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt isdeductible for tax purposes), and if there are few, not many, noninterest tax benefits.

QUESTION 313A company has two divisions. Division A has operating income of $500 and total assets of $1,000. Division B has operating income of $400 and total assets of$1,600. The required rate of return for the company is 10%. The company's residual income would be which of the following amounts?

A. $0B. $260C. $640D. $900



Choice "c" is correct. Residual income is the difference between net income and the required return. The required return is net book value (total assets) times thehurdle rate (required rate of return). The calculations are as follows:

Choice "a" is incorrect. Residual income would certainly not be $0 in this question because the operating income is greater than the required return for both DivisionA and Division B. Choice "b" is incorrect. The $260 is the total required return, not the total residual income. Choice "d" is incorrect. The $900 is the total operatingincome, not the total residual income.

QUESTION 314At the beginning of year 1, $10,000 is invested at 8% interest, compounded annually. What amount of interest is earned for year 2?

A. $800.00B. $806.40C. $864.00D. $933.12


Explanation/Reference:Explanation:Choice "c" is correct. This question is a compound interest question because the interest is to be determined at the end of the second year. The calculation is asfollows and uses different symbols than the SI = PIN formula in the text to show candidates the PRT formula as well (the CPA exam often uses differentterminology):

Interest = PRT (for the first year)Interest = $1,000 x .08 x 1 = $800 and adding the $800 to the beginning principal Interest = PRT (for the second year)Interest = $1,800 x .08 x 1 = $864

It is obvious from the answer that the interest earned in year 2 is interest earned on the original principal ($10,000 x .08 = $800) plus interest on the year 1 interest($800 x .08 = $64). Choice "a" is incorrect. This answer is interest only on the original principal, and not on the year 1 interest.Choice "b" is incorrect. This answer has a decimal point error in calculating the year 2 interest on year 1 interest.

Choice "d" is incorrect. This answer is apparently made up. It is sometimes difficult to come up with 3 decent wrong answers, especially with simple questions.

QUESTION 315The optimal capitalization for an organization usually can be determined by the:

A. Maximum degree of financial leverage (DFL).B. Maximum degree of total leverage (DTL).C. Lowest total weighted-average cost of capital (WACC).D. Intersection of the marginal cost of capital and the marginal efficiency of investment.



Choice "c" is correct. The optimal capitalization for an organization usually can be determined by the lowest total weighted-average cots of capital (WACC).Capitalization at WACC serves to maximize shareholder's equity.Choice "a" is incorrect. The degree of financial leverage relates to the risk assumed by a firm using fixed debt service costs to finance operations notcomprehensively to capital structure. Choice "b" is incorrect. The degree of total leverage relates the risk assumed by a firm using a combination of both debtservices costs to finance operations and fixed costs to operate the business, not comprehensively to capital structure.Choice "d" is incorrect. The intersection of the marginal cost of capital and the marginal efficiency of investment does not indicate optimal capitalization.

QUESTION 316Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date and anincrease in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements?

A. Bonds.B. Common stock.C. Long-term debt.D. Short-term debt.



Choice "b" is correct. Common stock is an equity security that conveys ownership. Common stock does not require any payment, it does not mature and, because itincreases equity while having no effect on debt, it decreases the debt equity ratio and increases the credit-worthiness of the firm. Choice "a" is incorrect. Bonds aredebt instruments that require specific fixed payments, mature at a specific time and increase debt. Immediately after issue, increases in debt increase the debtequity ratio and decrease credit worthiness.Choice "c" is incorrect. Long-term debt requires specific fixed payments, includes maturity at a specific time and (by definition), increases debt. Immediately afterissue, increases in debt increase the debt equity ratio and decrease credit worthiness.Choice "d" is incorrect. Short-term debt requires specific fixed payments, includes maturity at a specific time and, by definition, increase debt. Immediately afterissue, increases in debt increase the debt equity ratio and decrease credit worthiness.

QUESTION 317Which of the following formulas should be used to calculate the economic rate of return on common stock?

A. (Dividends + change in price) divided by beginning price.B. (Net income - preferred dividend) divided by common shares outstanding.C. Market price per share divided by earnings per share.D. Dividends per share divided by market price per share.


Explanation/Reference:Explanation:Choice "a" is correct. The economic rate of return on common stock measures the dividend income and capital growth in relation to the initial investment, thebeginning price of the stock. Choice "b" is incorrect. The proposed solution is earnings per share, a ratio generally computed as the earnings available to commonshareholders (net income after payment of preferred shares) divided by the common shares outstanding.Choice "c" is incorrect. Market price per share divided by earnings per share is the price/earnings or P/E ratio, not the economic rate of return on common stock.Choice "d" is incorrect. The dividends per share divided by the market price per share does not represent the economic rate of return on common stock, the ratioincludes change in stock value in the denominator rather than the numerator of the equation.

QUESTION 318Which of the following factors is inherent in a firm's operations if it utilizes only equity financing?

A. Financial risk.B. Business risk.C. Interest rate risk.D. Marginal risk.

Correct Answer: BSection: Business Environment and Concepts (Volume C)

Explanation


Choice "b" is correct. Business risk represents the risk associated with the unique circumstances of a particular company, as they might affect the shareholdervalue of that company. If an entity purely uses its own cumulative earnings in capitalizing its operations, it is exposed to the risks of its own unique circumstances.Choice "a" is incorrect. Financial risk, also called default risk, relates to the exposure of lenders to the failure of borrowers to repay principal and interest on debt. Anentity using its own cumulative earnings in capitalizing its operations is not exposed to default risk. Choice "c" is incorrect. A business that exclusively uses equitycapitalization would not be exposed to the risk that the value of its financial instruments will change as a result of changes in interest rates. Choice "d" is incorrect.Incremental changes in risk would be limited if a firm exclusively used its own equity financing to capitalize its operations.Financial Statement and Business Implications of Liquid Asset Management

QUESTION 319Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make in their own firms increaseshareholder value. Managers have met that responsibility if the return on the capital investment:

A. Exceeds the rate of return associated with the firm's beta factor.B. Is less than the rate of return associated with the firm's beta factor.C. Is greater than the prime rate of return.D. Is less than the prime rate of return.



Choice "a" is correct. A capital investment whose rate of return exceeds the rate of return associated with the firm's beta factor will increase the value of the firm.Choice "b" is incorrect. A capital investment whose rate of return is less than the rate of return associated with the firm's beta factor will decrease the value of thefirm. Choice "c" is incorrect. The return on a capital investment in relation to the prime rate of return will not necessarily indicate if the investment increases ordecreases the value of the company without knowing the relative risk of the firm in relation to the market and its relationship to the prime rate. Choice "d" isincorrect. The return on a capital investment in relation to the prime rate of return will not necessarily indicate if the investment increases or decreases the value ofthe company without knowing the relative risk of the firm in relation to the market and its relationship to the prime rate.

QUESTION 320The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identifieda source of funds which is given below:

Pay a factor to buy the company's receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to

80 percent of the face value of receivables at 10 percent and charge a fee of 2 percent on all receivables purchaseD. The controller estimates that the firm wouldsave $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.Assume a 360-day year in all of your calculations.The cost of factoring is:





QUESTION 321Spotech Co.'s budgeted sales and budgeted cost of sales for the coming year are $212,000,000 and $132,500,000 respectively. Short-term interest rates areexpected to average 5 percent. If Spotech could increase inventory turnover from its current 8 times per year to 10 times per year, its expected cost savings in thecurrent year would be:

A. $165,625

B. $331,250C. $81,812D. $250,000



Choice "a" is correct. $165,625 expected cost savings by increasing inventory turnover from its current 8 times to 10 times per year.

QUESTION 322The amount of inventory that a company would tend to hold in stock would increase as the:

A. Cost of carrying inventory decreases.B. Variability of sales decreases.C. Cost of running out of stock decreases.D. Length of time that goods are in transit decreases.



Explanation:

Choice "a" is correct. The amount of inventory that a company would tend to hold in stock would increase as the cost of carrying inventory decreases.The amount of inventory that a company would tend to hold in stock would decrease as the:

B. Variability of sales decreases.C. Cost of running out of stock decreases.D. Length of time that goods are in transit decreases.

QUESTION 323Average daily cash outflows are $3 million for Evans Inc. A new cash management system can add two days to the disbursement schedule. Assuming Evans earns10 percent on excess funds, how much should the firm be willing to pay per year for this cash management system?

A. $3,000,000B. $1,500,000C. $600,000D. $150,000



Choice "c" is correct. $600,000 allowed for new cash management system.

QUESTION 324Jackson Distributors sells to retail stores on credit terms of 2/10, net 30. Daily sales average 150 units at a price of $300 each. Assuming that all sales are on creditand 60 percent of customers take the discount and pay on Day 10 while the rest of the customers pay on Day 30, the amount of Jackson's accounts receivable is:

A. $990,000

B. $900,000C. $810,000D. $450,000



Choice "c" is correct. $810,000 accounts receivable.


QUESTION 325If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year.




Choice "d" is correct. 31.81% annual cost of not taking the discount. Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 326If a firm borrows $500,000 at 10 percent and is required to maintain $50,000 as a minimum compensating balance at the bank, what is the effective interest rate onthe loan?




Choice "a" is correct. 11.1% effective interest rate on loan.

This question pertains to the computation of the effective rate of interest on a $500,000 note with a 10% stated rate that requires a $50,000 compensating balance.The answer computes the effective rate at 11.1% by taking the ratio of the amount paid $50,000 to the funds available $450,000 ($500,000 - $50,000). Why wouldthe $50,000 in interest payments not also be deducted in arriving at the effective rate?The simple answer is that the note is not discounted by the interest. It is only subject to the compensating balance.The borrower receives $500,000 in proceeds but must hold out $50,000 and pay back $550,000, principal + interest, to the lender. At the conclusion of the loan, thecompensating balance requirement is removed.

QUESTION 327A company has daily cash receipts of $150,000. The treasurer of the company has investigated a lockbox service whereby the bank that offers this service willreduce the company's collection time by four days at a monthly fee of $2,500. If money market rates average four percent during the year, the additional annualincome (loss) from using the lockbox service would be:

A. $6,000B. $(6,000)C. $12,000D. $(12,000)



Choice "b" is correct. $(6,000). A company's decision to commit to a lockbox plan is an example of marginal analysis. In other words, do the marginal benefitsexceed the marginal costs of the plan?


QUESTION 328Assume that each day a company writes and receives checks totaling $10,000. If it takes five days for the checks to clear and be deducted from the company'saccount, and only four days for the deposits to clear, what is the float?

A. $10,000B. $0C. $(10,000)D. $25,000



Choice "a" is correct. $10,000. Float is the difference between the balance of checks outstanding, which have not cleared the bank and deposits made but whichhave not yet cleared the bank here.

Choices "b", "c", and "d" are incorrect, per the above calculation.

QUESTION 329The optimal level of inventory would be affected by all of the following, except the:

A. Cost per unit of inventory.B. Current level of inventory.C. Cost of placing an order for merchandise.D. Lead time to receive merchandise ordered.



Choice "b" is correct. The current level of inventory has no impact on the optimal level of inventory. Choices "a", "c", and "d" are incorrect. The optimal level ofinventory is affected by:

1. The inventory usage rate.2. The cost per unit of inventory - which will have a direct impact on inventory carrying costs.3. The cost of placing on order impacts order frequency, which affects order size and optimal inventory levels.

QUESTION 330During 1990, Mason Company's current assets increased by $120, current liabilities decreased by $50, and net working capital:

A. Increased by $70.B. Decreased by $170.C. Increased by $170.D. Decreased by $70.



Choice "c" is correct. Net working capital is the difference between current assets and current liabilities. Because current assets went up $120 and current liabilitiesdown by $50, the net effect is an increase in net working capital of $170.

Therefore, working capital has increased $170,000.Choices "a", "b", and "d" are incorrect, per the above calculation.

QUESTION 331As a company becomes more conservative with respect to working capital policy, it would tend to have a (n):

A. Increase in the ratio of current liabilities to noncurrent liabilities.B. Decrease in the operating cycle.

C. Decrease in the quick ratio.D. Increase in the ratio of current assets to noncurrent assets.



RULE: Working capital policy is deemed to be more conservative as an increasing portion of an organization's long-term assets, permanent current assets, andtemporary current assets are funded by long-term financing.

Choice "d" is correct. An increase in the ratio of current assets to non-current assets would be indicative of an increasingly conservative working capital policy. Withno other information, an increase in current assets would indicate that a growing percentage of current assets are financed by non current liabilities and that,nominally, the absolute amount of working capital and the current ratio is improving.

Choice "a" is incorrect. An increase in the ratio of current liabilities to noncurrent liabilities would indicate that an increasing portion of our assets are funded bycurrent liabilities, a more aggressive approach to working capital management.

Choice "b" is incorrect. A decrease in the operating cycle implies that the time to convert inventory into sales (receivables) and receivables into cash has decreased.Assuming no change in liabilities or sales, a decreased operating cycle infers declining current asset balances, greater funding of assets by current liabilities and amore aggressive rather than conservative working capital policy. Choice "c" is incorrect. A decrease in the quick ratio would indicate that either temporary currentassets are decreasing (and are therefore increasingly funded by current liabilities, indicating a more aggressive working capital policy) or that current liabilities areincreasing, signaling a decrease in the amount of noncurrent liabilities used to fund temporary current assets, a sign of an increasingly aggressive working capitalpolicy.

QUESTION 332In inventory management, the safety stock will tend to increase if the:

A. Carrying cost increases.B. Cost of running out of stock decreases.C. Variability of lead-time increases.D. Fixed order cost decreases.



Explanation:

Choice "c" is correct. If lead times became more variable, the amount of safety stock needed to reduce the risk of stock outs will increase.Choice "a" is incorrect. A high carrying cost would decrease safety stock. Choice "b" is incorrect. A lower stockout cost would decrease safety stock. Choice "d" isincorrect. If order costs decrease, then inventory will be ordered more frequently and less safety stock will be needed.

QUESTION 333Quantree Company is quoted credit terms of 3/15, net 60 (using a 360-day year). The effective cost of not taking this discount and paying on day 60 is (rounded tonearest hundredth):




Choice "a" is correct. The formula for computing the cost of credit discounts is:


QUESTION 334Which of the following inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize totalinventory cost?

A. Economic order quantity.B. Just-in-time.C. Materials requirements planning.D. ABC.



Choice "a" is correct. The economic order quantity (EOQ) method of inventory control anticipates orders at the point where carrying costs are nearest to restockingcosts. The objective of EOQ is to minimize total inventory costs. The formula for EOQ is:

Choice "b" is incorrect. Just in time (JIT) inventory models were developed to reduce the lag time between inventory arrival and inventory use.Choice "c" is incorrect. Materials requirements planning (MRP) is a method of determining inventory requirements when a given number of units is needed. Themethod is used to create precise schedules of which items will be needed and what times they will be needed. Choice "d" is incorrect. ABC is an acronym forActivity Based Costing, a method of cost assignment that identifies value added activities and related cost drivers. It is not an inventory management approach.

QUESTION 335Which of the following ratios is appropriate for the evaluation of accounts receivable?

A. Days sales outstanding.B. Return on total assets.C. Collection to debt ratio.

D. Current ratio.



Choice "a" is correct. Among the ratios listed, the ratio that is appropriate for the evaluation of accounts receivable is the number of days sales are outstanding.Sales are related to accounts receivable, so the more days the sales are outstanding, the longer the receivables are outstanding. Choice "b" is incorrect. Return ontotal assets is not appropriate for the evaluation of accounts receivable.It is appropriate for the evaluation of return and of total assets, but not for the evaluation of account receivable specifically.Choice "c" is incorrect. The collection to debt ratio has nothing to do with the evaluation of accounts receivable.Choice "d" is incorrect. The current ratio is appropriate for the evaluation of liquidity (one of the ways to evaluate liquidity) but has nothing to do with the evaluation ofaccounts receivable, other than that accounts receivable is in the numerator of the current ratio.

QUESTION 336Which of the following is not a typical characteristic of a just-in-time (JIT) production environment?

A. Lot sizes equal to one.B. Insignificant setup times and costs.C. Push-through system.D. Balanced and level workloads.



Choice "c" is correct. Just-in-time has the goal to minimize the level of inventory carried. Typical characteristics include lot sizes equal to one, insignificant set-uptimes and costs, and balanced and level workloads. In a just-in-time environment, the flow of goods is controlled by a "pull" approach, where an item is producedonly when it is needed down the line, and not a "push-through" system. Choices "a", "b", and "d" are incorrect based on the above Explanation:.

QUESTION 337Bell Co. changed from a traditional manufacturing philosophy to a just-in-time philosophy. What are the expected effects of this change on Bell's inventory turnoverand inventory as a percentage of total assets reported on Bell's balance sheet?




Choice "c" is correct. In a just-in-time system, products are produced just-in-time to be sold. Therefore, JIT systems maintain a much smaller level of inventorywhen compared to traditional systems. Inventory turnover (cost of goods sold divided by average inventory) increases with a switch to JIT, and inventory as apercentage of total assets decreases. Choices "a", "b", and "d" are incorrect based on the above Explanation:.

QUESTION 338The benefits of a just-in-time system for raw materials usually include:

A. Elimination of nonvalue adding operations.B. Increase in the number of suppliers, thereby ensuring competitive bidding.C. Maximization of the standard delivery quantity, thereby lessening the paperwork for each delivery.D. Decrease in the number of deliveries required to maintain production.



Choice "a" is correct. The just-in-time system focuses on expediting the production process by having materials available as needed without having to store themprior to usage. Thus, the nonvalue adding operation of storing materials is eliminated.Choice "b" is incorrect. A just-in-time system is designed to facilitate the flow of materials whether the materials come from one or more suppliers. Competitivebidding is not a major benefit of the just-in- time system.Choice "c" is incorrect. Maximizing the delivery quantity of materials may increase the need to store the materials prior to using them. The just-in-time systemfocuses on minimizing storage time and storage costs. Lessening paperwork is not a focus of the just-in-time system. Choice "d" is incorrect. With a just-in-timesystem, deliveries are made as materials are needed. A decrease in deliveries may increase the delivery quantity, thus increasing the need to store the materialsprior to using them. The just-in-time system focuses on minimizing storage time and storage costs.

QUESTION 339Amicable Wireless, Inc. offers credit terms of 2/10, net 30 for its customers. Sixty percent of Amicable's customers take the 2% discount and pay on day 10. Theremainder of Amicable's customers pay on day 30. How many days' sales are in Amicable's accounts receivable?

A. 6B. 12C. 18D. 20



Choice "c" is correct. Days' sales in accounts receivable is normally calculated as Days' sales = Ending accounts receivable / Average daily sales. However, thatformula will not work in this case because the necessary information is not provided. However, enough information about payments is provided so that the totaldays' sales can be determined on a weighted average basis. In this question, nobody pays before the 10th day and 60% of the customers pay on the 10th day, sothere are 10 x .60, or 6 day's sales there. The other 40% of the customers pay on the 30th day so there are 30 x .40, or 12 day's sales there. The total is 18 dayssales.

Choice "a" is incorrect. This answer is apparently calculated from just the 60% of the customers who pay on the 10th day. The others have to be included also.Choice "b" is incorrect. This answer is apparently calculated from just the 40% of the customers who pay on the 30th day. The others have to be included also.Choice "d" is incorrect. This answer is apparently calculated by as the difference between the 30th day and the 10th day. The answer does not take into accounthow many customers pay when.

QUESTION 340Management accountants are frequently asked to analyze various decision situations including the following.

A. The cost of a special device that is necessary if a special order is accepted.II. The cost proposed annually for the plant service for the grounds at corporate headquarters.

III. Joint production costs incurred, to be considered in a sell-at-split versus a process-further decision.IV. The costs associated with alternative uses of plant space, to be considered in a make/buy decision.

B. The cost of obsolete inventory acquired several years ago, to be considered in a keep-versusdisposal decision.The cost described in situation II above is a:

C. Prime cost.D. Sunk cost.E. Discretionary cost.F. Relevant cost.



Choice "c" is correct. Discretionary cost. The proposed cost for plant service for the grounds at corporate headquarters is an example of an avoidable cost that isdiscretionary. Choice "a" is incorrect. Prime costs are direct materials and direct labor. Choice "b" is incorrect. Sunk costs are costs previously incurred and notrelevant. Choice "d" is incorrect. Relevant costs are expected future costs that vary with the action taken.

QUESTION 341Companies that adopt just-in-time purchasing systems often experience:

A. A reduction in the number of suppliers.B. Fewer deliveries from suppliers.C. A greater need for inspection of goods as the goods arrive.D. Less need for linkage with a vendor's computerized order entry system.



Choice "a" is correct. Just-in-time purchasing systems usually results in a reduction in the number of suppliers. Because a company that adopts J-I-T is verydependent on supplier performance, usually fewer suppliers are used and a very close working relationship is developed. Choice "b" is incorrect. Just-in-timerequires more deliveries from suppliers. Choice "c" is incorrect. Usually there is more reliance on quality control by the supplier. Finding defective goods as theyarrive is too late; a stock-out could cause production to shut down. Choice "d" is incorrect. There is much more need for linkage with the vendor's order entry

system with JI- T because the company is dependent on timely deliveries from the vendor.

QUESTION 342In a decision analysis situation, which one of the following costs is generally not relevant to the decision?

A. Incremental cost.B. Avoidable cost.C. Historical cost.D. Opportunity cost.



Choice "c" is correct. Historical cost is generally not relevant in a decision analysis situation. All of the following costs are relevant in a decision analysis situation:

A. Incremental costB. Avoidable costD. Opportunity cost

QUESTION 343The relevance of a particular cost to a decision is determined by:

A. Riskiness of the decision.B. Number of decision variables.C. Potential effect on the decision.D. Accuracy of the cost.



Choice "c" is correct. The relevance of a particular cost to a decision is determined by potential effect on the decision. Relevant costs are expected future costs thatvary with the action taken. All other costs are assumed to be constant and thus have no effect on the decision. The relevance of a particular cost to a decision is not

determined by:

A. Riskiness of the decision.B. Number of decision variables.D. Accuracy of the cost.

QUESTION 344Capital budgeting decisions include all but which of the following?

A. Selecting among long-term investment alternatives.B. Financing short-term working capital needs.C. Making investments that produce returns over a long period of time.D. Financing large expenditures.



Choice "b" is correct. Capital budgeting decisions do not include the financing of short-term working capital needs, which are more operational in nature.Choices "a", "c", and "d" are incorrect, as these are all types of capital budgeting decisions.

QUESTION 345An example of an indirect cash flow effect would be:

A. Cash committed at inception of the project.B. Increased payroll expenses due to the project.C. A depreciation tax shield.D. An increase in expected future operating cash flows.



Choice "c" is correct. A depreciation tax shield is one of the most common indirect cash flow effects. Choices "a", "b", and "d" are incorrect, as these are all directly

related to the capital investment and have an immediate effect on the amount of cash available to the company. Thus, they are all direct cash flow effects.

QUESTION 346The annual tax depreciation expense on an asset reduces income taxes by an amount equal to:

A. The firm's average tax rate times the depreciation amount.B. One minus the firm's average tax rate times the depreciation amount.C. The firm's marginal tax rate times the depreciation amount.D. One minus the firm's marginal tax rate times the depreciation amount.



Choice "c" is correct. The annual tax depreciation expense reduces income taxes by an amount equal to the firm's marginal tax rate (the tax on the next dollar ofincome) times the depreciation amount.Choices "a", "b", and "d" are incorrect, per above.

QUESTION 347When employing the MACRS method of depreciation in a capital budgeting decision, the use of MACRS as compared to the straight-line method of depreciation willresult in:

A. Equal total depreciation for both methods.B. MACRS producing less total depreciation than straight line.C. Equal total tax payments, after discounting for the time value of money.D. MACRS producing more total depreciation than straight line.



Choice "a" is correct. MACRS and straight line depreciation will be equal in total (only the timing differs).Choices "b" and "d" are incorrect, per above.Choice "c" is incorrect. The timing of the depreciation tax shields will differ. The discounting will result in different present values based on the differing timing.

QUESTION 348Kore Industries is analyzing a capital investment proposal for new equipment to produce a product over the next eight years. The analyst is attempting to determinethe appropriate "end-of-life" cash flows for the analysis. At the end of eight years, the equipment must be removed from the plant and will have a net book value ofzero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. Kore's effective tax rate is 40 percent. What is the appropriate "end-of-life" cash flow related to these items that should be used in the analysis?

A. $27,000B. $12,000C. $(18,000)D. $(30,000)



Choice "b" is correct. $12,000 "end-of-life" cash flow.The $75,000 loss on disposal is a non-cash reduction in taxable income that will reduce taxes paid by $30,000 (75,000 × 40%).

The cost to remove the equipment is a cash expense that will reduce taxable income by $40,000 and reduce taxes paid by $16,000 (40,000 × 40%), resulting in anet cash expense of $24,000 ($40,000 minus $16,000, or $40,000 × 60%).

The $10,000 salvage value will increase after-tax cash flow by $6,000 (10,000 × 60%).


QUESTION 349Which one of the following is most relevant to a manufacturing equipment replacement decision?

A. Original cost of the old equipment.B. Disposal price of the old equipment.C. Gain or loss on the disposal of the old equipment.D. A lump-sum write-off amount from the disposal of the old equipment.



Rule: Relevant costs are only those costs that will differ among many alternatives.

Choice "b" is correct. The disposal price of the old equipment is most relevant because it is an expected future inflow that will differ among alternatives. If this oldequipment is replaced, there will be a cash inflow from the sale of the old equipment. If the old equipment is kept, there will be no cash inflow from the sale of theold equipment.Choice "a" is incorrect. The original cost of the old equipment is a sunk cost and, therefore, not relevant.Choice "c" is incorrect. The gain or loss on the disposal of the old equipment is not relevant. The gain or loss is an accounting computation that combines the bookvalue, which is always not relevant, and the disposal value, which is relevant. The result is meaningless to future decisions and, therefore, is not relevant.Choice "d" is incorrect. The book value is not relevant to future decisions because the undepreciated sunk cost of an asset will only reduce net income in the futureas either depreciation expense or as a loss on disposal.

QUESTION 350Lawson Inc. is expanding its manufacturing plant, which requires an investment of $4 million in new equipment and plant modifications. Lawson's sales areexpected to increase by $3 million per year as a result of the expansion. Cash investment in current assets averages 30 percent of sales; accounts payable andother current liabilities are 10 percent of sales. What is the estimated total investment for this expansion?

A. $3.4 million.B. $4.3 million.C. $4.6 million.D. $4.9 million.

Correct Answer: C

Section: Business Environment and Concepts (Volume C)Explanation


Rule: The expansion of working capital (WC = CA-CL) is treated as an increase in investment. Choice "c" is correct. $4.6 million estimated total investment for thisexpansion.


QUESTION 351All of the following items are included in discounted cash flow analysis, except:

A. Future operating cash savings.B. The current asset disposal price.C. The future asset depreciation expense.D. The tax effects of future asset depreciation.



Choice "c" is correct. The future asset depreciation expense is not included in discounted cash flow analysis.Choices "a", "b", and "d" are incorrect. All of these are included in discounted cash flow analysis:

· Future operating cash savings· Current asset disposal price· Tax effects of future asset depreciation· Future asset disposal price

QUESTION 352The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project, using the company's minimum desired rate ofreturn is the:

A. Accounting rate of return method.B. Net present value method.C. Internal rate of return method.D. Payback method.



Choice "b" is correct. The net present value method recognizes the time value of money and discounts cash flows over the life of a project, using the minimumdesired (hurdle) rate. Choice "a" is incorrect. The accounting rate of return is the accrual accounting increase compared to the initial investment.Choice "c" is incorrect. IRR is similar to NPV, but does not assume a desired rate of return. The rate is calculated that produces a NPV of zero.Choice "d" is incorrect. Payback method does not recognize the time value of money.



Gunning Industries' net cash outflow in a capital budgeting decision would be:

A. $190,000B. $195,000C. $204,525D. $225,000



Choice "d" is correct. $225,000 net cash outflow.

Choices "a", "b", and "c" are incorrect, per the above calculation. Note: This question is the first from a series of questions on a prior exam. The last in the series ispresented for you in the regular homework questions (not the supplemental questions) for this chapter.

QUESTION 354A company has unlimited capital funds to invest. The decision rule for the company to follow in order to maximize shareholders' wealth is to invest in all projectshaving a (n):

A. Present value greater than zero.B. Net present value greater than zero.C. Internal rate of return greater than zero.D. Accounting rate of return greater than the hurdle rate used in capital budgeting analyses.



Choice "b" is correct.Rule: If the net present value is positive (greater than zero), a project should be accepted, unless there is a better project. If, however, a company has unlimitedfunds, all projects with a net present value greater than zero should be accepted in order to maximize shareholder wealth. Choice "a" is incorrect. Considering onlypresent value greater than zero accounts for future net cash inflows, but it ignores cash outflows from the initial capital investment. Choice "c" is incorrect.Considering only internal rate of return greater than zero may result in the acceptance of a project with an internal rate of return less than the company's minimumdesired rate of return.Choice "d" is incorrect. Considering only accounting rate of return greater than hurdle rate ignores the time value of money.

QUESTION 355When determining net present value in an inflationary environment, adjustments should be made to:

A. Increase the discount rate, only.B. Increase the estimated cash inflows and increase the discount rate.C. Increase the estimated cash inflows but not the discount rate.D. Decrease the estimated cash inflows and increase the discount rate.



Choice "b" is correct.Rule: In an inflationary environment, future cash flows (except for cash flows generated from the tax effect of depreciation) should be increased to the extent ofpredicted inflation. For internal consistency, an inflationary factor should also be added to the discount rate. Choices "a", "c", and "d" are incorrect, per the aboveExplanation:.

QUESTION 356For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:

A. Wants to use equity funding exclusively.B. Believes bank loans are riskier than capital investments.C. Believes capital investment proposals involve average risk.D. Wants to factor risk into its consideration of projects.



Choice "d" is correct. Management would select a high hurdle rate for certain projects to factor risk into its consideration of projects. The higher hurdle ratediscounts future cash flows more, creating a smaller present value. By "devaluing" the cash flows of certain projects, risk has been compensated for. Choices "a"and "b" are incorrect. The method and cost of funding are independent of the hurdle rate for screening investments.Choice "c" is incorrect. If capital investment proposals involve average risk, no adjustment upward is needed for risk.

QUESTION 357McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicitythat the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at theend of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimatedincome tax rate and a 16 percent hurdle rate to evaluate capital projects.

Discount rates for a 16 percent rate are as follows.

What is the net present value of this project?

A. $15,842B. $13,278

C. $9,432D. $(35,454)



Choice "b" is correct. $13,278 net present value.

QUESTION 358Barker Inc. has no capital rationing constraint and is analyzing many independent investment alternatives. Barker should accept all investment proposals:

A. If debt financing is available for them.B. That have positive cash flows.C. That provide returns greater than the after-tax cost of debt.D. That have a positive net present value.



Choice "d" is correct. Accept all investment alternatives that have a positive net present value (NPV). A positive NPV means the return on the investment exceedsthe hurdle rate (the minimum acceptable rate of return).Choice "a" is incorrect. The cost of debt financing is a factor in determining the hurdle rate. Choice "b" is incorrect. The cash flow may be positive but the return oninvestment may be unacceptable.Choice "c" is incorrect. The cost of debt financing is a factor in determining the hurdle rate.

QUESTION 359The net present value (NPV) of a project has been calculated to be $215,000. Which one of the following changes in assumptions would decrease the NPV?

A. Decrease the estimated effective income tax rate.B. Extend the project life and associated cash inflows.C. Increase the estimated salvage value.D. Increase the discount rate.



Choice "d" is correct. An increase in the discount rate will decrease the present value of future cash inflows and, therefore, decrease the net present value of theproject.Each of the other options would increase the NPV:Choice "a" is incorrect. A decrease in the estimated effective income tax rate will reduce the depreciation tax shield and therefore increase the cash inflow. A largercash inflow in the future will increase the present value of the cash inflows and therefore increase the net present value of the project. Choice "b" is incorrect.Increasing the project life and associated cash inflows will increase the present value of the cash inflows and therefore increase the net present value. Choice "c" is

incorrect. An increase in the estimated salvage value will decrease the present value of the cash outflow and therefore increase the net present value.

QUESTION 360The net present value method of capital budgeting assumes that cash flows are reinvested at:

A. The risk-free rate.B. The cost of debt.C. The rate of return of the project.D. The discount rate used in the analysis.



Choice "d" is correct. The net present value method of capital budgeting assumes that cash flows are reinvested at the discount rate used in the analysis.Choices "a", "b", and "c" are incorrect, per the above Explanation:.

QUESTION 361Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willisprojects that earnings and cash flow will increase as follows.

The net present value of this investment is:

A. Negative, $64,000B. Negative, $14,000C. Positive, $18,600D. Positive, $200,000



Choice "c" is correct. Positive NPV, $18,600.

QUESTION 362The net present value of a proposed investment is negative; therefore, the discount rate used must be:

A. Greater than the project's internal rate of return.B. Less than the project's internal rate of return.C. Greater than the firm's cost of equity.D. Less than the incremental borrowing rate.



Choice "a" is correct. If the NPV of a proposed investment is negative, the discount rate used must be greater than the project's internal rate of return (IRR). TheIRR is the discount rate that results in a NPV of zero. If a discount rate used is greater than the project's IRR, the present value of future cash inflows will be lowerresulting in a negative net present value.If a discount rate used is less than the project's IRR, the present value of future cash inflows will be higher resulting in a positive net present value.Choices "b", "c", and "d" are incorrect, per the above discussion.

QUESTION 363A disadvantage of the net present value method of capital expenditure evaluation is that it:

A. Is calculated using sensitivity analysis.B. Does not provide the true rate of return on investment.C. Is difficult to apply because it uses a trial and error approach.D. Is difficult to adapt for risk.



Choice "b" is correct. The net present value (NPV) method of capital expenditure evaluation does not provide the true rate of return on investment. The NPVindicates whether or not an investment will earn the "hurdle rate" used in the NPV calculation. If the NPV is positive, the return on investment will exceed the hurdlerate. If the NPV is negative, the return on investment will be less than the hurdle rate. If the NPV is zero, the return on investment will be exactly equal to the hurdlerate. Choice "a" is incorrect. Sensitivity analysis is a "what if" technique that asks how a given organization will change if the original estimates used in the capitalbudgeting model are changed. Choice "c" is incorrect. NPV calculations do not use a trial and error approach. Choice "d" is incorrect. NPV method is not difficult toadapt for risk. To adapt for increased risk, a higher hurdle rate is used. To adapt for less risk, a lower hurdle rate is used.

QUESTION 364Andrew Corporation is evaluating a capital investment that would result in a $30,000 higher contribution margin benefit and increased annual personnel costs of$20,000. The effects of income taxes on the net present value computation on these benefits and costs for the project are to:

A. Decrease both benefits and costs.B. Decrease benefits but increase costs.C. Increase benefits but decrease costs.D. Increase both benefits and costs.



Choice "a" is correct. The effects of income taxes on the net present value computations will decrease both benefits and costs for the project. Net present valuecomputations focus of the present value of cash flows. Income taxes decrease both the benefit and the cost of cash flows. Choices "b", "c", and "d" are incorrect,per the above Explanation:.

QUESTION 365

The Keego Company is planning a $200,000 equipment investment, which has an estimated five-year life with no estimated salvage value. The company hasprojected the following annual cash flows for the investment.

The net present value for the investment is:

A. $18,800B. $196,200C. $(3,800)D. $91,743



Choice "a" is correct. $18,800 net present value. The net present value of an investment is calculated as the present value of the cash inflows minus the presentvalue of the cash outflows. In this case, there is only one cash outflow (at the purchase date), and that amount ($200,000) is already at present value (or, ismultiplied by a present value factor of 1.0).

QUESTION 366The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:

A. Raising the hurdle rate necessary to justify the project.B. Lowering the net present value of the project.C. Increasing the present value of the depreciation tax shield.D. Increasing the cash outflows at the initial point of the project.



Rule: The greater the depreciation expense, the greater the depreciation tax shield.

Deprecation Tax Shield =Depreciation Expense × Marginal Tax Rate

Choice "c" is correct. Use of an accelerated method instead of the straight-line method of depreciation in computing the NPV of a project has the effect ofincreasing the PV of the deprecation tax shield. Choice "a" is incorrect. Depreciation method does not affect the hurdle rate. The hurdle rate is independentlyselected by management.Choice "b" is incorrect. Using an accelerated method instead of the straight-line method of depreciation will increase the present value of the deprecation tax shieldand therefore increase the net present value of the project.Choice "d" is incorrect. Depreciation method does not affect cash outflows at the initial point of the project.

QUESTION 367The internal rate of return for a project can be determined:

A. Only if the project cash flows are constant.B. By finding the discount rate that yields a net present value of zero for the project.C. By subtracting the firm's cost of capital from the project's profitability index.D. Only if the project's profitability index is greater than one.



Choice "b" is correct. The internal rate of return (IRR) is the discount rate that produces a NPV of zero. Choice "a" is incorrect. IRR valuation does not require cashflows that are constant. Choice "c" is incorrect. Cost of capital is a percentage, profitability index is a ratio; this won't work. Choice "d" is incorrect. IRR can bedetermined even if the profitability index is less than 1.0. A profitability index of less than 1.0 means a negative NPV, which means the IRR is less than the discountrate being used.

QUESTION 368The internal rate of return is the:

A. Rate of interest that equates the present value of cash outflows and the present value of cash inflows.B. Risk-adjusted rate of return.C. Required rate of return.D. Weighted average rate of return generated by internal funds.



Choice "a" is correct. The internal rate of return is defined as the technique that determines the present value factor such that the present value of the after-tax cashflows equals the initial investment on the project. Alternately, the internal rate of return (IRR) is the discount rate that produces a NPV of zero. Choices "b", "c", and"d" are incorrect, per the above Explanation:.

QUESTION 369The internal rate of return (IRR) is the:

A. Hurdle rate.B. Rate of interest where the net present value is greater than 1.0.C. Rate of interest where the net present value is equal to zero.D. Rate of return generated from the operational cash flows.



Choice "c" is correct. IRR is the rate of interest where the NPV is zero. Choice "a" is incorrect. The hurdle rate is a desired or minimum rate of return, set bymanagement, to evaluate investments.Choice "b" is incorrect. NPV will be greater than zero when the IRR is higher than the hurdle rate. Choice "d" is incorrect. IRR is the rate of return of all cash flowsproduced by the investment.

QUESTION 370The method that divides a project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment isthe:

A. Internal rate of return method.B. Accounting rate of return method.C. Payback method.D. Net present value method.



Choice "b" is correct. Accounting rate of return divides annual after-tax net income by average investment amount.Choices "a", "c", and "d" are incorrect. IRR, NPV and payback all use cash flows, not net income.

QUESTION 371

The length of time required to recover the initial cash outlay of a capital project is determined by using the:

A. Discounted cash flow method.B. Payback method.C. Net present value method.D. Accounting rate of return method.



Choice "b" is correct. The payback method measures the time required to recover the initial investment. Choice "a" is incorrect. Discounted cash flows are used forseveral methods of capital budgeting; this is a generic term.Choice "c" is incorrect. The NPV method does not measure the length of time required to recover the initial cash outlay.Choice "d" is incorrect. The accounting rate of return does not measure the time to recover the initial investment.

QUESTION 372A characteristic of the payback method (before taxes) is that it:

A. Incorporates the time value of money.B. Neglects total project profitability.C. Uses accrual accounting inflows in the numerator of the calculation.D. Uses the estimated expected life of the asset in the denominator of the calculation.



Choice "b" is correct. The payback method neglects total project profitability. It simply looks at the time required to recover the initial investment; subsequentreceipts are ignored. Choice "a" is incorrect. Payback does not incorporate the time value of money. Choice "c" is incorrect. Payback uses cash flow, not accrualaccounting income. Choice "d" is incorrect. The denominator is the annual cash inflows.

QUESTION 373McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity

that the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at theend of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimatedincome tax rate and a 16 percent hurdle rate to evaluate capital projects.Discount rates for a 16 percent rate are as follows:

The payback period for this investment would be:

A. 2.95 yearsB. 1.76 yearsC. 2.09 yearsD. 2.94 years



Choice "c" is correct. 2.09 years payback period.

At the beginning of year 3, $6,000 is needed to recover the investment. Because an inflow of $69,000 is expected throughout the year, only 6,000 ÷ 69,000 = .09years is needed to recover the $6,000. Thus, the payback is 2.09 years. The $6,000 in salvage is excluded from the totals for year 3. Amounts are not realized untilthe end of the year while savings and depreciation tax shield occur throughout the year and are relevant to the partial year payback.

QUESTION 374Which one or the following statements about the payback method of investment analysis is correct? The payback method:

A. Does not consider the time value of money.B. Uses discounted cash flow techniques.C. Generally leads to the same decision as other methods for long-term projects.D. Is rarely used in practice.



Choice "a" is correct. The payback method does not consider the time value of money. Choice "b" is incorrect. The payback method does not use discounted cashflow techniques. The time value of money is ignored.

Choice "c" is incorrect. The payback method may or may not lead to the same decision as other methods for long-term projects.Choice "d" is incorrect. The payback method is frequently used in practice because of its simplicity.

QUESTION 375Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willisprojects that earnings and cash flow will increase as follows.

What is the payback period of this investment?

A. 1.50 yearsB. 3.00 yearsC. 3.33 yearsD. 4.00 years



Choice "b" is correct. 3.00 year payback period.

Note: After 3 years, the initial investment is recovered, as the cumulative cash inflows equal $400,000. The cash flows are not discounted when the paybackmethod is used.

QUESTION 376Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated six-year life with zerosalvage value. Whatney uses straightline depreciation for both financial reporting and income tax reporting purposes and has a 40 percent corporate income taxrate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a four-year payback period. To meet Whatney's desired payback period, the pressmust produce a minimum annual before-tax, operating cash savings of:

A. $90,000B. $110,000C. $114,000D. $150,000

Correct Answer: BSection: Business Environment and Concepts (Volume D)Explanation


Choice "b" is correct. $110,000 minimum annual before-tax operating cash savings.

Step 1: Determine the after-tax annual cash savings. The question provides the cash outflow and the desired payback period (which is calculated using after-taxcash flows). The $90,000 annual after-tax cash flows is calculated as follows:

Step 2: Determine the amount of the annual depreciation expense. Because the question asks for annual before-tax cash savings, we will need to convert the$90,000 after-tax cash savings we calculated in Step 1,above, to a before-tax amount. The depreciation tax shield plays a role in the after-tax cash flows, so theannual depreciation of $60,000 must be calculated, as follows:

Step 3: Use algebra to determine the before-tax cash savings. Before-tax cash savings is equal to the after-tax cash savings plus the taxes paid. So:

Let B = annual before-tax operating cash savings

$90,000 after tax cash savings + [(B - $60,000 depreciation expense ) (.40 tax rate)] = B $90,000 + [(B - $60,000) (.40)] = B$90,000 + [.40B - $24,000] = B$90,000 - $24,000 = .60B$66,000 = .60B$110,000 = B = annual before-tax operating cash savings

QUESTION 377When evaluating capital budgeting analysis techniques, the payback period emphasizes:

A. Liquidity.

B. Profitability.C. Net income.D. The accounting period.

Correct Answer: ASection: Business Environment and Concepts (Volume D)Explanation


Choice "a" is correct. The payback period is the time period required for cash inflows to recover the initial investment. The emphasis of the technique is on liquidity(i.e., cash flow). Choices "b", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 378The term underwriting spread refers to the:

A. Commission percentage an investment banker receives for underwriting a security lease.B. Discount investment bankers receive on securities they purchase from the issuing company.C. Difference between the price the investment banker pays for a new security issue and the price at which the securities are resold.D. Commission a broker receives for either buying or selling a security on behalf of an investor.

Correct Answer: CSection: Business Environment and Concepts (Volume D)Explanation


Choice "c" is correct. Investment bankers are paid their fees partly by being allowed to purchase the new securities they are underwriting for a discount and thenreselling those securities on the market.This is known as the underwriting spread.Choices "a" and "d" are incorrect, as both of these describe either fees or commissions and not an underwriting spread.Choice "b" is incorrect. The underwriting spread is the difference between the discount price paid and the resale price.

QUESTION 379The principle measure of non-diversifiable risk included in the CAPM formula is the beta coefficient. The beta coefficient measures the volatility or risk inherent in aninvestment by:

A. Computing the ratio of changes in earnings per share to changes in sales.

B. Computing the ratio of stock price to earnings per share.C. Computing the ratio of percentage changes in a stock's price to percentage changes in overall market values during the same period.D. Computing the ratio of percentage changes in the expected value of alpha equivalents to derivative fluctuations.



Choice "c" is correct. The beta coefficient represents the measure of a particular stock's percentage change compared to the percentage change in the market overthe same perioD. The equation for the beta coefficient is as follows:

% in Stock Price% in Market price

Choice "a" is incorrect. The percentage change in earnings per share related to a percentage change in sales represents the degree of combined leverage.Choice "b" is incorrect. The ratio of stock price to earnings per share is the price earnings ratio. Choice "d" is incorrect. Choice "d" represents a word saladdistracter of nonsense terms.

QUESTION 380Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year.The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas todetermine the company's leverage.

The degree of operating leverage for Carlisle Company is:

A. 2.4B. 1.78C. 1.35D. 2.3



Choice "b" is correct. Calculation of operating leverage is:



The degree of financial leverage for Carlisle Company is:

A. 2.4B. 1.78C. 1.35

D. 2.3



Choice "c" is correct. To calculate financial leverage, EBIT must first be calculated:



If Carlisle Company did not have preferred stock, the degree of total leverage would:

A. Decrease in proportion to a decrease in financial leverage.B. Increase in proportion to an increase in financial leverage.C. Decrease but not be proportional to the decrease in financial leverage.D. Decrease but not have an effect on financial leverage.



Choice "a" is correct. Without preferred stock, the denominator in the total leverage calculation would be larger (because preferred stock is subtracted to arrive atthe denominator). The same holds true for financial leverage. Therefore, both financial and total leverage would decrease in proportion. Choices "b", "c", and "d" areincorrect, per above Explanation:.

QUESTION 383

A firm with a higher degree of operating leverage when compared to the industry average implies that the:

A. Firm has higher variable costs.B. Firm's profits are more sensitive to changes in sales volume.C. Firm is more profitable.D. Firm uses a significant amount of debt financing.



Rule: Operating leverage is the presence of fixed costs in operations, which allows a small change in sales to produce a larger relative change in profits.Choice "b" is correct. A firm with a higher degree of operating leverage when compared to the industry average implies that the firm's profits are more sensitive tochanges in sales volume. Choice "a" is incorrect. Higher variable costs imply a lower degree of operating leverage. Choice "c" is incorrect. Profits will depend uponsales. Choice "d" is incorrect. A firm using a significant amount of debt financing has a higher degree of "financial leverage."

QUESTION 384Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debtand 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, andthe risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change?

A. No, because the cost of equity capital will increase.B. Yes, because the cost of equity capital will decrease.C. Yes, because the weighted average cost of capital will decrease.D. No, because the weighted average cost of capital will increase.



Choice "c" is correct. First, compute Datacomp's current weighted average cost of capital by using the capital asset pricing model (CAPM):

Because there is no debt, the WACC is equal to the CAPM formula for equity or 15.5%. When debt is introduced, the WACC is calculated by first using the CAPMto determine the required return on equity:

Assuming an after tax cost of debt is equal to 7.5%, the WACC becomes:(.165 × (.70)) + (.075 × (.3)) = 13.8%Therefore, Datacomp should change its capital structure because its WACC will decrease (Choice "c").Choices "a", "b", and "d" are incorrect, per above.

QUESTION 385The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital are:

A. Current dividends per share, expected growth rate in earnings per share, and current market price per share of common stock.B. Current earnings per share, expected growth rate in dividends per share, and current market price per share of common stock.C. Current earnings per share, expected growth rate in earnings per share, and current book value per share of common stock.D. Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock.

Correct Answer: DSection: Business Environment and Concepts (Volume D)Explanation


Choice "d" is correct. The three elements needed to estimate the cost of equity capital are:

1. Current dividends per share (D)2. Expected growth rate in dividends (g) and

3. Current market price per share of common stock (P)

The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost ofcapital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is: R = D/P + gChoice "d" is consistent with our text, the Explanation: and the Gordon Growth Model. Use of earnings per share, as suggested by choice "a" is sometimes referredto as the constant growth model and assumes that all earnings per share are either ultimately distributed or reinvested for the benefit of the shareholder. Earningsare anticipated to grow to infinity.

QUESTION 386A firm's target or optimal capital structure is consistent with which one of the following?

A. Minimum cost of debt.B. Minimum risk.C. Minimum cost of equity.D. Minimum weighted average cost of capital.


Explanation/Reference:Explanation:Choice "d" is correct. Minimum weighted average cost of capital is consistent with a firm's target or optimal capital structure.Choice "a" is incorrect. Minimum cost of debt is a component of minimum weighted average cost of capital.Choice "b" is incorrect. Minimum risk results in a cost of capital heavily weighted in equity. Choice "c" is incorrect. Minimum cost of equity results in a cost of capitalheavily weighted in debt.

QUESTION 387Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sellunlimited amounts of all instruments.

· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bondwould be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percentpreferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock iscurrently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. Thestock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 ofretained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equityfinancing.· Williams' preferred capital structure is:Long-term debt 30%Preferred stock 20

Common stock 50

The cost of funds from the sale of common stock for Williams, Inc. is:




Choice "b" is correct. 7.6%. Williams would receive $92 per share ($100 less $5 flotation cost and $3 underpricing) and pay an annual dividend of $7/share. Theannual cost is:

This question purely asks the cost of new common shares issued. The problem gives you the expected dividend to be paid annually ($7) and the net proceeds afterissue costs and market adjustments $92 (current selling price of $100 minus the $3 market adjustment and the $5 floatation costs). The cost of common sharesissued is the finance charge (dividend) divided by the net proceeds of the issue $92 or 7.6%.Choices "a", "c", and "d" are incorrect, per above.


· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bondwould be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percentpreferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock iscurrently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. Thestock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 ofretained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equityfinancing.· Williams' preferred capital structure is:

Long-term debt 30%Preferred stock 20Common stock 50

If Williams, Inc. needs a total of $200,000, the firm's weighted-average cost of capital would be closestto:




Choice "b" is correct. 6.6%. Williams' after tax cost of debt is 4.8% and cost of preferred stock is 8.4% ($105/share less issue costs of $5/share). The cost of equity(as calculated in a prior question) is 7.0%. This question pertains to the manner in which changes in the required amount of capital will impact the weighted averagecost of capital governed by the target capital structure. The rates are given, and you must derive the weights.The company needs a total of $200,000. The question gives you the amount of Retained Earnings at $100,000, the source of 7% dividend payments on commonshares. If all that is needed is $200,000, then, by definition, the target capital structure is "priced out" as shown with 7% common equity of $100,000 being equal to50% of the target capital structure totaling $200,000 without any modification:

Choices "a", "c", and "d" are incorrect, per the above Explanation:.


· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bondwould be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percentpreferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock iscurrently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. Thestock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 ofretained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equityfinancing.· Williams' preferred capital structure is:Long-term debt 30%Preferred stock 20Common stock 50

If Williams, Inc. needs a total of $1,000,000, the firm's weighted-average cost of capital would be:




Choice "a" is correct. 6.8%.This question pertains to the manner in which changes in the required amount of capital will impact the weighted average cost of capital governed by the targetcapital structure. The rates are given, and you must derive the weights.The company needs a total of $1,000,000. The total Retained Earnings is $100,000, which will only represent 10% of the total amount needed. In J92-1.01, wecomputed the cost of new common share issues at 7.6%, and we know that we can issue unlimited amounts of each security. Based on these assumptions, weknow that the target capital structure will remain unchanged but that the components of common equity will be priced differently because Retained Earnings onlyequals $100/$1,000 (or 10%).If the target capital structure calls for 50% common stock and only 10% is available from retained earnings, then 40% must come from the issuance of newcommon shares. The weighted average is computed as follows:

Choices "b", "c", and "d" are incorrect, per the above calculcation.

QUESTION 390Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the followingcorporate objectives is consistent with the announcement?

A. Maximize earnings per share.B. Minimize the cost of debt.C. Maximize the net worth of the firm.D. Minimize the cost of equity.



Choice "c" is correct. The optimal capital structure is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of thecompany. Choices "a", "b", and "d" are incorrect. Strategies (not objectives) for creating an optimal capital structure to maximize net worth include:

1. Maximizing earnings per share (choice "a").2. Minimizing the cost of debt (choice "b").3. Minimizing the cost of equity (choice "d").4. Maximizing cash flow (choice not given).

QUESTION 391Youngsten Electric is contemplating new projects for the next year that will require $30,000,000 of new financing. In keeping with its capital structure, Youngstenplans to use debt & equity financing as follows:

* Issue $10,000,000 of 20-year bonds at a price of 101.5, with a coupon of 10%, and flotation costs of 2.5% of par value.

* Use internal funds generated from earnings of $20,000,000.

The equity market is expected to earn 15%. U.S. treasury bonds currently are yielding 9%. The beta coefficient for Youngsten's common stock is estimated to be .8.Youngsten is subject to a 40% corporate income tax rate. Youngsten has a price/earnings ratio of 10, a constant dividend payout ratio of 40%, and an expectedgrowth rate of 12%.An analysis of Youngsten's planned equity financing using Capital Asset Pricing Model (or Security Market Line) would incorporate only the:

A. Expected market earnings, the current U.S. Treasury bond yield, and the beta coefficient.B. Expected market earnings and the price' earnings ratio.C. Current U.S. Treasury bond yield, the price/earnings ratio, and the beta coefficient.D. Current U.S. Treasury bond yield and the dividend payout ratio.



Choice "a" is correct. The capital asset pricing model formula is:

R = RF + B (RM-RF)

Where:R = Required return rate on equityRF = Risk free rate earned on U.S. treasury bonds.B = Beta coefficientRM = Expected market return (earnings).

Choices "b", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 392

Additional Data

· The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.· Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds. · The current risk-free rate (U.S. treasury bonds) is 7 percent. · Martin'scommon stock is currently selling at $32 per share.· The expected market return is currently 15 percent.· The beta value for Martin is 1.25.· Martin's effective corporate income tax rate is 40 percent.

Using the Capital Asset Pricing Model (CAPM), Corporation's current cost of common equity is:


Correct Answer: C

Section: Business Environment and Concepts (Volume D)Explanation


Choice "c" is correct. 17.00 percent. Using the CAPM model, Martin's current cost of common equity would be:

Cost of equity = Capital risk free rate + Beta (market rate - risk free rate) Cost of equity = 7% + 1.25 (15% - 7%)Cost of equity = 7% + 1.25 (8%)Cost of equity = 7% + 10%Cost of equity = 17%

QUESTION 393DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance theinvestment.

· Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par.· Use $35 million of funds generated from earnings.

The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent. The beta coefficient for DQZ is estimated to be .60. DQZ issubject to an effective corporate income tax rate of 40 percent.The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is:




Choice "b" is correct. 8.08 percent before-tax cost of debt financing, net of flotation costs.

QUESTION 394Assume the following facts about Martin Corporation:

· The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.· Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds. · The current risk-free rate (U.S. treasury bonds) is 7 percent. · Martin'scommon stock is currently selling at $32 per share.· The expected market return is currently 15 percent.· The beta value for Martin is 1.25.· Martin's effective corporate income tax rate is 40 percent.

Based on these assumptions, what is the current net after-tax cost of debt for Martin Corporation?




Choice "c" is correct. 5.1 percent current net cost of debt. The fact pattern states that debt can be currently secured at 150 basis points above the Treasury bondrate. A basis point is equal to 1/100 of 1% (1% of 1%).Applying the decimals it's:150 basis points x 1/100 of 1% (or .0001)this yields .015 or 1.5%

Add the additional basis points converted to percentage (1.5%) to the Treasury bond rate of 7% to arrive at the pre-tax debt cost of 8.5%. Apply 1 - tax rate to arriveat the current net cost of debt as follows:

QUESTION 395When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying:

A. Working capital management.B. Return maximization.C. Financial leverage.D. Operating leverage.



Choice "a" is correct. Appropriate working capital management matches the maturity life of each asset with the length of the financial instrument used to financethat asset. Choice "b" is incorrect. Return maximization seeks to obtain the optimal return rate by asset utilization. It is not necessarily related to the maturity of theasset. Choice "c" is incorrect. Financial leverage is the amount of debt used to finance an asset. Higher leverage equals more debt. It is unrelated to the maturity lifeof an asset. Choice "d" is incorrect. Operating leverage is the degree that fixed costs are used in the production process. Operating leverage is unrelated to themethods used to finance assets.

QUESTION 396Net working capital is the difference between:

A. Current assets and current liabilities.B. Fixed assets and fixed liabilities.C. Total assets and total liabilities.D. Total assets and current liabilities.



Choice "a" is correct. Current assets minus current liabilities equals net working capital. Choices "b", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 397Which one of the following would increase the working capital of a firm?

A. Purchase of a new plant financed by a 20-year mortgage.B. Cash collection of accounts receivable.C. Payment of a 20-year mortgage payable with cash.D. Refinancing a short-term note payable with a two-year note payable.



Choice "d" is correct. Refinancing a short-term note payable with a two-year note payable would increase the working capital of a firm.

Choice "a" is incorrect. The purchase of a new plant (fixed asset) financed by a 20-year mortgage (longterm debt with a one-year current portion) would reduceworking capital because current liabilities would be increased.Choice "b" is incorrect. The cash collection of accounts receivable has no effect on working capital- cash increases by the amount that A/R decreases.Choice "c" is incorrect. The payment of a 20-year mortgage payable (long-term debt) would reduce cash and have no effect on current liabilities, thereby reducingworking capital.

QUESTION 398If a firm increases its cash balance by issuing additional shares of common stock, working capital:

A. Remains unchanged and the current ratio remains unchanged.B. Increases and the current ratio remains unchanged.C. Increases and the current ratio decreases.D. Increases and the current ratio increases.



Choice "d" is correct. If a firm increases its cash balance by issuing additional shares of common stock, working capital increases and the current ratio increases.

QUESTION 399A firm has daily cash receipts of $100,000. A bank has offered to reduce the collection time on the firm's deposits by two days for a monthly fee of $500. If moneymarket rates are expected to average 6 percent during the year, the net annual benefit (loss) from having this service is:

A. $3,000B. $12,000C. $6,000D. $(6,000)



Choice "c" is correct. $6,000 net annual benefit from using a lockbox system.

QUESTION 400Determining the appropriate level of working capital for a firm requires:

A. Changing the capital structure and dividend policy of the firm.B. Maintaining short-term debt at the lowest possible level because it is generally more expensive than long-term debt.C. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.

D. Maintaining a high proportion of liquid assets to total assets in order to maximize the return on total investments.



Choice "c" is correct. Determining the appropriate level of working capital for a firm requires offsetting the benefit of current assets and current liabilities against theprobability of technical insolvency. Choice "a" is incorrect. Changing the capital structure (common stock vs. preferred stock vs. long-term debt) and dividend policyhas nothing to do with the level of working capital required for day-to-day operations of the business.Choice "b" is incorrect. The relative interest cost of short-term vs. long-term debt does not determine the appropriate level of working capital.Choice "d" is incorrect. Because profitability varies inversely with liquidity, maximizing the return on total investments would require a low (not high) level of liquidassets and a high level of liquid assets does nothing to determine the required level of working capital.

QUESTION 401As a company becomes more conservative in its working capital policy, it would tend to have a (n):

A. Decrease in its acid-test ratio.B. Increase in the ratio of current assets to units of output.C. Increase in funds invested in common stock and a decrease in funds invested in marketable securities.D. Decrease in its level of permanent working capital.



Choice "b" is correct. As a company becomes more conservative in its working capital policy, it would tend to have an increase in the ratio of current assets to unitsof output. Choice "a" is incorrect. Acid-test ratio would tend to increase with conservatism. Choice "c" is incorrect. Marketable securities investments would tend toincrease while common stock investments would tend to decrease.Choice "d" is incorrect. Permanent working capital would tend to increase.

QUESTION 402Which of the following transactions does not change the current ratio and does not change the total current assets?

A. A cash advance is made to a divisional office.

B. A cash dividend is declared.C. Short-term notes payable are retired with cash.D. Equipment is purchased with a three-year note and a 10 percent cash down payment.



Choice "a" is correct. This does not change the current ratio because the reduction of cash is offset by an increase in accounts receivable.Choice "b" is incorrect. A cash dividend increases current liabilities without increasing current assets. Although current assets remain unchanged (until the paymenthappens), the current ratio will change. Choice "c" is incorrect. Cash is reduced and current liabilities are reduceD. Total current assets will change (they will bereduced).Choice "d" is incorrect. The payment of cash reduces current assets. Long-term assets are increased, as well as long-term and short-term liabilities. The currentratio is reduced.

QUESTION 403The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations is the policy that finances:

A. Fluctuating current assets with long-term debt.B. Permanent current assets with long-term debt.C. Permanent current assets with short-term debt.D. Fluctuating current assets with short-term debt.



Choice "c" is correct. The working capital financing policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of beingunable to meet the firm's maturing obligations.Choices "a" and "b" are incorrect because the use of long-term debt financing produces the smallest risk of being unable to meet maturing obligations.Choice "d" is incorrect because, although financing fluctuating current assets with short-term debt exposes the firm to some risk, it is not the greatest or thesmallest.

QUESTION 404

When managing cash and short-term investments, a corporate treasurer is primarily concerned with:

A. Maximizing rate of return.B. Minimizing taxes.C. Investing in common stock due to the dividend exclusion for federal income tax purposes.D. Liquidity and safety.



Choice "d" is correct. When managing cash and short-term investments, a corporate treasurer is primarily concerned with liquidity and safety.Choice "a" is incorrect. The board of directors and general management would be interested in maximizing rate of return on company operations.Choices "b" and "c" are incorrect. The tax manager would be interested in minimizing taxes, and investing in common stock due to the dividend exclusion for federalincome tax purposes.

QUESTION 405An increase in sales collections resulting from an increased cash discount for prompt payment would be expected to cause a (n):

A. Increase in the operating cycle.B. Increase in the average collection period.C. Decrease in the cash conversion cycle.D. Increase in bad debt losses.



Choice "c" is correct. An increase in sales collections would decrease the cash conversion cycle. Choice "a" is incorrect because the operating cycle (as well as thecash conversion cycle) would decrease.Choice "b" is incorrect, as the average collection period would decrease. Choice "d" is incorrect. Bad debt losses would decrease from an increase in salescollections.

QUESTION 406

Wyley Inc. purchases an item on credit with terms of 3/10, net 45. Based on a 360-day year, Wyley's annual interest cost of foregoing the cash discount and makingpayment on the last day of the credit period is:

A. 24.00%B. 30.86%C. 31.81%D. 37.11%



Choice "c" is correct. The formula for computing the cost of credit discounts is:


QUESTION 407A firm can best delay disbursements through the use of:

A. A centralized disbursement function.B. Drafts.C. Factoring.D. Trade discounts.



Choice "b" is correct. Paying by means of a draft (or check) allows the firm to take advantage of the float period. This delays cash disbursements.Choice "a" is incorrect. A centralized disbursement function will not necessarily delay cash disbursements.Choice "c" is incorrect. Factoring is the sale of accounts receivable to a factor. This has no effect on cash disbursements.Choice "d" is incorrect. Trade discounts are discounts on account receivable and do not impact cash disbursements.

QUESTION 408The following information applies to Brandon Company.

Forty percent of purchases are paid for in cash at the time of purchase, and 30 percent is paid for in each of the next two months. Purchases for the previousNovember and December were $150,000 per month.Payroll is 10 percent of sales in the month it occurs, and operating expenses are 20 percent of the following months sales (July sales were $220,000). Interestpayments were $20,000 paid quarterly in January and April. Brandon's cash disbursements for the month of April were:

A. $152,000B. $200,000C. $248,000D. $254,000



Explanation:

Choice "d" is correct. Cash disbursements in April would include paying for purchases made in February and March. It would also include payroll expense andoperating expenses. The calculation would be:

Choices "a", "b", and "c" are incorrect, per above calculations.

QUESTION 409Newman Products has received proposals from several banks to establish a lockbox system to speed up receipts. Newman receives an average of 700 checks perday averaging $1,800 each, and its cost of short-term funds is 7 percent per year. Assuming that all proposals will produce equivalent processing results and usinga 360-day year, which one of the following proposals is optimal for Newman?

A. A flat fee of $125,000 per year.B. A fee of 0.03 percent of the amount collected.C. A compensating balance of $1,750,000.D. A fee of $0.35 per check plus 0.01 percent of the amount collected.



Choice "c" is correct. The optimal proposal is that which has the lowest cost for Newman.

Thus, the lowest cost is "c" at $122,500.Choices "a", "b", and "d" are incorrect, per the above calculations/Explanation:.

QUESTION 410The treasury analyst for Garth Manufacturing has estimated the cash flows for the first half of next year (ignoring any short-term borrowings) as follows:

Garth has a line of credit of up to $4 million on which it pays interest monthly at a rate of 1 percent of the amount utilized. Garth is expected to have a cash balanceof $2 million on January 1 and no amount utilized on its line of credit. Assuming all cash flows occur at the end of the month, approximately how much will Garth payin interest during the first half of the year?

A. $61,000B. $80,000C. $132,000D. $240,000



Choice "a" is correct. First, determine the amount and timing of cash needs:

Comments1 Given2 Computed balance, positive cash flows3 Computed balance, negative cash flows4 Borrow from LOC5 Computed balance, negative cash flows + interest6 Cumulative LOC Balance7 Computed positive cash flows8 Computed balance, positive cash flows - interest9 Immediate pay down of LOCChoices "b", "c", and "d" are incorrect, per the above calculation.

QUESTION 411MFC Corporation has 100,000 shares of stock outstanding. Below is part of MFC's Statement of Financial Position for the last fiscal year.

What is the maximum amount MFC can pay in cash dividends per share and maintain a minimum current ratio of 2 to 1? Assume that all accounts other than cashremain unchanged.

A. $2.05B. $2.50C. $3.35D. $3.80



Choice "b" is correct. The current ratio is found by dividing current assets by current liabilities.Presently current assets are:

Because current liabilities must be two times current liabilities, the current assets cannot go below $1,800,000. Thus current assets can go down:

On a per share basis this is $250,000 / 100,000 shares or $2.50 per share. Choices "a", "c", and "d" are incorrect, per the above calculation.

QUESTION 412Kemple Cleaning Services is a newly established janitorial firm, and the owner is deciding which type of checking account to open. Kemple is planning to keep a$500 minimum balance in the account for emergencies and plans to write an average of 80 checks per month. The bank charges $10 per month plus a $0.10 percheck charge for a standard business checking account with no minimum balance. Kemple also has the option of a premium business checking account, whichrequires a $2,500 minimum balance but has no monthly fees or per check charges. If Kemple's cost of funds is 10 percent, which account should Kemple choose?

A. Standard account, since the savings is $34 per year.B. Premium account, since the savings is $34 per year.C. Standard account, since the savings is $16 per year.D. Premium account, since the savings is $16 per year.



Choice "d" is correct. The total cost for a standard account is:

Cost per year for premium is cost of the extra amount ($2,000) that Kemple must maintain in the account.Total per year premium (10% × $2,000) = $200The premium account will save $16.Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 413The collection of accounts receivable can be accelerated by the use of:

A. Turnaround documents.B. A lockbox system.C. Bank drafts.D. Remittance advices.



Choice "b" is correct. Lockboxes are systems of mailboxes, usually in many locations, where customers send payments. The company's bank checks thesemailboxes frequently and immediately deposits checks received. This accelerates the collection of accounts receivable. Choice "a" is incorrect. A turnarounddocument is a computer output that can later be used as a source document. No relevance to A/R collections.Choice "c" is incorrect. A bank draft is a document issued by a bank to indicate that payment has been made.Choice "d" is incorrect. A bank remittance advice is a document generated by a bank to indicate that payment has been made by a customer.

QUESTION 414A working capital technique that increases the payable float and, therefore, delays the outflow of cashis:

A. Concentration banking.B. A draft.C. A lock-box system.D. The use of a local post office box.


Explanation/Reference:Explanation:Choice "b" is correct. A draft is a working capital technique that increases the payable float and, therefore, delays the outflow of cash.Each of the three following choices accelerate the flow of cash and/or data:Choice "a" is incorrect. Concentration banking automatically channels funds from every source of the business into a single usable account, thus quickly identifyingavailable funds each day, and moving them to accounts that have funding requirements that day, and investing the remainder in short-term, interestbearinginstruments until needed.Choice "c" is incorrect. A lock-box system is simply a central collection location that receives payment checks (generally, the bank where a central checking accountis maintained by the firm). Choice "d" is incorrect. The use of a local post office box allows more rapid access to mail than actual delivery to a street address.

QUESTION 415Hagar Company's bank requires a compensating balance of 20 percent on a $100,000 loan. If the stated interest on the loan is 7 percent, what is the effective costof the loan?




Choice "d" is correct. Total interest for the loan is $100,000 × 7% or $7,000. The effective amount received is $80,000 after the 20% compensating balance. Theeffective interest is $7,000 / $80,000 = 8.75%Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 416Which one of the following represents methods for converting accounts receivable to cash?

A. Trade discounts, collection agencies, and credit approval.B. Factoring, pledging, and electronic funds transfers.C. Cash discounts, collection agencies, and electronic funds transfers.D. Trade discounts, cash discounts, and electronic funds transfers.



Choice "c" is correct. The following are methods of converting accounts receivable (AR) into cash:

1. Collection agencies - used to collect overdue AR.2. Factoring AR - selling AR to a factor for cash.3. Cash discounts - offering cash discounts to customers for paying AR quickly (or paying at all).For example: 2/10, net 30.4. Electronic fund transfers - a method of payment, which electronically transfers funds between banks.

Therefore, only choice "c" matches the above list.Choice "a" is incorrect. Trade discounts offer discounts on future merchandise purchases offered to trade customers. These discounts do not turn AR into cash.Choice "b" is incorrect. Pledging AR as collateral on a loan does not convert AR into cash.Choice "d" is incorrect, per choice for "a" above.

QUESTION 417Foster Inc. is considering implementing a lock-box collection system at a cost of $80,000 per year. Annual sales are $90 million, and the lock-box system willreduce collection time by 3 days. If Foster can invest funds at 8 percent, should it use the lock-box system? Assume a 360-day year.

A. Yes, producing savings of $60,000 per year.B. No, producing a loss of $20,000 per year.C. No, producing a loss of $60,000 per year.D. No, producing a loss of $140,000 per year.



Choice "b" is correct. No, do not use the lock-box system, which produces a loss of $20,000 per year.

QUESTION 418When a company offers credit terms of 2/10, net 30, the annual interest cost, based on a 360-day year,is:




Choice "d" is correct. The formula for calculating the cost of a credit policy is:

Therefore, the cost of customers taking this discount is 36.7% of the invoice price of the sale. Choices "a", "b", and "c" are incorrect, per the above answer.

QUESTION 419If a firm's credit terms require payment within 45 days but allow a discount of 2 percent if paid within 15 days (using a 360 day year), the approximate cost/benefit ofthe trade credit terms is:

A. 16 percent.B. 48 percent.C. 24 percent.D. 36 percent.



Choice "c" is correct. The formula for computing the cost/benefit for trade discounts is:

Choice is 24% ("c").Choices "a", "b", and "d" are incorrect, per the above calculations.

QUESTION 420Using a 360-day year, what is the opportunity cost to a buyer of not accepting terms 3/10, net 45?




Choice "b" is correct. 31.81%Formula:

QUESTION 421Which one of the following statements concerning cash discounts is correct?

A. The cost of not taking a 2/10, net 30 cash discount is usually less than the prime rate.B. With trade terms of 2/15, net 60, if the discount is not taken, the buyer receives 45 days of free credit.C. The cost of not taking the discount is higher for terms of 2/10, net 60 than for 2/10, net 30.D. The cost of not taking a cash discount is generally higher than the cost of a bank loan.



Choice "d" is correct. The cost of not taking a cash discount is generally higher than the cost of a bank loan.Choice "a" is incorrect. The cost of not taking a 2/10, net 30 cash discount is usually more than the prime rate.Choice "b" is incorrect. With trade terms of 2/15, net 60, if the discount is not taken, the buyer receives 60 (not 45) days of free credit.Choice "c" is incorrect. The cost of not taking the discount is lower (not higher) for terms of 2/10, net 60 than for 2/10, net 30.

QUESTION 422Commercial paper:

A. Has a maturity date greater than one year.B. Is generally sold only through investment banking dealers.C. Generally does not have an active secondary market.D. Has an interest rate lower than treasury bills.



Choice "c" is correct. Although commercial paper has a secondary market available, it is generally not an active secondary market. Commercial paper is usuallysold to the money markets by highly creditworthy companies.Choice "a" is incorrect. The maturity dates are generally less than 270 days. Choice "b" is incorrect. Commercial paper can be sold to the money markets through avariety of intermediaries including brokers, dealers, investment brokers, etC. It can also be sold direct from one company to another.Choice "d" is incorrect. The interest rate on commercial paper is below the prime rate, but generally above the Treasury bill rate.

QUESTION 423Which one of the following is not a characteristic of a negotiable certificate of deposit? Negotiable certificates of deposit:

A. Have a secondary market for investors.B. Are regulated by the Federal Reserve System.C. Are usually sold in denominations of a minimum of $100,000.D. Have yields considerably greater than bankers' acceptances and commercial paper.



Choice "d" is correct. Negotiable CDs generally carry interest rates slightly lower than bankers' acceptances (which are drafts drawn on deposits at a bank) orcommercial paper (which is unsecured debt issued by credit worthy customers).Choice "a" is incorrect. Negotiable CDs have a formal secondary market. Choice "b" is incorrect. Negotiable CDs are a product of the banking industry, which isregulated by the Federal Reserve Board.Choice "c" is incorrect. Negotiable CDs are usually sold in denominations of a minimum of $100,000.

QUESTION 424All of the following are alternative marketable securities suitable for investment, except:

A. Eurodollars.B. Commercial paper.C. Bankers' acceptances.D. Convertible bonds.


Explanation/Reference:Explanation:Choice "d" is correct. Convertible bonds. Temporarily idle cash should be inverted in very liquid, low risk short-term investments only. U.S. T-bills are basically risk-free. Banker's acceptances and Eurodollars are only slightly more risky. Commercial paper, the short-term unsecured notes of the most credit-worthy large U.S.corporations is a little riskier, but still relatively low risk. However, convertible bonds are subject to default risk, liquidity risk, and maturity (interest rate) risk, and assuch are inappropriate securities for short-term marketable security investment.

QUESTION 425Which one of the following responses is not an advantage to a corporation that uses the commercial paper market for short-term financing?

A. The borrower avoids the expense of maintaining a compensating balance with a commercial bank.B. There are no restrictions as to the type of corporation that can enter into this market.C. This market provides a broad distribution for borrowing.D. A benefit accrues to the borrower because its name becomes more widely known.



Choice "b" is correct. There are restrictions as to the type of corporation that can enter into the commercial paper market for short-term financing, since the use ofthe open market is restricted to a comparatively small number of the most credit-worthy large corporations.The commercial paper market:

A. Avoids the expense of maintaining a compensating balance with a commercial bank.C. Provides a broad distribution for borrowing.D. Accrues a benefit to the borrower because its name becomes more widely known.

QUESTION 426Corbin Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be $1,200. The effective annualizedpercentage cost of the financing, based on a 360-day year, would be:

A. 2.16%B. 8.48%C. 8.65%D. 8.00%



Choice "c" is correct. The cost to issue the commercial paper is the $20,000 original issue discount ($1 million - $980,000), plus transaction costs of $1,200 for atotal of $21,200. Therefore, it costs $21,200 to borrow $980,000 for 3 months. The 3-month interest cost is 2.16% ($21,200 / $980,000).The annual interest cost is 8.65%Choices "a", "b", and "d" are incorrect, per the above calculation.

QUESTION 427All of the following are valid reasons for a business to hold cash and marketable securities, except to:

A. Satisfy compensating balance requirements.B. Maintain adequate cash needed for transactions.C. Maintain a precautionary balance.D. Earn maximum returns on investment assets.

Correct Answer: DSection: Business Environment and Concepts (Volume D)

Explanation


Choice "d" is correct. There are three primary motives for holding cash:

1. Transactions demand2. Precautionary demand3. Speculative demand

However, cash is generally held in very short-term liquid investments which are low risk, low return.

QUESTION 428The marketable securities with the least amount of default risk are:

A. Federal government agency securities.B. U.S. treasury securities.C. Repurchase agreements.D. Bankers' acceptances.


Explanation/Reference:Explanation:Choice "b" is correct. Default risk is the risk that the security will not be repaid because the issuing entity is insolvent or illiquid. U.S. Treasury securities are issuedby the Treasury Department, which has virtually no risk of being insolvent or illiquid.Choice "a" is incorrect. Securities issued by certain federal government agencies carry slightly more default risk than U.S. treasuries because these agencies are(usually) not as large or liquid as the U.S.Treasury.Choice "c" is incorrect. Repurchase agreements are sales by dealers in government securities who agree to repurchase these securities at a specific time andprice. The risk of default is high because it is based upon the ability of the dealer to repurchase the securities. Choice "d" is incorrect. Bankers' acceptances aredrafts drawn on a bank, which guarantees payment at maturity. The default risk is higher because the execution of the acceptance is based upon the solvency ofthe bank.

QUESTION 429When purchasing temporary investments, which one of the following best describes the risk associated with the ability to sell the investment in a short period of timewithout significant price concessions?

A. Interest rate risk.B. Purchasing power risk.C. Financial risk.D. Liquidity risk.



Choice "d" is correct. Liquidity risk is associated with the ability to sell the temporary investment in a short period of time without significant price concessions.Choice "a" is incorrect. Interest rate risk is the fluctuation in the value of a "financial asset" when interest rates change.Choice "b" is incorrect. Purchasing power risk is the risk that price levels will change and affect asset values (mostly real estate).Choice "c" is incorrect. Financial risk is a general category of risk that includes:

· Interest rate risk· Market risk· Purchasing power risk· Liquidity risk· Default risk

QUESTION 430A firm averages $4,000 in sales per day and is paid, on an average, within 30 days of the sale. After they receive their invoice, 55 percent of the customers pay bycheck, while the remaining 45 percent pay by credit card. Approximately how much would the company show in accounts receivable on its balance sheet on anygiven date?

A. $120,000B. $48,000C. $54,000D. $21,600



Choice "a" is correct. $120,000 accounts receivable approximation. There is no effect on total A/R based on how (i.e., check or credit card) the customers actuallypay their A/R.

QUESTION 431A company plans to tighten its credit policy. The new policy will decrease the average number of days in collection from 75 to 50 days and will reduce the ratio ofcredit sales to total revenue from 70 to 60 percent. The company estimates that projected sales would be five percent less if the proposed new credit policy isimplemented. If projected sales for the coming year are $50 million, calculate the dollar impact on accounts receivable of this proposed change in credit policy.Assume a 360-day year.

A. $3,817,445 decrease.B. $6,500,000 decrease.C. $3,333,334 decrease.D. $18,749,778 increase.



Choice "c" is correct. $3,333,334 decrease in accounts receivable.

QUESTION 432

A company enters into an agreement with a firm who will factor the company's accounts receivable. The factor agrees to buy the company's receivables, whichaverage $100,000 per month and have an average collection period of 30 days. The factor will advance up to 80 percent of the face value of receivables at anannual rate of 10 percent and charge a fee of 2 percent on all receivables purchased. The controller of the company estimates that the company would save$18,000 in collection expenses over the year.Fees and interest are not deducted in advance. Assuming a 360-day year, what is the annual cost of financing?




Choice "d" is correct. 17.5% annual cost of financing.

QUESTION 433Gartshore Inc. is a mail-order book company. The Company recently changed its credit policy in an attempt to increase sales. Gartshore's variable cost ratio is 70percent and its required rate of return is 12 percent. The company projects that annual sales will increase from the current level of $360,000 to $432,000, but theaverage collection period on receivables will go from 30 days to 40 days. Ignoring any tax implications, what is the cost of carrying the additional investment inaccounts receivable, using a 360-day year?

A. $1,512B. $2,000C. $2,160D. $12,600



Choice "a" is correct. The cost of carrying accounts receivable now is the variable cost of creating the account receivable times the cost of that capital during thecollection period. The cost of the investment in accounts receivable is now:

Choice "c" is incorrect. This considers the entire account receivable as a cost. Choices "b" and "d" are incorrect, per the above calculation.

QUESTION 434Which of the following represents a firm's average gross receivable balance?

A. Days' sales in receivables x accounts receivable turnover.II. Average daily sales x average collection period.III. Net sales ÷ average gross receivables.

B. I only.C. I and II only.D. II only.

E. II and III only.



Choice "c" is correct. II only - Average daily sales ($27,397) × Average collection period (36.5) = $1,000,000 Avg gross A/RNot I - Days' sales in receivables (36.5) × AR turnover 10 = 365 days in year. Not III - Net sales ($10,000,000) ÷ Avg gross receivables ($1,000,000) = 10 ARturnover.

QUESTION 435Clauson Inc. grants credit terms of 1/15, net 30 and projects gross sales for next year of $2,000,000. The credit manager estimates that 40 percent of theircustomers pay on the discount date, 40 percent on the net due date, and 20 percent pay 15 days after the net due date. Assuming uniform sales and a 360- dayyear, what is the projected days sales outstanding (rounded to the nearest whole day)?

A. 20 days.B. 24 days.C. 27 days.D. 30 days.



Choice "c" is correct. 27 days projected days sales outstanding.

QUESTION 436A change in credit policy has caused an increase in sales, an increase in discounts taken, a reduction in the investment in accounts receivable, and a reduction inthe number of doubtful accounts. Based upon this information, we know that:

A. Net profit has increased.B. The average collection period has decreased.C. Gross profit has declined.D. The size of the discount offered has decreased.



Choice "b" is correct. Whenever accounts receivable (AR) are decreasing when sales are increasing (and the decrease in AR is not due to an increase in bad debtwrite offs), this would indicate that the average collection period for AR has decreased.Choices "a", "c", and "d" are incorrect. There is insufficient information in the question to draw conclusions about these items.

QUESTION 437The following information regarding a change in credit policy was assembled by the Wilson Wax Company. The company has a required rate of return of 10 percentand a variable cost ratio of 60 percent.

The pretax cost of carrying the additional investment in receivables, using a 360-day year, would be:

A. $5,760B. $9,600C. $8,160D. $960



Choice "a" is correct.Step 1 Determine the average accounts receivable balance and the additional accounts receivable as follows:

Therefore, the accounts receivable balance is $96,000 higher under the new credit policy. Step 2 Determine the additional INVESTMENT in the additional accountsreceivable. Although Wilson has an additional $96,000 in accounts receievable, Wilson's actual investment in the additional accounts receivable is only 60% of$96,000 (because variable costs are 60% of sales). Wilson's investment in the additional accounts receivable is calculated as follows:$96,000 x 60% = $57,600

Step 3 Calculate the cost of carrying the additional accounts receivable. Wilson's additional investment in accounts receivable is $57,600 and we are given a 10%required rate of return. This means that Wilson's carrying cost of $5,760 is calculated as follows:$57,600 x 10% = $5,760


QUESTION 438An organization would usually offer credit terms of 2/10, net 30 when:

A. The organization can borrow funds at a rate less than the annual interest cost.B. The cost of capital approaches the prime rate.C. Most competitors are not offering discounts, and the organization has a surplus of cash.D. Most competitors are offering the same terms, and the organization has a shortage of cash.



Explanation:

Choice "d" is correct. Offering favorable credit terms is usually a response to either competitive forces in the market or to improve cash flow.Choice "a" is incorrect, although the payment terms of AR is a form of borrowing (or lending) to customers, companies are more likely to extend credit termsbecause of competitive pressures rather than because it represents a cheaper form of borrowing.Choice "b" is incorrect. The cost of capital at (or approaching) the prime rate is irrelevant without additional information.Choice "c" is incorrect. If most competitors are not offering discounts or credit terms, there is no reason to offer them. Also, if there is a surplus of cash, there is noreason to accelerate accounts receivable collection by offering credit terms.

QUESTION 439The average collection period for a firm measures the number of days:

A. After a typical credit sale is made until the firm receives the payment.B. It takes a typical check to "clear" through the banking system.C. Before a typical account becomes delinquent.D. In the inventory cycle.



Choice "a" is correct. The average collection period for a firm measures the number of days after a typical credit sale is made until the firm receives the payment.Choice "b" is incorrect. "Float" measures the number of days it takes a typical check to "clear" through the banking system.Choice "c" is incorrect. "Credit period (term)" measures the number of days before a typical account becomes delinquent.Choice "d" is incorrect. "Average days sales in inventory" measures the number of days in the inventory cycle.

QUESTION 440A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company'saverage collection period for new customers is expected to be 75 days; and the payment behavior of the existing customers is not expected to change.Variable costs are 80 percent of sales. The firm's opportunity cost is 20 percent before taxes. Assuming a 360-day year, what is the company's benefit (loss) on theplanned change in credit terms?

A. $28,800B. $144,000C. $120,000D. $126,000



Choice "c" is correct. $120,000 benefit on the planned change in credit standards.

This question pertains to the economic benefit associated with a change in credit terms. The question tells us that the credit sales will increase by $720,000 if werelax our credit terms. We know variable costs are 80%, so we will earn $144,000 as a result of the expanded sales. The 20% contribution margin is equal to the20% opportunity cost so there is no better investment of our resources for the expanded credit sales relative to its margin.What about the variable costs, though?

We have $576,000 in variable costs that will be outstanding, pro rata, 75 days of the year. So the resources we will use to produce our sales is 75/360ths of$576,000, or $120,000 at any given time during the year. These $120,000 in resources could earn 20% annual return or $24,000. The $24,000 opportunity cost,compared to the $144,000 margin results in a $120,000 benefit in relaxing credit terms.Choices "a", "b", and "d" are incorrect, per the above calculation/discussion.

QUESTION 441A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investmentin accounts receivable. Based upon this information, the company's:

A. Average collection period has decreased.B. Percentage discount offered has decreased.C. Accounts receivable turnover has decreased.D. Working capital has increased.



Choice "a" is correct. Average collection period has decreased due to a change in credit policy that has caused:

1. Increase in sales,2. Increase in discounts taken,3. Decrease in the amount of bad debt; and4. Decrease in the investment in accounts receivable

Choice "b" is incorrect. Percentage discount offered has probably increased, as discounts taken has increased.Choice "c" is incorrect. Accounts receivable turnover has increased, as sales are up and accounts receivable are down.Choice "d" is incorrect. Change in gross profit and working capital is not determinable from these facts.

QUESTION 442Which one of the following statements is most correct if a seller extends credit to a purchaser for a period of time longer than the purchaser's operating cycle? Theseller:

A. Will have a lower level of accounts receivable than those companies whose credit period is shorter than the purchaser's operating cycle.B. Is, in effect, financing more than just the purchaser's inventory needs.C. Is, in effect, financing the purchaser's long-term assets.D. Has no need for a stated discount rate or credit period.



Choice "b" is correct. If a seller extends credit to a purchaser for a period of time longer than the purchaser's operating cycle, the seller is, in effect, financing morethan just the purchaser's inventory needs.Choice "a" is incorrect. Accounts receivable would be higher than those companies whose credit period is shorter than the purchaser's operating cycle.Choice "c" is incorrect. Seller is financing the purchaser, but not necessarily long-term assets. Choice "d" is incorrect. It is appropriate for the seller to have statedpolicies for discount rate and credit periods.

QUESTION 443The sales manager at Ryan Company feels confident that if the credit policy at Ryan's was changed, sales would increase and, consequently, the company wouldutilize excess capacity. The two credit proposals being considered are as follows:

Currently, payment terms are net 30. The proposal payment terms for Proposal A and Proposal B are net 45 and net 90, respectively. An analysis to compare thesetwo proposals for the change in credit policy would include all of the following factors, except the:

A. Cost of funds for Ryan.B. Current bad debt experience.C. Impact on the current customer base of extending terms to only certain customers.D. Bank loan covenants on days sales outstanding.



Choice "b" is correct. Because the bad debt percentage is the same under either of the two proposals, there is no differential cost associated with bad debt.Because it is not a differential cost, it is not considered in comparing the two alternatives.Choice "a" is incorrect. Because Proposal A and B have different net collection dates, Proposal B will cause a greater amount of accounts receivable with acorresponding increase in working capital. The cost to fund this will be greater for Proposal B, so this is a legitimate concern. Choice "c" is incorrect. Customersmay feel they should be given the extended terms. If this is granted, the additional working capital need will be even greater. Choice "d" is incorrect. Banks mayrequire that days sales outstanding cannot exceed a certain number of days. If so, it will be harder to meet this covenant with Proposal B.

QUESTION 444The amount of inventory that a company would tend to hold in safety stock would increase as the:

A. Cost of carrying inventory decreases.B. Variability of sales decreases.C. Costs of running out of stock decreases.D. Length of time that goods are in transit decreases.



Choice "a" is correct. As the cost of carrying inventory decreases, safety stock would tend to increase to reduce the risk of stock outs.Choice "b" is incorrect. As sales become more predictable (sales variability decreases), less (not more) safety stock would be needed because the risk of stockouts would have decreased. Choice "c" is incorrect. If the cost of stock outs decrease, safety stock would decrease. Choice "d" is incorrect. If lead-time decreases,safety stock would decrease.

QUESTION 445The level of safety stock in inventory management depends on all of the following, except the:

A. Level of uncertainty of the sales forecast.B. Level of customer dissatisfaction for back orders.C. Level of uncertainty in lead-time for stock shipments.D. Cost to reorder stock.



Choice "d" is correct. Reorder costs do not impact the level of safety stock. Choices "a", "b", and "c" are incorrect. Safety stock levels are affected by:1. Uncertain sales forecasts - greater uncertainty means a higher level of safety stock should be carried.2. Dissatisfaction of customers - if customers are dissatisfied with back orders (which occur when there are stock outs), then more safety stock should be carried toprevent stock outs.3. Uncertain lead times - greater uncertainty means a higher level of safety stock is needed.

QUESTION 446The following information regarding inventory policy was assembled by the JRJ Corporation. The company uses a 50-week year in all calculations.

The reorder point is:

A. 3,300 units.B. 2,100 units.C. 1,300 units.D. 5,200 units.


Explanation/Reference:Explanation:Choice "b" is correct. A 50-week year would mean that 200 units are sold per week (10,000 units per year over 50 weeks). Therefore, 800 units are sold during thelead-time (4 weeks × 200 units per week). Required safety stock is 1,300 units, which means that no less than 1,300 units must be on hand at any time. The reorderpoint is then 2,100 units (1,300 safety stock plus the 800 units used during lead time). Choices "a", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 447All of the following are inventory carrying costs, except:

A. Insurance.B. Opportunity cost on inventory investment.C. Obsolescence and spoilage.D. Inspections.



Choice "d" is correct. Inspections. Inspections are part of order costs, not carrying costs. Choices "a" and "c" are incorrect. Inventory carrying costs include all costsassociated with warehousing (storing) inventory (e.g., storage, insurance, obsolescence, and spoilage associated with holding inventory).Choice "b" is incorrect. The economic cost of holding inventory includes the implicit (opportunity) cost of foregoing a return on the money invested in inventory.

QUESTION 448Which one of the following would not be considered a carrying cost associated with inventory?

A. Insurance costs.B. Cost of capital invested in the inventory.C. Cost of obsolescence.D. Shipping costs.



Choice "d" is correct. Shipping costs (which are selling costs) would not be considered a carrying cost associated with inventory.Choices "a", "b", and "c" are incorrect. Each of the following would be considered a carrying cost associated with inventory.A. Insurance costs.B. Cost of capital invested in the inventory.C. Cost of obsolescence.

QUESTION 449Handyman Inc. operates a chain of hardware stores across New England. The controller wants to determine the optimum safety stock levels for an air purifier unit.The inventory manager has compiled the following data.

· The annual carrying cost of inventory approximates 20 percent of the investment in inventory.· The inventory investment per unit averages $50.· The stockout cost is estimated to be $5 per unit.· The company orders inventory on the average of ten times per year.· Total cost = carrying cost + expected stockout cost.· The probabilities of a stockout per order cycle with varying levels of safety stock are as follows.

The total cost of safety stock on an annual basis with a safety stock level of 100 units is:

A. $1,750B. $1,950C. $2,000D. $650



Choice "a" is correct. $1,750 total annual cost of safety stock of 100 units.


QUESTION 450An example of a carrying cost is:

A. Disruption of production schedules.B. Quantity discounts lost.C. Handling costs.D. Obsolescence.



Choice "d" is correct. Obsolescence is an example of a carrying cost. Choices "a", "b", and "c" are incorrect. Carrying cost is not:A. Disruption of production schedules.B. Quantity discounts lost.C. Handling costs.

QUESTION 451When the Economic Order Quantity (EOQ) model is used for a firm, which manufactures its inventory, ordering costs consist primarily of:

A. Insurance and taxes.B. Storage and handling.C. Production set-up.D. Cost of funds.



Choice "c" is correct. When the economic order quantity (EOQ) model is used for a firm that manufactures its own inventory, ordering costs consist primarily ofproduction set-up. Choices "a", "b", and "d" are incorrect, per the above Explanation:.

QUESTION 452Edwards Manufacturing Corporation uses the standard Economic Order Quantity (EOQ) model. If the EOQ for Product A is 200 units and Edwards maintains a 50-unit safety stock for the item, what is the average inventory of Product A?

A. 250 units.B. 150 units.C. 125 units.D. 100 units.



Choice "b" is correct. 150 units is the average inventory including a 50-unit safety stock.


QUESTION 453A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6 percent. As a condition of the loan, the company is required to maintain acompensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2 percent. Ordinarily, the companymaintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?




Choice "a" is correct. 6.44%. To calculate the effective interest rate:

QUESTION 454A company obtained a short-term bank loan of $500,000 at an annual interest rate of eight percent. As a condition of the loan, the company is required to maintain acompensating balance of $100,000 in its checking account. The checking account earns interest at an annual rate of three percent. Ordinarily, the companymaintains a balance of $50,000 in its account for transaction purposes. What is the effective interest rate of the loan?




Choice "d" is correct. 8.56%. To calculate the effective annualized percentage cost of financing:

Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 455Which one of the following financial instruments generally provides the largest source of short-term credit for small firms?

A. Installment loans.B. Commercial paper.C. Trade credit.D. Bankers' acceptances.



Choice "c" is correct. Trade credit generally provides the largest source of short-term credit for small firms.

Choices "a", "b", and "d" are incorrect, per the above Explanation:.

QUESTION 456Which one of the following provides a spontaneous source of financing for a firm?

A. Accounts payable.B. Accounts receivable.C. Debentures.D. Preferred stock.



Choice "a" is correct. Accounts payable provide a spontaneous source of financing for a firm. Choice "b" is incorrect. Accounts receivable take time to factor.Choices "c" and "d" are incorrect.Each of the following take time to issue:C. Debentures.D. Preferred stock.

QUESTION 457Which one of the following statements about trade credit is correct? Trade credit is:

A. Not an important source of financing for small firms.B. A source of long-term financing to the seller.C. Subject to risk of buyer default.D. Usually an inexpensive source of external financing.



Choice "c" is correct. Trade credit is subject to risk of buyer default. Choice "a" is incorrect. Trade credit is an important source of financing for small firms. Choice"b" is incorrect. Trade credit is not a source of long-term financing to the seller. Choice "d" is incorrect. Trade credit is usually an expensive source of external

financing.

QUESTION 458CyberAge outlet, a relatively new store, is a cafe that offers customers the opportunity to browse the Internet or play computer games at their tables while they drinkcoffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee shirts, and computer accessories.CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge's two majorvendors, including average monthly purchases and credit terms.

Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company's weighted annual interest rate for trade credit(ignoring the effects of compounding) for these two vendors is:




Choice "b" is correct. 28% weighted annual interest rate. This question pertains to a complex computation of effective rates on lost discounts for multiple terms andmultiple balances. The computation of the annual percentage cost of the lost discount is equal to the effective rate of interest for the period (for example 2/10, net30 is 2% interest charge/ 98% proceeds) times the number of times this period occurs in a year (for example 2/10, net 20 is 360 days per year divided by 20 dayperiod during which the lost discount is used or 18 times). Extension of this logic to the referenced question involves allocating the computed annual rates to therelative balances of the outstanding payables as follows:

QUESTION 459CyberAge outlet, a relatively new store, is a cafe that offers customers the opportunity to browse the Internet or play computer games at their tables while they drinkcoffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee shirts, and computer accessories.CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge's two majorvendors, including average monthly purchases and credit terms.

Should CyberAge use trade credit and continue paying at the end of the credit period?

A. No, if the cost of alternative short-term financing is more.B. Yes, if the firm's weighted average cost of capital is equal to its weighted average trade credit.C. No, if the cost of alternative long-term financing is more.D. Yes, if the cost of alternative short-term financing is more.



Choice "d" is correct. Yes, CyberAge should use trade credit and continue paying at the end of the credit period, if the cost of alternative short-term financing ismore. Choices "a", "b", and "c" are incorrect, per the above Explanation:.

QUESTION 460The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identifiedfour alternative sources of funds, which are given below.

A. Pay a factor to buy the company's receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance upto 80 percent of the face value of receivables at 10 percent and charge a fee of 2 percent of all receivables purchaseD. The controller estimates that the firmwould save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.

B. Borrow $110,000 from a bank at 12 percent interest. A 9 percent compensating balance would be required.C. Issue $110,000 of six-month commercial paper to net $100,000. (New paper would be issued every 6 months.)D. Borrow $125,000 from a bank on a discount basis at 20 percent. No compensating balance would be required.Assume a 360-day year in all of your

calculations.The cost of Alternative B is:E. 10.5 percent.F. 12.0 percent.G. 13.2 percent.H. 21.0 percent.





QUESTION 461The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identifiedfour alternative sources of funds, which are given below.

A. Pay a factor to buy the company's receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance upto 80 percent of the face value of receivables at 10 percent and charge a fee of 2 percent of all receivables purchaseD. The controller estimates that the firmwould save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.

B. Borrow $110,000 from a bank at 12 percent interest. A 9 percent compensating balance would be required.C. Issue $110,000 of six-month commercial paper to net $100,000. (New paper would be issued every 6 months.)D. Borrow $125,000 from a bank on a discount basis at 20 percent. No compensating balance would be required.Assume a 360-day year in all of your

calculations.The cost of Alternative D. is:E. 10.0 percent.F. 20.0 percent.G. 25.0 percent.H. 40.0 percent.





QUESTION 462A company has total costs of $100,000, of which 40% is variable costs. What is the operating leverage?

A. .40B. .60C. 1.5

D. 2.5



Choice "c" is correct. A shortcut computation for operating leverage is the ratio of fixed costs to variable costs. If total cost is $100,000 and variable cost is 40% oftotal costs (or $40,000), then fixed costs must be 60% (or $60,000). Operating leverage is then calculated as follows:$60,000/$40,000 = 1.5

Choice "a" is incorrect. .4 is obtained by dividing $100,000 into the variable cost of $40,000. Choice "b" is incorrect. .6 is obtained by dividing total costs into fixedcosts. Choice "d" is incorrect. 2.5 is obtained by dividing total costs by variable costs.

QUESTION 463In planning and controlling capital expenditures, the most logical sequence is to begin with:

A. Analyzing capital addition proposals.B. Analyzing and evaluating all promising alternatives.C. Identifying capital addition projects and other capital needs.D. Developing capital budgets.



Choice "c" is correct. The most logical sequence in planning and controlling capital expenditures is to begin with identifying capital addition projects and other capitalneeds. Choice "a" is incorrect. Analyzing capital addition proposals omits other capital needs. Choice "b" is incorrect. Analyzing and evaluating all promisingalternatives is beyond the scope of planning and controlling capital expenditures.Choice "d" is incorrect. Developing capital budgets is the same as planning and controlling capital expenditures.

QUESTION 464Return on assets:

A. Is a measure of profitability and indicates how much is left of each sales dollar to cover operating expenses and profit.

B. Is a profitability measure and can be used to evaluate the efficiency of asset usage and management, and the effectiveness of business strategies to createprofits.

C. Measures the amount of operating income earned above the imputed cost of capital for the operating unit. If the measure is positive, returns exceed the cost offinancing the operating unit.

D. Measures asset activity and the ability of the firm to generate sales through the use of assets.Generally, the more sales dollars generated per dollar of assetsused, the better the net income of an entity.



Choice "b" is correct. Return on assets is a profitability measure and can be used to evaluate the efficiency of asset usage and management, and the effectivenessof business strategies to create profits. Choice "a" is incorrect. This option defines gross profit margin. Choice "c" is incorrect. This option defines residual income.Choice "d" is incorrect. This option defines total asset turnover.

QUESTION 465Limitations of the information provided by total asset turnover include:

A. A good measure for trend analysis of a particular company, but variable ways of calculating cost of goods sold limit its usefulness for comparative analysis.B. The calculation can be affected by varying accounting assumptions, which affect the calculation of net income.C. Because of differing costs of capital, the measure cannot be effectively used for comparative analysis.D. When making the calculation, total assets may need to be refined by the elimination of assets that do not relate to sales as the inclusion of these items could

distort the measure.



Choice "d" is correct. When calculating the turnover, total assets may need to be refined by the elimination of assets that do not relate to sales as the inclusion ofthese items could distort the measure. Choice "a" is incorrect. This option pertains to gross profit margin. Choice "b" is incorrect. This option pertains to return onthe investment in assets. Choice "c" is incorrect. This option pertains to residual income.

QUESTION 466Of the following items, the one item that would not be considered in evaluating the adequacy of the budgeted annual operating income for a company is:

A. Return on assets.B. Long-range profit objectives.C. Industry average for earnings on sales.D. Internal rate of return.



Choice "d" is correct. In evaluating the adequacy of the budgeted annual operating income, you would not use the internal rate of return calculation. The internalrate of return is used for capital budgeting. Choices "a", "b", and "c" are incorrect. Return on assets, long range profit objectives, industry average for earnings onsales, and earnings per share [not mentioned as an option] are all measures for evaluating the adequacy of the budgeted annual operating income.

QUESTION 467The selection of the denominator in the return on investment (ROI) formula is critical to the measure's effectiveness. Which denominator is criticized because itcombines the effects of operating decisions made at one level of the organization with financing decisions made at another organization level?

A. Total assets available.B. Total assets employed.C. Working capital plus other assets.D. Shareholder's equity.



Choice "d" is correct. Shareholders' equity is the ROI denominator that has been criticized because it combines the effects of operating decisions made at anotherorganization level. Choices "a", "b", and "c" are incorrect, per the above Explanation:.

QUESTION 468Micro Manufacturers uses a performance reporting system that combines both financial and nonfinancial measures to evaluate division performance. All of thefollowing measure operational efficiency, except:

A. Operating leverage.B. Days' sales in accounts receivables.C. Inventory turnover.D. Residual income.



Choice "d" is correct. Residual income measures profitability in excess of a target rate of return.Operational efficiency is not considered.Choices "a", "b", and "c" are incorrect. Operating leverage, days' sales in accounts receivable, and inventory are all measures of operational efficiency, specifically,efficiency in managing working capital.

QUESTION 469Managerial performance can be measured in many different ways including return on investment (ROI) and residual income (RI). A good reason for using RIinstead of ROI is that:

A. RI can be computed without regard to identifying an investment base.B. Goal congruence is more likely to be promoted by using RI.C. RI is well understood and often used in the financial press.D. ROI does not take into consideration both the investment turnover ratio and return-on-sales percentage.



Choice "b" is correct. Goal congruence is promoted through the use of the residual income approach. The ROI approach may cause segments that achieve highreturns to reject investments that may benefit the company but lower the segment's rate of return.Choices "a", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 470The imputed interest rate used in the residual income approach to performance evaluation can best be described as the:

A. Historical weighted average cost of capital for the company.B. Target return on investment set by the company's management.C. Average return on investments for the company over the last several years.D. Marginal after-tax cost of capital on new equity capital.



Choice "b" is correct. The imputed interest rate used in the residual income approach can best be described as the target return on investment set by thecompany's management. Choice "a" is incorrect, but it is a close second. The historical weighted average cost of capital may be how management sets the targetreturn on investment.Choice "c" is incorrect. The average return on investments for past years may not be a good indication of management's future intentions.Choice "d" is incorrect. Marginal after-tax cost of capital on new equity may be how management sets its targets, but it may not be, too.

QUESTION 471One approach to measuring divisional performance is return on investment. Return on investment is expressed as operating income:

A. Divided by the current year's capital expenditures plus cost of capital.B. Divided by fixed assets.C. Divided by current assets.D. Divided by total assets.



Choice "d" is correct. Return on investment is operating income divided by total assets. Choice "a" is incorrect. Current year's capital expenditures plus cost ofcapital would be a meaningless denominator.Choice "b" is incorrect. This omits the current assets employed by the division.Choice "c" is incorrect. This omits fixed assets.

QUESTION 472The following selected data pertain to the Darwin Division of Beagle Co. for 1994:

What was Darwin's 1994 residual income?

A. $0B. $4,000C. $10,000D. $30,000



Choice "d" is correct. Residual income is income less the imputed interest rate times average invested capital. Capital turnover is equal to sales / average investedcapital.

Choice "a" is incorrect. Residual income is greater than zero. The imputed interest rate times average invested capital needs to be compared with operatingincome. Choice "b" is incorrect. Residual income is not simply the imputed interest rate times operating income.The imputed interest rate times average invested capital needs to be compared with operating income. Choice "c" is incorrect. Residual income is not simplyimputed interest rate times average invested capital. The operating income must be considered.


· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bondwould be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percentpreferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock iscurrently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. Thestock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 ofretained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equityfinancing.· Williams' preferred capital structure is:

Long-term debt 30%Preferred stock 20Common stock 50

The cost of funds from retained earnings for Williams, Inc. is:




Choice "a" is correct. 7.0 percent cost of funds from retained earnings. The cost of retained earnings is equal to the rate of return required by the firm's commonshareholders (or, in effect, the return "lost" by them when the firm chooses to fund with retained earnings). While oftentimes this rate is somewhat subjective, weare given the facts to exactly answer the question in this case. The stock is currently selling for $100/share, and the dividend is given at $7/share.$7 / $100 = 7%Choices "b", "c", and "d" are incorrect, per the above Explanation:/calculation.

QUESTION 474Sam, CPA, is one of the partners in a limited liability partnership with other CPAs. Sam avoids personal liability for:

A. The wrongful acts of employees acting under his supervision.B. His own negligent acts.C. The malpractice of his partners regarding errors and omissions.D. The negligent actions of his subordinates under his direct control.



Choice "c" is correct.Rule: A partner in a LLP is personally liable for tort liabilities arising from his own negligence and the negligence of his direct subordinates and for breach of contractdamages. He is NOT personally liable for the negligent actions committed by his partners.Choices "a", "b", and "d" are incorrect, per the above rule.

QUESTION 475A limited liability partnership must:

A. File registration documents with the state in which it is formed.B. Hold all partners personally liable for all debts and liabilities of the partnership and partners.C. Carry no less than one hundred thousand dollars of property insurance.D. Not have partners with professional licenses.



Choice "a" is correct.Rule: To have limited liability, an LLP must file with the state a registration statement usually referred to as Articles of LLP. It is generally designed for professionalswho desire to be partners with other like professionals and yet not have liability for the malpractice of their partners. Some states require that personal liabilityinsurance (not property insurance) be carried to protect those harmed by the professionals' malpractice.Choices "b", "c", and "d" are incorrect, per the above rule.

QUESTION 476Jones, Smith, and Bay wanted to form a company called JSB Co. but were unsure about which type of entity would be most beneficial based on their concerns.They all desired the opportunity to make taxfree contributions and distributions where appropriate. They wanted earnings to accumulate tax-free. They did not wantto be subject to personal holding tax and did not want double taxation of income. Bay was going to be the only individual giving management advice to the companyand wanted to be a member of JSB through his current company, Channel, InC. Which of the following would be the most appropriate business structure to meet allof their concerns?

A. Proprietorship.B. S corporation.C. C corporation.D. Limited liability partnership.


Explanation/Reference:Explanation:Choice "d" is correct. An LLP does not pay taxes on its earnings. Instead, the profits and losses flow through to the partners as in a general partnership. The LLPfiles an informational tax return like that of a general partnership. The partners may agree to have the entity managed by one or more of the partners.A partner may be another entity.Choice "a" is incorrect. A proprietorship by definition has only one owner, not three owners. Choice "b" is incorrect. While an S corporation allows for the sametreatment of its earnings and distributions as in the facts, it is prohibited from having another company as an owner. Choice "c" is incorrect. A C corporation pays itsown taxes on its earnings, and any distributions to its shareholders are again taxed at the shareholder level (known as "double taxation").

QUESTION 477A sole proprietorship would be an ideal form of business to select if:

A. The individual desired no liability beyond his capital investment.B. The individual wanted to be able sell the business at will.C. The individual wanted the business to be a separate entity from the sole proprietor.D. The individual wanted the business to continue indefinitely.



Choice "b" is correct. A sole proprietor is free to transfer or sell the business at will. Choice "a" is incorrect because a sole proprietor is personally liable for allobligations of the business. Choice "c" is incorrect. A sole proprietorship is not considered an entity separate from the sole proprietor.Choice "d" is incorrect because a sole proprietorship ends with the death of the sole proprietor.

QUESTION 478Formation of which of the following types of business does not require the filing of documents with the state?




Choice "c" is correct. A sole proprietorship can be formed without filing with the state. Formation of either a corporation or a limited partnership requires a filing.Choices "a", "b", and "d" are incorrect per the Explanation: above.

QUESTION 479Which of the following forms of business can be formed with only one individual owning the business?




Choice "b" is correct. A sole proprietorship and (in most states) a limited liability company can be formed with only one owner. A partnership requires two or morepartners. Choices "a", "c", and "d" are incorrect per the Explanation: above.

QUESTION 480Noll Corp. and Orr Corp. are contemplating entering into an unincorporated joint venture. Such a joint venture:

A. Will be treated as a partnership in most important legal respects.B. Must be dissolved upon the completion of a single undertaking.C. Will be treated as an association for federal income tax purposes and taxed at the prevailing corporate rates.D. Must file a certificate of limited partnership with the appropriate state agency.



Choice "a" is correct. The legal requirements, the consequences, the advantages, and disadvantages of forming a joint venture generally are identical to those of ageneral partnership. Joint ventures are treated as a partnership in most important legal aspects. Choice "b" is incorrect. A joint venture need not be dissolved uponthe completion of a single undertaking. Joint ventures may be formed for a single transaction or for a related series of transactions.Choice "c" is incorrect because a joint venture would be taxed like a partnership, not a corporation. Choice "d" is incorrect because a joint venture, like apartnership, may be formed without filing with the state.

QUESTION 481For what purpose will a stockholder of a publicly held corporation be permitted to file a stockholders' derivative suit in the name of the corporation?

A. To compel payment of a properly declared dividend.B. To enforce a right to inspect corporate records.C. To compel dissolution of the corporation.D. To recover damages from corporate management for an ultra vires management act.

Correct Answer: D

Section: Business Environment and Concepts (Volume D)Explanation

Explanation/Reference:Explanation:Choice "d" is correct. A derivative action is an action by a stockholder in the name of the corporation to recover damages or to seek some other remedy on behalf ofthe corporation when the corporation does not enforce its own rights. Such actions are often brought when the directors or officers have breached their duty to thecorporation and have refused to sue themselves. An ultra vires act is an act outside of a director's or an officer's scope of authority and thus is a breach of duty tothe corporation. Choices "a", "b", and "c" are incorrect, because these would all be causes of action against the corporate directors or officers on behalf of thestockholder to recover damages or seek some other remedy against the corporate directors or officers on behalf of the stockholder, not on behalf of thecorporation.

QUESTION 482Select Co. had the following 1994 financial statement relationships:

Asset turnover 5Profit margin on sales 0.02

What was Select's 1994 percentage return on assets?



Explanation/Reference:Explanation:Choice "d" is correct. Return on assets equals income divided by average assets. This formula can be further divided into the components of profit margin timesasset turnover (referred to as the Dupont formula):

Choices "a", "b", and "c" are incorrect, per the above calculation.

QUESTION 483In a general partnership, the authorization of all partners is required for an individual partner to bind the partnership in a business transaction to:

A. Purchase inventory.B. Hire employees.C. Sell goodwill.D. Sign advertising contracts.



Choice "c" is correct. All partners have apparent authority to enter into transactions apparently within the regular scope of the partnership business. No suchauthority exists, however, for transactions outside the regular scope of business. The sale of a business's goodwill is extraordinary and is outside the ordinary scopeof business. Thus, a partner must get authorization from all other partners to make the sale.Choice "a" is incorrect. All partners have apparent authority to enter into transactions apparently within the regular scope of the partnership business. Purchasinginventory is within the regular scope of business, so a partner need not get permission from the other partners to bind the partnership. Choice "b" is incorrect. Allpartners have apparent authority to enter into transactions apparently within the regular scope of the partnership business. Hiring employees is within the regularscope of a business, so a partner need not get permission from the other partners to bind the partnership. Choice "d" is incorrect. All partners have apparentauthority to enter into transactions apparently within the regular scope of the partnership business. Entering into advertising contracts is within the regular course ofbusiness, and so a partner need not get permission from the other partners to bind the partnership.

QUESTION 484The following information pertains to Quest Co.'s Gold Division for 1993:

Quest's return on investment was:

A. 10.00 percent.

B. 13.33 percent.C. 27.50 percent.D. 30.00 percent.



Choice "c" is correct. Return on investment equals net income divided by average invested capital:


QUESTION 485Managers that anticipate greater return for greater risk are referred to as having what attitude toward risk?

A. Risk indifferent.B. Risk averse.C. Risk seeking.D. Cautious.



Choice "b" is correct. Risk averse behavior describes managers who demand more return on an investment as risk increases. These managers expect to becompensated for increased risk. Choice "a" is incorrect. Risk indifferent behavior describes a manager who is neutral with regard to the return associated with aparticular investment. Typically, the amount of a risk free rate of return associated with an investment of a given amount compared to a higher return associated

with higher risk is viewed as having equal value.Choice "c" is incorrect. Risk seeking behavior describes managers who seek reduced return for higher risk.Choice "d" is incorrect. The term "cautious" is a distracter. Although caution is an attitude, it is not a technical term.

QUESTION 486If the U.S. dollar increases in value relative to the other major currencies, aggregate demand should:

A. Increase as U.S. goods become more attractive overseas.B. Decrease as U.S. goods become less attractive overseas.C. Depends on supply of foreign goods.D. Not necessarily change.



Choice "b" is correct. If the dollar gains in value, net exports will suffer as U.S. goods become more expensive overseas; hence aggregate demand will decrease.The supply of foreign goods domestically should increase as imports become cheaper.Choice "a" is incorrect. Demand should decrease, not increase.Choice "c" is incorrect. Irrelevant to the question.Choice "d" is incorrect. Demand should decrease, not remain the same.

QUESTION 487In markets that are imperfectly competitive, such as monopoly and monopolistic competition, firms produce at an output where:

A. Price equals marginal cost.B. Average costs are minimized.C. Price equals average cost.D. Marginal cost equals marginal revenue.



Choice "d" is correct. Firms produce up to the point where marginal cost equals marginal revenue, whether the markets are perfectly competitive or imperfectlycompetitive. Choice "a" is incorrect. Very close, but it's actual marginal revenue, not price. It is assumed that revenue is not fixed on a unit basis.Choice "b" is incorrect. Beyond the point of average costs being minimized, marginal cost will rise. Still, it will make sense to increase production until marginal costequals marginal revenue. Choice "c" is incorrect. Marginal revenue, not price, as revenue is assumed to vary on a per unit basis, and not average cost, since it willincrease profits to expand production until marginal revenue equals marginal cost.

QUESTION 488Under the Revised Model Business Corporation Act, when a corporation's bylaws grant stockholders preemptive rights, which of the following rights is(are) includedin that grant?




Rule: Preemptive rights provide a shareholder with a right of first refusal to buy a share of newly issued shares sufficient to maintain the shareholder's proportionateshare of rights in any newly issued shares. Rule: Preemptive rights do not provide a shareholder with the right to a proportionate share of corporate assets ondissolution.Choice "c" is correct. "No - Yes."Choices "a", "b", and "d" are incorrect, per the above rules.

QUESTION 489All of the following are the rates used in net present value analysis, except for the:

A. Cost of capital.B. Hurdle rate.C. Discount rate.D. Accounting rate of return.



Choice "d" is correct. The accounting rate of return is a capital budgeting technique, not a rate. Choices "a", "b", and "c" are incorrect. All of these are rates used innet present value analysis:

· Cost of capital· Hurdle rate· Discount rate· Required rate of return

Cost of capital is the cost of borrowing. The hurdle rate, the discount rate, and the required rate of return are synonymous terms for an arbitrary rate set bymanagement.

QUESTION 490In evaluating the impact of relative inflation rates on the demand for a foreign currency, which of the following is true?

A. Inflation is irrelevant to currency demand.B. As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency falls.C. As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency increases.D. As inflation associated with a foreign economy decreases in relation to a domestic economy, demand for the foreign currency falls.



Choice "b" is correct. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflationweakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for aforeign import will reduce the demand for its currency. Choice "a" is incorrect. Inflation, along with interest rates and trade restrictions are significant determinants ofexchange rates.Choice "c" is incorrect. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflationweakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for aforeign import will reduce the demand for its currency, not increase demand. Choice "d" is incorrect. As inflation associated with a foreign currency decreases inrelation to a domestic economy, demand for the foreign currency rises. Inflation weakens the domestic currency in relation to the foreign currency and makesforeign products less expensive and increases demand. Increased demand for a foreign import will increase the demand for its currency, not decrease demand.

QUESTION 491The local video store's business increased by 12 percent after the movie theater raised its prices from $6.50 to $7.00. This is an example of:

A. Substitute goods.B. Superior goods.C. Complementary goods.D. Independent goods.



Choice "a" is correct. For substitute goods, as the price of one good goes up, the demand for another, substitute good increases as consumers desire the lower-priced substitute good. Choice "b" is incorrect. Superior goods. Just as the demand for inferior goods declines with an increase in the income level of a consumer,superior goods will experience a spurt in demand as prices are raised.Choice "c" is incorrect. The demands for mutually "complementary goods" fluctuate together (e.g., more cereal purchases are accompanied by an increase in thedemand for milk). Choice "d" is incorrect. Independent goods have unrelated demand functions (e.g., bread and vacuum cleaners).

QUESTION 492In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers. Amber Corp.'s directors are elected by its:

A. Officers.

B. Outgoing directors.C. Stockholders.



Choice "c" is correct. Directors are elected by the stockholders.

QUESTION 493When parties intend to create a partnership that will be recognized under the Revised Uniform Partnership Act, they must agree to:




Choice "b" is correct. "Yes - No."Rule: A partnership is an agreement between two or more persons to carry on, as co-owners, a business for profit; partners share management and profits andlosses, not gross receipts. Choices "a", "c", and "d" are incorrect, per the above rule.

QUESTION 494Which of the following documents would most likely contain specific rules for the management of a business corporation?

A. Articles of incorporation.B. Bylaws.C. Certificate of authority.D. Shareholders' agreement.



Choice "b" is correct. The bylaws are adopted by the incorporators or directors, are not required to be filed, and generally will contain rules desired regarding theoperation of the corporation. Choice "a" is incorrect. Articles of incorporation are filed with the state and contain information regarding the formation of thecorporation.Choice "c" is incorrect. A certificate of authority is filed with the foreign state that a business wishes to do business in and with permission from that state.Choice "d" is incorrect. A shareholder agreement is a contract between shareholders for any rights or duties agreed upon between the parties.

QUESTION 495The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plantand $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, themachine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulationspermit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40percent.

What is the net cash flow for the tenth year of the project that Moore Corporation should use in a capital budgeting analysis?

A. $81,000B. $68,400C. $63,000D. $60,000



Explanation:

Choice "c" is correct. $63,000 net cash flow for the tenth year.

Alternate Computation:In year 10, Moore will generate a $100,000 profit from the incremental sales (2000 units × ($500 - $450)). This profit will be taxed at 40%, so the net after-taxincrease in cash flow is $60,000. The machine is fully depreciated in year 10 because it was depreciated over a 5-year life. The tax basis of the machine is zero onthe date Moore receives a $5,000 salvage value for the machine. The gain on the machine of $5,000 ($5,000 SV - $0 Basis) is taxed at 40%, or $2,000 in total taxoutflow for the gain, so the net inflows on the salvage is $3,000. Therefore, the total after-tax cash flows in year 10 for the new machine is $60,000 + $3,000 =$63,000.

QUESTION 496The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the:

A. Historical weighted average cost of capital for the company.B. Average return on investment that has been earned by the company over a particular time period.

C. Average return on assets employed over a particular time period.D. Average prime lending rate for the year being evaluated.



Choice "a" is correct. Historical weighted average cost of capital is usually used as the target or hurdle rate in the residual income approach.Choices "b", "c", and "d" are incorrect, per the above definition.

QUESTION 497A company uses the following formula in determining its optimal level of cash.

Where:b = Fixed cost per transactioni = Interest rate on marketable securitiesT = Total demand for cash over a period of time

This formula is a modification of the Economic Order Quantity (EOQ) formula used for inventory management. Assume that the fixed cost of selling marketablesecurities is $10 per transaction, and the interest rate on marketable securities is 6 percent per year. The company estimates that it will make cash payments of$12,000 over a one-month perioD. What is the average cash balance (rounded to the nearest dollar)?

A. $1,000B. $2,000C. $3,464D. $6,928



Choice "c" is correct. Like the EOQ, this formula represents the amount of cash brought in by the sale of marketable securities. Also like the EOQ, this cash goes tozero (or the safety level) over time. The average cash (like the average inventory) is one half of the amount collected. Remember also to convert the interest rate toa per month figure of 0.5%

Choices "a", "b", and "d" are incorrect, per above.

QUESTION 498Which one of the following statements concerning pure monopolies is correct?

A. The demand curve of a monopolist is perfectly elastic.B. The price at which a monopolist maximizes its profit is where price equals both marginal cost and marginal revenue.C. A monopolist's marginal revenue curve lies below its demand curve.D. The supply curve of a monopolist is perfectly inelastic.



Choice "c" is correct. A monopolist's marginal revenue curve lies below its demand curve. Choice "a" is incorrect. The demand curve of a monopolist is not perfectlyelastic. Choice "b" is incorrect. A monopolist sets its price higher than marginal revenue. Choice "d" is incorrect. A monopolist can change the quantity supplied orfix the price but cannot do both simultaneously. In any case, its supply curve is not perfectly inelastic.

QUESTION 499In 1990, Amber Corp., a closely held corporation, was formed by Adams, Frank, and Berg as incorporators and stockholders. Adams, Frank, and Berg executed awritten voting agreement which provided that they would vote for each other as directors and officers. In 1994, stock in the corporation was offered to the public.This resulted in an additional 300 stockholders. After the offering, Adams holds 25%, Frank holds 15%, and Berg holds 15% of all issued and outstanding stock.

Adams, Frank, and Berg have been directors and officers of the corporation since the corporation was formed. Regular meetings of the board of directors andannual stockholders meetings have been held. For this question refer to the formation of Amber Corp. and the rights and duties of its stockholders, directors, andofficers.

A. Adams, Frank, and Berg must be elected as directors because they own 55% of the issued and outstanding stock.B. Adams, Frank, and Berg must always be elected as officers because they own 55% of the issued and outstanding stock.C. Adams, Frank, and Berg must always vote for each other as directors because they have a voting agreement.



Choice "c" is correct. Shareholders in a voting agreement must vote their shares in accordance with the agreement. There is no requirement that majorityshareholders be elected as directors or officers.Business Cycles and Reasons for Business Fluctuations

QUESTION 500Considering the SCOR Model of supply chain operations, which of the following key management processes does managing accounts receivable and collectionsfrom customers fall into?




Choice "d" is correct. The "deliver" process encompasses all the activities of getting the finished product into the hands of the ultimate consumers to meet theirplanned demand. Managing accounts receivable and collections from customers falls into the "deliver" process. Choices "a", "b", and "c" are incorrect, per theabove Explanation: .

QUESTION 501

Which of the following would lead to the most inflation?

A. Both aggregate demand and aggregate supply increase.B. Both aggregate demand and aggregate supply decrease.C. Aggregate demand increases and aggregate supply decreases.D. Aggregate demand decreases and aggregate supply increases.



Choice "c" is correct. Choice "c" contains both demand-pull inflation (when the aggregate demand curve shifts right) and cost-push inflation (when the aggregatesupply curve shifts left). An increase in aggregate demand causes output to rise and the price level to rise. A decrease in aggregate supply causes output to fall andthe price level to rise. Thus, an increase in aggregate demand and a decrease in aggregate supply is the most inflationary.Choice "a" is incorrect. If aggregate supply increases, the price level will fall (reducing inflation). Choice "b" is incorrect. If aggregate demand decreases, the pricelevel will fall (reducing inflation).Choice "d" is incorrect per above Explanation: .

QUESTION 502In which type of business organization are income taxes always required to be paid by the entity on profits earned as well as by the owners upon distributionthereof?

A. General partnership.B. Limited liability company.C. Subchapter C corporation.D. Subchapter S corporation.



Choice "c" is correct. A Subchapter C corporation is taxed as an entity for income tax purposes. Additionally, distributions made to stockholders are treated astaxable income to the stockholders. [Note that this type of corporation is more often called a C corporation instead of a Subchapter C corporation.]Choice "a" is incorrect. A general partnership is not taxed as a separate entity for income tax purposes. Choice "b" is incorrect. An LLC is not taxed as a separate

entity for income tax purposes unless the LLC specifically elects to be taxed like a corporation. [Of course, the word "always" in the question takes care of that.]Choice "d" is incorrect. A Subchapter S corporation is taxed as a partnership. Thus, it is not taxed as a separate entity for income tax purposes. [Note that this typeof corporation is more often called an S corporation instead of a Subchapter S corporation.]

QUESTION 503A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share. If the taxrate is 40 percent, the cost of funds (capital) for the preferred stock is:




Choice "d" is correct. The stock is issued for a net of $96 per share ($101 less $5 underwriting fee). Because preferred stock dividends are not tax deductible, thecost to the company is $10/share (the tax rate is a distractor). Therefore, the cost of the preferred stock is:

Choices "a", "b", and "c" are incorrect, per the above Explanation:/calculation.

QUESTION 504When a partner in a general partnership lacks actual or apparent authority to contract on behalf of the partnership, and the party contracted with is aware of thisfact, the partnership will be bound by the contract if the other partners:




Choice "b" is correct. "Yes - No."Rule: The authority of partners is governed by agency law. Under agency law, a principal is not bound to the third party unless the agent had actual authority orapparent authority. When the agent has no actual authority and no apparent authority, the principal (in this case the partnership) will only be liable if it chooses toadopt the agreement (i.e., ratify).Rule: Amending the partnership agreement (presumably to grant authority) will not cause the partnership to be bound because authority must exist at the time thecontract is made or the partnership must ratify the contract.Choices "a", "c", and "d" are incorrect, per the above rules.

QUESTION 505Park and Graham entered into a written partnership agreement to operate a retail store. Their agreement was silent as to the duration of the partnership. Parkwishes to dissociate from the partnership. Which of the following statements is correct?

A. Park may dissociate from the partnership at any time.B. Unless Graham consents to the dissociation, Park must apply to a court and obtain a decree ordering the dissociation.C. Park may not dissociate from the partnership unless Graham consents.D. Park may dissociate from the partnership only after notice of the proposed dissolution is given to all partnership creditors.



Choice "a" is correct. Because the agreement is silent as to duration, it is a partnership at will. A partner may dissociate from a partnership at will at any time.Choice "b" is incorrect. Because the agreement is silent as to duration, it is a partnership at will. A partner may dissociate from a partnership at will at any time. Nocourt order is required. Choice "c" is incorrect. Partnerships are consensual relationships, so any partner has the power to dissociate at any time; he or she neednot obtain the consent of the other partners (though absent consent, the partner will be liable for damages if the dissociation is wrongful). Choice "d" is incorrect.There is no requirement of giving partnership creditors a formal notice of intent to dissociate, but it is a good idea to do so to avoid liability on future partnershipobligations.

Auditing and Attestation (I)

QUESTION 1Which of the following statements is correct concerning an auditor's responsibilities regarding financial statements?

A. An auditor may not draft an entity's financial statements based on information from management's accounting system.B. The adoption of sound accounting policies is an implicit part of an auditor's responsibilities.C. An auditor's responsibilities for audited financial statements are confined to the expression of the auditor's opinion.D. Making suggestions that are adopted about an entity's internal control environment impairs an auditor's independence.

Correct Answer: CSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "c" is correct. An auditor's responsibility is to express an opinion on financial statements based on an audit.Choice "a" is incorrect. An auditor may draft an entity's financial statements based on information from management's financial system. This would be referred to asa compilation engagement.Choice "b" is incorrect. The adoption of sound accounting policies is an implicit part of management's responsibilities, not the auditor's responsibilities. Choice "d" isincorrect. An auditor often makes suggestions that are adopted about an entity's internal control environment.

Professional Standards

QUESTION 2Which of the following accurately depicts the auditor's responsibility with respect to Statements on Auditing Standards?

A. The auditor is required to follow the guidance provided by the Standards, without exception.B. The auditor is generally required to follow the guidance provided by Standards with which he or she is familiar, but will not be held responsible for departing from

provisions of which he or she was unaware.C. The auditor is generally required to follow the guidance provided by the Standards, unless following such guidance would result in an audit that is not cost-

effective.D. The auditor is generally required to follow the guidance provided by the Standards, and should be able to justify any departures.

Correct Answer: DSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Explanation:

Choice "d" is correct. The auditor is generally required to follow the guidance provided by the Standards, and should be able to justify any departures. Choice "a" isincorrect. On rare occasions, the auditor may depart from the guidance provided by the SASs, but he or she must justify such departures. Choice "b" is incorrect.Lack of familiarity with a SAS is not a valid reason for departing from its guidance.The auditor is expected to have sufficient knowledge of the SASs to identify those that are applicable to a given audit engagement.Choice "c" is incorrect. The cost associated with following the guidance provided by a SAS is not an acceptable reason for departing from its guidance.

QUESTION 3The concept of materiality would be least important to an auditor when considering the:

A. Adequacy of disclosure of a client's illegal act.B. Discovery of weaknesses in a client's internal control.C. Effects of a direct financial interest in the client on the CPA's independence.D. Decision whether to use positive or negative confirmations of accounts receivable.



Choice "c" is correct. Any direct financial interest in a client impairs independence, even if it is immaterial.Choice "a" is incorrect. A material illegal act may require disclosure in or adjustment to the financial statements, whereas an immaterial illegal act may not requiredisclosure. Choice "b" is incorrect. A material weakness in internal control will affect the nature, timing, and extent of audit procedures, whereas an immaterialweakness in internal control may have little impact on the audit.Choice "d" is incorrect. An auditor is likely to use positive confirmations for material accounts receivable, but may consider negative confirmations for immaterialreceivable balances.

QUESTION 4An auditor of a nonpublic company must conduct the audit in accordance with:


A. ASB standards.II. PCAOB standards.

B. I.C. Both I and II.D. Either I or II, but not both.E. II.

Correct Answer: ASection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "a" is correct. An auditor of a nonpublic company must conduct the audit in accordance with ASB standards.Choice "b" is incorrect. An auditor of a nonpublic company is not required to conduct the audit in accordance with PCAOB standards.Choice "c" is incorrect. While an auditor is only required to conduct the audit in accordance with ASB standards, the auditor may choose to follow PCAOB standardsas well. Choice "d" is incorrect. An auditor of a nonpublic company is not required to conduct the audit in accordance with PCAOB standards.

QUESTION 5Because of the risk of material misstatement, an audit of financial statements in accordance with generally accepted auditing standards should be planned andperformed with an attitude of:

A. Objective judgment.B. Independent integrity.C. Professional skepticism.D. Impartial conservatism.



Choice "c" is correct. The auditor should plan and perform the audit with an attitude of professional skepticism. This attitude includes a questioning mind and acritical assessment of audit evidence.Choices "a", "b", and "d" are incorrect. Objectivity, independence, integrity, and impartiality are basic ethical characteristics and professional qualities embodied in

the general standards.

QUESTION 6Which of the following is not an example of the application of professional skepticism?

A. Designing additional auditing procedures to obtain more reliable evidence in support of a particular financial statement assertion.B. Obtaining corroboration of management's Explanation: s through consultation with a specialist.C. Inquiring of prior year engagement personnel regarding their assessment of management's honesty and integrity.D. Using third party confirmations to provide support for management's representations.



Choice "c" is correct. The auditor should consider that fraud might occur regardless of any past experience with the entity. An assessment of management'shonesty and integrity performed during the previous year would not necessarily be relevant to the current year's audit. Choice "a" is incorrect. An auditor might applyprofessional skepticism by performing additional audit procedures designed to improve the reliability of evidence. Choice "b" is incorrect. Corroboratingmanagement's Explanation: s is an example of the application of professional skepticism, since the auditor is obtaining additional support rather than simplyaccepting the Explanation: as given.Choice "d" is incorrect. Using third party confirmations to provide support for management's representations is an example of the application of professionalskepticism, since the auditor is obtaining additional support rather than simply accepting the Explanation: as given.

QUESTION 7Which of the following categories is included in generally accepted auditing standards?

A. Standards of review.B. Standards of planning.C. Standards of fieldwork.D. Standards of evidence.



Choice "c" is correct. Generally accepted auditing standards include three categories: general standards, standards of fieldwork, and standards of reporting.Choices "a", "b", and "d" are incorrect, based on the above Explanation: .

Reports on Audited Financial Statements

QUESTION 8When qualifying an opinion because of an insufficiency of audit evidence, an auditor should refer to the situation in the:


Correct Answer: BSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "b" is correct. When a qualified opinion is issued due to a lack of sufficient audit evidence, the lack of evidence should be disclosed in an explanatoryparagraph before the opinion paragraph. Since insufficient evidence is a scope limitation, the scope paragraph should also be modified to refer to the limitation andto the explanatory paragraph that discusses it. Choices "a" and "c" are incorrect. Management (and not the auditor) prepares the notes to the financial statements.The auditor therefore would not refer to this (or any other) situation in the notes to the financial statements.Choice "d" is incorrect. The auditor does refer to the situation in the scope paragraph.

QUESTION 9When an auditor believes there is substantial doubt about the ability of an entity to continue as a going concern, all of the following should be included in the auditdocumentation, except:

A. The conditions that gave rise to the substantial doubt.

B. The auditor's conclusion about whether substantial doubt remains or is alleviated.C. Management's conclusion regarding whether substantial doubt remains or is alleviated.D. The effect of the auditor's conclusion on the auditor's report.



Choice "c" is correct. Whether substantial doubt remains or is alleviated is a judgment call made by the auditor, and there is no requirement to documentmanagement's opinion on the matter. Choices "a", "b", and "d" are incorrect. When an auditor believes there is substantial doubt about the ability of an entity tocontinue as a going concern, the conditions that gave rise to the substantial doubt, the auditor's conclusion about whether substantial doubt remains or is alleviated,and the effect of the auditor's conclusion on the auditor's report should all be documented.

QUESTION 10Which of the following statements is a basic element of the auditor's standard report?

A. The disclosures provide reasonable assurance that the financial statements are free of material misstatement.B. The auditor evaluated the overall internal control.C. An audit includes assessing significant estimates made by management.D. The financial statements are consistent with those of the prior period.



Choice "c" is correct. The auditor's standard audit report includes a statement that "An audit includes assessing...significant estimates made by management..."Choice "a" is incorrect. The standard audit report does not state that disclosures provide reasonable assurance that the financial statements are free of materialmisstatement. The correct statement is:"...standards require that we plan and perform the audit to obtain reasonable assurance that the financial statements are free of material misstatement." Choice "b"is incorrect. The standard audit report does not state that the auditor evaluated the overall internal control. The correct statement is "An audit includes...evaluatingthe overall financial statement presentation." Internal control is not mentioned in the standard audit report. Choice "d" is incorrect. The standard audit report doesnot state "The financial statements are consistent with those of the prior period." According to the second standard of reporting, consistency is implicitly reported.Only if there is an inconsistency is an explicit statement included.

QUESTION 11An auditor may not issue a qualified opinion when:

A. An accounting principle at variance with GAAP is used.B. The auditor lacks independence with respect to the audited entity.C. A scope limitation prevents the auditor from completing an important audit procedure.D. The auditor's report refers to the work of a specialist.



Choice "b" is correct. If the auditor lacks independence with respect to an audit client, the auditor must disclaim an opinion on the financial statements. A qualifiedopinion is not an option. Choice "a" is incorrect. A departure from GAAP (which is not sufficiently material to warrant an adverse opinion) may justify a qualificationof the auditor's report. Choice "c" is incorrect. A scope limitation may result in a qualified opinion or a disclaimer of opinion.Choice "d" is incorrect. The auditor's report may make reference to the use of a specialist only if the specialist's findings result in a change to the auditor's report,such as a qualified opinion.

QUESTION 12An auditor most likely would express an unqualified opinion and would not add explanatory language to the report if the auditor:

A. Wishes to emphasize that the entity had significant transactions with related parties.B. Concurs with the entity's change in its method of computing depreciation.C. Discovers that supplementary information required by FASB has been omitted.D. Believes that there is a probable likelihood of a material loss resulting from an uncertainty that is sufficiently supported and disclosed.



Choice "d" is correct. An auditor most likely would express an unqualified opinion and would not add explanatory language to the report if the auditor believes thatthere is a probable likelihood of a material loss resulting from an uncertainty that is sufficiently supported and disclosed.Choice "a" is incorrect. Emphasis of a matter, such as the existence of significant transactions with related parties, may result in an additional explanatoryparagraph appended to an otherwise unqualified opinion.

Choice "b" is incorrect. A change in accounting principle does result in an additional explanatory paragraph appended to an otherwise unqualified opinion. Choice"c" is incorrect. Omission of supplemental information required by GAAP does result in an additional explanatory paragraph appended to an otherwise unqualifiedopinion.

QUESTION 13An auditor would express an unqualified opinion with an explanatory paragraph added to the auditor's report for:




Choice "d" is correct. An unjustified accounting change may cause the auditor to issue a qualified or adverse opinion. A material weakness must be reported tomanagement and those charged with governance, but would not be disclosed in an explanatory paragraph appended to an otherwise unqualified opinion.Choices "a", "b", and "c" are incorrect, as per the above Explanation: .

QUESTION 14Digit Co. uses the FIFO method of costing for its international subsidiary's inventory and LIFO for its domestic inventory. Under these circumstances, the auditor'sreport on Digit's financial statements should express an:

A. Unqualified opinion.B. Opinion qualified because of a lack of consistency.

C. Opinion qualified because of a departure from GAAP.D. Adverse opinion.



Choice "a" is correct. GAAP allows a company to use different methods for costing different inventories as long as the methods are disclosed. Thus, the audit reportwould be unqualified; there is no departure from GAAP.Choice "b" is incorrect. The consistency standard refers to changes in application of accounting practices between periods, affecting the comparability of financialstatements. There is no indication Digit made any change in methods.Choice "c" is incorrect. Use of different methods for costing inventory is permissible under GAAP, and would not result in a qualification of the auditor's report.Choice "d" is incorrect. Use of different methods for costing inventory is permissible under GAAP, and would not result in an adverse report.

QUESTION 15In which of the following circumstances would an auditor not express an unqualified opinion?

A. There has been a material change between periods in accounting principles.B. Quarterly financial data required by the SEC has been omitted.C. The auditor wishes to emphasize an unusually important subsequent event.D. The auditor is unable to obtain audited financial statements of a consolidated investee.



Choice "d" is correct. The inability to obtain audited financial statements of a consolidated investee represents a scope limitation which may result in either aqualified opinion or a disclaimer of opinion.Choice "a" is incorrect. A material change in accounting principles between periods is disclosed in an explanatory paragraph added to an otherwise unqualifiedopinion. Choice "b" is incorrect. Omission of selected quarterly data required by SEC regulations is disclosed in an explanatory paragraph added to an otherwiseunqualified opinion. Choice "c" is incorrect. Emphasis of a matter is disclosed in an explanatory paragraph added to an otherwise unqualified opinion.

QUESTION 16Management of Edgington Industries plans to disclose an uncertainty as follows:

The Company is a defendant in a lawsuit alleging infringement of certain patent rights and claiming damages. Discovery proceedings are in progress. The ultimateoutcome of the litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in theaccompanying financial statements. The auditor is satisfied that sufficient audit evidence supports management's assertions about the nature and disclosure of theuncertainty. What type of opinion should the auditor express under these circumstances?

A. Unqualified without an explanatory paragraph.B. "Subject to" qualified.C. "Except for" qualified.D. Disclaimer of opinion.



Choice "a" is correct. The note presented describes an uncertainty that is properly discloseD. An explanatory paragraph is not required in the unqualified opinion.Choice "b" is incorrect. A "subject to" qualified opinion should never be issued. Choice "c" is incorrect. Since the auditor is satisfied that the assertion and disclosureare supported by the existing evidence, a qualified opinion is not required. Choice "d" is incorrect. Since the auditor is satisfied that the assertion and disclosure aresupported by the existing evidence, there is no need for the auditor to disclaim an opinion.

QUESTION 17Kane, CPA, concludes that there is substantial doubt about Lima Co.'s ability to continue as a going concern for a reasonable period of time. If Lima's financialstatements adequately disclose its financial difficulties, Kane's auditor's report is required to include an explanatory paragraph that specifically uses the phrase(s):

A. Option AB. Option BC. Option C

D. Option D



Choice "d" is correct. If, after considering identified conditions and events and management's plans, the auditor concludes that substantial doubt about the entity'sability to continue as a going concern for a reasonable period of time remains, the audit report should include an explanatory paragraph (following the opinionparagraph) to reflect that conclusion. This conclusion should be expressed through the use of the phrase "substantial doubt about its (the entity's) ability to continueas a going concern" [or similar wording that includes the terms "substantial doubt" and "going concern"]. The "reasonable period...not to exceed one year" isinherent in the definition of going concern and is not explicitly stated in the audit report. The phrase "possible discontinuation of operations" may be included in thegoing concern disclosure but is not specifically required.Choices "a", "b", and "c" are incorrect, as per the above Explanation: .

QUESTION 18Mead, CPA, had substantial doubt about Tech Co.'s ability to continue as a going concern when reporting on Tech's audited financial statements for the year endedJune 30, 19X4. That doubt has been removed in 19X5. What is Mead's reporting responsibility if Tech is presenting its financial statements for the year ended June30, 19X5, on a comparative basis with those of 19X4?

A. The explanatory paragraph included in the 19X4 auditor's report should not be repeated.B. The explanatory paragraph included in the 19X4 auditor's report should be repeated in its entirety.C. A different explanatory paragraph describing Mead's reasons for the removal of doubt should be included.D. A different explanatory paragraph describing Tech's plans for financial recovery should be included.



Choice "a" is correct. If substantial doubt about the entity's ability to continue as a going concern has been removed in the current period, the explanatory paragraphincluded in the prior period auditor's report should not be repeated, and no description of the reasons or plans for recovery need be included.Choice "b" is incorrect. If doubt about the going concern assumption has been removed in the current period, it is not appropriate to include the explanatoryparagraph from the prior year in the auditor's report for the current year.Choice "c" is incorrect. If doubt about the going concern assumption has been removed in the current period, no explanatory paragraph is required since thesituation no longer exists. The auditor does not have to explain the reason for the change. Choice "d" is incorrect. If doubt about the going concern assumption hasbeen removed in the current period, no explanatory paragraph is required since the situation no longer exists. The entity does not have to describe its plans for the

future.

QUESTION 19March, CPA, is engaged by Monday Corp., a client, to audit the financial statements of Wall Corp., a company that is not March's client. Monday expects to presentWall's audited financial statements with March's auditor's report to 1st Federal Bank to obtain financing in Monday's attempt to purchase Wall. In thesecircumstances, March's auditor's report would usually be addressed to:

A. Monday Corp., the client that engaged March.B. Wall Corp., the entity audited by March.C. 1st Federal Bank.D. Both Monday Corp. and 1st Federal Bank.



Choice "a" is correct. The auditors should address their report to the entity that engaged them. In this case, Monday Corp. engaged the auditor to perform anacquisition audit and the report should be addressed to Monday.Choice "b" is incorrect. Wall Corp. did not engage the auditors and thus the report should not be addressed to them.Choices "c" and "d" are incorrect. Even though the bank will be relying on the audited financial statements in determining whether to make the loan, the bank did notdirectly engage the auditing firm and accordingly, the report should not be addressed to them.

QUESTION 20An auditor issued an audit report that was dual dated for a subsequent event occurring after the original date of the auditor's report but before issuance of therelated financial statements. The auditor's responsibility for events occurring subsequent to the original report date was:

A. Limited to include only events occurring up to the date of the last subsequent event referenced.B. Limited to the specific event referenced.C. Extended to subsequent events occurring through the later date.D. Extended to include all events occurring since the original report date.



Choice "b" is correct. When an auditor issues a report that is dual dated for a subsequent event occurring after the original date of the auditor's report, but beforeissuance of the related financial statements, the auditor's responsibility for events occurring subsequent to the original report date is limited to the specific eventreferenced.Choices "a", "c", and "d" are incorrect. The auditor takes responsibility for only the specific event noted in the dual dating and no other event occurring subsequentto the original report date.

QUESTION 21When an independent CPA is associated with the financial statements of a publicly held entity but has not audited or reviewed such statements, the appropriateform of report to be issued must include a(an):

A. Regulation S-X exemption.B. Report on pro forma financial statements.C. Unaudited association report.D. Disclaimer of opinion.



Choice "d" is correct. When an accountant is associated with the financial statements of a public entity, but has not audited or reviewed such statements, theaccountant must issue a report disclaiming any opinion on the statements.Choices "a", "b", and "c" are incorrect since a disclaimer is required in this case.

QUESTION 22Which of the following auditing procedures most likely would assist an auditor in identifying conditions and events that may indicate substantial doubt about anentity's ability to continue as a going concern?

A. Inspecting title documents to verify whether any assets are pledged as collateral.B. Confirming with third parties the details of arrangements to maintain financial support.C. Reconciling the cash balance per books with the cut-off bank statement and the bank confirmation.D. Comparing the entity's depreciation and asset capitalization policies to other entities in the industry.



Choice "b" is correct. Confirming with third parties the details of arrangements to provide or "maintain (needed) financial support" is an audit procedure that mayidentify doubts about an entity's ability to continue as a going concern.Choice "a" is incorrect. Inspecting title documents provides evidence of ownership of assets but would not necessarily identify conditions affecting an entity's abilityto continue as a going concern.Choice "c" is incorrect. Reconciling the cash balance per books with the cut-off bank statement and the bank confirmation provides evidence of completeness andvaluation, but would not necessarily identify conditions affecting an entity's ability to continue as a going concern. Choice "d" is incorrect. Comparing an entity'spolicies to other entities in the industry would not necessarily identify conditions affecting an entity's ability to continue as a going concern.

QUESTION 23When an independent CPA assists in preparing the financial statements of a publicly held entity, but has not audited or reviewed them, the CPA should issue adisclaimer of opinion. In such situations, the CPA has no responsibility to apply any procedures beyond:

A. Documenting that internal control is not being relied on.B. Reading the financial statements for obvious material misstatements.C. Ascertaining whether the financial statements are in conformity with GAAP.D. Determining whether management has elected to omit substantially all required disclosures.



Choice "b" is correct. The accountant is only required to read the financial statements for obvious material misstatements.Choice "a" is incorrect. The accountant need not document that internal control is not being relied on.Choices "c" and "d" are incorrect. The accountant is not required to evaluate conformity with GAAP, but any known departures (including inadequate disclosure)should be described in the disclaimer.

QUESTION 24When an auditor concludes there is substantial doubt about a continuing audit client's ability to continue as a going concern for a reasonable period of time, theauditor's responsibility is to:

A. Issue a qualified or adverse opinion, depending upon materiality, due to the possible effects on the financial statements.B. Consider the adequacy of disclosure about the client's possible inability to continue as a going concern.C. Report to the client's audit committee that management's accounting estimates may need to be adjusted.D. Reissue the prior year's auditor's report and add an explanatory paragraph that specifically refers to "substantial doubt" and "going concern."



Choice "b" is correct. When an auditor concludes there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time,the auditor's responsibility is to consider the adequacy of disclosure about the entity's possible inability to continue as a going concern and include an explanatoryparagraph in the audit report. Choice "a" is incorrect. The auditor would include an explanatory paragraph following the unqualified opinion, or disclaim an opiniondue to a material uncertainty. A qualified or adverse opinion is not appropriate for doubt about an entity's ability to continue as a going concern. Choice "c" isincorrect. Management's accounting estimates are unrelated to going concern issues.Choice "d" is incorrect. Going concern issues are considered prospectively. It is not appropriate to reissue a prior audit report if doubt arises about an entity's abilityto continue in a future period.

QUESTION 25Reference in a principal auditor's report to the fact that part of the audit was performed by another auditor most likely would be an indication of the:

A. Divided responsibility between the auditors who conducted the audits of the components of the overall financial statements.B. Lack of materiality of the portion of the financial statements audited by the other auditor.C. Principal auditor's recognition of the other auditor's competence, reputation, and professional certification.D. Different opinions the auditors are expressing on the components of the financial statements that each audited.



Choice "a" is correct. Reference to another auditor indicates division of responsibility for the audits of the components of the overall financial statements. Choice "b"is incorrect. Reference to another auditor would not generally be made if the other auditor's portion of the financial statements were immaterial. Choice "c" isincorrect. The reference in the report is not meant to recognize the qualifications of the other auditor, but simply to divide the responsibility between the two auditors.Choice "d" is incorrect. The reference to the other auditor would be made regardless of what type of opinion is expressed by each auditor.

QUESTION 26An auditor includes a separate paragraph in an otherwise unmodified report to emphasize that the entity being reported on had significant transactions with relatedparties. The inclusion of this separate paragraph:

A. Is considered an "except for" qualification of the opinion.B. Violates generally accepted auditing standards if this information is already disclosed in footnotes to the financial statements.C. Necessitates a revision of the opinion paragraph to include the phrase "with the foregoing Explanation: ."D. Is appropriate and would not negate the unqualified opinion.



Choice "d" is correct. Emphasis of a matter should be disclosed in an explanatory paragraph appended to an otherwise unqualified opinion.Choice "a" is incorrect. An "except for" qualification is used for a scope limitation or a departure from GAAP, but not for emphasis of a matter.Choice "b" is incorrect. The auditor may emphasize a matter even if it is included in the footnotes.Choice "c" is incorrect. A phrase such as "with the foregoing Explanation: " should not be used in an unqualified opinion.

QUESTION 27When there has been a change in accounting principles, but the effect of the change on the comparability of the financial statements is not material, the auditorshould:

A. Refer to the change in an explanatory paragraph.B. Explicitly concur that the change is preferred.C. Not refer to consistency in the auditor's report.D. Refer to the change in the opinion paragraph.



Choice "c" is correct. If an accounting change has no material effect on the comparability of the financial statements, the auditor does not need to recognize thechange in the current year's audit report.Choice "a" is incorrect. The change would only be referred to in an explanatory paragraph if the effect were material.Choice "b" is incorrect. The auditor does not explicitly concur with the change in the report. Choice "d" is incorrect. Even if the change had a material effect, theopinion paragraph would not be affected. The explanatory paragraph would follow the opinion paragraph.

QUESTION 28

When single-year financial statements are presented, an auditor ordinarily would express an unqualified opinion in an unmodified report if the:

A. Auditor is unable to obtain audited financial statements supporting the entity's investment in a foreign affiliate.B. Entity declines to present a statement of cash flows with its balance sheet and related statements of income and retained earnings.C. Auditor wishes to emphasize an accounting matter affecting the comparability of the financial statements with those of the prior year.D. Prior year's financial statements were audited by another CPA whose report, which expressed an unqualified opinion, is not presented.



Choice "d" is correct. Since only single-year financial statements are presented, the fact that another CPA audited the prior year's financial statements is notrelevant. Therefore, the auditor would express an unqualified opinion in an unmodified report. Choice "a" is incorrect. The situation described would result in aqualified opinion or disclaimer of opinion due to a scope limitation.Choice "b" is incorrect. The situation described would result in an qualified opinion due to inadequate disclosure.Choice "c" is incorrect. The situation described would result in an otherwise unqualified opinion modified by adding an additional explanatory paragraph after theopinion paragraph.

QUESTION 29Park, CPA, was engaged to audit the financial statements of Tech Co., a new client, for the year ended December 31, 20X3. Park obtained sufficient audit evidencefor all of Tech's financial statement items except Tech's opening inventory. Due to inadequate financial records, Park could not verify Tech's January 1, 20X3,inventory balances. Park's opinion on Tech's 20X3 financial statements most likely will be:




Choice "b" is correct. When the auditor is unable to satisfy himself or herself regarding the amount of beginning inventory, he or she must disclaim an opinion on theincome statement because of the inability to verify the cost of goods sold during the year. The auditor may, however, still be able to issue an unqualified opinion onthe balance sheet, since inventory can be verified as of the balance sheet date.Choices "a", "c", and "d" are incorrect, based on the Explanation: above.

QUESTION 30Which paragraphs of an auditor's standard report on financial statements should refer to generally accepted auditing standards (GAAS) and generally acceptedaccounting principles (GAAP)?



Explanation/Reference:Explanation:Choice "c" is correct. The auditor states that the audit was conducted in accordance with GAAS in the scope paragraph. The auditor expresses an opinion on thefinancial statements' conformity with GAAP in the opinion paragraph.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 31In which of the following circumstances would an auditor be most likely to express an adverse opinion?

A. The chief executive officer refuses the auditor access to minutes of board of directors' meetings.B. Tests of controls show that the entity's internal control is so poor that it cannot be relied upon.C. The financial statements are not in conformity with the FASB Statements regarding the capitalization of leases.D. Information comes to the auditor's attention that raises substantial doubt about the entity's ability to continue as a going concern.



Choice "c" is correct. An adverse opinion is issued when the financial statements are not presented in accordance with GAAP.Choice "a" is incorrect. The client's refusal to provide access to the minutes of the Board of Directors' meetings would result in a disclaimer of opinion. Choice "b" isincorrect. If internal control is so poor that it cannot be relied upon, the auditor must consider the effect on the audit procedures and subsequent report, but wouldnot issue an adverse opinion.Choice "d" is incorrect. Substantial doubt with regard to the entity's ability to continue as a going concern should be disclosed in an additional explanatory paragraphappended to an otherwise unqualified opinion.

QUESTION 32When disclaiming an opinion due to a client-imposed scope limitation, an auditor should indicate in a separate paragraph why the audit did not comply withgenerally accepted auditing standards.The auditor should also omit the:




Choice "d" is correct. When disclaiming an opinion because of scope limitations, the auditor should indicate in a separate paragraph(s) the reasons that the auditdid not comply with GAAS. The auditor should also omit the scope paragraph. The opinion paragraph is not omitted; however it indicates that no opinion isexpressed.Choices "a", "b", and "c" are incorrect, as per the above Explanation: .

QUESTION 33An auditor decides to issue a qualified opinion on an entity's financial statements because a major inadequacy in its computerized accounting records prevents theauditor from applying necessary procedures. The opinion paragraph of the auditor's report should state that the qualification pertains to:

A. A client-imposed scope limitation.B. A departure from generally accepted auditing standards.C. The possible effects on the financial statements.D. Inadequate disclosure of necessary information.



Choice "c" is correct. When an auditor qualifies his opinion because of a scope limitation, the wording in the opinion paragraph should indicate that the qualificationpertains to the possible effects on the financial statements and not to the scope limitation itself. Choice "a" is incorrect. When an auditor qualifies his opinionbecause of a scope limitation, the wording in the opinion paragraph should indicate that the qualification pertains to the possible effects on the financial statementsand not to the scope limitation itself. Choice "b" is incorrect. A scope limitation is a departure from generally accepted auditing standards.However, when an auditor qualifies his opinion because of a scope limitation, the wording in the opinion paragraph should indicate that the qualification pertains tothe possible effects on the financial statements and not to the scope limitation itself. Choice "d" is incorrect. Inadequate disclosure of necessary information is adeparture from GAAP, rather than a scope limitation.

QUESTION 34When an auditor qualifies an opinion because of inadequate disclosure, the auditor should describe the nature of the omission in a separate explanatory paragraphand modify the:




Choice "d" is correct. In a report qualified for inadequate disclosure, the auditor would add an explanatory paragraph and modify the opinion paragraph, but theintroductory and scope paragraphs would not be modified.Choices "a", "b", and "c" are incorrect, as per the above Explanation: .

QUESTION 35An entity changed from the straight-line method to the declining balance method of depreciation for all newly acquired assets. This change has no material effect onthe current year's financial statements, but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the financialstatements, the auditor should issue a report with a(an):

A. "Except for" qualified opinion.B. Explanatory paragraph.C. Unqualified opinion.D. Consistency modification.



Choice "c" is correct. If an accounting change has no material effect on the financial statements in the current year, but a material future effect, the auditor mustensure that the change is disclosed in the footnotes whenever the financial statements of the change period are presented, but does not have to recognize thechange in the current year's audit report. Choice "a" is incorrect. Accounting changes that are accounted for properly do not result in qualified opinions.Choices "b" and "d" are incorrect. A consistency modification (explanatory paragraph) is not necessary when the effect of a change is immaterial.

QUESTION 36If a publicly held company issues financial statements that purport to present its financial position and results of operations but omits the statement of cash flows,the auditor ordinarily will express a(an):

A. Disclaimer of opinion.B. Qualified opinion.C. Review report.D. Unqualified opinion with a separate explanatory paragraph.



Choice "b" is correct. If a company issues financial statements that purport to present financial position and results of operations but omits the related statement ofcash flows, the auditor will normally conclude that the omission requires qualification of the opinion. Choice "a" is incorrect. If the company fails to present itsstatement of cash flows, this is considered inadequate disclosure. The auditor would not issue a disclaimer of opinion for inadequate disclosure.Choice "c" is incorrect. The auditor would not issue a review report when performing an audit. Choice "d" is incorrect. The auditor cannot issue an unqualified reportif the client omits a statement of cash flows from the financial statements.

QUESTION 37In which of the following circumstances would an auditor most likely add an explanatory paragraph to the standard report while not affecting the auditor's unqualifiedopinion?

A. The auditor is asked to report on the balance sheet, but not on the other basic financial statements.B. There is substantial doubt about the entity's ability to continue as a going concern.C. Management's estimates of the effects of future events are unreasonable.D. Certain transactions cannot be tested because of management's records retention policy.

Correct Answer: B

Section: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "b" is correct. If, after considering identified conditions and events and management's plans, the auditor concludes that substantial doubt about the entity'sability to continue as a going concern for a reasonable period of time remains, the audit report should include an explanatory paragraph to reflect that conclusion.Choice "a" is incorrect. Reporting on just the balance sheet is acceptable provided access to financial information is not limited. Such reporting does not require anexplanatory paragraph. Choice "c" is incorrect. If the auditor concludes that management's estimate is unreasonable and that its effect is to cause the financialstatements to be materially misstated, the auditor should express a qualified or an adverse opinion.Choice "d" is incorrect. Restrictions on the scope of the audit, whether imposed by the client or by circumstances, may require the auditor to qualify or to disclaim anopinion.

QUESTION 38When an entity changes its method of accounting for income taxes, which has a material effect on comparability, the auditor should refer to the change in anexplanatory paragraph added to the auditor's report. This paragraph should identify the nature of the change and:

A. Explain why the change is justified under generally accepted accounting principles.B. Describe the cumulative effect of the change on the audited financial statements.C. State the auditor's explicit concurrence with or opposition to the change.D. Refer to the financial statement note that discusses the change in detail.



Choice "d" is correct. The paragraph should refer to the note in the financial statements that discusses the change in detail. Following is an example of anappropriate explanatory paragraph:"As discussed in Note X to the financial statements, the company changed its method of accounting for income taxes in X2."Choice "a" is incorrect. The auditor need not explain why a change from one generally accepted accounting principle to another is justified.Choice "b" is incorrect. The paragraph should not identify the cumulative effect of the change on the audited financial statements.Choice "c" is incorrect. The auditor should never explicitly state concurrence with a change. If the auditor opposes the change, a qualified or adverse opinion shouldbe issued.

QUESTION 39Green, CPA, was engaged to audit the financial statements of Essex Co. after its fiscal year had ended. The timing of Green's appointment as auditor and the startof fieldwork made confirmation of accounts receivable by direct communication with the debtors ineffective. However, Green applied other procedures and was

satisfied as to the reasonableness of the account balances. Green's auditor's report most likely contained a(an):

A. Unqualified opinion.B. Unqualified opinion with an explanatory paragraph.C. Qualified opinion due to a scope limitation.D. Qualified opinion due to a departure from generally accepted auditing standards.



Choice "a" is correct. There is a presumption that the auditor will request the confirmation of accounts receivable during an audit unless accounts receivable areimmaterial, the use of confirmations would be ineffective, or the assessed inherent risk is so low that the evidence expected to be provided by analytical proceduresor other substantive tests of details would be sufficient. In this example, the confirmation of accounts receivable by direct communication with the debtors would beineffective. If Green was able to apply alternative audit procedures and was satisfied as to the reasonableness of the account balances, then an unqualified opinioncould be issued.Choice "b" is incorrect. Since Green was satisfied as far as the accounts receivable balances, there is no need to add an explanatory paragraph.Choice "c" is incorrect. Since Green was able to perform alternative procedures and was satisfied as far as the reasonableness of the account balances, there is noscope limitation. Choice "d" is incorrect. Since Green was able to perform alternative procedures and was satisfied as far as the reasonableness of the accountbalances, there is no departure from generally accepted auditing standards.

QUESTION 40Davis, CPA, believes there is substantial doubt about the ability of Hill Co. to continue as a going concern for a reasonable period of time. In evaluating Hill's plansfor dealing with the adverse effects of future conditions and events, Davis most likely would consider, as a mitigating factor, Hill's plans to:

A. Accelerate research and development projects related to future products.B. Accumulate treasury stock at prices favorable to Hill's historic price range.C. Purchase equipment and production facilities currently being leased.D. Negotiate reductions in required dividends being paid on preferred stock.



Choice "d" is correct. Negotiating reductions in required dividends would conserve cash, which would be a mitigating factor in Davis' concerns about Hill's ability tocontinue as a going concern.Choice "a" is incorrect. Accelerating R&D projects would use cash and impair the company's ability to continue as a going concern.Choice "b" is incorrect. Accumulating treasury stock would consume cash and aggravate the situation.Choice "c" is incorrect. Purchasing equipment that is currently leased would use cash and impair the company further.

QUESTION 41In the auditor's report, the principal auditor decides not to make reference to another CPA who audited a client's subsidiary. The principal auditor could justify thisdecision if, among other requirements, the principal auditor:

A. Issues an unqualified opinion on the consolidated financial statements.B. Learns that the other CPA issued an unqualified opinion on the subsidiary's financial statements.C. Is unable to review the audit programs and audit documentation of the other CPA.D. Is satisfied as to the independence and professional reputation of the other CPA.



Choice "d" is correct. If, among other requirements, the principal auditor is satisfied as to the independence and the professional reputation of the other auditor, theprincipal auditor may express an opinion on the financial statements taken as a whole without making reference to the audit of the other auditor.Choice "a" is incorrect. Whether or not an unqualified opinion is issued is not the determining factor as to whether the principal auditor must make reference toanother CPA. Choice "b" is incorrect. Whether or not an unqualified opinion is issued on the subsidiary's financial statements is not the determining factor as towhether the principal auditor must make reference to another CPA.Choice "c" is incorrect. If the principal auditor is unable to review the audit programs and audit documentation of the other CPA, he or she is likely to divideresponsibility by making reference to the other CPA in the auditor's report.

QUESTION 42A limitation on the scope of an audit sufficient to preclude an unqualified opinion will usually result when management:

A. Is unable to obtain audited financial statements supporting the entity's investment in a foreign subsidiary.B. Refuses to disclose in the notes to the financial statements related party transactions authorized by the Board of Directors.C. Does not provide the auditor with an engagement letter specifying the responsibilities of both the entity and the auditor.D. Fails to correct a significant deficiency in internal control communicated to those charged with governance after the prior year's audit.

Correct Answer: ASection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The Basics

Explanation


Choice "a" is correct. Restrictions on the scope of the audit, such as the timing of the work, the inability to obtain sufficient appropriate audit evidence, or aninadequacy in the accounting records, may require the auditor to qualify or disclaim an opinion. Inability to obtain audited financial statements supporting the entity'sinvestment in a foreign subsidiary is such a restriction on the scope of the audit.Choice "b" is incorrect. Client refusal to disclose related party transactions in the notes to the financial statements is a GAAP problem, not a scope problem. For aGAAP problem, the auditor must either issue a qualified or adverse opinion.Choice "c" is incorrect. The auditor sends an engagement letter to the client, not vice versa. Choice "d" is incorrect. Management may choose not to correct asignificant deficiency in internal control if the cost of correcting the condition outweighs the benefit.

QUESTION 43When an auditor expresses an adverse opinion, the opinion paragraph should include:

A. The principal effects of the departure from generally accepted accounting principles.B. A direct reference to a separate paragraph disclosing the basis for the opinion.C. The substantive reasons for the financial statements being misleading.D. A description of the uncertainty or scope limitation that prevents an unqualified opinion.



Choice "b" is correct. The opinion paragraph in an adverse opinion reads, "in our opinion, because of the effects of the matters discussed in the precedingparagraphs, the financial statements...."Choice "a" is incorrect. The principal effects of the departure from GAAP are included in the explanatory paragraph, not the opinion paragraph.Choice "c" is incorrect. The "substantive reasons for the financial statements being misleading" are discussed in the explanatory paragraph, not the opinionparagraph. Choice "d" is incorrect. Scope limitations pertain to disclaimers of opinion, not adverse opinions. (It is very important to memorize the qualifying phrasesin the qualified, adverse, and disclaimer of opinions.)

QUESTION 44Under which of the following circumstances would a disclaimer of opinion not be appropriate?

A. The financial statements fail to contain adequate disclosure of related party transactions.B. The client refuses to permit its attorney to furnish information requested in a letter of audit inquiry.

C. The auditor is engaged after fiscal year-end and is unable to observe physical inventories or apply alternative procedures to verify their balances.D. The auditor is unable to determine the amounts associated with illegal acts committed by the client's management.



Choice "a" is correct. The failure of the financial statements to contain adequate disclosure of related party transactions, or other required disclosures, would resultin a qualified or adverse opinion, not a disclaimer of opinion.Choice "b" is incorrect. A client's refusal to permit its attorney to furnish information requested in a letter of audit inquiry would generally result in a disclaimer ofopinion. Choice "c" is incorrect. The auditor's inability to observe physical inventories or apply alternative procedures to verify their balances could result in adisclaimer. Choice "d" is incorrect. The auditor's inability to determine the amounts associated with illegal acts committed by the client's management could result ina disclaimer.

QUESTION 45Green, CPA, concludes that there is substantial doubt about JKL Co.'s ability to continue as a going concern. If JKL's financial statements adequately disclose itsfinancial difficulties, Green's auditor's report should:




Choice "a" is correct. "Yes - Yes - Yes."When a CPA concludes that there is substantial doubt about an entity's ability to continue as a going concern and the entity adequately discloses its financialdifficulties, an unqualified opinion is appropriate.An explanatory paragraph (following the opinion paragraph) should be used to highlight the situation.This paragraph should include the phrases "substantial doubt" and "going concern." Choices "b", "c", and "d" are incorrect, per above.

QUESTION 46An auditor may reasonably issue an "except for" qualified opinion for a(an):




Choice "c" is correct. Yes - Yes.An "except for" qualified opinion is expressed when the "exceptions to GAAP" are not material enough to warrant an adverse opinion, or when scope restrictions arenot material enough to warrant a disclaimer.

Choices "a", "b", and "d" are incorrect, per rule above.

QUESTION 47The following explanatory paragraph was included in an auditor's report to indicate a lack of consistency:"As discussed in note T to the financial statements, the company changed its method of computing depreciation in X0."

How should the auditor report on this matter if the auditor concurred with the change? Type of Location of opinion explanatory paragraph

A. Unqualified Before opinion paragraphB. Unqualified After opinion paragraphC. Qualified Before opinion paragraphD. Qualified After opinion paragraph



Choice "b" is correct. If the auditor concurred with the change, a lack of consistency in applying GAAP would result in an unqualified opinion with an explanatoryparagraph following the opinion paragraph.Choice "c" is incorrect. If the change in accounting principle is not accounted for properly, then a qualified opinion would be appropriate and the explanatoryparagraph would appear before the opinion paragraph.Choices "a" and "d" are incorrect, per the above rules.

QUESTION 48How does an auditor make the following representations when issuing the standard auditor's report on comparative financial statements?

A. Option AB. Option B

C. Option CD. Option D


Explanation/Reference:Explanation:Choice "d" is correct. Explicitly - Implicitly.The auditor explicitly states in the scope paragraph of his opinion: "an audit includes examining, on a test basis, evidence supporting..."Consistency is implied in the auditor's standard report. Choices "a", "b", and "c" are incorrect, as per above Explanation: .

QUESTION 49An auditor was unable to obtain sufficient appropriate audit evidence concerning certain transactions due to an inadequacy in the entity's accounting records. Theauditor would choose between issuing a(an):

A. Qualified opinion and an unqualified opinion with an explanatory paragraph.B. Unqualified opinion with an explanatory paragraph and an adverse opinion.C. Adverse opinion and a disclaimer of opinion.D. Disclaimer of opinion and a qualified opinion.



Choice "d" is correct. Client-imposed restrictions of scope such as those caused by inadequate records would cause the auditor to choose between issuing adisclaimer of opinion and a qualified opinion.Choice "a" is incorrect. An unqualified opinion would only be justified if the transactions in question were not material, but in such situations, no explanatoryparagraph would be required. Choices "b" and "c" are incorrect. An adverse opinion pertains to GAAP and would not be used for reporting restrictions of scope.

QUESTION 50In which of the following situations would a principal auditor least likely make reference to another auditor who audited a subsidiary of the entity?

A. The other auditor was retained by the principal auditor and the work was performed under the principal auditor's guidance and control.B. The principal auditor finds it impracticable to review the other auditor's work or otherwise be satisfied as to the other auditor's work.

C. The financial statements audited by the other auditor are material to the consolidated financial statements covered by the principal auditor's opinion.D. The principal auditor is unable to be satisfied as to the independence and professional reputation of the other auditor.


Explanation/Reference:Explanation:Choice "a" is correct. When the principal auditor assumes responsibility for the other auditor's work, the principal auditor would not mention the other auditor in hisaudit report (opinion). The principal auditor would generally assume responsibility after reviewing the audit documentation of the other auditor and performingsupplemental audit tests, or by reputation, e.g., if the other auditor is a correspondent (foreign) firm in which the principal auditor has developed confidence.Choices "b" and "c" are incorrect. When the principal auditor finds it impractical to review the other auditor's work, or when the FS audited by the other auditor arematerial, it is more likely that the principal auditor will divide responsibility and make reference to the other auditor. Choice "d" is incorrect. The principal auditorshould always make inquiries regarding the independence and professional reputation of the other auditor. Inability to become satisfied in this regard wouldconstitute a scope limitation, resulting in a qualified opinion or disclaimer of opinion. In either of these scenarios, it is likely that the other auditor would be mentionedwithin an explanatory paragraph.

QUESTION 51In which of the following situations would an auditor ordinarily issue an unqualified audit opinion without an explanatory paragraph?

A. The auditor wishes to emphasize that the entity had significant related party transactions.B. The auditor decides to make reference to the report of another auditor as a basis, in part, for the auditor's opinion.C. The entity issues financial statements that present financial position and results of operations, but omits the statement of cash flows.D. The auditor has substantial doubt about the entity's ability to continue as a going concern, but the circumstances are fully disclosed in the financial statements.



Choice "b" is correct. An auditor would generally issue an unqualified audit opinion without an explanatory paragraph when the auditor decides to make reference tothe report of another auditor as a basis, in part, for the auditor's opinion. The auditor would modify his/her report (all three paragraphs), but would not add anexplanatory paragraph. Choices "a" and "d" are incorrect. An auditor ordinarily would issue an unqualified opinion with an explanatory paragraph if he or she wishesto emphasize that the entity had significant related party transactions, or if the auditor has substantial doubt about the entity's ability to continue as a going concern(even if the circumstances are fully disclosed in the financial statements). Choice "c" is incorrect. If the entity issues financial statements that present financialposition and results of operations but omit the statement of cash flows, the opinion will be qualified.

QUESTION 52When there has been a change in accounting principle that materially affects the comparability of the comparative financial statements presented and the auditorconcurs with the change, the auditor should:




Choice "a" is correct. No - No - Yes.When a change in accounting principle materially affects the comparability of the comparative FS, the auditor should refer to the change in an explanatoryparagraph following the unqualified opinion paragraph.Choices "b" and "c" are incorrect. The auditor's concurrence with a change in GAAP is implicit, not explicit.Choice "d" is incorrect. An unqualified opinion should be issued, not an "except for" qualified opinion.

QUESTION 53When a qualified opinion results from a limitation on the scope of the audit, the situation should be described in an explanatory paragraph:

A. Preceding the opinion paragraph and referred to only in the scope paragraph of the auditor's report.B. Following the opinion paragraph and referred to in both the scope and opinion paragraphs of the auditor's report.C. Following the opinion paragraph and referred to only in the scope paragraph of the auditor's report.

D. Preceding the opinion paragraph and referred to in both the scope and opinion paragraphs of the auditor's report.



Choice "d" is correct. When a qualified opinion results from a limitation of scope, it should be described in an explanatory paragraph preceding the opinionparagraph and referred to in both the scope and opinion paragraphs of the auditor's report. Choices "a", "b", and "c" are incorrect, as they do not comply with therule above.

QUESTION 54Restrictions imposed by a client prohibit the observation of physical inventories, which account for 35% of all assets. Alternative audit procedures cannot be applied,although the auditor was able to examine satisfactory evidence for all other items in the financial statements. The auditor should issue a(an):

A. "Except for" qualified opinion.B. Disclaimer of opinion.C. Unqualified opinion with a separate explanatory paragraph.D. Unqualified opinion with an Explanation: in the scope paragraph.



Choice "b" is correct. Restrictions of scope imposed on the audit of such a large (35%) asset would require a disclaimer of opinion.Choices "a" and "c" are incorrect. The asset not audited is too large for a qualified opinion and much too large for an unqualified opinion.Choice "d" is incorrect. Explanatory language does not get inserted into the scope paragraph, nor is an unqualified opinion appropriate.

QUESTION 55An auditor concludes that there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. If the entity's disclosuresconcerning this matter are adequate, the audit report may include a(an):




Choice "d" is correct. Yes - No.If an auditor concludes that there is substantial doubt about an entity's ability to continue as a going concern and that the entity's disclosures are adequate, then theaudit report may be either:- Unqualified with explanatory paragraph, or- Disclaimed.(Generally, an unqualified opinion is issued, but the auditor is not prohibited from choosing to issue a disclaimer.)Choice "a" is incorrect. An "except for" qualified opinion would be appropriate if the entity's disclosures were inadequate.Choice "b" is incorrect. While an unqualified opinion is generally issued, the auditor is not prohibited from choosing to issue a disclaimer; for example, in areasinvolving a high degree of uncertainty.Choice "c" is incorrect, per Explanation: above.

QUESTION 56An auditor should disclose the substantive reasons for expressing an adverse opinion in an explanatory paragraph:

A. Preceding the scope paragraph.B. Preceding the opinion paragraph.C. Following the opinion paragraph.D. Within the notes to the financial statements.


Explanation/Reference:Explanation:Choice "b" is correct. The auditor should disclose the substantive reasons for expressing an adverse opinion in a separate explanatory paragraph preceding theopinion paragraph. Choice "a" is incorrect. There are no circumstances where an explanatory paragraph precedes the scope paragraph.Choice "c" is incorrect. The explanatory paragraph follows the opinion paragraph when there is a change in accounting principle or when there is doubt as to goingconcern. Choice "d" is incorrect. The auditor cannot include an explanatory paragraph in the financial statements, which are the responsibility of management.

QUESTION 57When management does not provide reasonable justification that a change in accounting principle is preferable and it presents comparative financial statements,the auditor should express a qualified opinion:

A. Only in the year of the accounting principle change.B. Each year that the financial statements initially reflecting the change are presented.C. Each year until management changes back to the accounting principle formerly used.D. Only if the change is to an accounting principle that is not generally accepted.



Choice "b" is correct. When management does not provide reasonable justification that a change in accounting principle is preferable and it presents comparativeFS, the auditor should express a qualified opinion each year that the FS initially reflecting the change are presented. Choices "a", "c", and "d" are incorrect, per therule stated above.

QUESTION 58When an independent CPA is associated with the financial statements of a publicly held entity but has not audited or reviewed such statements, the appropriateform of report to be issued must include a(an):

A. Compilation report.B. Disclaimer of opinion.C. Unaudited association report.D. Qualified opinion.



Choice "b" is correct. A "disclaimer of opinion" must be issued when a CPA is "associated" with FS of a publicly held entity, but has not audited or (interim) reviewedsuch FS. Choice "a" is incorrect. A "compilation report" refers to a report related to a non-public entity. Choice "c" is incorrect. There is no such thing as an"unaudited association report." Choice "d" is incorrect. The auditor did not audit the FS, so he/she cannot issue an opinion on them.

QUESTION 59Restrictions imposed by a retail entity that is a new client prevent an auditor from observing any physical inventories. These inventories account for 40% of theentity's assets. Alternative auditing procedures cannot be applied due to the nature of the entity's records. Under these circumstances, the auditor should express a(an):

A. Disclaimer of opinion.B. Qualified opinion.C. Adverse opinion.D. Unqualified opinion with an explanatory paragraph.



Choice "a" is correct. Since the auditor is unable to observe inventory or apply alternative audit procedures, a scope limitation exists. Due to the significance of theinventory balance (40% of total assets is quite material), a disclaimer of opinion (rather than simply a qualification) is appropriate.Choice "b" is incorrect. Since the inventory balance is so material, a qualified opinion is not sufficient in this case.Choice "c" is incorrect. An adverse opinion is not an appropriate response to a scope limitation. Choice "d" is incorrect. Since the scope limitation relates to amaterial balance, an unqualified opinion is not appropriate.

QUESTION 60Which of the following audit procedures most likely would assist an auditor in identifying conditions and events that may indicate substantial doubt about an entity'sability to continue as a going concern?

A. Reading the minutes of meetings of the stockholders and the board of directors.B. Comparing the market value of property to amounts owed on the property.

C. Reviewing lease agreements to determine whether leased assets should be capitalized.D. Inspecting title documents to verify whether any assets are pledged as collateral.


Explanation/Reference:Explanation:Choice "a" is correct. The auditor should examine any evidence that appears contrary to the basic principle of going concern. Reviewing the minutes fromstockholder and board of director meetings is one procedure that is used in this regard. Choice "b" is incorrect. Comparison of the market value of property toamounts owed on the property determines its net value, but would not necessarily indicate a going concern issue. Choice "c" is incorrect. Reviewing leaseagreements to determine whether leased assets should be capitalized is important in evaluating the financial statements, but it would not provide evidence of goingconcern issues.Choice "d" is incorrect. Inspecting title documents to verify whether any assets are pledged as collateral provides information regarding presentation and disclosure,but would not provide evidence of going concern issues.

QUESTION 61Which of the following procedures most likely would assist an auditor in identifying conditions and events that may indicate substantial doubt about an entity's abilityto continue as a going concern?

A. Performing cutoff tests of sales transactions with customers with long-standing receivable balances.B. Evaluating the entity's procedures for identifying and recording related party transactions.C. Inspecting title documents to verify whether any real property is pledged as collateral.D. Inquiring of the entity's legal counsel about litigation, claims, and assessments.



Choice "d" is correct. If a liability is significant enough, it may give rise to a situation in which there is substantial doubt about an entity's ability to continue as a goingconcern. Inquiring of an entity's legal counsel about litigation, claims, and assessments is one way to determine whether such a liability exists.Choice "a" is incorrect. Cutoff tests are used to determine whether sales are recorded in the proper period. Applying such tests to customer accounts with long-standing receivable balances would not provide information about the entity's ability to continue a as a going concern. Choice "b" is incorrect. Evaluating the entity'sprocedures for identifying and recording related party transactions is a means for the auditor to evaluate financial statement presentation and disclosure, but it doesnot provide information about going concern issues. Choice "c" is incorrect. Identifying situations in which real property is pledged as collateral is a means for theauditor to evaluate financial statement presentation and disclosure, but it does not provide information about going concern issues.

QUESTION 62A CPA's standard report on audited financial statements would be inappropriate if it referred to:

A. Management's responsibility for the financial statements.B. An assessment of the entity's accounting principles.C. Significant estimates made by management.D. The CPA's assessment of sampling risk factors.



Choice "d" is correct. The CPA's standard report on audited financial statements does not include matters related to the auditor's assessment of specific riskfactors. Choice "a" is incorrect. The CPA's standard report on audited financial statements states that, "These financial statements are the responsibility of theCompany's management." Choices "b" and "c" are incorrect. The CPA's standard report on audited financial statements states that, "An audit also includesassessing the accounting principles used and significant estimates made by management."

QUESTION 63When an auditor has substantial doubt about an entity's ability to continue as a going concern because of the probable discontinuance of operations, the auditormost likely would express a qualified opinion if:

A. The effects of the adverse financial conditions likely will cause a bankruptcy filing.B. Information about the entity's ability to continue as a going concern is not disclosed.C. Management has no plans to reduce or delay future expenditures.D. Negative trends and recurring operating losses appear to be irreversible.



Choice "b" is correct. In a situation where it is likely that an entity's operations will be discontinued, disclosure of information about the entity's ability to continue as agoing concern is required by GAAP.Failure to make such disclosure would be a departure from GAAP, resulting in either a qualified or adverse opinion.

Choice "a" is incorrect. As long as the going concern situation is adequately disclosed, the fact that there will be a bankruptcy filing would not cause the auditor toexpress a qualified opinion. Generally, an explanatory paragraph would be added following the opinion paragraph of the unqualified report.Choice "c" is incorrect. As long as the going concern situation is adequately disclosed, the fact that management does not intend to reduce or delay futureexpenditures would not cause the auditor to express a qualified opinion. Generally, an explanatory paragraph would be added following the opinion paragraph of theunqualified report. Choice "d" is incorrect. As long as the going concern situation is adequately disclosed, the fact that negative trends and recurring operating losesappear to be irreversible would not cause the auditor to express a qualified opinion. Generally, an explanatory paragraph would be added following the opinionparagraph of the unqualified report.

QUESTION 64An auditor believes that there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. In evaluating the entity'splans for dealing with the adverse effects of future conditions and events, the auditor most likely would consider, as a mitigating factor, the entity's plans to:

A. Repurchase the entity's stock at a price below its book value.B. Issue stock options to key executives.C. Lease rather than purchase operating facilities.D. Accelerate the due date of an existing mortgage.



Choice "c" is correct. Leasing rather than purchasing operating facilities results in reduced (or at least delayed) expenditures, which is a mitigating factor in a goingconcern situation. Choice "a" is incorrect. Mitigating factors in a going concern situation include plans to dispose of assets, plans to borrow money or restructuredebt, plans to reduce or delay expenditures, or plans to increase ownership equity. Repurchasing stock is an outflow of cash that would reduce ownership equity; assuch, it is not a mitigating factor. Choice "b" is incorrect. Mitigating factors in a going concern situation include plans to dispose of assets, plans to borrow money orrestructure debt, plans to reduce or delay expenditures, or plans to increase ownership equity. Issuing stock options does not fall into any of these categories andwould not be considered a mitigating factor. Choice "d" is incorrect. Mitigating factors in a going concern situation include plans to dispose of assets, plans toborrow money or restructure debt, plans to reduce or delay expenditures, or plans to increase ownership equity. Accelerating the due date of an existing mortgagewould increase expenditures, and therefore would not be a mitigating factor.

QUESTION 65Which of the following is true regarding the standard audit report for an issuer?

A. Reference should be made in the scope paragraph to both PCAOB standards and generally accepted auditing standards.B. PCAOB standards should not be mentioned at all, although their use is implied in the standard auditor's report.C. Reference should be made in the scope paragraph to PCAOB standards, and in the opinion paragraph to generally accepted accounting principles.D. Reference may be made in the scope paragraph to either PCAOB standards or generally accepted auditing standards.



Choice "c" is correct. An auditor reporting on the audit of financial statements of an issuer should indicate in the scope paragraph that the engagement wasconducted in accordance with PCAOB standards, and should refer to GAAP in the opinion paragraph. Choice "a" is incorrect. An auditor reporting on the audit offinancial statements of a nonissuer may (but is not required to) refer to both PCAOB standards and generally accepted auditing standards in the scope paragraph.Audit reports for audits of issuers refer only to PCAOB standards in the scope paragraph.Choice "b" is incorrect. An auditor reporting on the audit of financial statements of an issuer should indicate in the scope paragraph that the engagement wasconducted in accordance with PCAOB standards. This is an explicit statement in the report; it is not implied or assumed. Choice "d" is incorrect. An auditor reportingon the audit of financial statements of an issuer should indicate in the scope paragraph that the engagement was conducted in accordance with PCAOB standards.Referring to generally accepted auditing standards instead is not an option, as audits of issuers must follow PCAOB standards.

QUESTION 66Under which of the following circumstances would an auditor's expression of an unqualified opinion be inappropriate?

A. The auditor is unable to obtain the audited financial statements of a significant subsidiary.B. The financial statements are prepared on the entity's income tax basis.C. There are significant deficiencies in the design and operation of the entity's internal control.D. Analytical procedures indicate that many year-end account balances are not comparable with the prior year's balances.



Choice "a" is correct. If the auditor is unable to obtain the audited financial statements of a significant subsidiary, a scope limitation exists. Assuming the effect ismaterial, the auditor would issue either a qualified opinion or a disclaimer of opinion. Choice "b" is incorrect. Financial statements prepared on an entity's income taxbasis are "other comprehensive basis of accounting" (OCBOA) financial statements. The auditor may issue a special report, which can include an unqualifiedopinion, on OCBOA financial statements. Choice "c" is incorrect. Significant deficiencies in the design and operation of an entity's internal control do not precludeissuance of an unqualified opinion, although they do increase the risk of material misstatement and will likely result in modifications to the nature, timing, and extentof the auditor's testing.Choice "d" is incorrect. An unqualified opinion may still be expressed when there are significant changes in year-end account balances as compared to prior yearbalances, as long as the auditor has obtained sufficient appropriate audit evidence about the current balances.Reports on Comparative Financial Statements

QUESTION 67Jewel, CPA, audited Infinite Co.'s prior-year financial statements. These statements are presented with those of the current year for comparative purposes withoutJewel's auditor's report, which expressed a qualified opinion. In drafting the current year's auditor's report, Crain, CPA, the successor auditor, should:

A. Not name Jewel as the predecessor auditor.II. Indicate the type of report issued by Jewel.III. Indicate the substantive reasons for Jewel's qualification.

B. I only.C. I and II only.D. II and III only.E. I, II, and III.



Choice "d" is correct. If the financial statements of a prior period have been audited by a predecessor auditor whose report is not presented, the successor auditorshould indicate in the introductory paragraph of the report 1) that the financial statements of the prior period were audited by another auditor, 2) the date of hisreport, 3) the type of report issued by the predecessor auditor, and 4) if the report was other than a standard unqualified report, the substantive reasons therefor.The successor auditor may name the predecessor auditor only if the predecessor auditor's practice was acquired by or merged with that of the successor auditor.Choices "a", "b", and "c" are incorrect, based on the above Explanation: .

QUESTION 68A registration statement filed with the SEC contains the reports of two independent auditors on their audits of financial statements for different periods. Thepredecessor auditor who audited the prior-period financial statements generally should obtain a letter of representation from the:

A. Successor independent auditor.B. Client's audit committee.C. Principal underwriter.D. Securities and Exchange Commission.



Choice "a" is correct. Before reissuing the prior year's audit report on the financial statements of a former client, the auditor should 1) read the financial statementsof the current period, 2) compare the prior period information that the auditor reported on with the financial statements to be presented for comparative purposes,and 3) obtain letters of representation from management of the former client and from the successor auditor. The representation letter from management shouldindicate whether any of management's previous representations should be modified and whether there have been any subsequent events that would affect theprevious financial statements. The representation letter from the successor auditor should state whether the successor auditor's audit disclosed any issues of amaterial nature that might affect the previous financial statements.Choice "b" is incorrect. The predecessor auditor is seeking independent confirmation regarding issues that might materially affect the previous financial statements.A representation letter from the client's audit committee would not provide this confirmation. Choice "c" is incorrect. The predecessor auditor is seeking independentconfirmation regarding issues that might materially affect the previous financial statements. A representation letter from the principal underwriter would not providethis confirmation. Choice "d" is incorrect. The predecessor auditor is seeking independent confirmation regarding issues that might materially affect the previousfinancial statements. A representation letter from the SEC would not provide this confirmation.

QUESTION 69Before reissuing the prior year's auditor's report on the financial statements of a former client, the predecessor auditor should obtain letters of representation fromthe:

A. Former client's management and the board of directors.B. Former client's attorney and management.C. Former client's board of directors and the successor auditor.D. Successor auditor and the former client's management.



Choice "d" is correct. Before reissuing the prior year's auditor's report on the financial statements of a former client, the auditor should 1) read the financialstatements of the current period, 2) compare the prior-period information that the auditor reported on with the financial statements to be presented for comparativepurposes, 3) obtain a letter of representation from the successor auditor, and 4) obtain a letter of representation from the former client's management. Therepresentation letter from the successor auditor will state whether the successor's audit revealed any issues of a material nature that might affect the previousfinancial statements. The representation letter from the former client's management will indicate whether its previous representations are still accurate and whetherthere have been any subsequent events affecting the previous financial statements.Choices "a", "b", and "c" are incorrect. The predecessor does not request representation letters from the former client's board of directors or attorney.

QUESTION 70In May X4, an auditor reissues the auditor's report on the X2 financial statements at a continuing client's request. The X2 financial statements are not restated and

the auditor does not revise the wording of the report. The auditor should:

A. Dual date the reissued report.B. Use the release date of the reissued report.C. Use the original report date on the reissued report.D. Use the current-period auditor's report date on the reissued report.



Choice "c" is correct. If the auditor reissues the audit report at the client's request, the auditor should use the original report date on the reissued report. Use of asubsequent date implies that the auditor has done additional work.Choice "a" is incorrect. Use of a date subsequent to the original report date implies that the auditor has performed work subsequent to that date.Choice "b" is incorrect. Use of a date subsequent to the original report date implies that the auditor has performed work subsequent to that date.Choice "d" is incorrect. Use of a date subsequent to the original report date implies that the auditor has performed work subsequent to that date.

QUESTION 71An auditor expressed a qualified opinion on the prior year's financial statements because of a lack of adequate disclosure. These financial statements are properlyrestated in the current year and presented in comparative form with the current year's financial statements. The auditor's updated report on the prior year's financialstatements should:

A. Be accompanied by the auditor's original report on the prior year's financial statements.B. Continue to express a qualified opinion on the prior year's financial statements.C. Make no reference to the type of opinion expressed on the prior year's financial statements.D. Express an unqualified opinion on the restated financial statements of the prior year.


Explanation/Reference:Explanation:Choice "d" is correct. If an auditor has previously qualified his or her opinion on financial statements of a prior period, and the prior period statements are restated toconform with GAAP, the auditor should express an unqualified opinion on the restated financial statements. In addition, the auditor would state the substantivereasons for the change in opinion in an explanatory paragraph preceding the opinion paragraph. Choice "a" is incorrect. The original report would not be presented.Choice "b" is incorrect. The auditor would change the opinion on the restated financial statements from that previously issued.

Choice "c" is incorrect. The auditor would state the substantive reasons for the change in opinion in an explanatory paragraph preceding the opinion paragraph.

QUESTION 72Comparative financial statements include the financial statements of the prior year that were audited by a predecessor auditor whose report is not presented. If thepredecessor's report was qualified, the successor should:

A. Indicate the substantive reasons for the qualification in the predecessor auditor's opinion.B. Request the client to reissue the predecessor's report on the prior year's statements.C. Issue an updated comparative audit report indicating the division of responsibility.D. Express an opinion only on the current year's statements and make no reference to the prior year's statements.



Choice "a" is correct. If the financial statements of a prior period have been audited by a predecessor auditor whose report is not presented, the successor auditorshould indicate in the introductory paragraph of the audit report (1) that the financial statements of the prior period were audited by another auditor, (2) the type ofreport issued, and (3) if the report was other than standard, the substantive reasons therefor.Choice "b" is incorrect. The predecessor auditor, not the client, may reissue the previous year's audit report.Choice "c" is incorrect. An audit report would indicate a division of responsibility when the principal auditor's opinion is based in part on the report of another auditor.Choice "d" is incorrect. If the prior year's financial statements are issued, the previous year's audit opinion must also be disclosed.

QUESTION 73An auditor has previously expressed a qualified opinion on the financial statements of a prior period because of a departure from generally accepted accountingprinciples. The prior-period financial statements are restated in the current period to conform with generally accepted accounting principles.The auditor's updated report on the prior-period financial statements should:

A. Express an unqualified opinion concerning the restated financial statements.B. Be accompanied by the original auditor's report on the prior period.C. Bear the same date as the original auditor's report on the prior period.D. Qualify the opinion concerning the restated financial statements because of a change in accounting principle.



Explanation:

Choice "a" is correct. When prior-period financial statements are restated in the current period to conform with GAAP, the auditor's updated report on the prior-period financial statements should express an unqualified opinion concerning the restated financial statements. Choice "b" is incorrect. The original auditor's reporton the prior period should not be presented. Choice "c" is incorrect. The original report date is used only if the original report is reissued unchanged.Choice "d" is incorrect. A change in accounting principle that is properly accounted for does not result in a qualified opinion.Events Occurring After Year-end

QUESTION 74Which of the following statements is not true regarding the auditor's responsibility for subsequent events?

A. The auditor has an active responsibility to make continuing inquiries between the date of the auditor's report and the date on which the report is submitted.B. The auditor has an active responsibility to make continuing inquiries between the date of the financial statements and the date of the auditor's report.C. The auditor has an active responsibility to make continuing inquiries between the date of the financial statements and the date on which sufficient appropriate

audit evidence has been obtained.D. The auditor has no active responsibility to make continuing inquiries after the date of the auditor's report.



Choice "a" is correct. The auditor has no active responsibility to make continuing inquiries between the date of the auditor's report and the date on which the reportis submitted. The auditor's active responsibility stops on the date of the auditor's report. Choice "b" is incorrect. The auditor does have an active responsibility tomake continuing inquiries between the date of the financial statements and the date of the auditor's report. Choice "c" is incorrect. The auditor does have an activeresponsibility to make continuing inquiries between the date of the financial statements and the date on which sufficient appropriate audit evidence has beenobtained.Choice "d" is incorrect. The auditor has no active responsibility to make continuing inquiries after the date of the auditor's report.

QUESTION 75Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of subsequent events?

A. Confirming a sample of material accounts receivable established after year-end.B. Comparing the financial statements being reported on with those of the prior period.C. Investigating personnel changes in the accounting department occurring after year-end.D. Inquiring as to whether any unusual adjustments were made after year-end.

Correct Answer: D



Choice "d" is correct. An auditor would most likely inquire as to whether any unusual adjustments were made after year-end that would require adjustment to and/ordisclosure in the year-end financial statements.Choice "a" is incorrect. Obtaining evidence about A/R that were established after year-end would not provide the auditor with information about subsequent events,since any information about these A/R would not require adjustment to or disclosure in the prior year financial statements. Choice "b" is incorrect. Comparing thefinancial statements being reported on with those of the prior period is not a very good source of subsequent event information. Choice "c" is incorrect. Changes inaccounting personnel at any time would probably not result in any subsequent event financial statement adjustment or disclosure.

QUESTION 76Which of the following events occurring after the issuance of an auditor's report most likely would cause the auditor to make further inquiries about the previouslyissued financial statements?

A. An uninsured natural disaster occurs that may affect the entity's ability to continue as a going concern.B. A contingency is resolved that had been disclosed in the audited financial statements.C. New information is discovered concerning undisclosed lease transactions of the audited period.D. A subsidiary is sold that accounts for 25% of the entity's consolidated net income.



Choice "c" is correct. The question addresses the subsequent discovery of facts that may have existed at the balance sheet date. Such events will often require anadjustment to the financial statements. An example is new information discovered about undisclosed lease transactions of the audited period. As a result, theauditor should make further inquiry to determine whether the information is reliable and whether the facts existed at the date of the report. Choice "a" is incorrect.The natural disaster is an example of a subsequent event occurring after the date of the auditor's report that the auditor has no obligation to investigate. Choice "b"is incorrect. The resolution of a disclosed contingency is an example of a subsequent event occurring after the date of the auditor's report that the auditor has noobligation to investigate.Choice "d" is incorrect. Sale of a subsidiary occurring after the date of the auditor's report is an example of a subsequent event that the auditor has no obligation toinvestigate.

QUESTION 77An auditor is considering whether the omission of a substantive procedure considered necessary at the time of an audit may impair the auditor's present ability tosupport the previously expressed opinion. The auditor need not apply the omitted procedure if the:

A. Financial statements and auditor's report were not distributed beyond management and the board of directors.B. Auditor's previously expressed opinion was qualified because of a departure from GAAP.C. Results of other procedures that were applied tend to compensate for the procedure omitted.D. Omission is due to unreasonable delays by client personnel in providing data on a timely basis.



Choice "c" is correct. When the auditor concludes that an auditing procedure considered necessary at the time of the audit was omitted, the auditor should assessthe importance of the procedure to the present ability to support the previously issued opinion. The results of other procedures that were applied may tend tocompensate for the one omitted or make its omission less important.Choice "a" is incorrect. If a procedure has been omitted, the auditor must consider whether other parties may be relying on the financial statements, even if the auditreport had limited distribution.Choice "b" is incorrect. The fact that the previous opinion was qualified does not negate the need to apply the omitted procedure.Choice "d" is incorrect. Delays by client personnel may extend audit work, but do not provide a reason for omitting a procedure.

QUESTION 78Subsequent to the issuance of an auditor's report, the auditor became aware of facts existing at the report date that would have affected the report had the auditorthen been aware of such facts. After determining that the information is reliable, the auditor should next:

A. Determine whether there are persons relying or likely to rely on the financial statements who would attach importance to the information.B. Request that management disclose the newly discovered information by issuing revised financial statements.C. Issue revised pro forma financial statements taking into consideration the newly discovered information.D. Give public notice that the auditor is no longer associated with financial statements.


Explanation/Reference:Explanation:Choice "a" is correct. When subsequently discovered information is found both to be reliable and to have existed at the date of the auditor's report, the auditorshould determine whether there are persons relying or likely to rely on the financial statements who would attach importance to the information.Choice "b" is incorrect. The auditor would request that management disclose the newly discovered information only after determining whether there are personsrelying on the information.

Choice "c" is incorrect. Management, not the auditor, may issue revised financial statements. Choice "d" is incorrect. The auditor would give public notice that he/she is no longer associated with the FS only after determining that there are persons relying on the information and only if the client refuses to issue revised FS.

QUESTION 79On March 15, X4, Kent, CPA, issued an unqualified opinion on a client's audited financial statements for the year ended December 31, X3. On May 4, X4, Kent'sinternal inspection program disclosed that engagement personnel failed to observe the client's physical inventory. Omission of this procedure impairs Kent's presentability to support the unqualified opinion. If the stockholders are currently relying on the opinion, Kent should first:

A. Advise management to disclose to the stockholders that Kent's unqualified opinion should not be relied on.B. Undertake to apply alternative procedures that would provide a satisfactory basis for the unqualified opinion.C. Reissue the auditor's report and add an explanatory paragraph describing the departure from generally accepted auditing standards.D. Compensate for the omitted procedure by performing tests of controls to reduce audit risk to a sufficiently low level.



Choice "b" is correct. In the event of omitted audit procedures, the auditor should first attempt to perform alternative procedures in order to ascertain whether theoriginal opinion can be relied upon.Choice "a" is incorrect. The auditor would only advise the client to notify all stockholders and other financial statement users that the unqualified opinion cannot berelied upon if the auditor cannot satisfy himself (with alternative procedures) as to the propriety of the original opinion. Choice "c" is incorrect. The auditor may needto reissue the audit report if the auditor is unable to satisfy himself using alternative procedures; the opinion issued should be qualified or disclaimed, due to thescope limitation.Choice "d" is incorrect. Tests of controls are not appropriate alternative procedures.


A. A technological development that could affect the entity's future ability to continue as a going concern.B. The discovery of information regarding a contingency that existed before the financial statements were issued.C. The entity's sale of a subsidiary that accounts for 30% of the entity's consolidated sales.D. The final resolution of a lawsuit explained in a separate paragraph of the auditor's report.



Choice "b" is correct. With respect to events occurring after the issuance of an auditor's report, the auditor is only responsible for information that existed at theaudit report date. Choice "a" is incorrect. Since the information did not exist at the report date, the auditor has no obligation to make any further inquiry.Choice "c" is incorrect. Since the information did not exist at the report date, the auditor has no obligation to make any further inquiry.Choice "d" is incorrect. Since the information did not exist at the report date, the auditor has no obligation to make any further inquiry.

QUESTION 81Wilson, CPA, obtained sufficient appropriate audit evidence to render an opinion on Abco's December 31, X1, financial statements on March 6, X2. A subsequentevent requiring adjustment to the X1 financial statements occurred on April 10, X2, and came to Wilson's attention on April 24, X2. If the adjustment is made withoutdisclosure of the event, Wilson's report ordinarily should be dated:

A. March 6, X2.B. April 10, X2.C. April 24, X2.D. Using dual dating.



Choice "a" is correct. Since the financial statements were adjusted without disclosure of the event in the footnotes, Wilson's report should be dated as of March 6,X2, the date on which sufficient appropriate audit evidence was obtained.Choice "b" is incorrect. An April 10, X2 report date would be used only if the event were disclosed and Wilson wanted to extend the responsibility for all significantevents through April 10, X2.Choice "c" is incorrect. An April 24, X2 report date would be used only if the event were disclosed and Wilson wanted to extend the responsibility for all significantevents through April 24, X2.Choice "d" is incorrect. Dual dating would only be used if the event were disclosed in the notes to the financial statements.

QUESTION 82An auditor concludes that a substantive auditing procedure considered necessary during the prior period's audit was omitted. Which of the following factors wouldmost likely cause the auditor promptly to apply the omitted procedure?

A. There are no alternative procedures available to provide the same evidence as the omitted procedure.B. The omission of the procedure impairs the auditor's present ability to support the previously expressed opinion.

C. The source documents needed to perform the omitted procedure are still available.D. The auditor's opinion on the prior period's financial statements was unqualified.



Choice "b" is correct. The factor most likely to cause the auditor to promptly apply the omitted procedure would be if the omission impairs the auditor's presentability to support the previously expressed opinion.Choice "a" is incorrect. The auditor would first need to determine whether the omission of the procedure impairs the ability to support the previously expressedopinion. It is possible that other procedures already performed tended to compensate for the omitted procedure, and therefore no further action would benecessary.Choice "c" is incorrect. The availability of the source documents needed to perform the procedure has little bearing on whether the auditor determines that it isnecessary to perform the procedure.Choice "d" is incorrect. The rendering of a clean opinion has little importance. The issue is "support of the previously expressed opinion," not what the opinion was.

QUESTION 83After issuing a report, an auditor has no obligation to make continuing inquiries or perform other procedures concerning the audited financial statements, unless:

A. Information, which existed at the report date and may affect the report, comes to the auditor's attention.B. Management of the entity requests the auditor to reissue the auditor's report.C. Information about an event that occurred after the date of the auditor's report comes to the auditor's attention.D. Final determinations or resolutions are made of contingencies that had been disclosed in the financial statements.



Choice "a" is correct. After issuing a report, an auditor has no obligation to make continuing inquiries or perform other procedures concerning the audited financialstatements, unless information, which existed at the report date and may affect the report, comes to the auditor's attention. In this case the auditor would performprocedures to determine if the information affects the report and is important to the external users. Choice "b" is incorrect. The auditor has no obligation to performother procedures if management of the entity requests the auditor to reissue the auditor's report (if no significant changes have occurred since the report date).Choice "c" is incorrect. The auditor has no obligation to perform other procedures if information about an event that occurred after the date of the auditor's reportcomes to the auditor's attention (and the auditor has not been asked to reissue the report). Choice "d" is incorrect. Most contingencies are eventually resolved;

however, such resolution does not require the auditor to perform other procedures.

QUESTION 84Which of the following procedures would an auditor most likely perform in obtaining evidence about subsequent events?

A. Examine a sample of transactions that occurred since the year-end to verify the effectiveness of computer controls.B. Inquire of management whether there have been significant changes in working capital since the year-end.C. Recompute depreciation charges for plant assets sold for substantial gains since the year-end.D. Reperform the tests of controls that indicated significant deficiencies in the operation of internal control.



Choice "b" is correct. In obtaining evidence about subsequent events, the auditor would most likely inquire of management whether there have been significantchanges in working capital since year-end.Such changes could be indicative of a going concern problem, which would require financial statement disclosure.Choice "a" is incorrect. Subsequent events are material events or transactions occurring subsequent to the balance sheet date, but prior to the issuance of thefinancial statements, that require adjustment to or disclosure in the financial statements. Reviewing a sample of transactions occurring after year-end to verify theeffectiveness of computer controls would not be likely to provide information about subsequent events. Choice "c" is incorrect. Subsequent events are materialevents or transactions occurring subsequent to the balance sheet date, but prior to the issuance of the financial statements, that require adjustment to or disclosurein the financial statements. Recomputing depreciation related to assets sold after year-end is not likely to provide information about subsequent events. Salesoccurring after year-end are not considered to be subsequent events. Choice "d" is incorrect. Subsequent events are material events or transactions occurringsubsequent to the balance sheet date, but prior to the issuance of the financial statements, that require adjustment to or disclosure in the financial statements.Control deficiencies do not fall within this definition, so reperforming tests of controls would not provide evidence about subsequent events.


A. A lawsuit is resolved that is explained in a separate paragraph of the prior-year's auditor's report.B. New information is discovered concerning undisclosed related party transactions of the prior year.C. A technological development occurs that affects the entity's ability to continue as a going concern.D. The entity sells a subsidiary that accounts for 35% of the entity's consolidated sales.

Correct Answer: BSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The Basics

Explanation


Choice "b" is correct. If an auditor becomes aware of material information that existed at the date of the auditor's report, and which would have affected that report,the auditor needs to take appropriate action.Since related party transactions should be disclosed in the financial statements, it is likely that the auditor would need to make further inquiries to determine whetherthe lack of disclosure will affect the previously issued report.Choice "a" is incorrect. Resolution of a lawsuit that was disclosed in the prior year's audit report would not be likely to affect the audit report, as auditors are notrequired to update their reports for events occurring after the fact.Choice "c" is incorrect. A technological development that affects the entity's ability to continue as a going concern would not be likely to affect the previous year'saudit report, as auditors are not required to update their reports for events occurring after the fact. Choice "d" is incorrect. Sale of a subsidiary would not be likely toaffect the previous year's audit report, as auditors are not required to update their reports for events occurring after the fact.

QUESTION 86On February 9, Brown, CPA, expressed an unqualified opinion on the financial statements of Web Co. On October 9, during a peer review of Brown's practice, thereviewer informed Brown that engagement personnel failed to perform a search for subsequent events for the Web engagement. Brown should first:

A. Request Web's permission to perform substantive procedures that would provide a satisfactory basis for the opinion.B. Inquire of Web whether there are persons currently relying, or likely to rely, on the financial statements.C. Take no additional action because subsequent events have no effect on the financial statements that were reported on.D. Assess the importance of the omitted procedures to Brown's present ability to support the opinion.



Choice "d" is correct. If an omitted audit procedure is discovered, the auditor should assess the importance of the omitted procedure to the auditor's ability tosupport the opinion. It might be the case that other audit procedures tended to compensate for the omitted procedure, in which case no further action would benecessary.Choice "a" is incorrect. The auditor would only request permission to perform substantive procedures if no other procedures compensated for the missing one, andif there were persons relying (or likely to rely) on the financial statements. Choice "b" is incorrect. The auditor would need to determine whether there were personsrelying (or likely to rely) on the financial statements, but this would not be done unless it had already been determined that no other audit procedures compensatedfor the missing one. Choice "c" is incorrect. If the omitted audit procedure impairs the auditor's ability to support the opinion, no other procedures compensated forthe missing one, and there were persons relying (or likely to rely) on the financial statements, the auditor would need to apply substantive procedures. Taking noaction would not be an acceptable response.Reporting on Other Information

QUESTION 87Which of the following is not true regarding an engagement to provide a written report on the application of accounting principles?

A. An accountant is prohibited from providing a report on the application of accounting principles to a transaction not involving the facts and circumstances of aspecific entity.

B. The accountant's written report on the application of accounting principles should include an identification of the specific entity involved.C. An accountant is prohibited from providing a report on the application of accounting principles to a proposed future transaction involving the facts and

circumstances of a specific entity.D. The accountant's written report on the application of accounting principles should include a paragraph restricting the use of the report.



Choice "c" is correct. An accountant may report on the application of accounting principles to a proposed future transaction as long as the transaction involves thefacts and circumstances of a specific entity.Choice "a" is incorrect. An accountant is prohibited from providing a report on the application of accounting principles to "hypothetical transactions," which aredefined as those not involving the facts and circumstances of a specific entity.Choices "b" and "d" are incorrect. The accountant's written report on the application of accounting principles should include an identification of the specific entityinvolved, a description of the transaction(s), a statement of the relevant facts, circumstances, and assumptions (and a statement that any changes therein maychange the report), a statement about the source of the information, a statement describing the appropriate accounting principles or type of opinion that may berendered, the reasons for the accountant's conclusions, a statement regarding management's responsibility, and a restrictive use paragraph.

QUESTION 88Before reporting on the financial statements of a U.S. entity that have been prepared in conformity with another country's accounting principles, an auditor practicingin the U.S. should:

A. Understand the accounting principles generally accepted in the other country.B. Be certified by the appropriate auditing or accountancy board of the other country.C. Notify management that the auditor is required to disclaim an opinion on the financial statements.D. Receive a waiver from the auditor's state board of accountancy to perform the engagement.


Explanation/Reference:Explanation:Choice "a" is correct. Before reporting on the financial statements of a U.S. entity that have been prepared in conformity with another country's accountingprinciples, the auditor practicing in the U.S. should understand the accounting principles generally accepted in the other country. Choice "b" is incorrect. The auditorpracticing in the U.S. would be able to report on the financial statements of the U.S. entity without obtaining certification in the other country. Choice "c" is incorrect.The auditor need not disclaim an opinion on the financial statements prepared in conformity with another country's accounting principles. Choice "d" is incorrect. Awaiver to perform the engagement is not necessary.

QUESTION 89In connection with a proposal to obtain a new client, an accountant in public practice is asked to prepare a written report on the application of accounting principlesto a specific transaction. The accountant's report should include a statement that:

A. Any difference in the facts, circumstances, or assumptions presented may change the report.B. The engagement was performed in accordance with Statements on Standards for Consulting Services.C. The guidance provided is for management use only and may not be communicated to the prior or continuing auditors.D. Nothing came to the accountant's attention that caused the accountant to believe that the accounting principles violated GAAP.



Choice "a" is correct. The accountant's report on the application of accounting principles should include a statement that should any facts or circumstances differfrom those presented to the accountant, the accountant's conclusions may change. Choice "b" is incorrect. The report should state that the engagement wasperformed in accordance with "AICPA Standards," not statements on Standards for Consulting Services. Choice "c" is incorrect. The report's use is restricted to"specified parties," which may include parties other than management (e.g., the board of directors). Also, the preparers of the financial statements and the reportingaccountant should consult with the entity's continuing accountant. Choice "d" is incorrect. The report does not provide negative assurance with respect to GAAP;rather, it may describe the appropriate accounting principles to be applied.

QUESTION 90Blue, CPA, has been asked to render an opinion on the application of accounting principles to a specific transaction by an entity that is audited by another CPA.Blue may accept this engagement, but should:

A. Consult with the continuing CPA to obtain information relevant to the transaction.B. Report the engagement's findings to the entity's audit committee, the continuing CPA, and management.C. Disclaim any opinion that the hypothetical application of accounting principles conforms with generally accepted accounting principles.D. Notify the entity that the report is for the general use of all interested parties.



Choice "a" is correct. When rendering an opinion on the application of accounting principles to a specific transaction, the reporting CPA should consult with thecontinuing CPA to obtain information relevant to the transaction.Choice "b" is incorrect. The reporting CPA has no obligation to report the engagement's findings to the continuing CPA. Generally, the report would be addressed tothe requesting party (e.g., management, the board of directors, etc.).Choice "c" is incorrect. There is no disclaimer in the report; however, the CPA does state that the preparers of the financial statements are responsible for properaccounting treatment. Choice "d" is incorrect. Use of the report is restricted to specified parties.

QUESTION 91The financial statements of KCP America, a U.S. entity, are prepared for inclusion in the consolidated financial statements of its non-U.S. parent. These financialstatements are prepared in conformity with the accounting principles generally accepted in the parent's country and are for use only in that country.How may KCP America's auditor report on these financial statements?

A. A U.S.-style report (unmodified).II. A U.S.-style report modified to report on the accounting principles of the parent's country.III. The report form of the parent's country.

B. Option AC. Option BD. Option CE. Option D



Explanation:

Choice "d" is correct. No - Yes - Yes. When financial statements are prepared in conformity with the accounting principles generally accepted in the parent's countryand are for use only in that country, the auditor may report using either a U.S.-style report modified to report on the accounting principles of the parent's country orthe report form of the parent's country. Choices "a", "b", and "c" are incorrect, per the above Explanation: .

QUESTION 92Which of the following is true regarding the auditor's responsibility to report on information accompanying the basic financial statements in a client-prepareddocument?

A. The auditor may report on information accompanying the basic financial statements in a clientprepared document only if he or she has been specificallyengaged to do so.

B. The auditor is required to express an opinion on whether information accompanying the basic financial statements in a client-prepared document is fairly statedin all material respects in relation to the financial statements taken as a whole.

C. If an auditor chooses to report on information accompanying the basic financial statements in a clientprepared document, the report should include a descriptionof the character of the audit work performed.

D. If an auditor chooses to report on information accompanying the basic financial statements in a clientprepared document, the report should include an opinionon the information but should not describe the character of the audit work performed.



Choice "c" is correct. If an auditor chooses to report on information accompanying the basic financial statements in a client-prepared document, the report shouldinclude a description of both the character of the audit work performed and the degree of responsibility assumed. Choice "a" is incorrect. There is no requirementthat the auditor be specifically engaged to report on such information. If auditing procedures have been applied to the information, the auditor is permitted to reportthereon.Choice "b" is incorrect. The auditor is permitted but not required to report on such information. Choice "d" is incorrect. If an auditor chooses to report on informationaccompanying the basic financial statements in a client-prepared document, the report should include an opinion on the information and a description of both thecharacter of the audit work performed and the degree of responsibility assumed.

QUESTION 93Which of the following reporting options is least likely with regard to supplementary information that is required by GAAP?

A. The auditor's report on the financial statements makes no reference to the supplementary information.B. A disclaimer of opinion is issued on supplementary information that is not clearly distinguished from the financial statements and is not marked "unaudited."C. The auditor's report on the financial statements includes both an opinion on the supplementary information and a statement restricting the use of the report.

D. The auditor's report on the financial statements includes an opinion regarding whether the supplementary information is fairly stated in all material respects inrelation to the financial statements taken as a whole.



Choice "c" is correct. There is no requirement that the auditor's report on supplementary information required by GAAP be restricted.Choice "a" is incorrect. An auditor is not required to audit supplementary information, and in such cases the auditor's report on the basic financial statements wouldnot generally include a reference to such information.Choice "b" is incorrect. When supplementary information that is not clearly distinguished from the financial statements is not marked "unaudited," the auditor wouldgenerally issue a disclaimer on that information.Choice "d" is incorrect. When the auditor chooses to apply auditing procedures to the supplementary information, he or she may express an opinion regardingwhether the supplementary information is fairly stated in all material respects in relation to the financial statements taken as a whole.

QUESTION 94When an auditor submits a document containing audited financial statements to a client, and those financial statements include supplementary information requiredby GAAP, the auditor may choose any of the following options, except:

A. Express an opinion on the information, if he or she has been engaged to examine such information.B. Express negative assurance on the information, if review procedures have been appropriately performed.C. Report on whether the information is fairly stated in relation to the financial statements taken as a whole, if appropriate auditing procedures have been applied.D. Disclaim an opinion on the information.


Explanation/Reference:Explanation:Choice "b" is correct. The auditor would not perform a review or express negative assurance on supplementary information required by GAAP that is included in anauditor-submitted document.Choice "a" is incorrect. The auditor may express an opinion on the information, if he or she has been engaged to examine it.Choice "c" is incorrect. The auditor may report on whether the information is fairly stated in relation to the financial statements taken as a whole, if appropriateauditing procedures have been applied.Choice "d" is incorrect. The auditor may disclaim an opinion on the information.

QUESTION 95

An auditor may report on condensed financial statements that are derived from complete financial statements if the:

A. Condensed financial statements are distributed to stockholders along with the complete financial statements.B. Auditor describes the additional procedures performed on the condensed financial statements.C. Auditor indicates whether the information in the condensed financial statements is fairly stated in all material respects in relation to the complete financial

statements from which it has been derived.D. Condensed financial statements are presented in comparative form with the prior year's condensed financial statements.



Choice "c" is correct. An auditor may report on condensed financial statements that are derived from financial statements that he or she has audited, indicating (1)that he or she has audited and expressed an opinion on the complete financial statements, (2) the date of the auditor's report, (3) the type of opinion expressed,and (4) that the information contained in the condensed financial statements is fairly stated in all material respects in relation to the complete financial statementsfrom which it has been derived.Choice "a" is incorrect. The condensed financial statements do not have to be distributed to the stockholders.Choice "b" is incorrect. The audit report on condensed financial statements does not require that additional procedures be described.Choice "d" is incorrect. Condensed financial statements do not need to be presented in comparative form with the prior year's financial statements.

QUESTION 96An auditor is engaged to report on selected financial data that are included in a client-prepared document containing audited financial statements. Under thesecircumstances, the report on the selected data should:

A. Be limited to data derived from the audited financial statements.B. Be distributed only to senior management and the board of directors.C. State that the presentation is a comprehensive basis of accounting other than GAAP.D. Indicate that the data are not fairly stated in all material respects.



Choice "a" is correct. An auditor's report on selected information included in a client-prepared document containing audited financial statements should be limited to

data derived from audited financial statements.Choice "b" is incorrect. It is not necessary to limit distribution of such a report. Choice "c" is incorrect. Selected financial data is not an "other comprehensive basisof accounting."Choice "d" is incorrect. The auditor indicates whether the selected financial data is fairly stated, in all material respects, in relation to the financial statements fromwhich it has been derived.

QUESTION 97If information accompanying the basic financial statements in an auditor-submitted document has been subjected to auditing procedures, the auditor may include inthe auditor's report on the financial statements an opinion that the accompanying information is fairly stated in:

A. Accordance with generally accepted auditing standards.B. Conformity with generally accepted accounting principles.C. All material respects in relation to the basic financial statements taken as a whole.D. Accordance with attestation standards expressing a conclusion about management's assertions.



Choice "c" is correct. When an auditor submits a document that contains information in addition to the client's basic financial statements, and this information wassubjected to auditing procedures, the auditor may include in the auditor's report an opinion that the information is fairly stated in all material respects in relation tothe basic financial statements taken as a whole. This statement would follow the opinion paragraph in the standard report. Choice "a" is incorrect. Information in anASD is not stated in an auditor's report to be in accordance with GAAS. Instead, the auditor would state that the "information has been subjected to the auditingprocedures applied in the audit of the basic financial statements..." Choice "b" is incorrect. The auditor would not state that ASD information was fairly stated inaccordance with GAAP. The information in an ASD is in addition to that required by GAAP. Choice "d" is incorrect. Reports on ASD are not "attest engagements."

QUESTION 98An auditor concludes that there is a material inconsistency in the other information in an annual report to shareholders containing audited financial statements. Theauditor believes that the financial statements do not require revision, but the client is unwilling to revise or eliminate the material inconsistency in the otherinformation. Under these circumstances, what action would the auditor most likely take?

A. Consider the situation closed because the other information is not in the audited financial statements.B. Issue an "except for" qualified opinion after discussing the matter with the client's audit committee.C. Disclaim an opinion on the financial statements after explaining the material inconsistency in a separate explanatory paragraph.D. Revise the auditor's report to include a separate explanatory paragraph describing the material inconsistency.

Correct Answer: D



Choice "d" is correct. If the auditor discovers a material inconsistency in other information accompanying the audited financial statements, the financial statementsdo not require revision, and the client refuses to eliminate or revise the inconsistency, the auditor should consider 1) revising the report to include a separateparagraph describing the inconsistency, 2) withholding the report, or 3) withdrawing from the engagement.Choice "a" is incorrect. Even though the auditor has no responsibility to audit or otherwise corroborate other information accompanying the financial statements, theauditor has a responsibility to read the other information accompanying the financial statements for consistency and to identify any material misstatements of factincluded therein. Choice "b" is incorrect. A qualified opinion is generally not warranted because the financial statements are fairly stated.Choice "c" is incorrect. A disclaimer of opinion is generally not warranted because there is no limitation on scope.

QUESTION 99In the standard report on condensed financial statements that are derived from a public entity's audited financial statements, a CPA should indicate that the:

A. Condensed financial statements are prepared in conformity with another comprehensive basis of accounting.B. CPA has audited and expressed an opinion on the complete financial statements.C. Condensed financial statements are not fairly presented in all material respects.D. CPA expresses limited assurance that the financial statements conform with GAAP.



Choice "b" is correct. The auditor's report on condensed statements derived from audited statements should indicate (1) that the CPA audited and expressed anopinion on the complete financial statements,(2) the date of the auditor's report on the complete financial statements, (3) the type of opinion expressed, and (4) whether, in the auditor's opinion, the informationset forth in the condensed financial statements is fairly stated in all material respects in relation to the complete financial statements from which it was derived.Choice "a" is incorrect. Condensed financial statements are not prepared in conformity with a comprehensive basis of accounting other than GAAP.Choice "c" is incorrect. The auditor's report on condensed financial statements does not indicate whether they are fairly presented in all material respects; rather,the report indicates whether they are fairly presented in relation to the complete financial statements. Choice "d" is incorrect. The auditor does not express anopinion (or provide any assurance) on whether condensed FS conform with GAAP; only whether such statements are fairly stated in relation to the complete FS.

QUESTION 100Investment and property schedules are presented for purposes of additional analysis in an auditor submitted document. The schedules are not required parts of thebasic financial statements, but accompany the basic financial statements. When reporting on such additional information, the measurement of materiality is the:

A. Same as that used in forming an opinion on the basic financial statements taken as a whole.B. Lesser of the individual schedule of investments or schedule of property taken by itself.C. Greater of the individual schedule of investments or schedule of property taken by itself.D. Combined total of both the individual schedules of investments and property taken as a whole.



Choice "a" is correct. When reporting on additional information accompanying the audited financial statements, the measure of materiality would be the same asthat used in forming an opinion on the financial statements taken as a whole. Choices "b", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 101What is an auditor's responsibility for supplementary information which is outside the basic financial statements, but required by the FASB?

A. The auditor has no responsibility for required supplementary information as long as it is outside the basic financial statements.B. The auditor's only responsibility for required supplementary information is to determine that such information has not been omitted.C. The auditor should apply certain limited procedures to the required supplementary information, and report deficiencies in, or omissions of, such information.D. The auditor should apply tests of details of transactions and balances to the required supplementary information, and report any material misstatements in such

information.



Choice "c" is correct. For additional supplementary information required by the FASB, the auditor should apply certain limited procedures to the information, andreport deficiencies in or omissions of such information.Choice "a" is incorrect. Required supplementary information is considered an essential part of financial reporting, and therefore certain limited procedures should beapplied by the auditor. Choice "b" is incorrect. For additional supplementary information required by the FASB, the auditor should apply certain limited procedures tothe information, and report deficiencies in or omissions of such information.Choice "d" is incorrect. Certain limited procedures should be applied to required supplementary information, but this information need not be audited.

QUESTION 102

Which of the following best describes the auditor's reporting responsibility concerning information accompanying the basic financial statements in an auditor-submitted document?

A. The auditor has no reporting responsibility concerning information accompanying the basic financial statements.B. The auditor should report on the information accompanying the basic financial statements only if the auditor participated in its preparation.C. The auditor should report on the information accompanying the basic financial statements only if the auditor did not participate in its preparation.D. The auditor should report on all the information included in the document.


Explanation/Reference:Explanation:Choice "d" is correct. When an auditor submits a document containing audited financial statements to the client or others, the auditor has a responsibility to reporton all the information included in the document.Choice "a" is incorrect. The auditor does have additional reporting responsibilities concerning information that accompanies the basic financial statements in anauditor-submitted document. Choice "b" is incorrect. The auditor has responsibility to report on any additional information regardless of whether the auditorparticipated in the preparation of the information. Choice "c" is incorrect. The auditor has reporting responsibilities regardless of whether the auditor participated inthe preparation of the information.

QUESTION 103When audited financial statements are presented in a client's document containing other information, the auditor should:

A. Perform inquiry and analytical procedures to ascertain whether the other information is reasonable.B. Add an explanatory paragraph to the auditor's report without changing the opinion on the financial statements.C. Perform the appropriate substantive auditing procedures to corroborate the other information.D. Read the other information to determine that it is consistent with the audited financial statements.



Choice "d" is correct. The auditor should read the "other information" in a client's document containing audited FS to determine that it is consistent with the auditedFS. Choice "a" is incorrect. Performing analytical procedures or any other procedure is not necessary.Choice "b" is incorrect. An explanatory paragraph is not required. Choice "c" is incorrect. The auditor has no obligation to perform any procedure to corroborate"other information" contained in a document such as an annual report.

QUESTION 104An auditor may report on condensed financial statements that are derived from complete audited financial statements if the:

A. Auditor indicates whether the information in the condensed financial statements is fairly stated in all material respects.B. Condensed financial statements are presented in comparative form with the prior year's condensed financial statements.C. Auditor describes the additional review procedures performed on the condensed financial statements.D. Condensed financial statements are distributed only to management and the board of directors.



Choice "a" is correct. When reporting on condensed financial statements that are derived from complete audited financial statements, the auditor should indicate inhis report whether the information in the condensed financial statements is fairly stated in all material respects (in relation to the basic financial statements taken asa whole). Choices "b" and "d" are incorrect. There is no requirement that the condensed financial statements be presented in comparative form, or that they bedistributed only to management and the board of directors (i.e., distribution is not restricted). Choice "c" is incorrect. The auditor would not perform or describeadditional review procedures related to the condensed financial statements.

QUESTION 105If management (of a governmental body) declines to present supplementary information required by the Governmental Accounting Standards Board (GASB), theauditor should issue a(an):

A. Adverse opinion.B. Qualified opinion with an explanatory paragraph.C. Unqualified opinion.D. Unqualified opinion with an additional explanatory paragraph.



Choice "d" is correct. If management (of a governmental body) declines to present information required by the GASB, the auditor should issue an unqualifiedopinion with an additional explanatory paragraph.

Choices "a", "b", and "c" are incorrect, per the above Explanation: .

QUESTION 106The objective of auditing procedures applied to segment information is to provide the auditor with a reasonable basis for concluding whether:

A. The information is useful for comparing a segment of one enterprise with a similar segment of another enterprise.B. Sufficient audit evidence has been obtained to allow the auditor to be associated with the segment information.C. A separate opinion on the segment information is necessary due to inconsistent application of accounting principles.D. The information is presented in conformity with the FASB Statement on segment information.



Choice "d" is correct. The auditor's objective is to provide a reasonable basis for concluding whether segment information is presented in conformity with GAAP.Choice "a" is incorrect. The auditor is not required to see that segment information included is comparable to other enterprises.Choice "b" is incorrect. Sufficient audit evidence must be obtained to ensure that segment information is presented in accordance with GAAP, not to allow theauditor to be associated with such information.Choice "c" is incorrect. The inclusion of segment information is a GAAP requirement, and a separate opinion is not required.

QUESTION 107Green, CPA, is requested to render an opinion on the application of accounting principles by an entity that is audited by another CPA. Green may:

A. Not accept such an engagement because to do so would be considered unethical.B. Not accept such an engagement because Green would lack the necessary information on which to base an opinion without conducting an audit.C. Accept the engagement but should form an independent opinion without consulting with the continuing CPA.D. Accept the engagement but should consult with the continuing CPA to ascertain all the available facts relevant to forming a professional judgment.



Choice "d" is correct. A "reporting accountant" (an accountant in public practice who is requested to render an opinion on the application of GAAP by an entityaudited by another CPA) may accept the engagement, but should consult with the "continuing CPA" to ascertain the available facts relevant to forming a

professional judgment. Choices "a" and "b" are incorrect. A reporting CPA may accept an engagement to render an opinion on GAAP of an entity audited by anotherCPA. The reporting CPA should consult with the continuing CPA to obtain pertinent information.Choice "c" is incorrect. The reporting accountant should consult with the continuing accountant to ascertain all the available, relevant facts.

QUESTION 108In its annual report to shareholders, Lake Co. included a separate management report that contained additional information. Lake's auditor is expressing anunqualified opinion on Lake's financial statements but has not been engaged to examine and report on this additional information. What is the auditor'sresponsibility concerning such a report?

A. The auditor should add an explanatory paragraph to the report on the financial statements disclaiming an opinion on the additional information.B. The auditor has no obligation to read the management report or to verify the accuracy or appropriateness of its contents.C. The auditor should request Lake to place the management report in its annual report where it will not be misinterpreted to be the auditor's assertion.D. The auditor should read the management report and consider whether it contains a material misstatement of fact.



Choice "d" is correct. The auditor should read other information accompanying the basic financial statements and consider whether it contains a materialinconsistency or material misstatement of fact.Choice "a" is incorrect. The auditor generally does not add a disclaimer paragraph in this situation.Choice "b" is incorrect. The auditor should read other information accompanying the basic financial statements and consider whether it contains a materialinconsistency or material misstatement of fact.Choice "c" is incorrect. Even if the management report were included in the annual report, the auditor still has the same responsibility regarding both themanagement report and the annual report: the auditor should read the information and consider whether it contains a material inconsistency or materialmisstatement of fact.

QUESTION 109An auditor is reporting on condensed financial statements for an annual period that are derived from the audited financial statements of a publicly-held entity. Theauditor's opinion should indicate whether the information in the condensed financial statements is fairly stated in all material respects:

A. In conformity with accounting principles generally accepted in the United States of America.B. In relation to the complete financial statements.C. In conformity with an other comprehensive basis of accounting.D. In relation to supplementary filings under federal security statutes.

Correct Answer: B



Choice "b" is correct. The auditor should report whether the information in the condensed financial statements is fairly stated, in all material respects, in relation tothe financial statements from which it has been derived.Choice "a" is incorrect. Condensed financial statements do not include all of the disclosures required by GAAP, and therefore would not typically be presented inconformity with GAAP. Choice "c" is incorrect. Condensed financial statements are presented in less detail than complete financial statements, but the fact patterngives no indication that any comprehensive basis of accounting other than GAAP has been used.Choice "d" is incorrect. The auditor should report whether the information in the condensed financial statements is fairly stated, in all material respects, in relation tothe financial statements from which it has been derived, not in relation to supplementary filings under federal security statutes.

QUESTION 110An auditor determines that the entity is presenting certain supplementary financial disclosures of pension information that are required by the GASB. Under thesecircumstances, the auditor should:

A. Add an explanatory paragraph to the auditor's report that refers to the required supplementary information.B. State that the audit is not being performed in accordance with generally accepted auditing standards.C. Document in the working papers that the required supplementary information is presented, but should not apply any procedures to the information.D. Compare the required supplementary information for consistency with the audited financial statements.



Choice "d" is correct. The auditor should perform certain limited procedures on supplementary information accompanying the financial statements, includingevaluating whether the information is consistent with the audited financial statements. Choice "a" is incorrect. Generally, the auditor's report on the financialstatements would not include a reference to required supplementary information unless there were a problem with it (e.g., it was omitted, inappropriately prepared,or the auditor was unable to satisfactorily complete required procedures).Choice "b" is incorrect. An audit can and should be performed in accordance with generally accepted auditing standards even when required supplementaryinformation is presented. Choice "c" is incorrect. The auditor should perform certain limited procedures on supplementary information accompanying the financialstatements.

QUESTION 111Pell, CPA, decides to serve as principal auditor in the audit of the financial statements of Tech Consolidated, Inc. Smith, CPA, audits one of Tech's subsidiaries. Inwhich situation(s) should Pell make reference to Smith's audit?

A. Pell reviews Smith's audit documentation and assumes responsibility for Smith's work, but expresses a qualified opinion on Tech's financial statements.II. Pell is unable to review Smith's audit documentation; however, Pell's inquiries indicate that Smith has an excellent reputation for professional competence andintegrity.




Choice "b" is correct. II only. If Pell is unable to review Smith's audit documentation, but inquiries indicate that Smith has an excellent reputation for professionalcompetence and integrity, Pell should divide responsibility by making reference to Smith's audit. Choices "a", "c", and "d" are incorrect. Since the principal auditor insituation I reviews Smith's audit documentation and assumes responsibility for Smith's work, no mention of Smith should be made.

QUESTION 112According to the profession's ethical standards, which of the following events may justify a departure from a Statement of Financial Accounting Standards?





Choice "c" is correct. Yes - Yes. Rule 203 of the code of professional conduct of the AICPA states that if the financial statements or data contain a GAAP departure,the departure may be justified if the CPA can demonstrate that due to unusual circumstances, such as new legislation or the evolution of a new form of businesstransaction, the FS would otherwise be misleading. Under these circumstances, the auditor's report should describe the departure, its approximate effects, ifpracticable, and the reasons why compliance with the generally accepted principle would result in a misleading statement.Choices "a", "b", and "d" are incorrect, per the above Explanation: .

QUESTION 113Which of the following conditions or events most likely would cause an auditor to have substantial doubt about an entity's ability to continue as a going concern?

A. Cash flows from operating activities are negative.B. Research and development projects are postponed.C. Significant related party transactions are pervasive.D. Stock dividends replace annual cash dividends.

Correct Answer: ASection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The Basics

Explanation


Choice "a" is correct. Negative cash flows from operating activities most likely would cause an auditor to have substantial doubt about an entity's ability to continueas a going concern. Choices "b" and "d" are incorrect. Plans to reduce or delay cash expenditures are mitigating factors conserving cash (e.g., postponing R&Dprojects and replacing cash dividends with stock dividends). This would not ordinarily cause an auditor to have substantial doubt about an entity's ability to continueas a going concern.Choice "c" is incorrect. The existence of significant related party transactions should be disclosed but would not ordinarily cause an auditor to have substantial doubtabout an entity's ability to continue as a going concern.

QUESTION 114For an entity that does not receive governmental financial assistance, an auditor's standard report on financial statements generally would not refer to:

A. Significant estimates made by management.B. An assessment of the entity's accounting principles.C. Management's responsibility for the financial statements.D. The entity's internal control.



Choice "d" is correct. The auditor's standard report generally does not make reference to the entity's internal control. Note that for an entity that does receivegovernmental financial assistance, a written report on internal control is required. Also, note that an auditor may (but is not required to) expand his or her auditreport to clarify that a GAAS audit does not require the level of testing and reporting on internal control that is required for issuers. Choices "a" and "b" are incorrect.The scope paragraph states that, "an audit also includes assessing the accounting principles used and significant estimates made by management." Choice "c" isincorrect. The introductory paragraph states that the "financial statements are the responsibility of the company's management."

QUESTION 115Which of the following procedures should an auditor generally perform regarding subsequent events?

A. Compare the latest available interim financial statements with the financial statements being audited.B. Send second requests to the client's customers who failed to respond to initial accounts receivable confirmation requests.C. Communicate material weaknesses in the internal control structure to those charged with governance.D. Review the cut-off bank statements for several months after the year-end.



Choice "a" is correct. When performing procedures regarding subsequent events, the auditor generally will compare the latest available interim financial statementswith the financial statements being audited to determine if any significant subsequent event occurred that would need to be reflected in the statements beingaudited. Choice "b" is incorrect. Sending second requests to the client's customers who failed to respond to initial A/R confirmation requests is a substantiveprocedure that provides evidence about receivables existing at year end, not about subsequent events. Choice "c" is incorrect. Internal control weaknesses shouldbe communicated to those charged with governance, but this communication provides no evidence about subsequent events. Choice "d" is incorrect. Bank cut-offstatements generally are reviewed for only a week to ten days subsequent to year-end. Reviewing them for a longer period such as "several months" would providelittle additional audit evidence regarding the YE FS and thus would not be a cost beneficial procedure.

QUESTION 116An auditor's report contains the following sentences:We did not audit the financial statements of JK Co., a wholly owned subsidiary, which statements reflect total assets and revenues constituting 17 percent and 19percent, respectively, of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion,insofar as it relates to the amounts included for JK Co., is based solely on the report of the other auditors.These sentences:

A. Are an improper form of reporting.B. Divide responsibility.C. Disclaim an opinion.D. Qualify the opinion.



Choice "b" is correct. The report indicates a division of responsibility. Choice "a" is incorrect. Words describing the percentages of revenues and assets audited byother auditors are proper in dividing responsibility.Choice "c" is incorrect. Dividing responsibility does not affect the unqualified opinion, nor does it require a disclaimer of opinion.Choice "d" is incorrect. Dividing responsibility does not affect the unqualified opinion, nor does it require a qualified opinion.

QUESTION 117

Which of the following phrases should be included in the opinion paragraph when an auditor expresses a qualified opinion?




Choice "d" is correct. No - No.A qualified opinion phrase is, "in our opinion, except for [Explanation: of problem] as discussed in the preceding paragraph . . ."Choice "a" is incorrect, as "when read in conjunction with Note X" is not a phrase included in the opinion paragraph of a qualified opinion.Choice "b" is incorrect, as "with the foregoing Explanation: " is not a phrase included in the opinion paragraph of a qualified opinion.Choice "c" is incorrect. Neither phrase is included in the opinion paragraph of a qualified opinion.(This is why it's important to memorize the qualifying phrases as well as the standard independent auditor's report.)

QUESTION 118Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of subsequent events?

A. Recomputing a sample of large-dollar transactions occurring after year-end for arithmetic accuracy.B. Investigating changes in stockholders' equity occurring after year-end.C. Inquiring of the entity's legal counsel concerning litigation, claims, and assessments arising after yearend.D. Confirming bank accounts established after year-end.



Choice "c" is correct. The auditor would most likely inquire of the entity's legal counsel concerning litigation, claims and assessments arising after year-end in orderto obtain evidence about the occurrence of subsequent events. Claims arising after year-end might well impact the year-end financial statements.Choice "a" is incorrect. Recomputing a sample of large-dollar transactions occurring after year- end for arithmetic accuracy would not provide evidence about year-end amounts. Choice "b" is incorrect. The auditor would inquire about changes in stockholders' equity occurring after year-end, but would not generally perform aninvestigation of such items. Choice "d" is incorrect. Confirming bank accounts established after year-end is generally not done (only those in existence at year-endare confirmed). Accounts established after year-end generally would not be relevant to year-end amounts.

QUESTION 119What is an auditor's responsibility for supplementary information required by the GASB that is placed outside the basic financial statements?

A. Label the information as unaudited and expand the auditor's report to include a disclaimer on the information.B. Add an explanatory paragraph to the auditor's report and refer to the information as "required supplementary information."C. Apply limited procedures to the information and report deficiencies in, or the omission of, the information.D. Audit the required supplementary information in accordance with generally accepted governmental auditing standards.



Choice "c" is correct. With respect to supplementary information required by the GASB that is placed outside the basic financial statements, the auditor should applylimited procedures to the information (to determine that it is consistent with the basic audited financial statements) and report deficiencies in or the omission of theinformation (via an explanatory paragraph). Choice "a" is incorrect. If the information is labeled "unaudited," a disclaimer generally would not be necessary.Choice "b" is incorrect. The explanatory paragraph is only added if the supplemental information required by the GASB is deficient, omitted entirely, if the auditorcannot complete procedures, or if there is doubt about conformity with guidelines.Choice "d" is incorrect. The supplementary information required by the GASB is not required to be audited since it is placed outside of the basic financialstatements; however, an opinion is permitted.

QUESTION 120An auditor's responsibility to express an opinion on the financial statements is:

A. Implicitly represented in the auditor's standard report.B. Explicitly represented in the opening paragraph of the auditor's standard report.C. Explicitly represented in the scope paragraph of the auditor's standard report.D. Explicitly represented in the opinion paragraph of the auditor's standard report.



Choice "b" is correct. The auditor's responsibility to express an opinion on the FS is explicitly represented in the last sentence of the opening paragraph: "Ourresponsibility is to express an opinion on these financial statements based on our audit." Choice "a" is incorrect. The responsibility to express an opinion is explicitlyrepresented (i.e., clearly stated), not implicitly represented (i.e., assumed). Choice "c" is incorrect. There are no words in the scope paragraph that represent anauditor's responsibility to express an opinion.Choice "d" is incorrect. The opinion paragraph includes the auditor's opinion, but does not specifically mention the auditor's responsibility to express an opinion.

QUESTION 121When an independent CPA assists in preparing the financial statements of a publicly held entity, but has not audited or reviewed them, the CPA should issue adisclaimer of opinion. In such situations, the CPA has no responsibility to apply any procedures beyond:

A. Ascertaining whether the financial statements are in conformity with generally accepted accounting principles.B. Determining whether management has elected to omit substantially all required disclosures.C. Documenting that the internal control structure is not being relied on.D. Reading the financial statements for obvious material misstatements.



Choice "d" is correct. When an independent CPA assists in preparing the FS of a publicly held entity, but has not "audited" or "reviewed" them, the CPA shouldissue a disclaimer of opinion and has only the responsibility to read the FS for obvious material misstatements. Choice "a" is incorrect. A disclaimer does not requireascertaining whether the FS are in conformity with GAAP.Choice "b" is incorrect. A disclaimer does not require ascertaining whether management has elected to omit substantially all required disclosures. Choice "c" isincorrect. A disclaimer of opinion does not require ascertaining whether or not the internal control structure is being relied upon.

QUESTION 122An auditor issued an audit report that was dual dated for a subsequent event occurring after the original date of the auditor's report. The auditor's responsibility forevents occurring subsequent to the original date was:

A. Extended to subsequent events occurring through the date of reissuance of the report.B. Extended to include all events occurring since the original date of the auditor's report.C. Limited to the specific event referenced.D. Limited to include only events occurring up to the date of the last subsequent event referenced.



Choice "c" is correct. When an auditor issues a report that is dual dated for a subsequent event occurring after the original date of the auditor's report, the auditor'sresponsibility for events occurring subsequent to the original date of the auditor's report is limited to the specific event referenced.Choices "a", "b", and "d" are incorrect. The auditor takes responsibility for only the specific event noted in the dual dating and for no other event occurringsubsequent to the original date of the auditor's report.

QUESTION 123An auditor most likely would issue a disclaimer of opinion because of:

A. Inadequate disclosure of material information.B. The omission of the statement of cash flows.C. A material departure from generally accepted accounting principles.D. Management's refusal to furnish written representations.



Choice "d" is correct. Management's refusal to furnish written representations is a significant client imposed restriction on the scope of an audit, ordinarily warrantinga disclaimer of opinion. Choice "a" is incorrect. Inadequate disclosure would result in a qualified or adverse opinion. Choice "b" is incorrect. A qualified report wouldbe appropriate when a "statement of cash flows" is omitted and the scope of the audit is not restricted. Choice "c" is incorrect. A departure from GAAP would resultin either a qualified or adverse opinion, depending on materiality.

QUESTION 124When an auditor qualifies an opinion because of the inability to confirm accounts receivable by direct communication with debtors, the wording of the opinionparagraph of the auditor's report should indicate that the qualification pertains to the:

A. Limitation on the auditor's scope.B. Possible effects on the financial statements.C. Lack of sufficient appropriate audit evidence.D. Departure from generally accepted auditing standards.



Choice "b" is correct. When an auditor qualifies his or her opinion because of a scope limitation, such as the inability to confirm A/R, the wording in the opinionparagraph should indicate that the qualification pertains to the possible effects on the FS and not to the scope limitation itself. The opinion paragraph should notrefer to the scope limitation itself, the lack of evidence, or the departure from GAAS.Choices "a", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 125The adverse effects of events causing an auditor to believe there is substantial doubt about an entity's ability to continue as a going concern would most likely bemitigated by evidence relating to the:

A. Ability to expand operations into new product lines in the future.B. Feasibility of plans to purchase leased equipment at less than market value.C. Marketability of assets that management plans to sell.D. Committed arrangements to convert preferred stock to long-term debt.



Choice "c" is correct. The adverse effects of events causing an auditor to believe there is a substantial doubt about an entity's ability to continue as a going concernwould most likely be mitigated by evidence relating to the marketability of assets that management plans to sell. By providing evidence that there is a ready market

for assets that could be converted to cash, management has demonstrated that the company could remain in operation for a longer period of time, therebymitigating the need for an explanatory paragraph describing the matter. Choices "a", "b", and "d" are incorrect. Evidence regarding the ability to expand operationsinto new product lines in the future, the feasibility of plans to purchase leased equipment at less than market value, or committed arrangements to convert preferredstock to long-term debt would not be sufficient to mitigate doubts about an entity's ability to continue as a going concern, unless it could also be demonstrated thatthe events would provide adequate cash flow to fund operations for at least the next year.

QUESTION 126An auditor was unable to obtain audited financial statements or other evidence supporting an entity's investment in a foreign subsidiary. Between which of thefollowing opinions should the entity's auditor choose?

A. Adverse and unqualified with an explanatory paragraph added.B. Disclaimer and unqualified with an explanatory paragraph added.C. Qualified and adverse.D. Qualified and disclaimer.



Choice "d" is correct. When an auditor is unable to obtain audited financial statements or other evidence supporting an entity's investment in a subsidiary (foreign ordomestic), the auditor should issue a qualified or disclaimer of opinion depending on the materiality of the investment in the subsidiary.Choices "a", "b", and "c" are incorrect. An adverse opinion is only issued when the FS are not presented fairly in conformity with GAAP, and an unqualified opinionwith an explanatory paragraph is not appropriate for a scope limitation.

QUESTION 127Which of the following standards requires a critical review of the work done and the judgment exercised by those assisting in an audit at every level of supervision?

A. Proficiency.B. Audit risk.C. Inspection.D. Due care.



Explanation:Choice "d" is correct. The third general standard is: "The auditor must exercise due professional care in the planning and performance of the audit and thepreparation of the report." This standard is interpreted to require a critical review of the work performed and the judgment exercised at every level of supervision.Choice "a" is incorrect. Proficiency relates to the first general standard (technical training and proficiency of an auditor).Choice "b" is incorrect. Audit risk and materiality underlie the application of all the standards of fieldwork and reporting, but are not standards themselves. Choice "c"is incorrect. Inspection pertains to the audit evidence standard, which is the third standard of fieldwork.

QUESTION 128Six months after issuing an unqualified opinion on audited financial statements, an auditor discovered that the engagement personnel failed to confirm several ofthe client's material accounts receivable balances.The auditor should first:

A. Request the permission of the client to undertake the confirmation of accounts receivable.B. Perform alternative procedures to provide a satisfactory basis for the unqualified opinion.C. Assess the importance of the omitted procedures to the auditor's ability to support the previously expressed opinion.D. Inquire whether there are persons currently relying, or likely to rely, on the unqualified opinion.



Choice "c" is correct. When an auditor discovers the omission of an audit procedure related to a previously issued report, the auditor should first assess theimportance of the omitted procedure to the auditor's ability to support the previously expressed opinion. Choice "a" is incorrect. The auditor would request thepermission of the client to undertake the confirmation of accounts receivable only after determining that the procedure was necessary to support the previouslyexpressed opinion and no other alternative procedure had been performed. Choice "b" is incorrect. Alternative procedures would be performed only after the auditordetermined that the procedure was necessary to support the previously expressed opinion. Choice "d" is incorrect. The auditor needs to be able to support (orrevise) the previously issued opinion regardless of whether or not there are persons currently relying on it.

QUESTION 129Which of the following procedures would an auditor ordinarily perform during the review of subsequent events?

A. Review the cut-off bank statements for the period after the year-end.B. Inquire of the client's legal counsel concerning litigation.C. Investigate significant deficiencies in internal control previously communicated to the client.D. Analyze related party transactions to discover possible irregularities.

Correct Answer: B



Choice "b" is correct. An auditor would most likely obtain a letter from the entity's legal counsel describing any pending litigation, unasserted claims, or losscontingencies, to obtain evidence that might impact the year-end financial statements. Choice "a" is incorrect. Reviewing cut-off bank statements for the period afteryear-end generally is performed to evaluate the year-end cash balance, not to identify subsequent events. Choice "c" is incorrect. Investigating significantdeficiencies in internal control previously communicated to the client would be a procedure performed as part of the planning process and would provide the auditorwith information regarding the internal control structure, not subsequent events.Choice "d" is incorrect. Analyzing related party transactions to discover possible irregularities generally is performed to evaluate financial statement disclosure, notto identify subsequent events.

QUESTION 130An annual shareholders' report includes audited financial statements and contains supplementary information required by GAAP. Is it permissible for the auditor toreport on such information?

A. No, because such reporting may lead to the belief that the auditor is responsible for the information.B. No, because the auditor has no responsibility to read the other information in a document containing audited financial statements.C. Yes, provided the report provides negative assurance only.D. Yes, provided the auditor performs sufficient audit procedures to determine whether the information is fairly stated, in all material respects, in relation to the

financial statements.



Choice "d" is correct. If the auditor performs sufficient procedures, he or she may report on whether the information is fairly stated, in all material respects, inrelation to the financial statements.Choices "a" and "b" are incorrect. The auditor may report on such information. Choice "c" is incorrect. The report provides positive assurance about whether theinformation is fairly stated, in all material respects, in relation to the financial statements.

QUESTION 131Tech Company has disclosed an uncertainty due to pending litigation. The auditor's decision to issue a qualified opinion rather than an unqualified opinion mostlikely would be determined by the:

A. Lack of sufficient evidence.

B. Inability to estimate the amount of loss.C. Entity's lack of experience with such litigation.D. Lack of insurance coverage for possible losses from such litigation.



Choice "a" is correct. Lack of sufficient evidence to support management's assertions would most likely cause an auditor to issue a qualified or disclaimer ofopinion. Choice "b" is incorrect. As long as it is fully disclosed, an inability to estimate the amount of loss from a future event (outcome of pending legislation) wouldmost likely result in an unqualified opinion.Choices "c" and "d" are incorrect. Neither a lack of experience nor a lack of insurance coverage would impact the auditor's report.

QUESTION 132It is not appropriate to refer a reader of an auditor's report to a financial statement footnote for details concerning:

A. Subsequent events.B. The pro forma effects of a business combination.C. Sale of a discontinued operation.D. The results of confirmation of receivables.



Choice "d" is correct. Details concerning the results of audit procedures (such as the results of confirmation of receivables) generally do not appear in the footnotes.Choice "a" is incorrect. Subsequent events may be discussed in an explanatory paragraph of the auditor's report, which would also refer to the related footnote.Choice "b" is incorrect. The pro forma effects of a business combination may be included in an explanatory paragraph of the auditor's report, which would also referto the related footnote. Choice "c" is incorrect. Sale of a discontinued operation may be discussed in an explanatory paragraph of the auditor's report, which wouldalso refer to the related footnote.

QUESTION 133Morris, CPA, suspects that a pervasive scheme of illegal bribes exists throughout the operations of Worldwide Import-Export, Inc., a new audit client. Morris notifiedthe audit committee and Worldwide's legal counsel, but neither could assist Morris in determining whether the amounts involved were material to the financial

statements or whether senior management was involved in the scheme. Under these circumstances, Morris should:

A. Express an unqualified opinion with a separate explanatory paragraph.B. Disclaim an opinion on the financial statements.C. Express an adverse opinion on the financial statements.D. Issue a special report regarding the illegal bribes.



Choice "b" is correct. Since the CPA could not determine whether the suspected illegal bribes were material to the financial statements, or whether seniormanagement was involved in the scheme, Morris should disclaim an opinion on the financial statements. Choice "a" is incorrect. An unqualified opinion with aseparate explanatory paragraph is not appropriate if suspected material illegal bribes cannot be disproven. Choice "c" is incorrect. An adverse opinion isinappropriate since the suspected material illegal bribes have not been proven, nor has any material effect on the financial statements been determined.Choice "d" is incorrect. Special reports are not issued regarding illegal bribes.

QUESTION 134The first general standard requires that an audit of financial statements is to be performed by a person or persons having:

A. Seasoned judgment in varying degrees of supervision and review.B. Adequate technical training and proficiency.C. Knowledge of the standards of fieldwork and reporting.D. Independence with respect to the financial statements and supplementary disclosures.



Choice "b" is correct. The "first" general standard states that the auditor must have adequate technical training and proficiency to perform the audit. Comment: It isimportant to memorize the 10 auditing standards. Choices "a", "c", and "d" are incorrect, as they do not represent a requirement of the first general standard ofreporting.

QUESTION 135

An auditor's report that refers to the use of an accounting principle at variance with generally accepted accounting principles contains the words, "In our opinion,with the foregoing Explanation: , the financial statements referred to above present fairly...." This is considered an:

A. Adverse opinion.B. "Except for" qualified opinion.C. Unqualified opinion with an explanatory paragraph.D. Example of inappropriate reporting.



Choice "d" is correct. "In our opinion, with the foregoing Explanation: , the FS referred to above present fairly" is an example of inappropriate reporting. When anauditor's report refers to the use of an accounting principle at variance with GAAP, the words, "in our opinion, except for the effects of the matters discussed in thepreceding paragraph, the FS referred to above present fairly,..." should be used.Choice "a" is incorrect. An adverse opinion would include the phrase, "...do not present fairly..." Choice "b" is incorrect. A qualified opinion would include the phrase,"In our opinion, except for the [problem] discussed in the preceding paragraph,..." Choice "c" is incorrect. An unqualified opinion would not include the phrase "withthe foregoing Explanation: " in an explanatory paragraph.

QUESTION 136Management of Hill Company has decided not to account for a material transaction in accordance with the provisions of an FASB Standard. In setting forth itsreasons in a note to the financial statements, management has clearly demonstrated that due to unusual circumstances the financial statements presented inaccordance with the FASB Standard would be misleading. The auditor's report should include a separate explanatory paragraph and contain a(an):

A. "Except for" qualified opinion.B. "Subject to" qualified opinion.C. Adverse opinion.D. Unqualified opinion.



Choice "d" is correct. In unusual circumstances, where the literal application of accounting standards would make the FS misleading (e.g., new legislation or new

business practices), the proper accounting treatment is that which will more fairly present the FS. In such a case, the auditor should express an unqualified opinionon the financial statements and include a separate explanatory paragraph.Choice "a" is incorrect. Under the circumstances, the method of accounting selected by the client is justified. There is no need for an "except for" qualification.Choice "b" is incorrect. "Subject to" opinions are not acceptable under any circumstances. Choice "c" is incorrect. An adverse opinion is not appropriate since thefinancial statements as prepared by the client are fairly presented.

QUESTION 137A former client requests a predecessor auditor to reissue an audit report on a prior period's financial statements. The financial statements are not restated and thereport is not reviseD. What date(s) should the predecessor auditor use in the reissued report?

A. The date of the prior-period report.B. The date of the client's request.C. The date of reissue.D. The dual-dates.



Choice "a" is correct. The date of the prior-period report should be used as long as the FS are not restated, the report is not revised, and no significant changeshave occurred that would affect the prior FS.Choices "b" and "c" are incorrect. Using the date of the client's request or the date of reissue would extend the auditor's responsibility to that date. Choice "d" isincorrect. The auditor may dual date the report if a material subsequent event has occurred, but dual dating is not used for reissuing a report.

QUESTION 138Does an auditor make the following representations explicitly or implicitly when issuing the standard auditor's report on comparative financial statements?




Choice "c" is correct. Implicitly - Explicitly.When issuing the standard auditor's report on comparative FS, an auditor implicitly represents consistent application of GAAP, but explicitly states, "An auditincludes examining, on a test basis, evidence supporting . . ."(Again, it is essential that you memorize the "auditor's standard report.") Choices "a", "b", and "d" are incorrect, based on the above Explanation: .

QUESTION 139An auditor may issue a qualified opinion under which of the following circumstances?




Choice "a" is correct. Yes - Yes.An auditor may issue a qualified opinion (or a disclaimer, depending on materiality) when there is a lack of sufficient appropriate audit evidence, or when there arerestrictions on the scope of the audit.Choices "b", "c", and "d" are incorrect, as explained above.

QUESTION 140Grant Company's financial statements adequately disclose uncertainties that concern future events, the outcome of which are not susceptible of reasonableestimation. The auditor's report should include a (an):

A. Unqualified opinion.B. "Subject to" qualified opinion.C. "Except for" qualified opinion.D. Adverse opinion.



Choice "a" is correct. The auditor should issue an "unqualified opinion" when management adequately discloses future events, the outcome of which are notsusceptible of reasonable estimation. No reference to the uncertainty need be made in the auditor's opinion. Choice "b" is incorrect. "Subject to" qualified opinionsare not permitted. Choice "c" is incorrect. An "except for" qualified opinion would not be used as there is adequate disclosure and there are no scope limitations.Choice "d" is incorrect. An adverse opinion would not be used because the FS are presented "fairly" in conformity with GAAP.

QUESTION 141How are management's responsibility and the auditor's responsibility represented in the standard auditor's report?




Choice "a" is correct. The responsibility of the auditor and the responsibility of management are stated explicitly in the introductory paragraph of the standardauditor's report. Choices "b", "c", and "d" are incorrect, as explained above.

QUESTION 142When there is a significant change in accounting principle, an auditor's report should refer to the lack of consistency in:

A. The scope paragraph.B. An explanatory paragraph between the second paragraph and the opinion paragraph.C. The opinion paragraph.D. An explanatory paragraph following the opinion paragraph.



Choice "d" is correct. When there is a significant change in accounting principle, the auditor's report should refer to the lack of consistency in an explanatoryparagraph following the opinion paragraph. The explanatory paragraph should identify the change and refer to the note in the FS that discusses the change in detail.The auditor's concurrence with the change in GAAP is implicit, unless he or she takes exception.Choice "a" is incorrect. Lack of consistency is not a scope limitation. Choice "b" is incorrect. An explanatory paragraph is often inserted between the secondparagraph and opinion paragraph. However, where a change is accounted for in accordance with GAAP, the explanatory paragraph should follow the unqualifiedopinion paragraph. Choice "c" is incorrect. The lack of consistency would not be disclosed in an opinion paragraph unless the auditor does not concur and wishes toqualify the opinion. In such case an explanatory paragraph would precede the opinion paragraph and the opinion paragraph would be qualified.

QUESTION 143

When a principal auditor decides to make reference to another auditor's examination, the principal auditor's report should always indicate clearly, in the introductory,scope, and opinion paragraphs, the:

A. Magnitude of the portion of the financial statements examined by the other auditor.B. Disclaimer of responsibility concerning the portion of the financial statements examined by the other auditor.C. Name of the other auditor.D. Division of responsibility.



Choice "d" is correct. Reference to the division of responsibility should be made in the introductory, scope and opinion paragraphs of the principal auditor's report.Choice "a" is incorrect. The magnitude of the portion of the FS examined by the other auditor appears only in the introductory paragraph.Choice "b" is incorrect. The principal auditor is not disclaiming responsibility, just dividing it. Choice "c" is incorrect. The name of the other auditor is generally notmentioned, but may be mentioned with permission and if the other auditor's report is also presented. (Watch out for exclusive words such as "always" or "never.")

QUESTION 144Information accompanying the basic financial statements in an auditor-submitted document should not include:

A. An analysis of inventory by location.B. A statement that the allowance for doubtful accounts is adequate.C. A statement that the depreciable life of a new asset is 20 years.D. An analysis of revenue by product line.



Choice "b" is correct. A statement that the "allowance for doubtful accounts is adequate" is generally not included in information accompanying the basic FS in anauditor-submitted document (ASD) because it expresses an opinion rather than providing details or Explanation: s. Choices "a", "c", and "d" are incorrect, becausethe following information, which contains additional details or Explanation: s, may accompany the basic FS in an ASD:

A. An analysis of inventory by location.

C. Depreciable lives of assets.D. An analysis of revenue by product line.

QUESTION 145For a particular entity's financial statements to be presented fairly in conformity with generally accepted accounting principles, it is not required that the principlesselected:

A. Be appropriate in the circumstances for the particular entity.B. Reflect transactions in a manner that presents the financial statements within a range of acceptable limits.C. Present information in the financial statements that is classified and summarized in a reasonable manner.D. Be applied on a basis consistent with those followed in the prior year.



Choice "d" is correct. For a particular entity's FS to be presented fairly in conformity with GAAP, it is not required that the principles selected be applied on a basisconsistent with those followed in the prior year, merely that any changes in accounting principle be properly accounted for and disclosed.Choice "a" is incorrect. The principles selected must be appropriate in the circumstances for the particular entity.Choice "b" is incorrect. The principles selected must reflect transactions in a manner that present the FS within a range of acceptable limits.Choice "c" is incorrect. The principles selected must present information in the FS that is classified and summarized in a reasonable manner.

QUESTION 146An auditor has been asked to report on the balance sheet of Kane Company but not on the other basic financial statements. The auditor will have access to allinformation underlying the basic financial statements. Under these circumstances, the auditor:

A. May accept the engagement because such engagements merely involve limited reporting objectives.B. May accept the engagement but should disclaim an opinion because of an inability to apply the procedures considered necessary.C. Should refuse the engagement because there is a client-imposed scope limitation.D. Should refuse the engagement in accordance with generally accepted auditing standards.



Choice "a" is correct. The auditor may accept the engagement because there is no scope limitation, merely a limited reporting objective. It is acceptable to give anopinion on one FS and not report on the other FS, if the scope is not limited. Choices "b" and "c" are incorrect. The client is not imposing any audit scope limitations.Choice "d" is incorrect. A limited reporting objective is not a departure from GAAS.

QUESTION 147If an accounting change has no material effect on the financial statements in the current year, but the change is reasonably certain to have a material effect in lateryears, the change should be:

A. Treated as a consistency modification in the auditor's report for the current year.B. Disclosed in the notes to the financial statements of the current year.C. Disclosed in the notes to the financial statements and referred to in the auditor's report for the current year.D. Treated as a subsequent event.



Choice "b" is correct. If an accounting change does not have a material effect on the FS of the current year, it will be disclosed in the notes to the FS for the currentyear, but no modification of the auditor's report is necessary.Choices "a" and "c" are incorrect. If the change in accounting principle were material for the current year, it would be treated as a consistency modification in theauditor's report for the current year. Since there is no material effect in the current year, no modification to the auditor's report is required.Choice "d" is incorrect. A change in accounting principle is not a "subsequent event."

QUESTION 148To exercise due professional care an auditor should:

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



Explanation:

Choice "a" is correct. To exercise due professional care, an auditor should critically review the judgment exercised by those assisting in the audit.Choice "b" is incorrect. An auditor examines some (but not all) available corroborating evidence supporting management's assertions. Examination of all evidencewould not be feasible. Choice "c" is incorrect. An auditor has a reasonable responsibility to design the audit to detect material instances of illegal acts, errors, andirregularities. It would not be feasible to design an audit to detect all instances of illegal acts.Choice "d" is incorrect. "Due professional care" pertains to the performance of the audit and the preparation of the report. The training standard relates to thebalance of professional experience and formal education of those performing the audit.

QUESTION 149This question presents independent factual situations an auditor might encounter in conducting an audit. List A represents the types of opinions the auditorordinarily would issue. Select as the best answer for this item, the action the auditor normally would take. The types of opinions in List A may be selected once,more than once, or not at all.

Assume:

· The auditor is independent.· The auditor previously expressed an unqualified opinion on the prior year's financial statements.· Only single-year (not comparative) statements are presented for the current year. · The conditions for an unqualified opinion exist unless contradicted in thefactual situations. · The conditions stated in the factual situations are material. · No report modifications are to be made except in response to the factual situation.

Item to Be AnsweredIn auditing the long-term investments account, an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditorconcludes that sufficient appropriate audit evidence regarding this investment cannot be obtained.

List ATypes of Options

A. An "except for" qualified opinion.B. An unqualified opinion.C. An adverse opinion.D. A disclaimer of opinion.E. Either an "except for" qualified opinion or an adverse opinion.F. Either a disclaimer of opinion or an "except for" qualified opinion.G. Either an adverse opinion or a disclaimer of opinion.

Correct Answer: FSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "F" is the correct opinion. This is a scope limitation. Either a disclaimer of opinion (if the item is very material) or an "except for" qualified opinion (if the itemis material) should be issued.

QUESTION 150This question presents independent factual situations an auditor might encounter in conducting an audit. List B represents the report modifications (if any) thatwould be necessary. Select as the best answer for each item, the action the auditor normally would take. The report modifications in List B may be selected once,more than once, or not at all.

Assume:· The auditor is independent.· The auditor previously expressed an unqualified opinion on the prior year's financial statements.· Only single-year (not comparative) statements are presented for the current year. · The conditions for an unqualified opinion exist unless contradicted in thefactual situations. · The conditions stated in the factual situations are material. · No report modifications are to be made except in response to the factual situation.

Item to Be AnsweredIn auditing the long-term investments account, an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditorconcludes that sufficient appropriate audit evidence regarding this investment cannot be obtained.

List BReport Modifications

A. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph without modifying the three standard paragraphs.B. Describe the circumstances in an explanatory paragraph following the opinion paragraph without modifying the three standard paragraphs.C. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the opinion paragraph.D. Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the opinion paragraph.E. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the scope and opinion paragraphs.F. Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the scope and opinion paragraphs.G. Describe the circumstances within the scope paragraph without adding an explanatory paragraph.H. Describe the circumstances within the opinion paragraph without adding an explanatory paragraph.I. Describe the circumstances within the scope and opinion paragraphs without adding an explanatory paragraph.J. Issue the standard auditor's report without modification.

Correct Answer: ESection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "E" is the correct modification. The situation calls for a qualified opinion or a disclaimer of opinion, but none of the choices adequately describes adisclaimer. Therefore, a qualified opinion is the best answer. The circumstances should be described in an explanatory paragraph preceding the opinion paragraphand the scope and opinion paragraphs should be modified.



Item to Be AnsweredDue to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for areasonable period of time. However, the financial statement disclosures concerning these matters are adequate.





Choice "B" is the correct opinion. In a going concern situation that is properly disclosed, an unqualified opinion should be issued.



Item to Be AnsweredDue to recurring operating losses and working capital deficiencies, an auditor has substantial doubt about an entity's ability to continue as a going concern for areasonable period of time. However, the financial statement disclosures concerning these matters are adequate.





Choice "B" is the correct modification. The circumstances should be described in an explanatory paragraph following the opinion paragraph without modifying thethree standard paragraphs.



Item to Be AnsweredA principal auditor decides to take responsibility for the work of another CPA who audited a wholly-owned subsidiary of the entity and issued an unqualified opinion.The total assets and revenues of the subsidiary represent 17% and 18%, respectively, of the total assets and revenues of the entity being audited.





Choice "B" is the correct opinion. An unqualified opinion should be issued.



Item to Be AnsweredA principal auditor decides to take responsibility for the work of another CPA who audited a wholly-owned subsidiary of the entity and issued an unqualified opinion.The total assets and revenues of the subsidiary represent 17% and 18%, respectively, of the total assets and revenues of the entity being audited.



Correct Answer: JSection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "J" is the correct modification. When assuming responsibility for another auditor's work, the principal auditor should issue the standard auditor's reportwithout modification.

QUESTION 155This question presents independent factual situations an auditor might encounter in conducting an audit.List A represents the types of opinions the auditor ordinarily would issue. Select as the best answer for this item, the action the auditor normally would take. Thetypes of opinions in List A may be selected once, more than once, or not at all.


Item to Be AnsweredAn entity issues financial statements that present financial position and results of operations but omits the related statement of cash flows. Management disclosesin the notes to the financial statements that it does not believe the statement of cash flows to be a useful financial statement.





Choice "A" is the correct opinion. Failure to include a statement of cash flows is a GAAP violation that requires an "except for" qualified opinion to be issued.



Item to Be AnsweredAn entity issues financial statements that present financial position and results of operations but omits the related statement of cash flows. Management disclosesin the notes to the financial statements that it does not believe the statement of cash flows to be a useful financial statement.





Choice "C" is the correct modification. The circumstances should be described in an explanatory paragraph preceding the opinion paragraph and the opinionparagraph should be modified.



Item to Be AnsweredAn entity changes its depreciation method for production equipment from the straight-line to a units-of production method based on hours of utilization. The auditorconcurs with the change although it has a material effect on the comparability of the entity's financial statements.





Choice "B" is the correct opinion. When an accounting change is properly accounted for, an unqualified opinion should be issued.



Item to Be AnsweredAn entity changes its depreciation method for production equipment from the straight-line to a units-of production method based on hours of utilization. The auditorconcurs with the change although it has a material effect on the comparability of the entity's financial statements.

List B

Report Modifications




Choice "B" is the correct modification. Such changes should be described in an explanatory paragraph following the opinion paragraph without modifying the threestandard paragraphs.



Item to Be AnsweredAn entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, the ultimate outcome of the litigation cannot be reasonably estimated bymanagement. The auditor believes there is a reasonable possibility of a significantly material loss, but the lawsuit is adequately disclosed in the notes to thefinancial statements.

List A

Types of Options




Choice "B" is the correct opinion. Since the uncertainty is adequately disclosed, an unqualified opinion should be issued.



Item to Be AnsweredAn entity discloses in the notes to the financial statements certain lease obligations. The auditor believes that the failure to capitalize these leases is a departurefrom generally accepted accounting principles.


A. An "except for" qualified opinion.B. An unqualified opinion.

C. An adverse opinion.D. A disclaimer of opinion.E. Either an "except for" qualified opinion or an adverse opinion.F. Either a disclaimer of opinion or an "except for" qualified opinion.G. Either an adverse opinion or a disclaimer of opinion.

Correct Answer: ESection: Auditing and Attestation (I) (Volume A) Audited Financial Statements - The BasicsExplanation


Choice "E" is the correct opinion. This is a GAAP departure. Either an "except for" qualified opinion (if the item is material) or an adverse opinion (if the item is verymaterial) should be issued.



Item to Be AnsweredAn entity discloses in the notes to the financial statements certain lease obligations. The auditor believes that the failure to capitalize these leases is a departurefrom generally accepted accounting principles.


A. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph without modifying the three standard paragraphs.B. Describe the circumstances in an explanatory paragraph following the opinion paragraph without modifying the three standard paragraphs.C. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the opinion paragraph.D. Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the opinion paragraph.E. Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the scope and opinion paragraphs.

F. Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the scope and opinion paragraphs.G. Describe the circumstances within the scope paragraph without adding an explanatory paragraph.H. Describe the circumstances within the opinion paragraph without adding an explanatory paragraph.I. Describe the circumstances within the scope and opinion paragraphs without adding an explanatory paragraph.J. Issue the standard auditor's report without modification.



Choice "C" is the correct modification. The circumstances should be described in an explanatory paragraph preceding the opinion paragraph and the opinionparagraph should be modified.Quality Control Standards

QUESTION 162The nature and extent of a CPA firm's quality control policies and procedures depend on:




Choice "a" is correct. The nature and extent of a CPA firm's quality controls depend on a number of factors, such as its size, the degree of operating autonomyallowed its personnel and its practice offices, the nature of its practice, its organization, and appropriate cost-benefit considerations.Choices "b", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 163Would the following factors ordinarily be considered in planning an audit engagement's personnel requirements?




Choice "a" is correct. When assigning personnel to an engagement, the firm should consider the following factors in achieving a balance of engagement manpowerrequirements, personnel skills, and individual development and utilization: 1) engagement size and complexity, 2) personnel availability, 3) special expertiserequired, 4) timing of the work to be performed, 5) continuity and periodic rotation of personnel, and 6) opportunities for on-the-job training. Choices "b", "c", and "d"are incorrect, based on the above Explanation: .

QUESTION 164After fieldwork audit procedures are completed, a partner of the CPA firm who has not been involved in the audit performs a second or wrap-up review of the auditdocumentation. This second review usually focuses on:

A. The fair presentation of the financial statements in conformity with GAAP.B. Fraud involving the client's management and its employees.C. The materiality of the adjusting entries proposed by the audit staff.D. The communication of internal control weaknesses to those charged with governance.



Choice "a" is correct. The primary purpose of a second partner review is to ensure that the financial statements are presented in accordance with GAAP. Choice "b"is incorrect. A search for fraud is typically not part of a second partner review. Choice "c" is incorrect. The materiality of adjusting entries proposed by the audit staffmay be reviewed by a second partner, but they are not the primary focus of such a review. Choice "d" is incorrect. The communication of internal controlweaknesses to those charged with governance is not a primary focus of a second partner review.

QUESTION 165The primary purpose of establishing quality control policies and procedures for deciding whether to accept a new client is to:

A. Enable the CPA firm to attest to the reliability of the client.B. Satisfy the CPA firm's duty to the public concerning the acceptance of new clients.C. Minimize the likelihood of association with clients whose management lacks integrity.D. Anticipate before performing any fieldwork whether an unqualified opinion can be expressed.



Choice "c" is correct. Policies and procedures should be established for deciding whether to accept or continue a client in order to minimize the likelihood ofassociation with a client whose management lacks integrity.Choice "a" is incorrect. Suggesting that there should be procedures to decide whether to accept a client does not imply that a firm vouches for the integrity orreliability of a client. Choice "b" is incorrect. Suggesting that there should be procedures to decide whether to accept a client does not imply that a firm has a duty toanyone but itself with respect to the acceptance, rejection, or retention of clients.Choice "d" is incorrect. The decision to express an unqualified opinion should be made after the completion of the audit, not upon client acceptance.

QUESTION 166A CPA firm evaluates its personnel advancement experience to ascertain whether individuals meeting stated criteria are assigned increased degrees ofresponsibility. This is evidence of the firm's adherence to which of the following prescribed standards:

A. Professional ethics.B. Supervision and review.C. Accounting and review services.D. Quality control.



Choice "d" is correct. The AICPA's Statements on Quality Control Standards assert that professional development policies and procedures should be established bythe firm in order to provide reasonable assurance that personnel will have the knowledge required to perform their work and progress within the firm.Choice "a" is incorrect. The auditors' responsibility is to the public and is defined in the "AICPA Code of Professional Conduct," which includes a set of mandatoryrules and which derives its authority from the bylaws of the AICPA.Choice "b" is incorrect. Supervision and review are part of GAAS fieldwork standards. Choice "c" is incorrect. Accounting and review services pertain to theunaudited financial statements of a nonpublic company.

QUESTION 167The primary purpose of establishing quality control policies and procedures for deciding whether to accept new clients is to:

A. Minimize the likelihood of association with clients whose management lacks integrity.B. Monitor significant deficiencies in the design and operation of the client's internal control.C. Identify noncompliance with aspects of contractual agreements that affect the financial statements.D. Provide reasonable assurance that personnel will be adequately trained to fulfill their assigned responsibilities.



Choice "a" is correct. Policies and procedures should be established for deciding whether to accept a new client in order to minimize the likelihood of associationwith a client whose management lacks integrity.

Choice "b" is incorrect. Policies and procedures established for deciding whether to accept a new client would not aid in monitoring internal control deficiencies. Areview of internal control would not occur until after a new client was accepted. Choice "c" is incorrect. Policies and procedures established for deciding whether toaccept a new client would not aid in identifying noncompliance with contractual agreements. Reviewing the terms of contractual agreements would not occur untilafter a new client was accepted. Choice "d" is incorrect. Policies and procedures established for deciding whether to accept a new client would not aid in theadequate training of personnel. Personnel management policies would be used to ensure that training needs are met.

QUESTION 168Jackson & Company, CPAs, plan to audit the financial statements of Perigee Technologies, an issuer as defined under the Sarbanes-Oxley Act of 2002. Which ofthe following situations would impair Jackson's independence?

A. Provision of personal tax services to Johnson, the accounts payable manager of Perigee.B. Preparation of Perigee's routine annual tax return, where Jackson's fee will be calculated as a percentage of the tax refund obtained.C. An audit of Perigee's internal control is performed contemporaneously with the annual financial statement audit.D. Discovering that Lowe, the chief financial officer of Perigee, started his accounting career ten years earlier as a staff accountant for Jackson & Company, and

continues to maintain ties with current partners at the firm.



Choice "b" is correct. The provision of services involving contingent fee arrangements impairs the auditor's independence.Choice "a" is incorrect. Personal tax services provided to employees do not impair the auditor's independence; however, personal tax services provided to corporateofficers or their families would impair independence.Choice "c" is incorrect. Independence is not impaired by the performance of an audit of Perigee's internal control; in fact, such services are required by PCAOBAuditing Standard No. 5 (covered in a later class).Choice "d" is incorrect. The prohibition against auditing companies whose corporate officers worked for the auditing firm only applies if those officers worked on theaudit during the preceding year.

QUESTION 169Which of the following are true regarding communication requirements an auditor must follow when providing tax services to an audit client who is an issuer underthe Sarbanes-Oxley Act of 2002?

A. The auditor must communicate to the audit committee, in writing, regarding the proposed tax services and related fees.II. The auditor must communicate to the audit committee, in writing, when the proposed tax services involve contingent fee arrangements.III. The auditor must discuss with the audit committee the potential effects of the proposed tax services on the firm's independence.

B. I and II only.C. I, II, and III.

D. I and III only.E. II and III only.


Explanation/Reference:Explanation:Choice "c" is correct. The auditor must communicate to the audit committee, in writing, regarding the proposed tax services and related fees, and must discuss withthe audit committee the potential effects of the proposed tax services on the firm's independence. Tax services related to contingent fee arrangements, confidentialtax transactions, and certain aggressive tax transactions are expressly prohibited.Choices "a", "b", and "d" are incorrect, based on the above Explanation: .Other Engagements, Reports, and Accounting Services

QUESTION 170Financial information is presented in a printed form that prescribes the wording of the independent auditor's report. The form is not acceptable to the auditorbecause the form calls for statements that are inconsistent with the auditor's responsibility. Under these circumstances, the auditor most likely would:

A. Withdraw from the engagement.B. Reword the form or attach a separate report.C. Express a qualified opinion with an Explanation: .D. Restrict use of the report to the party who designed the form.



Choice "b" is correct. An auditor should not sign a preprinted report form that includes statements that are inconsistent with the auditor's responsibility. Instead, theform should be revised or a separate, more accurate report should be attached. Choice "a" is incorrect. Provided the form can be revised or a separate report canbe attached, there is no need to withdraw from the engagement.Choice "c" is incorrect. Qualified opinions relate to departures from GAAP and/or scope limitations, neither of which is the case here.Choice "d" is incorrect. Even if the use of the report is restricted, an auditor should never sign a report including statements that are inconsistent with the auditor'sresponsibility.

QUESTION 171Field is an employee of Gold Enterprises. Hardy, CPA, is asked to express an opinion on Field's profit participation in Gold's net income. Hardy may accept this

engagement only if:

A. Hardy also audits Gold's complete financial statements.B. Gold's financial statements are prepared in conformity with GAAP.C. Hardy's report is available for distribution to Gold's other employees.D. Field owns controlling interest in Gold.



Choice "a" is correct. The engagement described is one to express an opinion on a specified element, account, or item of the financial statements. Since Field'sprofit participation is based on Gold's net income or stockholders' equity, Hardy can accept the engagement only if Hardy also audited the complete financialstatements.Choice "b" is incorrect. If the auditor can express an opinion that the specified elements, accounts, or items are presented fairly on a basis of accounting other thanGAAP, then the auditor can accept the engagement.Choice "c" is incorrect. Hardy's report need not be available for distribution to Gold's other employees.Usually the distribution of this type of report is restricted to those within the entity and the parties to the contract or agreement. This is necessary because the basisof presentation is determined by reference to a document that would not generally be available to other third parties. Mandatory distribution of an audit report isnever required. Choice "d" is incorrect. Field does not need to own a controlling interest in Gold.

QUESTION 172Due to a scope limitation, an auditor disclaimed an opinion on the financial statements taken as a whole, but the auditor's report included a statement that thecurrent asset portion of the entity's balance sheet was fairly stated. The inclusion of this statement is:

A. Not appropriate because it may tend to overshadow the auditor's disclaimer of opinion.B. Not appropriate because the auditor is prohibited from reporting on only one basic financial statement.C. Appropriate provided the auditor's scope paragraph adequately describes the scope limitation.D. Appropriate provided the statement is in a separate paragraph preceding the disclaimer of opinion paragraph.



Choice "a" is correct. Piecemeal opinions (opinions on parts of the financial statements, when those parts constitute a major portion of the financial statements) arenot appropriate if the auditor has disclaimed an opinion or issued an adverse opinion, because they may overshadow the auditor's opinion on the financialstatements taken as a whole. An opinion on specified elements that does not constitute a piecemeal opinion may be expressed, but should not accompany thedisclaimer of opinion or the adverse opinion. Choice "b" is incorrect. The auditor may express an opinion on one financial statement, even if the auditor must issue adisclaimer on the financial statements taken as a whole. Choice "c" is incorrect. Even with adequate description in the scope paragraph, an opinion on the currentasset portion of the balance sheet cannot be included in a disclaimer of opinion, as it might overshadow the disclaimer.Choice "d" is incorrect. It is not appropriate to include an opinion on the current asset portion of the balance sheet in a disclaimer of opinion, as it might overshadowthe disclaimer.

QUESTION 173When an auditor reports on financial statements prepared on an entity's income tax basis, the auditor's report should:

A. Disclaim an opinion on whether the statements were examined in accordance with generally accepted auditing standards.B. Not express an opinion on whether the statements are presented in conformity with the comprehensive basis of accounting used.C. Include an Explanation: of how the results of operations differ from the cash receipts and disbursements basis of accounting.D. State that the basis of presentation is a comprehensive basis of accounting other than GAAP.



Choice "d" is correct. When reporting on financial statements prepared in conformity with a basis of accounting other than GAAP, the auditor should identify in aseparate paragraph the basis as a comprehensive basis other than GAAP.Choice "a" is incorrect. The statements would be examined in accordance with GAAS; however, no opinion (or disclaimer) is given regarding this fact. Choice "b" isincorrect. The auditor should express an opinion on the financial statements' conformity with the comprehensive basis other than GAAP. Choice "c" is incorrect. Theauditor would include a statement indicating that the basis differs from GAAP, but need not quantify the differences among various bases of accounting.

QUESTION 174A CPA is permitted to accept a separate engagement (not in conjunction with an audit of financial statements) to audit an entity's:




Choice "a" is correct. An independent auditor may express an opinion on one or more specified elements, accounts, or items of a financial statement as a specialengagement, not in conjunction with an audit.Choices "b", "c", and "d" are incorrect, per above Explanation: .

QUESTION 175Delta Life Insurance Co. prepares its financial statements on an accounting basis insurance companies use pursuant to the rules of a state insurance commission.If Wall, CPA, Delta's auditor, discovers that the statements are not suitably titled, Wall should:

A. Disclose any reservations in an explanatory paragraph and qualify the opinion.B. Apply to the state insurance commission for an advisory opinion.C. Issue a special statutory basis report that clearly disclaims any opinion.D. Explain in the notes to the financial statements the terminology used.



Explanation:

Choice "a" is correct. Financial statements prepared in accordance with a comprehensive basis of accounting other than GAAP that are not suitably titled require aqualified opinion with an explanatory paragraph.Choice "b" is incorrect. The financial statements are not suitably titleD. The auditor does not need any advice from the insurance commission as to how thestatements should be titled or as to how to handle the situation.Choice "c" is incorrect. The auditor would not disclaim an opinion unless there is a scope limitation or independence problem.Choice "d" is incorrect. The notes to the financial statements are communications from management, not from the auditor.

QUESTION 176Helpful Co., a nonprofit entity, prepared its financial statements on an accounting basis prescribed by a regulatory agency solely for filing with that agency. Greenaudited the financial statements in accordance with generally accepted auditing standards and concluded that the financial statements were fairly presented on theprescribed basis. Green should issue a:

A. Qualified opinion.B. Standard three paragraph report with reference to footnote disclosure.C. Disclaimer of opinion.D. Special report.



Choice "d" is correct. A "special report" (unqualified) would be issued in an audit of financial statements prepared on an accounting basis prescribed by a regulatoryagency solely for filing with that agency.

Special reports are also issued for:

1. Financial statements that are prepared in accordance with a comprehensive basis of accounting other than GAAP.2. Specified elements, accounts or items of a financial statement.3. Compliance with contractual or regulatory requirements related to audited financial statements.4. Financial information presented in prescribed forms, or schedules that require a prescribed form of auditor's report.

Choices "a" and "c" are incorrect. The special report would be unqualified since Green concluded that the financial statements were fairly presented on theprescribed basis. Choice "b" is incorrect. The wording of the special report varies slightly from the auditor's standard three paragraph report, and includes anadditional explanatory paragraph.

QUESTION 177

An auditor's report would be designated a special report when it is issued in connection with:

A. Interim financial information of a publicly held company that is subject to a limited review.B. Compliance with aspects of regulatory requirements related to audited financial statements.C. Application of accounting principles to specified transactions.D. Limited use prospective financial statements such as a financial projection.



Choice "b" is correct. An auditor's report would be designated a special report when it is issued in connection with compliance with aspects of regulatoryrequirements related to audited financial statements.Choice "a" is incorrect. A "review report" (not a "special report") should be issued in connection with a limited review of interim financial information of a publicly heldcompany. Choice "c" is incorrect. Special reports are not issued in connection with the application of accounting principles to specified transactions.Choice "d" is incorrect. An auditor may compile, examine, or apply agreed-upon procedures to limited use prospective financial statements (PFS) such as afinancial projection, but this would not constitute a special report.

QUESTION 178When a CPA reports on audited financial statements prepared on the cash receipts and disbursements basis of accounting, the report should:

A. Explain why this basis of accounting is more useful for the readers of this entity's financial statements than GAAP.B. Refer to the note in the financial statements that describes management's responsibility for the financial statements.C. State that the basis of presentation is a comprehensive basis of accounting (OCBOA) other than GAAP.D. Include a separate explanatory paragraph that discusses the justification for, and the CPA's concurrence with, the departure from GAAP.



Choice "c" is correct. A report on other comprehensive basis of accounting ("OCBOA") financial statements should include an explanatory paragraph stating thebasis, referring to the footnote that describes it, and indicating that it is a non-GAAP basis. Choice "a" is incorrect. A report on other comprehensive basis ofaccounting ("OCBOA") financial statements does not include an evaluation of the usefulness of the basis of accounting. Choice "b" is incorrect. A report on othercomprehensive basis of accounting ("OCBOA") financial statements makes reference to the note in the financial statements that describes the accounting basis,

not to a note describing management's responsibility. Choice "d" is incorrect. The separate explanatory paragraph states the basis, refers to the footnote describingit, and indicates that it is a non-GAAP basis. It does not discuss the justification for the non-GAAP basis, nor does the CPA indicate concurrence.

QUESTION 179Which option best describes the level of assurance provided in the following special reports?




Choice "a" is correct. Positive assurance is provided in all of the listed reports except "compliance with contractual or regulatory requirements related to auditedfinancial statements." Negative assurance is provided in this report.Choices "b", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 180

Which of the following situations would not result in restricted use language being included in an auditor's special report?

A. A report on a specified element in a financial statement, where that element is prepared in accordance with the terms specified in a related contract.B. A report on a client's compliance with a regulatory requirement, assuming the report is prepared based on a financial statement audit of the complete financial

statements.C. An "OCBOA" report on financial statements prepared in conformity with requirements established by a regulatory agency, assuming that the auditor's report is a

matter of public record.D. A report on an incomplete financial presentation that is prepared in conformity with GAAP, assuming that the presentation and report will be filed with a

regulatory agency and included in a document distributed to the general public.



Choice "d" is correct. A report on an incomplete financial presentation that is otherwise prepared in conformity with GAAP generally would contain restricted uselanguage; however, an exception occurs when the presentation and the report are filed with a regulatory agency and included in a document distributed to thegeneral public. Choice "a" is incorrect. A report on a specified element in a financial statement, where that element is prepared in accordance with the termsspecified in a related contract, would contain restricted use language.Choice "b" is incorrect. A report on a client's compliance with a regulatory requirement, assuming the report is prepared based on a financial statement audit of thecomplete financial statements, would contain restricted use language.Choice "c" is incorrect. An "OCBOA" report on financial statements prepared in conformity with requirements established by a regulatory agency should containrestrictive use language. This is appropriate even though law or regulation may make the auditor's report is a matter of public record.

Compilation and Review of Financial Statements

QUESTION 181Which of the following is true about management representations obtained during an engagement to review the financial statements of a nonissuer?

A. Written representations from the current management are required for all periods being reported on.B. Written representations with respect to prior periods should not be provided by the current management if they were not present during those periods.C. Written representations should be addressed to members of management whom the accountant believes are responsible for and knowledgeable about the

matters covered in the representation letter.D. Written representations need not include information concerning subsequent events.



Choice "a" is correct. Written representations from the current management are required for all periods being reported on.Choice "b" is incorrect. Written representations from the current management are required for all periods being reported on, even if the current management wasnot present during all such periods.Choice "c" is incorrect. Written representations should be addressed to the accountant. The letter should be signed by members of management whom theaccountant believes are responsible for and knowledgeable about the matters covered in the representation letter. Choice "d" is incorrect. Written representationsshould include information concerning subsequent events.

QUESTION 182In reviewing the financial statements of a nonissuer, an accountant is required to modify the standard review report for which of the following matters?




Choice "d" is correct. Modifications are made to the standard review report only when there is a departure from generally accepted accounting principles. Neither aninability to assess risk nor a discovery of internal control deficiencies constitutes a departure from GAAP, and therefore neither would result in a modified reviewreport. Note that assessing the risk of material misstatement due to fraud is a requirement of an audit, not a review. Also, note that testing of internal control is notrequired in a review of financial statements of a nonissuer. Choices "a", "b", and "c" are incorrect, based on the above Explanation: .

QUESTION 183An accountant has compiled the financial statements of a nonissuer but declines to issue a compilation report. This is an example of:

A. An inappropriate reporting decision, because SSARS require that a report be issued whenever an accountant is associated with financial statements.B. An inappropriate reporting decision, if the accountant is not independent with respect to the nonpublic entity.C. An appropriate reporting decision, if the compiled financial statements are not expected to be used by a third party.D. An appropriate reporting decision, as long as the financial statements are prepared in conformity with GAAP.



Choice "c" is correct. If the accountant has compiled the financial statements of a nonissuer, and the compiled financial statements are not expected to be used bya third party, the accountant may decline to issue a compilation report.Choice "a" is incorrect, since SSARS allow the accountant to decline to issue a compilation report when the compiled financial statements are not expected to beused by a third party. Choice "b" is incorrect, since there is no requirement that the accountant be independent when the accountant declines to issue a compilationreport. Note that an accountant who lacks independence is still permitted to compile the financial statements of a nonissuer entity. Choice "d" is incorrect, sincethere is no requirement that the financial statements be prepared in conformity with GAAP when the accountant declines to issue a compilation report.

QUESTION 184An accountant compiles unaudited financial statements that are not expected to be used by a third party. The accountant may decline to issue a compilation reportprovided:

A. Each page of the financial statements is clearly marked to restrict its use.II. A written engagement letter is used to document the understanding with the client.III. A written representation letter is obtained from the client's management.

B. Option AC. Option B

D. Option CE. Option D


Explanation/Reference:Explanation:Choice "b" is correct. The accountant may decline to issue a compilation report provided that each page of the financial statements is clearly marked to restrict itsuse and a written engagement letter is used to document the understanding with the client. Choice "a" is incorrect, since a written engagement letter is required todocument the understanding with the client, and since representation letters are not required in compilation engagements.Choice "c" is incorrect, since the accountant may decline to issue a compilation report provided that each page of the financial statements is clearly marked torestrict its use and a written engagement letter is used to document the understanding with the client. Representation letters are not required in compilationengagements.Choice "d" is incorrect, since the accountant may decline to issue a compilation report provided that each page of the financial statements is clearly marked torestrict its use (and a written engagement letter is used to document the understanding with the client).

QUESTION 185An accountant has compiled the financial statements of a nonissuer in accordance with Statements on Standards for Accounting and Review Services (SSARS).The financial statements are expected to be used by a third party. Does SSARS require that the compilation report be printed on the accountant's letterhead andthat the report be manually signed by the accountant?


Correct Answer: D


Explanation/Reference:Explanation:Choice "d" is correct. SSARS does not require that the compilation report be printed on the accountant's letterhead, nor does it require a manual signature.According to SSARS, a compilation report must state that a compilation has been performed, describe what a compilation is, and emphasize that since no audit orreview was performed, no assurance is provided. Although a signature is required, it need not be manual. Choices "a", "b", and "c" are incorrect, per the aboveExplanation: .

QUESTION 186An accountant is required to comply with the provisions of Statements on Standards for Accounting and Review Services when:

A. Reproducing client-prepared financial statements without modification, as an accommodation to a client.II. Preparing standard monthly journal entries for depreciation and expiration of prepaid expenses.




Choice "d" is correct. An accountant is required to comply with the provisions of Statements on Standards for Accounting and Review Services when submittingunaudited financial statements. Submission is defined as: presenting to a client or third parties financial statements the accountant has prepared. An accountantwho reproduces client-prepared financial statements has not prepared those statements. Preparation of standard monthly journal entries is a bookkeeping servicethat also does not involve preparation of financial statements.

QUESTION 187If requested to perform a review engagement for a nonissuer in which an accountant has an immaterial direct financial interest, the accountant is:

A. Not independent and, therefore, may not be associated with the financial statements.B. Not independent and, therefore, may not issue a review report.C. Not independent and, therefore, may issue a review report, but may not issue an auditor's opinion.D. Independent because the financial interest is immaterial and, therefore, may issue a review report.



Choice "b" is correct. An accountant with an immaterial direct financial interest in a client is no longer independent with respect to that client. The accountant isprecluded from issuing a review report on the financial statements of an entity with respect to which he is not independent. If the accountant is not independent, hemay issue a compilation report provided he complies with the compilation standards.Choice "a" is incorrect. An accountant who is not independent may still be associated with the financial statements; for example, by performing a compilationengagement. Choice "c" is incorrect. The accountant is precluded from issuing a review report on the financial statements of an entity with respect to which he is notindependent. Choice "d" is incorrect. An accountant with any direct financial interest in a client (even an immaterial interest) is no longer independent with respect tothat client.

QUESTION 188Kell engaged March, CPA, to submit to Kell a written personal financial plan containing unaudited personal financial statements. March anticipates omitting certaindisclosures required by GAAP because the engagement's sole purpose is to assist Kell in developing a personal financial plan. For March to be exempt fromcomplying with the requirements of SSARS 1, Compilation and Review of Financial Statements, Kell is required to agree that the:

A. Financial statements will not be presented in comparative form with those of the prior period.B. Omitted disclosures required by GAAP are not material.C. Financial statements will not be disclosed to a non-CPA financial planner.D. Financial statements will not be used to obtain credit.



Choice "d" is correct. An accountant may submit a written personal financial plan containing unaudited personal financial statements to a client without complyingwith requirements of SSARS 1 when both of the following conditions exist:

1) The accountant establishes an understanding with the client that the financial statements will be used solely to assist the client in developing a financial plan andwill not be used to obtain credit, and2) Nothing comes to the accountant's attention during the engagement indicating that the financial statements will be used to obtain credit.Choice "a" is incorrect. Comparative balance sheets may be presented. Choice "b" is incorrect. It does not matter whether the omitted disclosures required byGAAP are material.

Choice "c" is incorrect. The client is not required to agree that the financial statements will not be disclosed to a non-CPA financial planner.

QUESTION 189When providing limited assurance that the financial statements of a nonissuer require no material modifications to be in accordance with generally acceptedaccounting principles, the accountant should:

A. Assess the risk that a material misstatement could occur in a financial statement assertion.B. Confirm with the entity's lawyer that material loss contingencies are disclosed.C. Understand the accounting principles of the industry in which the entity operates.D. Develop audit programs to determine whether the entity's financial statements are fairly presented.



Choice "c" is correct. In a review engagement, the auditor should possess a level of knowledge of the accounting principles and practices of the industry in whichthe entity operates. This will provide, through the performance of inquiry and analytical procedures, a reasonable basis for expressing limited assurance that thereare no material modifications that should be made to the financial statements to be in conformity with generally accepted accounting principles. Choice "a" isincorrect. Assessing the risk that a material misstatement could occur in a financial statement assertion is an audit procedure, not a review procedure. Choice "b" isincorrect. Confirmation with the entity's attorney is an audit procedure, not a review procedure.Choice "d" is incorrect. Development of audit programs are part of an audit engagement, not a review procedure.

QUESTION 190What type of analytical procedure would an auditor most likely use in developing relationships among balance sheet accounts when reviewing the financialstatements of a nonissuer?

A. Trend analysis.B. Regression analysis.C. Ratio analysis.D. Risk analysis.



Choice "c" is correct. Ratio analysis is often used to examine relationships between balance sheet accounts.Choice "a" is incorrect. Trend analysis would be more appropriate for examining income statement accounts.Choice "b" is incorrect. Regression analysis would not likely be used since twenty to thirty past observations are generally required to reliably make estimates.Choice "d" is incorrect. Risk analysis would not be used to evaluate relationships between balance sheet accounts.

QUESTION 191Compiled financial statements should be accompanied by an accountant's report stating that:

A. A compilation includes assessing the accounting principles used and significant management estimates, as well as evaluating the overall financial statementpresentation.

B. The accountant compiled the financial statements in accordance with Statements on Standards for Accounting and Review Services.C. A compilation is substantially less in scope than an audit in accordance with GAAS, the objective of which is the expression of an opinion.D. The accountant is not aware of any material modifications that should be made to the financial statements to conform with GAAP.



Choice "b" is correct. Compiled financial statements should be accompanied by a report stating that the financial statements were compiled in accordance withSSARS issued by the AICPA. Choice "a" is incorrect. An audit, not a compilation, includes assessing the accounting principles used and significant managementestimates, as well as evaluating the overall financial statement presentation.Choice "c" is incorrect. A review report, not a compilation report, includes the phrase, "is substantially less in scope than an audit."Choice "d" is incorrect. The accountant expresses no such assurance in a compilation engagement; limited assurance (i.e., "...accountant is not aware of...") isexpressed in a review engagement.

QUESTION 192Moore, CPA, has been asked to issue a review report on the balance sheet of Dover Co., a nonissuer.Moore will not be reporting on Dover's statements of income, retained earnings, and cash flows.Moore may issue the review report provided the:

A. Balance sheet is presented in a prescribed form of an industry trade association.B. Scope of the inquiry and analytical procedures has not been restricted.C. Balance sheet is not to be used to obtain credit or distributed to creditors.D. Specialized accounting principles and practices of Dover's industry are disclosed.

Correct Answer: B



Choice "b" is correct. An accountant may issue a review report on one financial statement, such as a balance sheet, and not on other related financial statements, ifthe scope of the accountant's inquiry and analytical procedures has not been restricted. Choice "a" is incorrect. The balance sheet need not be presented in aprescribed form of an industry trade association.Choice "c" is incorrect. There is no limitation on the use of a reviewed financial statement. Choice "d" is incorrect. Specialized accounting principles should beconsidered by the accountant when performing the review, but need not be disclosed.

QUESTION 193Baker, CPA, was engaged to review the financial statements of Hall Co., a nonissuer. During the engagement Baker uncovered a complex scheme involving clientillegal acts and fraud that materially affect Hall's financial statements. If Baker believes that modification of the standard review report is not adequate to indicate thedeficiencies in the financial statements, Baker should:

A. Disclaim an opinion.B. Issue an adverse opinion.C. Withdraw from the engagement.D. Issue a qualified opinion.



Choice "c" is correct. If the accountant believes that modification of the standard report is not adequate to indicate the deficiencies in the financial statements takenas a whole, the accountant should withdraw from the review engagement and provide no further services with respect to those financial statements.Note that the accountant should also request that management consider the effect of the scheme on the financial statements.Choice "a" is incorrect. Since Baker believes modification of the standard report is not adequate, a disclaimer is inappropriate. Baker should withdraw from theengagement. Choices "b" and "d" are incorrect. No opinion may be given based on a review engagement.

QUESTION 194Each page of a nonissuer's financial statements reviewed by an accountant should include the following reference:

A. See Accompanying Accountant's Footnotes.B. Reviewed, No Material Modifications Required.

C. See Accountant's Review Report.D. Reviewed, No Accountant's Assurance Expressed.

Correct Answer: CSection: Auditing and Attestation (I) (Volume B)Explanation


Choice "c" is correct. Each page of the financial statements reviewed by the accountant should include a reference such as "See Accountant's Review Report."Choices "a", "b", and "d" are incorrect, based on the above Explanation: .

QUESTION 195An accountant has been engaged to review a nonissuer's financial statements that contain several departures from GAAP. If the financial statements are notrevised and modification of the standard review report is not adequate to indicate the deficiencies, the accountant should:

A. Withdraw from the engagement and provide no further services concerning these financial statements. B. Inform management that the engagement canproceed only if the accountant's report is restricted to internal use.

B. Determine the effects of the departures from GAAP and issue a special report on the financial statements.C. Issue a modified review report provided the entity agrees that the financial statements will not be used to obtain credit.

Correct Answer: ASection: Auditing and Attestation (I) (Volume B)Explanation


Choice "a" is correct. If an auditor believes that modification of the standard report is not adequate to indicate the deficiencies in the financial statements, he shouldwithdraw from the review engagement and provide no additional services with respect to the financial statements. Choice "b" is incorrect. Limiting the use of thereport is not an acceptable option for financial statements under review that contain several departures from GAAP. Choice "c" is incorrect. Issuing a special reportis inappropriate for financial statements under review that contain several departures from GAAP.Choice "d" is incorrect. If modification of the standard review report is not adequate to indicate departures from GAAP, a modified report should not be issueD. Useof the financial statements is irrelevant.

QUESTION 196Statements on Standards for Accounting and Review Services (SSARS) require an accountant to report when the accountant has:

A. Typed client-prepared financial statements, without modification, as an accommodation to the client.

B. Provided a client with a financial statement format that does not include dollar amounts, to be used by the client in preparing financial statements.C. Proposed correcting journal entries to be recorded by the client that change client-prepared financial statements.D. Prepared, through the use of computer software, financial statements that are in conformity with a comprehensive basis of accounting other than GAAP, and

which are expected to be used by a third party.

Correct Answer: DSection: Auditing and Attestation (I) (Volume B)Explanation


Choice "d" is correct. SSARS apply when an accountant "submits" financial statements. Submission is defined as presenting financial statements to a client or thirdparty that the accountant has prepared, either manually or through use of computer software. Preparing financial statements that are in conformity with anothercomprehensive basis of accounting constitutes a submission of financial statements under SSARS. If the financial statements are expected to be used by a thirdparty, SSARS would require the accountant to report. Choice "a" is incorrect. Typing or reproducing client-prepared financial statements, without modification, as anaccommodation to a client does not constitute submission of financial statements because the accountant has not prepared those statements. Choice "b" isincorrect. Providing a client with a financial statement format does not constitute a submission of financial statements (the accountant is not preparing the financialstatements) and therefore, this does not fall within the guidelines of SSARS. Choice "c" is incorrect. Proposing correcting journal entries does not constitutesubmission of financial statements because the client will be the one recording the entries.

QUESTION 197Which of the following procedures should an accountant perform during an engagement to review the financial statements of a nonissuer?

A. Communicating significant deficiencies discovered during the assessment of control risk.B. Obtaining a client representation letter from members of management.C. Sending bank confirmation letters to the entity's financial institutions.D. Examining cash disbursements in the subsequent period for unrecorded liabilities.

Correct Answer: BSection: Auditing and Attestation (I) (Volume B)Explanation

Explanation/Reference:Explanation:Choice "b" is correct. An accountant performing a review should obtain a client representation letter from the owner, manager, or chief executive officer, and, ifappropriate, the chief financial officer.Choice "a" is incorrect. A review does not contemplate obtaining an understanding of internal control or assessing control risk.Choice "c" is incorrect. Confirmation is a substantive audit procedure that is not appropriate for a review engagement.Choice "d" is incorrect. A search for unrecorded liabilities is an audit procedure that is not appropriate for a review engagement.

QUESTION 198An accountant who had begun an audit of the financial statements of a nonissuer was asked to change the engagement to a review because of a restriction on thescope of the audit. If there is reasonable justification for the change, the accountant's review report should include reference to the:




Choice "c" is correct. If the accountant concludes that there is reasonable justification to change the engagement, the accountant's review report should not includereference to the original engagement, to any auditing procedures that may have been performed, or to the scope limitation that resulted in the changedengagement.Choices "a", "b", and "d" are incorrect, per above Explanation: .

QUESTION 199Which of the following statements should be included in an accountant's standard report based on the compilation of a nonissuer's financial statements?

A. A compilation consists principally of inquiries of company personnel and analytical procedures applied to financial data.B. A compilation is limited to presenting in the form of financial statements information that is the representation of management.C. A compilation is not designed to detect material modifications that should be made to the financial statements.D. A compilation is substantially less in scope than an audit in accordance with generally accepted auditing standards.



Choice "b" is correct. The accountant's compilation report should state that a compilation is limited to presenting in the form of financial statements information thatis the representation of management.Choice "a" is incorrect. A review (not a compilation) consists principally of inquiries of management and analytical procedures applied to financial data. Choice "c" isincorrect. While a compilation is not designed to detect material misstatements in the financial statements, no mention of this limitation is made in the compilationreport. Choice "d" is incorrect. The review report states that a review is substantially less in scope than an audit in accordance with GAAS.

QUESTION 200Miller, CPA, is engaged to compile the financial statements of Web Co., a nonissuer, in conformity with the income tax basis of accounting. If Web's financialstatements do not disclose the basis of accounting used, Miller should:

A. Disclose the basis of accounting in the accountant's compilation report.B. Clearly label each page "Distribution Restricted-Material Modifications Required."C. Issue a special report describing the effect of the incomplete presentation.D. Withdraw from the engagement and provide no further services to Web.



Choice "a" is correct. If financial statements have been compiled on a basis other than GAAP, and the client makes no disclosures in the financial statements to thateffect, the accountant should disclose the basis of accounting in the accountant's compilation report. Choice "b" is incorrect. Under the circumstances, theaccountant need only make reference to the other basis of accounting used to compile the financial statements; special labeling of the financial statements is notrequired.Choice "c" is incorrect. A special report is not warranted in the circumstances. Choice "d" is incorrect. It is not necessary to withdraw from the engagement.

QUESTION 201When an accountant is engaged to compile a nonissuer's financial statements that omit substantially all disclosures required by GAAP, the accountant shouldindicate in the compilation report that the financial statements are:

A. Not designed for those who are uninformed about the omitted disclosures.B. Prepared in conformity with a comprehensive basis of accounting other than GAAP.C. Not compiled in accordance with Statements on Standards for Accounting and Review Services.D. Special-purpose financial statements that are not comparable to those of prior periods.



Choice "a" is correct. If substantially all disclosures required by GAAP are omitted from compiled financial statements, the accountant's compilation report shouldstate that the financial statements are not designed for those who are not informed about such matters. Choice "b" is incorrect. Omission of substantially alldisclosures is not a comprehensive basis of accounting other than GAAP.Choice "c" is incorrect. If the disclosure is made, the compilation is prepared in accordance with SSARS.Choice "d" is incorrect. Omission of substantially all disclosures does not make these special- purpose financial statements.

QUESTION 202North Co., a privately-held entity, asked its tax accountant, King, a CPA in public practice, to prepare North's interim financial statements on King's microcomputerwhen King prepared North's quarterly tax return. King should not submit these financial statements to North unless, as a minimum, King complies with theprovisions of:

A. Statements on Standards for Accounting and Review Services.B. Statements on Standards for Unaudited Financial Services.C. Statements on Standards for Consulting Services.D. Statements on Standards for Attestation Engagements.


Explanation/Reference:Explanation:Choice "a" is correct. An accountant should not submit unaudited financial statements unless the auditor complies with the provisions applicable to a compilationengagement (under SSARS). Choices "b", "c", and "d" are incorrect, per above Explanation: .

QUESTION 203Davis, CPA, accepted an engagement to audit the financial statements of Tech Resources, a nonissuer. Before the completion of the audit, Tech requested Davisto change the engagement to a compilation of financial statements. Before Davis agrees to change the engagement, Davis is required to consider the:




Choice "b" is correct. When an auditor is requested to change the engagement from an audit to a compilation, the auditor must consider the effort needed tocomplete the audit, the cost of completing the audit, and the reasons for the client's request. If the audit is substantially complete or an insignificant effort is neededto complete the audit, the auditor should consider the propriety of agreeing to the request.In addition, if the reason for the request is to limit the scope of the auditor's examination, the auditor must consider whether the information affected by the scopelimitation is incorrect, incomplete, or otherwise unsatisfactory.A change in circumstance (e.g., an audit is no longer necessary) or a misunderstanding as to the nature of an audit would, on the other hand, be considered areasonable basis for the change. Choices "a", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 204Smith, CPA, has been asked to issue a review report on the balance sheet of Cone Company, a nonissuer, and not on the other related financial statements. Smithmay do so only if:

A. Smith compiles and reports on the related statements of income, retained earnings, and cash flows.B. Smith is not aware of any material modifications needed for the balance sheet to conform with GAAP.C. The scope of Smith's inquiry and analytical procedures is not restricted.D. Cone is a new client and Smith accepts the engagement after the end of Cone's fiscal year.



Choice "c" is correct. An accountant may issue a review report on one financial statement, such as a balance sheet, as long as the scope of the inquiry andanalytical procedures has not been restricted.Choice "a" is incorrect. There is no requirement that Smith compile the other financial statements.Choice "b" is incorrect. An accountant can still review only the balance sheet, even if the review discloses material departures from GAAP. These departures shouldbe reflected in the accountant's report, however.Choice "d" is incorrect. Smith may audit only the balance sheet even if Cone is a continuing client.

QUESTION 205May an accountant accept an engagement to compile or review the financial statements of a not- for-profit entity if the accountant is unfamiliar with the specializedindustry accounting principles, but plans to obtain the required level of knowledge before compiling or reviewing the financial statements?



Explanation/Reference:Explanation:Choice "d" is correct. Knowledge of the accounting principles and practices of the industry is required in order to perform a compilation or review engagement;however, there is no requirement that such knowledge be obtained prior to accepting such an engagement.Choices "a", "b", and "c" are incorrect, per above.

QUESTION 206An accountant should perform analytical procedures during an engagement to:




Choice "d" is correct. Analytical procedures are part of a review engagement, but not necessary for a compilation engagement.Choices "a", "b", and "c" are incorrect, per above Explanation: s.

QUESTION 207Which of the following procedures most likely would not be included in a review engagement of a nonissuer?

A. Obtaining a management representation letter.B. Considering whether the financial statements conform with GAAP.C. Assessing control risk.D. Inquiring about subsequent events.

Correct Answer: C

Section: Auditing and Attestation (I) (Volume B)Explanation


Choice "c" is correct. An accountant is not required to assess control risk as part of a review engagement. Assessment of control risk would be appropriate for anaudit engagement. Choice "a" is incorrect. Obtaining a management representation letter is an appropriate review procedure.Choice "b" is incorrect. Considering whether the financial statements are in accordance with GAAP is an appropriate review procedure.Choice "d" is incorrect. Inquiring of management regarding subsequent events is an appropriate review procedure.

QUESTION 208Compiled financial statements should be accompanied by a report stating that:

A. A compilation is substantially less in scope than a review or an audit in accordance with generally accepted auditing standards.B. The accountant does not express an opinion but expresses only limited assurance on the compiled financial statements.C. A compilation is limited to presenting in the form of financial statements information that is the representation of management.D. The accountant has compiled the financial statements in accordance with standards established by the Auditing Standards Board.



Choice "c" is correct. The accountant's report includes a statement that the compilation is limited to presenting in the form of financial statements information that isthe representation of management.Choice "a" is incorrect. The report must state that the financial statements have not been audited or reviewed, but does not compare the scope of a compilation tothe scope of a review or an audit.Choice "b" is incorrect. The accountant expresses no assurance in a compilation engagement; limited assurance is expressed in a review engagement. Choice "d"is incorrect. The financial statements are compiled in accordance with SSARS issued by the AICPA, rather than "standards established by the Auditing StandardsBoard."

QUESTION 209An accountant may compile a nonissuer's financial statements that omit all of the disclosures required by GAAP only if the omission is:

A. Clearly indicated in the accountant's report.II. Not undertaken with the intention of misleading the financial statement users.

B. I only.

C. II only.D. Both I and II.E. Either I or II.



Choice "c" is correct. An accountant may issue a compilation report for a client's financial statements that omit all required GAAP disclosures, provided the omissionis not intended to mislead financial statement users and the omission is clearly indicated in the accountant's report. Choices "a", "b", and "d" are incorrect, perabove Explanation: .

QUESTION 210An accountant's standard report on a review of the financial statements of a nonissuer should state that the accountant:

A. Does not express an opinion or any form of limited assurance on the financial statements.B. Is not aware of any material modifications that should be made to the financial statements for them to conform with GAAP.C. Obtained reasonable assurance about whether the financial statements are free of material misstatement.D. Examined evidence, on a test basis, supporting the amounts and disclosures in the financial statements.



Choice "b" is correct. The accountant's report on a review engagement should state that the accountant is not aware of any material modifications that should bemade to the financial statements for them to conform with GAAP.Choice "a" is incorrect. An accountant expresses limited assurance in a review engagement. Choice "c" is incorrect. "Reasonable assurance about whether thefinancial statements are free of material misstatement" is required for audit engagements, but is not necessary for review engagements.Choice "d" is incorrect. Examining evidence on a test basis is required for an audit engagement; procedures for a review engagement are limited to inquiry andanalytical procedures.

QUESTION 211An accountant has been asked to issue a review report on the balance sheet of a nonissuer but not to report on the other basic financial statements. Theaccountant may not do so:

A. Because compliance with this request would result in a violation of the ethical standards of the profession.B. Because compliance with this request would result in an incomplete review.C. If the review of the balance sheet discloses material departures from GAAP.D. If the scope of the inquiry and analytical procedures has been restricted.



Choice "d" is correct. An accountant may issue a review report on one financial statement, such as a balance sheet, as long as the scope of the inquiry andanalytical procedures has not been restricted.Choice "a" is incorrect. Compliance with this request would not violate any ethical standards of the profession.Choice "b" is incorrect. Compliance with this request would not necessarily result in an incomplete review.Choice "c" is incorrect. An accountant can still review only the balance sheet, even if the review discloses material departures from GAAP. However, thesedepartures should be reflected in the accountant's report.

QUESTION 212When performing an engagement to review a nonissuer's financial statements, an accountant most likely would:

A. Confirm a sample of significant accounts receivable balances.B. Ask about actions taken at board of directors' meetings.C. Obtain an understanding of internal control.D. Restrict the use of the accountant's report.



Choice "b" is correct. As part of the inquiries made during a review engagement, an accountant would ask about actions taken at board of directors' meetings thataffect the financial statements. Choice "a" is incorrect. Certain procedures, such as confirmation of receivables and observation of inventory, are customarilyperformed in an audit but not in compilation or review engagements.Choice "c" is incorrect. A review engagement does not include obtaining an understanding of the client's internal control.Choice "d" is incorrect. The accountant would not normally restrict the use of the review report.

QUESTION 213During an engagement to review the financial statements of a nonissuer an accountant becomes aware of a material departure from GAAP. If the accountantdecides to modify the standard review report because management will not revise the financial statements, the accountant should:

A. Express negative assurance on the accounting principles that do not conform with GAAP.B. Disclose the departure from GAAP in a separate paragraph of the report.C. Issue an adverse or an "except for" qualified opinion, depending on materiality.D. Express positive assurance on the accounting principles that conform with GAAP.



Choice "b" is correct. If the accountant concludes that modification of the standard report is appropriate, the departure should be disclosed in a separate paragraphof the report. Choice "a" is incorrect. An accountant would not express negative assurance on the accounting principles that do not conform with GAAP in a reviewengagement. Choice "c" is incorrect. An accountant would not issue an opinion in a review engagement. Choice "d" is incorrect. An accountant would not expresspositive assurance (i.e., an opinion) on the accounting principles that conform with GAAP in a review engagement.

QUESTION 214Which of the following representations does an accountant make implicitly when issuing the standard report for the compilation of a nonissuer's financialstatements?

A. The accountant is independent with respect to the entity.B. The financial statements have not been audited.C. A compilation consists principally of inquiries and analytical procedures.D. The accountant does not express any assurance on the financial statements.



Choice "a" is correct. If the accountant is not independent, he should specifically disclose the lack of independence. Otherwise, independence is implied. Choice "b"is incorrect. The report accompanying compiled financial statements explicitly states that the financial statements have not been audited. Choice "c" is incorrect.

Inquiry and analytical procedures are not performed in a compilation engagement.Choice "d" is incorrect. The report accompanying compiled financial statements explicitly states that the accountant provides no assurance on the financialstatements.

QUESTION 215Which of the following accounting services may an accountant perform without being required to issue a compilation or review report under the Statements onStandards for Accounting and Review Services?

A. Preparing a working trial balance.II. Preparing standard monthly journal entries.




Choice "c" is correct. An accountant can prepare a working trial balance and prepare standard monthly journal entries without being required to issue a compilationor review report under the SSARS as long as the performance of these services does not carry forward into the submission of financial statements.Choice "a" is incorrect. Monthly journal entries can be prepared. Choice "b" is incorrect. A working trial balance can be prepared. Choice "d" is incorrect. Both ofthese services can be rendered as long as they do not carry forward into the preparation of financial statements.

QUESTION 216Which of the following inquiry or analytical procedures ordinarily is performed in an engagement to review a nonissuer's financial statements?

A. Analytical procedures designed to test the accounting records by obtaining corroborating evidential matter.B. Inquiries concerning the entity's procedures for recording and summarizing transactions.C. Analytical procedures designed to test management's assertions regarding continued existence.D. Inquiries of the entity's attorney concerning contingent liabilities.


Explanation/Reference:Explanation:Choice "b" is correct. When reviewing a nonissuer's financial statements, an accountant ordinarily makes inquiries concerning the entity's procedures for recordingand summarizing transactions.Choices "a", "c", and "d" are incorrect. The following audit procedures generally are not performed in a review engagement:

A. Tests of the accounting records.C. Tests of management's assertions regarding continued existence. D. Inquiries of the entity's attorney concerning contingent liabilities.

QUESTION 217When compiling the financial statements of a nonissuer, an accountant should:

A. Review agreements with financial institutions for restrictions on cash balances.B. Understand the accounting principles and practices of the entity's industry.C. Inquire of key personnel concerning related parties and subsequent events.D. Perform ratio analyses of the financial data of comparable prior periods.



Choice "b" is correct. When compiling the financial statements of a nonissuer, an accountant should understand the accounting principles and practices of theentity's industry. Choice "a" is incorrect. Reviewing agreements with financial institutions for restrictions is generally performed during an audit.Choice "c" is incorrect. Inquiring of key personnel concerning related parties and subsequent events is not required in a compilation.Choice "d" is incorrect. Performing ratio analyses of the financial data of comparable prior periods is generally performed for review engagements and audits, notcompilations.

QUESTION 218Jones Retailing, a nonissuer, has asked Winters, CPA, to compile financial statements that omit substantially all disclosures required by generally acceptedaccounting principles. Winters may compile such financial statements provided the:

A. Reason for omitting the disclosures is explained in the engagement letter and acknowledged in the management representation letter.B. Financial statements are prepared on a comprehensive basis of accounting other than generally accepted accounting principles.C. Use of the financial statements is restricted to internal use only.D. Omission is not undertaken to mislead the users of the financial statements and is properly disclosed in the accountant's report.

Correct Answer: D



Choice "d" is correct. An accountant may compile FS that omit substantially all disclosures required by GAAP provided the omission is not undertaken to misleadthe users of the FS and is properly disclosed in the accountant's report as an additional third paragraph. Choice "a" is incorrect. There is no requirement that thereason for omitting the disclosures be explained in an engagement letter or acknowledged in the management representation letter (which, by the way, is notrequired for compilation engagements). Choice "b" is incorrect. Financial statements compiled in accordance with GAAP may omit substantially all requireddisclosures.Choice "c" is incorrect. Substantially all disclosures required by GAAP may be omitted in a compilation without restricting use to internal parties.

QUESTION 219Which of the following procedures is usually performed by the accountant in a review engagement of a nonissuer?

A. Sending a letter of inquiry to the entity's lawyer.B. Comparing the financial statements with statements for comparable prior periods.C. Confirming a significant percentage of receivables by direct communication with debtors.D. Communicating significant deficiencies discovered during the study of the internal control structure.



Choice "b" is correct. Comparing the financial statements with statements for comparable prior periods (analytical procedures) is a procedure that is usuallyperformed by the accountant in a review engagement of a nonissuer.Choice "a" is incorrect. Sending a letter of inquiry to the entity's lawyer is a procedure generally performed only in an audit of an entity's financial statements. Choice"c" is incorrect. Confirming a significant percentage of receivables by direct communication with debtors is a procedure generally performed only in an audit of anentity's financial statements.Choice "d" is incorrect. Communicating significant deficiencies discovered during the study of the internal control structure is a procedure generally performed onlyin an audit of an entity's financial statements.(The internal control structure is generally not evaluated in a review engagement.)

QUESTION 220Which of the following procedures is more likely to be performed in a review engagement of a nonissuer than in a compilation engagement?

A. Gaining an understanding of the entity's business transactions.

B. Making a preliminary assessment of control risk.C. Obtaining a representation letter from the chief executive officer.D. Assisting the entity in adjusting the accounting records.



Choice "c" is correct. Obtaining a representation letter from the CEO is more likely to be performed in a review engagement of a nonissuer (where obtaining theletter is required) than in a compilation engagement.Choice "a" is incorrect. Gaining an understanding of the entity's business transactions would be performed in both a compilation and a review engagement. Choice"b" is incorrect. Making a preliminary assessment of control risk would only be performed in an audit, not in a compilation or review. Choice "d" is incorrect.Assisting the entity in adjusting (compiling) the accounting records is more likely to be performed in a compilation engagement than in a review.

QUESTION 221Statements on Standards for Accounting and Review Services establish standards and procedures for which of the following engagements?

A. Proposing adjustments to the books of account for a partnership.B. Reviewing interim financial data required to be filed with the SEC.C. Preparing standard monthly journal entries.D. Compiling an individual's personal financial statement to be used to obtain a mortgage.



Choice "d" is correct. Statements on Standards for Accounting and Review Services (SSARS) establish standards and procedures for an engagement to compilean individual's personal financial statements to be used to obtain a mortgage. Choice "a" is incorrect. Proposing adjustments to the books of account for apartnership is an engagement that does not pertain to SSARS, as it falls short of submitting financial statements. Choice "b" is incorrect. Reviewing interim financialdata required to be filed with the SEC is covered under PCAOB standards. SSARS only applies to nonissuers. Choice "c" is incorrect. Preparing standard monthlyjournal entries is not covered by SSARS, as it falls short of submitting financial statements.

QUESTION 222When compiling a nonissuer's financial statements, an accountant would be least likely to:

A. Perform analytical procedures designed to identify relationships that appear to be unusual.B. Read the compiled financial statements and consider whether they appear to include adequate disclosure.C. Omit substantially all of the disclosures required by generally accepted accounting principles.D. Issue a compilation report on one or more, but not all, of the basic financial statements.



Choice "a" is correct. During a compilation of a nonissuer's financial statements, an accountant generally would not perform analytical procedures. (Analyticalprocedures are required in a review.)Choice "b" is incorrect. The accountant compiling financial statements generally would read those statements to consider whether they appear to include adequatedisclosure. Choice "c" is incorrect. The accountant compiling financial statements might omit substantially all of the disclosures required by GAAP.Choice "d" is incorrect. The accountant compiling financial statements might issue a compilation report on one or more, but not all, of the basic financial statements.

QUESTION 223Which of the following procedures would most likely be included in a review engagement of a nonissuer?

A. Preparing a bank transfer schedule.B. Inquiring about related party transactions.C. Assessing the internal control structure.D. Performing cutoff tests on sales and purchases transactions.



Choice "b" is correct. A review engagement is based on inquiry and analytical procedures. Inquiring about related party transactions is a procedure which wouldmost likely be included in a review engagement of a nonpublic entity.Choice "a" is incorrect. Preparing a bank transfer schedule pertains to an audit engagement. Choice "c" is incorrect. Assessing the internal control structure pertainsto an audit engagement. Choice "d" is incorrect. Performing cutoff tests on sales and purchases transactions pertains to an audit engagement.

QUESTION 224

Baker, CPA, was engaged to review the financial statements of Hall Company, a nonissuer. Evidence came to Baker's attention that indicated substantial doubt asto Hall's ability to continue as a going concern. The principal conditions and events that caused the substantial doubt have been fully disclosed in the notes to Hall'sfinancial statements. Which of the following statements best describes Baker's reporting responsibility concerning this matter?

A. Baker is not required to modify the accountant's review report.B. Baker is not permitted to modify the accountant's review report.C. Baker should issue an accountant's compilation report instead of a review report.D. Baker should express a qualified opinion in the accountant's review report.



Choice "a" is correct. Since the principal conditions and events that caused the substantial doubt as to the company's ability to continue as a going concern havebeen fully disclosed in the notes to Hall's financial statements, Baker is not required to modify the accountant's review report. Baker may, however, choose toemphasize this issue in the report. Choice "b" is incorrect. The auditor is permitted to modify his review report as he/she feels appropriate in the circumstances.Choice "c" is incorrect. Baker did not perform a compilation; therefore, a compilation report would not be appropriate.Choice "d" is incorrect. Since the facts have been fully disclosed in the notes to the financial statements, no modification to the review report is required. Also, anopinion is never expressed based on a review engagement.

QUESTION 225The authoritative body designated to promulgate standards concerning an accountant's association with unaudited financial statements of an entity that is notrequired to file financial statements with an agency regulating the issuance of the entity's securities is the:

A. Financial Accounting Standards Board.B. General Accounting Office.C. Accounting and Review Services Committee.D. Auditing Standards Board.



Choice "c" is correct. The accounting and review services committee is the authoritative body designated to promulgate standards concerning an accountant's

association with unaudited financial statements of a nonissuer (i.e., an entity that is not required to file financial statements with an agency regulating the issuanceof the entity's securities). Choice "a" is incorrect. The Financial Accounting Standards Board (FASB) is responsible for GAAP standards.Choice "b" is incorrect. The General Accounting Office (GAO) is responsible for audit standards under the federal "Single Audit Act."Choice "d" is incorrect. The Auditing Standards Board (ASB) is responsible for auditing standards under GAAS.

QUESTION 226When an accountant performs more than one level of service (for example, a compilation and a review, or a compilation and an audit) concerning the financialstatements of a nonissuer, the accountant generally should issue the report that is appropriate for:

A. The lowest level of service rendered.B. The highest level of service rendered.C. A compilation engagement.D. A review engagement.



Choice "b" is correct. When an accountant performs more than one level of service (for example, a compilation and a review, or a compilation and an audit)concerning the financial statements of a nonissuer, the accountant generally should issue the report that is appropriate for the highest level of service rendered.Choices "a", "c", and "d" are incorrect. The report should be appropriate for the highest level of service rendered.

QUESTION 227An accountant who reviews the financial statements of a nonissuer should issue a report stating that a review:

A. Is substantially less in scope than an audit.B. Provides negative assurance that the internal control structure is functioning as designed.C. Provides only limited assurance that the financial statements are fairly presented.D. Is substantially more in scope than a compilation.


Explanation/Reference:Explanation:Choice "a" is correct. An accountant who reviews the financial statements of a nonissuer should issue a report stating that a review is substantially less in scope

than an audit. (This is why you have to "memorize" the key phrases in the review and compilation reports.) Choice "b" is incorrect. Internal control inquiries are notpart of a review, and therefore assurances related to internal control are inappropriate. Choice "c" is incorrect. A review does provide limited assurance as to GAAP,but this is not the appropriate wording for the report.Choice "d" is incorrect. Review report language compares a review with an audit, not with a compilation.

QUESTION 228Before performing a review of a nonissuer's financial statements, an accountant should:

A. Complete a series of inquiries concerning the entity's procedures for recording, classifying, and summarizing transactions.B. Apply analytical procedures to provide limited assurance that no material modifications should be made to the financial statements.C. Obtain a sufficient level of knowledge of the accounting principles and practices of the industry in which the entity operates.D. Inquire whether management has omitted substantially all of the disclosures required by generally accepted accounting principles.



Choice "c" is correct. Before performing a review of a nonissuer's financial statements, an accountant should obtain a sufficient level of knowledge of the accountingprinciples and practices of the industry in which the entity operates. Choices "a", "b", and "d" are incorrect. These are appropriate steps performed during thereview, not prior to it.

QUESTION 229Which of the following is not true about documentation requirements related to a review of a nonissuer's financial statements?

A. Written documentation from a compilation engagement may be used to provide support for the review report.B. A management representation letter should be included in the documentation files.C. The auditor must document evidence obtained about the operating effectiveness of controls.D. Documentation should include the results of analytical procedures.



Choice "c" is correct. The accountant is not required to evaluate control risk or test the operating effectiveness of controls in a review of a nonpublic entity's financial

statements. Choice "a" is incorrect. Written documentation from other types of engagements may be used to provide support for the review report.Choice "b" is incorrect. A management representation letter should be obtained in review engagements, and a copy should be included in the documentation files.Choice "d" is incorrect. Documentation should include the results of analytical procedures (i.e., procedures performed, expectations and how they were developed,results of comparison to recorded amounts, and procedures performed with respect to significant differences).

QUESTION 230An accountant performing a compilation or review of the financial statements of a nonissuer should:

A. Be able to justify departures from SSARS.B. Never depart from SSARS guidelines.C. Exercise professional judgment in applying SSARS, since they are considered recommendations as opposed to standards.D. Not depart from Statements on Auditing Standards.



Choice "a" is correct. An accountant should be able to justify departures from SSARS. Choice "b" is incorrect. An accountant may occasionally depart from SSARSguidelines, but should be prepared to justify such departures.Choice "c" is incorrect. While it is true that an accountant should exercise professional judgment in applying SSARS, it is not true that SSARS are consideredrecommendations. SSARS are professional standards, which the accountant should generally follow. Choice "d" is incorrect. Statements on Auditing Standards donot apply to compilations or reviews of the financial statements of a nonissuer.

QUESTION 231When performing an engagement to review a nonissuer's financial statements, an accountant most likely would:

A. Obtain an understanding of the entity's internal control.B. Limit the distribution of the accountant's report.C. Confirm a sample of significant accounts receivable balances.D. Ask about actions taken at board of directors' meetings.



Choice "d" is correct. A review is based on inquiry and analytical procedures. The accountant should inquire about actions authorized by the stockholders, the boardof directors, or other management groups.Choice "a" is incorrect. The accountant is not required to obtain an understanding of internal control in a review engagement under SSARS. An understandingwould be required in an audit or in a review of the interim financial statements of a public entity, conducted under auditing (PCAOB) standards.Choice "b" is incorrect. Distribution of a review report is not limited; however, each page of the financial statements should be marked, "See Accountant's ReviewReport." Choice "c" is incorrect. Confirmation is an auditing procedure used to corroborate stated account balances. A review is based on inquiry and analyticalprocedures, and would not include confirmation of balances.

QUESTION 232Which of the following should be the first step in reviewing the financial statements of a nonissuer?

A. Comparing the financial statements with statements for comparable prior periods and with anticipated results.B. Completing a series of inquiries concerning the entity's procedures for recording, classifying, and summarizing transactions.C. Obtaining a general understanding of the entity's organization, its operating characteristics, and its products or services.D. Applying analytical procedures designed to identify relationships and individual items that appear to be unusual.



Choice "c" is correct. In reviewing the financial statements of a nonissuer, the accountant's first step would be to obtain a general understanding of the entity'sorganization, its operating characteristics, and its products or services.Choices "a", "b", and "d" are incorrect. Inquiry and analytical review procedures would be performed after a general understanding of the client is obtained. Thisunderstanding will help the accountant more appropriately tailor the inquiry and analytical review procedures to the specific client engagement.

QUESTION 233An accountant has been asked to issue a review report on the balance sheet of a nonissuer without reporting on the related statements of income, retainedearnings, and cash flows. The accountant may issue the requested review report only if:

A. The balance sheet is not to be used to obtain credit or distributed to the entity's creditors.B. The balance sheet is part of a comprehensive personal financial plan developed to assist the entity.C. There have been no material changes during the year in the entity's accounting principles.D. The scope of the accountant's inquiry and analytical procedures has not been restricted.

Correct Answer: DSection: Auditing and Attestation (I) (Volume B)

Explanation


Choice "d" is correct. A review engagement may involve reporting on only one financial statement, provided the scope of the engagement was not limited. Choice"a" is incorrect. A review engagement may involve reporting on only one financial statement, provided the scope of the engagement was not limited. There are norequirements regarding the use of the balance sheet.Choice "b" is incorrect. A review engagement may involve reporting on only one financial statement, provided the scope of the engagement was not limited. There isno requirement that the balance sheet be part of a comprehensive personal financial plan. Choice "c" is incorrect. A review engagement may involve reporting ononly one financial statement, provided the scope of the engagement was not limited. There is no requirement that accounting principles remain consistent duringthe year.

QUESTION 234An accountant is asked to issue a review report on the balance sheet, but not on other related statements. The scope of the inquiry and analytical procedures hasnot been restricted, but the client failed to provide a representation letter. Which of the following should the accountant issue under these circumstances?

A. Review report with a qualification.B. Review report with a disclaimer.C. Review report and footnote exceptions.D. Compilation report with the client's consent.



Choice "d" is correct. A management representation letter is required for a review engagement. If no representation letter is provided, the review is incomplete anda no review report may be issued. Since there is no requirement for a representation letter in relation to a compilation engagement, the engagement may bechanged to a compilation engagement (with the client's consent).Choices "a", "b", and "c" are incorrect. Incomplete reviews do not result in any sort of modification to the review report; rather, no review report may be issued.

QUESTION 235Which of the following procedures is usually the first step in reviewing the financial statements of a nonissuer?

A. Make preliminary judgments about risk and materiality to determine the scope and nature of the procedures to be performed.B. Obtain a general understanding of the entity's organization, its operating characteristics, and its products or services.C. Assess the risk of material misstatement arising from fraudulent financial reporting and the misappropriation of assets.

D. Perform a preliminary assessment of the operating efficiency of the entity's internal control activities.



Choice "b" is correct. In reviewing the financial statements of a nonpublic entity, one of the first steps would be to obtain sufficient knowledge of the entity'sbusiness, including its organization, operating characteristics, and products or services. Choice "a" is incorrect. In an audit, preliminary judgments about risk andmateriality are used to determine the scope and nature of procedures to be performed. A review is substantially less in scope than an audit and consists principallyof inquiries and analytical procedures. Choice "c" is incorrect. In an audit, the risk of material misstatement arising from fraud must be assessed in order todetermine the scope and nature of procedures to be performed. A review is substantially less in scope than an audit and consists principally of inquiries andanalytical procedures. While inquiries would be made about fraud, a formal fraud risk assessment is not required.Choice "d" is incorrect. In a review of a nonissuer's financial statements, no assessment or testing of internal control is required.

QUESTION 236An accountant's standard report issued after compiling the financial statements of a nonissuer should state that:

A. I am not aware of any material modifications that should be made to the accompanying financial statements.B. A compilation consists principally of inquiries of company personnel and analytical procedures.C. A compilation is limited to presenting in the form of financial statements information that is the representation of management.D. A compilation is substantially less in scope than an audit in accordance with GAAS, the objective of which is the expression of an opinion.



Choice "c" is correct. An accountant's standard report issued after compiling the financial statements of a nonissuer should state that "a compilation is limited topresenting in the form of financial statements information that is the representation of management." Choice "a" is incorrect. A review report (and not a compilationreport) states that, "I am not aware of any material modifications that should be made to the accompanying financial statements."Choice "b" is incorrect. A review report (and not a compilation report) states that a review "consists principally of inquiries of company personnel and analyticalprocedures." Choice "d" is incorrect. A review report (and not a compilation report) states that a review "is substantially less in scope than an audit in accordancewith GAAS, the objective of which is the expression of an opinion."

QUESTION 237Which of the following would be used on a review engagement?

A. Examination of board minutes.B. Confirmation of cash and accounts receivable.C. Comparison of current-year to prior-year account balances.D. Recalculation of depreciation expense.



Choice "c" is correct. A review consists of inquiries and analytical procedures. Comparison of current year and prior year account balances is an analyticalprocedure that would often be performed as part of a review.Choice "a" is incorrect. Examining board minutes is an audit procedure that would not typically be performed in a review.Choice "b" is incorrect. Confirmations of cash and accounts receivable are audit procedures that would not typically be performed in a review.Choice "d" is incorrect. Recalculation of expenses is an audit procedure that would not typically be performed in a review.

QUESTION 238Which of the following statements is true regarding an accountant's consideration of fraud/illegal acts in compilation and review engagements?

A. The accountant is not required to perform procedures designed to detect material misstatements due to fraud or illegal acts.B. The accountant must inform an appropriate level of management of all instances of fraud or illegal acts.C. The accountant must report only definite instances of fraud or an illegal act, but need not report information indicating that fraud or an illegal act may have

occurred.D. Information indicating that fraud or an illegal act may have occurred should be reported in writing to an appropriate level of management.



Choice "a" is correct. The accountant is not required to specifically assess fraud risk or to perform procedures designed to detect material misstatements due tofraud or illegal acts. Choice "b" is incorrect. Inconsequential instance of fraud or illegal acts need not be reported to management.Choice "c" is incorrect. The accountant should report to an appropriate level of management any evidence or information that comes to his or her attentionindicating that fraud or an illegal act may have occurred.Choice "d" is incorrect. Information indicating that fraud or an illegal act may have occurred should be reported to an appropriate level of management, but it need

not be in writing. Oral communication to management should be documented.

QUESTION 239An accountant had begun to audit the financial statements of a nonissuer. Which of the following circumstances most likely would be considered a reasonable basisfor agreeing to the entity's request to change the engagement to a compilation?

A. The entity's management does not provide the accountant with a signed representation letter.B. The accountant is prohibited from corresponding with the entity's legal counsel.C. The entity's principal creditors no longer require the entity to furnish audited financial statements.D. The accountant is prevented from examining the minutes of the board of directors' meetings.



Choice "c" is correct. An audit may be changed to a compilation or review due to a change in client requirements. Since the creditors no longer require auditedfinancial statements, this is a valid reason for requesting a change.Choices "a", "b", and "d" are incorrect. Client-imposed scope limitations, such as refusing to provide a signed representation letter, prohibiting correspondence withlegal counsel, or refusing to allow examination of board minutes, are indicative of a lack of cooperation by management. Such limitations would not be a valid basisfor changing an engagement from an audit to a compilation.

QUESTION 240Which of the following statements is correct regarding a review engagement of a nonissuer's financial statements performed in accordance with the Statements onStandards for Accounting and Review Services (SSARS)?

A. An accountant must establish an understanding with the client in an engagement letter.B. An accountant must obtain an understanding of the client's internal control when performing a review.C. A review provides an accountant with a basis for expressing limited assurance on the financial statements.D. A review report contains an accountant's opinion of the financial statements taken as a whole.



Choice "c" is correct. A review report is issued when inquiry and analytical procedures provide a reasonable basis for the expression of limited assurance on thefinancial statements. Choice "a" is incorrect. While the accountant is required to establish an understanding with the client, preferably in writing, an engagementletter is not required. Choice "b" is incorrect. When performing a review under SSARS, the accountant is not required to obtain an understanding of the client'sinternal control. Choice "d" is incorrect. A review results in the expression of limited assurance that no material modifications are necessary for the financialstatements to be in conformity with generally accepted accounting principles. The limited nature of the work performed during a review does not provide sufficientevidence for an opinion on the financial statements taken as a whole.

QUESTION 241Which of the following procedures does a CPA normally perform first in a review engagement in accordance with Statements on Standards for Accounting andReview Services (SSARS)?

A. Inquiry regarding the client's principles and practices and the method of applying them.B. Inquiry concerning the effectiveness of the client's system of internal control.C. Inquiry to identify transactions between related parties and management.D. Inquiry of the client's professional advisors, including bankers, insurance agents, and consultants.



Choice "a" is correct. In performing a review engagement in accordance with SSARS, the accountant should inquire of management regarding the accountingprinciples and practices used, and the method of applying them.Choice "b" is incorrect. When performing a review under SSARS, the accountant is not required to make inquiries concerning the client's system of internal control.Choice "c" is incorrect. The accountant may inquire about the existence of related party transactions, but would likely make a more basic inquiry, about the client'saccounting principles and practices, first.Choice "d" is incorrect. In performing a review engagement in accordance with SSARS, the accountant generally directs his/her inquiries to members ofmanagement, not to external parties.

QUESTION 242Which of the following describes how the objective of a review of financial statements differs from the objective of a compilation engagement?

A. The primary objective of a review engagement is to test the completeness of the financial statements prepared, but a compilation tests for reasonableness.B. The primary objective of a review engagement is to provide positive assurance that the financial statements are fairly presented, but a compilation provides no

such assurance.C. In a review engagement, accountants provide limited assurance, but a compilation expresses no assurance.D. In a review engagement, accountants provide reasonable or positive assurance that the financial statements are fairly presented, but a compilation provides

limited assurance.



Choice "c" is correct. A review provides limited assurance that there are no material modifications that should be made to the financial statements in order for themto be in conformity with generally accepted accounting principles, whereas a compilation provides no assurance.Choice "a" is incorrect. A review does not test for completeness, nor does a compilation test for reasonableness. A review provides limited assurance about thefinancial statements based on inquiry and analytical review procedures, while a compilation provides no assurance and includes no testing for reasonableness.Choice "b" is incorrect. A review provides limited assurance that there are no material modifications that should be made to the financial statements in order forthem to be in conformity with generally accepted accounting principles, and it is based on inquiry and analytical review procedures. Positive assurance (such as anaudit opinion) is only provided when more extensive procedures have been performed.Choice "d" is incorrect. A review provides limited assurance that there are no material modifications that should be made to the financial statements in order forthem to be in conformity with generally accepted accounting principles, and it is based on inquiry and analytical review procedures. Positive or reasonableassurance (such as an audit opinion) is only provided when more extensive procedures have been performed. A compilation provides no assurance at all.

QUESTION 243The standard report issued by an accountant after reviewing the financial statements of a nonissuer should state that:

A. A review is limited to presenting in the form of financial statements information that is the representation of management.B. A review consists of inquiries of company personnel and analytical procedures applied to financial data.C. The accountant does not express an opinion or any other form of assurance on the financial statements.D. The accountant did not obtain an understanding of the entity's internal control or assess control risk.



Choice "b" is correct. The standard report issued by an accountant after reviewing the financial statements of a nonissuer states that a review consists of inquiriesof company personnel and analytical procedures applied to financial data.Choice "a" is incorrect. A compilation report uses language similar to this, stating that a compilation is limited to presenting, in the form of financial statements,information that is the representation of management.Choice "c" is incorrect. A compilation report uses language similar to this, stating that the accountant does not express an opinion or any other form of assurance onthe financial statements. A review provides negative assurance.Choice "d" is incorrect. While it is true that a review of the financial statements of a nonpublic entity does not require the accountant to obtain an understanding of

the entity's internal control or assess control risk, the report does not explicitly state this.

QUESTION 244While auditing the financial statements of a nonissuer, a CPA was requested to change the engagement to a review in accordance with Statements on Standardsfor Accounting and Review Services (SSARS) because of a scope limitation. If the CPA believes the client's request is reasonable, the CPA's review report should:

A. Refer to the scope limitation that caused the change.II. Describe the auditing procedures that have already been applied.




Choice "d" is correct. If the CPA believes the client's request is reasonable, he/she must comply with the standards for a review and issue an appropriate report.The report should not refer to the original engagement, to any auditing procedures performed, or to the scope limitation. Choices "a", "b", and "c" are incorrect,based on the above Explanation: .Reporting on Comparative Financial Statements

QUESTION 245When unaudited financial statements of a nonissuer are presented in comparative form with audited financial statements in the subsequent year, the unauditedfinancial statements should be clearly marked to indicate their status and:

A. The report on the unaudited financial statements should be reissued.II. The report on the audited financial statements should include a separate paragraph describing the responsibility assumed for the unaudited financialstatements.

B. I only.C. II only.D. Both I and II.E. Either I or II.


Explanation


Choice "d" is correct. When audited financial statements are presented in comparative form with unaudited financial statements from a prior year, the auditor shouldeither reissue his or her report on the unaudited statements or include a separate paragraph in the current year report describing the responsibility assumed for theunaudited statements. Choices "a", "b", and "c" are incorrect, per above Explanation: .

QUESTION 246When unaudited financial statements are presented in comparative form with audited financial statements in a document filed with the Securities and ExchangeCommission, such statements should be:




Choice "a" is correct. When unaudited financial statements (generally the first quarter of the following year in an annual report) are presented in comparative formwith audited financial statements in documents filed with the SEC, such statements should be clearly marked as "unaudited," but should not be referred to in theauditor's report. The statements need not be withheld until audited.Choices "b", "c", and "d" are incorrect, based on Explanation: above.

QUESTION 247Clark, CPA, compiled and properly reported on the financial statements of Green Co., a nonissuer, for the year ended March 31, 20X1. These financial statementsomitted substantially all disclosures required by generally accepted accounting principles (GAAP). Green asked Clark to compile the statements for the year endedMarch 31, 20X2, and to include all GAAP disclosures for the 20X2 statements only, but otherwise present both years' financial statements in comparative form.What is Clark's responsibility concerning the proposed engagement?

A. Clark may not report on the comparative financial statements because the 20X1 statements are not comparable to the 20X2 statements that include the GAAPdisclosures.

B. Clark may report on the comparative financial statements provided the 20X1 statements do not contain any obvious material misstatements.C. Clark may report on the comparative financial statements provided an explanatory paragraph is added to Clark's report on the comparative financial statements.D. Clark may report on the comparative financial statements provided Clark updates the report on the 20X1 statements that do not include the GAAP disclosures.



Choice "a" is correct. Compiled financial statements that omit substantially all the disclosures required by GAAP are not comparable to financial statements that doinclude required GAAP disclosures.Accordingly, the 20X1 statements are not comparable to the 20X2 statements and Clark cannot report on them.Choice "b" is incorrect. The lack of material misstatements does not alter the fact that the statements are not comparable and therefore Clark may not report onthem. Choice "c" is incorrect. Compiled financial statements that omit substantially all of the disclosures required by GAAP are not comparable to financialstatements that include such disclosures. Accordingly, Clark may not report on the comparative financial statements, even if an explanatory paragraph is added.Choice "d" is incorrect. Updating the auditor's report does not change the fact that the financial statements for the two periods are not comparable.Review of Interim Financial Information

QUESTION 248Silver, CPA, has been hired by Andrews Co., a publicly held company, to conduct a review of its interim financial information. While performing review procedures,Silver becomes aware of a significant change in the control activities at one of Andrew's branch locations. Which of the following might Silver consider performing inresponse to this situation?

A. Making additional inquiries, such as whether management has monitored the changes and considered whether they were operating as intended.B. Employing analytical procedures with a less precise expectation.C. Both "a" and "b" above.D. Neither "a" nor "b" above.

Correct Answer: A



Choice "a" is correct. An accountant's knowledge of an entity's business and its internal control influences the inquiries made and analytical procedures performed.A significant change in control activities would likely result in further inquiry of management. Choice "b" is incorrect. An accountant's knowledge of an entity'sbusiness and its internal control influences the inquiries made and analytical procedures performed. A significant change in control activities would likely result in theaccountant employing analytical procedures with a more precise expectation, since more precise expectations are more effective at detecting misstatements.Choices "c" and "d" are incorrect. Only choice "a" is correct, as explained above.

QUESTION 249Davidson, CPA, is performing a review under auditing standards of Gold's interim financial information.As part of planning, Davidson reads the audit documentation from the preceding year's annual audit. Which of the following is least likely to affect Davidson'sreview?

A. A summary of both corrected and uncorrected misstatements.B. Identified risks of material misstatement due to fraud.C. Significant weaknesses in internal control.D. Scope limitations that were overcome through acceptable alternative procedures.



Choice "d" is correct. Scope limitations relate to problems in performing the audit, and, especially since they were overcome, they would bear little relationship toprocedures performed in a review.Choice "a" is incorrect. The nature of corrected misstatements should be considered, as they may be indicative of an ongoing problem. Uncorrected misstatementsmust also be considered as misstatements in one period often affect subsequent periods. Choice "b" is incorrect. Identified risks of material misstatement due tofraud help the accountant to identify the types of material misstatements that may occur in the interim financial information, and to consider the likelihood of theiroccurrence. Choice "c" is incorrect. Consideration of significant weaknesses in internal control helps the accountant identify the types of material misstatements thatmay occur in the interim financial information, and to consider the likelihood of their occurrence.

QUESTION 250The annual financial statements of a publicly held company have been audited, and its interim financial statements have been reviewed. Which of the following istrue about the application of professional standards to this review?

A. PCAOB standards apply.B. Statements on Standards for Accounting and Review Services apply.C. Both PCAOB standards and SSARS apply.D. None of the above.


Explanation/Reference:Explanation:Choice "a" is correct. A review of the interim financial information of a publicly held company is conducted in accordance with PCAOB standards, and it is thesestandards which should be referenced in the auditor's review report. (Note, however, that the PCAOB has adopted, at least initially, generally accepted auditingstandards in this area.) Choices "b" and "c" are incorrect. Statements on Standards for Accounting and Review Services apply to reviews of the financial statementsof nonissuers. Choice "d" is incorrect. A review of the interim financial information of a publicly held company is conducted in accordance with PCAOB standards.

QUESTION 251Which of the following is not a required procedure in an engagement to review the interim financial information of a publicly held entity?

A. Obtaining corroborating evidence about the entity's ability to continue as a going concern.B. Comparing disaggregated revenue data for the current interim period with that of comparable prior periods.C. Obtaining evidence that the interim financial information reconciles with the accounting records.D. Inquiring of management about their knowledge of fraud or suspected fraud.



Choice "a" is correct. A review of interim financial information is not designed to provide information regarding an entity's ability to continue as a going concern.Even if such information comes to the accountant's attention, the accountant is not required to corroborate it. Choice "b" is incorrect. As part of a review, theaccountant is required to compare disaggregated revenue data for the current interim period with that of comparable prior periods. Choice "c" is incorrect. As part ofa review, the accountant is required to obtain evidence that the interim financial information reconciles with the accounting records. Choice "d" is incorrect. As partof a review, the accountant is required to inquire of management about their knowledge of fraud, suspected fraud, or allegations of fraud.

QUESTION 252In which case would the accountant be least likely to perform a review of interim financial information under PCAOB (auditing) standards?

A. Quarterly reports are required to be filed with the SEC.B. Selected quarterly financial data is included in an annual report.C. Quarterly financial data is included in the financial statements of a nonissuer.D. The accountant is performing an initial audit of financial statements that include selected quarterly data.



Choice "c" is correct. A review of data included in financial statements of a nonissuer is performed under Statements on Standards for Accounting and ReviewServices, not under PCAOB (auditing) standards. A review of interim financial information under PCAOB (auditing) standards is only conducted for publiccompanies (or companies anticipating going public). Choice "a" is incorrect. When an entity is required by the SEC to file a quarterly report, the SEC also requiresthat an independent accountant perform a review (of the interim financial information) in accordance with PCAOB (auditing) standards before the report is filed.Choice "b" is incorrect. When a company is required by the SEC to include selected quarterly financial data in its annual report or in other SEC filings, a review (ofthe interim financial information) in accordance with PCAOB (auditing) standards is required. Choice "d" is incorrect. An accountant performing an initial audit offinancial statements that include selected quarterly data should also perform a review (of the interim financial information) in accordance with PCAOB (auditing)standards as part of the overall audit.

QUESTION 253An independent accountant's report is based on a review of interim financial information. If this report is presented in a registration statement, a prospectus shouldinclude a statement clarifying that the:

A. Accountant's review report is not a part of the registration statement within the meaning of the Securities Act of 1933.B. Accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the report.C. Accountant's review was performed in accordance with standards established by the Securities and Exchange Commission.D. Accountant obtained corroborating evidence to determine whether material modifications are needed for such information to conform with GAAP.



Choice "a" is correct. If a report on a review of interim financial information is presented in a registration statement, the prospectus should include a statement thatthe report is not a "report" or "part" of the registration statement. The accountant should also read the other portions of the registration statement to ensure that hisor her name is not used in a way that indicates greater responsibility than s/he intends.

Choice "b" is incorrect. The auditor is responsible to update the report for events occurring after the date of the report but prior to filing.Choice "c" is incorrect. The accountant's review of interim financial information is performed in accordance with PCAOB standards, as approved (not established)by the SEC. Choice "d" is incorrect. Obtaining corroborating evidence is an audit procedure, not a review procedure.

QUESTION 254The objective of a review of interim financial information of a public entity is to provide an accountant with a basis for reporting whether:

A. A reasonable basis exists for expressing an updated opinion regarding the financial statements that were previously audited.B. Material modifications should be made to conform with generally accepted accounting principles.C. The financial statements are presented fairly in accordance with standards of interim reporting.D. The financial statements are presented fairly in accordance with generally accepted accounting principles.



Choice "b" is correct. The objective of a review is to provide the accountant with a reasonable basis for expressing limited assurance that there are no materialmodifications that should be made to the accompanying financial statements for them to be in conformity with generally accepted accounting principles.Choice "a" is incorrect. When performing a review, the accountant does not gather enough evidence to update an audit opinion.Choice "c" is incorrect. There are no "standards of interim reporting." Choice "d" is incorrect. Expressing an opinion as to whether the financial statements arepresented fairly in accordance with GAAP is the result of an audit, not a review.

QUESTION 255The quarterly data required by SEC Regulation S-K have been omitted. Which of the following statements must be included in the auditor's report?

A. The auditor was unable to review the data.B. The company's internal control provides an adequate basis to complete the review.C. The company has not presented the selected quarterly financial data.D. The auditor will review the selected data during the review of the subsequent quarterly financial data.


Explanation/Reference:Explanation:Choice "c" is correct. If the quarterly data required by SEC Regulation S-K have been omitted, the auditor's report must include a statement indicating that the

company has not presented such data.Choice "a" is incorrect. The auditor's report should only state that the auditor was unable to review quarterly data required by SEC Regulation S-K when the datahave been included, but the auditor has not reviewed such data.Choice "b" is incorrect. Generally, the auditor's report does not make reference to a review of interim financial information, since such information is not a requiredpart of GAAP financial statements. (Note, however, that the auditor's report might be modified to indicate that the company's internal control was not sufficient toprovide an adequate basis for a review of such information, in situations where quarterly data is included but not reviewed). Choice "d" is incorrect. If an entity isrequired to file quarterly reports, a review of this quarterly data is also required. Such review should be completed before the quarterly report is filed, not postponedto a subsequent quarter.

Letters for Underwriters

QUESTION 256Which of the following matters is covered in a typical comfort letter?

A. Negative assurance concerning whether the entity's internal controls operated as designed during the period being audited.B. An opinion regarding whether the entity complied with laws and regulations under Government Auditing Standards and the Single Audit Act of 1984.C. Positive assurance concerning whether unaudited condensed financial information complied with generally accepted accounting principles.D. An opinion as to whether the audited financial statements comply in form with the accounting requirements of the SEC.



Choice "d" is correct. In a typical comfort letter, the accountants express an opinion (i.e., positive assurance) concerning the financial statements' compliance (as toform) with the pertinent accounting requirements of the SEC.Choice "a" is incorrect. No assurance is generally provided in a comfort letter regarding the operation of an entity's internal control.Choice "b" is incorrect. A typical comfort letter is addressed to the underwriters of the securities. Government Auditing Standards and the Single Audit Act are notapplicable to a comfort letter related to the issuance of securities.Choice "c" is incorrect. Negative assurance (not positive) is typically provided regarding unaudited condensed financial information.

QUESTION 257Comfort letters ordinarily are signed by the client's:

A. Independent auditor.B. Underwriter of securities.C. Audit committee.D. Senior management.



Choice "a" is correct. A comfort letter is a letter containing a negative assurance from the CPA to the underwriter or certain other requesting parties just before theregistration of the client's securities.Choice "b" is incorrect. The comfort letter is sent to the underwriter. Choice "c" is incorrect. The audit committee does not sign a comfort letter. Choice "d" isincorrect. Senior management may sign a client representation letter, not a comfort letter.

QUESTION 258When an accountant issues to an underwriter a comfort letter containing comments on data that have not been audited, the underwriter most likely will receive:

A. Negative assurance on capsule information.B. Positive assurance on supplementary disclosures.C. A limited opinion on "pro forma" financial statements.D. A disclaimer on prospective financial statements.



Choice "a" is correct. When an accountant issues to an underwriter a comfort letter containing comments on data that have not been audited, the underwriter mostlikely will receive negative assurance on capsule information.Choice "b" is incorrect. Positive assurance cannot be given if the information was not audited. Choices "c" and "d" are incorrect. A comfort letter generally coversthe period from the date of the last auditor's report to the effective date of the registration. It does not cover "pro forma" or prospective financial statements.

QUESTION 259Comfort letters ordinarily are:




Choice "d" is correct. A comfort letter is a letter from the independent auditor to the named underwriter just before the registration of the client's securities. Choices"a", "b", and "c" are incorrect, based on the above Explanation: .Attest Engagements

QUESTION 260A CPA in public practice is required to comply with the provisions of the Statements on Standards for Attestation Engagements (SSAE) when:





Choice "c" is correct. Statements on Standards for Attestation Engagements provide guidance with respect to compilation of a financial projection, but they do notaddress services involving advocating for a client, such as testifying as an expert witness. Choices "a", "b", and "d" are incorrect, per above Explanation: .

QUESTION 261In an attest engagement, use of the accountant's report should be restricted to specified parties in all of the following situations, except:

A. When the criteria used to evaluate the subject matter are appropriate for only a limited number of parties.B. When reporting on an assertion about the subject matter instead of reporting directly on the subject matter.C. When reporting directly on the subject matter and a written assertion has not been provided.D. When reporting on an agreed-upon procedures engagement.



Choice "b" is correct. There is no requirement that the accountant's report be restricted to specified parties when reporting on an assertion about the subject matterinstead of reporting directly on the subject matter.Choice "a" is incorrect, since use of the accountant's report should be restricted to specified parties when the criteria used to evaluate the subject matter areappropriate for only a limited number of parties.Choice "c" is incorrect, since use of the accountant's report should be restricted to specified parties when reporting directly on the subject matter and a writtenassertion has not been provided.Choice "d" is incorrect, since use of the accountant's report should be restricted to specified parties when reporting on an agreed-upon procedures engagement.

QUESTION 262Which of the following is a term for an attest engagement in which a CPA assesses a client's commercial Internet site for predefined criteria that are designed tomeasure transaction integrity, information protection, and disclosure of business practices?

A. ElectroNet.B. EDIFACT.C. TechSafe.D. WebTrust.



Choice "d" is correct. A WebTrust engagement is an attestation engagement designed to measure transaction integrity, information protection, and disclosure ofbusiness practices. When an unqualified report is issued, the client may add the CPA WebTrust Seal to its Web site, indicating that its site is a reasonably safe andprivate place for e-commerce. Choice "a" is incorrect. ElectroNet is an Internet service provider. Choice "b" is incorrect. EDIFACT refers to standards developed bythe United Nations for Electronic Data Interchange for Administration, Commerce, and Transport. These standards facilitate information flow among tradingpartners in many industries. The scope and format of these standards is similar, but not identical, to those developed in the United States.Choice "c" is incorrect. TechSafe is a distracter.

QUESTION 263An entity engaged a CPA to determine whether the client's web sites meet defined criteria for standard business practices and controls over transaction integrityand information protection. In performing this engagement, the CPA should comply with the provisions of:

A. Statements on Assurance Standards.B. Statements on Standards for Attestation Engagements.C. Statements on Standards for Management Consulting Services.D. Statements on Auditing Standards.



Choice "b" is correct. A WebTrust engagement is an attestation engagement in which the CPA determines whether the client's web site meets defined criteriarelating to transaction integrity, information protection, and disclosure of business practices. Attestation engagements should be performed in accordance withStatements on Standards for Attestation Engagements (SSAEs). Choice "a" is incorrect. Statements on Assurance Standards is a distracter. Choice "c" is incorrect.Consulting services provided by CPAs range from advice on accounting- related matters to a wide range of services involving diverse technical disciplines.Consulting services performed by CPAs should be performed in accordance with Statements on Standards for Consulting Services (SSCSs).

Choice "d" is incorrect. Audits (generally of financial statements) performed by CPAs should be performed in accordance with Statements on Auditing Standards(SASs).

QUESTION 264A CPA's report on agreed-upon procedures related to management's assertion about an entity's compliance with specified requirements should contain:

A. A statement of limitations on the use of the report.B. An opinion about whether management's assertion is fairly stated.C. Negative assurance that control risk has not been assessed.D. An acknowledgment of responsibility for the sufficiency of the procedures.



Choice "a" is correct. The practitioner's report on agreed-upon procedures related to management's assertion about the entity's compliance with specifiedrequirements is intended solely for the use of specified parties. Thus, the report should include a statement of limitations on the use of the report.Choice "b" is incorrect. The report is in the form of procedures and findings. Since the work performed is less in scope than an examination, the accountantdisclaims any opinion. Choice "c" is incorrect. The auditor does not provide any negative assurance relative to assessment of control risk or to compliance with thespecified requirements. Choice "d" is incorrect. The report contains a statement that the sufficiency of the procedures is solely the responsibility of the partiesspecifying the procedures and a disclaimer of responsibility on the part of the accountant.

QUESTION 265An examination of a financial forecast is a professional service that involves:

A. Compiling or assembling a financial forecast that is based on management's assumptions.B. Limiting the distribution of the accountant's report to management and the board of directors.C. Assuming responsibility to update management on key events for one year after the report's date.D. Evaluating the preparation of a financial forecast and the support underlying management's assumptions.



Choice "d" is correct. An examination of a financial forecast is a professional service that involves:

1) evaluating the preparation of the prospective financial statements,2) evaluating the support underlying the assumptions,3) evaluating the presentation of the prospective financial statements in conformity with AICPA guidelines, and4) issuing an examination report.Choice "a" is incorrect. Compiling or assembling a financial forecast based on management's assumptions is part of a compilation engagement, not an examinationengagement. Choice "b" is incorrect. A financial forecast may be issued for general use. Choice "c" is incorrect. The accountant's standard report specifically statesthat the accountant assumes no responsibility to update the report for events and circumstances occurring after the date of the report.

QUESTION 266An accountant may accept an engagement to apply agreed-upon procedures to prospective financial statements provided that:

A. Use of the report is restricted to the specified parties.B. The prospective financial statements are also examined.C. Responsibility for the adequacy of the procedures performed is taken by the accountant.D. Negative assurance is expressed on the prospective financial statements taken as a whole.



Choice "a" is correct. An accountant may accept an engagement to apply agreed-upon procedures to prospective financial statements provided that certainconditions are met, including that the use of the report be restricted to the specified parties. Choice "b" is incorrect. There is no requirement that the prospectivefinancial statements be examined.In fact, the practitioner's report on the application of agreed-upon procedures states that the auditor did not perform an examination.Choice "c" is incorrect. The specified parties must understand that they take responsibility for the sufficiency of the attest procedures.Choice "d" is incorrect. No assurance is expressed in an agreed-upon procedures engagement.

QUESTION 267An accountant's compilation report on a financial forecast should include a statement that:

A. The forecast should be read only in conjunction with the audited historical financial statements.B. The accountant expresses only limited assurance on the forecasted statements and their assumptions.C. There will usually be differences between the forecasted and actual results.D. The hypothetical assumptions used in the forecast are reasonable in the circumstances.



Choice "c" is correct. The accountant's compilation report on a client's financial forecast should include a caveat that the prospective results may not be achieved.Choice "a" is incorrect. The historical financial statements upon which the forecast is based need not be audited, nor must they accompany the forecastcompilation. Choice "b" is incorrect. The accountant expresses no assurance in the compilation report on forecasted statements.Choice "d" is incorrect. A compilation of a financial forecast would not include evaluation of the support for the assumptions underlying the forecast.

QUESTION 268Which of the following is a conceptual difference between the attestation standards and generally accepted auditing standards?

A. The attestation standards provide a framework for the attest function beyond historical financial statements.B. The requirement that the practitioner be independent in mental attitude is omitted from the attestation standards.C. The attestation standards do not permit an attest engagement to be part of a business acquisition study or a feasibility study.D. None of the standards of fieldwork in generally accepted auditing standards are included in the attestation standards.



Choice "a" is correct. Attestation standards provide a framework for the attest function beyond historical financial statements.Choice "b" is incorrect. The independence standard is almost the same for both attest engagements and audits.Choice "c" is incorrect. An attest engagement may be part of a larger engagement (such as a business acquisition study or a feasibility study).Choice "d" is incorrect. Attestation standards include two of the three GAAS fieldwork standards: planning/supervision and evidence. They do not include theinternal control standard.

QUESTION 269An accountant's report on a review of pro forma financial information should include a:

A. Statement that the entity's internal control was not relied on in the review.B. Disclaimer of opinion on the financial statements from which the pro forma financial information is derived.C. Caveat that it is uncertain whether the transaction or event reflected in the pro forma financial information will ever occur.D. Reference to the financial statements from which the historical financial information is derived.



Choice "d" is correct. The accountant's report on a review of pro forma financial information should include a reference to the financial statements from which thehistorical information is derived and a statement as to whether such financial statements were audited or reviewed. Choice "a" is incorrect. No statement on theentity's internal control is necessary. Choice "b" is incorrect. If the auditor has audited the financial statements from which the pro forma financial information isderived, an opinion on those statements may be expressed. Choice "c" is incorrect. The report on a review of pro forma financial information would include anExplanation: of the objective and limitations of the information, but would not discuss the uncertainty surrounding occurrence of the transaction or event.

QUESTION 270In performing an attest engagement, a CPA typically:

A. Supplies litigation support services.B. Assesses control risk at a low level.C. Issues a report on subject matter (or on an assertion about subject matter) that is the responsibility of another party.D. Provides management consulting advice.



Choice "c" is correct. In performing an attest engagement, a CPA typically issues a report on subject matter (or on an assertion about subject matter) that is theresponsibility of another party. Choice "a" is incorrect. Supplying litigation support services is not an attest engagement because the CPA is not reporting on subjectmatter (or an assertion about subject matter) that is the responsibility of another party.Choice "b" is incorrect. An attest engagement may include a report on internal control; however, the assessed level of control risk may or may not be at a low level.Choice "d" is incorrect. Management consulting advice is not considered to be an attest engagement because the CPA is not reporting on subject matter (or on anassertion about subject matter) that is the responsibility of another party.

QUESTION 271An accountant's standard report on a compilation of a projection should not include a:

A. Statement that a compilation of a projection is limited in scope.

B. Disclaimer of responsibility to update the report for events occurring after the report's date.C. Statement that the accountant expresses only limited assurance that the results may be achieved.D. Separate paragraph that describes the limitations on the presentation's usefulness.



Choice "c" is correct. A compilation of prospective financial statements is not intended to provide assurance on the prospective financial statements or theassumptions underlying such statements.Choice "a" is incorrect. The report on a compilation should include a statement that a compilation is limited in scope.Choice "b" is incorrect. The report on a compilation should include a statement that the accountant assumes no responsibility to update the report for eventssubsequent to the report date.Choice "d" is incorrect. The report on a compilation should include a separate paragraph that describes the limitations on the presentation's usefulness.

QUESTION 272Which of the following is not an attestation standard?

A. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report.B. The report shall identify the assertion being reported on and state the character of the engagement.C. The work shall be adequately planned and assistants, if any, shall be properly supervised.D. A sufficient understanding of internal control shall be obtained to plan the engagement.



Choice "d" is correct. A sufficient understanding of internal control is not required to be obtained in an attestation engagement.Choice "a" is incorrect. In an attestation engagement, sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in thereport. Choice "b" is incorrect. An attestation report should identify the assertion being reported on and state the character of the engagement.Choice "c" is incorrect. In an attestation engagement, the work should be adequately planned and assistants, if any, should be properly supervised.

QUESTION 273An accountant's compilation report on a financial forecast should include a statement that the:

A. Compilation does not include evaluation of the support of the assumptions underlying the forecast.B. Hypothetical assumptions used in the forecast are reasonable.C. Range of assumptions selected is one in which one end of the range is less likely to occur than the other.D. Prospective statements are limited to presenting, in the form of a forecast, information that is the accountant's representation.



Choice "a" is correct. An accountant's compilation report on a financial forecast should include a statement that the compilation does not include evaluation of thesupport of the assumptions underlying the forecast. (An examination of the financial forecast would include evaluation of the support).Choice "b" is incorrect. An accountant does not give any form of assurance related to hypothetical assumptions, which are not used in financial forecasts anyway.(Hypothetical assumptions are used in financial projections).Choice "c" is incorrect. No mention of the range of assumptions selected is made in the compilation report.Choice "d" is incorrect. A compilation is limited to presenting, in the form of a forecast, information that is management's representation.

QUESTION 274An attest engagement is one in which a CPA is engaged to:

A. Issue an examination, a review, or an agreed-upon procedures report on subject matter, or on an assertion about the subject matter, that is the responsibility ofanother party.

B. Provide tax advice or prepare a tax return based on financial information the CPA has not audited or reviewed.C. Testify as an expert witness in accounting, auditing, or tax matters, given certain stipulated facts.D. Assemble the financial statements of a nonissuer based on the assumptions of the entity's management without expressing any assurance.



Choice "a" is correct. An attest engagement is one in which a CPA is engaged to issue an examination, a review, or an agreed-upon procedures report on subjectmatter, or on an assertion about subject matter, that is the responsibility of another party. Choice "b" is incorrect. Providing tax advice or preparing a tax returnbased upon financial information the CPA has not audited or reviewed does not require the CPA to "attest" to anything.Choice "c" is incorrect. Testifying as an expert witness in accounting, auditing, or tax matters given certain stipulated facts is not considered to be an attestation

engagement. Choice "d" is incorrect. Assembling the financial statements of a nonissuer based on the assumptions of the entity's management without expressingany assurance is a compilation engagement that falls under SSARS and no attestation is provided.

QUESTION 275Which of the following professional services would be considered an attest engagement?

A. A management consulting engagement to provide EDP advice to a client.B. An engagement to report on management's discussion and analysis (MD&A).C. An income tax engagement to prepare federal and state tax returns.D. The compilation of financial statements from a client's accounting records.



Choice "b" is correct. An engagement to report on management's discussion and analysis (MD&A) would be considered an attest engagement, because theaccountant is issuing an examination, review, or agreed-upon procedures report on another party's assertion. Choice "a" is incorrect. A management consultingengagement to provide EDP advice to a client is not considered to be an attest engagement, because the accountant is not issuing an examination, review, oragreed-upon procedures report on another party's assertion. Choice "c" is incorrect. An income tax engagement to prepare federal and state tax returns is notconsidered to be an attest engagement.Choice "d" is incorrect. The compilation of financial statements from a client's accounting records (a compilation engagement) is not considered to be an attestengagement. (Note that although a compilation of prospective financial statements is covered under Statements on Standards for Attestation Engagements, thequestion does not indicate that prospective financial statements are involved).

QUESTION 276Which of the following statements concerning prospective financial statements is correct?

A. Only a financial forecast would normally be appropriate for limited use.B. Only a financial projection would normally be appropriate for general use.C. Any type of prospective financial statements would normally be appropriate for limited use.D. Any type of prospective financial statements would normally be appropriate for general use.



Explanation:

Choice "c" is correct. Any type of prospective financial statements (financial forecasts and financial projections) would normally be appropriate for limited use.Choice "a" is incorrect. Both financial forecasts and financial projections are appropriate for limited use.Choice "b" is incorrect. Financial projections are appropriate for limited use only - not for general use.Choice "d" is incorrect. Normally financial projections are not appropriate for general use, but financial forecasts are.

QUESTION 277Negative assurance may be expressed when an accountant is requested to report on the:

A. Compilation of prospective financial statements.B. Compliance with the provisions of the Foreign Corrupt Practices Act.C. Results of performing a review of management's assertion.D. Audit of historical financial statements.



Choice "c" is correct. Negative assurance may be expressed when an accountant is requested to report on the results of performing a review of management'sassertion. Choice "a" is incorrect. No assurance is provided in a compilation of prospective financial statements.Choice "b" is incorrect. Whether an entity is in compliance with the provisions of the Foreign Corrupt Practices Act is a legal determination. An accountant mayperform an examination or an agreed-upon procedures engagement with respect to such compliance but may not perform a review, and therefore would notexpress negative assurance. Choice "d" is incorrect. When reporting on an audit of historical financial statements, negative assurance is not an appropriatereporting option. The auditor must either express an opinion (positive assurance) or disclaim an opinion (no assurance).

QUESTION 278When an accountant examines a financial forecast that fails to disclose several significant assumptions used to prepare the forecast, the accountant shoulddescribe the assumptions in the accountant's report and issue a (an):

A. "Except for" qualified opinion.B. "Subject to" qualified opinion.C. Unqualified opinion with a separate explanatory paragraph.D. Adverse opinion.


Explanation


Choice "d" is correct. When an accountant examines a financial forecast that fails to disclose significant assumptions used to prepare the forecast, the accountantshould issue an adverse opinion.Choice "a" is incorrect. A qualified opinion might be appropriate when AICPA presentation guidelines are not followed, but would not be used when "severalsignificant assumptions used to prepare the forecast" are not disclosed.Choice "b" is incorrect. "Subject to" is not acceptable wording for an accountant's report. Choice "c" is incorrect. An unqualified opinion is not acceptable whensignificant assumptions are not disclosed.

QUESTION 279Prospective financial information presented in the format of historical financial statements that omit either gross profit or net income is deemed to be a:

A. Partial presentation.B. Projected balance sheet.C. Financial forecast.D. Financial projection.



Choice "a" is correct. "Partial presentations" are presentations of prospective financial information which would not ordinarily be appropriate for general use becausethey omit one or more of these essential elements: (a) sales or gross revenue, (b) gross profit or cost of sales, (c) unusual or infrequently occurring items, (d)provision for income taxes, (e) discontinued operations or extraordinary items, (f) income from continuing operations, (g) net income, (h) earnings per share, and (i)significant changes in financial position. Choices "b", "c", and "d" are incorrect. Projected balance sheets, financial forecasts and financial projections are forms ofprospective financial statements.

QUESTION 280Which of the following activities would most likely be considered an attestation engagement?

A. Consulting with management representatives of a firm to provide advice.B. Issuing a report about a firm's compliance with laws and regulations.C. Advocating a client's position on tax matters that are being reviewed by the IRS.D. Preparing a client's tax returns.



Choice "b" is correct. Attest engagements may result in reports related to compliance with laws and regulations.Choices "a", "c", and "d" are incorrect. Attestation engagements specifically exclude consulting services, advocacy services, and return preparation.

QUESTION 281Which of the following professional services would be considered an attestation engagement?

A. Advocating on behalf of a client about trust tax matters under review by the Internal Revenue Service.B. Providing financial analysis, planning, and capital acquisition services as a part-time, in-house controller.C. Advising management in the selection of a computer system to meet business needs.D. Preparing the income statement and balance sheet for one year in the future based on client expectations and predictions.



Choice "d" is correct. Preparing future financial statements constitutes a compilation of prospective financial statements, which is considered to be an attestationservice. Choices "a" and "c" are incorrect. Attestation engagements specifically exclude advocacy services and consulting services.Choice "b" is incorrect. Attest engagements include those in which a practitioner is engaged to issue or does issue an examination, a review, or an agreed-uponprocedures report on subject matter, or on an assertion about the subject matter, that is the responsibility of another party, as well as engagements related toprospective financial statements. Performing the role of in-house controller part-time does not fit into any of these categories.

QUESTION 282When an accountant compiles a financial forecast, the accountant's report should include a(an):

A. Explanation: of the differences between a financial forecast and a financial projection.B. Caveat that the prospective results of the financial forecast may not be achieved.C. Statement that the accountant's responsibility to update the report is limited to one year.D. Disclaimer of opinion on the reliability of the entity's internal controls.



Choice "b" is correct. Whenever an accountant reports on prospective financial statements, the report should include a caveat that prospective results may not beachieved. Choice "a" is incorrect. A compilation report on a financial forecast does not include an Explanation: of the differences between a forecast and aprojection. Choice "c" is incorrect. Whenever an accountant reports on prospective financial statements, the report should include a statement that the accountantassumes no responsibility to update the report for events and circumstances occurring after the date of the report. Choice "d" is incorrect. A compilation report on afinancial forecast does not include a disclaimer of opinion on the reliability of the entity's internal controls.

QUESTION 283Which of the following is a professional engagement that a CPA may perform to provide assurance on a system's reliability?

A. MAS AssurAbility.B. CPA WebMaster.C. MAS AttestSure.D. CPA SysTrust.



Choice "d" is correct. A SysTrust engagement is an attest engagement that provides assurance on the reliability of any defined electronic system.Choice "a" is incorrect. There is no professional engagement by this name. Choice "b" is incorrect. There is no professional engagement by this name. Choice "c" isincorrect. There is no professional engagement by this name.

QUESTION 284An accountant's standard report on a compilation of a projection should not include a statement that:

A. There will usually be differences between the forecasted and actual results.B. The hypothetical assumptions used in the projection are reasonable in the circumstances.C. The accountant has no responsibility to update the report for future events and circumstances.D. The compilation of a projection is limited in scope.



Choice "b" is correct. An accountant's standard report on a compilation of a projection does not include a statement that the hypothetical assumptions used in theprojection are reasonable in the circumstances.Choice "a" is incorrect. An accountant's standard report on a compilation of a projection does state that there will usually be differences between the forecasted andactual results. Choice "c" is incorrect. An accountant's standard report on a compilation of a projection does state that the accountant has no responsibility to updatethe report for future events and circumstances.Choice "d" is incorrect. An accountant's standard report on a compilation of a projection does state that the compilation of a projection is limited in scope ("Acompilation is limited to presenting in the form of a projection information that is the representation of management and does not include evaluation of the supportfor the assumptions underlying the projection.")

QUESTION 285A practitioner's report on agreed-upon procedures that is in the form of procedures and findings should contain:

A. Negative assurance that the procedures did not necessarily disclose all significant deficiencies in internal control.B. An acknowledgment of the practitioner's responsibility for the sufficiency of the procedures.C. A statement of restrictions on the use of the report.D. A disclaimer of opinion on the entity's financial statements.



Choice "c" is correct. A practitioner's report on agreed-upon procedures that is in the form of procedures and findings should contain a statement of restrictions onthe use of the report. Choice "a" is incorrect. Agreed-upon procedures engagements do not provide assurance of any sort.Choice "b" is incorrect. The responsible party (not the practitioner) is responsible for the sufficiency of the procedures.Choice "d" is incorrect. The subject matter of an agreed-upon procedures engagement varies, and may be unrelated to the financial statements.

QUESTION 286When an accountant compiles projected financial statements, the accountant's report should include a separate paragraph that:

A. Explains the difference between a compilation and a review.

B. Documents the assessment of the risk of material misstatement due to fraud.C. Expresses limited assurance that the actual results may be within the projected range.D. Describes the limitations on the projection's usefulness.



Choice "d" is correct. The accountant's report on compiled projected financial statements should include a separate paragraph that describes the limitations on theprojection's usefulness. For example, the paragraph states that there will usually be differences between projected and actual results, and indicates that theaccountant has no responsibility to update the report for events occurring after the date of the report.Choice "a" is incorrect. The accountant's report on compiled projected financial statements does not include an Explanation: of the difference between a compilationand a review. Choice "b" is incorrect. The accountant's report on compiled projected financial statements does not document the assessment of the risk of materialmisstatement due to fraud. Choice "c" is incorrect. The accountant's report on compiled projected financial statements does not express limited assurance that theactual results may be within the projected range. In fact, it specifically states that no opinion or any other form of assurance is expressed, and that there usually willbe differences between projected and actual results.

QUESTION 287A CPA is engaged to examine management's assertion that the entity's schedule of investment returns is presented in accordance with specific criteria. Inperforming this engagement, the CPA should comply with the provisions of:

A. Statements on Standards for Accounting and Review Services (SSARS).B. Statements on Auditing Standards (SAS).C. Statements on Standards for Consulting Services (SSCS).D. Statements on Standards for Attestation Engagements (SSAE).



Choice "d" is correct. Statements on Standards for Attestation Engagements apply to engagements in which a practitioner is engaged to issue or does issue anexamination, a review, or an agreed-upon procedures report on subject matter, or on an assertion about the subject matter, which is the responsibility of anotherparty. An engagement to examine management's assertion that the entity's schedule of investment returns is presented in accordance with specific criteria wouldfall within this scope.

Choice "a" is incorrect. Statements on Standards for Accounting and Review Services apply to engagements involving the unaudited financial statements of anonissuer. An engagement to examine management's assertion that the entity's schedule of investment returns is presented in accordance with specific criteriadoes not fall within this scope. Choice "b" is incorrect. Statements on Auditing Standards apply to audits of financial statements. An engagement to examinemanagement's assertion that the entity's schedule of investment returns is presented in accordance with specific criteria does not fall within this scope. Choice "c" isincorrect. Statements on Standards for Consulting Services apply to a broad range of consulting services. An engagement to examine management's assertion thatthe entity's schedule of investment returns is presented in accordance with specific criteria is not a consulting service.

QUESTION 288An accountant may accept an engagement to apply agreed-upon procedures to prospective financial statements provided the:

A. Provisions of Statements on Standards for Accounting and Review Services (SSARS) are followed.B. Accountant also examines the prospective financial statements.C. Distribution (use) of the report is restricted to the specified users.D. The accountant takes responsibility for the adequacy of the procedures performed.



Choice "c" is correct. In an agreed-upon procedures engagement, use of the report is restricted to the specified users.Choice "a" is incorrect. Statements on Standards for Accounting and Review Services apply to the unaudited financial statements of a nonissuer, not toengagements to apply agreed-upon procedures to prospective financial statements.Choice "b" is incorrect. There is no requirement that the accountant also examine prospective financial statements in an agreed-upon procedures engagement.Choice "d" is incorrect. In an agreed-upon procedures engagement, the specified parties (and not the accountant) take responsibility for the sufficiency of theprocedures for their purposes.


QUESTION 289Accepting an engagement to compile a financial projection for a publicly held company most likely would be inappropriate if the projection were to be distributed to:

A. A bank with which the entity is negotiating for a loan.B. A labor union with which the entity is negotiating a contract.C. The principal stockholder, to the exclusion of the other stockholders.D. All stockholders of record as of the report date.

Correct Answer: D



Choice "d" is correct. Accepting an engagement to compile a financial projection for a publicly held company most likely would be inappropriate if the projectionwere to be distributed to all stockholders of record as of the report date (general use). Only a financial forecast is suitable for general use.Choices "a", "b", and "c" are incorrect. Financial projections are for limited use, and may be used by the responsible party alone (choice "c" - the principalstockholder only), or by the responsible party and third parties with whom the responsible party is negotiating directly (choices "a" and "b"- a bank or a labor unionwith which the entity is negotiating).

QUESTION 290When an accountant compiles projected financial statements, the accountant's report should include a separate paragraph that:

A. Describes the differences between a projection and a forecast.B. Identifies the accounting principles used by management.C. Expresses limited assurance that the actual results may be within the projection's range.D. Describes the limitations on the projection's usefulness.



Choice "d" is correct. The report on compiled projected financial statements should include a separate paragraph that describes the limitations on the usefulness ofthe presented statements. Choice "a" is incorrect. The accountant's report on a compilation of a forecast or a projection does not describe the differences betweenthem.Choice "b" is incorrect. The report would not identify the accounting principles used by management.Choice "c" is incorrect. A report on compiled projected financial statements does not express any assurance regarding the achievability of results.

QUESTION 291A CPA firm should establish procedures for conducting and supervising work at all organizational levels to provide reasonable assurance that the work performedmeets the firm's standards of quality. To achieve this goal, the firm most likely would establish procedures for:

A. Evaluating prospective and continuing client relationships.B. Reviewing audit documentation and engagement reports.C. Requiring personnel to adhere to the applicable independence rules.

D. Maintaining personnel files containing documentation related to the evaluation of personnel.



Choice "b" is correct. Procedures for reviewing audit documentation and engagement reports are established to ensure that the work performed meets the firm'squality standards. This relates to the quality control element of engagement performance. Choice "a" is incorrect. Evaluations of prospective and continuing clientrelationships are performed to minimize the likelihood of association with a client whose management lacks integrity. This relates to the quality control element ofacceptance and continuance of clients and engagements. Such evaluations do not ensure that the work performed meets the firm's quality control standardsChoice "c" is incorrect. Requiring personnel to adhere to the applicable independence rules relates to the quality control element of independence, integrity, andobjectivity. Such requirements are established to provide independence, but they do not ensure that the work performed meets the firm's quality control standards.Choice "d" is incorrect. Maintaining personnel files and periodic evaluations of personnel are part of the quality control element of personnel management. Suchpolicies are established to provide for appropriate hiring, assignment, development, and advancement of employees, but they would not ensure that the workperformed meets the firm's quality control standards.

QUESTION 292Which of the following are elements of a CPA firm's quality control that should be considered in establishing its quality control policies and procedures?




Choice "b" is correct. Quality control elements are:

(1) Independence, integrity, and objectivity,(2) Personnel management,(3) Acceptance and continuance of clients and engagements, (4) Engagement performance, and(5) Monitoring.Choices "a", "c", and "d" are incorrect based on the above Explanation: .

QUESTION 293A CPA firm would be reasonably assured of meeting its responsibility to provide services that conform with professional standards by:

A. Adhering to generally accepted auditing standards.B. Having an appropriate system of quality control.C. Joining professional societies that enforce ethical conduct.D. Maintaining an attitude of independence in its engagements.



Choice "b" is correct. Quality control standards relate to the conduct of a firm's audit practice. They set forth standards for the establishment of policies andprocedures to provide reasonable assurance of conforming with professional standards. Choice "a" is incorrect. GAAS relate to the conduct of individual auditengagements. Choice "c" is incorrect. Joining professional societies that enforce ethical conduct (e.g., the AICPA or state CPA society) will not assure the firm ofmeeting its responsibility to conform with GAAS. A system of policies and procedures (i.e., a system of quality control) must be established to provide thisassurance.Choice "d" is incorrect. Independence is part of the quality control element of independence, integrity, and objectivity, but maintaining independence alone will nothelp the firm meet its responsibility to conform with professional standards.

QUESTION 294One of a CPA firm's basic objectives is to provide professional services that conform with professional standards. Reasonable assurance of achieving this basicobjective is provided through:

A. A system of quality control.

B. A system of peer review.C. Continuing professional education.D. Compliance with generally accepted reporting standards.



Choice "a" is correct. A system of quality control establishes policies and procedures that provide reasonable assurance of conforming with professional standards.Choice "b" is incorrect. Peer review is a process whereby one CPA firm reviews another. It can be part of the monitoring element of quality control, but it does not(in and of itself) provide reasonable assurance that a CPA firm will comply with professional standards. Choice "c" is incorrect. The objective of continuingprofessional education (CPE) is to increase the competency of auditors. Professional development activities such as this are part of the personnel managementelement of quality control, but they do not (in and of themselves) provide reasonable assurance that a CPA firm will comply with professional standards. Choice "d"is incorrect. Compliance with the standards of reporting (part of the ten generally accepted auditing standards) helps ensure that audit results are appropriatelycommunicated to the users of financial statements, but such compliance does not provide assurance regarding conformity with professional standards.

QUESTION 295Which of the following is not a comprehensive basis of accounting other than generally accepted accounting principles?

A. Cash receipts and disbursements basis of accounting.B. Basis of accounting used by an entity to file its income tax return.C. Basis of accounting used by an entity to comply with the financial reporting requirements of a government regulatory agency.D. Basis of accounting used by an entity to comply with the financial reporting requirements of a lending institution.



Choice "d" is correct. A basis of accounting used by an entity to comply with the financial reporting requirements of a lending institution is not a comprehensivebasis because such a requirement, in itself, would not have substantial support. A comprehensive basis of accounting other than GAAP is one of the following:

1. Cash basis and modified cash basis2. Tax basis3. Prescribed regulatory basis

4. Other basis with substantial support (e.g., price-level basis). Choices "a", "b", and "c" are incorrect, as explained above.

QUESTION 296Which of the following accounting bases may be used to prepare financial statements in conformity with a comprehensive basis of accounting other than generallyaccepted accounting principles?

A. Basis of accounting used by an entity to file its income tax return.II. Cash receipts and disbursements basis of accounting.




Choice "c" is correct. Both the basis of accounting used by an entity to file its income tax return and the cash receipts and disbursements basis of accounting arecomprehensive bases of accounting other than GAAP.OCBOAs also include:

* A basis prescribed by a regulatory agency* A definite set of criteria having substantial support (e.g., price-level basis)

QUESTION 297A CPA is required to comply with the provisions of Statements on Standards for Accounting and Review Services when:




Choice "d" is correct. A CPA is not required to comply with the provisions of Statements on Standards for Accounting and Review Services when proposingcorrecting journal entries or preparing standard monthly journal entries, since these activities do not constitute a "submission" of financial statements.Choices "a", "b", and "c" are incorrect, per above Explanation: .

QUESTION 298An auditor's special report on financial statements prepared in conformity with the cash basis of accounting should include a separate explanatory paragraph beforethe opinion paragraph that:

A. Justifies the reasons for departing from generally accepted accounting principles.B. States whether the financial statements are fairly presented in conformity with another comprehensive basis of accounting.C. Refers to the note to the financial statements that describes the basis of accounting.D. Explains how the results of operations differ from financial statements prepared in conformity with generally accepted accounting principles.



Choice "c" is correct. An auditor's special report on financial statements prepared in conformity with the cash basis of accounting should include a separateexplanatory paragraph before the opinion paragraph that refers to the note to the financial statements that describes the basis of accounting.Choice "a" is incorrect. The auditor should not include a separate explanatory paragraph that justifies the reasons for any departure from GAAP.Choice "b" is incorrect. The opinion paragraph (not the preceding explanatory paragraph) states whether the financial statements are fairly presented in conformitywith the other comprehensive basis of accounting.Choice "d" is incorrect. The auditor's report does not explain the differences between GAAP and the OCBOA, but merely states that they are different.

QUESTION 299

The standard report issued by an accountant after reviewing the financial statements of a nonissuer states that:

A. A review includes assessing the accounting principles used and significant estimates made by management.B. A review includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.C. The accountant is not aware of any material modifications that should be made to the financial statements.D. The accountant does not express an opinion or any other form of assurance on the financial statements.


Explanation/Reference:Explanation:Choice "c" is correct. The standard report issued by an accountant after reviewing the FS of a nonissuer states that the accountant is not aware of any materialmodifications that should be made to the financial statements (see the third paragraph of the standard review report). This is a "negative assurance."Choice "a" is incorrect. The standard audit report includes a statement regarding assessing the accounting principles used and significant estimates made bymanagement. Choice "b" is incorrect. The standard audit report includes a statement regarding examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. Choice "d" is incorrect. A compilation report states that the accountant does not express an opinion or any other form ofassurance on the financial statements. A review report provides limited assurance.

QUESTION 300Which of the following procedures is not usually performed by the accountant during a review engagement of a nonissuer?

A. Inquiring about actions taken at meetings of the board of directors that may affect the financial statements.B. Issuing a report stating that the review was performed in accordance with standards established by the AICPA.C. Reading the financial statements to consider whether they conform with generally accepted accounting principles.D. Communicating any material weaknesses discovered during the consideration of internal control.



Choice "d" is correct. Since internal control inquiries are not part of a review, there is generally no consideration of internal control in a review engagement. Choice"a" is incorrect. Inquiries to be made during a review may relate to meetings of the board of directors.Choice "b" is incorrect. A standard review report does state that the review was performed in accordance with SSARS, issued by the AICPA.Choice "c" is incorrect. Analytical procedures to be performed during a review should include reading the financial statements.

QUESTION 301When reporting on financial statements prepared on the same basis of accounting used for income tax purposes, the auditor should include in the report aparagraph that:

A. States that the income tax basis of accounting is a comprehensive basis of accounting other than generally accepted accounting principles.B. Justifies the use of the income tax basis of accounting.C. Emphasizes that the financial statements are not intended to have been audited in accordance with generally accepted auditing standards.D. Refers to the authoritative pronouncements that explain the income tax basis of accounting being used.



Choice "a" is correct. When reporting on financial statements prepared on the same basis of accounting used for income tax purposes, the auditor should include inthe report a paragraph that states that the income tax basis of accounting is a comprehensive basis of accounting other than GAAP (included in the third paragraphof the special report). Choice "b" is incorrect. The special report does not justify the use of the income tax basis of accounting.Choice "c" is incorrect. The financial statements are audited in accordance with GAAS (as stated in the first sentence in the second paragraph of the report). Choice"d" is incorrect. The report does not refer to the authoritative pronouncements that explain the income tax basis of accounting being used.

QUESTION 302Which of the following statements should not be included in an accountant's standard report based on the compilation of an entity's financial statements?

A. A statement that the compilation was performed in accordance with Statements on Standards for Accounting and Review Services issued by the AmericanInstitute of CPAs.

B. A statement that the accountant has not audited or reviewed the financial statements.C. A statement that the accountant does not express an opinion but expresses only limited assurance on the financial statements.D. A statement that a compilation is limited to presenting, in the form of financial statements, information that is the representation of management.



Choice "c" is correct. An accountant's standard compilation report of an entity's financial statements should not include a statement that the accountant does notexpress an opinion but expresses only limited assurance on the financial statements. An accountant should not express any level of assurance on compiled

financial statements. Choice "a" is incorrect. An accountant's standard compilation report should include the statement that the compilation was performed inaccordance with Statements on Standards for Accounting and Review Services issued by the AICPA.Choice "b" is incorrect. An accountant's standard compilation report should include the statement that the accountant has not audited or reviewed the financialstatements. Choice "d" is incorrect. An accountant's standard compilation report should include the statement that a compilation is limited to presenting, in the formof financial statements, information that is the representation of management.

QUESTION 303The objective of a review of interim financial information of a public entity is to provide the accountant with a basis for:

A. Determining whether the prospective financial information is based on reasonable assumptions.B. Expressing a limited opinion that the financial information is presented in conformity with generally accepted accounting principles.C. Deciding whether to perform substantive audit procedures prior to the balance sheet date.D. Reporting whether material modifications should be made for such information to conform with generally accepted accounting principles.



Choice "d" is correct. The objective of a review of interim financial information of a public entity is to provide the accountant with a basis for reporting whethermaterial modifications should be made to conform with GAAP.Choice "a" is incorrect. Prospective financial information (concerning future events) is not part of the interim financial information filed by a public company. Choice"b" is incorrect. No form of opinion is expressed based on a review; however, limited assurance is provided regarding the financial statements. Choice "c" isincorrect. The objective of an interim review is not to provide guidance regarding the timing of audit procedures.

QUESTION 304How does an accountant make the following representations when issuing the standard report for the compilation of a nonissuer's financial statements?




Choice "b" is correct. Financial statements of a nonissuer that have been compiled should be accompanied by a report explicitly stating that the accountant hascompiled the financial statements and stating that the accountant has not audited or reviewed the financial statements. Choices "a", "c", and "d" are incorrect, sincethese representations are made explicitly as per above.

QUESTION 305Financial statements of a nonissuer that have been reviewed by an accountant should be accompanied by a report stating that:

A. The scope of the inquiry and analytical procedures performed by the accountant has not been restricted.B. All information included in the financial statements is the representation of the management of the entity.C. A review includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.D. A review is greater in scope than a compilation, the objective of which is to present financial statements that are free of material misstatements.



Choice "b" is correct. Financial statements of a nonissuer that have been reviewed by an accountant should be accompanied by a report stating that all informationincluded in the financial statements is the representation of the management of the entity (per the first paragraph of the review report).Choice "a" is incorrect. The report does not state that the scope of the inquiry and analytical procedures performed by the accountant has not been restricted.Choice "c" is incorrect. An audit (and not a review) includes examining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements. Choice "d" is incorrect. The report does not state that a review is greater in scope than a compilation. In addition, presenting financial statements thatare free of material misstatements is not the objective of a compilation.

QUESTION 306Performing inquiry and analytical procedures is the primary basis for an accountant to issue a:

A. Report on compliance with requirements governing major federal assistance programs in accordance with the Single Audit Act.B. Review report on prospective financial statements that present an entity's expected financial position, given one or more hypothetical assumptions.C. Management advisory report prepared at the request of a client's audit committee.D. Review report on comparative financial statements for a nonissuer in its second year of operations.



Choice "d" is correct. Performing inquiry and analytical procedures is the primary basis for an accountant to issue a review report on comparative financialstatements for a nonissuer in its second year of operations.Choice "a" is incorrect. Reporting on compliance with requirements governing major federal assistance programs in accordance with the Single Audit Act is anattest engagement designed to provide a high level of assurance on an assertion (an "examination"). Inquiry and analytical procedures alone generally would beinsufficient to support this level of assurance. Choice "b" is incorrect. Prospective financial statements that present an entity's expected financial position (given oneor more hypothetical assumptions) may be subject to (1) an examination; (2) a compilation; or (3) agreed-upon procedures; but not to a review. Choice "c" isincorrect. Management advisory services (also known as consulting services) require the accountant to develop findings, conclusions, and recommendations.Generally this would require procedures beyond inquiry and analytical procedures.

QUESTION 307An auditor's report on financial statements prepared in accordance with an other comprehensive basis of accounting should include all of the following, except:

A. An opinion as to whether the basis of accounting used is appropriate under the circumstances.B. An opinion as to whether the financial statements are presented fairly in conformity with the other comprehensive basis of accounting.C. Reference to the note to the financial statements that describes the basis of presentation.D. A statement that the basis of presentation is a comprehensive basis of accounting other than generally accepted accounting principles.



Choice "a" is correct. The auditor would not indicate in his/her report an opinion as to whether the method of accounting used is appropriate.Choice "b" is incorrect. The auditor would include in his report an opinion as to whether the financial statements are presented fairly in conformity with the othercomprehensive basis of accounting.

Choice "c" is incorrect. The auditor would include in his report reference to the note to the financial statements that describes the basis of presentation. Choice "d" isincorrect. The auditor would include in his report a statement that the basis of presentation is a comprehensive basis of accounting other than generally acceptedaccounting principles.

QUESTION 308When an independent accountant's report based on a review of interim financial information is presented in a registration statement, a prospectus should include astatement about the accountant's involvement.

This statement should clarify that the:

A. Accountant is not an "expert" within the meaning of the Securities Act of 1933.B. Accountant's review report is not a "part" of the registration statement within the meaning of the Securities Act of 1933.C. Accountant performed only limited auditing procedures on the interim financial statements.D. Accountant's review was performed in accordance with standards established by the American Institute of CPAs.



Choice "b" is correct. When an independent accountant's report based on a review of interim financial information is presented in a registration statement, theprospectus should include a statement clarifying that the accountant's review report is not a "part" of the registration statement within the meaning of the SecuritiesAct of 1933. Choice "a" is incorrect. The accountant is an "expert" within the meaning of the Securities Act of 1933.Choice "c" is incorrect. The accountant generally does not perform any auditing procedures during a review.Choice "d" is incorrect. The fact that the accountant's review is performed in accordance with standards established by the AICPA is not mentioned in the statement(about the accountant's involvement) in the prospectus.

QUESTION 309Before issuing a report on the compilation of financial statements of a nonissuer, the accountant should:

A. Apply analytical procedures to selected financial data to discover any material misstatements.B. Corroborate at least a sample of the assertions management has embodied in the financial statements.C. Inquire of the client's personnel whether the financial statements omit substantially all disclosures.D. Read the financial statements to consider whether the financial statements are free from obvious material errors.



Choice "d" is correct. Before issuing a report on the compilation of financial statements of a nonissuer, the accountant should read the financial statements toconsider whether the financial statements are free from obvious material errors.Choice "a" is incorrect. Application of analytical procedures is a review procedure, and is not required in a compilation engagement.Choice "b" is incorrect. Corroboration of a sample of management assertions is an audit procedure, and is not required in a compilation engagement. Choice "c" isincorrect. Inquiry is generally a review procedure; however, it should also be obvious to the accountant if substantially all disclosures are omitted.

QUESTION 310During a review of the financial statements of a nonissuer, an accountant becomes aware of a lack of adequate disclosure that is material to the financialstatements. If management refuses to correct the financial statement presentations, the accountant should:

A. Issue an adverse opinion.B. Issue an "except for" qualified opinion.C. Disclose this departure from generally accepted accounting principles in a separate paragraph of the report.D. Express only limited assurance on the financial statement presentations.



Choice "c" is correct. If, during a review of the financial statements of a nonissuer, an accountant becomes aware of a lack of adequate disclosure that is material tothe financial statements, and management refuses to correct the financial statement presentations, the accountant should disclose this departure from GAAP in aseparate paragraph of the report. Choices "a" and "b" are incorrect. Adverse opinions and "except for" qualified opinions pertain to audit reports. Opinions are notrendered based on review engagements. Choice "d" is incorrect. The accountant expresses only limited assurance on the financial statements as a result of areview even when there are no GAAP departures. GAAP departures require that a separate paragraph be added to the standard report, and that the limitedassurance be modified to read, "...with the exception of the matter described in the following paragraph, I am not aware of any material modifications..."

QUESTION 311Unaudited financial statements for the prior year presented in comparative form with audited financial statements for the current year should be clearly marked toindicate their status and

A. The report on the prior period should be reissued to accompany the current period report.II. The report on the current period should include as a separate paragraph a description of the responsibility assumed for the prior period's financial statements.

B. I only.

C. II only.D. Both I and II.E. Either I or II.



Choice "d" is correct. Either I or II.Unaudited FS for the prior year presented in comparative form with audited FS for the current year should be clearly marked to indicate their status ("unaudited"),and either the report on the prior period should be reissued or the report on the current period should include a separate explanatory paragraph describing theresponsibility assumed for the prior period's financial statements.

QUESTION 312Comfort letters ordinarily are addressed to:

A. The Securities and Exchange Commission.B. Underwriters of securities.C. Creditor financial institutions.D. The client's audit committee.



Choice "b" is correct. Comfort letters (containing comments on data that have not been audited) ordinarily are addressed to underwriters of securities, and mostlikely convey negative assurance on financial information.Choice "a" is incorrect. The SEC is not the addressee. Choice "c" is incorrect. Creditor financial institutions are not the addressees. Choice "d" is incorrect. Whilethe client (or its audit committee) may receive a copy, ordinarily comfort letters are addressed to the underwriters.

QUESTION 313This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'

review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.

Accountant's Review Report

We have reviewed and audited the accompanying balance sheets of Tech Co. as of December 31, 20X2 and 20X1, and the related statements of income, retainedearnings, and cash flows for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the AmericanInstitute of Certified Public Accountants and generally accepted auditing standards. All information included in these financial statements is the representation of themanagement of Tech Co.

A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit inaccordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements. Because of the inherentlimitations of a review engagement, this report is intended for the information of management and should not be used for any other purpose.

The financial statements for the year ended December 31, 20X1, were audited by us and our report was dated March 2, 20X2. We have no responsibility forupdating that report for events and circumstances occurring after that date.

Jordan and Stone, CPAsMarch 1, 20X3

Supervisor's Review Notes

There should be no reference to the prior year's audited financial statements in the first (introductory) paragraph.

A. CorrectB. Incorrect



Correct. The auditors are issuing a review report this year and issued an audit opinion last year. A review report gives less assurance than an audit. The auditorsshould not make reference in the first paragraph to the fact that they audited last year's financial statements even though they are being comparatively shown,because it may mislead the reader of the financial statements as to the auditors' degree of assurance on this year's financial statements.

QUESTION 314

This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.

Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.

Accountant's Review ReportWe have reviewed and audited the accompanying balance sheets of Tech Co. as of December 31, 20X2 and 20X1, and the related statements of income, retainedearnings, and cash flows for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the AmericanInstitute of Certified Public Accountants and generally accepted auditing standards. All information included in these financial statements is the representation of themanagement of Tech Co.

A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit inaccordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.

Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements. Because of the inherentlimitations of a review engagement, this report is intended for the information of management and should not be used for any other purpose.

The financial statements for the year ended December 31, 20X1, were audited by us and our report was dated March 2, 20X2. We have no responsibility forupdating that report for events and circumstances occurring after that date.



All the current-year basic financial statements are not properly identified in the first (introductory) paragraph.




Incorrect. The basic financial statements are properly identified in the introductory paragraph.

QUESTION 315This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.


We have reviewed and audited the accompanying balance sheets of Tech Co. as of December 31, 20X2 and 20X1, and the related statements of income, retainedearnings, and cash flows for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the AmericanInstitute of Certified Public Accountants and generally accepted auditing standards. All information included in these financial statements is the representation of themanagement of Tech Co.A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit inaccordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements. Because of the inherentlimitations of a review engagement, this report is intended for the information of management and should not be used for any other purpose.The financial statements for the year ended December 31, 20X1, were audited by us and our report was dated March 2, 20X2. We have no responsibility forupdating that report for events and circumstances occurring after that date.



There should be no reference to the American Institute of Certified Public Accountants in the first (introductory) paragraph.




Incorrect. There is and should be a reference to the American Institute of Certified Public Accountants in the first paragraph because the auditors are performing areview this year and not an audit.

QUESTION 316This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructedKent to include a separate paragraph in the current year's review report describing the responsibility assumed for the prior year's audited financial statements. Thisis an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.





The accountant's review and audit responsibilities should follow management's responsibilities in the first (introductory) paragraph.




Incorrect. The accountant's review and audit responsibilities should not follow management's responsibilities in the introductory paragraph.





Supervisor's Review NotesNegative assurance should be expressed on the current year's reviewed financial statements in the second (scope) paragraph.




Incorrect. The auditors should not express negative assurance or any degree of assurance in the second (scope) paragraph.

QUESTION 318

This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.





There should be a statement that no opinion is expressed on the current year's financial statements in the second (scope) paragraph.




Correct. Because the auditors do substantially less work in a review than in an audit, the auditors should state that they do not express an opinion.

QUESTION 319This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements of

Tech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.

Accountant's Review ReportWe have reviewed and audited the accompanying balance sheets of Tech Co. as of December 31, 20X2 and 20X1, and the related statements of income, retainedearnings, and cash flows for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the AmericanInstitute of Certified Public Accountants and generally accepted auditing standards. All information included in these financial statements is the representation of themanagement of Tech Co.A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit inaccordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements. Because of the inherentlimitations of a review engagement, this report is intended for the information of management and should not be used for any other purpose.The financial statements for the year ended December 31, 20X1, were audited by us and our report was dated March 2, 20X2. We have no responsibility forupdating that report for events and circumstances occurring after that date.



There should be a reference to "conformity with generally accepted accounting principles" in the third paragraph.




Correct. There should be reference to conformity with generally accepted accounting principles in the third paragraph.

QUESTION 320This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'

review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.





There should be no restriction on the use of the accountant's review report in the third paragraph.




Correct. There should be no restriction on use in a review report.

QUESTION 321This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.

Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.





There should be no reference to "material modifications" in the third paragraph.



Explanation/Reference:Explanation:Incorrect. There should be a reference to the fact that the auditors are not aware of any material modifications that should be made (limited assurance).

QUESTION 322This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.

Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.




Supervisor's Review NotesThere should be an indication of the type of opinion expressed on the prior year's audited financial statements in the fourth (separate) paragraph.




Correct. An example of such a separate paragraph is the following: "The financial statements for the year ended December 31, 20X1 were audited by us and weexpressed an unqualified opinion on them in our report dated March 1, 20X2 but we have not performed any auditing procedures since that date."






There should be an indication that no auditing procedures were performed after the date of the report on the prior year's financial statements in the fourth (separate)paragraph.




Correct. In the fourth paragraph, there should be an indication that the auditors performed no auditing procedures after the date of the report on the prior year'sfinancial statements.

QUESTION 324This question consists of an item pertaining to possible deficiencies in an accountant's review report. Jordan & Stone, CPAs, audited the financial statements ofTech Co., a nonissuer, for the year ended December 31, 20X1, and expressed an unqualified opinion. For the year ended December 31, 20X2, Tech issuedcomparative financial statements. Jordan & Stone reviewed Tech's 20X2 financial statements and Kent, an assistant on the engagement, drafted the accountants'review report below.Land, the engagement supervisor, decided not to reissue the prior year's auditors' report, but instructed Kent to include a separate paragraph in the current year'sreview report describing the responsibility assumed for the prior year's audited financial statements. This is an appropriate reporting procedure.

Land reviewed Kent's draft and indicated in the Supervisor's Review Notes below that there were several deficiencies in Kent's draft.





There should be no reference to "updating the prior year's auditor's report for events and circumstances occurring after that date" in the fourth (separate)paragraph.




Correct. The report should not state that the auditors have no responsibility for updating the prior year's audit report for events and circumstances that occurredafter that date. This type of comment is included in a report on prospective financial statements, not in a report on the financial statements of a nonissuer.

Planning and Supervision

QUESTION 325Which of the following is true about the term "likely misstatement?"

A. It refers to misstatements that have not been specifically identified, but which are likely to exist based on the auditor's judgment.B. It refers to the cumulative effect of misstatements from prior years on the current year's financial statements.C. It refers to misstatements that have been specifically identified by the auditor.D. It includes both identified misstatements and an estimate of unidentified misstatements.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. A "likely misstatement" is one that has not been specifically identified, but which is likely to exist based on the auditor's judgment. Choice "b" isincorrect. "Likely misstatement" does not refer to the cumulative effect of prior year errors.It is a measure of misstatements the auditor considers likely to exist, that have not been specifically identified.Choice "c" is incorrect. "Likely misstatement" is a measure of misstatements the auditor considers likely to exist, that have not been specifically identified. Choice"d" is incorrect. The term "likely misstatement" includes only an estimate of potential errors. It does not include specific misstatements identified during the audit.

QUESTION 326A successor auditor ordinarily should request to review the predecessor's audit documentation relating to:




Explanation:ExplanationChoice "a" is correct. A review of the predecessor's audit documentation related to matters of continuing accounting and auditing significance would be permitted.This would include documentation concerning contingencies and internal controls. Choice "b" is incorrect. It is appropriate for the successor auditor to review thepredecessor's audit documentation relating to internal controls.Choice "c" is incorrect. It is appropriate for the successor auditor to review the predecessor's audit documentation relating to contingencies as they may have animpact on the current year financial statements.Choice "d" is incorrect. It is appropriate for the successor auditor to review the predecessor's audit documentation relating to internal controls and contingencies.

QUESTION 327An auditor's engagement letter most likely would include:

A. Management's acknowledgment of its responsibility for maintaining effective internal control.B. The auditor's preliminary assessment of the risk factors relating to misstatements arising from fraudulent financial reporting.C. A reminder that management is responsible for illegal acts committed by employees.D. A request for permission to contact the client's lawyer for assistance in identifying litigation, claims, and assessments.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. An understanding with the client should be established regarding management's responsibilities, which include establishing and maintainingeffective internal control over financial reporting. This is generally documented in an engagement letter. Choice "b" is incorrect. During the planning process, theauditor must document evidence of the assessment of the risk of material misstatement due to fraud. This information would be included in the auditdocumentation, not in the engagement letter. Choice "c" is incorrect. Management is not responsible for illegal acts committed by employees, and therefore theengagement letter would not include such a statement. Choice "d" is incorrect. The auditor generally does not contact the client's lawyer directly; rather, a letter issent from management to the lawyer requesting corroboration of information related to litigation, claims, and assessments. The engagement letter therefore wouldnot include a request for permission to contact the attorney.

QUESTION 328Which of the following auditor concerns most likely could be so serious that the auditor concludes that a financial statement audit cannot be performed?

A. Management fails to modify prescribed internal controls for changes in information technology.B. Internal control activities requiring segregation of duties are rarely monitored by management.C. Management is dominated by one person who is also the majority stockholder.D. There is a substantial risk of intentional misapplication of accounting principles.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Intentional misapplication of accounting principles would indicate that management lacks integrity and as a result, the auditor might concludethat a financial statement audit cannot be performed.Choice "a" is incorrect. Management's failure to modify prescribed internal controls for changes in information technology would preclude the auditor from relying onthose controls but would not prevent the auditor from performing a financial statement audit. Choice "b" is incorrect. If management rarely monitors segregation ofduties, the auditor would not rely on that particular control, but this would not prevent the auditor from performing a financial statement audit.Choice "c" is incorrect. If management is dominated by one person who is also the majority stockholder, the risk of fraudulent financial reporting is increased, butthis would not preclude the auditor from performing a financial statement audit.

QUESTION 329Which of the following factors would a CPA ordinarily consider in the planning stage of an audit engagement?

A. Financial statement accounts likely to contain a misstatement.II. Conditions that require extension of audit tests.



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. During the planning stage, the auditor assesses the risk of material misstatement in financial statement accounts. Based on this assessment,the auditor plans the audit procedures to provide reasonable assurance that material misstatements in the financial statements will be detected.Additionally, during the planning stage, conditions may come to the auditor's attention that indicate a necessary extension of audit tests. The auditor would need toconsider this factor in determining the time budget and staffing needs for the engagement. Choices "a", "b", and "d" are incorrect. The auditor would need toconsider both factors (financial statement accounts likely to contain a misstatement and conditions that require an extension of audit tests) in planning the audit.

QUESTION 330In assessing the objectivity of internal auditors, the independent CPA who is auditing the entity's financial statements most likely would consider the:

A. Internal auditing standards developed by The Institute of Internal Auditors.B. Tests of internal control activities that could detect errors and fraud.C. Materiality of the accounts recently inspected by the internal auditors.D. Results of the tests of transactions recently performed by the internal auditors.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Objectivity is reflected by the organizational level to which the internal auditor reports as well as by policies prohibiting audits of areas wherethe internal auditor lacks independence.In assessing the objectivity of internal auditors, the independent CPA who is auditing the entity's financial statements considers information obtained from previousexperience, from discussions with management, from external quality reviews (if performed), and from professional internal auditing standards (such as thosedeveloped by The Institute of Internal Auditors). Choice "b" is incorrect. Tests of internal control activities that could detect errors and fraud would not help the CPAassess the objectivity of the internal auditor. Choice "c" is incorrect. The materiality of the accounts recently inspected by the internal auditors would not help theCPA assess the objectivity of the internal auditor. Choice "d" is incorrect. Results of the tests of transactions recently performed by the internal auditor would aid theauditor in evaluating the internal auditor's competence rather than his or her objectivity.

QUESTION 331Which of the following factors most likely would cause a CPA to not accept a new audit engagement?

A. The prospective client has already completed its physical inventory count.B. The CPA lacks an understanding of the prospective client's operations and industry.C. The CPA is unable to review the predecessor auditor's audit documentation.D. The prospective client is unwilling to make all financial records available to the CPA.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor must consider the availability and adequacy of the client's accounting records and the integrity of management in deciding whetheror not to accept a new audit engagement. A prospective client that is unwilling to provide all financial records would give the auditor cause for concern about both ofthese issues. Choice "a" is incorrect. The auditor may apply acceptable alternative procedures to audit inventory.Choice "b" is incorrect. The auditor can accept the engagement and obtain an understanding of the client's operations and industry after acceptance. Choice "c" is

incorrect. Inability to review the predecessor's audit documentation means the auditor will expend greater effort auditing beginning balances. It does not mean theengagement should be declined.

QUESTION 332A CPA wishes to determine how various publicly-held companies have complied with the disclosure requirements of a new financial accounting standarD. Which ofthe following information sources would the CPA most likely consult for this information?

A. AICPA Codification of Statements on Auditing Standards.B. AICPA Accounting Trends and Techniques.C. SEC Quality Control Review.D. SEC Statement 10-K Guide.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The AICPA's Accounting Trends & Techniques is an annual survey of accounting practices followed in 600 stockholders' annual reports.Choices "a", "c", and "d" are incorrect. These sources do not provide comparative information about accounting practices.

QUESTION 333Which of the following factors most likely would lead a CPA to conclude that a potential audit engagement should be rejected?

A. The details of most recorded transactions are not available after a specified period of time.B. Internal control activities requiring the segregation of duties are subject to management override.C. It is unlikely that sufficient appropriate evidence is available to support an opinion on the financial statements.D. Management has a reputation for consulting with several accounting firms about significant accounting issues.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. A CPA cannot render an opinion on financial statements unless he or she has obtained sufficient appropriate audit evidence supporting thatopinion. If such evidence were unlikely to be available, the CPA would most likely reject the potential audit engagement. Choice "a" is incorrect. The auditor takesthe availability of information into account when planning the audit, and would need to perform testing throughout the period, but this would not be cause for

rejecting a potential audit engagement. Choice "b" is incorrect. The risk of management override is considered during planning and would not be cause for rejectinga potential audit engagement. Choice "d" is incorrect. Management may consult with several accounting firms, and this would not be cause for rejecting a potentialaudit engagement.

QUESTION 334Which of the following factors most likely would cause a CPA to decide not to accept a new audit engagement?

A. The CPA's lack of understanding of the prospective client's internal auditor's computer- assisted audit techniques.B. Management's disregard of its responsibility to maintain an adequate internal control environment.C. The CPA's inability to determine whether related party transactions were consummated on terms equivalent to arm's-length transactions.D. Management's refusal to permit the CPA to perform substantive tests before the year-end.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The control environment is the foundation for all other components of internal control. Management's disregard of its responsibility to maintainan adequate internal control environment therefore compromises its ability to provide reasonable assurance regarding reliable financial reporting. The auditor mayconclude that the risk of misrepresentation in the financial statements is great enough that an audit should not be conducted. Choice "a" is incorrect. The CPA doesnot need to understand the internal auditor's techniques in order to accept a new audit engagement.Choice "c" is incorrect. Related party transactions (by definition) are not considered to be arm's- length transactions, and evaluation of such transactions does notaffect the CPA's decision regarding acceptance of new clients.Choice "d" is incorrect. Substantive tests are generally performed after year-end, since prior to that time the financial statements have not been finalized.

QUESTION 335Which of the following matters generally is included in an auditor's engagement letter?

A. Management's responsibility for the entity's compliance with laws and regulations.B. The factors to be considered in setting preliminary judgments about materiality.C. Management's vicarious liability for illegal acts committed by its employees.D. The auditor's responsibility to search for significant internal control deficiencies.



Explanation:ExplanationChoice "a" is correct. An understanding with the client should be established regarding management's responsibilities, which include identifying and ensuring thatthe entity complies with applicable laws and regulations. The understanding should be documented through a written communication, such as an engagementletter.Choice "b" is incorrect. Judgments about materiality are the auditor's responsibility and would not be included in an engagement letter.Choice "c" is incorrect. Management would not necessarily be responsible for illegal acts committed by employees.Choice "d" is incorrect. The auditor is not responsible for searching for significant internal control deficiencies.

QUESTION 336Before accepting an engagement to audit a new client, a CPA is required to obtain:

A. An understanding of the prospective client's industry and business.B. The prospective client's signature to the representation letter.C. A preliminary understanding of the prospective client's control environment.D. The prospective client's consent to make inquiries of the predecessor auditor, if any.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Inquiry of the predecessor auditor is a required pre-acceptance procedure. However, consent of the prospective client must be obtainedbefore a CPA can make such inquiries of the predecessor auditor.Choice "a" is incorrect. Obtaining an understanding of the client's industry and business is a planning procedure performed after an engagement is accepted.Choice "b" is incorrect. A management representation letter is not obtained until the end of the audit.Choice "c" is incorrect. Obtaining a preliminary understanding of the client's control environment is an audit procedure (required by the second standard offieldwork) that would be performed after an engagement is accepted.

QUESTION 337In assessing the objectivity of internal auditors, an independent auditor should:

A. Evaluate the quality control program in effect for the internal auditors.B. Examine documentary evidence of the work performed by the internal auditors.C. Test a sample of the transactions and balances that the internal auditors examined.D. Determine the organizational level to which the internal auditors report.

Correct Answer: D


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. When assessing the internal auditors' objectivity, the auditor should obtain information about whether the internal auditor reports to an officerof sufficient status to ensure broad audit coverage and adequate consideration of, and action on, the findings and recommendations of the internal auditors.Choice "a" is incorrect. A quality control program would impact the competence of the internal audit staff, not their objectivity.Choice "b" is incorrect. Examining documentary evidence produced by the internal auditors would help the auditor evaluate the quality and effectiveness of theinternal auditors' work, but would not help assess objectivity.Choice "c" is incorrect. Testing a sample of transactions and balances examined by the internal auditors would help the auditor evaluate the quality andeffectiveness of the internal auditors' work, but would not help assess objectivity.

QUESTION 338Which of the following auditor concerns most likely could be so serious that the auditor concludes that a financial statement audit cannot be conducted?

A. The entity has no formal written code of conduct.B. The integrity of the entity's management is suspect.C. Procedures requiring segregation of duties are subject to management override.D. Management fails to modify prescribed controls for changes in conditions.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Serious concerns about the integrity of management may indicate a risk of management misrepresentation in the financial statements that isso great that an audit cannot be conducted. If the integrity of management is suspect, there would be a presumption of dishonesty. The auditor would then need toquestion the genuineness of all records and documents obtained from the client and would require conclusive rather than persuasive evidence to corroborate allmanagement representations. An audit conducted on these terms would be unreasonably costly and impractical.Choice "a" is incorrect. A formal written code of conduct is generally considered a positive control, but the lack of one would not preclude an audit from beingconducted. Choice "c" is incorrect. Management override of internal controls (such as segregation of duties) is an inherent limitation of any internal control andwould not prevent an audit from being performed.Choice "d" is incorrect. A failure by management to modify prescribed controls for changes in conditions may increase control risk, but since the auditor cangenerally compensate for weak internal controls with increased substantive testing, this would not preclude an audit.

QUESTION 339The work of internal auditors may affect the independent auditor's:

A. Procedures performed in obtaining an understanding of internal control.II. Procedures performed in assessing the risk of material misstatement.III. Substantive procedures performed in gathering direct evidence.

B. I and II only.C. I and III only.D. II and Ill only.E. I, II, and III.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The internal auditors' work may affect the nature, timing, and extent of the audit, including procedures the auditor performs when obtaining anunderstanding of the entity's internal control, when assessing risk, and when performing substantive procedures. Choice "a" is incorrect. It is likely that manyprocedures performed by internal auditors will affect the independent auditor's substantive testing, by providing direct evidence about material misstatements inassertions.Choice "b" is incorrect. It is likely that the work of internal auditors will aid the independent auditor in assessing control risk, since so much of the internal auditors'function is involved with monitoring the control structure.Choice "c" is incorrect. It is very likely that the work of internal auditors will affect the independent auditor's procedures for obtaining an understanding of internalcontrol, because monitoring the control system is the primary responsibility of the internal auditors. Their flowcharts, narratives, and analyses of controls could behelpful to the independent auditor.

QUESTION 340Which of the following statements is correct concerning an auditor's use of the work of a specialist?

A. The auditor need not obtain an understanding of the methods and assumptions used by the specialist.B. The auditor may not use the work of a specialist in matters material to the fair presentation of the financial statements.C. The reasonableness of the specialist's assumptions and their applications are strictly the auditor's responsibility.D. The work of a specialist who has a contractual relationship with the client may be acceptable under certain circumstances.



Explanation:ExplanationChoice "d" is correct. The purpose of using the work of a specialist is to provide the auditor with specialized skill or knowledge the auditor may lack. The work of aspecialist who has a relationship with a client may be acceptable under certain circumstances. If the specialist has a relationship with the client, the auditor shouldassess the risk that the specialist's objectivity might be impaired. If the auditor believes that the relationship might impair the specialist's objectivity, the auditorshould perform additional procedures with respect to the specialist's assumptions, methods, or findings to determine that the findings are not unreasonable orshould engage another specialist for that purpose.Choice "a" is incorrect. Although the appropriateness and reasonableness of methods or assumptions used and their application are the responsibility of thespecialist, the auditor should obtain an understanding of the methods or assumptions used in order to determine whether the findings are suitable for corroboratingthe representations in the financial statements. Choice "b" is incorrect. The auditor may use, and in fact is encouraged to use, the work of a specialist in mattersmaterial to the fair presentation of the financial statements. Choice "c" is incorrect. The appropriateness and reasonableness of methods or assumptions used andtheir application are the responsibility of the specialist; the auditor should, however, obtain an understanding of the methods or assumptions used in order todetermine whether the findings are suitable for corroborating the representations in the financial statements.

QUESTION 341The element of the audit planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the:

A. Evidence to be gathered to provide a sufficient basis for the auditor's opinion.B. Procedures to be undertaken to discover litigation, claims, and assessments.C. Pending legal matters to be included in the inquiry of the client's attorney.D. Timing of inventory observation procedures to be performed.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. In order to observe the physical inventory count, the auditor would have to coordinate schedules with the client. This timing is usually agreedupon before implementation of the audit strategy.Choice "a" is incorrect. It would not be appropriate for the client to be involved in determining the amount of evidence necessary to provide a basis for an opinion.Choice "b" is incorrect. It would not be appropriate for the client to be involved in determining the procedures necessary to obtain evidence about litigation, claimsand assessments. Choice "c" is incorrect. Determination of the pending legal matters to be included in a letter to the client's attorney would not generally be madeduring the planning stage of the audit.

QUESTION 342Which of the following statements would least likely appear in an auditor's engagement letter?

A. Fees for our services are based on our regular per diem rates, plus travel and other out-of- pocket expenses.

B. During the course of our audit we may observe opportunities for economy in, or improved controls over, your operations.C. Our engagement is subject to the risk that material errors or fraud, including defalcations, if they exist, will not be detected.D. After performing our preliminary analytical procedures we will discuss with you the other procedures we consider necessary to complete the engagement.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor does not consult with the client about audit procedures that will be performed.Choice "a" is incorrect. Since the engagement letter serves as a contract between the auditor and client, fee arrangements are typically disclosed in the letter.Choice "b" is incorrect. A discussion regarding possible auditor suggestions is appropriate for inclusion in an engagement letter.Choice "c" is incorrect. The fact that audit risk exists and that an audit only provides reasonable assurance of the detection of errors and fraud is typically disclosedin an engagement letter.

QUESTION 343Which of the following procedures would an auditor most likely perform in planning a financial statement audit?

A. Inquiring of the client's legal counsel concerning pending litigation.B. Comparing the financial statements to anticipated results.C. Examining computer generated exception reports to verify the effectiveness of internal controls.D. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. A requirement during planning is to perform analytical procedures, which involve comparisons of recorded amounts to expectations. Choice"a" is incorrect. Inquiry of the client's legal counsel is typically performed near the end of fieldwork.Choice "c" is incorrect. Tests of controls are performed after audit planning is complete. Choice "d" is incorrect. The search for unrecorded liabilities is generallyperformed at or after year-end.

QUESTION 344The in-charge auditor most likely would have a supervisory responsibility to explain to the staff assistants:

A. That fraud is not to be reported to those charged with governance.B. How the results of various auditing procedures performed by the assistants should be evaluated.C. What benefits may be attained by the assistants' adherence to established time budgets.D. Why certain documents are being transferred from the current file to the permanent file.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Assistants should be informed of their responsibilities and the objectives of the procedures that they are to perform. Part of the assistant'sresponsibility is to properly evaluate audit results, and the in-charge auditor would likely discuss this with them. Choice "a" is incorrect. Fraud that causes a materialmisstatement or involves senior management should be reported to those charged with governance. Choice "c" is incorrect. Preparation and maintenance of thetime budget is related to planning rather than supervision.Choice "d" is incorrect. The reasons for transferring documents from the permanent file to the current file need not be explained to the staff assistants.

QUESTION 345Analytical procedures used in planning an audit should focus on:

A. Reducing the scope of tests of controls and substantive tests.B. Providing assurance that potential material misstatements will be identified.C. Enhancing the auditor's understanding of the client's business.D. Assessing the adequacy of the available audit evidence.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Analytical procedures used in planning the audit should focus on enhancing the auditor's understanding of the client's business and thetransactions and events that have occurred since the last audit date.Choice "a" is incorrect. Analytical procedures used in planning do not reduce tests of controls or substantive tests.Choice "b" is incorrect. Analytical procedures used in planning are not designed to identify material misstatements.Choice "d" is incorrect. Audit evidence has not yet been gathered during the planning process, so its adequacy cannot be assessed.

QUESTION 346

Which of the following relatively small misstatements most likely could have a material effect on an entity's financial statements?

A. An illegal payment to a foreign official that was not recorded.B. A piece of obsolete office equipment that was not retired.C. A petty cash fund disbursement that was not properly authorized.D. An uncollectible account receivable that was not written off.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. An illegal payment of an otherwise immaterial amount could be material if there is a reasonable possibility that it could lead to a materialcontingent liability or a material loss of revenue.Choice "b" is incorrect. Failure to retire a piece of obsolete office equipment is not likely to have ramifications beyond the immaterial misstatement that would resultdirectly from it. Choice "c" is incorrect. Failure to properly authorize a petty cash fund disbursement is not likely to have ramifications beyond the immaterialmisstatement that would result directly from it. Choice "d" is incorrect. Failure to write off a relatively small uncollectible account receivable is not likely to haveramifications beyond the immaterial misstatement that would result directly from it.

QUESTION 347Which of the following risks may be assessed in nonquantitative terms?


Correct Answer: CSection: Auditing and Attestation (I) (Volume B)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Both the risk of material misstatement (including control risk and inherent risk) and detection risk may be assessed in quantitative terms suchas percentages or in nonquantitative terms that range, for example, from a minimum to a maximum. Choices "a", "b", and "d" are incorrect, based on the aboveexplanation.

QUESTION 348Which of the following would an auditor most likely use in determining the auditor's preliminary judgment about materiality?

A. The anticipated sample size of the planned substantive tests.B. The entity's annualized interim financial statements.C. The results of the internal control questionnaire.D. The contents of the management representation letter.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The auditor's preliminary judgment about materiality is generally based on either annualized interim financial statements or annual financialstatements from a prior period. Choice "a" is incorrect. The anticipated sample size for substantive tests is irrelevant in making a preliminary judgment aboutmateriality.Choice "c" is incorrect. The results of the internal control questionnaire would be relevant for making a preliminary assessment of control risk; however, theseresults are irrelevant for determining a preliminary level of materiality.Choice "d" is incorrect. The management representation letter is obtained at the end of the audit and would not be available when preliminary assessments ofmateriality are made during planning.

QUESTION 349An auditor should design the written audit plan so that:

A. All material transactions will be selected for substantive testing.B. Substantive tests prior to the balance sheet date will be minimized.C. The audit procedures selected will achieve specific audit objectives.D. Each account balance will be tested under either tests of controls or tests of transactions.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. An audit plan aids in instructing assistants in the work to be done. It should set forth in reasonable detail the audit procedures that the auditorbelieves are necessary to accomplish the objectives of the audit.Choice "a" is incorrect. Auditors make extensive use of sampling to perform audit tests. Tests of all material transactions would not be economically feasible.Choice "b" is incorrect. Assuming that incremental risk can be controlled, substantive tests can be performed prior to year-end.Choice "d" is incorrect. An account balance does not necessarily have to have tests of controls or tests of transactions applied to it.

QUESTION 350In auditing the financial statements of Star Corp., Land discovered information leading Land to believe that Star's prior year's financial statements, which wereaudited by Tell, require substantial revisions.Under these circumstances, Land should:

A. Notify Star's audit committee and stockholders that the prior year's financial statements cannot be relied on.B. Request Star to reissue the prior year's financial statements with the appropriate revisions.C. Notify Tell about the information and make inquiries about the integrity of Star's management.D. Request Star to arrange a meeting among the three parties to resolve the matter.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. If, during the audit, the successor auditor becomes aware of information indicating that the financial statements reported on by thepredecessor auditor may require revision, he or she should request the client to arrange a meeting among the three parties to discuss the information and attemptto resolve the matter. Choice "a" is incorrect. It is not the successor auditor's responsibility to inform readers that the financial statements, which were audited byanother firm, cannot be relied upon. Choice "b" is incorrect. The prior year's financial statements should not be reissued until the two auditing firms and the clienthave an opportunity to discuss the matter. There is a reasonable likelihood that the successor firm is unaware of other information that supports the currentcondition of the prior year financial statements.Choice "c" is incorrect. The successor firm should not notify the predecessor directly but should request that the client do so.

QUESTION 351An internal auditor's work would most likely affect the nature, timing, and extent of an independent CPA's auditing procedures when the internal auditor's workrelates to assertions about the:

A. Existence of contingencies.B. Valuation of intangible assets.C. Existence of fixed asset additions.D. Valuation of related party transactions.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. In making judgments about the extent of the effect of the internal auditor's work on the auditor's procedures, the auditor considers themateriality of financial statement amounts, the risk of material misstatement of the assertions related to these financial statement amounts, and the degree ofsubjectivity involved in the evaluation of the audit evidence gathered in support of the assertions. As the degree of subjectivity increases, the need for the auditor toperform tests of the assertions increases.Testing the existence of fixed asset additions involves very little subjectivity, and thus work performed by the internal auditor may reduce the auditor's testing in thisarea. Choice "a" is incorrect. Testing the existence of contingencies involves much subjectivity, and should, therefore, be performed by the auditor.Choice "b" is incorrect. Testing the valuation of intangible assets involves much subjectivity, and should, therefore, be performed by the auditor.Choice "d" is incorrect. Testing the valuation of related party transactions involves much subjectivity, and should, therefore, be performed by the auditor.

QUESTION 352During an audit an internal auditor may provide direct assistance to an independent CPA in:



Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Internal auditors may assist the auditor in obtaining an understanding of internal control and in performing tests of controls and substantivetests. Choices "a", "b", and "c" are incorrect, based on the above explanation.

QUESTION 353Which of the following statements is correct concerning an auditor's use of the work of a specialist?

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


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The work of a specialist who has a relationship with a client may be acceptable under certain circumstances. If the specialist is related to theclient, the auditor should consider performing additional procedures with respect to the specialist's assumptions, methods, or findings to determine that the findingsare not unreasonable, or should engage another specialist for that purpose.Choice "b" is incorrect. If the auditor believes the findings are unreasonable, the auditor should apply additional procedures, which may include obtaining the opinionof another specialist. This does not imply that there is a problem with the financial statements, and therefore would not necessarily result in a qualified opinion.Choice "c" is incorrect. If there is a material difference between a specialist's findings and the assertions in the financial statements, and if the specialist's findingsare deemed reasonable, either a qualified or an adverse opinion may be issued. (Note that it is also possible that the specialist's findings turn out to be erroneous,in which case an unqualified opinion might be issued.)Choice "d" is incorrect. A specialist may be used to determine the physical characteristics relating to inventory (e.g., quantity on hand or condition).

QUESTION 354In using the work of a specialist, an auditor of a nonissuer may refer to the specialist in the auditor's report if, as a result of the specialist's findings, the auditor:

A. Becomes aware of conditions causing substantial doubt about the entity's ability to continue as a going concern.

B. Desires to disclose the specialist's findings, which imply that a more thorough audit was performed.C. Is able to corroborate another specialist's earlier findings that were consistent with management's representations.D. Discovers significant deficiencies in the design of the entity's internal control that management does not correct.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor may, as a result of the report or findings of the specialist, decide to add explanatory language to the auditor's standard report ordepart from an unqualified opinion. Reference to and identification of the specialist may be made in the auditor's report if the auditor believes such reference willfacilitate an understanding of the reason for the explanatory paragraph or the departure from the unqualified opinion. Choice "b" is incorrect. The auditor should notrefer to the work or findings of the specialist unless the specialist's work results in a change to the auditor's report. Choice "c" is incorrect. The auditor should notrefer to the work or findings of the specialist unless the specialist's work results in a change to the auditor's report. Choice "d" is incorrect. The identification ofsignificant deficiencies in the design of the client's internal control would not result in a change to the auditor's report. The auditor should not refer to the work orfindings of the specialist unless the specialist's work results in a change to the auditor's report.

QUESTION 355Which of the following procedures would an auditor most likely include in the initial planning of a financial statement audit?

A. Obtaining a written representation letter from the client's management.B. Examining documents to detect illegal acts having a material effect on the financial statements.C. Considering whether the client's accounting estimates are reasonable in the circumstances.D. Determining the extent of involvement of the client's internal auditors.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor considers several factors in planning the nature, timing and extent of auditing procedures. One of these factors is the extent ofinvolvement of the client's internal auditors.Choice "a" is incorrect. Representation letters are obtained by the auditor at the end of the audit. The representation letter should not be dated earlier than the dateof the auditor's report. Choice "b" is incorrect. The auditor does not perform tests to detect illegal acts during the planning process.Choice "c" is incorrect. The auditor does obtain and evaluate evidence to support significant accounting estimates, but this occurs subsequent to initial planning.

QUESTION 356Which of the following factors most likely would influence an auditor's determination of the auditability of an entity's financial statements?

A. The complexity of the information system relevant to financial reporting.B. The existence of related party transactions.C. The adequacy of the accounting records.D. The operating effectiveness of controls.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Inadequate financial records may preclude the auditor from obtaining sufficient appropriate audit evidence.Choice "a" is incorrect. The complexity of the client's information system generally would not influence an auditor's determination of auditability, although it mightindicate the need for an information technology expert.Choice "b" is incorrect. The existence of related party transactions generally would not influence the auditor's determination of auditability.Choice "d" is incorrect. The operating effectiveness of internal controls is determined long after the decision about auditability is made.

QUESTION 357Hill, CPA, has been retained to audit the financial statements of Monday Co. Monday's predecessor auditor was Post, CPA, who has been notified by Monday thatPost's services have been terminated.Under these circumstances, which party should initiate the communications between Hill and Post?

A. Hill, the successor auditor.B. Post, the predecessor auditor.C. Monday's controller or CFO.D. The chairman of Monday's board of directors.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The initiative to communicate with the predecessor auditor rests with the successor auditor. Note, however, that the successor auditor mustfirst receive permission from the client.

Choice "b" is incorrect. The predecessor auditor should respond promptly and fully to reasonable inquiries. However, the predecessor is not responsible for initiatingcommunications. Choice "c" is incorrect. The prospective client should authorize the predecessor to respond fully to the successor's inquiries. However, the client isnot responsible for initiating communications. Choice "d" is incorrect. The prospective client should authorize the predecessor to respond fully to the successor'sinquiries. However, the client is not responsible for initiating communications.

QUESTION 358The senior auditor responsible for coordinating the fieldwork usually schedules a pre-audit conference with the audit team primarily to:

A. Give guidance to the staff regarding both technical and personnel aspects of the audit.B. Discuss staff suggestions concerning the establishment and maintenance of time budgets.C. Establish the need for using the work of specialists and internal auditors.D. Provide an opportunity to document staff disagreements regarding technical issues.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Pre-audit planning meetings are typically held to plan technical and personnel aspects of the audit. Assistants should be informed of theirresponsibilities and the objectives of the procedures that they are to perform. Choice "b" is incorrect. While staff suggestions regarding time budgets may bediscussed, this is not typically the primary reason for the meeting.Choice "c" is incorrect. Establishing the need for specialists and internal auditors may be discussed, but this is not the primary reason for the meeting. Choice "d" isincorrect. Disagreements about technical issues arise and are resolved after testing begins, not during the pre-audit conference.

QUESTION 359To obtain an understanding of a continuing client's business in planning an audit, an auditor most likely would:

A. Perform tests of details of transactions and balances.B. Review prior-year audit documentation and the permanent file for the client.C. Read specialized industry journals.D. Reevaluate the client's internal control environment.



ExplanationChoice "b" is correct. Knowledge of an entity's business is ordinarily obtained through experience with the entity or its industry and inquiry of personnel of the entity.Audit documentation from prior years may contain useful information about the nature of the business, its organizational structure, its operating characteristics, andtransactions that may require special consideration.Choice "a" is incorrect. Tests of details of transactions and balances are not performed during the planning stage of an audit.Choice "c" is incorrect. Reading industry journals would provide information about the industry in which the entity operates, but reviewing prior-year auditdocumentation and the permanent file would provide a more thorough understanding of the specific client's business. Choice "d" is incorrect. The client's internalcontrol is not reevaluated during the planning stage of an audit.

QUESTION 360In planning an audit of a new client, an auditor most likely would consider the methods used to process accounting information because such methods:

A. Influence the design of internal control.B. Affect the auditor's preliminary judgment about materiality levels.C. Assist in evaluating the planned audit objectives.D. Determine the auditor's acceptable level of audit risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor should consider the methods the entity uses to process accounting information in planning the audit because such methodsinfluence the design of internal control. The extent to which computer processing is used in significant accounting applications, as well as the complexity of theprocessing, may also influence the nature, timing, and extent of audit procedures.Choice "b" is incorrect. Materiality is a matter of professional judgment and is influenced by the auditor's perceptions of the needs of a reasonable person. It wouldnot be affected by the methods used to process accounting information.Choice "c" is incorrect. The auditor develops specific audit objectives based on financial statement assertions. The methods used to process accounting informationwould not be relevant to the development of objectives.Choice "d" is incorrect. Audit risk is the risk that the auditor may unknowingly fail to modify the opinion on financial statements that are materially misstated. Theacceptable level of audit risk is a matter of auditor judgment, but it would not be affected by the methods used to process accounting information.

QUESTION 361The existence of audit risk is recognized by the statement in the auditor's standard report that the:

A. Auditor is responsible for expressing an opinion on the financial statements, which are the responsibility of management.B. Financial statements are presented fairly, in all material respects, in conformity with GAAP.C. Audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.

D. Auditor obtains reasonable assurance about whether the financial statements are free of material misstatement.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The existence of audit risk is recognized by the statement in the standard report that the auditor obtained reasonable assurance aboutwhether the financial statements are free of material misstatement. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion onfinancial statements that are materially misstated. Choice "a" is incorrect. This statement defines the distinction between the responsibility of the auditor and that ofmanagement.Choice "b" is incorrect. The purpose of this section is to note that fair presentation is not necessarily impacted by immaterial errors.Choice "c" is incorrect. This statement explains the nature of an audit.

QUESTION 362Which of the following statements is not correct about materiality?

A. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other mattersare not important.

B. An auditor considers materiality for planning purposes in terms of the largest aggregate level of misstatements that could be material to any one of the financialstatements.

C. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgments.D. An auditor's consideration of materiality is influenced by the auditor's perception of the needs of a reasonable person who will rely on the financial statements.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Materiality levels include an overall level for each statement; however, because the statements are interrelated, and for reasons of efficiency,the auditor ordinarily considers materiality for planning purposes in terms of the smallest aggregate level of misstatements that could be considered material to anyone of the financial statements. Choice "a" is incorrect. The concept of materiality recognizes that some matters, either individually or in the aggregate, areimportant for the fair presentation of financial statements in conformity with GAAP, while other matters are not important. Choice "c" is incorrect. Materialityjudgments are made in light of the surrounding circumstances and necessarily involve both quantitative and qualitative considerations. Choice "d" is incorrect. Theauditor's consideration of materiality is influenced by his or her perception of the needs of a reasonable person relying on the financial statements.

QUESTION 363

Which of the following documentation is not required for an audit in accordance with generally accepted auditing standards?

A. A written audit plan setting forth the procedures necessary to accomplish the audit's objectives.B. An indication that the accounting records agree or reconcile with the financial statements.C. A client engagement letter that summarizes the timing and details of the auditor's planned fieldwork.D. The basis for the auditor's decision not to perform tests of controls concurrently with obtaining an understanding of internal control.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor is not required to evaluate operating effectiveness as part of obtaining an understanding of internal control, and therefore need notdocument the basis for this decision.Choice "a" is incorrect. The auditor is required to prepare a written audit plan. Choice "b" is incorrect. Audit documentation should be sufficient to show that theaccounting records agree or reconcile with the financial statements. Choice "c" is incorrect. Establishing an understanding with the client is required by GAAS, andan engagement letter is a presumptively mandatory requirement.

QUESTION 364When assessing the internal auditors' competence, the independent CPA should obtain information about the:

A. Organizational level to which the internal auditors report.B. Educational background and professional certification of the internal auditors.C. Policies prohibiting the internal auditors from auditing areas where relatives are employed.D. Internal auditors' access to records and information that is considered sensitive.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. When assessing the internal auditors' competence, the auditor should obtain information about such factors as educational level, experience,professional certification, continuing education, supervision, review, and evaluation of performance. Choice "a" is incorrect. The organizational level to which theinternal auditors report is related to their objectivity.Choice "c" is incorrect. Policies prohibiting internal auditors from auditing areas where relatives are employed are related to objectivity.Choice "d" is incorrect. Access to sensitive records and information is related to the overall objectives of the internal audit function, not to internal auditor

competence.

QUESTION 365Which of the following is required documentation in an audit in accordance with generally accepted auditing standards?

A. A flowchart or narrative of the information system relevant to financial reporting describing the recording and classification of transactions for financial reporting.B. An audit plan setting forth in detail the procedures necessary to accomplish the engagement's objectives.C. A planning memorandum establishing the timing of the audit procedures and coordinating the assistance of entity personnel.D. An internal control questionnaire identifying controls that assure specific objectives will be achieved.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. In an audit conducted in accordance with GAAS, the auditor must document the audit plan, setting forth in detail the procedures necessary toaccomplish the engagement's objectives.Choice "a" is incorrect. Documentation of the auditor's understanding of the client's internal control is required, but may take different forms. A narrative, an internalcontrol questionnaire, a flowchart, or simply a memorandum (for a small client) may be sufficient. Choice "c" is incorrect. A planning memo, while recommended, isnot required under GAAS. Choice "d" is incorrect. Documentation of the auditor's understanding of the client's internal control is required, but may take differentforms: narrative, internal control questionnaire, flowchart, or simply a memorandum (for a small client) may be sufficient. In addition, controls do not assure theachievement of objectives.

QUESTION 366In using the work of a specialist, an auditor referred to the specialist's findings in the auditor's report. This would be an appropriate reporting practice if the:

A. Client is not familiar with the professional certification, personal reputation, or particular competence of the specialist.B. Auditor, as a result of the specialist's findings, adds an explanatory paragraph emphasizing a matter regarding the financial statements.C. Auditor understands the form and content of the specialist's findings in relation to the representations in the financial statements.D. Auditor, as a result of the specialist's findings, decides to indicate a division of responsibility with the specialist.


Explanation/Reference:Explanation:Explanation

Choice "b" is correct. When expressing an unqualified opinion, the auditor generally will not refer to the work or findings of a specialist. The auditor may, however,make reference to a specialist in an explanatory paragraph if such a reference will facilitate understanding of the explanatory paragraph or of the departure from anunqualified opinion. Choice "a" is incorrect. Lack of client familiarity with the specialist does not affect the auditor's report. Also, it is the auditor (not the client) whomust be satisfied regarding the specialist's qualifications.Choice "c" is incorrect. The auditor must understand the form and content of the specialist's findings in relation to the representations in the financial statements tobe able to review the specialist's work. However, this does not affect whether or not the auditor refers to the specialist in the auditor's report.Choice "d" is incorrect. An auditor should not divide responsibility for the audit with a specialist. Further, making reference to the specialist in an unmodifiedunqualified report generally is inappropriate.

QUESTION 367The auditor with final responsibility for an engagement and one of the assistants have a difference of opinion about the results of an auditing procedure. If theassistant believes it is necessary to be disassociated from the matter's resolution, the CPA firm's procedures should enable the assistant to:

A. Refer the disagreement to the AICPA's Quality Review Committee.B. Document the details of the disagreement with the conclusion reached.C. Discuss the disagreement with the entity's management or its audit committee.D. Report the disagreement to an impartial peer review monitoring team.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Each assistant has a professional responsibility to bring to the attention of appropriate individuals in the firm, disagreements or concerns theassistant might have with respect to accounting and auditing issues that he or she believes are of significance to the financial statements or auditor's report. Inaddition, each assistant should have a right to document his or her disagreement if he or she believes it is necessary to be disassociated from the resolution of thematter.Choice "a" is incorrect. Quality control committees are primarily concerned with determining whether quality control policies and procedures are being effectivelyapplied. Generally, they would not get involved with disagreements related to specific engagements. Choice "c" is incorrect. Disagreements among an audit firm'sstaff would generally be handled internally.Discussion of such matters with the client would be inappropriate. Choice "d" is incorrect. Impartial peer review teams are primarily concerned with determiningwhether quality control policies and procedures are being effectively applied. Generally, they would not get involved with disagreements related to specificengagements.

QUESTION 368In considering materiality for planning purposes, an auditor believes that misstatements aggregating $10,000 would have a material effect on an entity's incomestatement, but that misstatements would have to aggregate $20,000 to materially affect the balance sheet. Ordinarily, it would be appropriate to design auditingprocedures that would be expected to detect misstatements that aggregate:

A. $10,000B. $15,000C. $20,000D. $30,000


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Because the statements are interrelated, the auditor ordinarily considers materiality for planning purposes in terms of the smallest aggregatelevel of misstatement that could be considered material to any one of the financial statements. Choices "b", "c", and "d" are incorrect, based on the aboveexplanation.

QUESTION 369Analytical procedures used in planning an audit should focus on:

A. Evaluating the adequacy of evidence gathered concerning unusual balances.B. Testing individual account balances that depend on accounting estimates.C. Enhancing the auditor's understanding of the client's business.D. Identifying material weaknesses in internal control.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The purpose of applying analytical procedures in planning the audit is to assist in planning the nature, timing, and extent of auditingprocedures that will be used to obtain audit evidence for specific account balances or classes of transactions. To accomplish this, the analytical procedures used inplanning the audit should focus on (a) enhancing the auditor's understanding of the client's business and the transactions and events that have occurred since thelast audit date, and (b) identifying areas that may represent specific risks relevant to the audit. Choice "a" is incorrect. Analytical procedures to assess the adequacyof evidence would be used in the final review stage.Choice "b" is incorrect. Testing individual account balances that depend on accounting estimates would be a substantive application of analytical procedures andwould not be used in the planning stages of an audit.Choice "d" is incorrect. Analytical procedures are generally not useful in detecting material weaknesses in the client's internal control.

QUESTION 370For which of the following judgments may an independent auditor share responsibility with an entity's internal auditor who is assessed to be both competent andobjective?



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Because the auditor has the ultimate responsibility to express an opinion on the financial statements, judgments about assessments of risk,the materiality of misstatements, the sufficiency of tests performed, the evaluation of significant accounting estimates, and other matters affecting the auditor'sreport should always be those of the auditor. Choices "a", "b", and "d" are incorrect, based on the above explanation.

QUESTION 371Which of the following procedures would an auditor least likely perform in planning a financial statement audit?

A. Coordinating the assistance of entity personnel in data preparation.B. Discussing matters that may affect the audit with firm personnel responsible for non-audit services to the entity.C. Selecting a sample of vendors' invoices for comparison to receiving reports.D. Reading the current year's interim financial statements.

Correct Answer: CSection: Auditing and Attestation (I) (Volume B)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Selecting a sample of vendors' invoices for comparison to receiving reports is performed during fieldwork. This is not part of the planningphase. Choice "a" is incorrect. Coordinating the assistance of entity personnel in data preparation is usually performed during the planning phase.Choice "b" is incorrect. During the planning phase, matters that may affect the audit should be discussed with firm personnel responsible for non-audit services tothe entity. Choice "d" is incorrect. During the planning phase, the auditor generally would read the current year's interim financial statements.

QUESTION 372When assessing an internal auditor's competence, a CPA ordinarily obtains information about all of the following, except:

A. Quality of audit documentation.B. Educational level and professional experience.C. The audit plan and audit procedures.D. Access to information about related parties.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The degree of access the independent auditor has to information about related parties provides no information regarding an internal auditor'scompetence. Choice "a" is incorrect. In evaluating the work of internal auditors, the independent auditor should examine, on a test basis, documentary evidence ofthe work performed by internal auditors and should consider such factors as whether the scope of the work is appropriate, the audit plan is adequate, auditdocumentation adequately documents work performed, conclusions reached are appropriate in the circumstances, and any reports prepared are consistent with theresults of the work performed.Choice "b" is incorrect. When considering the competence of internal auditors, the independent auditor should inquire about the qualifications of the internal auditstaff, including for example, consideration of the client's practices for hiring, training, and supervising internal audit staff. This includes inquiries as to the internalauditor's educational level and professional experience. Choice "c" is incorrect. In evaluating the work of internal auditors, the independent auditor should examine,on a test basis, documentary evidence of the work performed by internal auditors and should consider such factors as whether the scope of the work is appropriate,the audit plan is adequate, audit documentation adequately documents work performed, conclusions reached are appropriate in the circumstances, and any reportsprepared are consistent with the results of the work performed.

QUESTION 373When an auditor increases the assessed level of control risk because certain control activities were determined to be ineffective, the auditor most likely wouldincrease the:

A. Level of detection risk.B. Extent of tests of details.C. Level of inherent risk.D. Extent of tests of controls.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. An increase in the assessed level of control risk means that the assessed risk of material misstatement has also increased, and this requiresa corresponding decrease in detection risk to maintain the same (presumably low) level of overall audit risk. Increasing the extent of tests of details will result in areduction in detection risk. Choice "a" is incorrect. Increasing detection risk would result in a corresponding increase in overall audit risk, which is the opposite of thedesired response. Choice "c" is incorrect. The auditor cannot change the level of inherent risk, which is based on the nature of the related assertion.Choice "d" is incorrect. If the auditor has already determined that certain control activities are ineffective, increasing the extent of those tests is not likely to behelpful. The auditor needs to find a way to compensate for the increased level of risk in order to keep overall audit risk to a low level.

QUESTION 374A CPA wishes to determine how various publicly-held companies have complied with the disclosure requirements in a Statement of Financial AccountingStandards. Which of the following information sources would the CPA most likely consult for this information?

A. AICPA Accounting Trends & Techniques.B. FASB Technical Bulletins.C. AICPA Audit and Accounting Manual.D. FASB Statements of Financial Accounting Concepts.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The AICPA's Accounting Trends & Techniques is an annual survey of accounting practices followed in 600 stockholders' annual reports.Choice "b" is incorrect. FASB Technical Bulletins are considered to be a source of established accounting principles that expand upon or further clarify GAAP. Theydo not provide information regarding how various companies comply with GAAP. Choice "c" is incorrect. AICPA Audit and Accounting Guides are interpretivepublications that provide additional guidance regarding the application of auditing standards. They do not provide information regarding how various companiescomply with GAAP. Choice "d" is incorrect. FASB Statements of Financial Accounting Concepts establish the objectives and concepts for use by the FASB in

developing accounting and reporting standards. They do not provide information regarding how various companies comply with GAAP.

QUESTION 375An auditor's engagement letter most likely would include a statement regarding:

A. Management's responsibility to provide certain written representations to the auditor.B. Conditions under which the auditor may modify the preliminary judgment about materiality.C. Internal control activities that would reduce the auditor's assessment of risk.D. Materiality matters that could modify the auditor's preliminary assessment of fraud risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor is required to establish an understanding with the client, and this understanding should be documented in the form of anengagement letter. The understanding (and therefore the letter) should encompass management's responsibilities, which include providing the auditor with arepresentation letter at the conclusion of the engagement. Choices "b", "c", and "d" are incorrect. An understanding generally is not obtained with respect to specificaudit procedures, and therefore these items would not be included in an engagement letter.

QUESTION 376A successor auditor should make specific and reasonable inquiries of the predecessor auditor regarding the predecessor's:

A. Understanding of the reasons for the change in auditors.B. Methodology used in applying sampling techniques.C. Opinion on subsequent events that have occurred since the balance sheet date.D. Perception of the competency and reliance on the client's internal audit function.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The successor auditor is required to make inquiries of the predecessor auditor before accepting an engagement. These inquiries shouldinclude the predecessor's understanding as to the reasons for the change in auditors. Choice "b" is incorrect. The successor auditor would not typically inquireregarding audit methodology used during the prior audit.

Choices "c" and "d" are incorrect. The successor auditor is responsible for making his or her own judgments regarding the audit, and would not typically inquireregarding the predecessor auditor's judgments with respect to subsequent events or the internal audit function.

QUESTION 377An auditor reviews a client's accounting policies and procedures when considering which of the following planning matters?

A. Method of sampling to be used.B. Preliminary judgments about materiality levels.C. Nature of reports to be rendered.D. Understanding the client's operations and business.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor would review the client's accounting policies and procedures as part of obtaining an understanding of the client's operations andbusiness. This understanding is important because it affects the design of internal control, which in turn impacts planned auditing procedures.Choice "a" is incorrect. Although the auditor might consider the client's accounting policies and procedures when designing a sampling plan, this is not the primaryreason for the auditor's review of the client's policies and procedures.Choice "b" is incorrect. The client's accounting policies and procedures would not affect preliminary judgments about materiality, which are generally based oneither annualized interim financial statements or annual financial statements from a prior period. Choice "c" is incorrect. The client's accounting policies andprocedures would not affect the nature of reports to be rendered. The nature of reports to be rendered would be based on the type of engagement and the specificresults of that engagement.

QUESTION 378An auditor is required to obtain an understanding of the entity's business, including business cycles and reasons for business fluctuations. What is the audit purposemost directly served by obtaining this understanding?

A. To enable the auditor to accurately identify significant deficiencies in internal control.B. To assist the auditor in accurately interpreting information obtained during an audit.C. To allow the auditor to more accurately perform tests of controls.D. To decide whether it will be necessary to perform analytical procedures.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. As part of audit planning, the auditor should obtain an understanding of the entity's business. This understanding enables the auditor to betterunderstand events, transactions, and practices that may affect the financial statements, to plan and perform appropriate audit tests, and to properly understand andevaluate the results of those tests. Choice "a" is incorrect. Obtaining an understanding of the entity's business would not be particularly helpful in identifyingsignificant deficiencies in internal control. Also, such deficiencies are typically identified during the fieldwork stage of the audit, while obtaining an understanding ofthe entity's business typically occurs during planning. Choice "c" is incorrect. Obtaining an understanding of the entity's business would not result in a more accurateperformance of tests of controls. Accurate performance of audit tests is dependent upon factors such as existence of an appropriate audit trail, client cooperation,training and supervision of audit staff, etc.Choice "d" is incorrect. Analytical procedures are always required in an audit, during the planning and overall review stages.

QUESTION 379A retail entity uses electronic data interchange (EDI) in executing and recording most of its purchase transactions. The entity's auditor recognizes that thedocumentation of the transactions will be retained for only a short period of time. To compensate for this limitation, the auditor most likely would:

A. Increase the sample of EDI transactions to be selected for cutoff tests.B. Perform tests several times during the year, rather than only at year-end.C. Plan to make a 100% count of the entity's inventory at or near the year-end.D. Decrease the assessed level of control risk for the existence or occurrence assertions.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. When an entity transmits, processes, maintains, or accesses significant information electronically, some accounting data and sourcedocuments may be available only in electronic form, or only at a certain point in time. The auditor would generally perform tests of controls several times during theyear to compensate for this limitation. Choice "a" is incorrect. Increasing the sample size related to cutoff testing will not provide evidence about transactionsoccurring throughout the period under audit, since cutoff testing relates to year-end.Choice "c" is incorrect. Auditing 100% of the year-end inventory does not provide evidence about transactions occurring throughout the period under audit. Choice"d" is incorrect. Failure to retain documentation for longer periods of time would not imply that control risk is reduced. If anything, this might lead to an increase incontrol risk, making it less likely that phony transactions would be detected after the fact.

QUESTION 380An auditor assesses control risk because it:

A. Is relevant to the auditor's understanding of the control environment.

B. Provides assurance that the auditor's materiality levels are appropriate.C. Indicates to the auditor where inherent risk may be the greatest.D. Affects the level of detection risk that the auditor may accept.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor uses the assessed level of control risk (together with the assessed level of inherent risk) to determine the assessed risk ofmaterial misstatement, which in turn affects the acceptable level of detection risk for financial statement assertions. Choice "a" is incorrect. The auditor assessescontrol risk after obtaining an understanding of internal control. Assessment is not required to obtain an understanding of the control environment or any of the otherfour components of internal control. Choice "b" is incorrect. Assessment of control risk is unrelated to assessments of materiality levels.Choice "c" is incorrect. Inherent risk is assessed independently of any consideration of relevant controls.

Control risk does not affect inherent risk.

QUESTION 381As the acceptable level of detection risk decreases, an auditor may:

A. Reduce substantive testing by relying on the assessments of inherent risk and control risk.B. Postpone the planned timing of substantive tests from interim dates to the year-end.C. Eliminate the assessed level of inherent risk from consideration as a planning factor.D. Lower the assessed level of control risk.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. As the acceptable level of detection risk decreases, the assurance provided from substantive tests should increase. Consequently, the auditorshould do one or more of the following: 1) change the nature of substantive tests from a less effective to a more effective procedure, 2) change the timing of thesubstantive tests, such as performing them at year-end rather than at an interim date, or 3) change the extent of substantive tests, such as using a larger samplesize.Choice "a" is incorrect. As acceptable detection risk decreases, the extent of substantive tests should increase rather than decrease. The auditor cannot reassessinherent risk and control risk to compensate for the lower acceptable detection risk.

Choice "c" is incorrect. Inherent risk is an integral part of the risk of material misstatement and cannot be eliminated from the computation of acceptable detectionrisk. Choice "d" is incorrect. The auditor cannot lower the assessed level of control risk unless tests of controls support that assessment.

QUESTION 382Control risk should be assessed in terms of:

A. Specific controls.B. Types of potential irregularities.C. Financial statement assertions.D. Control environment factors.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The auditor identifies internal controls relevant to specific financial statement assertions, and then performs tests of controls to evaluate theireffectiveness in preventing material misstatements in those assertions. Control risk should be assessed in terms of financial statement assertions.Choice "a" is incorrect. Control risk is not assessed in terms of specific controls. Choice "b" is incorrect. Control risk is not assessed in terms of types of potentialfraud. Choice "d" is incorrect. Control risk is not assessed in terms of control environment factors.

QUESTION 383The acceptable level of detection risk is inversely related to the:

A. Assurance provided by substantive tests.B. Risk of misapplying auditing procedures.C. Preliminary judgment about materiality levels.D. Risk of failing to discover material misstatements.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The acceptable level of detection risk is inversely related to the assurance provided by substantive tests. For example, if the acceptable levelof detection risk decreases, more assurance is required from substantive tests.

Choice "b" is incorrect. The acceptable level of detection risk is determined independently of the risk of misapplying auditing procedures (non-sampling risk). Choice"c" is incorrect. The acceptable level of detection risk is determined independently of the preliminary judgment about materiality levels (tolerable error). Choice "d" isincorrect. The acceptable level of detection risk is directly related to the risk of failing to discover material misstatements (audit risk).

QUESTION 384Samples to test internal control are intended to provide a basis for an auditor to conclude whether:

A. The control activities are operating effectively.B. The financial statements are materially misstated.C. The risk of incorrect acceptance is too high.D. Materiality for planning purposes is at a sufficiently low level.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Samples to test internal control are intended to provide a basis for an auditor to conclude whether the control activities are operatingeffectively. Choice "b" is incorrect. Tests of controls may provide evidence regarding the likelihood of misstatement, but they do not provide a basis for concludingwhether the financial statements are materially misstated.Choice "c" is incorrect. The risk of incorrect acceptance is an aspect of sampling risk related to substantive tests, not tests of controls.Choice "d" is incorrect. Samples to test controls do not provide evidence regarding materiality levels for planning purposes.

QUESTION 385Which of the following factors most likely would lead a CPA to conclude that a potential audit engagement should not be accepted?

A. There are significant related party transactions that management claims occurred in the ordinary course of business.B. Internal control activities requiring the segregation of duties are subject to management override.C. Management continues to employ an inefficient system of information technology to record financial transactions.D. It is unlikely that sufficient appropriate audit evidence is available to support an opinion on the financial statements.



Choice "d" is correct. If it is unlikely that sufficient appropriate audit evidence will be available to support an opinion on the financial statements, it would be pointlessto conduct an audit. Choice "a" is incorrect. The existence of significant related party transactions would not prevent the auditor from accepting an auditengagement, regardless of the whether or not such transactions occurred in the ordinary course of business. The auditor would simply need to evaluatemanagement's methods for identifying and disclosing related party transactions, and ultimately evaluate financial statement disclosure, as part of the audit. Choice"b" is incorrect. Internal control activities are often subject to management override, but this is no reason to reject a potential audit engagement. Rather, this riskshould be assessed, and audit procedures should be designed only after taking into account the assessed level of risk. Choice "c" is incorrect. An inefficient systemof information technology for recording financial transactions may not be optimal for the company, but as long as it is an effective system (i.e., as long as it providesreliable financial reporting), it will not affect the auditor's decision regarding acceptance of a new audit engagement.

QUESTION 386Prior to commencing field work, an auditor usually discusses the general audit strategy with the client's management. Which of the following details do managementand the auditor usually agree upon at this time?

A. The specific matters to be included in the communication with those charged with governance.B. The minimum amount of misstatements that may be considered to be significant deficiencies in internal control.C. The schedules and analyses that the client's staff should prepare.D. The effects that inadequate controls may have over the safeguarding of assets.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Prior to commencing field work, the auditor would likely discuss with management any assistance desired from client staff. This is part ofestablishing an understanding with the client.Choice "a" is incorrect. Prior to commencing field work, the auditor likely would be unaware of the specific matters to be included in the communication to thosecharged with governance. Choice "b" is incorrect. While the auditor may set a preliminary measure of materiality, this is a matter of auditing judgment and would nottypically be discussed with the client. In addition, significant internal control weaknesses are reported because they indicate a potential for material misstatement,regardless of whether any actual misstatements exceed a particular threshold. Choice "d" is incorrect. Prior to commencing field work, the auditor would be unlikelyto have identified inadequate controls or evaluated their possible effects.

QUESTION 387As the acceptable level of detection risk increases, an auditor may change the:

A. Assessed level of control risk from low to high.B. Assurance provided by tests of controls by using a larger sample size than planned.C. Timing of substantive tests from year-end to an interim date.D. Nature of substantive tests from a less effective to a more effective procedure.

Correct Answer: CSection: Auditing and Attestation (I) (Volume C)Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. As the acceptable level of detection risk increases, the assurance (effectiveness) that must be provided from substantive tests can decrease.Thus the auditor may change the timing of substantive tests from year-end to an interim date. Choice "a" is incorrect. The assessed level of control risk is used todetermine the acceptable level of detection risk, not vice versa.Choice "b" is incorrect. The acceptable level of detection risk affects the nature, timing and extent of substantive audit procedures, not control tests. Choice "d" isincorrect. As the acceptable level of detection risk increases, the level of assurance required from substantive tests decreases, and therefore the substantiveprocedures need not be as effective.

QUESTION 388An auditor plans to apply substantive tests to the details of asset and liability accounts as of an interim date rather than as of the balance sheet date. The auditorshould be aware that this practice:

A. Eliminates the use of certain statistical sampling methods that would otherwise be available.B. Presumes that the auditor will reperform the tests as of the balance sheet date.C. Should be especially considered when there are rapidly changing economic conditions.D. Potentially increases the risk that errors that exist at the balance sheet date will not be detected.

Correct Answer: DSection: Auditing and Attestation (I) (Volume C)Explanation

Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Applying substantive tests to the details of asset and liability accounts as of an interim date increases risk, as it is possible that errors willoccur between the date of interim testing and the balance sheet date. For this reason, the auditor generally selects for interim examination only accounts that arereasonably predictable with respect to amount, relative significance, and composition, and must also identify procedures sufficient to extend interim conclusions toyear-end.Choice "a" is incorrect. The use of statistical sampling methods is not affected by the timing of audit procedures.Choice "b" is incorrect. Applying substantive tests to the details of asset and liability accounts as of an interim date increases risk, but it does not require all suchtests to be reperformed. Instead, the auditor should perform procedures designed to extend the interim conclusions to year-end. Such procedures should be less inscope than the initial procedures performed at interim; otherwise, it would make more sense to have simply applied the more extensive tests at year-end in the firstplace.Choice "c" is incorrect. Generally, accounts selected for interim examination should be reasonably predictable with respect to amount, relative significance, and

composition. Rapidly changing economic conditions might affect the valuation, significance, or composition of certain assets or liabilities, and therefore would maketesting at interim less likely.

QUESTION 389Regardless of the assessed level of control risk, an auditor would perform some:

A. Tests of controls to determine the effectiveness of internal control.B. Analytical procedures to verify the design of internal control.C. Substantive tests to restrict detection risk for significant transaction classes.D. Dual purpose tests to evaluate both the risk of monetary misstatement and preliminary control risk.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Regardless of the assessed level of control risk, an auditor would perform some level of substantive tests to restrict detection risk forsignificant transaction classes. Even with the lowest possible assessed level of control risk, substantive testing cannot be entirely eliminated for significanttransaction classes or balances. Choice "a" is incorrect. An auditor generally would not perform tests of controls if it would not be efficient to do so.Choice "b" is incorrect. Analytical procedures are substantive audit procedures used by the auditor to test account balances, not to verify the design of internalcontrols. Choice "d" is incorrect. Dual purpose tests are often performed because they increase audit efficiency, but they are not required to be performed in everycase.

QUESTION 390In assessing the competence of a client's internal auditor, an independent auditor most likely would consider the:

A. Internal auditor's compliance with professional internal auditing standards.B. Client's policies that limit the internal auditor's access to management salary data.C. Evidence supporting a low assessed level of control risk.D. Results of ratio analysis that may identify unusual transactions and events.

Correct Answer: ASection: Auditing and Attestation (I) (Volume C)Explanation


Choice "a" is correct. In assessing the competence of a client's internal auditor, an independent auditor would consider the internal auditor's compliance withprofessional auditing standards. Such compliance could be evaluated by reviewing the audit plan and auditing procedures used by the internal auditor, as well as byassessing the quality of audit documentation provided. Choice "b" is incorrect. The internal auditor's access to management salary data has no bearing on his or hercompetency.Choice "c" is incorrect. The external auditor's assessment of control risk might be based in part on the existence and effectiveness of an internal audit group, butsuch assessment would not provide information regarding the competency of the internal auditor. Choice "d" is incorrect. Ratio analysis might be used to identifyunusual transactions or events, but it would not provide information regarding the competency of the internal auditor.

QUESTION 391When an auditor increases the assessed level of control risk because certain control activities were determined to be ineffective, the auditor would most likelyincrease the:

A. Extent of tests of controls.B. Level of detection risk.C. Extent of tests of details.D. Level of inherent risk.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. As the assessed level of control risk increases, the acceptable level of detection risk for financial statement assertions decreases. To attain adecreased level of detection risk, greater assurance is needed from substantive tests. Increasing the extent of tests will provide greater assurance.Choice "a" is incorrect. Tests of controls are used to assess the level of control risk. Once such assessment is made, there is no need to perform further tests ofcontrols. Choice "b" is incorrect. As the assessed level of control risk increases, the acceptable level of detection risk decreases. In this way, the auditor can keeptotal audit risk to an acceptable level. Choice "d" is incorrect. Inherent risk is based on the nature of the assertion and cannot be changed.

QUESTION 392A successor auditor is required to attempt communication with the predecessor auditor prior to:

A. Performing test of controls.B. Testing beginning balances for the current year.C. Making a proposal for the audit engagement.D. Accepting the engagement.

Correct Answer: DSection: Auditing and Attestation (I) (Volume C)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "d" is correct. A successor auditor is required to attempt communication with the predecessor auditor prior to accepting a new engagement. Choice "a" isincorrect. A successor auditor is required to attempt communication with the predecessor auditor prior to accepting a new engagement. This certainly implies thatsuch attempt will be made before any audit tests are performed; however, the requirement is stated in reference to the date of acceptance.Choice "b" is incorrect. A successor auditor is required to attempt communication with the predecessor auditor prior to accepting a new engagement. This certainlyimplies that such attempt will be made before any audit tests are performed; however, the requirement is stated in reference to the date of acceptance.Choice "c" is incorrect. A successor auditor is not required to attempt communication with the predecessor auditor prior to making a proposal for the auditengagement (remember that more than one auditor may be bidding for the engagement -- and it wouldn't be reasonable to expect the predecessor auditor torespond to all bidders). However, once a successor has been selected, that auditor must attempt communication with the predecessor auditor before actuallyaccepting the engagement.

QUESTION 393If the business environment is experiencing a recession, the auditor most likely would focus increased attention on which of the following accounts?

A. Purchase returns and allowances.B. Allowance for doubtful accounts.C. Common stock.D. Noncontrolling interest of a subsidiary purchased during the year.

Correct Answer: BSection: Auditing and Attestation (I) (Volume C)Explanation

Explanation/Reference:Explanation:ExplanationChoice "b" is correct. During an economic downturn, it is more likely that customers will default on payments owed. The auditor should therefore focus increasedattention on the allowance for doubtful accounts, to ensure that it has been adjusted to appropriately reflect this increased risk. Choice "a" is incorrect. A recessionis not likely to affect purchase returns and allowances, though it might result in a decline in purchases.Choice "c" is incorrect. A recession is not likely to directly affect the common stock account. Choice "d" is incorrect. A recession is not likely to directly affect a pre-existing, noncontrolling interest in a subsidiary.

QUESTION 394The existence of audit risk is recognized by the statement in the auditor's standard report that the auditor:

A. Obtains reasonable assurance about whether the financial statements are free of material misstatement.

B. Assesses the accounting principles used and also evaluates the overall financial statement presentation.C. Realizes some matters, either individually or in the aggregate, are important while other matters are not important.D. Is responsible for expressing an opinion on the financial statements, which are the responsibility of management.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The existence of audit risk is recognized by the statement in the auditor's standard report that the auditor obtains "reasonable assurance" (asopposed to absolute assurance) about whether the financial statements are free of material misstatement. The existence of audit risk (the risk that the auditor mayunknowingly fail to appropriately modify his or her opinion on materially misstated financial statements) is implied in this statement. Choice "b" is incorrect.Assessing the accounting principles used and evaluating the overall financial statement presentation relate to determining that the statements have been preparedin conformity with GAAP, not to recognizing the existence of audit risk. Choice "c" is incorrect. Realizing that some matters are more important than othersillustrates the concept of materiality; however, this is not a statement included in the auditor's standard report. Choice "d" is incorrect. Indicating that the financialstatements are the responsibility of management while the auditor's responsibility is to express an opinion on those financial statements delineates responsibilityrather than illustrating the concept of audit risk.

QUESTION 395As the acceptable level of detection risk decreases, the assurance directly provided from:

A. Substantive tests should increase.B. Substantive tests should decrease.C. Tests of controls should increase.D. Tests of controls should decrease.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. As the acceptable level of detection risk (the risk that an auditor will not detect a material misstatement that exists in an assertion) decreases,the assurance directly provided from substantive tests should increase. The level of detection risk will decline as the benefit of direct tests increases.Choice "b" is incorrect. If the assurance directly provided from substantive tests decreased, detection risk would increase because the direct tests have becomeless beneficial. Choices "c" and "d" are incorrect. Changing the extent of tests of controls does not affect the level of detection risk.

QUESTION 396On the basis of audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk, and therefore the risk of materialmisstatement, from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would:

A. Increase inherent risk.B. Increase materiality levels.C. Decrease substantive testing.D. Decrease detection risk.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Decrease "detection risk." Overall audit risk is made up of the risk of material misstatement and detection risk. The risk of materialmisstatement is itself comprised of two separate risks, inherent risk and control risk. When the assessed level of control risk is increased, the risk of materialmisstatement also increases, and detection risk must be decreased to achieve an overall audit risk level that is substantially the same as the planned audit risklevel. Choice "a" is incorrect. The auditor cannot change inherent risk. Choice "b" is incorrect. The established materiality level is not a component of overall auditrisk. Choice "c" is incorrect. If the assurance directly provided from substantive tests decreased, detection risk would increase because direct tests have becomeless beneficial.

QUESTION 397Which of the following would an auditor most likely use in determining the auditor's preliminary judgment about materiality?

A. The results of the initial assessment of control risk.B. The anticipated sample size for planned substantive tests.C. The entity's financial statements of the prior year.D. The assertions that are embodied in the financial statements.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The auditor would most likely use the entity's financial statements of the prior year in the preliminary determination of materiality. The prioryear financial statements would be a good starting point in estimating the current year's expected results, especially for a continuing client.

Choice "a" is incorrect. The assessment of control risk affects the design of audit procedures but is not relevant in determining materiality.Choice "b" is incorrect. The anticipated sample size for planned substantive tests is set after the preliminary materiality level is determined.Choice "d" is incorrect. Management assertions embodied in the financial statements have little relationship to materiality.

QUESTION 398Holding other planning considerations equal, a decrease in the amount of misstatements in a class of transactions that an auditor could tolerate most likely wouldcause the auditor to:

A. Apply the planned substantive tests prior to the balance sheet date.B. Perform the planned auditing procedures closer to the balance sheet date.C. Increase the assessed level of control risk for relevant financial statement assertions.D. Decrease the extent of auditing procedures to be applied to the class of transactions.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. A decrease in the amount of misstatements that the auditor can tolerate will cause the auditor to modify the nature, timing and/or extent ofauditing procedures. Performing the planned procedures closer to the balance sheet date is a timing modification that addresses this change.Choice "a" is incorrect. The auditor would perform substantive procedures before year-end if the amount of misstatements the auditor could tolerate wereincreased. The earlier in the year that the auditor performs substantive testing, the greater the incremental risk the auditor accepts regarding the year-end financialstatements.Choice "c" is incorrect. A change in the level of tolerable misstatement does not have a direct effect on the assessed level of control risk.Choice "d" is incorrect. A decrease in the amount of misstatements that can be tolerated would necessitate an increase in the extent of auditing procedures.

QUESTION 399When issuing an unqualified opinion, the auditor who evaluates the audit findings should be satisfied that the:


A. Amount of known misstatement is documented in the management representation letter.

B. Estimate of the total misstatement is less than a material amount.C. Amount of known misstatement is acknowledged and recorded by the client.D. Estimate of the total likely misstatement includes the adjusting entries already recorded by the client.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. An unqualified opinion states that the financial statements are presented fairly, in all material respects. Accordingly, if the auditor believes thattotal misstatement (including both known and likely misstatements) is immaterial, an unqualified opinion is appropriate.Choice "a" is incorrect. Documenting misstatements in the management representation letter is not required, nor would it eliminate the need to modify the opinion ifthe known misstatements were material.Choice "c" is incorrect. Even if the client adjusts the financial statements to correct known misstatements, the auditor still must feel comfortable that any remainingunidentified misstatements would not be material to the financial statements before rendering an unqualified opinion.Choice "d" is incorrect. An auditor is not concerned with misstatements already corrected by the client. It is the auditor's estimate of uncorrected--and perhapsunknown--errors that affects the type of opinion rendered.

QUESTION 400Which of the following procedures would an auditor most likely include in the planning phase of a financial statement audit?

A. Obtain an understanding of the entity's risk assessment process.B. Identify specific internal control activities designed to prevent fraud.C. Evaluate the reasonableness of the entity's accounting estimates.D. Perform cutoff tests of the entity's sales and purchases.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. In all audits, the auditor should obtain a sufficient understanding of each of the five components of internal control in order to properly plan theaudit. The entity's risk assessment process is one of the five components of internal control. Choice "b" is incorrect. Identification and testing of specific controlactivities generally occurs during the performance of the audit.Choice "c" is incorrect. Evaluating the reasonableness of accounting estimates generally occurs during the performance of the audit.Choice "d" is incorrect. Cutoff testing of sales and purchases generally occurs during the performance of the audit.

QUESTION 401In designing a written audit plan, an auditor should establish specific audit objectives that relate primarily to the:

A. Timing of audit procedures.B. Cost-benefit of gathering evidence.C. Selected audit techniques.D. Financial statement assertions.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. In designing a written audit plan, an auditor should establish specific audit objectives that relate primarily to the financial statement assertions.Choice "a" is incorrect. Although the timing of audit procedures is an important consideration in designing a written audit plan, obtaining audit evidence relating tothe financial statement assertions is the primary objective.Choice "b" is incorrect. The cost-benefit of gathering evidence is an important consideration in establishing a written audit plan, but audit objectives are not basedon such considerations. Choice "c" is incorrect. The specific audit objectives should relate primarily to financial statement assertions. Selected audit techniques arethen developed in order to meet the identified objectives.

QUESTION 402Which of the following is not a type of financial statement assertion?

A. Rights and obligations.B. Fairness and accuracy.C. Valuation and allocation.D. Understandability and classification.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. "Fairness and accuracy" is not a type of financial statement assertion. Choices "a", "c", and "d" are incorrect. The assertions include:Rights and obligations

Valuation and allocationUnderstandability and classification

QUESTION 403Which of the following factors most likely would influence an auditor's determination of the auditability of an entity's financial statements?

A. The complexity of the accounting system.B. The existence of related party transactions.C. The adequacy of the accounting records.D. The operating effectiveness of control activities.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. An auditor cannot audit inadequate accounting records (i.e., records that do not exist or are so poor that they cannot be relied upon). Choices"a" and "b" are incorrect. The following factors would be considered when accepting an audit engagement and might require extensions of audit work, but are notfactors that would prevent the financial statements from being audited:A. The complexity of the accounting system.B. The existence of related party transactions.Choice "d" is incorrect. The operating effectiveness of control activities does not affect the auditability of financial statements, and it is not considered whenaccepting an audit engagement.

QUESTION 404Which of the following auditor concerns most likely could be so serious that the auditor concludes that a financial statement audit cannot be conducted?

A. The entity has no formal written code of conduct.B. The integrity of the entity's management is suspect.C. Procedures requiring segregation of duties are subject to management override.D. Management fails to modify prescribed controls for changes in conditions.



ExplanationChoice "b" is correct. An auditor's faith in the integrity of management is of the utmost importance in performing a financial statement audit. When an auditor isconcerned that the integrity of management is suspect, the situation is serious enough to prevent the auditor from performing the audit.Choice "a" is incorrect. A lack of a written code of conduct is not unusual in a small company and certainly would not prevent an audit from being performed. Choice"c" is incorrect. Procedures requiring segregation of duties are almost always subject to management override, even in the best internal control system. Choice "d"is incorrect. An auditor would simply modify the appropriate audit procedures when management fails to modify prescribed controls for changes in conditions.

QUESTION 405In developing an overall audit strategy, an auditor should consider:

A. Whether the allowance for sampling risk exceeds the achieved upper precision limit.B. Findings from substantive tests performed at interim dates.C. Whether the inquiry of the client's attorney identifies any litigation, claims, or assessments not disclosed in the financial statements.D. Preliminary evaluations of materiality, audit risk, and internal control.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. In developing an overall audit strategy, an auditor should consider preliminary evaluations of materiality, audit risk, and internal control. Choice"a" is incorrect. Evaluation of results from sampling applications would be performed during fieldwork, after the planning process has been completed. Choice "b" isincorrect. Findings from interim audit testing would be considered during fieldwork, after the planning process has been completed. Choice "c" is incorrect. Inquiry ofa client's attorney and evaluation of the attorney's response is performed during fieldwork, after the planning process has been completed.

QUESTION 406A retailing entity uses the Internet to execute and record its purchase transactions. The entity's auditor recognizes that the documentation of details of transactionswill be retained for only a short period of time. To compensate for this limitation, the auditor most likely would:

A. Compare a sample of paid vendors' invoices to the receiving records at year-end.B. Plan for a large measure of tolerable misstatement in substantive tests.C. Perform tests several times during the year, rather than only at year-end.D. Increase the sample of transactions to be selected for cutoff tests.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. When an entity transmits, processes, maintains, or accesses significant information electronically, some accounting data and sourcedocuments may be available only in electronic form, or only at a certain point in time. The auditor would generally perform tests of controls several times during theyear to compensate for this limitation. Choice "a" is incorrect. Comparing a sample of paid vendors' invoices to receiving records provides evidence that thecompany received the goods for which it paid, but only if records are available in sufficient detail to make such a comparison. If detailed records are retained foronly a short period of time, such comparisons would need to be performed throughout the year, not just at year-end.Choice "b" is incorrect. The auditor's judgment as to an appropriate level of tolerable misstatement is based on considerations of materiality and audit risk.Increasing this level implies that the auditor is willing to accept a larger error, which would not be an appropriate response to the limitation described.Choice "d" is incorrect. Increasing the sample size related to cutoff testing will not provide evidence about transactions occurring throughout the period under audit,since cutoff testing relates to year-end.

QUESTION 407Prior to commencing fieldwork, an auditor usually discusses the general audit strategy with the client's management. Which of the following matters do the auditorand management agree upon at this time?

A. The appropriateness of the entity's plans for dealing with adverse economic conditions.B. The determination of the fraud risk factors that exist within the client's operations.C. The control weaknesses to be included in the communication with those charged with governance.D. The coordination of the assistance of the client's personnel in data preparation.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Prior to commencing fieldwork, an auditor would establish an understanding with the client as to the services to be performed and the overallaudit strategy. This understanding may include arrangements involving the conduct of the engagement, such as timing, client assistance, and the availability ofdocuments. Choice "a" is incorrect. The auditor does not evaluate the appropriateness of the entity's plans for dealing with adverse economic conditions prior tocommencing fieldwork. The auditor might consider this as part of evaluating the client's ability to continue as a going concern, but this would not occur prior tocommencing fieldwork.Choice "b" is incorrect. Determination of existing fraud risk factors is generally made during the fieldwork stage of the audit, as information and evidence isobtained. Also, fraud risk factors are assessed by the auditor, and would not necessarily be agreed upon with management. Choice "c" is incorrect. Identificationand evaluation of control weaknesses generally occurs during the fieldwork stage of the audit, as information and evidence is obtained, not prior to thecommencement of fieldwork.

QUESTION 408An auditor's engagement letter most likely would include a statement that:

A. Lists potential significant deficiencies discovered during the prior year's audit.B. Explains the analytical procedures that the auditor expects to apply.C. Describes the auditor's responsibility to evaluate going concern issues.D. Limits the auditor's responsibility to detect errors and fraud.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor's engagement letter typically includes discussion of limitations of the engagement, such as the fact that the auditor will obtain onlyreasonable assurance, and therefore a material misstatement may remain undetected. Choice "a" is incorrect. An auditor's engagement letter typically covers theobjectives of the engagement, management's responsibilities, the auditor's responsibilities, limitations of the engagement, and other matters involving the conductof the audit. Potential significant deficiencies discovered during the prior year's audit would not typically be included in the engagement letter.Choice "b" is incorrect. While the auditor's engagement letter might include a discussion of the overall audit strategy, it typically would not include specific auditprocedures. Choice "c" is incorrect. While the auditor's engagement letter might include a discussion of the auditor's responsibilities, this is usually discussed infairly general terms. An engagement letter would not describe the auditor's responsibility with respect to specific issues (such as going concern issues).

QUESTION 409Which of the following statements is correct concerning materiality in a financial statement audit?

A. Analytical procedures performed during an audit's review stage usually decrease materiality levels.B. If the materiality amount used in evaluating audit findings increases from the amount used in planning, the auditor should apply additional substantive tests.C. The auditor's materiality judgments generally involve quantitative, but not qualitative, considerations.D. Materiality levels are generally considered in terms of the smallest aggregate level of misstatement that could be considered material to any one of the financial

statements.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Because the financial statements are interrelated, materiality levels are generally considered in terms of the smallest level of misstatementthat could be material to any one of the financial statements.Choice "a" is incorrect. Analytical procedures are performed during an audit's review stage to evaluate the overall financial statement presentation and to assess the

conclusions reacheD. They generally would not result in a change in materiality levels. Choice "b" is incorrect. If the materiality amount used in evaluating auditfindings increases from the amount used in planning, the auditor should consider whether the audit plan needs to be modified.Typically, an increase in materiality levels would result in a decrease in audit risk, which would result in less substantive testing, not more.Choice "c" is incorrect. Qualitative considerations may lead to situations in which misstatements that do not exceed materiality limits are still likely to influence theeconomic decisions of users. In such cases, an otherwise immaterial misstatement is deemed to be material.

QUESTION 410Which of the following is an analytical procedure that an auditor most likely would perform when planning an audit?

A. Confirming bank balances with the financial institutions.B. Scanning accounts receivable for amounts over credit limits.C. Recalculating inventory extensions of physical inventory counts.D. Comparing the current-year account balances for conformity with predictable patterns.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. During planning, analytical procedures consist of a review of data aggregated at a high level, with an objective of enhancing the auditor'sunderstanding of the client. Comparing the current-year account balances for conformity with predictable patterns would fulfill this purpose.Choice "a" is incorrect. Confirmation of bank balances is a substantive audit procedure (not an analytical procedure) that would be performed during the fieldworkstage of the audit. Choice "b" is incorrect. Scanning accounts receivable for amounts over credit limits is a detailed procedure related to one specific account, and itwould be performed during the fieldwork stage of the audit.Choice "c" is incorrect. Recalculating inventory extensions of physical inventory counts is a detailed procedure related to one specific account, and it would beperformed during the fieldwork stage of the audit.

QUESTION 411An auditor intends to use the work of an actuary who has a relationship with the client. Under these circumstances, the auditor:

A. Is required to disclose the contractual relationship in the auditor's report.B. Should assess the risk that the actuary's objectivity might be impaired.C. Is not permitted to rely on the actuary because of a lack of independence.D. Should communicate this matter to those charged with governance as a significant deficiency in internal control.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. While a specialist who is unrelated to the client will provide the auditor with greater assurance of reliability, a specialist who is related to theclient may be acceptable in certain circumstances. In such situations, the auditor would likely perform additional procedures to verify objectivity.Choice "a" is incorrect. If the auditor is expressing a standard unqualified opinion, no reference would be made to the specialist in the auditor's report. Choice "c" isincorrect. While a specialist who is unrelated to the client will provide the auditor with greater assurance of reliability, a specialist who is related to the client may beacceptable in certain circumstances.Choice "d" is incorrect. The fact that the actuary has a relationship with the client is not considered to be a significant deficiency in internal control.

QUESTION 412Before applying principal substantive tests to an entity's accounts receivable at an interim date, an auditor should:

A. Consider the likelihood of assessing the risk of incorrect rejection too low.B. Project sampling risk at the maximum for tests covering the remaining period.C. Ascertain that accounts receivable are immaterial to the financial statements.D. Assess the difficulty in controlling the incremental audit risk.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. When audit procedures are performed before year-end, the auditor must assess the incremental risk involved and determine whethersufficient alternative procedures exist to extend the interim conclusions to year-end. Choice "a" is incorrect. The risk of incorrect rejection relates to the efficiency ofaudit testing, since an item that is initially (and erroneously) rejected will be subject to additional audit testing that should correct the error. The likelihood ofassessing this risk lower than it should be does not affect the auditor's decision regarding the appropriate timing of audit work. Choice "b" is incorrect. When auditprocedures are performed before year-end, the auditor must assess the incremental risk involved, but this risk would not necessarily be assessed at the maximumlevel.Choice "c" is incorrect. Interim testing may be performed on material accounts, as long as the auditor assesses the incremental risk involved and determineswhether sufficient alternative procedures exist to extend the interim conclusions to year-end. Immaterial accounts would not need to be tested.

QUESTION 413Which of the following procedures would a CPA most likely perform in the planning stage of a financial statement audit?

A. Obtain representations from management regarding the availability of all financial records.B. Communicate with those charged with governance concerning the prior year's audit adjustments.

C. Make inquiries of the client's attorney regarding pending and threatened litigation and assessments.D. Compare recorded financial information with anticipated results from budgets and forecasts.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The planning process should include application of analytical procedures, such as comparison of the financial statements with budgeted oranticipated results. Choice "a" is incorrect. Management representations are typically obtained at the end of the audit, not during the planning stage.Choice "b" is incorrect. Assuming all of those charged with governance are not also involved with managing the entity, the auditor is required to communicate withthose charged with governance concerning adjustments arising from the current year's audit, not adjustments from the previous year.Choice "c" is incorrect. Inquiries are typically made of the client's attorney during the fieldwork stage of the audit, not during the planning stage.

QUESTION 414An auditor is required to establish an understanding with a client regarding the services to be performed for each engagement. This understanding generallyincludes:

A. The auditor's responsibility for determining the preliminary judgments about materiality and audit risk factors.B. Management's responsibility for identifying mitigating factors when the auditor has doubt about the entity's ability to continue as a going concern.C. The auditor's responsibility for ensuring that those charged with governance are aware of any significant deficiencies in internal control that come to the auditor's

attention.D. Management's responsibility for providing the auditor with an assessment of the risk of material misstatement due to fraud.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. An understanding between the auditor and the client generally includes the auditor's responsibilities. One of the auditor's responsibilities is toensure that those charged with governance (e.g., the audit committee) are aware of any significant deficiencies in internal control that come to the auditor'sattention.Choice "a" is incorrect. An understanding between the auditor and the client generally would not include the auditor's responsibility for determining preliminaryjudgments about materiality and audit risk factors, as an understanding generally is not obtained with respect to audit procedures or specific audit assessments.Choice "b" is incorrect. Management is not responsible for identifying mitigating factors when the auditor has doubt about the entity's ability to continue as a goingconcern. The auditor, however, would look for and evaluate mitigating factors to determine if such factors alleviate doubt about the entity's ability to continue as a

going concern. Choice "d" is incorrect. Management is not responsible for providing the auditor with an assessment of the risk of material misstatement due tofraud. The auditor, however, is responsible for making such an assessment.

Fraud and Illegal Acts

QUESTION 415Which statement is true with respect to discussion among engagement personnel regarding the risk of material misstatement due to fraud?

A. Discussion among engagement personnel regarding the risk of material misstatement due to fraud is recommended but not required.B. All key members of the audit team should be brought to a single location to facilitate communication.C. The discussion should occur only during the planning stage of the audit.D. Audit documentation must include a description of the discussion.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Audit documentation is required to include a description of the discussion among engagement personnel regarding the risk of materialmisstatement due to fraud. Choice "a" is incorrect. Discussion among engagement personnel regarding the risk of material misstatement due to fraud is required.Choice "b" is incorrect. The discussion should include all key members of the audit team, but if an audit involves more than one location, there could be multiplediscussions with team members in different locations.Choice "c" is incorrect. Communication among audit team members about the risks of material misstatement due to fraud should continue throughout the audit.

QUESTION 416Which statement is true regarding the three fraud risk factors (incentives/pressures, opportunity, and rationalization/attitude)?

A. The auditor should determine whether and to what extent fraud risk factors are present as part of the final overall review stage of the audit.B. The fraud risk factors should be discussed by engagement personnel during planning.C. The existence of all three fraud risk factors indicates that fraud has occurred.D. Lack of observation of all three fraud risk factors indicates that fraud has not occurred.



ExplanationChoice "b" is correct. During planning, the audit team is required to discuss the potential for material misstatement due to fraud, and the fraud risk factors should beincluded in that discussion.Choice "a" is incorrect. The auditor should determine whether and to what extent fraud risk factors are present during the planning stage of the audit, not during thefinal overall review stage.Choice "c" is incorrect. The existence of all three fraud risk factors does not necessarily imply that fraud has occurred, although it is indicative of a greater risk offraud. Choice "d" is incorrect. Lack of observation of all three fraud risk factors does not necessarily imply that fraud has not occurred, as one factor may besignificant enough on its own to result in fraud.

QUESTION 417Which of the following is not an inquiry the auditor should make to identify the risks of material misstatement due to fraud?

A. How management communicates to employees its views on acceptable business practices.B. Whether operating personnel have communicated to management regarding internal control and how it functions to prevent, deter, or detect material

misstatement due to fraud.C. Whether there are any particular business segments for which a risk of fraud may be more likely to exist.D. Whether management is aware of any allegations of fraud.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The auditor should inquire whether management (not operating personnel) has communicated to those charged with governance (notmanagement) regarding internal control and how it functions to prevent, deter, or detect material misstatement due to fraud. Choice "a" is incorrect. The auditorshould inquire how management communicates to employees its views on acceptable business practices. Choice "c" is incorrect. The auditor should inquirewhether there are any particular business segments for which a risk of fraud may be more likely to exist. Choice "d" is incorrect. The auditor should inquire whethermanagement is aware of any allegations of fraud.

QUESTION 418Which of the following journal entries would the auditor least likely examine in an effort to address the risk of management override of controls?

A. A journal entry made to record recurring periodic accounting estimates.B. A journal entry made by an individual who does not typically make journal entries.C. A journal entry recorded as a post-closing entry that has no explanation or description.D. A journal entry made to a seldom-used account.

Correct Answer: A

Section: Auditing and Attestation (I) (Volume C)Explanation

Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Inappropriate or unauthorized journal entries are often used to override controls and manipulate the financial reporting process. Periodic,recurring accounting estimates are least likely to be subject to management override since they are expected and occur regularly. Choice "b" is incorrect.Inappropriate or unauthorized journal entries are often used to override controls and manipulate the financial reporting process. A journal entry made by a personwho generally does not have that responsibility might be indicative of such management override. Choice "c" is incorrect. Inappropriate or unauthorized journalentries are often used to override controls and manipulate the financial reporting process. A journal entry recorded after closing without an appropriate explanationor description might be indicative of such management override.Choice "d" is incorrect. Inappropriate or unauthorized journal entries are often used to override controls and manipulate the financial reporting process. A journalentry made to a seldom-used account might be indicative of such management override.

QUESTION 419Which of the following is least likely to aid the auditor in evaluating the risk of improper revenue recognition due to fraud?

A. Analysis of sales commissions over the most recent five-year period.B. Comparison of sales volume, as determined from recorded revenue amounts, with production capacity.C. Trend analysis of revenues and sales returns by month.D. Comparison of revenue reported by month and by product line for the current and prior years.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Items other than revenue may affect sales commissions (e.g., changes to the commission structure), and therefore analyzing salescommissions is least likely to aid the auditor in evaluating the risk of improper revenue recognition due to fraud. Choice "b" is incorrect. An excess of sales volumeover production capacity may be indicative of the recording of fictitious sales.Choice "c" is incorrect. Analysis of sales and returns by month might indicate situations where unauthorized shipments are sent in an effort to overstate revenue.(Larger than average sales in one month would be followed by larger than average returns in the next month.) Choice "d" is incorrect. Analytical procedures usingdisaggregated revenue data may indicate unusual relationships that are indicative of fraud.

QUESTION 420An auditor has identified a risk of material misstatement due to fraud related to the inventory function. Which is least likely to be an appropriate response?

A. Observing inventory counts on an unannounced basis.

B. Requesting that management more closely monitor the inventory function.C. Assigning more experienced personnel to the engagement.D. Requesting that inventory be counted on a date close to the end of the reporting period.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. An auditor should respond to fraud risk by designing appropriate audit procedures. Requesting that management more closely monitor theinventory function does not improve the auditor's likelihood of detecting fraud. Choice "a" is incorrect. Observing inventory counts on an unannounced basisimproves the likelihood that the auditor will detect fraud, since perpetrators may be caught unaware and may be less able to hide their fraudulent activities.Choice "c" is incorrect. Assigning more experienced personnel to the engagement is an appropriate response to identified risk, since more experienced personnelmay be less likely to overlook a condition indicative of fraud.Choice "d" is incorrect. Requesting that inventory be counted on a date close to the end of the reporting period is an appropriate response to identified risk, since itminimizes the risk of manipulation of balances prior to the end of the reporting period.

QUESTION 421Which of the following factors most likely would heighten an auditor's concern about the risk of fraudulent financial reporting?

A. Large amounts of liquid assets that are easily convertible into cash.B. Low growth and profitability as compared to other entities in the same industry.C. Financial management's participation in the initial selection of accounting principles.D. An overly complex organizational structure involving unusual lines of authority.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor identifies factors indicative of potential fraud ("fraud risk factors") as part of assessing the risk of material misstatement. An overlycomplex organization structure involving unusual lines of authority provides an opportunity for fraudulent financial reporting that would heighten the auditor'sconcern. Choice "a" is incorrect. Large amounts of liquid assets that are easily convertible into cash would heighten an auditor's concern about misappropriation ofassets, not about fraudulent financial reporting.Choice "b" is incorrect. Low growth and profitability might heighten an auditor's concern if it became severe or if management faced excessive pressure to meetfinancial expectations, but would not necessarily in and of itself heighten an auditor's concern. Choice "c" is incorrect. Nonfinancial management's participation in

the selection of accounting principles might heighten the auditor's concern; financial management is expected to participate in such activities.

QUESTION 422Which of the following procedures would an auditor most likely perform during an audit engagement's overall review stage in formulating an opinion on an entity'sfinancial statements?

A. Obtain assurance from the entity's attorney that all material litigation has been disclosed in the financial statements.B. Verify the clerical accuracy of the entity's proof of cash and its bank cutoff statement.C. Determine whether inadequate provisions for the safeguarding of assets have been corrected.D. Consider whether the results of audit procedures affect the assessment of the risk of material misstatement due to fraud.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. During every stage of the audit, the auditor should consider the assessment of the risk of material misstatement. During the overall reviewstage, the auditor should consider whether the results of any of the audit procedures affect the assessment of the risk of material misstatement due to fraud.Choice "a" is incorrect. The entity's attorney does not provide assurance regarding financial statement disclosure.Choice "b" is incorrect. Verifying clerical accuracy of client schedules would be performed during the audit, not during the overall review stage. Choice "c" isincorrect. Evaluating whether control weaknesses have been corrected is not typically performed during the overall review stage.

QUESTION 423Management's attitude toward aggressive financial reporting and its emphasis on meeting projected profit goals most likely would significantly influence an entity'scontrol environment when:

A. External policies established by parties outside the entity affect its accounting practices.B. Management is dominated by one individual who is also a shareholder.C. Internal auditors have direct access to the board of directors and the entity's management.D. Those charged with governance are active in overseeing the entity's financial reporting policies.



Choice "b" is correct. When management is dominated by one individual who is also a shareholder, there may be an opportunity for management to override controlprocedures. Choice "a" is incorrect. Influence of external parties serves an oversight role that strengthens the control environment and minimizes the effect ofmanagement's attitude. Choice "c" is incorrect. Existence of internal auditors with direct access to the board of directors strengthens the control environment andlessens the effect of management's attitude. Choice "d" is incorrect. Active participation of those charged with governance serves an oversight role that strengthensthe control environment and lessens the effect of management's attitude.

QUESTION 424Which of the following characteristics most likely would heighten an auditor's concern about the risk of material misstatements in an entity's financial statements?

A. The entity's industry is experiencing declining customer demand.B. Employees who handle cash receipts are not bonded.C. Bank reconciliations usually include in-transit deposits.D. Equipment is often sold at a loss before being fully depreciated.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. In assessing the risk related to material misstatements in an entity's financial statements, the auditor would consider situations that threatenfinancial stability or profitability, since such situations might provide an incentive to fraudulently misstate the financial statements. Included as one of thesecharacteristics is declining customer demand. Choice "b" is incorrect. Even though the bonding of employees who handle cash is recommended, it is not asignificant characteristic in assessing the risk related to material misstatement in an entity's financial statements.Choice "c" is incorrect. Bank reconciliations with in-transit deposits are not unusual and would not heighten the auditor's concern about the risk of materialmisstatement. In-transit deposits can be verified with the bank at a later date.Choice "d" is incorrect. Since depreciation does not adjust an asset to market value, the sale of equipment at a loss before being fully depreciated is not unusualand would not heighten an auditor's concern.

QUESTION 425Which of the following characteristics most likely would heighten an auditor's concern about the risk of intentional manipulation of financial statements?

A. Turnover of senior accounting personnel is low.B. Insiders recently purchased additional shares of the entity's stock.C. Management places substantial emphasis on meeting earnings projections.D. The rate of change in the entity's industry is slow.

Correct Answer: CSection: Auditing and Attestation (I) (Volume C)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Excessive pressure on management to meet financial targets is a fraud risk factor that would heighten an auditor's concern about the risk ofintentional manipulation of financial statements.Choice "a" is incorrect. Low turnover would reduce the auditor's concern about intentional manipulation of the financial statements.Choice "b" is incorrect. Insider purchases of company stock would not be a factor that would cause any particular concerns about intentional manipulation offinancial statements. Choice "d" is incorrect. A slow rate of change in the entity's industry would reduce the auditor's concern about the risk of intentionalmanipulation of the financial statements.

QUESTION 426Which of the following statements reflects an auditor's responsibility for detecting errors and fraud?

A. An auditor is responsible for detecting employee errors and fraud, but not for discovering fraud involving employee collusion or management override.B. An auditor should plan the audit to detect errors and fraud that are caused by departures from GAAP.C. An auditor is not responsible for detecting errors and fraud unless the application of GAAS would result in such detection.D. An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor should assess the risk that errors and fraud may cause the financial statements to contain a material misstatement. Based on thatassessment, the auditor should design the audit to provide reasonable assurance of detecting material errors and fraud. Choice "a" is incorrect. An auditor isresponsible for designing the audit to provide reasonable assurance of detecting material misstatement. This responsibility is the same regardless of the cause ofthe misstatement. The presence of employee collusion or management override does not change the auditor's responsibility, although it might explain why aproperly planned and executed audit did not result in the discovery of material fraud. Choice "b" is incorrect. The audit should be designed to detect material errorsand fraud, regardless of the cause.Choice "c" is incorrect. The auditor is not "responsible for detecting errors and fraud," but is responsible for designing the audit to provide reasonable assurance ofdetecting material misstatement, whether due to errors or fraud. Note that the auditor's responsibility relates to the design and execution of the audit, and that evenan audit performed in accordance with GAAS may miss a material misstatement.

QUESTION 427During the annual audit of Ajax Corp., a publicly held company, Jones, CPA, a continuing auditor, determined that illegal political contributions had been madeduring each of the past seven years, including the year under audit. Jones notified the board of directors about the illegal contributions, but they refused to take anyaction because the amounts involved were immaterial to the financial statements.

Jones should reconsider the intended degree of reliance to be placed on the:

A. Letter of audit inquiry to the client's attorney.B. Prior years' audit plan.C. Management representation letter.D. Preliminary judgment about materiality levels.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The auditor should consider the implications of an illegal act in relation to other aspects of the audit, particularly the reliability ofrepresentations of management. Choice "a" is incorrect. The integrity of the client's attorney would not necessarily be affected by illegal acts performed by the client.Choice "b" is incorrect. The prior year audit plan would not be affected by the discovery of illegal acts in past years.Choice "d" is incorrect. The auditor should consider the quantitative and qualitative materiality of the illegal act. However, this does not change the preliminaryjudgment about materiality levels.

QUESTION 428Which of the following circumstances most likely would cause an auditor to consider whether material misstatements exist in an entity's financial statements?

A. Management places little emphasis on meeting earnings projections.B. The board of directors makes all major financing decisions.C. Significant deficiencies in internal control previously communicated to management are not corrected.D. Transactions selected for testing are not supported by proper documentation.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Vouching recorded transactions to supporting documentation provides support for the occurrence assertion. The lack of supportingdocumentation calls into question the occurrence of the transactions under examination. Choice "a" is incorrect. Little emphasis on meeting earnings projectionswould be considered a positive factor in preventing material misstatements from occurring. Choice "b" is incorrect. As the representatives of shareholder interests,an active board of directors is considered a positive control.Choice "c" is incorrect. The existence of significant deficiencies in internal control may represent a conscious decision by management to accept that degree of risk

because of cost or other considerations.Therefore, although failure to correct such deficiencies is considered a fraud risk factor, the auditor is more likely to be concerned about transactions that are notsupported by proper documentation.

QUESTION 429An auditor concludes that a client has committed an illegal act that has not been properly accounted for or disclosed. The auditor should withdraw from theengagement if the:

A. Auditor is precluded from obtaining sufficient appropriate evidence about the illegal act.B. Illegal act has an effect on the financial statements that is both material and direct.C. Auditor cannot reasonably estimate the effect of the illegal act on the financial statements.D. Client refuses to accept the auditor's report as modified for the illegal act.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor should withdraw from the engagement if the client refuses to accept the auditor's modified report.Choice "a" is incorrect. If the auditor is precluded from obtaining sufficient evidence, the auditor should consider disclaiming an opinion.Choice "b" is incorrect. The auditor must consider the effects of a direct material illegality on the financial statements and on other aspects of the audit, but need notwithdraw from the engagement.Choice "c" is incorrect. If the auditor cannot estimate the effect of the illegal act on the financial statements, the auditor should consider disclaiming an opinion.

QUESTION 430An auditor who discovers that client employees have committed an illegal act that has a material effect on the client's financial statements most likely wouldwithdraw from the engagement if:

A. The illegal act is a violation of generally accepted accounting principles.B. The client does not take the remedial action that the auditor considers necessary.C. The illegal act was committed during a prior year that was not audited.D. The auditor has already assessed control risk at a high level.



Explanation:ExplanationChoice "b" is correct. The auditor may conclude that withdrawal is necessary if the client does not take the remedial action that the auditor considers necessary inthe circumstances, even when the illegal act is not material to the financial statements. Choice "a" is incorrect. Whether or not the illegal act is a violation of GAAPdoes not determine the need to withdraw from the engagement.Choice "c" is incorrect. An illegal act committed in the prior year would not necessarily cause an auditor to withdraw from a current engagement.Choice "d" is incorrect. Assessment of control risk at a high level would cause an auditor to modify the nature, timing, or extent of audit procedures, but would notcause withdrawal from an engagement.

QUESTION 431Which of the following factors most likely would heighten an auditor's concern about the risk of fraudulent financial reporting?

A. Inability to generate cash flows from operations while reporting substantial earnings growth.B. Management's lack of interest in increasing the entity's stock trend.C. Large amounts of liquid assets that are easily convertible into cash.D. Inability to borrow necessary capital without granting debt covenants.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. An auditor's concern about the risk of fraudulent financial reporting would be heightened if the entity were unable to generate cash flows fromoperations, but still reported substantial earnings growth, since these two occurrences are somewhat inconsistent. Choice "b" is incorrect. Management's excessiveinterest in increasing the stock price and earnings trend is a fraud risk factor; lack of such interest would not cause concern. Choice "c" is incorrect. Large amountsof liquid assets that are easily convertible into cash would heighten an auditor's concern about misappropriation of assets, not about fraudulent financial reporting.Choice "d" is incorrect. The need to grant debt covenants when borrowing capital is an ordinary occurrence that would not heighten the auditor's concern.

QUESTION 432Which of the following statements is correct concerning an auditor's responsibility to report fraud?

A. The auditor is required to communicate to those charged with governance all minor fraudulent acts perpetrated by low-level employees, even if the amountsinvolved are inconsequential.

B. The disclosure of material management fraud to principal stockholders is required when both senior management and the board of directors fail to acknowledgethe fraudulent activities.

C. Fraudulent activities involving senior management of which the auditor becomes aware should be reported directly to the SEC.D. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is not ordinarily part of the

auditor's responsibility.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is not ordinarilypart of the auditor's responsibility.Choice "a" is incorrect. Only fraud that causes a material misstatement of the financial statements or fraud involving senior management should be reported tothose charged with governance.Choice "b" is incorrect. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is notordinarily part of the auditor's responsibility.Although there are certain exceptions to this rule, disclosure to stockholders is not one of them. Choice "c" is incorrect. Fraudulent activities involving seniormanagement of which the auditor becomes aware should be reported directly to those charged with governance, not to the SEC. (Only in certain limitedcircumstances would fraud be disclosed to the SEC via required regulatory reports.)

QUESTION 433Which of the following procedures would least likely result in the discovery of possible illegal acts?

A. Reading the minutes of the board of directors' meetings.B. Making inquiries of the client's management.C. Performing tests of details of transactions.D. Reviewing an internal control questionnaire.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Reviewing an internal control questionnaire provides information about control policies and procedures, but does not provide information aboutactual transactions or events that have occurred. Therefore, it is not likely to uncover any illegal acts. Choices "a" and "b" are incorrect. The auditor generally doesnot include procedures specifically to detect illegal acts, but may discover such acts through other procedures, such as reading the board minutes or makinginquiries of management or of legal counsel. Choice "c" is incorrect. Performing tests of details of transactions may provide information indicative of illegal acts,such as information regarding unauthorized or improperly recorded transactions; payments of unusual fines or penalties; payments that are unusually large orexcessive, especially those made in cash; unexplained payments; or payments for unspecified services.

QUESTION 434

Which of the following circumstances most likely would cause an auditor to suspect that there are material misstatements in an entity's financial statements?

A. Senior financial management participates in the selection of accounting principles and the determination of significant estimates.B. Supporting accounting records and files that should be readily available are not produced promptly when requested.C. Related party transactions take place in the ordinary course of business with an entity that is audited by another CPA firm.D. Senior management has an excessive interest in upgrading the entity's information technology capabilities.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Missing or unavailable documents or electronic evidence may be indicative of an intentional material misstatement in the entity's financialstatements (fraud). Choice "a" is incorrect. Senior financial management should participate in the selection of accounting principles and the determination ofsignificant estimates. This would not be indicative of material misstatements in the entity's financial statements. Choice "c" is incorrect. The auditor would need toaudit related party transactions to ensure that there is proper financial statement disclosure, but the existence of such transactions would not be indicative ofmaterial misstatements in the entity's financial statements. Choice "d" is incorrect. The fact that senior management wants to upgrade the entity's informationtechnology capabilities would not be indicative of material misstatements in the entity's financial statements.

QUESTION 435Which of the following circumstances would an auditor most likely consider a risk factor relating to misstatements arising from fraudulent financial reporting?

A. Several members of management have recently purchased additional shares of the entity's stock.B. Several members of the board of directors have recently sold shares of the entity's stock.C. The entity distributes financial forecasts to financial analysts that predict conservative operating results.D. Management is interested in maintaining the entity's earnings trend by using aggressive accounting practices.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. If the auditor becomes aware of management's interest in maintaining the entity's earnings trend by using aggressive accounting practices,this would be indicative of an attitude conducive to fraud.Choice "a" is incorrect. Management purchase of company stock does not necessarily indicate an increased risk of fraud.Choice "b" is incorrect. Sale by board members of company stock does not necessarily indicate an increased risk of fraud.

Choice "c" is incorrect. Prediction of conservative operating results is not a fraud risk factor; commitment to aggressive or unrealistic predictions would more likelybe indicative of fraud risk.

QUESTION 436Which of the following characteristics most likely would heighten an auditor's concern about the risk of material misstatement arising from fraudulent financialreporting?

A. There is a lack of interest by management in maintaining an earnings trend.B. Computer hardware is usually sold at a loss before being fully depreciated.C. Management had frequent disputes with the auditor on accounting matters.D. Monthly bank reconciliations usually include several large checks outstanding.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Frequent disputes between management and the auditor is a fraud risk factor that would heighten an auditor's concern about the risk ofmaterial misstatement arising from fraudulent financial reporting.Choice "a" is incorrect. Management's excessive interest in maintaining or increasing the stock price and earnings trend is a fraud risk factor, but management'slack of interest in maintaining an earnings trend would not constitute a fraud risk factor. Choice "b" is incorrect. Since depreciation does not adjust an asset tomarket value, the sale of computer hardware at a loss before being fully depreciated is not unusual and would not heighten an auditor's concern.Choice "d" is incorrect. Bank reconciliations with outstanding checks are not unusual and would not heighten the auditor's concern about the risk of materialmisstatement. Outstanding checks can also be verified with the bank at a later date, when the checks clear.

QUESTION 437Which of the following statements is correct regarding the auditor's consideration of the possibility of illegal acts by clients?

A. The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance that no illegal acts have been committed by clients.B. The auditor's training, experience, and understanding of the client should be used to provide a basis for the determination as to whether illegal acts have

occurred.C. If specific information concerning an illegal act comes to the auditor's attention, the auditor should apply audit procedures specifically directed to ascertaining

whether an illegal act has occurred.D. If an illegal act has occurred, the auditor should express a qualified opinion or an adverse opinion on the financial statements taken as a whole.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. If specific information concerning a possible illegal act comes to the auditor's attention, the auditor should apply additional audit procedures todetermine whether an illegal act has in fact occurred.Choice "a" is incorrect. The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance that the financial statements are free ofmaterial misstatement. This is a different level of assurance than stating that "no illegal acts" have been committed by clients, since it is possible for an immaterialillegal act (for example a theft of a few dollars from the petty cash fund) to occur and not be identified by the auditor. Choice "b" is incorrect. The auditor's training,experience, and understanding of the client may not be sufficient to provide a basis for the determination as to whether illegal acts (especially indirect effect illegalacts) have occurred.Choice "d" is incorrect. If an illegal act has occurred, but the act has been properly accounted for and/or disclosed, there would be no need to express a qualifiedopinion or an adverse opinion.

Risk Assessment

QUESTION 438In an audit of financial statements in accordance with generally accepted auditing standards, an auditor is required to:

A. Document the auditor's understanding of the entity's internal control.B. Search for significant deficiencies in the operation of internal control.C. Perform tests of controls to evaluate the effectiveness of the entity's information system relevant to financial reporting.D. Determine whether controls operated effectively to prevent or detect material misstatements.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor is required to document key elements of the understanding of the entity and its environment, including each of the components ofinternal control. Choice "b" is incorrect. Auditors are not required to search for significant deficiencies in the operation of internal control. They are merely required toreport such conditions discovered during the audit to those charged with governance.Choice "c" is incorrect. Auditors are not required to perform tests of controls unless they plan to place reliance on a particular control. Since auditors are notrequired to rely on the client's controls, tests of controls are generally not required. Choice "d" is incorrect. The auditor generally is not required to determinewhether the client's controls operated effectively to prevent or detect material errors. Such determination would only be required for controls on which the auditorplans to rely.

QUESTION 439The audit plan usually cannot be finalized until the:

A. Consideration of the entity's internal control has been completed.B. Representation letter has been signed by the client.C. Significant deficiencies in internal control have been communicated to those charged with governance.D. Search for unrecorded liabilities has been performed and documented.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor should obtain a sufficient understanding of the entity and its environment, including its internal control, to plan the audit of theentity's financial statements. Choice "b" is incorrect. The representation letter is not obtained until the end of the audit. Choice "c" is incorrect. Informing thosecharged with governance of significant deficiencies in internal control generally occurs during or at the completion of the audit. It is not required before completion ofthe audit plan.Choice "d" is incorrect. The search for unrecorded liabilities typically takes places after year-end, while the audit plan is prepared during planning. Informationobtained from the search is not needed to finalize the audit plan.

QUESTION 440The primary objective of procedures performed to obtain an understanding of the entity and its environment is to provide an auditor with:


A. Knowledge necessary for risk assessment and audit planning.B. Audit evidence to use in assessing inherent risk.C. A basis for issuing an opinion on the financial statements.D. An evaluation of the consistency of application of management's policies.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor should obtain an understanding of the entity and its environment sufficient to assess the risk of material misstatement and todesign and perform further audit procedures.Choice "b" is incorrect. Assessing inherent risk is not the primary objective of obtaining an understanding of the entity and its environment.Choice "c" is incorrect. Obtaining an understanding of the entity and its environment is not a sufficient basis for issuing an audit opinion.Choice "d" is incorrect. Procedures performed to gain an understanding of the entity and its environment would not ordinarily test the consistency of the applicationof management's policies. If the auditor intends to rely on a control, its consistency in application would then be tested.

QUESTION 441If an auditor's risk assessment is based on the effective operation of controls, the auditor will likely:

A. Apply analytical procedures to both financial data and nonfinancial information to detect conditions that may indicate weak controls.B. Perform tests of details of transactions and account balances to identify potential errors and fraud.C. Identify specific internal controls that are likely to detect or prevent material misstatements.D. Document that the additional audit effort to perform tests of controls exceeds the potential reduction in substantive testing.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Assessing risk based on the effective operation of controls involves (1) identifying specific internal controls relevant to specific assertions thatare likely to prevent or detect material misstatements in those assertions, and (2) performing tests of such controls to evaluate their effectiveness.Choice "a" is incorrect. Analytical procedures are used for planning purposes, as substantive tests, or as a final overall review. They are not used to support a riskassessment based on the effective operation of controls.Choice "b" is incorrect. Tests of details of transactions and account balances to identify potential errors and fraud are substantive tests. They are not used tosupport a risk assessment based on the effective operation of controls.Choice "d" is incorrect. The auditor may not assess risk based on the effective operation of controls unless tests of controls are performed. However, if the auditeffort required to perform tests of controls exceeds the potential reduction in substantive testing, tests of controls will not be performed because doing so wouldreduce audit efficiency.

QUESTION 442An advantage of using systems flowcharts to document information about internal control instead of using internal control questionnaires is that systems flowcharts:

A. Identify internal control weaknesses more prominently.

B. Provide a visual depiction of client's activities.C. Indicate whether control activities are operating effectively.D. Reduce the need to observe client's employees performing routine tasks.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. An advantage of using systems flowcharts to document internal information is that flowcharts provide a visual depiction of clients' activities.Choice "a" is incorrect. Identification of internal control weaknesses requires the understanding, testing, and evaluation of controls. Either flowcharts orquestionnaires can be used to obtain an understanding of internal control for this purpose.Choice "c" is incorrect. Determining whether control activities are operating effectively requires tests of controls, and generally cannot be determined based on aflowchart or a questionnaire. Choice "d" is incorrect. Observing tasks being performed (routine or otherwise) are tests of controls. The need to perform tests ofcontrols is not affected by the form of audit documentation selected.

QUESTION 443An auditor's risk assessment is based on the assumption that controls are operating effectively. Which of the following was not a step in making this assessment?

A. Evaluate the effectiveness of the internal controls with tests of controls.B. Obtain an understanding of the entity's accounting system and control environment.C. Perform tests of details of transactions to detect material misstatements in the financial statements.D. Consider whether control activities can have a pervasive effect on financial statement assertions.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Tests of details of transactions are used to detect material misstatements in the financial statements after the auditor has assessed risk, notas part of making this assessment. Choice "a" is incorrect. Tests of controls are required to support the auditor's assumption that controls are operating effectively.Choice "b" is incorrect. Obtaining an understanding of each of the five components of internal control is required before making an assessment of control risk. Theentity's accounting system (part of the information and communication component) and control environment are part of the five components.Choice "d" is incorrect. Considering whether control activities can have a pervasive effect on financial statement assertions is part of the auditor's risk assessmentprocess.Internal Control

QUESTION 444Which of the following procedures most likely would provide an auditor with evidence about whether an entity's internal control activities are suitably designed toprevent or detect material misstatements?

A. Reperforming the activities for a sample of transactions.B. Performing analytical procedures using data aggregated at a high level.C. Vouching a sample of transactions directly related to the activities.D. Observing the entity's personnel applying the activities.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Observation and inspection may be used to evaluate the design of controls. Observation of entity personnel applying control activities is aprocedure that would likely provide evidence about the design of the activities. Choice "a" is incorrect. Reperforming control activities provides the auditor withevidence about the operating effectiveness of specific control activities, not the design effectiveness. Choice "b" is incorrect. Analytical procedures would notprovide the auditor with evidence about the design of specific control activities.Choice "c" is incorrect. Vouching a sample of transactions directly related to control activities would not provide the auditor with evidence about the design ofspecific control activities.

QUESTION 445Management philosophy and operating style most likely would have a significant influence on an entity's control environment when:

A. The internal auditor reports directly to management.B. Management is dominated by one individual.C. Accurate management job descriptions delineate specific duties.D. Those charged with governance actively oversee the financial reporting process.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Management philosophy and operating style encompass a broad range of characteristics. Such characteristics may include the following:

management's approach to taking and monitoring business risks, management's attitudes and actions toward financial reporting, and management's attitudestoward information processing and accounting functions and personnel. These characteristics are more likely to have a significant influence on the controlenvironment when management is dominated by one individual, since there will be few alternative viewpoints presented.Choice "a" is incorrect. The internal audit function is part of the monitoring component of internal control, not part of the control environment. If the internal auditorreports directly to management, this would reduce their objectivity and perhaps make the monitoring function less effective, but it would have minimal impact on thecontrol environment. Choice "c" is incorrect. Accurate management job descriptions would not change the influence that management philosophy and operatingstyle have on the entity's control environment. Choice "d" is incorrect. The involvement of those charged with governance in the reporting process would tend tomoderate or offset the influence that management philosophy and operating style have on the entity's control environment.

QUESTION 446Which of the following is a management control method that most likely could improve management's ability to supervise company activities effectively?

A. Monitoring compliance with internal control requirements imposed by regulatory bodies.B. Limiting direct access to assets by physical segregation and protective devices.C. Establishing budgets and forecasts to identify variances from expectations.D. Supporting employees with the resources necessary to discharge their responsibilities.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The use of budgets and forecasts to identify variances improves managers' ability to supervise company activities. Variances from budgetsserve as signals to managers that a potential problem exists.Choice "a" is incorrect. Compliance with internal controls mandated by a regulatory body may be necessary, but would not necessarily enhance the ability of amanager to supervise company activities.Choice "b" is incorrect. Limiting access to assets serves as a deterrent to employee theft, but does not really improve managers' ability to supervise companyactivities. Choice "d" is incorrect. Supporting employees with adequate resources is important, but it does not necessarily increase the supervisory capability of amanager.

QUESTION 447In obtaining an understanding of a manufacturing entity's internal control concerning inventory balances, an auditor most likely would:

A. Analyze the liquidity and turnover ratios of the inventory.B. Perform analytical procedures designed to identify cost variances.C. Review the entity's descriptions of controls over inventory.D. Perform test counts of inventory during the entity's physical count.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. This question asks about internal control. Review of descriptions of controls would typically be performed while gaining an understanding of anentity's internal control (for any system or cycle, not just inventory). Choice "a" is incorrect. Analysis of inventory ratios is an analytical procedure, which is not usedto gain an understanding of internal control.Choice "b" is incorrect. Analytical procedures are used in planning the audit, as a substantive test, or for final overall review; they are not used to gain anunderstanding of internal control. Choice "d" is incorrect. Observation of physical inventory counts is a substantive test, not a procedure used to gain anunderstanding of internal control.

QUESTION 448The overall attitude and awareness of those charged with governance (i.e., an entity's board of directors) concerning the importance of internal control usually isreflected in its:

A. Computer-based controls.B. System of segregation of duties.C. Control environment.D. Safeguards over access to assets.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The control environment reflects the overall attitude, awareness and actions of those charged with governance (i.e., the board of directors,management, owners, and others) concerning the importance of control and its emphasis in the entity. Choice "a" is incorrect. Computer-based controls are acontrol activity. The overall attitude and awareness of those charged with governance is not a control activity. Choice "b" is incorrect. A system of segregation ofduties is a control activity. The overall attitude and awareness of those charged with governance is not a control activity. Choice "d" is incorrect. Safeguards overaccess to assets is a control activity. The overall attitude and awareness of those charged with governance is not a control activity.

QUESTION 449In an audit of financial statements, an auditor's primary consideration regarding internal control is whether the control:

A. Reflects management's philosophy and operating style.

B. Affects management's financial statement assertions.C. Provides adequate safeguards over access to assets.D. Enhances management's decision-making processes.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Assessing control risk is the process of evaluating the effectiveness of an entity's internal control in preventing or detecting materialmisstatements in the financial statements.Choice "a" is incorrect. Management's philosophy and operating style are considered a part of the control environment. They are not the primary consideration inevaluating internal control. Choice "c" is incorrect. Providing adequate safeguards over access to assets is a type of control activity, but it is not the auditor's primaryconsideration regarding internal control. Choice "d" is incorrect. Policies and procedures concerning the effectiveness, economy, and efficiency of certainmanagement decision-making processes are not relevant to the auditor's consideration of internal control.

QUESTION 450The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the risk that:

A. Tests of controls may fail to identify procedures relevant to assertions.B. Material misstatements may exist in the financial statements.C. Specified controls requiring segregation of duties may be circumvented by collusion.D. Entity policies may be overridden by senior management.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the risk that material misstatements exist in thefinancial statements. Choice "a" is incorrect. Tests of controls are used to assess control risk, not to identify procedures relevant to assertions.Choice "c" is incorrect. Collusion represents an inherent limitation in the effectiveness of internal control.The auditor does not assess control risk to evaluate such limitations. Choice "d" is incorrect. Management override of policies represents an inherent limitation inthe effectiveness of internal control. The auditor does not assess control risk to evaluate such limitations.

QUESTION 451

Management's attitude toward aggressive financial reporting and its emphasis on meeting projected profit goals most likely would significantly influence an entity'scontrol environment when:

A. The audit committee is active in overseeing the entity's financial reporting policies.B. External policies established by parties outside the entity affect its accounting practices.C. Management is dominated by one individual who is also a shareholder.D. Internal auditors have direct access to those charged with governance.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. When management is dominated by one individual who is also a shareholder, there may not be any factors to moderate management'saggressive style. In such situations, management's style is likely to have a strong impact on the control environment. Choice "a" is incorrect. An active auditcommittee tends to moderate management's aggressive reporting style.Choice "b" is incorrect. External policies established by outside parties would tend to moderate management's aggressive reporting style.Choice "d" is incorrect. An effective internal audit function would tend to moderate management's aggressive reporting style.

QUESTION 452When obtaining an understanding of an entity's internal controls, an auditor should concentrate on the substance of the controls rather than their form because:

A. The procedures may be operating effectively but may not be documented.B. Management may establish appropriate procedures but not enforce compliance with them.C. The procedures may be so inappropriate that no reliance is contemplated by the auditor.D. Management may implement procedures whose costs exceed their benefits.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. "Substance over form" concerns relate to controls that appear on the surface to exist but in reality are not operating effectively. Whenobtaining an understanding of a client's internal controls, an auditor should concentrate on the substance of controls rather than the form because even whenappropriate procedures are established, management may not enforce compliance.Choice "a" is incorrect. "Substance over form" concerns relate to controls that appear on the surface to exist but in reality are not operating effectively. Procedures

that are operating effectively, even if they are not documented, do not illustrate this situation. Choice "c" is incorrect. The auditor should first obtain anunderstanding of the controls in order to determine whether the controls are appropriate or inappropriate. The auditor would not focus at all on controls deemed tobe inappropriate.Choice "d" is incorrect. While the cost-benefit of internal control is of concern to management in the design of the system, it plays no role in the auditor's attempt togain an understanding of internal controls.

QUESTION 453When an auditor is to conduct an audit of a service organization, what considerations should the auditor make in the planning stages regarding internal controls ofthe organization?

A. The auditor should assess the control risk before obtaining an understanding of internal controls.B. The auditor should obtain an understanding of the entity's internal controls after performing substantive procedures.C. The auditor should obtain an understanding of the effect of the user organization upon the service organization.D. The auditor should be engaged to perform agreed-upon procedures.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. In some situations, the controls at a service organization are designed under the assumption that there will be certain complementary controlsimplemented by user organizations. These complementary controls should be included in the description of controls. The service auditor should obtain anunderstanding of such situations, in order to evaluate whether the complementary controls are necessary to achieve stated control objectives. Choice "a" isincorrect. The auditor would need to understand controls before assessing their operating effectiveness.Choice "b" is incorrect. Substantive procedures are not performed by a service auditor, who is either reporting on controls placed in operation, or on controls placedin operation and their operating effectiveness. Remember that a service auditor's engagement is not the same as an audit of financial statements.Choice "d" is incorrect. Although a service auditor's engagement differs from an audit of financial statements, it is performed in accordance with the generalstandards as well as the relevant fieldwork and reporting standards. It is not considered to be an agreed-upon procedures engagement, as the auditor has not beenengaged by the service organization to issue a report of findings based on specific, agreedupon procedures.

QUESTION 454Proper segregation of duties reduces the opportunities to allow any employee to be in a position to both:

A. Journalize cash receipts and disbursements and prepare the financial statements.B. Monitor internal controls and evaluate whether the controls are operating as intended.C. Adopt new accounting pronouncements and authorize the recording of transactions.D. Record and conceal fraudulent transactions in the normal course of assigned tasks.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Proper segregation of duties reduces the opportunities for any individual to both perpetrate and conceal errors or fraud.Choice "a" is incorrect. Proper segregation of duties typically involves assigning different people the responsibilities of authorizing transactions, recordingtransactions, and maintaining custody of the related assets. Since journalizing cash receipts and disbursements and preparing the financial statements are bothrecordkeeping functions, this would not be a violation of proper segregation of duties.Choice "b" is incorrect. Monitoring internal controls and evaluating whether those controls are operating as intended would properly be performed by one person.Combining these functions does not violate the concept of proper segregation of duties, since it does not encompass an inappropriate combination of authorization,recordkeeping, and custodial functions. Choice "c" is incorrect. Proper segregation of duties typically involves assigning different people the responsibilities ofauthorizing transactions, recording transactions, and maintaining custody of the related assets. Since adopting new accounting pronouncements and authorizing therecording of transactions are both authorization functions, this would not be a violation of proper segregation of duties.

QUESTION 455Management's emphasis on meeting projected profit goals most likely would significantly influence an entity's control environment when:

A. Internal auditors have direct access to the entity's board of directors.B. A significant portion of management compensation is represented by stock options.C. External policies established by parties outside the entity affect accounting policies.D. Those charged with governance are active in overseeing the entity's financial reporting policies.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Management's emphasis on meeting projected profit goals would significantly influence an entity's control environment when a significantportion of management compensation is represented by stock options, because management would then have a personal interest that might be at odds withaccurate financial reporting. Choice "a" is incorrect. An effective internal audit function would tend to moderate management's emphasis on meeting projected profitgoals, and would therefore tend to dampen the effect on the control environment.Choice "c" is incorrect. External policies established by outside parties would tend to moderate management's emphasis on meeting projected profit goals, andwould therefore tend to dampen the effect on the control environment.Choice "d" is incorrect. Active participation of those charged with governance would tend to moderate management's emphasis on meeting projected profit goals,and would therefore tend to dampen the effect on the control environment.

QUESTION 456Which of the following factors would most likely be considered an inherent limitation to an entity's internal control?

A. The complexity of the information processing system.B. Human judgment in the decision making process.C. The ineffectiveness of the board of directors.D. The lack of management incentives to improve the control environment.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Human error is an inherent limitation in internal control, because even a properly designed and operating internal control system cannotprevent errors in the use of information provided by the system.Choice "a" is incorrect. The complexity of the information processing system is not an inherent limitation of internal control, because controls can be adequatelydesigned to take such complexity into account.Choice "c" is incorrect. An ineffective board of directors is a weakness in internal control, but it is one that could and should be corrected. It is not an inherentlimitation of internal control. Choice "d" is incorrect. Lack of appropriate incentives to improve the control environment is a weakness in internal control, but it is onethat could and should be corrected. It is not an inherent limitation of internal control.

QUESTION 457In planning the audit, the auditor obtains a sufficient understanding of the existing internal control. Which one of the following is not among the auditor's primaryobjectives for obtaining such knowledge?

A. Identify types of material misstatements.B. Consider the factors that affect the risk of material misstatement.C. Make constructive suggestions to the client for improvement.D. Design effective substantive tests.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Making constructive suggestions to the client is not a primary objective for obtainingan understanding of internal control, although it may be a

desirable by-product of an audit engagement.Choices "a", "b", and "d" are incorrect, as the following are primary internal control planning objectives of an auditor in a financial statement audit:

A. Identify types of potential material misstatements. B. Consider factors that affect the risk of material misstatements.D. Design effective substantive tests.

QUESTION 458Which of the following components (elements) of an entity's internal control includes the development of personnel manuals documenting employee promotion andtraining policies?

A. Monitoring.B. Control environment.C. Information and communication system.D. Quality control system.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The control environment element of an entity's internal control relates to the tone of the organization, which includes human resource policiesand practices. Choice "a" is incorrect. Monitoring activities assess the quality of internal control performance over time.Choice "c" is incorrect. The information and communication system relates to the identification, capture, and exchange of information.Choice "d" is incorrect. A quality control system is not a component of an entity's internal control.

QUESTION 459Which of the following statements about internal control is correct?

A. Properly maintained internal control reasonably ensures that collusion among employees cannot occur.B. The establishment and maintenance of internal control is an important responsibility of the internal auditor.C. Exceptionally strong internal control is enough for the auditor to eliminate substantive tests on a significant account balance.D. The cost-benefit relationship is a primary criterion that should be considered in designing internal control.



Explanation:ExplanationChoice "d" is correct. The concept of reasonable assurance recognizes that the cost of an entity's internal control should not exceed the benefits that are expectedto be deriveD. The cost-benefit relationship is a primary criterion that should be considered in designing internal control. Choice "a" is incorrect. Even a properlymaintained system of internal control is unable to reasonably ensure that collusion among employees cannot occur. Choice "b" is incorrect. Establishing andmaintaining internal control is the responsibility of management - - not the internal auditor.Choice "c" is incorrect. An exceptionally strong internal control that has been tested and can be relied upon by the auditor will allow the auditor to reduce (but noteliminate) substantive tests on significant account balances.

QUESTION 460An auditor uses the knowledge provided by the understanding of internal control and the final assessed risk of material misstatement primarily to determine thenature, timing, and extent of the:

A. Attribute tests.B. Compliance tests.C. Tests of controls.D. Substantive tests.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor uses the knowledge provided by the understanding of internal control and the final assessed risk of material misstatement primarilyto determine the nature, timing, and extent of the substantive tests to be performed. Choices "a", "b", and "c" are incorrect. Attribute tests, compliance tests, andtests of controls are all tests that assist the auditor in assessing control risk and determining the final assessed risk of material misstatement, not the other wayaround.

QUESTION 461An auditor would most likely be concerned with internal controls that provide reasonable assurance about the:

A. Efficiency of management's decision-making process.B. Appropriate prices the entity should charge for its products.C. Methods of assigning production tasks to employees.D. Entity's ability to process and summarize financial data.


Explanation

Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor would most likely be concerned with internal controls that provide reasonable assurance about the entity's ability to process andsummarize financial data. Choice "a" is incorrect. The auditor is primarily concerned with the fair presentation of the financial statements, and would not particularlycare about the efficiency of management's decision-making process.Choice "b" is incorrect. The auditor is primarily concerned with the fair presentation of the financial statements. Pricing decisions made by management would notbe of much concern, as long as the related transactions were appropriately valued and recorded. Choice "c" is incorrect. The auditor is primarily concerned with thefair presentation of the financial statements. How the client assigns tasks to its employees generally is of little concern to the auditor.

QUESTION 462An auditor's primary consideration regarding an entity's internal control is whether the controls:

A. Affect the financial statement assertions.B. Prevent management override.C. Relate to the control environment.D. Reflect management's philosophy and operating style.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. An auditor's primary consideration regarding an entity's internal control is whether the controls affect the financial statement assertions (toevaluate the risk that a material misstatement may exist in the financial statements). Choice "b" is incorrect. An inherent limitation of an entity's internal control isthat its effectiveness can be reduced by management override, but whether this occurs or not is not the auditor's primary consideration.Choice "c" is incorrect. The control environment is a component of internal control, and the auditor needs to understand it, but it is not the auditor's primaryconsideration. Choice "d" is incorrect. An auditor needs to determine how management's philosophy and operating style affect internal control, but it is not theauditor's primary consideration.

QUESTION 463The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the:

A. Factors that raise doubts about the auditability of the financial statements.B. Operating effectiveness of internal control activities.C. Risk that material misstatements exist in the financial statements.

D. Possibility that the nature and extent of substantive tests may be reduced.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the risk that material misstatements exist in thefinancial statements. Choice "a" is incorrect. Sometimes risk assessment procedures may raise doubts about the auditability of the financial statements, but this isnot the ultimate purpose of assessing control risk.Choice "b" is incorrect. The auditor is required to obtain knowledge about the operating effectiveness of internal controls, if his or her risk assessment is based onthe effective operation of controls. Obtaining such knowledge, however, is not the ultimate purpose of assessing control risk.Choice "d" is incorrect. Although the nature and extent of substantive tests may be reduced based on the results of the control risk assessment, this is not theultimate purpose of assessing control risk.

QUESTION 464In obtaining an understanding of an entity's internal control, an auditor is required to obtain knowledge about the:




Explanation:ExplanationChoice "b" is correct. No - Yes. In obtaining an understanding of an entity's internal control, an auditor is required to obtain knowledge about the design of controlsand whether they have been implemented.The auditor is not required to obtain knowledge about the "operating effectiveness of controls" as part of obtaining an understanding of internal control. Choices "a","c", and "d" are incorrect, per the above explanation.

QUESTION 465Internal control includes which of the following components:



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Yes - Yes - Yes - Yes. In addition, "control activities" rounds out the five components of internal control.Choices "a", "b", and "d" are incorrect, per the above.

QUESTION 466Which of the following statements about internal control is correct?

A. There is no relationship between an entity's objectives and the components of internal control.B. Internal control is relevant to the entire entity, or to any of its operating units or business functions.C. All of the entity's objectives and related internal controls are relevant to an audit of the entity's financial statements.

D. An understanding of internal control relevant to each of the entity's operating units and business functions is necessary.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Internal control is relevant to the entire entity, or to any of its operating units or business functions.Choice "a" is incorrect. There is a direct relationship between:1. An entity's objectives, which are what the entity strives to achieve, and2. The components of internal control, which represent what is needed to achieve the objectives. Choice "c" is incorrect. Not all of the entity's objectives and relatedcontrols are relevant to an audit of the entity's financial statements.Choice "d" is incorrect. Although internal control is relevant to each of the entity's operating units and business functions, an understanding of internal controlrelevant to each operating unit and business function may not be necessary to plan and perform an efficient audit.

QUESTION 467Objectives of an entity include:




Explanation:ExplanationChoice "d" is correct. No - Yes - Yes. An entity's objectives consist of financial reporting, operations, and compliance. Information and communication is acomponent of internal control, not an objective.Choices "a", "b", and "c" are incorrect, per the above.

QUESTION 468Internal control over safeguarding of assets may include controls relating to:



Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Yes - Yes - No.Internal control over safeguarding of assets may relate to both financial reporting and operations objectives. For example, controls related to financial reportingmight include:1. Use of a lockbox system for collecting cash, or2. Passwords for limiting access to accounts receivable data files. Controls related to operations might include controls to prevent the excess use of materials inproduction. Internal control over safeguarding of assets generally would not relate to compliance objectives. (Note that the auditor generally would only beconcerned with the controls relevant to financial reporting, but this question does not ask which controls are important to the auditor.) Choices "b", "c", and "d" areincorrect, based on the above explanation.

QUESTION 469

The responsibility to establish, maintain and monitor internal controls is that of the entity's:

A. Accounting department.B. Internal auditor.C. Management.D. External auditor.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The entity's management is responsible for establishing, maintaining, and monitoring the entity's internal controls, considering whether thosecontrols are operating as intended, and modifying controls as conditions change. Choice "a" is incorrect. The accounting department is not responsible forestablishing, maintaining, and monitoring internal controls.Choice "b" is incorrect. The internal auditors contribute to the monitoring of the entity's activities, but are not responsible for establishing or maintaining them.Choice "d" is incorrect. The (external) auditor is required to obtain sufficient knowledge of internal control, but is not responsible for establishing, maintaining, and/ormonitoring internal control.

QUESTION 470Internal control is relevant to:

A. An entire entity.B. An entity's operating units.C. An entity's business functions.D. All of the above.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Internal control is relevant to the entity, its operating units, and its business functions.Choices "a", "b", and "c" are incorrect. Internal control is relevant to all parts of the entity, although not all controls may be relevant to a financial statement audit.

QUESTION 471

Which of the following is necessary in a financial statement audit?

A. An understanding of internal control relevant to each of an entity's operating units.B. An understanding of internal control relevant to each of an entity's business functions.C. An understanding of internal control relevant to an entity's financial reporting objective.D. An understanding of internal control relevant to an entity's compliance objective.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. An understanding of internal control relevant to an entity's financial reporting objective is necessary as part of audit planning. Choices "a" and"b" are incorrect. An understanding of internal control relevant to each of an entity's operating units and business functions may not always be necessary. Choice "d"is incorrect. Not all compliance objectives are relevant to an audit, since some are not related to financial reporting.

QUESTION 472Which of the following controls is least likely to be relevant to a financial statement audit?

A. Procedures that prevent the excess use of materials in production.B. Policies that relate to compliance with income tax regulations.C. Use of computer passwords to limit access to data files.D. Generation of production statistics used to evaluate variances.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Procedures to reduce inefficiency on the production line relate to operational objectives, and not necessarily to financial reporting objectives.Choices "b", "c", and "d" are incorrect. Compliance with income tax regulations, use of passwords to limit data access, and generation of reports to facilitatevariance analysis are all important controls related to financial reporting.

QUESTION 473If a budgetary reporting system provides adequate reports, but the reports are not analyzed and acted upon:

A. The control has been implemented and is operating effectively.B. The control has been implemented but is not operating effectively.C. The control has not been implemented and is not operating effectively.D. The control has not been implemented but is operating effectively.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The fact that budgetary reports are being generated indicates that the control has been implemented. The control, however, does not provideany assurance regarding achievement of the entity's objectives, since the report is not being analyzed or acted upon. Accordingly, the control is not operatingeffectively. Choices "a", "c", and "d" are incorrect. The control has been implemented but is not operating effectively per the explanation above.

QUESTION 474In obtaining an understanding of a manufacturing entity's internal control concerning inventory balances, an auditor most likely would:

A. Review the entity's descriptions of inventory controls.B. Perform test counts of inventory during the entity's physical count.C. Analyze inventory turnover statistics to identify slow-moving and obsolete items.D. Analyze monthly production reports to identify variances and unusual transactions.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. In obtaining an understanding of a manufacturing entity's internal control concerning inventory balances, an auditor would most likely reviewthe entity's descriptions of inventory controls.Choice "b" is incorrect. Performing test counts of inventory during the entity's physical count is a substantive procedure performed after obtaining an understandingof internal control. Choice "c" is incorrect. Analyzing inventory turnover statistics to identify slow-moving and obsolete items is a substantive procedure performedafter obtaining an understanding of internal control.Choice "d" is incorrect. Analyzing monthly production reports to identify variances and unusual transactions is a substantive procedure performed after obtaining anunderstanding of internal control.

QUESTION 475

Which of the following services performed by another entity would not be considered to be part of the client's information system?

A. Processing of the client's accounting transactions by an electronic data processing service center.B. Preparation of the client's financial statements by an outside accounting organization.C. Initiation of the client's weekly payroll transactions by a payroll processing organization.D. Sale (specifically authorized by the client) of investment securities by an external broker.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Services performed by another organization are not considered to be part of the client's information system if the services provided are limitedto executing transactions that are specifically authorized by the client.Choice "a" is incorrect. A service organization's services are part of an entity's information system if they affect any of the following: How the entity's transactions areinitiated; the accounting records, supporting information, and specific accounts in the financial statements involved in the processing and reporting of the entity'stransactions; the accounting processing involved from the initiation of transactions to their inclusion in the financial statements, including electronic means used totransmit, process, maintain, and access information; and the financial reporting process used to prepare the entity's financial statements, including significantaccounting estimates and disclosures.

Choice "b" is incorrect. As described more fully above, a service organization's services are part of an entity's information system if they affect the initiation,processing, or reporting of the entity's transactions.Choice "c" is incorrect. As described more fully above, a service organization's services are part of an entity's information system if they affect the initiation,processing, or reporting of the entity's transactions.

QUESTION 476Which of the following is an inherent limitation in internal control?

A. Incompatible duties.B. Lack of segregation of duties.C. Faulty human judgment.D. Lack of an audit committee.



Explanation:ExplanationChoice "c" is correct. Inherent limitations in internal control are limitations that exist despite implementation of appropriate controls. For example, faulty humanjudgment may result in errors in the design or use of internal controls.Choice "a" is incorrect. Assigning incompatible duties to a particular individual indicates a missing control, rather than an inherent limitation in internal control.Choice "b" is incorrect. Lack of segregation of duties indicates a missing control, rather than an inherent limitation in internal control.Choice "d" is incorrect. Lack of an audit committee indicates a missing control, rather than an inherent limitation in internal control.

QUESTION 477Quick Service Center processes the payroll for a variety of clients, including James Industries. Adams, CPA, is Quick's auditor, while Robinson, CPA, is the auditorfor James Industries.Which of the following is not required of Adams?

A. Issuing a report that describes the scope and nature of the procedures performed.B. Making inquiries regarding the professional reputation of Robinson, CPA.C. Inquiring of management regarding subsequent events that might significantly affect user organizations such as James Industries.D. Obtaining a letter of representation from the management of Quick Service Center.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The user auditor (Robinson) would make inquiries regarding the professional reputation of the service auditor (Adams), not vice versa. Choice"a" is incorrect. The service auditor is required to describe the scope and nature of the procedures performed.Choice "c" is incorrect. The service auditor is required to inquire of management regarding subsequent events that would have a significant effect on userorganizations. Choice "d" is incorrect. The service auditor is required to obtain a management representation letter.

QUESTION 478The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the risk that:

A. Specific internal control activities are not operating as designed.B. The collective effect of the control environment may not achieve the control objectives.C. Tests of controls may fail to identify activities relevant to assertions.D. Material misstatements may exist in the financial statements.


Explanation

Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The auditor's ultimate purpose of assessing control risk is to evaluate the risk of financial statement misstatement.Choice "a" is incorrect. The auditor's evaluation of whether or not specific internal control activities are operating as designed is part of his/her assessment ofcontrol risk; however, the ultimate purpose of making this assessment is to evaluate the risk of financial statement misstatement.Choice "b" is incorrect. The auditor's evaluation of the collective effect of the control environment is part of his/her assessment of control risk; however, the ultimatepurpose of making this assessment is to evaluate the risk of financial statement misstatement. Choice "c" is incorrect. Tests of controls are not used to identifyactivities relevant to assertions. Tests of controls are used to evaluate the operating effectiveness of internal control in preventing or detecting materialmisstatements.

QUESTION 479An auditor's primary consideration in evaluating controls is whether specific controls:

A. Affect financial statement assertions.B. Can be classified into one of the five internal control components.C. Improve the efficiency of the client's operations.D. Reduce detection risk to a sufficiently low level.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. An auditor's primary consideration in evaluating controls is whether specific controls affect financial statement assertions, since ultimately theauditor must render an opinion on whether those assertions are fairly stated. Choice "b" is incorrect. The five components of internal control provide a usefulframework for the auditor to evaluate the impact of such controls on an audit, but such classification is not the auditor's primary consideration.Choice "c" is incorrect. Although a proper system of internal control may improve the client's operational efficiency, it is not a primary consideration for the auditor.Choice "d" is incorrect. The auditor controls detection risk by varying the nature, timing, and extent of substantive tests. Whether or not a proper system of controlsis in place affects control risk, not detection risk.

Responding to Assessed Risk

QUESTION 480An auditor confirmed accounts receivable as of an interim date, and all confirmations were returned and appeared reasonable. Which of the following additionalprocedures most likely should be performed at year-end?

A. Send confirmations for all new customer balances incurred from the interim date to year-end.B. Resend confirmations for any significant customer balances remaining at year-end.C. Review supporting documents for new large balances occurring after the interim date, and evaluate any significant changes in balances at year-end.D. Review cash collections subsequent to the interim date and the year-end.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. When auditing procedures are performed before year-end, additional procedures should be performed to extend the interim conclusions toyear-enD. Large balances would be tested by reviewing supporting evidence, and significant changes in the balance would also be investigated.Choice "a" is incorrect. The auditor would not send confirmations for all new customer balances, but instead would focus on those that appear material. Choice "b"is incorrect. The purpose of performing tests at interim is to minimize the amount of work that needs to be performed at year end, to improve efficiency. Ifconfirmations were sent at interim, and the auditor was satisfied with the results of that testing, there would be no reason to send additional confirmations. Rather,interim conclusions would be extended by focusing on any material changes in the account, including new, large balances. Choice "d" is incorrect. Review ofsubsequent cash collections is a means of supporting a receivables balance when no confirmation response has been received. This procedure generally would notbe performed as a means of extending interim conclusions to year-end.

QUESTION 481In assessing control risk, an auditor ordinarily selects from a variety of techniques, including:

A. Inquiry and analytical procedures.B. Reperformance and observation.C. Comparison and confirmation.D. Inspection and verification.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Tests of controls used in assessing control risk ordinarily include procedures such as inquiry of appropriate entity personnel, inspection ofdocuments and reports indicating performance of the policy or procedure, observation of the application of the policy or procedure, and reperformance of theapplication of the policy or procedure by the auditor. Choice "a" is incorrect. Analytical procedures are used in planning the audit, as a form of substantive testing,and as a final review. They are not useful in assessing control risk. Choice "c" is incorrect. Confirmation is a form of substantive testing, not a test of controls for

assessing control risk.Choice "d" is incorrect. Verification is a form of substantive testing, not a test of controls for assessing control risk.

QUESTION 482Which of the following statements is correct concerning an auditor's assessment of control risk?

A. Assessing control risk may be performed concurrently during an audit with obtaining an understanding of the entity's internal control.B. Evidence about the operation of controls in prior audits may not be considered during the current year's assessment of control risk.C. The basis for an auditor's conclusions about the assessed level of control risk need not be documented unless the auditor's risk assessment is based on the

effective operation of controls.D. The lower the assessed level of control risk, the less assurance the evidence must provide that the controls are operating effectively.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Some risk assessment procedures performed to obtain an understanding of internal control may provide evidence about operatingeffectiveness, even if they were not intended for that purpose. This is possible because the procedures performed to achieve one objective may also provideevidence regarding the other. Choice "b" is incorrect. Audit evidence that was obtained in prior audits about the effective design or operation of internal controls maybe considered by the auditor in assessing control risk in the current audit.Choice "c" is incorrect. The auditor is always required to document the assessment of risk and the basis for the assessment.Choice "d" is incorrect. The lower the assessed level of control risk (that is, the greater the reliance placed on the control), the more assurance the auditor mustgather that the controls are operating effectively.

QUESTION 483When there are numerous property and equipment transactions during the year, an auditor who plans to assess control risk at a low level usually performs:

A. Tests of controls and extensive tests of property and equipment balances at the end of the year.B. Analytical procedures for current year property and equipment transactions.C. Tests of controls and limited tests of current year property and equipment transactions.D. Analytical procedures for property and equipment balances at the end of the year.



Explanation:ExplanationChoice "c" is correct. Since control risk is assessed at a low level, tests of controls would be required to evaluate the effectiveness of the internal controls to supportthat assessed level. However, the need for some substantive tests of transactions is never eliminated. Choice "a" is incorrect. Extensive tests of property andequipment balances would not typically be required when control risk is assessed at a low level. Choice "b" is incorrect. Since control risk is to be assessed at a lowlevel, tests of controls would be required. Analytical procedures would not be particularly useful, since property and equipment transactions are subject tomanagement discretion. Choice "d" is incorrect. Analytical procedures would not be particularly useful, since property and equipment transactions are subject tomanagement discretion. Year-end balances may therefore be unpredictable.

QUESTION 484After obtaining an understanding of the entity and its environment, including its internal control, an auditor decided to perform tests of controls. This is likelybecause:

A. The auditor's risk assessment is based on the effective operation of controls.B. Evidence to support a reduction in control risk is not available.C. An increase in the assessed level of control risk is justified for certain financial statement assertions.D. There were many internal control weaknesses that could allow errors to enter the accounting system.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. After obtaining an understanding the entity and its environment, including its internal control, the auditor may make a risk assessment thatassumes controls are operating effectively.In such cases, the auditor performs tests of controls to obtain evidence supporting this assessment.Choice "b" is incorrect. If evidence to support a reduction in control risk is not available, tests of controls would, by definition, not be possible.Choice "c" is incorrect. When auditors decide to perform tests of controls, they have made a preliminary assessment that controls are operating effectively.Accordingly, the performance of tests of controls is not indicative of an increase in the assessed level of control risk. Choice "d" is incorrect. When many internalcontrol weaknesses are identified, the auditor would not be likely to perform tests of controls. The assessed level of control risk is increased, and more reliancewould be placed on substantive tests as opposed to tests of controls.

QUESTION 485To obtain audit evidence about control risk, an auditor selects tests from a variety of techniques including:

A. Inquiry.B. Analytical procedures.C. Calculation.

D. Confirmation.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Tests of controls include such procedures as inspecting documentation, inquiry, observation, and reperformance.Choice "b" is incorrect. Analytical procedures are used for planning purposes, as substantive tests, and as an overall final review, but they do not provide evidenceabout control risk. Choice "c" is incorrect. Calculation is used as a substantive test rather than as a test of controls. Choice "d" is incorrect. Confirmation representsa substantive test rather than a test of controls.

QUESTION 486The objective of tests of details of transactions performed as tests of controls is to:

A. Monitor the design and use of entity documents such as prenumbered shipping forms.B. Determine whether internal controls have been implemented.C. Detect material misstatements in the account balances of the financial statements.D. Evaluate whether internal controls operated effectively.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The objective of tests of details used as tests of controls is to evaluate whether an internal control operated effectively.Choice "a" is incorrect. Tests of details of transactions would not typically be used to monitor the design and use of entity documents.Choice "b" is incorrect. Tests of details of transactions would not typically be used to determine whether internal controls have been implemented.Choice "c" is incorrect. The objective of tests of details of transactions performed as substantive tests is to detect material misstatements in the financialstatements.

QUESTION 487An auditor wishes to perform tests of controls on a client's cash disbursements procedures. If the controls leave no audit trail of documentary evidence, the auditormost likely will test the procedures by:

A. Confirmation and observation.

B. Observation and inquiry.C. Analytical procedures and confirmation.D. Inquiry and analytical procedures.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. For internal controls which leave no audit trail of documentary evidence (e.g., segregation of duties), the auditor must use inquiry andobservation to test the procedures. Choice "a" is incorrect. Confirmation is a substantive audit procedure not appropriate for tests of controls.Choice "c" is incorrect. Analytical procedures and confirmation are substantive audit procedures not appropriate for tests of controls.Choice "d" is incorrect. Analytical procedures are substantive audit procedures not appropriate for tests of controls.

QUESTION 488Which of the following audit techniques ordinarily would provide an auditor with the least assurance about the operating effectiveness of an internal control activity?

A. Inquiry of client personnel.B. Inspection of documents and reports.C. Observation of client personnel.D. Preparation of system flowcharts.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Preparation of system flowcharts may aid in the auditor's understanding of internal control, but would not indicate whether controls wereactually operating as designed. Choices "a", "b", and "c" are incorrect. Inquiry, inspection, observation (and reperformance) are all tests that may be used toevaluate the operating effectiveness of a control.

QUESTION 489Which of the following factors would least likely affect the extent of the auditor's consideration of the client's internal controls?

A. The amount of time budgeted to complete the engagement.

B. How frequently the control is performed.C. The expected deviation rate from the control.D. The extent to which other tests provide evidence about the same assertion.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The extent of the auditor's consideration of the client's internal controls is affected by a variety of factors, with the primary goal being to obtaina sufficient understanding the entity and its environment, including its internal control. The amount of time budgeted to complete the audit should not be a primaryfactor in determining the extent of consideration of the client's internal controls--if more time is needed to adequately consider internal control, then the budgetshould be revised.Choice "b" is incorrect. How frequently the control is performed would affect the extent of the auditor's consideration of the client's internal controls. Choice "c" isincorrect. The expected deviation rate would affect the extent of the auditor's consideration of the client's internal controls.Choice "d" is incorrect. The extent to which other tests provide evidence about the same assertion would affect the extent of the auditor's consideration of theclient's internal controls.

QUESTION 490Which of the following statements about performing tests of controls to support a lower level of control risk is not true?

A. Observation by the auditor provides more assurance than inquiry alone.B. Inquiry alone generally will support a conclusion for a lower assessed level of control risk.C. Prior audits may be considered by the auditor in assessing control risk in the current audit.D. An audit of financial statements is a cumulative process.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Inquiry alone generally will not support a conclusion for a lower assessed level of control risk.Choices "a", "c", and "d" are incorrect, as the following are true:A. Observation by the auditor provides more assurance than audit evidence obtained by inquiry alone.C. Prior audits may be considered by the auditor in assessing control risk in the current audit. D. An audit of financial statements is a cumulative process.

QUESTION 491Which of the following audit techniques most likely would provide an auditor with the most assurance about the effectiveness of the operation of internal control?

A. Inquiry of client personnel.B. Recomputation of account balance amounts.C. Observation of client personnel.D. Confirmation with outside parties.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Observation of client personnel provides an auditor with the most assurance about the effectiveness of the operation of an internal control.Choice "a" is incorrect. Observation by the auditor provides more assurance than mere inquiry. Inquiry alone generally will not support a conclusion for a lowerassessed level of control risk. Choices "b" and "d" are incorrect. Recomputation of account balance amounts and confirmation with outside parties are substantivetests of account balances, not tests of controls.

QUESTION 492To obtain audit evidence about control risk, an auditor ordinarily selects tests from a variety of techniques, including:

A. Analysis.B. Confirmation.C. Reperformance.D. Comparison.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Reperforming the application of relevant controls provides evidence regarding their operating effectiveness.Choices "a", "b", and "d" are incorrect. Analysis, confirmation, and comparison are substantive tests of account balances, not tests of controls.

QUESTION 493An auditor wishes to perform tests of controls on a client's cash disbursements procedures. If the control activities leave no audit trail of documentary evidence, the

auditor most likely will test the procedures by:

A. Inquiry and analytical procedures.B. Confirmation and observation.C. Observation and inquiry.D. Analytical procedures and confirmation.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. If an auditor wishes to perform a test of controls over a procedure that leaves no audit trail, then the auditor must use observation and inquiryto test the control. Choices "a", "b", and "d" are incorrect. Analytical procedures and confirmation are both substantive tests of balances, not tests of controls.

QUESTION 494Audit evidence concerning proper segregation of duties ordinarily is best obtained by:

A. Preparation of a flowchart of duties performed by available personnel.B. Inquiring whether control activities operated consistently throughout the period.C. Reviewing job descriptions prepared by the personnel department.D. Direct personal observation of the employees who apply control activities.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Audit evidence concerning proper segregation of duties ordinarily is best obtained by direct personal observation of the employees who applycontrol activities, especially if the control activities do not leave an audit trail. Choices "a" and "c" are incorrect. Preparation of a flowchart of duties performed byavailable personnel and reviewing job descriptions would assist the auditor in understanding internal control, but would provide no audit evidence regarding whethersuch procedures are actually functioning as documented.Choice "b" is incorrect. Inquiring whether control activities operated consistently throughout the period would provide a good source of information, but inquiry aloneis not as persuasive as direct personal observation.

QUESTION 495

An auditor may decide not to test controls related to certain assertions because the auditor believes:

A. Sufficient appropriate evidence to support the assertions is likely to be available.B. Evaluating the effectiveness of controls is inefficient.C. More emphasis on tests of controls than substantive tests is warranted.D. Considering the relationship of assertions to specific account balances is more efficient.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. An auditor may decide to assess control risk at the maximum level for certain assertions because the auditor believes evaluating theeffectiveness of controls is inefficient (i.e., it would be more efficient to test the assertions substantively). Choice "a" is incorrect. Whether there is sufficientappropriate evidence to support the assertions relates to the auditability of the financial statements, whereas the decision whether or not to test controls relates tothe audit strategy to be used (i.e., the balance between tests of controls and substantive testing).Choice "c" is incorrect. The auditor will need to test controls if more emphasis on tests of controls than substantive tests is warranted.Choice "d" is incorrect. The auditor will generally consider the relationship of assertions to specific account balances whether or not tests of controls are performed.

QUESTION 496After performing risk assessment procedures, an auditor decided not to perform tests of controls.The auditor most likely decided that:

A. The available evidence obtained through tests of controls would not support an increased level of control risk.B. A reduction in the assessed level of control risk is justified for certain financial statement assertions.C. It would be inefficient to perform tests of controls that would result in a reduction in planned substantive tests.D. The assessed level of inherent risk exceeded the assessed level of control risk.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. After performing risk assessment procedures, an auditor might decide not to perform tests of controls because it would be inefficient. In otherwords, the time required to perform tests of controls would be greater than the reduction in time spent on substantive testing. Choice "a" is incorrect. The auditormight decide not to perform tests of controls if the available audit evidence obtained through those tests would not support a decrease (not increase) in the level of

control risk.Choice "b" is incorrect. A reduction in the assessed level of control risk can only be justified based on tests of controls. If the auditor decides not to perform tests ofcontrols, the assessed level of control risk may not be reduced.Choice "d" is incorrect. The relationship of inherent risk to control risk does not determine the level of control testing to be performed.

QUESTION 497For certain controls, such as segregation of duties, documentary evidence may not exist. An auditor would most likely test the controls by:

A. Reperformance and corroboration.B. Observation and inquiry.C. Inspection and vouching.D. Confirmation and recomputation.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Controls for which documentary evidence does not exist, such as segregation of duties, would most likely be tested through observation andinquiry. Choice "a" is incorrect. Corroboration is a substantive test, which generally relies on documentary evidence.Choice "c" is incorrect. Vouching is a substantive test, which generally requires documentary evidence.Choice "d" is incorrect. Confirmation and recomputation are substantive tests, which generally depend on documentation.

QUESTION 498As part of understanding internal control, an auditor is not required to:

A. Consider factors that affect the risk of material misstatement.B. Ascertain whether internal controls have been implemented.C. Identify the types of potential misstatements that can occur.D. Obtain knowledge about the operating effectiveness of internal control.



Choice "d" is correct. As part of understanding internal control, an auditor is not required to obtain knowledge about the operating effectiveness of controls.Operating effectiveness is evaluated later, and only for those controls on which the auditor plans to rely. Choice "a" is incorrect. Considering factors that affect therisk of material misstatement is a part of understanding internal control.Choice "b" is incorrect. Ascertaining whether internal controls have been implemented is required as part of obtaining an understanding of internal control. Choice"c" is incorrect. Identifying the types of potential misstatements that can occur is part of understanding internal control.

QUESTION 499Which of the following types of evidence would an auditor most likely examine to determine whether internal controls are operating as designed?

A. Confirmations of receivables verifying account balances.B. Letters of representation corroborating inventory pricing.C. Attorneys' responses to the auditor's inquiries.D. Client records documenting the use of EDP programs.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The examination of client records documenting the use of EDP programs is a test of controls.Choice "a" is incorrect. Confirmations of receivables verifying account balances is a substantive test, not a test of controls.Choice "b" is incorrect. Obtaining letters of representation corroborating inventory pricing is a substantive test, not a test of controls.Choice "c" is incorrect. Attorneys' responses to the auditor's inquiries are part of a substantive test, not a test of controls.

QUESTION 500Which of the following statements concerning control risk is correct?

A. Assessing control risk and obtaining an understanding of an entity's internal control may be performed concurrently.B. Control risk may be assessed sufficiently high to eliminate substantive testing for significant transaction classes.C. Control risk may be assessed sufficiently low to eliminate substantive testing for significant transaction classes.D. When assessing control risk an auditor should not consider evidence obtained in prior audits about the operation of control activities.



ExplanationChoice "a" is correct. Assessing control risk and obtaining an understanding of an entity's internal control may be performed concurrently.Choices "b" and "c" are incorrect. Substantive testing can never be entirely eliminated for significant transaction classes.Choice "d" is incorrect. A standard procedure in assessing control risk is to consider evidence obtained in prior audits about the operation of control activities.

QUESTION 501Which of the following audit techniques most likely would provide an auditor with the most assurance about the effectiveness of the operation of internal control?

A. Confirmation with outside parties.B. Inquiry of client personnel.C. Recomputation of account balance amounts.D. Observation of client personnel.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Observation of client personnel is the audit technique most likely to provide an auditor with the most assurance about the effectiveness of theoperation of an internal control. This technique is especially effective for controls that leave little or no audit trail. Choice "a" is incorrect. Confirmation with outsideparties is a common substantive test (direct test of an account balance), not a procedure used to test controls. Choice "b" is incorrect. While inquiry of clientpersonnel can provide some evidence about the effectiveness of the operation of internal control, the auditor's direct observation generally provides greaterassurance than does inquiry.Choice "c" is incorrect. Recomputation of account balance amounts is a substantive test, not a test of controls.

QUESTION 502After obtaining an understanding of internal control and performing risk assessment procedures, an auditor decided not to perform tests of controls. The auditormost likely concluded that the:

A. Additional evidence to support a reduction in control risk was not cost-beneficial to obtain.B. Assessed level of inherent risk exceeded the assessed level of control risk.C. Internal control was properly designed and justifiably may be relied on.D. Evidence obtainable through tests of controls would not support an increased level of control risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. When an auditor decides not to perform tests of controls, the auditor most likely concluded that the additional evidence to support a reductionin control risk was not cost- beneficial to obtain. In other words, the additional costs that would be incurred to support a lower assessed level of control risk wouldnot be offset by the anticipated cost savings resulting from a lower level of substantive tests.Choice "b" is incorrect. The assessed level of inherent risk (which is the susceptibility of an assertion to a material misstatement based upon the nature of theaccount balance or transaction class) exists independently from and bears no direct relationship to control risk. Choice "c" is incorrect. Even if internal control isproperly designed, it cannot justifiably be relied upon unless tests of controls are performed.Choice "d" is incorrect. When performing additional tests of controls, an auditor is attempting to support a lower level of control risk, not higher.

QUESTION 503An auditor generally tests the segregation of duties related to inventory by:

A. Personal inquiry and observation.B. Test counts and cutoff procedures.C. Analytical procedures and invoice recomputation.D. Document inspection and reconciliation.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Tests of controls that do not provide documentary evidence (such as those controls related to segregation of duties) are generally tested bypersonal inquiry and observation by the auditor.Choice "b" is incorrect. Test counts and cut-off procedures are effective substantive tests of inventory (existence assertion).Choice "c" is incorrect. Analytical procedures and invoice recomputation are substantive tests performed by the auditor to gather evidence regarding management'sassertion of valuation of the inventory.Choice "d" is incorrect. Document inspection and reconciliation generally is not helpful in testing segregation of duties, since even appropriate segregation oftendoes not provide documentary evidence.

QUESTION 504Which of the following is not part of obtaining an understanding of internal control?

A. Considering the types of misstatements that may occur in an entity's financial statements.B. Determining whether internal controls are operating effectively.C. Considering knowledge obtained from previous audits.

D. Determining the extent to which internal controls are computerized.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The auditor is not required to obtain knowledge about operating effectiveness as part of the understanding of internal control. This knowledgeis obtained later, for specific controls on which the auditor plans to rely. Choices "a", "c", and "d" are incorrect. During the planning phase of the audit, the auditorobtains an understanding of the internal control system by considering:

· The types of misstatements that may occur.· The risk that misstatements may occur.· Factors that influence the design of tests of controls and substantive tests.· The assessment of inherent risk.· Judgments about materiality.· The complexity and sophistication of the entity's operations and systems. · The use of manual vs. computerized control procedures. Such knowledge may beobtained by appropriate inquiry, inspection, or observation. Knowledge may also be obtained based on previous experience with the client and/or an understandingof the industry in which the entity operates.

QUESTION 505Audit evidence concerning segregation of duties ordinarily is best obtained by:

A. Performing tests of transactions that corroborate management's financial statement assertions.B. Observing the employees as they apply control procedures.C. Obtaining a flowchart of activities performed by available personnel.D. Developing audit objectives that reduce control risk.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Audit evidence concerning segregation of duties ordinarily is best obtained by the auditor observing the employees as they apply controlprocedures. Generally the auditor's direct, personal knowledge obtained through observation, inspection and physical examination is more persuasive than indirectinformation.Choice "a" is incorrect. Performing tests of transactions that corroborate management's financial statement assertions would provide little audit evidence concerning

segregation of duties. Choice "c" is incorrect. Obtaining a flowchart of activities performed by available personnel may assist the auditor in understanding the designof the internal control system, but it provides no audit evidence regarding whether the segregation of duties is actually functioning as designed. Choice "d" isincorrect. Developing audit objectives that reduce control risk provides no audit evidence regarding the segregation of duties.

QUESTION 506After testing a client's internal control activities, an auditor discovers a number of significant deficiencies in the operation of a client's internal controls. Under thesecircumstances the auditor most likely would:

A. Issue a disclaimer of opinion about the internal controls as part of the auditor's report.B. Increase the assessment of control risk and increase the extent of substantive tests.C. Issue a qualified opinion of this finding as part of the auditor's report.D. Withdraw from the audit because the internal controls are ineffective.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The auditor uses tests of controls to evaluate control risk. In situations where there are a number of significant deficiencies in the operation ofthe client's internal controls, the auditor would increase the assessment of control risk (and the risk of material misstatement) and revise substantive testingaccordingly (for example, by increasing the extent of substantive tests).Choice "a" is incorrect. An auditor is required to communicate significant deficiencies to management and those charged with governance, and a disclaimer ofopinion on the effectiveness of controls would be included in this communication. However, such disclaimer would not be part of the auditor's report on the financialstatements. Choice "c" is incorrect. Since the auditor's report provides an opinion on the financial statements (and not on internal control), significant deficiencies ininternal control do not result in a qualified opinion.Choice "d" is incorrect. The auditor need not withdraw from an audit simply because internal controls are ineffective, but rather would increase the assessment ofcontrol risk and revise substantive testing accordingly.

QUESTION 507In which of the following circumstances is substantive testing of accounts receivable before the balance sheet date most appropriate?

A. The client has a new sales incentive program in place.B. Internal controls during the remaining period are effective.C. There is a high turnover of senior management.D. It is a first engagement of a new client.

Correct Answer: BSection: Auditing and Attestation (I) (Volume C)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The higher the auditor's risk assessment, the closer to period end substantive procedures should be performed. Conversely, effective controlsreduce control risk and reduce the risk of material misstatement, allowing more interim testing to occur. Choice "a" is incorrect. A new sales incentive programresults in an increase in the risk of material misstatement, making it less likely that interim testing will be performed. Choice "c" is incorrect. High turnover of seniormanagement results in an increase in the risk of material misstatement, making it less likely that interim testing will be performed. Choice "d" is incorrect. In the firstengagement of a new client, the auditor will have less knowledge of the client and therefore would be less inclined to utilize interim testing, which increases auditrisk.

QUESTION 508What is the most likely course of action that an auditor would take after determining that performing substantive tests on inventory will take less time thanperforming tests of controls?

A. Assess control risk at a low level.B. Perform both tests of controls and substantive tests on inventory.C. Perform only substantive tests on inventory.D. Perform only tests of controls on inventory.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. If it would take less time to perform substantive tests than it would to perform tests of controls, and if there is no other reason to test controls(i.e., if there is not a high degree of electronic processing), the auditor would not be likely to test controls. Choice "a" is incorrect. In order to assess control risk at alow level, tests of controls would need to be performed. However, if it is more efficient to perform substantive tests, the auditor would not be likely to test controls.Choice "b" is incorrect. If it would take less time to perform substantive tests than it would to perform tests of controls, and if there is no other reason to test controls(i.e., if there is not a high degree of electronic processing), the auditor would not be likely to test controls. Choice "d" is incorrect. Substantive procedures are alwaysbe necessary for all assertions relevant to material transaction classes, account balances, and disclosures. Assuming inventory is material, tests of controls alonewould not be sufficient.

QUESTION 509Which of the following procedures would an auditor least likely perform before the balance sheet date?

A. Confirmation of accounts payable.

B. Observation of merchandise inventory.C. Assessment of the risk of material misstatement.D. Identification of related parties.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor should consider whether the year-end balances of the particular asset or liability accounts that might be selected for interimexamination are reasonably predictable with respect to amount, relative significance, and composition. Accounts payable is relatively difficult to predict because itmay fluctuate at management's discretion. Choice "b" is incorrect. The auditor should consider whether the year-end balances of the particular asset or liabilityaccounts that might be selected for interim examination are reasonably predictable with respect to amount, relative significance, and composition. Inventory isrelatively predictable with respect to amount, composition and relative significance. Choice "c" is incorrect. During planning, the auditor is required to obtain anunderstanding of the entity and its environment, including its internal control, and to assess risk. Such preliminary planning is often conducted prior to the balancesheet date. Choice "d" is incorrect. Audit testing at interim dates may permit early consideration of significant matters affecting the year-end financial statements,such as the identification of related parties.


QUESTION 510Which of the following factors are included in an entity's control environment?



Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Yes - Yes - Yes. An entity's control environment includes participation of those charged with governance, management's philosophy, and theorganizational structure.

QUESTION 511Which of the following are considered control environment factors?



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Yes - No - Yes. Control environment factors include:

1. Communication and enforcement of integrity and ethical values.

2. Commitment to competence.3. Participation of those charged with governance.4. Management's philosophy and operating style.5. Organizational structure.6. Assignment of authority, responsibility, and accountability.7. Human resource policies and practices.

Choice "a" is incorrect. Detection risk is the risk that an auditor's procedures will lead to the conclusion that a material error does not exist in an account balancewhen, in fact, such error does exist.Choices "b" and "d" are incorrect, per the above.

QUESTION 512Which of the following circumstances would most likely cause an auditor to suspect that material misstatements arising from fraud exist in a client's financialstatements?

A. Property and equipment are usually sold at a loss before being fully depreciated.B. Significantly fewer responses to confirmation requests are received than expected.C. Monthly bank reconciliations usually include several in-transit items.D. Clerical errors are listed on an EDP-generated exception report.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Material fraud ("intentional" misstatements or omissions) may result from large amounts of fictitious accounts receivable. Receivingsignificantly fewer confirmation responses than expected implies some accounts receivable may be fictitious. Choice "a" is incorrect. Selling property and equipmentat a loss from book value is not unusual and would not necessarily be indicative of fraud.Choice "c" is incorrect. Bank reconciliations typically include in-transit items (e.g., deposits in transit and outstanding checks), and this would not necessarily beindicative of fraud. Choice "d" is incorrect. Clerical errors listed on an exception report would be a control over data processing that would tend to minimize the riskof material misstatement.

QUESTION 513Which of the following factors is most important concerning an auditor's responsibility to detect errors and fraud?

A. The susceptibility of the accounting records to intentional manipulations, alterations, and the misapplication of accounting principles.B. The probability that unreasonable accounting estimates result from unintentional bias or intentional attempts to misstate the financial statements.C. The possibility that management fraud, defalcations, and the misappropriation of assets may indicate the existence of illegal acts.

D. The risk that mistakes, falsifications, and omissions may cause the financial statements to contain material misstatements.




Choice "d" is correct. The most important factor concerning an auditor's responsibility to detect errors and fraud is the risk that mistakes, falsifications, andomissions may cause the financial statements to contain material misstatements.Choice "a" is incorrect. The susceptibility of the accounting records to intentional manipulations, alterations, and the misapplication of accounting principles issomething the auditor must consider, but it does not describe the auditor's responsibility to detect errors and fraud. Choice "b" is incorrect. The probability thatunreasonable accounting estimates result from unintentional bias or intentional attempts to misstate the financial statements is something the auditor mustconsider, but it does not describe the auditor's responsibility to detect errors and fraud.Choice "c" is incorrect. The possibility that management fraud, defalcations, and the misappropriation of assets may indicate the existence of illegal acts issomething the auditor must consider, but it does not describe the auditor's responsibility to detect errors and fraud.

QUESTION 514Disclosure of fraud to parties other than a client's senior management, those charged with governance, or its board of directors ordinarily is not part of an auditor'sresponsibility. However, to which of the following outside parties may a duty to disclose irregularities exist?



Explanation/Reference:Explanation:ExplanationChoice "d" is correct. The accountant may have a duty to disclose irregularities to all of the following outside parties:Yes - The SEC when the client reports an auditor change. Yes - A successor auditor when the successor makes appropriate inquiries. Yes - A government fundingagency from which the client receives financial assistance. Choices "a", "b", and "c" are incorrect, based on the above explanation.

QUESTION 515Which of the following statements describes why a properly designed and executed audit may not detect a material misstatement due to fraud?

A. Audit procedures that are effective for detecting an unintentional misstatement may be ineffective for an intentional misstatement that is concealed throughcollusion.

B. An audit is designed to provide reasonable assurance of detecting material errors, but there is no similar responsibility concerning material misstatement due tofraud.

C. The factors considered in assessing control risk indicated an increased risk of intentional misstatements, but only a low risk of unintentional errors in thefinancial statements.

D. The auditor didn't consider factors influencing audit risk for account balances that have effects pervasive to financial statements taken whole.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. A properly designed and executed audit may not detect a material misstatement that is concealed through collusion. The auditor'sresponsibility is to design audit procedures that can reasonably be expected to detect material misstatements (errors and fraud) in the financial statements.Intentional misstatements that are concealed through collusion, however, are very difficult to detect, and generally the auditor is not responsible to discover them.Choice "b" is incorrect. An audit is designed to provide reasonable assurance of detecting material misstatements (both errors and fraud).Choice "c" is incorrect. If the factors considered in assessing control risk indicated an increased risk of intentional misstatements, a properly designed and executedaudit would have taken the increased risk into consideration with additional audit procedures. Choice "d" is incorrect. In a properly designed and executed audit, theauditor would consider factors influencing audit risk for account balances that have effects pervasive to the financial statements taken as a whole.

QUESTION 516Which of the following circumstances most likely would cause an auditor to consider whether material misstatements exist in an entity's financial statements?

A. Supporting records that should be readily available are frequently not produced when requested.B. Significant deficiencies in internal control previously communicated have not been corrected.C. Clerical errors are listed on a monthly computer-generated exception report.D. Differences are discovered during the client's annual physical inventory count.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Supporting records that should be readily available but are frequently not produced when requested would cause an auditor to considerwhether material misstatements exist.Choice "b" is incorrect. Failure to correct significant deficiencies in internal control may represent a conscious decision by management to accept that degree of riskbecause of cost or other considerations.Although this is a fraud risk factor, the auditor is more likely to be concerned about missing audit evidence.Choice "c" is incorrect. Clerical errors listed on a monthly computer-generated exception report would be a control over data processing that would tend to minimizethe risk of material misstatement.Choice "d" is incorrect. Differences being discovered during the client's annual physical inventory count is a common occurrence at most companies and would notnecessarily indicate that a material misstatement exists.

QUESTION 517The most likely explanation why the auditor's examination cannot reasonably be expected to bring all illegal acts by the client to the auditor's attention is that:

A. Illegal acts are perpetrated by management override of internal accounting controls.B. Illegal acts by clients often relate to operating aspects rather than accounting aspects.C. The client's system of internal accounting control may be so strong that the auditor performs only minimal substantive testing.D. Illegal acts may be perpetrated by the only person in the client's organization with access to both assets and the accounting records.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. The audit should be designed to identify material misstatements due to illegal acts, but illegal acts that relate to operating aspects rather thanaccounting aspects may not directly affect the financial statements, and therefore they may be less likely to be discovered by the auditor.Choice "a" is incorrect. The audit should be designed to identify material misstatements due to illegal acts, even if they are caused by management override of (itsown) internal control. Choice "c" is incorrect. The audit should be designed to identify material misstatements due to illegal acts, even when minimal substantivetesting is performed by the auditor due to a very strong system of internal control.Choice "d" is incorrect. The audit should be designed to identify material misstatements due to illegal acts, even when those illegal acts were perpetrated by the onlyperson with access to both assets and the accounting records.

QUESTION 518An auditor of a manufacturer would most likely question whether that client has committed illegal acts if the client has:


A. Been forced to discontinue operations in a foreign country.B. Been an annual donor to a local political candidate.C. Failed to correct material weaknesses in internal accounting control that were reported after the prior year's audit.D. Disclosed several subsequent events involving foreign operations in the notes to the financial statements.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Being forced to discontinue operations in a foreign country would cause the auditor of the manufacturer to question whether that client hascommitted an illegal act. Choice "b" is incorrect. Making political contributions to local politicians is not illegal. (Bribes are illegal.) Choice "c" is incorrect. Failure tocorrect material weaknesses in internal accounting control may represent a conscious decision by management to accept that degree of risk because of cost orother considerations. Choice "d" is incorrect. Disclosure of subsequent events is not indicative of an illegal act.

QUESTION 519If specific information comes to an auditor's attention that implies the existence of possible illegal acts that could have a material, but indirect effect on the financialstatements, the auditor should next:

A. Apply audit procedures specifically directed to ascertaining whether an illegal act has occurred.B. Seek the advice of an informed expert qualified to practice law as to possible contingent liabilities.C. Report the matter to an appropriate level of management at least one level above those involved.D. Discuss the evidence with those charged with governance.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. If specific information comes to an auditor's attention that implies the existence of possible illegal acts that could have a material, but indirecteffect on the financial statements, the auditor should next apply audit procedures specifically directed to ascertaining whether an illegal act has occurred. Theauditor should obtain an understanding of the situation, inquire of management (at a level above those involved), consult legal counsel, and consider applyingadditional audit procedures if necessary.Choice "b" is incorrect. The auditor would consult with the client's legal counsel after obtaining an understanding of the situation and inquiring of management.Choice "c" is incorrect. The auditor would inquire of management at a level above those involved after obtaining an understanding of the situation. Choice "d" isincorrect. The auditor would only communicate with those charged with governance regarding detected illegal acts, not possible illegal acts.

QUESTION 520When an auditor becomes aware of a possible illegal act by a client, the auditor should obtain an understanding of the nature of the act to:

A. Evaluate the effect on the financial statements.B. Determine the reliability of management's representations.C. Consider whether other similar acts may have occurred.D. Recommend remedial actions to those charged with governance.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. When an auditor becomes aware of a possible client illegal act, the auditor should next obtain an understanding of the nature of the act inorder to evaluate the effect on the financial statements.Choices "b", "c", and "d" are incorrect. After evaluating the effect of the illegal act on the financial statements, the auditor may also determine the reliability ofmanagement's representations, consider whether other similar acts may have occurred, or recommend remedial actions to those charged with governance.

QUESTION 521The auditor should obtain sufficient knowledge of the client's information and communication system relevant to financial reporting to understand all of the following,except:

A. Classes of transactions in the entity's operations that are significant to the financial statements, and how those transactions are processed, from initiation toinclusion in the financial statements.

B. The financial reporting process, including development of significant accounting estimates and inclusion of appropriate disclosures.C. The means the entity uses to communicate roles, responsibilities, and significant matters relating to financial reporting.D. Control activities related to each account balance, transaction class, and disclosure component in the financial statements or to every assertion relevant to

them.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Ordinarily, audit planning does not require an understanding of the control activities related to each account balance, transaction class, anddisclosure component in the FS or to every assertion relevant to them.Choice "a" is incorrect. The auditor is required to understand significant classes of transactions and how they are processed.Choice "b" is incorrect. The auditor is required to understand the financial reporting process. Choice "c" is incorrect. The auditor is required to understand themethods used by the entity to communicate matters relevant to financial reporting.

QUESTION 522Which of the following information discovered during an audit most likely would raise a question concerning possible illegal acts?

A. Related party transactions, although properly disclosed, were pervasive during the year.B. The entity prepared several large checks payable to cash during the year.C. Material internal control weaknesses previously reported to management were not corrected.D. The entity was a campaign contributor to several local political candidates during the year.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Information that may raise a question concerning possible illegal acts include unusually large payments made to:

· Cash· Bearer· Purchase cashiers checks· Transfer funds to numbered accounts

Choice "a" is incorrect. Related party transactions may provide an indication of fraud, particularly if not made in the ordinary course of business, but they aregenerally not indicative of illegal acts.Choice "c" is incorrect. Failure to correct material internal control weaknesses may represent a conscious decision by management to accept that degree of riskbecause of cost or other considerations.Choice "d" is incorrect. Contributions to local political candidates are legal and generally would not raise a question about possible illegal acts.

QUESTION 523Which of the following is not a control environment factor?

A. Participation of those charged with governance.B. Hiring and advancement policies.C. Management's approach toward business risks.D. Proper segregation of duties.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Policies and procedures involving segregation of duties are control activities, not control environment factors.Choice "a" is incorrect. Participation of those charged with governance is a control environment factor. Choice "b" is incorrect. Hiring and advancement policies arepart of human resource policies and practices, which are control environment factors. Choice "c" is incorrect. Management's approach toward business risks is partof its philosophy and operating style, which is a control environment factor.

QUESTION 524An auditor who discovers that a client's employees have paid small bribes to public officials most likely would withdraw from the engagement if the:

A. Client receives financial assistance from a federal government agency.B. Audit evidence that is necessary to prove that the illegal acts were committed does not exist.C. Employees' actions affect the auditor's ability to rely on management's representations.D. Notes to the financial statements fail to disclose the employees' actions.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. When an auditor cannot rely on management's representations, he or she should withdraw from the engagement.Choice "a" is incorrect. As long as the client takes appropriate remedial action, the auditor would not need to withdraw from the engagement simply because theclient receives federal financial assistance.However, the auditor would be subject to a variety of reporting requirements related to this discovery.Choice "b" is incorrect. If there is no evidence that an illegal act was committed, management may be unable to take remedial action against the related employees.As long as the illegal act is immaterial and the auditor is satisfied that management's response is appropriate in the circumstances, there would be no reason for theauditor to withdraw. Choice "d" is incorrect. The auditor should evaluate the adequacy of disclosure in the financial statements with respect to the potential effects ofan illegal act. If the auditor concludes that disclosure is inadequate, he or she should express a qualified or adverse opinion, but would not necessarily need towithdraw from the engagement (unless the client refused to accept the modified report).

QUESTION 525Which of the following statements is true regarding the risk assessment component of internal control?

A. An auditor evaluates an entity's risk assessment because it is a component of overall audit risk in a financial statement audit.B. An auditor's evaluation of an entity's risk assessment may not be applicable to the audit of every entity.C. An auditor evaluates an entity's risk assessment to understand how management addresses risks relevant to financial reporting.

D. An auditor need not consider an entity's risk assessment because he or she is primarily concerned with audit risk in a financial statement audit.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The auditor needs to understand how management addresses risks relevant to financial reporting in order to properly plan the audit. Choice"a" is incorrect. An entity's risk assessment differs from an auditor's assessment of audit risk.The entity is concerned with managing risks that affect entity objectives (financial reporting, operations, and compliance) whereas the auditor is concerned with therisk that material misstatements could occur in the financial statements. Choice "b" is incorrect. The five components of internal control are applicable to the audit ofevery entity.Choice "d" is incorrect. The auditor needs to understand how management addresses risks relevant to financial reporting in order to properly plan the audit.

QUESTION 526Before applying principal substantive tests to the details of accounts at an interim date prior to the balance sheet date, an auditor should:

A. Assess control risk at a low level for the assertions embodied in the accounts selected for interim testing.B. Determine that the accounts selected for interim testing are not material to the financial statements taken as a whole.C. Consider whether the amounts of the year-end balances selected for interim testing are reasonably predictable.D. Obtain written representations from management that all financial records and related data will be made available.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Before performing substantive tests at an interim date, an auditor should consider whether the amounts of the year-end balances selected forinterim testing are reasonably predictable with respect to amount, relative significance and composition. Choice "a" is incorrect. It is not necessary for control risk tobe assessed at a low level level for the assertions relating to the accounts that will be substantively tested at an interim date. It may simply be more efficient toperform a substantive audit. As long as the balances tested at interim are reasonably predictable with respect to amount, relative significance and composition, theaccount may be tested at interim.Choice "b" is incorrect. Material account balances, such as accounts receivable and inventory, are commonly tested at an interim date.Choice "d" is incorrect. The written representation letter will not be obtained until after year-end.

QUESTION 527Which of the following is not true with respect to the control activities of an entity?

A. Control activities are the policies and procedures that help ensure that management directives are carried out.B. Control activities are the policies and procedures that help ensure that the financial statements are fairly presented in conformity with generally accepted

accounting principles.C. An understanding of control activities may be obtained while the auditor is obtaining an understanding of the other components of internal control.D. An understanding of control activities does not require an understanding of control activities related to each account balance included in the financial statements.


Explanation/Reference:Explanation:ExplanationChoice "b" is correct. Control activities are the policies and procedures that help ensure that management directives are carried out. These policies and proceduresmay relate to any of the three objectives (financial reporting, operations, and compliance), not strictly to the financial reporting objective.Choice "a" is incorrect. Control activities are defined as the policies and procedures that help ensure that management directives are carried out.Choice "c" is incorrect. As an auditor obtains an understanding about the other components of internal control, he or she is also likely to obtain some knowledgeabout control activities. Choice "d" is incorrect. Ordinarily, audit planning does not require an understanding of control activities related to each account balance,transaction class, and disclosure component.

QUESTION 528Before applying substantive tests to the details of asset accounts at an interim date, an auditor should assess:

A. Control risk at a low level.B. Inherent risk at a high level.C. The difficulty in controlling the incremental audit risk.D. Materiality for the accounts tested as insignificant.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. Before performing substantive tests at an interim date, the auditor must assess the difficulty in controlling the incremental audit risk from theinterim date (on which the substantive procedures are performed) to the year-end date (on which an opinion is rendered). Choice "a" is incorrect. The auditor wouldnot have to assess control risk at a low level in order to perform substantive tests at interim. It may simply be more efficient to perform a substantive audit. As longas the balances tested at interim are reasonably predictable with respect to amount, relative significance and composition, the account may be tested at interim.

Choice "b" is incorrect. Generally, inherent risk should be low in order to test substantively at interim.Choice "d" is incorrect. If the materiality level for those accounts to be tested is insignificant, then the auditor probably would not perform any substantive testing,since it is unlikely that a material error exists in an insignificant balance.

QUESTION 529Which of the following statements best describes how a detailed audit plan of a CPA who is engaged to audit the financial statements of a large publicly heldcompany compares with the audit client's comprehensive internal audit program?

A. The comprehensive internal audit plan is substantially identical to the audit plan used by the CPA because both cover substantially identical areas.B. The comprehensive internal audit plan is less detailed and covers fewer areas than would normally be covered by the CPA.C. The comprehensive internal audit plan is more detailed and covers areas that would normally not be covered by the CPA.D. The comprehensive internal audit plan is more detailed although it covers fewer areas than would normally be covered by the CPA.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. "Internal auditors" are part of the system of internal control. Their audits would cover more areas in greater depth than those of the"independent auditors," whose concerns are limited to areas materially affecting the "financial statements taken as a whole." Choices "a", "b", and "d" are incorrect,as described above.

QUESTION 530When assessing an internal auditor's objectivity, an independent auditor should:

A. Evaluate the adequacy of the internal auditor's audit plans.B. Inquire about the internal auditor's educational background and professional certification.C. Consider the organizational level to which the internal auditor reports.D. Review the internal auditor's audit documentation.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. When assessing an internal auditor's objectivity, an independent auditor should consider the organizational level to which the internal auditor

reports. Choice "a" is incorrect. Evaluating the adequacy of the internal auditor's audit plans would be performed when assessing an internal auditor's competence.Choice "b" is incorrect. Inquiring about the internal auditor's educational background and professional certification would be performed when assessing an internalauditor's competence. Choice "d" is incorrect. Reviewing the internal auditor's audit documentation (to determine the quality of the reports and recommendations)would be performed when assessing an internal auditor's competence.

QUESTION 531Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor auditor regarding:

A. Disagreements the predecessor had with the client concerning auditing procedures and accounting principles.B. The predecessor's evaluation of matters of continuing accounting significance.C. The degree of cooperation the predecessor received concerning the inquiry of the client's lawyer.D. The predecessor's assessments of inherent risk and judgments about materiality.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor auditor regardingdisagreements the predecessor had with the client concerning auditing procedures and accounting principles. Choice "b" is incorrect. The successor auditor maymake specific inquiries of the predecessor auditor regarding the predecessor's evaluation of matters of continuing accounting significance, but this would occurafter accepting the engagement. Choice "c" is incorrect. The successor auditor may make specific inquiries of the predecessor auditor regarding the degree ofcooperation the predecessor received concerning the inquiry of the client's lawyer, but this would occur after accepting the engagement. Choice "d" is incorrect. Thesuccessor auditor would generally come to his or her own conclusions regarding assessments of inherent risk and judgments about materiality without consultingthe predecessor auditor.

QUESTION 532Ordinarily, the predecessor auditor permits the successor auditor to review the predecessor's audit documentation relating to:




Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Ordinarily, the predecessor auditor permits the successor auditor to review the predecessor's audit documentation relating to matters ofcontinuing accounting and auditing significance, including both contingencies and balance sheet accounts. Contingencies have continuing significance as they maycontinue to affect the current year financial statements (either by remaining as contingencies or by being resolved); balance sheet accounts from the prior year-endhave continuing significance since they are the opening balances for the current year. Choices "b", "c", and "d" are incorrect, per above explanation.

QUESTION 533The understanding with a client of an auditor's contractual obligation ordinarily is set forth in the:

A. Management letter.B. Scope paragraph of the auditor's report.C. Engagement letter.D. Introductory paragraph of the auditor's report.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. An engagement letter, which is a presumptively mandatory requirement, sets forth the scope and nature of an auditor's contractual obligationto a client. Choice "a" is incorrect. A management letter (also known as a letter of recommendations, or a constructive services letter) is usually delivered by theauditor at the end of the audit. It identifies areas of weakness and provides recommended solutions. Choices "b" and "d" are incorrect. The scope and introductoryparagraphs of the auditor's report do provide some information regarding the work performed by the auditor, but they do not express the auditor's understandingwith the client as completely as does an engagement letter.

QUESTION 534An auditor should obtain knowledge of a client's information and communication system in order to understand each of the following, except:

A. How transactions are initiated, processed, and reported.

B. The process used to prepare financial statements.C. The means used by an entity to communicate financial reporting roles to its staff.D. The means used by an entity to ensure that management directives are carried out.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Control activities (not the information and communication system) are the policies and procedures that help ensure that managementdirectives are carried out. Choices "a", "b", and "c" are incorrect. The auditor obtains an understanding of an entity's information and communication system tounderstand how transactions are initiated, processed, and reported, the financial reporting process, and the means used by an entity to communicate financialreporting roles and responsibilities.

QUESTION 535The monitoring component of internal control excludes:

A. Assessing information derived from external parties.B. Assessing the quality of internal control performance over time.C. Improving controls that are not operating effectively.D. Eliminating controls that are not operating effectively.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Monitoring is the process of assessing the quality of internal control performance over time and taking necessary corrective actions.Eliminating a control that is not operating effectively would not be an appropriate corrective action. Choice "a" is incorrect. Information derived from external parties(such as customer complaints and regulator comments) may be useful in identifying problems with the internal control structure.Choices "b" and "c" are incorrect. Assessing the quality of internal control performance over time and improving controls that are not operating effectively are part ofthe monitoring process.

QUESTION 536In planning an audit of a new client, an auditor most likely would consider the methods used to process accounting information because such methods:

A. Influence the design of internal control.B. Affect the auditor's preliminary judgment about materiality levels.C. Assist in evaluating the planned audit objectives.D. Determine the auditor's acceptable level of audit risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor would consider the methods used to process accounting information in planning an audit of a new client, because such methodsinfluence the design of internal control. The auditor is required to obtain an understanding of the design of internal control in order to plan the audit and determinethe nature, timing, and extent of tests to be performed.Choice "b" is incorrect. The auditor's judgment about materiality levels is based upon the auditor's perception of the needs of a reasonable person who will rely onthe financial statements, not on the methods used to process accounting information. Choice "c" is incorrect. The planned audit objectives are based upon theauditor's desire to render an opinion on the fairness of the financial statements. This end goal is not influenced by the methods used by the client to processaccounting information. Choice "d" is incorrect. Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financialstatements that are materially misstated. The auditor's only acceptable level of audit risk is low, and this is not affected by the client's methods used to processaccounting information.

QUESTION 537Dunn, CPA, is auditing the financial statements of Taft Co. Taft uses Quick Service Center (QSC) to process its payroll. Price, CPA, is expressing an opinion on adescription of the controls placed in operation at QSC regarding the processing of its customers' payroll transactions. Dunn expects to consider the effects ofPrice's report on the Taft engagement.Price's report should contain a (an):

A. Description of the scope and nature of Price's procedures.B. Statement that Dunn may assess control risk based on Price's report.C. Assertion that Price assumes no responsibility to determine whether QSC's controls are suitably designed.D. Opinion on the operating effectiveness of QSC's internal controls.



Choice "a" is correct. Price, CPA (the "service auditor") should include in his or her report a description of the scope and nature of the procedures performed.Choices "b" and "d" are incorrect. A report on controls placed in operation does not provide an opinion on operating effectiveness, and therefore may not be used toassess control risk. Choice "c" is incorrect. A report on controls placed in operation includes a statement that, "our examination included procedures to obtainreasonable assurance about whether the controls were suitably designed."

QUESTION 538Payroll Data Co. (PDC) processes payroll transactions for a retailer. Cook, CPA, is engaged to express an opinion on a description of PDC's internal controls placedin operation as of a specific date. These controls are relevant to the retailer's internal control, so Cook's report may be useful in providing the retailer's independentauditor with information necessary to plan a financial statement audit. Cook's report should:

A. Contain a disclaimer of opinion on the operating effectiveness of PDC's controls.B. State whether PDC's controls were suitably designed to achieve the retailer's objectives.C. Identify PDC's controls relevant to specific financial statement assertions.D. Disclose Cook's assessed level of control risk for PDC.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. There are two types of reports on the processing of transactions by service organizations: "reports on controls placed in operation" and"reports on controls placed in operation and tests of operating effectiveness." The former do not include tests of operating effectiveness and, therefore, are notintended to provide the user auditor with a basis for reducing the assessment of control risk. Accordingly, such reports should include a disclaimer of opinionregarding the operating effectiveness of the controls. Choice "b" is incorrect. The report should contain an indication that the controls were suitably designed toachieve specified control objectives, but it does not provide any assurance regarding the achievement of the user organization's (in this case, the retailer's)objectives. Choice "c" is incorrect. The service auditor (Cook) is not required to identify the service organization's (i.e., PDC's) controls relevant to specific financialstatement assertions because this is not a financial statement audit.Choice "d" is incorrect. The service auditor (Cook) is not required to disclose the assessed level of control risk for the service organization (PDC).

QUESTION 539Computer Services Company (CSC) processes payroll transactions for schools. Drake, CPA, is engaged to report on CSC's internal controls placed in operation asof a specific date. These internal controls are relevant to the schools' internal control, so Drake's report will be useful in providing the schools' independent auditorswith information necessary to plan their audits. Drake's report expressing an opinion on CSC's internal controls placed in operation as of a specific date shouldcontain a(an):

A. Description of the scope and nature of Drake's procedures.B. Statement that CSC's management has disclosed to Drake all design deficiencies of which it is aware.C. Opinion on the operating effectiveness of CSC's internal controls.

D. Paragraph indicating the basis for Drake's assessment of control risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. A report on internal controls for a service organization should include a description of the scope and nature of Drake's procedures. Choice "b"is incorrect. No statement is made in the report that all design deficiencies have been disclosed. Choice "c" is incorrect. The service auditor's opinion is not intendedto provide evidence of operating effectiveness.Choice "d" is incorrect. No paragraph indicating the basis for the assessment of control risk is included in Drake's report.

QUESTION 540A successor auditor should request the new client to authorize the predecessor auditor to allow a review of the predecessor's:



Explanation/Reference:Explanation:ExplanationChoice "c" is correct. It is not appropriate for the successor auditor to request a review of the predecessor auditor's engagement letter. This is a business matterbetween the client and the predecessor auditor that has no impact on the successor's audit. Conversely, review of the predecessor auditor's audit documentation isappropriate and customary to facilitate the successor's audit.Choices "a", "b", and "d" are incorrect, based on the above explanation.

QUESTION 541When an auditor increases the planned assessed level of control risk because certain control activities were determined to be ineffective, the auditor would mostlikely increase the:

A. Extent of tests of details.B. Level of inherent risk.C. Extent of tests of controls.D. Level of detection risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. When an auditor increases the planned assessed level of control risk because certain control activities were determined to be ineffective,detection risk must be reduced accordingly.This may be accomplished by increasing the extent of tests of details. Choice "b" is incorrect. The level of inherent risk is not directly related to the planned level ofcontrol risk.Choice "c" is incorrect. The auditor performs tests of controls to evaluate the operating effectiveness of those controls. Once they have been determined to beineffective, there would be no reason to perform further tests of those controls. Choice "d" is incorrect. The level of detection risk that the auditor could accept woulddecrease if the planned level of control risk increased.

QUESTION 542Lake, CPA, is auditing the financial statements of Gill Co. Gill uses the EDP Service Center, Inc. to process its payroll transactions. EDP's financial statements areaudited by Cope, CPA, who recently issued a report on EDP's internal control structure. Lake is considering Cope's report on EDP's internal control structure inassessing control risk on the Gill engagement. What is Lake's responsibility concerning making reference to Cope as a basis, in part, for Lake's own opinion?

A. Lake may refer to Cope only if Lake is satisfied as to Cope's professional reputation and independence.B. Lake may refer to Cope only if Lake relies on Cope's report in restricting the extent of substantive tests.C. Lake may refer to Cope only if Lake's report indicates the division of responsibility.D. Lake may not refer to Cope under the circumstances above.



Explanation:ExplanationChoice "d" is correct. The user auditor should not make reference to the report of the service auditor as a basis, in part, for his or her own opinion on the userorganization's financial statements. Since the service auditor is not responsible for the examination of any part of the user organization's financial statements,division of responsibility would be inappropriate. Choices "a", "b", and "c" are incorrect, based on the above explanation.

QUESTION 543Which of the following items does not pertain to the control environment?

A. Management's philosophy and operating style.B. Participation of those charged with governance.C. The accounting records.D. Personnel policies and practices.


Explanation/Reference:Explanation:ExplanationChoice "c" is correct. The accounting records pertain to the information and communication system, not to the control environment.Choices "a", "b", and "d" are incorrect, as management's philosophy and operating style, participation of those charged with governance, and personnel policies andpractices are all part of the control environment.

Transaction Cycles

QUESTION 544On receiving a client's bank cutoff statement, an auditor most likely would trace:

A. Prior-year checks listed in the cutoff statement to the year-end outstanding checklist.B. Deposits in transit listed in the cutoff statement to the year-end bank reconciliation.C. Checks dated after year-end listed in the cutoff statement to the year-end outstanding checklist.D. Deposits recorded in the cash receipts journal after year-end to the cutoff statement.



Explanation:

Choice "a" is correct. The auditor should obtain bank cutoff statements that include transactions for 10 to 15 days after year-end. The outstanding checks anddeposits in transit at year-end on the bank reconciliation should agree with the information in the bank cutoff statement. Choice "b" is incorrect. The deposits intransit are listed in the year-end bank reconciliation and traced to actual deposits appearing on the bank cutoff statement. The cutoff statement includes actualdeposits received, not deposits in transit.Choice "c" is incorrect. Checks dated after year-end would not be included in the year-end outstanding checklist.Choice "d" is incorrect. Deposits recorded in the cash receipts journal after year-end do not affect the cash balance at year-end, and therefore the auditor would notperform audit procedures with respect to those deposits.

QUESTION 545Which of the following characteristics most likely would be indicative of check kiting?

A. High turnover of employees who have access to cash.B. Many large checks that are recorded on Mondays.C. Low average balance compared to high level of deposits.D. Frequent ATM checking account withdrawals.



Choice "c" is correct. Kiting occurs when a check drawn on one bank is deposited in another bank and no record is made of the disbursement in the balance of thefirst bank. Frequent kiting may result in a high level of deposits coupled with a low average balance. Choice "a" is incorrect. High turnover of employees who haveaccess to cash may be normal in certain industries, or it may be indicative of poor hiring policies, but it would not be indicative of check kiting.Choice "b" is incorrect. More checks may arrive on Mondays simply because Monday's mail includes the mail from over the weekend. This characteristic is notparticularly indicative of check kiting.Choice "d" is incorrect. Frequent ATM checking account withdrawals indicate a frequent need for cash, but this situation is not particularly indicative of check kiting.

QUESTION 546Which of the following fraudulent activities most likely could be perpetrated due to the lack of effective internal controls in the revenue cycle?

A. Fictitious transactions may be recorded that cause an understatement of revenues and overstatement of receivables.B. Claims received from customers for goods returned may be intentionally recorded in other customers' accounts.C. Authorization of credit memos by personnel who receive cash may permit the misappropriation of cash.D. The failure to prepare shipping documents may cause an overstatement of inventory balances.



Choice "c" is correct. The function of cash receipts is part of the treasurer's department and should be separate from the role of posting credits to the A/R ledger.Failure to separate the recordkeeping function from the custodial function allows an individual to misappropriate cash and then cover up the theft by posting creditsagainst the related A/R balance. Choice "a" is incorrect. If fictitious transactions in the revenue cycle are recorded, then the impact on revenues and receivableswould be the same; either both would be overstated (the most likely case) or both would be understated.Choice "b" is incorrect. Even the lack of effective internal controls would not allow this fraud to be perpetrated for long, since the customers that submitted the claimwould complain that the credit was not properly applied as soon as they received their next statement or invoice. Choice "d" is incorrect. The failure to prepareshipping documents may cause inventory to be overstated, but it is unlikely to be perpetrated as a fraud since it does not allow theft of cash. In addition, the internalcontrols in the revenue cycle typically relate to sales, receivables, and cash, not to inventory.

QUESTION 547Which of the following internal controls most likely would reduce the risk of diversion of customer receipts by an entity's employees?

A. A bank lockbox system.B. Prenumbered remittance advices.C. Monthly bank reconciliations.D. Daily deposit of cash receipts.



Choice "a" is correct. A lockbox system is the best means of preventing defalcation of cash by employees because the employees never have direct access to cashreceipts. Choice "b" is incorrect. The use of prenumbered remittance advices is not effective in preventing theft of receipts by employees because it does notprevent employee access to cash receipts. Choice "c" is incorrect. While the performance of monthly bank reconciliations is a good control, it would not be effectivein preventing the theft of receipts because it does not prevent employee access to cash receipts. (It might, however, be effective at detecting a theft that has alreadyoccurred).Choice "d" is incorrect. Daily deposit of cash receipts is not an effective control for preventing theft of receipts by employees because it does not prevent employeeaccess to cash receipts.

QUESTION 548In testing controls over cash disbursements, an auditor most likely would determine that the person who signs checks also:

A. Reviews the monthly bank reconciliation.B. Returns the checks to accounts payable.C. Is denied access to the supporting documents.D. Is responsible for mailing the checks.



Choice "d" is correct. Once signed, the check should be mailed to the payee by the check signer or an employee operating under the supervision of the checksigner to prevent defalcations of checks.Generally this occurs in the treasurer's department. Choice "a" is incorrect. The check signer would not normally review bank reconciliations. Choice "b" is incorrect.Accounts payable personnel should not have custody of signed checks since this would constitute a lack of segregation of duties between recording and custody.Choice "c" is incorrect. The check signer should have access to supporting documentation so that it can be reviewed before the check is signed.

QUESTION 549Which of the following sets of information does an auditor usually confirm on one form?

A. Accounts payable and purchase commitments.B. Cash in bank and collateral for loans.C. Inventory on consignment and contingent liabilities.D. Accounts receivable and accrued interest receivable.



Choice "b" is correct. The standard AICPA bank confirmation form includes spaces for the bank to confirm both cash balances on deposit at the bank and collateralpledged on loans originating from the bank.Choice "a" is incorrect. Purchase commitments are not typically confirmed on an accounts payable confirmation request.Choice "c" is incorrect. Contingent liabilities (confirmed in a letter of inquiry to the client's attorney or bank) and inventory on consignment (confirmed with theconsignee) are not confirmed together.Choice "d" is incorrect. Accrued interest receivable (usually on investments held by a trust company) is not typically confirmed along with trade accounts receivable.

QUESTION 550The usefulness of the standard bank confirmation request may be limited because the bank employee who completes the form may:

A. Not believe that the bank is obligated to verify confidential information to a third party.B. Sign and return the form without inspecting the accuracy of the client's bank reconciliation.C. Not have access to the client's cutoff bank statement.D. Be unaware of all the financial relationships that the bank has with the client.



Choice "d" is correct. A bank employee may not have access to all information about transactions with the audit client and thus may be unaware of all the financialrelationships the bank has with the client.Choice "a" is incorrect. Standard bank confirmations contain a signature from an authorized client employee and are a very commonly used audit procedure. It isunlikely that a bank would refuse the request since it has been authorized by the client. Choice "b" is incorrect. The confirmation is used to verify the bank balanceas of year-end. Bank employees generally would not have access to the client's bank reconciliation. Choice "c" is incorrect. Even though it is likely that the bankwould have access to a cutoff bank statement, the detail on this statement is unnecessary to confirm the final balance.

QUESTION 551Which of the following procedures would an auditor most likely perform in searching for unrecorded liabilities?

A. Vouch a sample of accounts payable entries recorded just before year-end to the unmatched receiving report file.B. Compare a sample of purchase orders issued just after year-end with the year-end accounts payable trial balance.C. Vouch a sample of cash disbursements recorded just after year-end to receiving reports and vendor invoices.D. Scan the cash disbursements entries recorded just before year-end for indications of unusual transactions.



Choice "c" is correct. The auditor is able to detect liabilities not recorded at year-end by comparing cash payments made after the balance sheet date to the relatedreceiving reports and vendor invoices; any payments made on transactions dated before year-end reflect a liability that should have been recorded.

Choice "a" is incorrect. Vouching a sample of recorded accounts payable entries to unmatched receiving reports does not test the completeness of the listing.Unrecorded liabilities would not be included in recorded accounts payable entries.Choice "b" is incorrect. Purchase orders issued after year-end should not be included in the year- end balance of accounts payable. This would be an example of anoverstated liability, rather than an unrecorded one.Choice "d" is incorrect. Examination of cash disbursements entries made just prior to the balance sheet date relates to liabilities that have been paid, which wouldnot be considered to be outstanding liabilities at year-end.

QUESTION 552An auditor traced a sample of purchase orders and the related receiving reports to the purchases journal and the cash disbursements journal. The purpose of thissubstantive audit procedure most likely was to:

A. Identify unusually large purchases that should be investigated further.B. Verify that cash disbursements were for goods actually received.C. Determine that purchases were properly recorded.D. Test whether payments were for goods actually ordered.



Choice "c" is correct. In general, an audit procedure can be restated as the question to be answered. In this case, tracing a sample of purchase orders and relatedreceiving reports to the purchases journal and the cash disbursements journal seeks to answer the question, "Were all purchases properly recorded?" (thecompleteness assertion). Choice "a" is incorrect. Tracing a sample of source documents to summary records would not identify unusually large transactionsrequiring additional attention. Choice "b" is incorrect. In order to verify that cash disbursements were for goods actually received, a sample of cash disbursementsshould be vouched back to receiving reports. Choice "d" is incorrect. In order to verify that cash disbursements were for goods actually ordered, a sample of cashdisbursements should be vouched back to purchase orders.

QUESTION 553Sound internal control dictates that, immediately upon receiving checks from customers by mail, a responsible employee should:

A. Add the checks to the daily cash summary.B. Verify that each check is supported by a prenumbered sales invoice.C. Prepare a duplicate listing of checks received.D. Record the checks in the cash receipts journal.

Correct Answer: CSection: Auditing and Attestation (I) (Volume C)

Explanation


Choice "c" is correct. Upon receipt of cash, a remittance listing should be prepared. Choice "a" is incorrect. Recording the check in the daily cash summary wouldordinarily be done by a second party after the initial listing has been prepared. Choice "b" is incorrect. Verifying that each check is supported by a valid invoice is notnecessary.Choice "d" is incorrect. Recording the check in the cash receipts journal would ordinarily be done by a second party after the initial listing has been prepared.

QUESTION 554To provide assurance that each voucher is submitted and paid only once, an auditor most likely would examine a sample of paid vouchers and determine whethereach voucher is:

A. Supported by a vendor's invoice.B. Stamped "paid" by the check signer.C. Prenumbered and accounted for.D. Approved for authorized purchases.



Choice "b" is correct. By stamping the voucher "paid," the check signer cancels the voucher so it cannot be resubmitted for payment.Choice "a" is incorrect. Even invoices that are supported by prenumbered sales invoices can be resubmitted for payment if they are not canceled, resulting induplicate payments. Choice "c" is incorrect. Accounting for the sequence of prenumbered vouchers would only test whether all vouchers are present. It would notprevent a voucher from being paid twice. Choice "d" is incorrect. Proper authorization would help ensure that payments were properly authorized, but would notprevent duplicate payments.

QUESTION 555Proper authorization of write-offs of uncollectible accounts should be approved in which of the following departments?

A. Accounts receivable.B. Credit.C. Accounts payable.D. Treasurer.



Choice "d" is correct. The treasurer does not perform duties that are incompatible with authorizing writeoffs since he or she is usually not involved with salestransactions or recordkeeping.Choice "a" is incorrect. Recording accounts receivable and authorizing write-offs would constitute an improper segregation of duties.Choice "b" is incorrect. Granting credit and authorizing write-offs represents an improper segregation of duties since non-existent customers could have creditauthorized and then have their accounts written off.Choice "c" is incorrect. The accounts payable department is typically involved in the expenditure cycle, not the revenue cycle.

QUESTION 556Which of the following procedures most likely would not be an internal control designed to reduce the risk of errors in the billing process?

A. Comparing control totals for shipping documents with corresponding totals for sales invoices.B. Using computer programmed controls on the pricing and mathematical accuracy of sales invoices.C. Matching shipping documents with approved sales orders before invoice preparation.D. Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger.



Choice "d" is correct. Reconciling control totals for sales invoices with the accounts receivable subsidiary ledger is not an effective control related to the billingprocess, since errors that exist in the preparation of invoices would likely carry through to accounts receivable. Choice "a" is incorrect. Comparing shipping totalswith sales invoice totals is an effective control to reduce billing errors.Choice "b" is incorrect. Computer controls related to pricing and mathematical accuracy will reduce billing errors.Choice "c" is incorrect. Matching shipping documents with approved sales orders ensures that invoices are properly authorized and only goods ordered have beenshipped.

QUESTION 557In assessing control risk for purchases, an auditor vouches a sample of entries in the voucher register to the supporting documents. Which assertion would this testof controls most likely support?

A. Completeness.B. Occurrence.C. Accuracy.D. Rights and obligations.



Choice "b" is correct. Vouching to supporting documents tests the occurrence assertion. Choice "a" is incorrect. Tracing from supporting documentation to thevoucher register would support the completeness assertion.Choice "c" is incorrect. The accuracy assertion would be tested by examining the details of the supporting documents.Choice "d" is incorrect. The rights and obligations assertion does not relate to transactions and events.

QUESTION 558Which of the following internal control activities is not usually performed in the vouchers payable department?

A. Matching the vendor's invoice with the related receiving report.B. Approving vouchers for payment by having an authorized employee sign the vouchers.C. Indicating the asset and expense accounts to be debited.D. Accounting for unused prenumbered purchase orders and receiving reports.



Choice "d" is correct. Accounting for unused prenumbered purchase orders and receiving reports is an effective control, but it would not typically be performed inthe vouchers payable department.Choice "a" is incorrect. Reconciling the vendor invoice with the related receiving report is typically performed by a vouchers payable clerk.Choice "b" is incorrect. The vouchers payable department is responsible for approving vouchers for payment.Choice "c" is incorrect. Indicating the asset and expense accounts to be debited is not an internal control procedure.

QUESTION 559Which of the following tests of controls most likely would help assure an auditor that goods shipped are properly billed?

A. Scan the sales journal for sequential and unusual entries.B. Examine shipping documents for matching sales invoices.C. Compare the accounts receivable ledger to daily sales summaries.D. Inspect unused sales invoices for consecutive prenumbering.



Choice "b" is correct. Tracing from a sample of shipping documents to matching sales invoices would provide support for the completeness assertion for billing.Choice "a" is incorrect. Scanning the sales journal for sequential and unusual entries tests the completeness and existence assertions for sales, but would notprovide assurance that shipped goods were properly billed.Choice "c" is incorrect. Comparing the accounts receivable ledger to the daily sales summary helps ensure that all sales were recorded as receivables and allreceivables were recorded as sales, but it does not provide assurance that shipped goods were properly billed. Choice "d" is incorrect. Inspecting the consecutivenumbering of unused sales invoices might identify fictitious sales, but it would not ensure that goods that have been shipped were properly billed.

QUESTION 560An auditor's purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain evidence concerning management'sassertions about:

A. Valuation and allocation.B. Understandability and classification.C. Existence.D. Rights and obligations.



Choice "a" is correct. Assertions about valuation and allocation deal with whether asset, liability, revenue, and expense components have been included in thefinancial statements at appropriate amounts, and any resulting valuation adjustments are appropriately recorded. For example, management asserts that tradeaccounts receivable included in the balance sheet are stated at net realizable value.Choice "b" is incorrect. Assertions about understandability and classification deal with whether financial information is appropriately presented and described, and

disclosures are clearly expressed. Reviewing credit ratings of delinquent customers does not provide evidence about this type of assertion.Choice "c" is incorrect. Assertions about existence deal with whether assets, liabilities, and equity interest of the entity exist at a given date. Reviewing credit ratingsof delinquent customers does not provide evidence about this type of assertion. Choice "d" is incorrect. Assertions about rights and obligations deal with whetherassets are the rights of the entity and liabilities are the obligations of the entity at a given date. Reviewing credit ratings of delinquent customers does not provideevidence about this type of assertion.

QUESTION 561Which of the following audit procedures would an auditor most likely perform to test controls relating to management's assertion concerning the completeness ofsales transactions?

A. Verify that extensions and footings on the entity's sales invoices and monthly customer statements have been recomputed.B. Inspect the entity's reports of prenumbered shipping documents that have not been recorded in the sales journal.C. Compare the invoiced prices on prenumbered sales invoices to the entity's authorized price list.D. Inquire about the entity's credit granting policies and the consistent application of credit checks.



Choice "b" is correct. Examination of reports of shipments not recorded in the sales journal is an appropriate test of controls to determine whether all sales havebeen recorded. Choice "a" is incorrect. Verification that extensions and footings on sales invoices and statements have been recomputed by client personnelensures that independent checks are being performed, but does not address whether all sales transactions have been recorded. Choice "c" is incorrect.Comparison of invoiced prices with the client's authorized price list ensures that the prices charged are authorized, but does not address whether all salestransactions have been recorded.Choice "d" is incorrect. Inquiring about credit policies is an appropriate audit procedure to verify authorization and valuation of sales transactions, not completeness.

QUESTION 562Which of the following internal controls most likely would assure that all billed sales are correctly posted to the accounts receivable ledger?

A. Daily sales summaries are compared to daily postings to the accounts receivable ledger.B. Each sales invoice is supported by a prenumbered shipping document.C. The accounts receivable ledger is reconciled daily to the control account in the general ledger.D. Each shipment on credit is supported by a prenumbered sales invoice.



Choice "a" is correct. Comparison of daily sales summaries to daily postings to the accounts receivable ledger would ensure the completeness of the accountsreceivable ledger. Choice "b" is incorrect. Comparison of sales invoices to shipping documents verifies occurrence of the sale, not completeness of the accountsreceivable ledger. Choice "c" is incorrect. Reconciliation of the accounts receivable ledger to the general ledger would not assure the accuracy and completeness ofthe accounts receivable ledger because a sale which was improperly excluded from receivables would likely be omitted from both ledgers. Choice "d" is incorrect.Ensuring that all shipments are billed verifies completeness of sales transactions, but does not provide evidence that all sales are recorded in the accountsreceivable ledger. In other words, the fact that a shipment was billed does not mean that the invoice was also recorded in the accounts receivable ledger.

QUESTION 563Under properly designed internal control, the same employee most likely would match vendors' invoices with receiving reports and also:

A. Post the detailed accounts payable records.B. Recompute the calculations on vendors' invoices.C. Reconcile the accounts payable ledger.D. Cancel vendors' invoices after payment.


Explanation/Reference:Explanation:Choice "b" is correct. Matching vendor's invoices with receiving reports provides authorization for payment and is generally performed in the accounts payabledepartment. Recalculation of vendor invoices is compatible with this authorization function. Choice "a" is incorrect. Posting the accounts payable records (recording)is incompatible with matching (authorization). Generally these functions would be performed by two different employees.Choice "c" is incorrect. This review procedure (independent verification) should be performed by someone independent of the employee who approved the invoicefor payment. Choice "d" is incorrect. Payment and cancellation of vendor invoices should be performed by someone (generally the treasurer) other than theindividual authorizing payment.

QUESTION 564An auditor who uses a transaction cycle approach to assessing control risk most likely would test control activities related to transactions involving the sale of goodsto customers with the:

A. Collection of receivables.B. Purchase of merchandise inventory.C. Payment of accounts payable.D. Sale of long-term debt.



Choice "a" is correct. The revenue cycle includes sales, receivables, and cash receipts, so an auditor using a transaction cycle approach would be likely to testsales and receivables together. Choice "b" is incorrect. Purchases are part of the expenditures cycle while sales are part of the revenue cycle, so an auditor using atransaction cycle approach would be unlikely to test these items together.Choice "c" is incorrect. Payables are part of the expenditures cycle while sales are part of the revenue cycle, so an auditor using a transaction cycle approach wouldbe unlikely to test these items together.Choice "d" is incorrect. Sale of long-term debt falls within the "other liabilities" transaction cycle while sales are part of the revenue cycle, so an auditor using atransaction cycle approach would be unlikely to test these items together.

QUESTION 565Tracing copies of computer-prepared sales invoices to copies of the corresponding computer- prepared shipping documents provides evidence that:

A. Shipments to customers were properly billed.B. Entries in the accounts receivable subsidiary ledger were for sales actually shipped.C. Sales billed to customers were actually shipped.D. No duplicate shipments to customers were made.



Choice "c" is correct. Tracing from invoices to shipping documents would provide evidence that sales billed to customers were actually shipped. An invoice forwhich the corresponding shipping documents could not be located might be indicative of fictitious sales (i.e., sales that were recorded but never actually shipped).Choice "a" is incorrect. The auditor would need to start with shipping documents and trace to invoices to ensure that shipments were properly billed. Choice "b" isincorrect. An invoice may exist for which no entry was made in the accounts receivable subsidiary ledger. Therefore, the auditor would need to trace from entries inthe accounts receivable subsidiary ledger (and not from invoices) to shipping documents, to obtain evidence that recorded receivables were for sales actuallyshipped. Choice "d" is incorrect. Tracing from invoices to shipping documents would not necessarily indicate when a duplicate shipment was made, as the auditorwould not necessarily realize that two sets of shipping documents related to the same invoice.

QUESTION 566Which of the following fraudulent activities most likely could be perpetrated due to the lack of effective internal controls in the revenue cycle?

A. Merchandise received is not promptly reconciled to the outstanding purchase order file.B. Obsolete items included in inventory balances are rarely reduced to the lower of cost or market value.C. The write-off of receivables by personnel who receive cash permits the misappropriation of cash.D. Fictitious transactions are recorded that cause an understatement of revenue and overstatement of receivables.



Choice "c" is correct. The function of cash receipts is part of the treasurer's department and should be separate from the role of writing off receivables. Failure toseparate the recordkeeping function from the custodial function allows an individual to misappropriate cash and then cover up the theft by writing off the relatedreceivable balance. Choice "a" is incorrect. Internal controls in the revenue cycle typically relate to sales, receivables, and cash, not to the purchase and receipt ofgoods. Choice "b" is incorrect. Internal controls in the revenue cycle typically relate to sales, receivables, and cash, not to inventory valuation.Choice "d" is incorrect. If fictitious transactions in the revenue cycle are recorded, then the impact on revenues and receivables would be the same; either bothwould be overstated (the most likely case) or both would be understated.

QUESTION 567An auditor observes the mailing of monthly statements to a client's customers and reviews evidence of follow-up on errors reported by the customers. This test ofcontrols most likely is performed to support management's financial statement assertions of:


Correct Answer: C

Section: Auditing and Attestation (I) (Volume C)Explanation


Choice "c" is correct. In testing the existence or occurrence assertion, the auditor is concerned that fictitious or overstated receivables may have been recorded.Observing the mailing of monthly statements and reviewing evidence of follow-up on errors reported by customers provides evidence that procedures are in place toidentify and correct such errors. Choice "a" is incorrect. Follow up of errors in monthly statements does not provide any evidence to support understandability andclassification.Choice "b" is incorrect. Follow up of errors in monthly statements does not provide any evidence to support understandability and classification, but does provideevidence regarding the existence of receivables.Choice "d" is incorrect. Follow up of errors in monthly statements does provide evidence regarding the existence of receivables, since customers will be likely toreport discrepancies.

QUESTION 568Several sources of GAAP consulted by an auditor are in conflict as to the application of an accounting principle. Which of the following should the auditor considerthe most authoritative?

A. FASB Technical Bulletins.B. AICPA Accounting Interpretations.C. FASB Statements of Financial Accounting Concepts.D. AICPA Technical Practice Aids.



Choice "a" is correct. In accordance with the GAAP hierarchy, FASB Technical Bulletins are considered the most authoritative of the sources listed in the question.Choice "b" is incorrect. Of the sources listed, AICPA Accounting Interpretations would be considered the second most authoritative.Choice "c" is incorrect. FASB Statements of Financial Accounting Concepts are among the least authoritative sources of GAAP available to auditors. Choice "d" isincorrect. AICPA Technical Practice Aids are among the least authoritative sources of GAAP available to auditors.

QUESTION 569In an environment that is highly automated, an auditor determines that it is not possible to reduce detection risk solely by substantive tests of transactions. Underthese circumstances, the auditor most likely would:

A. Perform tests of controls to support a lower level of assessed control risk.

B. Increase the sample size to reduce sampling risk and detection risk.C. Adjust the materiality level and consider the effect on inherent risk.D. Apply analytical procedures and consider the effect on control risk.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. When an entity transmits, processes, maintains, or accesses significant information electronically, factors unique to electronic processing maymake it impractical or impossible to reduce detection risk to an acceptable level through substantive testing alone. In such cases, tests of controls should beperformed.Choices "b", "c", and "d" are incorrect. Certain factors unique to electronic processing may make it impractical or impossible to reduce detection risk to anacceptable level through substantive testing alone.In such cases, tests of controls should be performed to address the increased potential for unauthorized access, the risks of insufficient paper-based auditevidence, and the fact that the appropriateness and sufficiency of evidence may be dependent to some extent on computerized controls. Simply expanding thesample size, adjusting materiality levels, or applying analytical procedures will not address these concerns.

QUESTION 570Which of the following events occurring in the year under audit would most likely indicate that internal controls utilized in previous years may be inadequate in theyear under audit?

A. The entity announced that the internal audit function would be eliminated after the balance sheet date.B. The audit committee chairperson unexpectedly resigned during the year under audit.C. The chief financial officer waived approvals on all checks to one vendor to expedite payment.D. The frequency of accounts payable check runs was changed from biweekly to weekly.



Choice "c" is correct. Vouchers should be approved before payment occurs. Overriding this control to expedite payment may result in unauthorized payments beingmade. The auditor would need to consider this change in evaluating current controls and determining the nature, timing, and extent of testing.Choice "a" is incorrect. If the internal audit function is being eliminated after the balance sheet date, there would be little effect on the current year's audit. Choice "b"is incorrect. Resignation of the audit committee chairperson would not imply that internal controls are less adequate than in the past, as long as a new, competent

person steps up to become chair.Choice "d" is incorrect. Changing the frequency of the accounts payable check runs from biweekly to weekly would not automatically imply that controls areinadequate. The auditor would need to review the new procedures to determine whether adequate controls were still in place.

QUESTION 571In which of the following situations would an auditor ordinarily choose between expressing an "except for" qualified opinion or an adverse opinion?

A. The auditor did not observe the entity's physical inventory and is unable to become satisfied as to its balance by other auditing procedures.B. The financial statements fail to disclose information that is required by generally accepted accounting principles.C. The auditor is asked to report only on the entity's balance sheet and not on the other basic financial statements.D. Events disclosed in the financial statements cause the auditor to have substantial doubt about the entity's ability to continue as a going concern.


Explanation/Reference:Explanation:Choice "b" is correct. Failure to disclose information that is required by GAAP is a departure from GAAP.Departures from GAAP result in a qualified or an adverse opinion. Choice "a" is incorrect. If the auditor is unable to observe physical inventory and is unable tobecome satisfied through alternative means, that is a scope limitation. Scope limitations result in either a qualified opinion or a disclaimer of opinion. Choice "c" isincorrect. The auditor can report on one financial statement and not the others. This does not preclude issuance of an unqualified opinion. Choice "d" is incorrect. If,after considering identified conditions and events and management's plans, the auditor concludes that substantial doubt about the entity's ability to continue as agoing concern for a reasonable period of time remains, the audit report should include an explanatory paragraph (after the opinion paragraph in the unqualifiedreport) to reflect that conclusion.

QUESTION 572To determine whether internal control relative to the revenue cycle of a wholesaling entity is operating effectively in minimizing the failure to prepare sales invoices,an auditor most likely would select a sample of transactions from the population represented by the:

A. Sales order file.B. Customer order file.C. Shipping document file.D. Sales invoice file.



Explanation:

Choice "c" is correct. Shipping documents provide evidence that a sale occurred, and therefore selecting from a population of shipping documents allows theauditor to test whether corresponding invoices exist for each sale.Choices "a" and "b" are incorrect. The existence of customer orders and sales orders does not necessarily imply that a sale occurred. For example, the particularitem requested may be out of stock.In such cases, there would properly be no sales invoice. Choice "d" is incorrect. Since the weakness the auditor is concerned about involves missing sales invoices,selecting from a sample of existing sales invoices would not identify this problem.

QUESTION 573Which of the following best describes what is meant by the term generally accepted auditing standards?

A. Rules acknowledged by the accounting profession because of their universal application.B. Pronouncements issued by the Auditing Standards Board.C. Measures of the quality of the auditor's performance.D. Procedures to be used to gather evidence to support financial statements.



Choice "c" is correct. Generally accepted auditing standards ("GAAS") are measures of the quality of the auditor's performance.Choice "a" is incorrect. GAAS are not "rules," nor are they universally applicable. GAAS are measures of the quality of an auditor's performance. Choice "b" isincorrect. The Auditing Standards Board (ASB) issues many types of pronouncements, including (but not limited to) "Statements on Auditing Standards" (SASs).While SASs are considered to be interpretations of GAAS, not all ASB pronouncements relate to audits. Therefore, just because something is issued by the ASBdoes not make it GAAS. Choice "d" is incorrect. Auditing standards differ from auditing procedures in that procedures relate to acts to be performed, whereasstandards deal with the quality of the performance of those acts.

QUESTION 574The third general standard states that due care is to be exercised in the performance of an audit.This standard is ordinarily interpreted to require:

A. Thorough review of the existing safeguards over access to assets and records.B. Limited review of the indications of employee fraud and illegal acts.C. Objective review of the adequacy of the technical training and proficiency of firm personnel.D. Critical review of the judgment exercised at every level of supervision.



Choice "d" is correct. The third general standard of due care is ordinarily interpreted to require critical review of the judgment exercised at every level of supervision,and the judgment exercised by those assisting in the audit.Choice "a" is incorrect. The third general standard of due care does not require a thorough review of the existing safeguards over access to assets and records.Choice "b" is incorrect. The standard of due care does not specifically require a limited review of the indications of employee fraud and illegal acts.Choice "c" is incorrect. The standard of due care does not require a review of audit staff training and proficiency.

QUESTION 575Before accepting an engagement to audit a new client, an auditor is required to:

A. Make inquiries of the predecessor auditor after obtaining the consent of the prospective client.B. Obtain an understanding of the entity and its environment, including its internal control.C. Prepare a memorandum setting forth the staffing requirements and documenting the preliminary audit plan.D. Discuss the management representation letter with the prospective client's audit committee.


Explanation/Reference:Explanation:ExplanationChoice "a" is correct. Prior to acceptance of a new engagement, an auditor must attempt to communicate with the predecessor auditor. Inquiry is important becausethe predecessor auditor may provide information critical to the acceptance decision. Under the Rules of the Code of Professional Conduct, the auditor must firstrequest the client's permission. Choice "b" is incorrect. Although the auditor is required to obtain an understanding of the entity and its environment, including itsinternal control, this typically happens after the engagement is accepted, not before.Choice "c" is incorrect. A planning memo setting forth staff requirements and documenting the preliminary audit plan is usually prepared after accepting anengagement. Choice "d" is incorrect. A management representation letter is usually obtained at the conclusion of the audit and is dated as of the date of auditor'sreport.

QUESTION 576In the first audit of a new client, an auditor was able to extend auditing procedures to gather sufficient evidence about consistency. Under these circumstances, theauditor should:

A. Not report on the client's income statement.B. Not refer to consistency in the auditor's report.C. State that the consistency standard does not apply.D. State that the accounting principles have been applied consistently.



Choice "b" is correct. The auditor's standard report implies that the auditor is satisfied that the comparability of financial statements between periods has not beenmaterially affected by changes in accounting principles and that such principles have been consistently applied between or among periods.Since the auditor has gathered sufficient evidence about consistency, no reference need be made in the report.Choice "a" is incorrect. If the auditor is able to obtain sufficient evidence about consistency, the auditor may report on the entity's financial statements. Choice "c" isincorrect. The consistency standard is one of the ten GAAS, and it does apply to this audit.Choice "d" is incorrect. If the auditor is able to obtain sufficient evidence about consistency, no mention of consistency need be made. Consistency is implied in thestandard report.

QUESTION 577An auditor reads the letter of transmittal accompanying a county's comprehensive annual financial report and identifies a material inconsistency with the financialstatements. The auditor determines that the financial statements do not require revision. Which of the following actions should the auditor take?

A. Request that the client revise the letter of transmittal.B. Include an explanatory paragraph in the auditor's report.C. Consider withdrawing from the engagement.D. Request a client representation letter acknowledging the inconsistency.



Choice "a" is correct. When information accompanies audited financial statements in a client- prepared document, the auditor is required to read the information. Ifsuch information is materially inconsistent with the financial statements and the financial statements do not require revision, the auditor should request that theinformation (in this case the letter of transmittal) be revised.Choice "b" is incorrect. The auditor would only revise the report to include discussion of the material inconsistency if the client were unwilling to revise the transmittal

letter appropriately. Choice "c" is incorrect. The auditor would only consider withdrawing from the engagement if the client were unwilling to revise the transmittalletter appropriately. Choice "d" is incorrect. The auditor would not request a client representation letter acknowledging the inconsistency, as correction (and notsimply acknowledgment) of the error is desired.


A. Determine that changes in employee pay rates after year-end were properly authorized.B. Recompute depreciation charges for plant assets sold after year-end.C. Inquire about payroll checks that were recorded before year-end but cashed after year-end.D. Investigate changes in long-term debt occurring after year-end.



Choice "d" is correct. In obtaining evidence about subsequent events, an auditor would investigate changes in long-term debt occurring after year-end to determineif there was an unrecorded liability as of the end of the year. In addition, subsequent sales of LT debt require footnote disclosure.Choice "a" is incorrect. Changes in employee pay rates occurring after year-end would have no effect on the year under audit.Choice "b" is incorrect. Plant assets sold after the end of the year (that were not related to a current year transaction such as a discontinued operation) have noimpact on the current year's financial statements.Choice "c" is incorrect.Following up on payroll checks that were cashed after year-end is generally not the most effective way to audit accrued payroll and would provide little evidenceabout subsequent events.

QUESTION 579Which of the following provides the most authoritative guidance for an auditor?

A. An AICPA audit and accounting guide that provides specific guidance with respect to the accounting practices in the client's industry.B. A Journal of Accountancy article discussing implementation of a new standard.C. General guidance provided by a Statement on Auditing Standards.D. Specific guidance provided by an interpretation of a Statement on Auditing Standards.



Choice "c" is correct. General guidance provided by a Statement on Auditing Standards is the most authoritative of level of auditing guidance. Auditors are requiredto comply with SASs, and should be prepared to justify any departures therefrom. Choices "a" and "d" are incorrect. AICPA audit and accounting guides and SASinterpretations are interpretive publications that provide guidance regarding how SASs should be applied in specific situations. They are not as authoritative asSASs. Choice "b" is incorrect. Journal of Accountancy articles have no authoritative status but may be helpful to the auditor.

QUESTION 580For an entity's financial statements to be presented fairly in conformity with generally accepted accounting principles, the principles selected should:

A. Be applied on a basis consistent with those followed in the prior year.B. Be approved by the Auditing Standards Board or the appropriate industry subcommittee.C. Reflect transactions in a manner that presents the financial statements within a range of acceptable limits.D. Match the principles used by most other entities within the entity's particular industry.



Choice "c" is correct. Financial statements are presented fairly in conformity with GAAP when there are no material misstatements included therein. The fact thatthere may occasionally be immaterial misstatements means that the financial statements are correct "within a range of acceptable limits."Choice "a" is incorrect. Accounting principles may change from year to year. As long as such changes are properly accounted for, the financial statements are still inconformity with GAAP. Choice "b" is incorrect. The AICPA and the FASB determine GAAP, not the Auditing Standards Board.Choice "d" is incorrect. There is no requirement that an entity's financial statements be prepared in accordance with prevalent industry practices in order to be inconformity with GAAP.

QUESTION 581An auditor uses the assessed level of control risk to:

A. Evaluate the effectiveness of the entity's internal control.B. Identify transactions and account balances where inherent risk is at the maximum.C. Indicate whether materiality thresholds for planning and evaluation purposes are sufficiently high.D. Determine the acceptable level of detection risk for financial statement assertions.


Explanation

Explanation/Reference:Explanation:ExplanationChoice "d" is correct. An auditor uses the assessed level of control risk to determine the risk of material misstatement, which in turn determines the acceptable levelof detection risk for financial statement assertions. Detection risk should bear an inverse relationship to control risk. For example, the less control risk an auditorbelieves exists, the greater the level of detection risk he or she can accept.Choice "a" is incorrect. The auditor's evaluation of the effectiveness of the entity's internal control is what the auditor uses to assess control risk, not vice versa.Choice "b" is incorrect. Inherent risk, which is the susceptibility of an assertion to a material misstatement based upon the nature of the account balance ortransaction class, exists independently from and bears no direct relationship to control risk. Choice "c" is incorrect. Materiality thresholds for planning and evaluationpurposes are based upon measurements of financial criteria, not the assessed level of control risk.

QUESTION 582When an accountant examines projected financial statements, the accountant's report should include a separate paragraph that:

A. Describes the limitations on the usefulness of the presentation.B. Provides an Explanation: of the differences between an examination and an audit.C. States that the accountant is responsible for events and circumstances up to one year after the report's date.D. Disclaims an opinion on whether the assumptions provide a reasonable basis for the projection.



Choice "a" is correct. The accountant's standard report on an examination of projected financial statements should include a caveat that the projected results maynot be achieveD. This is included in a separate paragraph that describes the limitations on the usefulness of the presentation: "...there will usually be differencesbetween the forecasted and actual results...[that] may be material."Choice "b" is incorrect. The accountant's report on the examination of projected financial statements would not include an Explanation: of the differences betweenan examination and an audit.Choice "c" is incorrect. A statement is included which specifically states that the accountant assumes no responsibility to update the report for events andcircumstances occurring after the date of the report.Choice "d" is incorrect. The accountant does express an opinion that "the underlying assumptions provide a reasonable basis for management's forecast."

QUESTION 583A successor auditor most likely would make specific inquiries of the predecessor auditor regarding:

A. Specialized accounting principles of the client's industry.B. The competency of the client's internal audit staff.C. The uncertainty inherent in applying sampling procedures.D. Disagreements with management as to auditing procedures.


Explanation/Reference:Explanation:ExplanationChoice "d" is correct. Inquiries should include specific questions regarding, among other things, facts that might bear on the integrity of management;disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters; communications with those charged withgovernance regarding fraud, illegal acts, and matters relating to internal control; and the predecessor's understanding as to the reasons for the change of auditors.Choice "a" is incorrect. Specialized industry accounting principles might be discussed; however, the successor would be more likely to inquire about items specificto the client. Choice "b" is incorrect. The competency of the client's internal audit staff might be discussed; however, inquiries of the predecessor auditor regardingthe staff are not required. Choice "c" is incorrect. The uncertainty in applying sampling procedures is not something that is typically discussed with the predecessorauditor.

QUESTION 584Jones, CPA, is auditing the financial statements of XYZ Retailing, Inc. What assurance does Jones provide that direct effect illegal acts that are material to XYZ'sfinancial statements, and illegal acts that have a material, but indirect effect on the financial statements will be detected?


Correct Answer: ASection: Auditing and Attestation (I) (Volume C)

Explanation

Explanation/Reference:Explanation:ExplanationChoice "a" is correct. The auditor should design the audit to provide reasonable assurance that direct effect illegal acts are detected. Because of the nature ofillegalities having an indirect effect on the financial statements, the auditor provides no assurance that such acts will be detected.Choices "b", "c", and "d" are incorrect, based on the above explanation.







There should be no comparison of the scope of a review to an audit in the second (scope) paragraph.




Incorrect. There is and should be a comparison between a review and an audit in the scope paragraph.

Auditing and Attestation (II)

QUESTION 1Which of the following factors would least likely affect the nature and extent of audit documentation?

A. The nature of the specific audit procedures.B. The risk of material misstatement.C. The extent to which judgment was required in performing the specific audit procedures.D. The content of the representation letter.

Correct Answer: DSection: Auditing and Attestation (II) (Volume D)Explanation


Choice "d" is correct. The content of the representation letter will generally not affect the nature and extent of audit documentation. Factors affecting the nature andextent of audit documentation include:

1. The risk of material misstatement;2. The extent to which judgment was required in performing the work and evaluating the results;3. The nature of the specific auditing procedure;4. The significance of the evidence obtained;5. The nature and extent of any problems identified; and6. The need to document conclusions that may not be obvious.

QUESTION 2Which of the following documentation is required for an audit in accordance with generally accepted auditing standards?

A. A flowchart or an internal control questionnaire that evaluates the effectiveness of the entity's internal control.B. A management representation letter that summarizes the timing and details of the auditor's planned fieldwork.C. An indication in the audit documentation that the accounting records agree or reconcile with the financial statements.D. A list of the procedures performed and the findings obtained.

Correct Answer: CSection: Auditing and Attestation (II) (Volume D)Explanation


Explanation:

Choice "c" is correct. The quantity, type, and content of audit documentation vary with the circumstances, but it should be sufficient to show that the accountingrecords agree or reconcile with the financial statements.Choice "a" is incorrect. The auditor's understanding of internal control can be documented in a variety of different ways. Flowcharts and internal controlquestionnaires are two methods that might be used to assist the auditor in obtaining an understanding of internal control, but they generally do not provideinformation about the effectiveness of the entity's internal controls. Choice "b" is incorrect. An engagement letter (and not a representation letter) summarizes thetiming and details of the auditor's planned field work.Choice "d" is incorrect. A list of procedures and findings is required for an agreed-upon procedures engagement, not for an audit.

QUESTION 3Audit documentation should be prepared in enough detail so that:

A. An experienced auditor who has worked with the client in the past can understand the procedures performed and the evidence obtained.B. A reader of the financial statements who has no previous connection with the audit can understand the procedures performed and the evidence obtained.C. A reader of the financial statements who has a background in financial analysis can understand the procedures performed and the evidence obtained.D. An experienced auditor who has no previous connection with the audit can understand the procedures performed and the evidence obtained.


Explanation/Reference:Explanation:Choice "d" is correct. Audit documentation should be prepared in enough detail so that an experienced auditor who has no previous connection with the audit canunderstand the procedures performed and the evidence obtained.Choice "a" is incorrect. The requirement is that audit documentation be detailed enough that an experienced auditor who has no previous connection with the auditcan understand the procedures performed and the evidence obtained. This is a higher standard than simply requiring the audit documentation to be appropriate foran auditor who is already familiar with the client. Choices "b" and "c" are incorrect. Readers of the financial statements typically would not have access to the auditdocumentation.

QUESTION 4Which of the following is not true about the report release date?


A. It is defined as the date after which existing documentation must not be deleted, and additions to the documentation file must be documented as such.B. It is often the date on which the report is delivered to the client.C. It is the date on which the auditor grants the client permission to use the report.D. It is used to define the beginning of the retention period.

Correct Answer: ASection: Auditing and Attestation (II) (Volume D)Explanation


Choice "a" is correct. The documentation completion date (and not the report release date) is defined as the date after which existing documentation must not bedeleted, and additions to the documentation file must be documented as such.Choice "b" is incorrect. The report release date is often the date on which the report is delivered to the client.Choice "c" is incorrect. The report release date is the date on which the auditor grants the client permission to use the report.Choice "d" is incorrect. The report release date is used to define the beginning of the retention period.

QUESTION 5Which best describes the documentation completion date?

A. Forty-five days from the report release date, based on PCAOB standards.B. Sixty days from the report release date, based on PCAOB standards.C. Seven years from the report release date, based on auditing standards.D. Five years from the report release date, based on auditing standards.



Choice "a" is correct. According to PCAOB standards, the documentation completion date is forty-five days following the report release date.Choice "b" is incorrect. According to auditing standards, the documentation completion date is sixty days following the report release date.Choices "c" and "d" are incorrect. Seven years and five years refer to the required retention period under PCAOB standards and auditing standards, respectively.

QUESTION 6An audit supervisor reviewed the work performed by the staff to determine if the audit was adequately performed. The supervisor accomplished this by primarilyreviewing which of the following?

A. Checklists.B. Working papers.C. Analytical procedures.D. Financial statements.

Correct Answer: BSection: Auditing and Attestation (II) (Volume D)Explanation


Choice "b" is correct. Audit documentation, or working papers, comprises the principal record of audit procedures performed, evidence obtained, and conclusionsreacheD. Reviewing the working papers allows a supervisor to understand the work performed and the evidence obtained, and to evaluate whether the audit wasadequately performed.Choice "a" is incorrect. Checklists might be used within the audit documentation, but checklists alone would not provide a comprehensive record of the auditprocedures performed, the evidence obtained, and conclusions reached.Choice "c" is incorrect. Analytical procedures might be documented within the working papers, but such procedures alone would not provide a comprehensiverecord of the audit procedures performed, the evidence obtained, and conclusions reached.Choice "d" is incorrect. Reviewing the financial statements would provide no information regarding the audit procedures performed, the evidence obtained, orconclusions reached, and therefore would provide no basis on which to review the work performed by the staff.

Audit Evidence

QUESTION 7Which of the following circumstances most likely would cause an auditor to suspect that material misstatements exist in a client's financial statements?

A. The assumptions used in developing the prior year's accounting estimates have changed.B. Differences between reconciliations of control accounts and subsidiary records are not investigated.

C. Negative confirmation requests yield fewer responses than in the prior year's audit.D. Management consults with another CPA firm about complex accounting matters.


Explanation/Reference:Explanation:Choice "b" is correct. If control accounts in the general ledger do not reconcile to the subsidiary ledgers, there may be a problem in the way transactions wererecorded and posteD. Failure to investigate such differences implies that, if such a problem exists, it has not been identified and corrected. The auditor wouldtherefore suspect that material misstatements exist in the client's financial statements.Choice "a" is incorrect. The assumptions used in developing accounting estimates generally do change as new information becomes available or as situations orconditions change. This would not necessarily indicate that a material misstatement exists.Choice "c" is incorrect. Since responses to negative confirmations are only received when there are discrepancies, a lower response rate likely would be indicativeof fewer problems with accounts receivable. This corresponds to a reduced likelihood of material misstatement. Choice "d" is incorrect. Management's consultationwith another CPA firm about complex accounting matters indicates proactive steps on the part of management to accurately address those matters. Materialmisstatements with respect to the complex accounting matters therefore would be less likely to exist.

QUESTION 8Which of the following is a true statement regarding documentation requirements for analytical procedures?

A. When an analytical procedure is used as the principal substantive test of a significant financial statement assertion, the auditor is required to document thereasons analytical procedures were performed instead of tests of details.

B. When an analytical procedure is used as the principal substantive test of a significant financial statement assertion, the auditor is required to document his orher expectation and management's concurrence with that expectation.

C. When an analytical procedure is used during the overall review stage of the audit, the auditor is required to document the auditor's expectation and anyadditional procedures performed to investigate significant unexplained differences.

D. When an analytical procedure is used as the principal substantive test of a significant financial statement assertion, the auditor is required to document both theauditor's expectation and the factors considered in developing that expectation.



Choice "d" is correct. When an analytical procedure is used as the principal substantive test of a significant financial statement assertion, the auditor is required todocument both the auditor's expectation and the factors considered in developing that expectation. Choice "a" is incorrect. There is no requirement that the auditor

document the reasons analytical procedures were performed instead of tests of details. Choice "b" is incorrect. There is no requirement that the auditor documentmanagement's concurrence with the expectation.Choice "c" is incorrect. When an analytical procedure is performed during the overall review stage, there are no specific documentation requirements. Therequirement that the auditor document the expectation and any additional procedures performed to investigate significant unexplained differences relates toanalytical procedures performed as principal substantive tests.

QUESTION 9To be effective, analytical procedures in the overall review stage of an audit engagement should be performed by:

A. The staff accountant who performed the substantive auditing procedures.B. The managing partner who has responsibility for all audit engagements at that practice office.C. A manager or partner who has a comprehensive knowledge of the client's business and industry.D. The CPA firm's quality control manager or partner who has responsibility for the firm's peer review program.



Choice "c" is correct. The manager and partner on a specific job generally bear a great deal of responsibility for the audit and the report. Typically they wouldperform analytical procedures during the final review stage, to evaluate overall financial statement presentation and to assess the conclusions reached. In order toevaluate the results of the analysis and to perform an effective review, the manager or partner should have a comprehensive knowledge of the client's business andthe industry. Choice "a" is incorrect. It is more effective to have a manager or partner perform this review rather than a staff accountant, because the manager orpartner is generally more experienced and knowledgeable, and because it provides a double check on the work of the staff accountant. Choices "b" and "d" areincorrect. The managing partner and the quality control manager or partner might not have a comprehensive knowledge of the client's business and industry.

QUESTION 10Analytical procedures performed in the overall review stage of an audit suggest that several accounts have unexpected relationships. The results of theseprocedures most likely would indicate that:

A. Irregularities exist among the relevant account balances.B. Internal control activities are not operating effectively.C. Additional tests of details are required.D. The communication with those charged with governance should be revised.



Choice "c" is correct. If analytical procedures suggest unexpected relationships, the auditor would perform additional tests of details of the accounts involved.Choice "a" is incorrect. The identification of unexpected relationships as a result of analytical procedures does not necessarily mean that irregularities exist in therelevant account balances, although this is a possible Explanation: .Choice "b" is incorrect. The identification of unexpected relationships as a result of analytical procedures does not necessarily mean that internal control activitiesare not operating effectively, although this is a possible Explanation: .Choice "d" is incorrect. The identification of unexpected relationships as a result of analytical procedures does not necessarily mean that communication with thosecharged with governance should be revised, although this is a possible consequence.

QUESTION 11Which of the following comparisons would an auditor most likely make in evaluating an entity's costs and expenses?

A. The current year's accounts receivable with the prior year's accounts receivable.B. The current year's payroll expense with the prior year's payroll expense.C. The budgeted current year's sales with the prior year's sales.D. The budgeted current year's warranty expense with the current year's contingent liabilities.



Choice "b" is correct. The most likely analytical review procedure involving costs and expenses would be to compare the current year's payroll expense (averageamount per employee) to the prior year, taking into consideration an average increase in wage rates. This is a very effective technique in auditing payroll expense.Choice "a" is incorrect. Comparing the current year's accounts receivable balance with the prior year provides little evidence because accounts receivable mayfluctuate based on timing of cash payments, which is unpredictable.Choice "c" is incorrect. Comparing the budgeted current year's sales with the prior year's sales provides evidence regarding the reasonableness of the current yearsales budget, but does not provide evidence about costs and expenses.Choice "d" is incorrect. The current year's budgeted warranty expense would likely be compared to the current year's actual warranty expense, not to all of thecontingent liabilities for the year.

QUESTION 12An auditor may achieve audit objectives related to particular assertions by:

A. Performing analytical procedures.

B. Adhering to a system of quality control.C. Preparing audit documentation.D. Increasing the level of detection risk.



Choice "a" is correct. The auditor relies on substantive tests to achieve audit objectives related to particular assertions. Analytical procedures are one type ofsubstantive procedure. Choice "b" is incorrect. CPA firms performing audits are required to adhere to a system of quality control, but adhering to such a systemdoes not directly help the firm achieve specific audit objectives. Choice "c" is incorrect. Audit documentation is used to record the results of audit procedures thathave been performed to achieve audit objectives. Mere preparation of audit documentation does not achieve audit objectives.Choice "d" is incorrect. Increasing the level of detection risk does not enable the auditor to achieve audit objectives related to a particular assertion.

QUESTION 13An auditor's analytical procedures most likely would be facilitated if the entity:

A. Segregates obsolete inventory before the physical inventory count.B. Uses a standard cost system that produces variance reports.C. Corrects material weaknesses in internal control before the beginning of the audit.D. Develops its data from sources solely within the entity.



Choice "b" is correct. An auditor's analytical procedures are facilitated when an entity uses a standard cost system with variance reports because the comparison ofactual to budget will already have been performed. In addition, it is likely that management will already be aware of significant variations from budget and will bebetter able to address any questions the auditor may have. Choice "a" is incorrect. Segregation of obsolete inventory would not be an important factor indetermining whether analytical procedures would be effective. Choice "c" is incorrect. Correction of internal control weaknesses prior to the beginning of the auditwould not affect analytical procedures.Choice "d" is incorrect. Analytical procedures using data developed solely within the entity are not as reliable as analytical procedures using data developedexternally.

QUESTION 14An auditor most likely would limit substantive audit tests of sales transactions when control risk is assessed as low for the occurrence assertion concerning salestransactions and the auditor has already gathered evidence supporting:

A. Opening and closing inventory balances.B. Cash receipts and accounts receivable.C. Shipping and receiving activities.D. Cutoffs of sales and purchases.



Choice "b" is correct. Examination of accounts receivable and cash receipts provides the auditor with evidence with respect to both the completeness and theoccurrence of sales transactions, thus limiting the need to test sales transactions.Choice "a" is incorrect. Examination of beginning and ending inventory balances may provide limited evidence of the occurrence of purchases and the cost of goodssold, but not of sales. Choice "c" is incorrect. Examination of shipping and receiving activities would not necessarily reduce the testing of sales transactions.Choice "d" is incorrect. Cutoffs of sales and purchases provides evidence regarding the sales occurring close to year-end, not necessarily all sales for the year.

QUESTION 15Tracing shipping documents to prenumbered sales invoices provides evidence that:

A. No duplicate shipments or billings occurred.B. Shipments to customers were properly invoiced.C. All goods ordered by customers were shipped.D. All prenumbered sales invoices were accounted for.



Choice "b" is correct. By tracing from the shipping documents to the invoices, the auditor confirms that goods that were shipped were properly billed.Choice "a" is incorrect. Tracing shipping documents to prenumbered invoices would not provide assurance that duplicate shipments or billings did not occur. Choice"c" is incorrect. In order to test whether all goods that were ordered were shipped, the auditor would trace customer purchase orders to shipping documents. Choice

"d" is incorrect. Determining that all prenumbered sales invoices are accounted for does not require examining shipping documents.

QUESTION 16In auditing intangible assets, an auditor most likely would review or recompute amortization and determine whether the amortization period is reasonable in supportof management's financial statement assertion of:

A. Valuation and allocation.B. Existence.C. Completeness.D. Rights and obligations.



Choice "a" is correct. Assertions about valuation and allocation deal with whether assets, liabilities, and equity interests have been included in the financialstatements at appropriate amounts. Recalculation of the amortization and review of the amortization period would test the valuation and allocation assertion.Choice "b" is incorrect. Assertions about existence deal with whether assets, liabilities, and equity interests exist at a given date. Evaluating amortization does notrelate to this assertion. Choice "c" is incorrect. Assertions about completeness deal with whether all assets, liabilities, and equity interests that should be presentedin the financial statements are so includeD. Evaluating amortization does not relate to this assertion.Choice "d" is incorrect. Assertions about rights and obligations deal with whether assets are the rights of the entity and liabilities are the obligations of the entity at agiven date. Evaluating amortization does not relate to this assertion.

QUESTION 17Analytical procedures used in the overall review stage of an audit generally include:

A. Gathering evidence concerning account balances that have not changed from the prior year.B. Retesting control activities that appeared to be ineffective during the assessment of control risk.C. Considering unusual or unexpected account balances that were not previously identified.D. Performing tests of transactions to corroborate management's financial statement assertions.



Choice "c" is correct. The objective of analytical procedures used in the overall review stage of the audit is to assist the auditor in assessing conclusions reachedand in the evaluation of the overall financial statement presentation. Analytical procedures applied in the overall review stage are used to consider the adequacy ofevidence gathered in response to unusual or unexpected balances identified in planning the audit, and to identify unusual or unexpected balances or relationshipsthat were not previously identified.Choice "a" is incorrect. If analytical procedures are used to gather evidence about account balances that have not changed from last year, they are functioning as asubstantive test rather than as a final review procedure.Choice "b" is incorrect. Analytical procedures are not used to test controls. Choice "d" is incorrect. If analytical procedures are used as a test of transactions, theyare functioning as a substantive test rather than as a final review procedure.

QUESTION 18Which of the following would not be considered an analytical procedure?

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


Explanation/Reference:Explanation:Choice "b" is correct. Analytical procedures involve comparison of recorded amounts, or ratios developed from recorded amounts, to expectations developed by theauditor. Projecting an error rate from a statistical sample does not involve such a comparison. Choice "a" is incorrect. An analytical procedure involves comparisonof an independently developed expectation to a recorded amount. Comparing an estimate of payroll expense (developed by multiplying the number of employees bythe average hourly rate and the total hours worked) to the recorded expense is an analytical procedure.Choice "c" is incorrect. An analytical procedure involves comparison of an independently developed expectation to a recorded amount. Ratio analysis is oftenperformed in order to compare recorded results to industry norms or to past performance, and therefore calculation of accounts receivable turnover is likely to be ananalytical procedure.Choice "d" is incorrect. An analytical procedure involves comparison of an independently developed expectation to a recorded amount. Comparing an estimate ofsales (developed based on a trend analysis) to the recorded amount is an analytical procedure.

QUESTION 19Which of the following procedures would an auditor most likely perform in auditing the statement of cash flows?

A. Compare the amounts included in the statement of cash flows to similar amounts in the prior year's statement of cash flows.B. Reconcile the cutoff bank statements to verify the accuracy of the year-end bank balances.C. Vouch all bank transfers for the last week of the year and first week of the subsequent year.

D. Reconcile the amounts included in the statement of cash flows to the other financial statements' balances and amounts.



Choice "d" is correct. To audit the statement of cash flows, the auditor reconciles the amounts on the statement to amounts on other financial statements.Choice "a" is incorrect. Comparison of amounts on the cash flow statement with those of the previous period is an analytical procedure that is not commonly used toaudit the statement of cash flows, since sources and uses of cash in the current year are not necessarily predictable based on sources and uses from the prioryear.Choice "b" is incorrect. Reconciling the cutoff bank statement is a procedure used to audit the cash balance, rather than the statement of cash flows.Choice "c" is incorrect. Vouching all bank transfers is a procedure used to audit the cash balance, rather than the statement of cash flows.


A. Determine that changes in employee pay rates after year-end were properly authorized.B. Recompute depreciation charges for plant assets sold after year-end.C. Inquire about payroll checks that were recorded before year-end but cashed after year-end.D. Investigate changes in long-term debt occurring after year-end.



Choice "d" is correct. Long-term debt that matures within one year is reported as a current liability on the balance sheet. An auditor reviews changes in long-termdebt occurring after year-end to evaluate whether such debt is appropriately classified on the balance sheet. Choice "a" is incorrect. Subsequent changes inemployee pay rates are not relevant to the current year's audit report.Choice "b" is incorrect. Depreciation charges for assets sold in the subsequent period are not relevant to the current year's audit report.Choice "c" is incorrect. Payroll checks that were recorded close to (but before) year-end often are not cashed until the subsequent period. The auditor would not beparticularly concerned about this.

QUESTION 21Which of the following presumptions is correct about the reliability of audit evidence?

A. Information obtained indirectly from outside sources is the most reliable evidential matter.B. To be reliable, audit evidence should be conclusive rather than persuasive.C. Reliability of audit evidence refers to the amount corroborative evidence obtained.D. An effective internal control structure provides more assurance about the reliability of audit evidence.



Choice "d" is correct. Reliability of audit evidence is enhanced by a satisfactory internal control structure.Choice "a" is incorrect. Information obtained directly from outside sources is more reliable than that obtained indirectly.Choice "b" is incorrect. In the great majority of cases, the auditor finds it necessary to rely on evidence that is persuasive rather than conclusive.Choice "c" is incorrect. The amount of corroborative evidence obtained refers to the sufficiency of the evidence, not its reliability.

QUESTION 22For audits of financial statements made in accordance with generally accepted auditing standards, the use of analytical procedures is required to some extent:




Choice "c" is correct. Analytical procedures are required to be applied to some extent in planning and in the final review stage. In addition, although not required,analytical procedures may be used as a substantive test when they are more effective or efficient than tests of details. Choices "a", "b", and "d" are incorrect, perthe above Explanation: .

QUESTION 23Which of the following ratios would an engagement partner most likely calculate when reviewing the balance sheet in the overall review stage of an audit?

A. Quick assets/current assets.B. Accounts receivable/inventory.C. Interest payable/interest receivable.D. Total debt/total assets.



Choice "d" is correct. During the final review stage of an audit, the auditor focuses on the overall presentation of the financial statements. Total debt/total assetsindicates the portion of assets financed by creditors, which is a meaningful ratio to calculate during the final audit review. Choice "a" is incorrect. Quick assets/current assets simply indicates the percentage of current assets that are also "quick" assets. It is not a particularly meaningful ratio. Choice "b" is incorrect.Accounts receivable/inventory is not a meaningful ratio because it compares a figure based on retail dollars with a cost-based figure. Choice "c" is incorrect. Interestpayable/interest receivable is not a meaningful ratio because these two amounts are not related.

QUESTION 24To measure how effectively an entity employs its resources, an auditor calculates inventory turnover by dividing average inventory into:

A. Net sales.B. Cost of goods sold.C. Operating income.D. Gross sales.



Choice "b" is correct. The appropriate numerator for calculating inventory turnover is cost of goods sold.Cost of goods sold is the expense most clearly associated with the sale (turnover) of inventory, which is priced at acquisition cost, not selling price.Choice "a" is incorrect. Net sales is a measure of revenue that reflects the price at which inventory was sold, not its recorded inventoriable value.Choice "c" is incorrect. Operating income does not tie specifically to the recorded value of inventory sold because it reflects the sales price after all operatingexpenses. Choice "d" is incorrect. Gross sales is a measure of revenue that reflects the price at which inventory was sold, not its recorded inventoriable value.

QUESTION 25What effect would the sale of a company's trading securities at their carrying amounts for cash have on each of the following ratios?




Choice "a" is correct. Trading securities are both current assets and quick assets. If they are sold for their carrying value, then both total current assets and totalquick assets remain constant since one type of current asset and quick asset is traded for another. Thus, both the current ratio and the quick ratio would beunaffected by the sale of trading securities. Choices "b", "c", and "d" are incorrect, per the above Explanation: .

QUESTION 26The following data pertain to Cowl, Inc., for the year ended December 31, 20X4:

What was Cowl's rate of return on assets for 20X4?

A. 5%

B. 6%C. 20%D. 24%



Choice "b" is correct. Rate of return on assets is defined as the net income divided by the average total assets. In this case:

$150,000 / [($2,000,000 + $3,000,000)/2]or [$150,000 / $2,500,000] = 6% rate of return.

Choice "a" is incorrect. Average total assets ($2,500,000) should be used, not ending assets ($3,000,000).Choice "c" is incorrect. Net income ($150,000) and average total assets ($2,500,000) should be used, not net sales ($600,000) and ending assets ($3,000,000).Choice "d" is incorrect. Net income ($150,000) should be used, not net sales ($600,000).

QUESTION 27Selected data pertaining to Lore Co. for the calendar year 20X4 is as follows:

The accounts receivable turnover for 20X4 was 5.0 times. What were Lore's 20X4 net credit sales?

A. $105,000B. $107,000C. $110,000D. $210,000

Correct Answer: A

Section: Auditing and Attestation (II) (Volume D)Explanation


Choice "a" is correct. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable. 5.0 = net credit sales / [($20,000 +$22,000)/2]. Net credit sales equal $105,000. Choice "b" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accountsreceivable.Choice "c" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable, not by year-end accounts receivable.Choice "d" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable, not by the sum of beginning andending accounts receivable.


What was the inventory turnover for 20X4?

A. 1.2 times.B. 1.5 times.C. 2.0 times.D. 3.0 times.



Choice "c" is correct. Inventory turnover equals cost of goods sold divided by average inventory. Beginning inventory ($6,000) plus purchases ($24,000) less endinginventory equals cost of goods sold ($18,000). Thus, ending inventory equals $12,000 and inventory turnover = $18,000 / [($6,000 + $12,000)/2] = 2.0.

Choice "a" is incorrect. Inventory turnover equals cost of goods sold divided by average inventory. Choice "b" is incorrect. Cost of goods sold should be divided byaverage inventory, not by ending inventory.Choice "d" is incorrect. Cost of goods sold should be divided by average inventory, not by beginning inventory.


Lore would use which of the following to determine the average days sales in inventory?




Choice "b" is correct. Average number of days sales in inventory is defined as 365 days per year divided by the inventory turnover.Choice "a" is incorrect. The denominator used to determine average days sales in inventory is inventory turnover. Inventory turnover is cost of goods sold divided byaverage inventory, not simply average inventory.

Choice "c" is incorrect. The days sales in inventory calculation uses the cost of goods sold figure, not the sales figure.Choice "d" is incorrect. The days sales in inventory calculation uses 365 in the numerator, not sales divided by 365.

QUESTION 30In analyzing a company's financial statements, which financial statement would a potential investor primarily use to assess the company's liquidity and financialflexibility?

A. Balance sheet.B. Income statement.C. Statement of retained earnings.D. Statement of cash flows.



Choice "a" is correct. Liquidity ratios and coverage ratios focus on balance sheet account balances. Choice "b" is incorrect. Income statement information isprimarily used for profitability analysis. Choice "c" is incorrect. The statement of retained earnings is primarily a reconciliation of the retained earnings account.Choice "d" is incorrect. The statement of cash flows assesses cash inflows and cash outflows.

QUESTION 31At December 31, 20X2, Curry Co. had the following balances in selected asset accounts:

Curry also had current liabilities of $1,000 at December 31, 20X2, and net credit sales of $7,200 for the year then ended.

What is Curry's acid-test ratio at December 31, 20X2?

A. 1.5B. 1.6C. 2.0D. 2.1



Choice "a" is correct. The acid-test ratio is calculated by taking the current assets excluding inventory and prepaid expenses and dividing by current liabilities. In thiscase, cash and accounts receivable ($300 + $1,200 = $1,500) are divided by current liabilities ($1,000), resulting in a ratio of $1,500/$1,000, or 1.5.Choice "b" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include prepaid expenses.Choice "c" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include inventory.Choice "d" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include inventory and prepaidexpenses.

QUESTION 32At December 31, 20X2, Curry Co. had the following balances in selected asset accounts:

Curry also had current liabilities of $1,000 at December 31, 20X2, and net credit sales of $7,200 for the year then ended.What was the average number of days to collect Curry's accounts receivable during 20X2?

A. 30.4

B. 40.6C. 50.7D. 60.8



Choice "c" is correct. The average number of days to collect accounts receivable is calculated by dividing 365 days by the accounts receivable turnover. Accountsreceivable turnover is net credit sales divided by the average accounts receivable:

Choice "a" is incorrect. The denominator should be net credit sales ($7,200) divided by average receivables $1,000), or 7.2, not 12.

Choice "b" is incorrect. The average receivable balance is $1,000, not $800. The right-hand column shows the increase over 20X1, so the 20X1 receivable balancewas $1,200 - $400, or $800. Since the 20X2 receivable balance was given as $1,200, the average receivable balance is $1,000. Choice "d" is incorrect. Averageinventory ($1,000), not ending inventory ($1,200), should be used.

QUESTION 33An independent auditor asked a client's internal auditor to assist in preparing a standard financial institution confirmation request for a payroll account that had beenclosed during the year under audit. After the internal auditor prepared the form, the controller signed it and mailed it to the bank. What was the major flaw in thisprocedure?

A. The internal auditor did not sign the form.B. The form was mailed by the controller.C. The form was prepared by the internal auditor.D. The account was closed, so the balance was zero.



Choice "b" is correct. The auditor should control the mailing of independent confirmations. Choice "a" is incorrect. It is appropriate for a member of management,such as the controller, to sign the confirmation request.Choice "c" is incorrect. It is acceptable for an internal auditor to provide direct assistance to the external auditor, such as by preparing confirmation forms. Choice"d" is incorrect. Confirmations may be sent to accounts that show a zero balance, to test for understatement errors or to obtain information about loans.

QUESTION 34Which of the following types of audit evidence generally is the most reliable?

A. Inquiries made of management.B. Confirmation of account information.C. Analytical procedures.D. Review of prior-year audit procedures.



Choice "b" is correct. Confirmations are among the most reliable types of evidence, as they constitute external evidence sent directly to the auditor.Choice "a" is incorrect. Inquiries provide oral evidence, which is less reliable than confirmations. Choice "c" is incorrect. Analytical procedures provide the auditorwith direct personal knowledge, but because these procedures often are based on internal accounting data, the evidence obtained is not as reliable as that obtainedfrom confirmations.Choice "d" is incorrect. Review of audit procedures from the previous year does not provide appropriate audit evidence regarding the current year's financialstatements.

QUESTION 35An auditor compares annual revenues and expenses with similar amounts from the prior year and investigates all changes exceeding 10%. This procedure mostlikely could indicate that:

A. Fourth quarter payroll taxes were properly accrued and recorded, but were not paid until early in the subsequent year.B. Unrealized gains from increases in the value of available-for-sale securities were recorded in the income account for trading securities.C. The annual provision for uncollectible accounts expense was inadequate because of worsening economic conditions.D. Notice of an increase in property tax rates was received by management, but was not recorded until early in the subsequent year.

Correct Answer: B



Choice "b" is correct. Unrealized gains on available-for-sale securities should properly be recorded in other comprehensive income. If such gains were erroneouslyrecorded in the income account for trading securities, this might be discovered through comparison of the current year and prior year revenues and expenses(assuming the error occurred only in the current year, and not in the prior year). Choice "a" is incorrect. If payroll taxes were properly accrued and recorded, there isunlikely to be a significant change in revenues and expenses for the current year as compared to the prior year. Payables would not be part of the comparison ofrevenues and expenses. Choice "c" is incorrect. In times of worsening economic conditions, one would expect the annual provision for uncollectible accounts toincrease. Since this answer option indicates that the provision was inadequate, it would appear that the client did not increase the provision appropriately.Investigating changes in revenues and expenses would not be likely to identify this error, since failing to increase the provision would likely result in there being littlechange between the two years. Choice "d" is incorrect. An increase in property tax rates should cause a corresponding increase in accrued property tax expense;however, the question indicates that the appropriate increase was not recorded in the current year. Investigating changes in revenues and expenses would not belikely to identify this error, since failing to increase the expense would likely result in there being little change between the two years.

QUESTION 36An auditor most likely would apply analytical procedures in the overall review stage of an audit to:

A. Enhance the auditor's understanding of subsequent events.B. Identify auditing procedures omitted by the staff accountants.C. Determine whether additional audit evidence may be needed.D. Evaluate the effectiveness of the internal control activities.



Choice "c" is correct. In performing analytical procedures as an overall review, the auditor determines whether adequate evidence has been gathered in response tounusual or unexpected balances identified during the audit, and may decide that additional audit procedures are warranted. In addition, the auditor may identifyunusual or unexpected balances not already noted during the audit, which would also require the application of further auditing procedures. Choice "a" is incorrect.Analytical procedures applied during the overall review stage of the audit are meant to evaluate the overall financial statement presentation, and to assess theconclusions reached by the auditor. This is a high-level review, and one that focuses on the financial statements. As such, it would not be likely to enhance theauditor's understanding of subsequent events. Choice "b" is incorrect. Analytical procedures applied during the overall review stage of the audit are meant toevaluate the overall financial statement presentation, and to assess the conclusions reached by the auditor. This is a high-level review, and one that focuses on thefinancial statements. As such, it would not be likely to identify omitted auditing procedures. Choice "d" is incorrect. Analytical procedures applied during the overallreview stage of the audit are meant to evaluate the overall financial statement presentation, and to assess the conclusions reached by the auditor. This is a high-

level review, and one that focuses on the financial statements. As such, it would not be useful in evaluating the effectiveness of the client's internal control activities.

QUESTION 37Analytical procedures performed during an audit indicate that accounts receivable doubled since the end of the prior year. However, the allowance for doubtfulaccounts as a percentage of accounts receivable remained about the same. Which of the following client Explanation: s would satisfy the auditor?

A. A greater percentage of accounts receivable are listed in the "more than 120 days overdue" category than in the prior year.B. Internal control activities over the recording of cash receipts have been improved since the end of the prior year.C. The client opened a second retail outlet during the current year and its credit sales approximately equaled the older outlet.D. The client tightened its credit policy during the current year and sold considerably less merchandise to customers with poor credit ratings.



Choice "c" is correct. If a second, similar retail outlet were opened, one would expect sales and accounts receivable to double. As long as the collection rates for thenew outlet's receivables were expected to be similar to those of the original outlet, the allowance for doubtful accounts as a percentage of accounts receivablewould remain the same. Choice "a" is incorrect. If more receivables are potentially uncollectible in the current year (as opposed to the prior year), the allowance fordoubtful accounts as a percentage of receivables should increase to reflect the greater level of estimated bad debts.Choice "b" is incorrect. Improved control activities related to the recording of cash receipts might result in a decrease in accounts receivable in the current year ascompared to the prior year, not an increase. In addition, improving such controls would not be likely to affect the allowance for doubtful accounts as a percentage ofreceivables.Choice "d" is incorrect. If the client sold less merchandise to customers with poor credit ratings, the allowance for doubtful accounts as a percentage of receivablesshould decrease to reflect the lower level of estimated bad debts.

QUESTION 38The most reliable procedure for an auditor to use to test the existence of a client's inventory at an outside location would be to:

A. Observe physical counts of the inventory items.B. Trace the total on the inventory listing to the general ledger inventory account.C. Obtain a confirmation from the client indicating inventory ownership.D. Analytically compare the current-year inventory balance to the prior-year balance.



Choice "a" is correct. The auditor's personal observation is generally one of the most reliable forms of evidence. Observing physical inventory counts providesreliable evidence that the inventory actually exists.Choice "b" is incorrect. Tracing totals from the inventory listing to the general ledger inventory account provides evidence of completeness, not existence.Choice "c" is incorrect. A confirmation from the client indicating ownership provides some evidence regarding rights and obligations, but does not provide evidenceof existence. Choice "d" is incorrect. Analytical comparisons of current year to prior year inventory balances might provide some evidence regarding completeness,existence, and valuation, but this is not as reliable a procedure for verifying existence as is the auditor's direct personal observation.

QUESTION 39An auditor compared the current-year gross margin with the prior-year gross margin to determine if cost of sales is reasonable. What type of audit procedure wasperformed?

A. Test of transactions.B. Analytical procedures.C. Test of controls.D. Test of details.



Choice "b" is correct. Analytical procedures are evaluations of financial information made by a study of plausible relationships among data, and they includecomparisons between current year and prior year financial information.Choice "a" is incorrect. Tests of transactions involve selecting specific transactions and evaluating whether they were properly recorded. Comparing current yearand prior year gross margin would not provide information regarding specific transactions.Choice "c" is incorrect. Tests of controls are performed to evaluate the effectiveness of controls. Comparing current year and prior year gross margin would notprovide information regarding controls. Choice "d" is incorrect. Test of details are audit procedures used to gather evidence to support specific account balances.Comparing current year and prior year gross margin does not provide much information regarding specific account balances, although it might identify an accountbalance worthy of further consideration.

QUESTION 40Which of the following procedures would yield the most reliable evidence?

A. A scanning of trial balances.B. An inquiry of client personnel.

C. A comparison of beginning and ending retained earnings.D. A recalculation of bad debt expense.



Choice "d" is correct. The auditor's direct personal knowledge (obtained through observation, examination, inspection, or recalculation) is one of the most reliableforms of evidence. Choice "a" is incorrect. Scanning of trial balances may indicate areas where more attention should be focused (e.g., unusual balances, zerobalances, etc.), but would seldom provide reliable evidence in and of itself.Choice "b" is incorrect. Inquiry of client personnel provides evidence that is not particularly reliable, which is why it often needs to be corroborated by the auditor.Choice "c" is incorrect. A comparison of beginning and ending retained earnings may provide information about certain transactions and events (e.g., dividends,income, etc.), but would not in and of itself provide evidence supporting those items.

QUESTION 41Which of the following procedures would be most effective in reducing attestation risk?

A. Discussion with responsible individuals.B. Examination of evidence.C. Inquiries of senior management.D. Analytical procedures.



Choice "b" is correct. Evidence obtained directly by the accountant (e.g., through physical examination) provides more persuasive evidence than evidence obtainedthrough inquiry, discussion, or analytical procedures, and therefore reduces attestation risk. Choices "a", "c", and "d" are incorrect, based on the aboveExplanation: .

QUESTION 42Which of the following factors would most likely influence an auditor's consideration of the reliability of data when performing analytical procedures?

A. Whether the data were developed in a computerized or a manual accounting system.

B. Whether the data were prepared on the cash basis or in conformity with GAAP.C. Whether the data were developed under a system with adequate controls.D. Whether the data were processed in an online system or a batch entry system.



Choice "c" is correct. Strong, effective internal controls improve the reliability of data. Choice "a" is incorrect. The type of accounting system used does not affect thereliability of data. Both computerized and manual accounting systems can provide reliable data, as long as there are appropriate controls in place.Choice "b" is incorrect. The accounting basis used does not affect the reliability of data. Reliable data may be provided regardless of whether the cash basis oraccrual basis (GAAP) is used, as long as there are appropriate controls in place.Choice "d" is incorrect. The type of processing system used does not affect the reliability of data. Both online systems and batch systems can provide reliable data,as long as there are appropriate controls in place.

QUESTION 43At the conclusion of an audit, an auditor is reviewing the evidence gathered in support of the financial statements. With regard to the valuation of inventory, theauditor concludes that the evidence obtained is not sufficient to support management's representations. Which of the following actions is the auditor most likely totake?

A. Consult with the audit committee and issue a disclaimer of opinion.B. Consult with the audit committee and issue a qualified opinion.C. Obtain additional evidence regarding the valuation of inventory.D. Obtain a statement from management supporting their inventory valuation.



Choice "c" is correct. If an auditor has doubts about a material assertion (such as the valuation of inventory), he/she should gather sufficient evidence to eliminatethe doubt. Choices "a" and "b" are incorrect. The auditor would not consult with the audit committee regarding the sufficiency of audit evidence obtained, as this isdetermined based on the auditor's own judgment. In addition, if the auditor is able to obtain additional evidence, it might be possible to issue an unqualified opinion.Finally, even if no additional evidence is available, the auditor will still need to decide whether a qualified opinion or a disclaimer of opinion is more appropriate,depending on materiality.

Choice "d" is incorrect. Since management representations are in fact "statements from management," obtaining additional statements from management wouldnot provide additional support.

QUESTION 44Which of the following procedures would an auditor most likely perform in auditing the statement of cash flows?

A. Reconcile the amounts included in the statement of cash flows to the other financial statements' amounts.B. Vouch a sample of cash receipts and disbursements for the last few days of the current year.C. Reconcile the cutoff bank statement to the proof of cash to verify the accuracy of the year-end cash balance.D. Confirm the amounts included in the statement of cash flows with the entity's financial institution.



Choice "a" is correct. To audit the statement of cash flows, the auditor reconciles the amounts on the statement to amounts on other financial statements.Choice "b" is incorrect. Vouching a sample of cash receipts and disbursements is a procedure used to audit the cash balance, rather than the statement of cashflows. Choice "c" is incorrect. Reconciling the cutoff bank statement to the proof of cash to verify the accuracy of the year-end cash balance is a procedure used toaudit the cash balance, rather than the statement of cash flows.Choice "d" is incorrect. Confirming cash amounts with the entity's financial institution is a procedure used to audit the cash balance, rather than the statement ofcash flows.Evidential Procedures for Selected Accounts

QUESTION 45An auditor reviews the reconciliation of payroll tax forms that a client is responsible for filing in orderto:

A. Verify that payroll taxes are deducted from employees' gross pay.B. Determine whether internal control activities are operating effectively.C. Uncover fictitious employees who are receiving payroll checks.D. Identify potential liabilities for unpaid payroll taxes.



Explanation:

Choice "d" is correct. An auditor reviews the reconciliation of payroll tax forms that a client is responsible for filing in order to identify potential liabilities for unpaidpayroll taxes. Choice "a" is incorrect. Payroll deductions are verified by inspecting the payroll register and, for a sample of employees, tracing deductions back toemployee authorization forms held in the personnel department.Choice "b" is incorrect. Review of the reconciliation of payroll tax forms is a substantive test that would not indicate whether internal control activities with respect topayroll are operating effectively. Choice "c" is incorrect. Review of the reconciliation of payroll tax forms would not uncover fictitious employees. The auditor wouldneed to observe payroll distribution (or examine direct deposits) to ensure that all personnel being paid are actually employed by the company.

QUESTION 46An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that:

A. Fictitious credit sales have been recorded during the year.B. Employees have stolen inventory just before the year-end.C. The client recently tightened its credit-granting policies.D. An employee has been lapping receivables in both years.



Choice "a" is correct. Recording fictitious sales generally has the same impact on revenues and receivables: both would be overstated by the same dollar amount.However, this will cause the accounts receivable turnover ratio to decrease, because the sales figure for the year is generally much larger than the averagereceivables amount. Since the numerator (sales) is being increased far less proportionately than is the denominator (receivables), overall the ratio will decline. (Tryusing actual numbers if you want to see how this works: Assume sales of $2,000,000 and average receivables of $300,000. What will happen to the ratio if youincrease both of these numbers by $50,000? It will go from 6.7% to 5.9%--a decline.)

Choice "b" is incorrect. Inventory stolen by employees just before year-end would not affect the accounts receivable turnover ratio, which is calculated as net creditsales divided by average gross receivables.Choice "c" is incorrect. A substantially lower accounts receivable turnover ratio may indicate collectability issues. This might be the result of the client loosening (nottightening) its credit-granting policies.Choice "d" is incorrect. If an employee has been lapping receivables in both years, the accounts receivable turnover ratio would not be substantially lower in oneyear compared to the other.

QUESTION 47Which of the following strategies most likely could improve the response rate of the confirmation of accounts receivable?

A. Including a list of items or invoices that constitute the account balance.

B. Restricting the selection of accounts to be confirmed to those customers with relatively large balances.C. Requesting customers to respond to the confirmation requests directly to the auditor by fax or e- mail.D. Notifying the recipients that second requests will be mailed if they fail to respond in a timely manner.



Choice "a" is correct. Some accounting systems facilitate the confirmation of single transactions rather than entire balances. In such cases, inclusion of statementsof account showing details of the balances being confirmed makes it easier for the customers to confirm the balances, and therefore may improve the overallresponse rate.Choice "b" is incorrect. Restricting the selection of accounts to be confirmed to those customers with large balances would not necessarily improve the responserate, as there is no particular relationship between balance size and the likelihood of response.Choice "c" is incorrect. Requesting customers to respond to the confirmation requests electronically would not necessarily improve the response rate. It also mightnot be appropriate to request responses in electronic form, since the auditor will still request that the original be mailed back. Choice "d" is incorrect. Notifying therecipients that second requests will be mailed would not necessarily improve the response rate, since the consequence of not responding (receiving a secondrequest) is relatively minor.

QUESTION 48In performing a count of negotiable securities, an auditor records the details of the count on a security count worksheet. What other information is usually includedon this worksheet?

A. An acknowledgment by a client representative that the securities were returned intact.B. An analysis of realized gains and losses from the sale of securities during the year.C. An evaluation of the client's internal control concerning physical access to the securities.D. A description of the client's procedures that prevent the negotiation of securities by just one person.



Choice "a" is correct. After performing a count of negotiable securities, the auditor would generally obtain an acknowledgment from the client that the securitieswere returned intact. This helps maintain accountability for the securities, and reduces the likelihood of employee misappropriation (e.g., if a client employee were tosteal a security and blame the auditor). Choice "b" is incorrect. The auditor generally would not include an analysis of realized gains and losses on a security count

worksheet, although this information would be included elsewhere in the audit documentation.Choice "c" is incorrect. The auditor generally would not include an evaluation of the client's internal control on a security count worksheet, although this informationwould be included elsewhere in the audit documentation.Choice "d" is incorrect. The auditor generally would not include a description of the client's control procedures on a security count worksheet, although thisinformation might be included elsewhere in the audit documentation.

QUESTION 49To reduce the risks associated with accepting e-mail responses to requests for confirmation of accounts receivable, an auditor most likely would:

A. Request the senders to mail the original forms to the auditor.B. Examine subsequent cash receipts for the accounts in question.C. Consider the e-mail responses to the confirmations to be exceptions.D. Mail second requests to the e-mail respondents.



Choice "a" is correct. E-mail responses to requests for confirmations of accounts receivable present a problem to the auditor, since the sender might not be asrequested and the content might be altered. To reduce these risks, the auditor should request the senders to mail the original forms to the auditor. Choice "b" isincorrect. Examination of subsequent cash receipts might be an acceptable alternative procedure, but it would not reduce the risks associated with accepting e-mailresponses to requests for confirmations of accounts receivable.Choice "c" is incorrect. Since the e-mail responses may be valid responses, the auditor should not consider them to be exceptions.Choice "d" is incorrect. Mailing second requests to the e-mail respondents would not be necessary, since the sender did receive and respond to the first request.Requesting that the original confirmation be returned is a more likely response.

QUESTION 50In testing plant and equipment balances, an auditor may inspect new additions listed on the analysis of plant and equipment. This procedure is designed to obtainevidence concerning management's assertions of:




Choice "b" is correct. Inspection of plant and equipment by the auditor provides evidence concerning the existence of the equipment; if the auditor can see it, itexists. However, physical inspection does not provide any evidence concerning whether the amounts paid for plant and equipment are properly presented,described, and disclosed. Only reviewing drafts of the financial statements will provide evidence regarding understandability and classification. Choice "a" isincorrect. Physical inspection does not provide any evidence concerning whether the amounts paid for plant and equipment are properly presented, described, anddisclosed. Choice "c" is incorrect. Physical inspection of equipment does not provide any evidence concerning whether the amounts paid for the equipment areproperly presented, described, and disclosed. Only reviewing drafts of the financial statements provides evidence regarding understandability and classification.However, inspection of plant and equipment by the auditor does provide evidence concerning the existence of the equipment; if the auditor can see it, it exists.Choice "d" is incorrect. Inspection of plant and equipment by the auditor does provide evidence concerning the existence of the equipment: if the auditor can see it,it exists.

QUESTION 51In auditing accounts receivable, the negative form of confirmation request most likely would be used when:

A. The total recorded amount of accounts receivable is immaterial to the financial statements taken as a whole.B. Response rates in prior years to properly designed positive confirmation requests were inadequate.C. Recipients are likely to return positive confirmation requests without verifying the accuracy of the information.D. The combined assessed level of inherent risk and control risk relative to accounts receivable is low.



Choice "d" is correct. Negative confirmations are most likely to be used when the assessed level of audit risk, including inherent and control risk, is low. Choice "a"is incorrect. If the total amount of accounts receivable is immaterial, the auditor is not likely to send any confirmations.

Choice "b" is incorrect. If prior year response rates were low, negative confirmations would not be used since the auditor would be concerned that the negativeconfirmations would not receive adequate attention from the recipients.Choice "c" is incorrect. An auditor would need to feel comfortable that the confirmations would receive adequate attention from the recipients before deciding tosend negative confirmations.

QUESTION 52An auditor usually tests the reasonableness of dividend income from investments in publicly-held companies by computing the amounts that should have beenreceived by referring to:

A. Dividend record books produced by investment advisory services.B. Stock indentures published by corporate transfer agents.C. Stock ledgers maintained by independent registrars.D. Annual audited financial statements issued by the investee companies.



Choice "a" is correct. Dividend income from investments is tested by referring to the dividend record books produced by investment advisory services, such as"Moody's Dividend Record." These books state the dividend that was declared and paid by the investee. Choice "b" is incorrect. Stock indentures (initial stockagreements) published by corporate transfer agents discuss intent with respect to dividend declaration, but actual dividend declarations may vary. In addition, it ismore efficient to use a single source (such as "Moody's") than to obtain and review stock indentures for each individual investment.Choice "c" is incorrect. Stock ledgers maintained by independent registrars indicate how many shares of stock are issued and outstanding, and identify theshareholders of record, but they do not contain information concerning dividends.Choice "d" is incorrect. Annual audited financial statements of the investee companies give the total dividends paid, but there may not be enough information todetermine exactly how much went to each type of stock and hence to each stockholder. In addition, it is more efficient to use a single source (such as "Moody's")than to obtain and review the financial statements of each investee.

QUESTION 53Which of the following controls would a company most likely use to safeguard marketable securities when an independent trust agent is not employed?

A. The investment committee of the board of directors periodically reviews the investment decisions delegated to the treasurer.B. Two company officials have joint control of marketable securities, which are kept in a bank safedeposit box.C. The internal auditor and the controller independently trace all purchases and sales of marketable securities from the subsidiary ledgers to the general ledger.D. The chairman of the board verifies the marketable securities, which are kept in a bank safe-deposit box, each year on the balance sheet date.

Correct Answer: B



Choice "b" is correct. Joint custody by two company officials over assets like cash and marketable securities helps safeguard the assets. Under joint custody,collusion is required for a defalcation to occur.Choice "a" is incorrect. Review of investment decisions made by the treasurer might reduce the probability of poor investment policies, but would not be likely tosafeguard marketable securities after purchase.Choice "c" is incorrect. Tracing purchases and sales from the subsidiary ledger to the general ledger would help ensure that all existing securities are recorded inthe financial statements, but would not help safeguard marketable securities.Choice "d" is incorrect. An annual count by the chairman of the board might provide a small safeguard, but the infrequent performance of the control makes it afairly weak one.

QUESTION 54When there are numerous property and equipment transactions during the year, an auditor who plans to assess control risk at a low level usually performs:

A. Tests of controls and extensive tests of property and equipment balances at the end of the year.B. Analytical procedures for current year property and equipment transactions.C. Tests of controls and limited tests of current year property and equipment transactions.D. Analytical procedures for property and equipment balances at the end of the year.



Choice "c" is correct. Since control risk is assessed at a low level, tests of controls would be required to evaluate the effectiveness of the internal controls to supportthat assessed level. Assuming controls are operating effectively, only limited substantive testing would be performed. Choice "a" is incorrect. Extensive tests ofproperty and equipment balances would not typically be required when control risk is assessed at a low level. Choice "b" is incorrect. Since control risk is to beassessed at a low level, tests of controls would be required. Analytical procedures would not be particularly useful, since property and equipment transactions aresubject to management discretion.Choice "d" is incorrect. Analytical procedures would not be particularly useful, since property and equipment transactions are subject to management discretion.Year-end balances may therefore be unpredictable.

QUESTION 55In determining the effectiveness of an entity's internal controls relating to the occurrence assertion for payroll transactions, an auditor most likely would inquire aboutand:

A. Observe the segregation of duties concerning personnel responsibilities and payroll disbursement.B. Inspect evidence of accounting for prenumbered payroll checks.C. Recompute the payroll deductions for employee fringe benefits.D. Verify the preparation of the monthly payroll account bank reconciliation.



Choice "a" is correct. The occurrence assertion as it relates to payroll transactions would correspond to an audit objective to determine that payroll transactionsactually occurred (i.e., that all payroll checks were issued to valid employees for hours actually worked). Segregation of duties between personnel and payrolldepartments is an important control to ensure that only valid employees receive paychecks. Choice "b" is incorrect. Inspecting evidence related to prenumbering ofpayroll checks would relate to the completeness assertion.Choice "c" is incorrect. Recomputing payroll deductions is a substantive test related to the accuracy assertion.Choice "d" is incorrect. Verifying the preparation of the monthly payroll account bank reconciliation would provide significant evidence for the accuracy assertion forpayroll transactions.

QUESTION 56A weakness in internal control over recording retirements of equipment may cause an auditor to:

A. Inspect certain items of equipment in the plant and trace those items to the accounting records.B. Review the subsidiary ledger to ascertain whether depreciation was taken on each item of equipment during the year.C. Trace additions to the "other assets" account to search for equipment that is still on hand but no longer being used.D. Select certain items of equipment from the accounting records and locate them in the plant.


Explanation/Reference:Explanation:Choice "d" is correct. Testing to see whether equipment listed in the accounting records is physically present in the plant and still in service is an effective way totest whether unrecorded disposals occurred.Choice "a" is incorrect. Tracing from equipment found in service to accounting records would be performed to test the completeness assertion that all equipment onhand has been recorded, rather than testing the assertion that all recorded equipment is still in service. Choice "b" is incorrect. Reviewing whether depreciation isstill being taken would not provide evidence about unrecorded fixed asset disposals unless the auditor also performs a physical inspection of the assets being

depreciated. Also, assets that are fully depreciated but still in service would not appear in depreciation records.Choice "c" is incorrect. Examining additions to the other assets account would not be likely to lead to discovery of unrecorded fixed asset disposals, since newerassets are not likely to have been retired.

QUESTION 57The confirmation of customers' accounts receivable rarely provides reliable evidence about the completeness assertion because:

A. Many customers merely sign and return the confirmation without verifying its details.B. Recipients usually respond only if they disagree with the information on the request.C. Customers may not be inclined to report understatement errors in their accounts.D. Auditors typically select many accounts with low recorded balances to be confirmed.



Choice "c" is correct. The completeness assertion states that all transactions that should be recorded are recorded. Accounts receivable confirmations rarelyprovide evidence about completeness since the recipients of the confirmations have a vested interest in not reporting understatements (i.e., transactions that havenot been recorded).Choice "a" is incorrect. While some customers may sign and return a confirmation without proper consideration, this is not the reason why confirmations do notprovide evidence about the completeness assertion relative to other assertions.Choice "b" is incorrect. If customers respond whenever they disagree with information printed on the confirmation, they would report both understatements andoverstatements, in which case confirmations would provide evidence about completeness. However, this is not what the auditor usually sees -- respondents areless likely to report understatement errors. Choice "d" is incorrect. The balance of the account is not a relevant factor in determining whether the completenessassertion is tested by sending confirmations. If there are many accounts with low balances, the auditor may decide to send negative confirmations.

QUESTION 58Which of the following Explanation: s most likely would satisfy an auditor who questions management about significant debits to the accumulated depreciationaccounts?

A. The estimated remaining useful lives of plant assets were revised upward.B. Plant assets were retired during the year.C. The prior year's depreciation expense was erroneously understated.D. Overhead allocations were revised at year-end.

Correct Answer: BSection: Auditing and Attestation (II) (Volume D)

Explanation


Choice "b" is correct. A debit to accumulated depreciation decreases the balance in that account. The retirement of plant assets necessitates the removal(decrease) of accumulated depreciation related to the retired asset by debiting accumulated depreciation.Choice "a" is incorrect. Remember that correction of an estimate is given prospective, not retroactive, treatment. Therefore, there would not be any decrease in theaccumulated depreciation taken in previous years, although future credits would be lower than previous credits had been. Choice "c" is incorrect. If the prior year'sdepreciation expense were understated (i.e., too low), the entry to correct the error would be a credit to accumulated depreciation. Choice "d" is incorrect. Revisionof overhead allocations would not result in a debit to accumulated depreciation.

QUESTION 59Which of the following circumstances most likely would cause an auditor to suspect an employee payroll fraud scheme?

A. There are significant unexplained variances between standard and actual labor cost.B. Payroll checks are disbursed by the same employee each payday.C. Employee time cards are approved by individual departmental supervisors.D. A separate payroll bank account is maintained on an imprest basis.



Choice "a" is correct. Significant unexplained variances between standard and actual labor costs may cause the auditor to suspect an employee payroll fraudscheme. Choice "b" is incorrect. Payroll checks generally are disbursed by the same person (or the same department) each payday, and this would not cause theauditor to suspect an employee payroll fraud scheme.Choice "c" is incorrect. Time card approval by departmental supervisors is a standard practice, and would not raise an auditor's suspicions of a payroll fraudscheme. Choice "d" is incorrect. Maintenance of a separate payroll bank account is a standard practice, and would not raise an auditor's suspicions of a payrollfraud scheme.

QUESTION 60An auditor generally tests the segregation of duties related to inventory by:

A. Personal inquiry and observation.B. Test counts and cutoff procedures.C. Analytical procedures and invoice recomputation.

D. Document inspection and reconciliation.



Choice "a" is correct. The independent auditor's direct personal knowledge, based on personal inquiry and observation, are auditing procedures commonly used totest segregation of duties. Choice "b" is incorrect. Test counts and cutoff procedures represent substantive tests, and they would not be used to test segregation ofduties.Choice "c" is incorrect. Analytical procedures and invoice recomputation represent substantive tests, and they would not be used to test segregation of duties.Choice "d" is incorrect. Document inspection and reconciliation represent substantive tests, and they would not be used to test segregation of duties.

QUESTION 61An auditor most likely would inspect loan agreements under which an entity's inventories are pledged to support management's financial statement assertion ofcompleteness with respect to:

A. Presentation and disclosure.B. Transactions and events.C. Account balances.D. All of the above.



Choice "a" is correct. Inspecting loan agreements under which an entity's inventories are pledged provides evidence regarding completeness with respect topresentation and disclosure, since such information must be disclosed in the financial statements. Choices "b", "c", and "d" are incorrect. Inspecting loanagreements under which an entity's inventories are pledged does not provide information regarding the completeness of transactions, events, or account balances.

QUESTION 62Tests designed to detect purchases made before the end of the year that have been recorded in the subsequent year most likely would provide assurance aboutmanagement's assertion regarding:

A. Accuracy.

B. Obligations.C. Cutoff.D. Classification.


Explanation/Reference:Explanation:Choice "c" is correct. If purchases made before the end of the year have been recorded in the subsequent year, inventory will not be complete. The auditor usescutoff tests to detect such situations and to determine that inventory quantities include all products, materials and supplies owned by the company. (Note that thecutoff assertion is closely related to the completeness and occurrence assertions.)Choice "a" is incorrect. Assertions about accuracy deal with whether data related to recorded transactions has been included in the financial statements atappropriate amounts. Cutoff tests do not provide evidence related to the accuracy assertion for purchases. Choice "b" is incorrect. Assertions about obligations dealwith account balances, not with transactions and events.Choice "d" is incorrect. Assertions about classification deal with whether particular components of the financial statements are properly presented, described, anddisclosed. Cutoff tests would not provide evidence relevant to classification.

QUESTION 63An auditor most likely would make inquiries of production and sales personnel concerning possible obsolete or slow-moving inventory to support management'sfinancial statement assertion of:

A. Valuation and allocation.B. Rights and obligations.C. Existence.D. Understandability and classification.



Choice "a" is correct. An audit objective for inventory valuation and allocation is to determine that slowmoving, excess, defective and obsolete items included ininventory are properly identified. Inquiries of production and sales personnel concerning possible excess or obsolete inventory items would support management'sassertion of valuation and allocation. Choice "b" is incorrect. Assertions about rights and obligations deal with whether assets are the rights of the entity andliabilities are the obligations of the entity at a given date. Choice "c" is incorrect. Assertions about existence deal with whether assets, liabilities, and equity interestsexist at a given date.

Choice "d" is incorrect. Assertions about understandability and classification deal with whether particular components of the financial statements are properlypresented, described, and disclosed.

QUESTION 64Which of the following statements is correct concerning the use of negative confirmation requests?

A. Unreturned negative confirmation requests rarely provide significant explicit evidence.B. Negative confirmation requests are effective when detection risk is low.C. Unreturned negative confirmation requests indicate that alternative procedures are necessary.D. Negative confirmation requests are effective when understatements of account balances are suspected.



Choice "a" is correct. Although returned negative confirmations may provide evidence about the financial statement assertions, unreturned negative confirmationrequests do not provide explicit evidence that the intended third parties received the confirmation requests and verified that the information contained in them iscorrect.Choice "b" is incorrect. Negative confirmation requests may be used when the combined assessed level of inherent and control risk is low, which would generallyimply that a somewhat higher level of detection risk could be accepted.Choice "c" is incorrect. Alternative procedures are necessary only for unreturned positive confirmation requests. Unreturned negative confirmation requestsgenerally imply that the respondent agrees with the stated balance.Choice "d" is incorrect. Accounts receivable confirmations in general provide little assurance when understatements of account balances are suspected, sincerecipients have a vested interest in not reporting such understatements.

QUESTION 65When an auditor does not receive replies to positive requests for year-end accounts receivable confirmations, the auditor most likely would:

A. Inspect the allowance account to verify whether the accounts were subsequently written off.B. Increase the assessed level of detection risk for the valuation and completeness assertions.C. Ask the client to contact the customers to request that the confirmations be returned.D. Increase the assessed level of inherent risk for the revenue cycle.



Choice "c" is correct. When using positive confirmation requests, the auditor should generally follow up with a second and sometimes third request to those partiesfrom whom replies have not been received.In addition, asking the client to contact its customers may encourage further responses. Choice "a" is incorrect. Confirmations are designed to provide evidence ofexistence, so nonresponses would require alternative procedures focused on existence as well. Verification that the account was subsequently written off tests thevaluation assertion, but does not provide evidence of existence. Choice "b" is incorrect. The auditor sets detection risk based on the assessed levels of inherent riskand control risk, and would only increase the acceptable level of detection risk in response to a decrease in inherent or control risk. Failure to receive confirmationswould not cause the auditor to make such a change.Choice "d" is incorrect. Inherent risk assessments would not be affected by confirmation response rates, which are not subject to client control.

QUESTION 66In confirming a client's accounts receivable in prior years, an auditor found that there were many differences between the recorded account balances and theconfirmation replies. These differences, which were not misstatements, required substantial time to resolve. In defining the sampling unit for the current year's audit,the auditor most likely would choose:

A. Individual overdue balances.B. Individual invoices.C. Small account balances.D. Large account balances.



Choice "b" is correct. The auditor should consider the nature of the information requested when determining the sampling unit for the current year audit. Certainrespondents' accounting systems may facilitate the confirmation of single transactions rather than of entire balances. Choice "a" is incorrect. The auditor would notlimit the population to overdue balances, since current balances can also be misstated.Choices "c" and "d" are incorrect. Defining the sampling unit based on account size would not address the problem that caused differences during the prior year.

QUESTION 67While observing a client's annual physical inventory, an auditor recorded test counts for several items and noticed that certain test counts were higher than therecorded quantities in the client's perpetual records.

This situation could be the result of the client's failure to record:

A. Purchase discounts.

B. Purchase returns.C. Sales.D. Sales returns.



Choice "d" is correct. Failure to record sales returns would result in actual inventory quantities being greater than those recorded in the perpetual inventory records.Choice "a" is incorrect. Failure to record purchase discounts would result in a difference in recorded costs, rather than recorded quantities.Choice "b" is incorrect. Failure to record purchase returns would result in actual inventory quantities being less than those recorded in the perpetual inventoryrecords. Choice "c" is incorrect. Failure to record sales would result in actual inventory quantities being less than those recorded in the perpetual inventory records.

QUESTION 68When control risk is assessed as low for assertions related to payroll, substantive tests of payroll balances most likely would be limited to applying analyticalprocedures and:

A. Observing the distribution of paychecks.B. Footing and crossfooting the payroll register.C. Inspecting payroll tax returns.D. Recalculating payroll accruals.



Choice "d" is correct. If the control risk is assessed as low, less substantive testing is necessary. In such an instance, substantive testing would normally be limitedto analytical procedures and recalculating yearend accruals.Choice "a" is incorrect. Observing distribution of paychecks is a test of controls, not a substantive test. Choice "b" is incorrect. Footing and crossfooting the payrollregister is an important substantive test, but it is limited in its effectiveness. Even if control risk is assessed as low, more effective substantive procedures should beperformed.Choice "c" is incorrect. Inspection of payroll tax returns is an extensive substantive test that would be performed if the control risk were assessed as high.

QUESTION 69

Which of the following questions would an auditor least likely include on an internal control questionnaire concerning the initiation and execution of equipmenttransactions?

A. Are requests for major repairs approved at a higher level than the department initiating the request?B. Are prenumbered purchase orders used for equipment and periodically accounted for?C. Are requests for purchases of equipment reviewed for consideration of soliciting competitive bids?D. Are procedures in place to monitor and properly restrict access to equipment?



Choice "d" is correct. Questions relating to access controls for assets would not normally be a part of a questionnaire related to controls over the initiation andexecution of equipment purchases. Choice "a" is incorrect. Questions about controls related to the authorization of major repairs would likely be included on aquestionnaire related to controls over the initiation and execution of equipment purchases.Choice "b" is incorrect. Questions about the existence of prenumbered purchase orders would likely be included on the internal control questionnaire sinceprenumbering functions as an important control supporting the completeness assertion.Choice "c" is incorrect. Questions about controls related to competitive bids would likely be included on a questionnaire related to controls over the initiation andexecution of equipment purchases.

QUESTION 70Which of the following auditing procedures most likely would provide assurance about a manufacturing entity's inventory valuation?

A. Testing the entity's computation of standard overhead rates.B. Obtaining confirmation of inventories pledged under loan agreements.C. Reviewing shipping and receiving cutoff procedures for inventories.D. Tracing test counts to the entity's inventory listing.



Choice "a" is correct. Testing the entity's computation of standard overhead rates generally provides assurance about a client's inventory valuation.Choice "b" is incorrect. Obtaining confirmation of inventories pledged under loan agreements provides assurance about the appropriate presentation, description,

and disclosure of such matters in the financial statements.Choice "c" is incorrect. Reviewing shipping and receiving cutoff procedures for inventories provides assurance about completeness and existence of inventory.Choice "d" is incorrect. Tracing test counts to the entity's inventory listing provides assurance about the completeness of the client's listing.

QUESTION 71In establishing the existence and ownership of a long-term investment in the form of publicly-traded stock, an auditor should inspect the securities or:

A. Correspond with the investee company to verify the number of shares owned.B. Inspect the audited financial statements of the investee company.C. Confirm the number of shares owned that are held by an independent custodian.D. Determine that the investment is carried at the lower of cost or market.



Choice "c" is correct. The auditor would confirm the number of shares held by an independent custodian to establish the existence and ownership of a long-terminvestment in publicly traded securities.Choice "a" is incorrect. The investee company may not have timely information regarding the ownership of its stock.Choice "b" is incorrect. Inspection of the audited financial statements of the investee company does not provide evidence about ownership of the securities.Choice "d" is incorrect. Determination that the investment is carried at the proper market value provides assurance about valuation and about appropriatepresentation and disclosure in the financial statements.

QUESTION 72Determining that proper amounts of depreciation are expensed provides assurance about management's assertion of:

A. Valuation, allocation, and accuracy.B. Completeness, accuracy, and occurrence.C. Rights and obligations, and valuation.D. Existence, completeness, and accuracy.



Choice "a" is correct. Determining that proper amounts of depreciation are expensed provides assurance with regard to valuation and allocation related to the asset,and accuracy in terms of financial statement presentation.Choices "b", "c", and "d" are incorrect. Verifying depreciation computations does not provide evidence with respect to completeness, rights and obligations,existence, or occurrence.

QUESTION 73In auditing accounts receivable the negative form of confirmation request most likely would be used when:

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



Choice "b" is correct. Negative confirmations are used when the combined assessed level of inherent and control risk is low, a large number of small balances isinvolved, and the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. Choice "a" is incorrect. Blank positiveconfirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information. Choice "c" is incorrect. If asmall number of accounts are involved and a large number of errors are anticipated, positive confirmations should be used.Choice "d" is incorrect. Confirmations are used exclusively as a substantive test, and are not used in the assessment of control risk.

QUESTION 74When using confirmations to provide evidence about the completeness assertion for accounts payable, the appropriate population most likely would be:

A. Vendors with whom the entity has previously done business.B. Amounts recorded in the accounts payable subsidiary ledger.C. Payees of checks drawn in the month after the year-end.D. Invoices filed in the entity's open invoice file.



Explanation:

Choice "a" is correct. When testing the completeness assertion for accounts payable, the appropriate population would be a list of vendors with whom the entity haspreviously done business. Choice "b" is incorrect. Confirming amounts recorded would test the existence assertion, rather than completeness.Choice "c" is incorrect. Checks drawn in the subsequent period represent only a subset of the client's vendor listing. (It would not include liabilities that have not yetbeen paid). In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected inthe client's financial statements. Choice "d" is incorrect. The invoices filed in the entity's open invoice file would provide only a subset of the client's vendor listing. (Itwould not include liabilities for which the invoice had not yet been received.)In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected in the client'sfinancial statements.

QUESTION 75A client maintains perpetual inventory records in both quantities and dollars. If the assessed level of control risk is high, an auditor would probably:

A. Increase the extent of tests of controls of the inventory cycle.B. Request the client to schedule the physical inventory count at the end of the year.C. Insist that the client perform physical counts of inventory items several times during the year.D. Apply gross profit tests to ascertain the reasonableness of the physical counts.



Choice "b" is correct. The assessment of control risk affects the nature, timing, and extent of substantive audit procedures. If the assessed level of control risk ishigh, the auditor would generally request that the client schedule the inventory at the end of the year. Choice "a" is incorrect. If the assessed level of control risk ishigh, an auditor would probably increase the extent of substantive testing, not the extent of tests of controls. Choice "c" is incorrect. Client performance of physicalcounts is an effective internal control, but requesting multiple inventory counts through the year is not an appropriate reaction to the auditor's assessment of controlrisk as high. The assessment of control risk affects the nature, timing, and extent of substantive audit procedures.Choice "d" is incorrect. The assessment of control risk affects the nature, timing, and extent of substantive audit procedures. Given the high assessment of controlrisk, the auditor would prefer more effective substantive procedures; analytical procedures are generally less effective.

QUESTION 76In auditing payroll, an auditor most likely would:

A. Verify that checks representing unclaimed wages are mailed.B. Trace individual employee deductions to entity journal entries.C. Observe entity employees during a payroll distribution.

D. Compare payroll costs with entity standards or budgets.



Choice "d" is correct. The analytical procedure comparing payroll to standards or budgets is the substantive procedure most likely used for payroll.Choice "a" is incorrect. Unclaimed payroll checks should be returned to an independent individual for follow up.Choice "b" is incorrect. Individual employee deductions may be difficult to trace directly to journal entries, as companies often make a single journal entry for thesum of individual employee deductions. Comparing payroll costs to standards or budgets is a more commonly used substantive audit procedure. Choice "c" isincorrect. Observing payroll distribution is an effective procedure to detect payments to fictitious employees, but with the advent of electronic payroll distribution, it isnot as likely to be performed as comparing payroll costs to standards or budgets.

QUESTION 77In auditing long-term bonds payable, an auditor most likely would:

A. Perform analytical procedures on the bond premium and discount accounts.B. Examine documentation of assets purchased with bond proceeds for liens.C. Compare interest expense with the bond payable amount for reasonableness.D. Confirm the existence of individual bondholders at year-end.



Choice "c" is correct. Comparing interest expense with the bond payable amount for reasonableness provides evidence that all interest expense was included andthat the outstanding balance of the bonds payable is reasonable, as well as providing limited evidence concerning the amortization of bond discounts or premiums.Choice "a" is incorrect. The auditor would recalculate bond premiums and discounts, rather than use an analytical procedure.Choice "b" is incorrect. The auditor would normally examine documentation of the bond instruments rather than of assets purchased to determine the existence ofany liens on the assets. Choice "d" is incorrect. The auditor would confirm the outstanding bonds payable balance, not the existence of individual bondholders.

QUESTION 78In performing tests concerning the granting of stock options, an auditor should:

A. Confirm the transaction with the Secretary of State in the state of incorporation.B. Verify the existence of option holders in the entity's payroll records or stock ledgers.C. Determine that sufficient treasury stock is available to cover any new stock issued.D. Trace the authorization for the transaction to a vote of the board of directors.



Choice "d" is correct. In auditing the granting of stock options, the auditor would normally trace the transactions to approval by the board of directors.Choice "a" is incorrect. The Secretary of State would not be able to confirm the granting of stock options.Choice "b" is incorrect. Verifying the existence of option holders provides little evidence to support management's financial statement assertions.Choice "c" is incorrect. Converted stock options may be distributed from authorized common shares rather than treasury stock.

QUESTION 79An auditor analyzes repairs and maintenance accounts primarily to obtain evidence in support of the audit assertion that all:

A. Noncapitalizable expenditures for repairs and maintenance have been recorded in the proper period.B. Expenditures for property and equipment have been recorded in the proper period.C. Noncapitalizable expenditures for repairs and maintenance have been properly charged to expense.D. Expenditures for property and equipment have not been charged to expense.



Choice "d" is correct. Analysis of repairs and maintenance expense provides assurance with regard to management's assertion that expenditures for property andequipment have been capitalized and have not been charged to expense.Choice "a" is incorrect. Analysis of repairs and maintenance accounts provides limited evidence about the appropriate cutoff of transactions for the period. Choice"b" is incorrect. Analysis of repairs and maintenance accounts does not provide evidence about the appropriate cutoff of expenditures for property and equipment.Choice "c" is incorrect. Analysis of capitalized expenditures might help identify noncapitalizable expenditures, which were capitalized erroneously.

QUESTION 80Which of the following internal controls most likely would prevent direct labor hours from being charged to manufacturing overhead?

A. Periodic independent counts of work-in-process for comparison to recorded amounts.B. Comparison of daily journal entries with approved production orders.C. Use of time tickets to record actual labor worked on production orders.D. Reconciliation of work-in-process inventory with periodic cost budgets.



Choice "c" is correct. The use of time tickets to record actual labor worked on production orders is the best way to prevent direct labor from being charged tomanufacturing overhead. Choice "a" is incorrect. The work-in-process inventory contains not only labor, but also materials and overhead.Choice "b" is incorrect. Daily journal entries are made to record the use of labor and materials. Reconciliation of the amount of daily labor to approved productionorders would not prevent direct labor from being charged to manufacturing overhead.Choice "d" is incorrect. The work-in-process inventory contains not only labor, but also materials and overhead.

QUESTION 81Which of the following internal controls most likely would be used to maintain accurate inventory records?

A. Perpetual inventory records are periodically compared with the current cost of individual inventory items.B. A just-in-time inventory ordering system keeps inventory levels to a desired minimum.C. Requisitions, receiving reports, and purchase orders are independently matched before payment is approved.D. Periodic inventory counts are used to adjust the perpetual inventory records.



Choice "d" is correct. In order to maintain accurate perpetual inventory records, periodic inventory counts should be used to adjust perpetual records.Choice "a" is incorrect. By comparing perpetual inventory records to current costs, the company ensures that the inventory is appropriately valued at the lower ofcost or market, but the accuracy of the perpetual inventory is not assured.Choice "b" is incorrect. While a just-in-time inventory system will usually reduce the amount of inventory on hand, it does not necessarily improve the accuracy ofinventory records. Choice "c" is incorrect. The matching of requisitions, receiving reports, and purchase orders is a control to ensure that purchases of inventory areproperly authorized, but it does not necessarily improve the accuracy of inventory records.

QUESTION 82When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud most likely would be reduced if the:

A. Trust company has no direct contact with the entity employees responsible for maintaining investment accounting records.B. Securities are registered in the name of the trust company, rather than the entity itself.C. Interest and dividend checks are mailed directly to an entity employee who is authorized to sell securities.D. Trust company places the securities in a bank safe-deposit vault under the custodian's exclusive control.



Choice "a" is correct. When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud would be reduced if the trustcompany deals only with the person reconciling the accounts, and not with the employees responsible for maintaining investment records. Choice "b" is incorrect.The securities should be in the entity's name, and not the trust company's. Choice "c" is incorrect. If interest and dividend checks are mailed directly (custody of theasset) to the employee authorized to sell the securities (authorization), incompatible duties would result which may result in fraud being concealed.Choice "d" is incorrect. Limiting access to the assets would reduce the possibility of theft, but would not reduce the possibility of concealing fraud.

QUESTION 83Which of the following circumstances most likely would cause an auditor to believe that material misstatements may exist in an entity's financial statements?

A. Accounts receivable confirmation requests yield significantly fewer responses than expected.B. Audit trails of computer-generated transactions exist only for a short time.C. The chief financial officer does not sign the management representation letter until the date of the auditor's report.D. Management consults with other accountants about significant accounting matters.



Choice "a" is correct. Confirmation of accounts receivable confirm the existence of the receivable. A lower than expected response rate could be indicative offictitious customer accounts. Choice "b" is incorrect. In a computerized accounting environment, audit trails generally exist for only a short time.Choice "c" is incorrect. The management representation letter should be signed and dated on the date of the auditor's report.

Choice "d" is incorrect. Consultation with other accountants would not cause an auditor to believe material misstatements have occurred.

QUESTION 84Which of the following procedures would an auditor most likely perform to obtain assurance that slowmoving and obsolete items included in inventories are properlyidentified?

A. Testing shipping and receiving cutoff procedures.B. Confirming inventories at locations outside the entity's premises.C. Examining an analysis of inventory turnover.D. Tracing inventory observation test counts to perpetual listings.



Choice "c" is correct. Examining an analysis of inventory turnover helps identify slow-moving, excess, defective, and obsolete items included in inventories. In orderfor inventory to be properly valued, these items may need to be written down.Choice "a" is incorrect. Testing shipping and receiving cutoff provides evidence regarding completeness of inventory and rights and obligations related to inventory,but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items. Choice "b" is incorrect. Confirming inventories atlocations outside the entity's premises provides evidence regarding existence and completeness of inventory, but it does not provide evidence regarding theidentification and valuation of slow-moving and obsolete items. Choice "d" is incorrect. Tracing inventory observation test counts to perpetual listings providesevidence regarding the completeness of inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items.

QUESTION 85An auditor scans a client's investment records for the period just before and just after the year-end to determine that any transfers between categories ofinvestments have been properly recorded. The primary purpose of this procedure is to obtain evidence about management's financial statement assertions of:

A. Rights and obligations, and existence.B. Valuation and accuracy, and rights and obligations.C. Existence, and understandability and classification.D. Understandability and classification, and valuation and accuracy.



Explanation:Choice "d" is correct. Investments may be classified as trading, available-for-sale, or held-to-maturity. The classification of each investment into one of these threecategories determines how it will be shown on the balance sheet (understandability and classification) and whether it will be valued at market or at amortized cost(valuation and accuracy).Choices "a", "b", and "c" are incorrect. Reviewing transfers of investments between categories will not provide evidence regarding rights and obligations orexistence. Rights and obligations and existence would be concerned with whether the securities actually exist and are owned by the client.

QUESTION 86Which of the following procedures represents a weakness in internal controls for payroll?

A. The payroll clerk distributes signed payroll checks. Undistributed checks are returned to the payroll department.B. The accounting department wires transfers funds to the payroll bank account. The transfer is based on totals from the payroll department summary.C. The payroll department prepares checks using a signature plate. The treasurer supervises the process before payroll checks are distributed.D. The payroll department prepares checks. The chief financial officer signs the payroll checks.



Choice "a" is correct. Unclaimed payroll checks should be returned to an independent party for follow up. Returning such checks (assets) to the payroll department(recordkeeping) represents an inadequate segregation of duties.Choice "b" is incorrect. It is acceptable for the accounting department to set up the transfer of funds into the payroll account, since the accounting department doesnot have access to the actual funds. Choice "c" is incorrect. The treasurer's supervision is crucial in this choice, serving to separate the recordkeeping function(payroll department) from the custodial function (the treasurer). Choice "d" is incorrect. It is an appropriate segregation of duties for the payroll department toprepare the checks, while the chief financial officer signs them. This separates the recordkeeping function from the custodial function.

QUESTION 87In auditing a manufacturing entity, which of the following procedures would an auditor least likely perform to determine whether slow-moving, defective, andobsolete items included in inventory are properly identified?

A. Test the computation of standard overhead rates.B. Tour the manufacturing plant or production facility.C. Compare inventory balances to anticipated sales volume.D. Review inventory experience and trends.

Correct Answer: ASection: Auditing and Attestation (II) (Volume D)

Explanation


Choice "a" is correct. Testing the computation of standard overhead rates relates to the accumulation of costs during the manufacturing process, and not to whetherthe inventory is slow-moving, defective, or obsolete after manufacture.Choice "b" is incorrect. During a tour of the manufacturing plant or production facility, the auditor should be alert for items that appear to be old, obsolete, ordefective. Choice "c" is incorrect. Comparisons of inventory balances with anticipated sales volume might indicate higher inventory levels than would be expected,perhaps due to slow-moving, defective, or obsolete inventory items.Choice "d" is incorrect. Review of inventory experience and trends may indicate slow-moving, defective, or obsolete inventory items. For example, the auditor maynotice a particular item that is building up in inventory, or a trend toward reduced sales of that item.

QUESTION 88When a company's stock record books are maintained by an outside registrar or transfer agent, the auditor should obtain confirmation from the registrar or transferagent concerning the:

A. Amount of dividends paid to related parties.B. Expected proceeds from stock subscriptions receivable.C. Number of shares issued and outstanding.D. Proper authorization of stock rights and warrants.



Choice "c" is correct. If a client uses a stock transfer agent, confirmations should be used to provide evidence of shares authorized, issued, and outstanding, as wellas to provide evidence of the individual transactions.Choice "a" is incorrect. It is the auditor's responsibility to identify, examine, and evaluate the disclosure of related party transactions. The stock transfer agent wouldnot necessarily know which parties are related to the client.Choice "b" is incorrect. The auditor should recalculate, or should review management's calculations of, stock subscriptions receivable. Confirmation from the stocktransfer agent would not be necessary to review this information.Choice "d" is incorrect. Proper authorization of stock rights and warrants would best be verified by reviewing the minutes of Board of Director meetings.Confirmation from the stock transfer agent would not be necessary to review this information.

QUESTION 89When a client engages in transactions involving derivatives, the auditor should:

A. Develop an understanding of the economic substance of each derivative.B. Confirm with the client's broker whether the derivatives are for trading purposes.C. Notify those charged with governance about the risks involved in derivative transactions.D. Add an explanatory paragraph to the auditor's report describing the risks associated with each derivative.



Choice "a" is correct. In auditing investments in securities and derivatives, the auditor must assess the reasonableness and appropriateness of assumptions,market variables, and valuation models. In order to do this, the auditor must consider whether the substance of transactions or events differs materially from theirform. Remember that generally accepted accounting principles require transactions and events to be reported in accordance with their economic substance, even ifthis differs from their form. Choice "b" is incorrect. While the auditor might confirm settled and unsettled transactions with the broker, whether a security is held fortrading purposes is based on management intent and would not be confirmed with the broker.Choice "c" is incorrect. There is no requirement that the auditor notify those charged with governance about the risks involved in derivative transactions.Choice "d" is incorrect. There is no requirement that the auditor add an explanatory paragraph to the auditor's report describing the risks associated with eachderivative.

QUESTION 90An auditor usually determines whether dividend income from publicly-held investments is reasonable by computing the amounts that should have been received byreferring to:

A. Stock ledgers maintained by independent registrars.B. Dividend records on file with the SEC.C. Records produced by investment services.D. Minutes of the investee's board of directors.



Choice "c" is correct. Investment income from dividends is generally recalculated by comparing recorded income with dividend record books produced byinvestment advisory services such as "Moody's Dividend Record." These books state the dividend that was declared and paid by the investee.Choice "a" is incorrect. Stock ledgers maintained by independent registrars indicate how many shares of stock are issued and outstanding, and identify the

shareholders of record, but they do not contain information concerning dividends.Choice "b" is incorrect. Dividend records on file with the SEC would probably include appropriate information, but it is more efficient to use a single source (such as"Moody's") than it is to obtain and review SEC records for each investee.Choice "d" is incorrect. Annual audited financial statements of the investee companies give the total dividends paid, but there may not be enough information todetermine exactly how much went to each type of stock and hence to each stockholder. In addition, it is more efficient to use a single source (such as "Moody's")than it is to obtain and review the financial statements of each investee.

QUESTION 91An auditor's inquiries of management disclosed that the entity recently invested in a series of energy derivatives to hedge against the risks associated withfluctuating oil prices. Under these circumstances, the auditor should:

A. Perform analytical procedures to determine if the derivatives are properly valued.B. Examine the contracts for possible risk exposure and the need to recognize losses.C. Confirm the marketability of the derivatives with a commodity specialist.D. Document the derivatives in the auditor's communication with those charged with governance.



Choice "b" is correct. Generally accepted accounting principles specify that, in order to qualify for hedge treatment, the entity must demonstrate and disclose anumber of transaction features including risk exposure. The auditor would therefore need to examine the contracts to evaluate the character of the hedge and thedegree to which losses should be recognized in the determination of income, as well as the character of any disclosures.Choice "a" is incorrect. Generally accepted accounting principles require this derivative to be valued at fair value. While the auditor does need to test management'sassertions about fair value, analytical procedures are not the most likely way to do this. More likely, the auditor would obtain quoted market prices from financialpublications, the exchanges, the National Association of Securities Dealers Automated Quotations System (NASDAQ), or pricing services. If quoted market priceswere not available, estimates based on valuation models would be used. Choice "c" is incorrect. The auditor would not generally confirm marketability with acommodity specialist, but rather would test the valuation of such securities by reference to quoted market prices, by using pricing services, or based on a valuationmodel. Choice "d" is incorrect. There is no requirement that investments in derivatives be communicated to those charged with governance.

QUESTION 92An auditor's principal objective in analyzing repairs and maintenance expense accounts is to:

A. Determine that all obsolete plant and equipment assets were written off before the year-end.B. Verify that all recorded plant and equipment assets actually exist.C. Discover expenditures that were expensed but should have been capitalized.D. Identify plant and equipment assets that cannot be repaired and should be written off.



Choice "c" is correct. The auditor reviews repair and maintenance expense accounts to test for completeness of asset additions (i.e., the auditor is looking for itemsrecorded as repairs or maintenance that would more properly have been capitalized as betterment of an asset). Choice "a" is incorrect. Analyzing the repairs andmaintenance account does not provide evidence about obsolete assets. The auditor might review asset records for old assets, or observe assets that are not beingused, in an effort to determine whether obsolete plant and equipment assets were written off before year-end.Choice "b" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about the existence of assets. The auditor might select recordedplant and equipment assets, and then physically locate and observe them, in order to verify existence. Choice "d" is incorrect. Analyzing the repairs andmaintenance account does not provide evidence about assets that cannot be repaired. The auditor might review asset records for old assets, or observe assets thatare not being used, in an effort to determine whether assets that cannot be repaired have been properly written off.

QUESTION 93The auditor's inventory observation test counts are traced to the client's inventory listing to test for which of the following financial statement assertions?

A. Completeness.B. Rights and obligations.C. Allocation and valuation.D. Understandability and classification.



Choice "a" is correct. The auditor should test the physical inventory report by tracing test counts taken by the auditor to the report, thereby verifying itscompleteness. Choice "b" is incorrect. Tracing from test counts to the client's inventory listing does not test rights and obligations. Rights and obligations might betested by examining paid vendors' invoices, inspecting consignment agreements and contracts, or by confirming inventory held at outside locations. Choice "c" isincorrect. Tracing from test counts to the client's inventory listing does not test allocation and valuation. Allocation and valuation might be tested by examining paidvendors' invoices, evaluating direct labor rates, recalculating overhead rates, or examining an analysis of inventory turnover.Choice "d" is incorrect. Tracing from test counts to the client's inventory listing does not test understandability and classification. Understandability and classificationmight be tested by confirming inventories pledged under loan agreements, examining drafts of the financial statements for appropriate balance sheet classification,etc.

QUESTION 94An analysis of which of the following accounts would best aid in verifying that all fixed assets have been capitalized?

A. Cash.B. Depreciation expense.C. Property tax expense.D. Repairs and maintenance.



Choice "d" is correct. An analysis of the repairs and maintenance account would best aid the auditor in verifying that all fixed assets have been capitalized. Thisaccount is generally analyzed to test for completeness of asset additions (i.e., the auditor is looking for items recorded as repairs or maintenance that would moreproperly have been capitalized as betterment of an asset). Choice "a" is incorrect. An analysis of cash would not identify fixed assets that were not properlycapitalized, since cash would be paid for the purchase regardless of whether the item were expensed or capitalized.Choice "b" is incorrect. An analysis of depreciation expense would not identify fixed assets that were not properly capitalized, since no depreciation would beincluded for items not already classified as assets.Choice "c" is incorrect. An analysis of property tax expense would not identify fixed assets that were not properly capitalized, since no property tax would beincluded for items not already classified as assets.

QUESTION 95Which of the following strategies most likely could improve the response rate of the confirmations of accounts receivable?

A. Restrict the selection of accounts to be confirmed to those customers with large balances.B. Include a list of items or invoices that constitute the customers' account balances.C. Explain to customers that discrepancies will be investigated by an independent third party.D. Ask customers to respond to the confirmation requests directly to the auditor by fax.



Choice "b" is correct. The auditor should consider the types of information respondents will be readily able to confirm. For instance, some accounting systems

facilitate the confirmation of single transactions rather than entire balances. In such cases, the auditor might consider including a client- prepared statement ofaccount showing details of the customer's account balance being confirmed. By making it easier for customers to determine which items are included in the balancebeing confirmed, the auditor also makes it more likely that those customers will respond. Choice "a" is incorrect. Restricting the selection of accounts to beconfirmed to those customers with large balances doesn't improve response rates, as customers with large balances are not necessarily more likely to respondthan customers with small balances. Choice "c" is incorrect. Explaining to customers that discrepancies will be investigated by an independent third party would notnecessarily encourage them to respond, as they might be reluctant to set off this investigation.Choice "d" is incorrect. Responses received by fax should be verified by calling the senders and requesting that the original confirmations be mailed back. Askingcustomers to respond by fax might actually reduce the response rate for receiving the original confirmation, since customers may decide that since they alreadysent the fax, they don't need to send the original back as well.

QUESTION 96In establishing the existence and ownership of long-term investments in the form of publicly-traded stock, an auditor most likely would inspect the securities or:

A. Correspond with the investee company to verify the number of shares owned.B. Confirm the number of shares owned that are held by an independent custodian.C. Apply analytical procedures to the dividend income and investments accounts.D. Inspect the cash receipts journal for amounts that could represent the sale of securities.



Choice "b" is correct. Confirmations should be requested from the custodian for securities that are in the possession of third parties.Choice "a" is incorrect. The investee company may not have timely information regarding the ownership of its stock, nor would an investee typically want tocorrespond with all of its shareholders in this manner.Choice "c" is incorrect. Analytical procedures might be used to test the reasonableness of dividend income, but this would not provide evidence about the existenceand ownership of the investments. Choice "d" is incorrect. Inspecting the cash receipts journal for amounts that could represent the sale of securities might provideevidence regarding sales (and gains or losses on sales), but would not provide evidence about the existence and ownership of the investments.

Audit Evidence: Miscellaneous Items

QUESTION 97Which of the following best describes the auditor's responsibility with respect to fair values?

A. The auditor should determine whether management has the intent and ability to carry out courses of action that may affect fair values.B. The auditor should assess the risk of material misstatement of fair value measurements.C. The auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity

with GAAP.D. The auditor should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.



Choice "c" is correct. The auditor's overall responsibility is to obtain sufficient appropriate audit evidence to provide reasonable assurance that fair valuemeasurements and disclosures are in conformity with GAAP.Choice "a" is incorrect. While it is true that the auditor should determine whether management has the intent and ability to carry out courses of action that may affectfair values, this is just one part of evaluating fair value measurements and not the best description of the auditor's overall responsibility. Choice "b" is incorrect.While it is true that the auditor should assess the risk of material misstatement of fair value measurements, this is done to determine the nature, timing, and extentof audit procedures. It is not the best representation of the auditor's overall responsibility. Choice "d" is incorrect. Management (and not the auditor) should makefair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.

QUESTION 98Which of the following would an auditor least likely consider with respect to fair values?

A. Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to thosetransactions.

B. The effect on fair value measurement and disclosures of information available subsequent to the audit.C. The role of information technology in determining fair value measurements and disclosures.D. Whether the valuation methods used are appropriate in relation to the industry in which the entity operates.



Choice "b" is correct. The auditor would consider subsequent events and transactions occurring before the completion of the audit, not after. The auditor is notresponsible for predicting the future, and would not be expected to evaluate the effect of conditions arising subsequent to the audit, that, if known at the time of theaudit, might have affected fair value measurements and disclosures. Choice "a" is incorrect. The auditor is responsible for understanding relevant controls.Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to those transactionsis a relevant control. Choice "c" is incorrect. The auditor is responsible for understanding the entity's process for determining fair value measurements anddisclosures. Considering the role of information technology in determining fair value measurements and disclosures is part of understanding this process. Choice

"d" is incorrect. The auditor should evaluate whether the valuation model is appropriate given the entity's circumstances. As part of this evaluation, the auditorshould consider whether the valuation method is appropriate in relation to the business, industry, and environment in which the entity operates.

QUESTION 99Which of the following procedures most likely would assist an auditor in determining whether management has identified all accounting estimates that could bematerial to the financial statements?

A. Inquire about the existence of related party transactions.B. Determine whether accounting estimates deviate from historical patterns.C. Confirm inventories at locations outside the entity.D. Review the lawyer's letter for information about litigation.



Choice "d" is correct. The auditor should inquire of management concerning pending or threatened litigation, and should obtain a letter from the client's lawyer tocorroborate this information. Included in this letter is either an identification of the omission of any pending or threatened litigation, claims, and assessments, or astatement that the list of such matters (as provided by management) is complete. Choice "a" is incorrect. Accounting estimates generally are not associated with theexistence of related party transactions.Choice "b" is incorrect. Evaluating deviations from historical patterns assists an auditor in determining if a recorded estimate is reasonable, but it does not provideassurance that management has identified all material accounting estimates.Choice "c" is incorrect. Accounting estimates generally are not associated with the existence of inventories at locations outside the entity.

QUESTION 100In evaluating the reasonableness of an entity's accounting estimates, an auditor normally would be concerned about assumptions that are:

A. Susceptible to bias.B. Consistent with prior periods.C. Insensitive to variations.D. Similar to industry guidelines.



Explanation:

Choice "a" is correct. An auditor would be concerned about assumptions that are susceptible to bias because it is more likely that estimates based on suchassumptions will be misstated. Choice "b" is incorrect. The auditor would not normally be concerned about assumptions that are consistent with prior periods, asestimates based on such assumptions are less likely to be misstated. Choice "c" is incorrect. The auditor would not normally be concerned about assumptions thatare insensitive to variation, as estimates based on such assumptions are less likely to be misstated. Choice "d" is incorrect. The auditor would not normally beconcerned about assumptions that are similar to industry guidelines, as estimates based on such assumptions are less likely to be misstated.

QUESTION 101The refusal of a client's attorney to provide information requested in an inquiry letter generally is considered:

A. Grounds for an adverse opinion.B. A limitation on the scope of the audit.C. Reason to withdraw from the engagement.D. Equivalent to a significant deficiency in internal control.



Choice "b" is correct. A lawyer's refusal to furnish the information requested in an inquiry letter would be a limitation on the scope of the audit sufficient to precludean unqualified opinion. Choice "a" is incorrect. An adverse opinion states that the financial statements do not present fairly the financial position or the results ofoperations or cash flows in conformity with generally accepted accounting principles. A lawyer's refusal to furnish the information requested in an inquiry letter doesnot necessarily mean that the financial statements are not fairly presented in conformity with GAAP. Choice "c" is incorrect. A lawyer's refusal to furnish theinformation requested in an inquiry letter is not a reason to withdraw from the engagement, as long as the lawyer's refusal is not based on the client's request.Choice "d" is incorrect. A lawyer's refusal to furnish the information requested in an inquiry letter is not considered to be a significant deficiency in internal control.

QUESTION 102A client's lawyer is unable to form a conclusion about the likelihood of an unfavorable outcome of pending litigation because of inherent uncertainties. If thelitigation's effect on the client's financial statements could be material but it is properly disclosed in the financial statements, the auditor most likely would:

A. Issue a qualified opinion in the auditor's report because of the lawyer's scope limitation.B. Withdraw from the engagement because of the lack of information furnished by the lawyer.C. Disclaim an opinion on the financial statements because of the materiality of the litigation's effect.D. Issue an unqualified opinion without modification.

Correct Answer: D



Choice "d" is correct. A lawyer may be unable to respond concerning the likelihood of an unfavorable outcome of litigation, claims, and assessments or the amountor range of potential loss, because of inherent uncertainties. Even if the effect of the matter on the financial statements could be material, if it is properly disclosed(and supported by available evidence), the auditor will ordinarily issue an unqualified opinion without any modification.Choice "a" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in aqualification. Choice "b" is incorrect. The auditor should consider withdrawing from the engagement only if the lawyer withholds information per the client's request.Given the fact pattern, there is no need for the auditor to withdraw from the engagement.Choice "c" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in adisclaimer of opinion.

QUESTION 103When auditing related party transactions, an auditor places primary emphasis on:

A. Ascertaining the rights and obligations of the related parties.B. Confirming the existence of the related parties.C. Verifying the valuation of the related party transactions.D. Evaluating the disclosure of the related party transactions.



Choice "d" is correct. The auditor should view related party transactions within the framework of existing pronouncements, placing primary emphasis on theadequacy of disclosure. Choice "a" is incorrect. Since related party transactions are (by definition) not considered to be at arm'slength, the auditor generally doesnot ascertain the rights and obligations of the related parties. Choice "b" is incorrect. The auditor generally does not confirm the existence of the related parties.Choice "c" is incorrect. Since related party transactions are (by definition) not considered to be at arm'slength, the auditor generally does not verify the valuation ofthe related party transactions.

QUESTION 104Which of the following procedures would an auditor ordinarily perform first in evaluating management's accounting estimates for reasonableness?

A. Develop independent expectations of management's estimates.

B. Consider the appropriateness of the key factors or assumptions used in preparing the estimates.C. Test the calculations used by management in developing the estimates.D. Obtain an understanding of how management developed its estimates.



Choice "d" is correct. In evaluating the reasonableness of an accounting estimate, the auditor should first obtain an understanding of how management developedits estimate. Choice "a" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditor should use one or a combinationof the following approaches: a) review and test the process used by management to develop the estimate, b) develop an independent expectation of the estimate tocorroborate the reasonableness of management's estimate, or c) review subsequent events. Choice "b" is incorrect. After having first obtained an understanding ofhow management developed its estimate, the auditor should consider testing management's process by assessing the appropriateness of the key factors orassumptions used in preparing the estimate. Choice "c" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditorshould use one or a combination of the following approaches: a) review and test the process used by management to develop the estimate, b) develop anindependent expectation of the estimate to corroborate the reasonableness of management's estimate, or c) review subsequent events.

QUESTION 105In evaluating the reasonableness of an accounting estimate, an auditor most likely would concentrate on key factors and assumptions that are:

A. Consistent with prior periods.B. Similar to industry guidelines.C. Objective and not susceptible to bias.D. Deviations from historical patterns.



Choice "d" is correct. In evaluating the reasonableness of an estimate, an auditor would normally concentrate on key factors and assumptions that are (1) significantto the accounting estimate, (2) sensitive to variations, (3) deviations from historical patterns, or (4) subjective and susceptible to misstatements and bias.Choice "a" is incorrect. The auditor need not concentrate on key factors or assumptions that are consistent with those of prior periods, since estimates based onsuch assumptions are less likely to be misstated.Choice "b" is incorrect. The auditor need not concentrate on key factors or assumptions that are similar to industry guidelines, since estimates based on such

assumptions are less likely to be misstated. Choice "c" is incorrect. The auditor need not focus on factors that are objective and not susceptible to bias, sinceestimates based on such assumptions are less likely to be misstated.

QUESTION 106The primary reason an auditor requests letters of inquiry be sent to a client's attorneys is to provide the auditor with:

A. The probable outcome of asserted claims and pending or threatened litigation.B. Corroboration of the information furnished by management about litigation, claims, and assessments.C. The attorneys' opinions of the client's historical experiences in recent similar litigation.D. A description and evaluation of litigation, claims, and assessments that existed at the balance sheet date.



Choice "b" is correct. A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished bymanagement concerning litigation, claims, and assessments.Choice "a" is incorrect. While the attorney is requested to provide the auditor with the likelihood of an unfavorable outcome, the primary source of this information ismanagement. Choice "c" is incorrect. The attorney's opinion of historical experiences may provide some information to the auditor, but it is not the primary goal ofaudit inquiry letters. Choice "d" is incorrect. While the attorney is asked to comment on management's description and evaluation of litigation, claims, andassessments that existed at the balance sheet date, the primary source of this information is management.

QUESTION 107After determining that a related party transaction has, in fact, occurred, an auditor should:

A. Add a separate paragraph to the auditor's standard report to explain the transaction.B. Perform analytical procedures to verify whether similar transactions occurred, but were not recorded.C. Obtain an understanding of the business purpose of the transaction.D. Substantiate that the transaction was consummated on terms equivalent to an arm's-length transaction.



Choice "c" is correct. After identifying the occurrence of a related party transaction, the auditor should apply the procedures considered necessary to obtainsatisfaction concerning the purpose and nature of the transaction and its effect on the financial statements. Choice "a" is incorrect. While an extra paragraph maybe added to emphasize a matter, there is no requirement that related party transactions be disclosed via explanatory language added to the auditor's report.Choice "b" is incorrect. Analytical procedures are generally not effective in the identification of related party transactions.Choice "d" is incorrect. It will generally not be possible to substantiate representations that the transaction was consummated on terms equivalent to those thatwould have prevailed in an arm's- length transaction.

QUESTION 108Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions?

A. Retesting ineffective internal controls previously reported to those charged with governance.B. Sending second requests for unanswered positive confirmations of accounts receivable.C. Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date.D. Inspecting communications with law firms for evidence of unreported contingent liabilities.



Choice "c" is correct. Unusual nonrecurring transactions near year-end are characteristic of related party transactions. Since related party transactions are not atarm's-length, management may use such transactions to bolster sales or assets.Choice "a" is incorrect. Retesting ineffective controls would not assist the auditor in identifying related party transactions.Choice "b" is incorrect. Confirmation of accounts receivable would not assist the auditor in identifying related party transactions.Choice "d" is incorrect. Finding unrecorded contingent liabilities would not assist the auditor in identifying related party transactions.

QUESTION 109Which of the following factors most likely would cause a CPA not to accept a new audit engagement?

A. The prospective client's unwillingness to permit inquiry of its legal counsel.B. The inability to review the predecessor auditor's working papers.C. The CPA's lack of understanding of the prospective client's operations and industry.D. The indications that management has not investigated employees in key positions before hiring them.



Choice "a" is correct. A direct letter of inquiry to the entity's legal counsel is required, and a client's refusal to permit such inquiry generally will result in a disclaimerof opinion. It is unlikely that a CPA would accept a new audit engagement under such circumstances. Choice "b" is incorrect. Inability to review the predecessorauditor's working papers would not cause a CPA to decline a new audit engagement. The CPA would simply need to perform an appropriate level of work tosubstantiate the opening financial statement balances. Choice "c" is incorrect. The CPA need not have an understanding of the prospective client's operations andindustry before accepting a new audit engagement. Such an understanding may be obtained after acceptance, during the planning phase of the engagement.Choice "d" is incorrect. Indications that management has not investigated employees in key positions before hiring them is a fraud risk factor that the auditor wouldneed to consider in planning the audit, but it would not cause the CPA to decline the engagement.

QUESTION 110Which of the following procedures most likely could assist an auditor in identifying related party transactions?

A. Performing tests of controls concerning the segregation of duties.B. Evaluating the reasonableness of management's accounting estimates.C. Reviewing confirmations of compensating balance arrangements.D. Scanning the accounting records for recurring transactions.



Choice "c" is correct. Compensating balance arrangements may be maintained by or for related parties. Choice "a" is incorrect. Performing tests of controlsconcerning the segregation of duties relates to the allocation of responsibilities among company employees; related party transactions typically relate to transactionswith affiliates, owners, or management.Choice "b" is incorrect. Evaluating the reasonableness of management's accounting estimates would not provide any evidence of transactions with affiliates,owners, or management. Choice "d" is incorrect. Related party transactions are more likely to be nonrecurring than recurring.

QUESTION 111"In connection with an audit of our financial statements, management has prepared, and furnished to our auditors a description and evaluation of certaincontingencies." The foregoing passage most likely is from a(an):

A. Audit inquiry letter to legal counsel.B. Management representation letter.C. Audit committee's communication to the auditor.D. Financial statement footnote disclosure.



Choice "a" is correct. Legal counsel is best able to corroborate the description and evaluation of contingencies provided by management.Choice "b" is incorrect. The management representation letter serves to confirm, in writing, representations provided to the auditor. It does not include a statementindicating that management has prepared and furnished a list of contingencies.Choice "c" is incorrect. The audit committee would not communicate to the auditor regarding the list of contingencies prepared by management.Choice "d" is incorrect. It would be inappropriate to indicate in the footnotes whether specific information was provided by management to the auditor.

QUESTION 112Which of the following procedures would an auditor ordinarily perform first in evaluating the reasonableness of management's accounting estimates?

A. Review transactions occurring prior to the completion of field work that indicate variations from expectations.B. Compare independent expectations with recorded estimates to assess management's process.C. Obtain an understanding of how management developed its estimates.D. Analyze historical data used in developing assumptions to determine whether the process is consistent.



Choice "c" is correct. In evaluating the reasonableness of an estimate, the auditor must first obtain an understanding of how management developed its estimate.Choices "a", "b", and "d" are incorrect. After obtaining an understanding of how management developed its estimate, the auditor would perform one or acombination of the following procedures:

1. Review subsequent events and transactions (occurring prior to completion of fieldwork) that corroborate the value of the estimate (choice "a").2. Develop an independent estimate of the item for comparative purposes (choice "b").3. Review and test the procedures used by management to develop the estimate (choice "d").

QUESTION 113Which of the following parties should request inquiry of a client's lawyer?

A. The auditor.B. The stockholders.C. Client management.D. The auditor's attorney.



Choice "c" is correct. The letter of inquiry to the client's attorneys is a request made by client management. Due to attorney-client privilege, the attorney would notbe able to respond to such a request made by any other party. Note that management would request the attorney to respond directly to the auditor.Choice "a" is incorrect. The auditor may request that the client include certain matters in the letter, but technically speaking, the request itself comes from clientmanagement. Choice "b" is incorrect. The stockholders would not have any involvement in the letter of audit inquiry. Choice "d" is incorrect. The auditor's attorneywould not have any involvement in the letter of audit inquiry related to specific client engagements.

QUESTION 114If a client will not permit inquiry of outside legal counsel, the auditor's report ordinarily will contain a(an):

A. Adverse opinion.B. Disclaimer of opinion.C. Unqualified opinion with a separate explanatory paragraph.D. Qualified opinion.



Choice "b" is correct. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion.Choice "a" is incorrect. Adverse opinions are used when there are very material departures from GAAP, which is not the case here.Choice "c" is incorrect. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion.An unqualified opinion with a separate explanatory paragraph would not be sufficient to address this situation. Choice "d" is incorrect. A client's refusal to permitinquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. A qualified opinion would not be sufficient toaddress this situation.

QUESTION 115The accounts receivable turnover ratio increased significantly over a two-year period. This trend could indicate that:

A. The accounts receivable aging has deteriorated.B. The company has eliminated its discount policy.C. The company is more aggressively collecting customer accounts.D. Customer sales have substantially decreased.



Choice "c" is correct. The accounts receivable turnover ratio is calculated as sales / receivables. More aggressive collection policies will result in a decrease in thereceivables balance, which in turn causes the turnover ratio to increase.Choice "a" is incorrect. A deterioration in the aging of receivables implies a greater receivables balance, which would cause the turnover ratio to decline. Choice "b"is incorrect. Elimination of the company's discount policy would increase both the sales figure and the receivables balance. The net effect on the turnover ratiowould depend upon the proportionate impact of each increase.Choice "d" is incorrect. A decline in sales would cause a decrease in both sales and receivables. The net effect on the turnover ratio would depend upon theproportionate impact of each decrease.

QUESTION 116Which of the following statements extracted from a client's lawyer's letter concerning litigation, claims, and assessments most likely would cause the auditor torequest clarification?

A. "I believe that the plaintiff will have problems establishing any liability."B. "I believe that this action has only a remote chance in establishing any liability."C. "I believe that the plaintiff's case against the company is without merit."D. "I believe that the company will be able to defend this action successfully."



Choice "a" is correct. The lawyer's comment that the plaintiff "will have problems establishing any liability" is vague...it does not provide an evaluation of the

likelihood of an unfavorable outcome. Does "will have problems" mean a loss is probable, reasonably possible, or remote? The auditor would likely want to requestclarification to ensure that the situation has been properly accounted for and disclosed.Choice "b" is incorrect. When a lawyer asserts that a contingent liability is improbable ("remote chance"), it is unlikely that the auditor would require furtherclarification. Choice "c" is incorrect. When a lawyer asserts that a contingent liability is improbable ("without merit"), it is unlikely that the auditor would require furtherclarification. Choice "d" is incorrect. When a lawyer asserts that a contingent liability is improbable ("able to defend this action successfully"), it is unlikely that theauditor would require further clarification.

QUESTION 117Which of the following events most likely would indicate the existence of related parties?

A. Granting stock options to key executives at favorable prices.B. High turnover of senior management and members of the board of directors.C. Failure to correct internal control weaknesses on a timely basis.D. Selling real estate at a price significantly different from appraised value.



Choice "d" is correct. Transactions based on terms that are significantly different from those that would be expected in an arm's length transaction, such as sellingreal estate at a price significantly different from appraised value, may be indicative of related party involvement. Choice "a" is incorrect. Executives are consideredto be related parties regardless of whether or not stock options at favorable prices are granted.Choice "b" is incorrect. High turnover of management and/or board members may be caused by any number of circumstances, but is unlikely to be related to theexistence of related parties. Choice "c" is incorrect. Failure to correct internal control weaknesses on a timely basis is a management decision that is unlikely to berelated to the existence of related parties.

QUESTION 118In evaluating an entity's accounting estimates, one of the auditor's objectives is to determine whether the estimates are:

A. Prepared in a satisfactory control environment.B. Consistent with industry guidelines.C. Based on verifiable objective assumptions.D. Reasonable in the circumstances.



Choice "d" is correct. The auditor has four responsibilities with respect to evaluating estimates: to assess management's practices, to verify that all materialestimates have been developed, to determine that accounting estimates are reasonable, and to ensure that accounting estimates are properly recorded anddisclosed.Choice "a" is incorrect. With respect to accounting estimates, the auditor would only be concerned with the entity's control environment in terms of assessingmanagement's policies and practices. It might be the case that the control environment is less than satisfactory, but as long as management has taken this intoaccount, and has properly developed, presented, and disclosed all material estimates, the poor control environment is irrelevant.Choice "b" is incorrect. The auditor is concerned with making sure that management has properly developed, presented, and disclosed all material estimates.Whether or not those estimates are consistent with industry guidelines is not a concern, as long as the estimates are reasonable in the circumstances.Choice "c" is incorrect. Estimates need not be based on verifiable objective assumptions. In fact, many estimates are subjective, and can be susceptible tomisstatement. The auditor should evaluate whether management has properly developed, presented, and disclosed all material estimates.

QUESTION 119Which of the following factors most likely would cause a CPA to decline to accept a new audit engagement?

A. The CPA does not understand the entity's operations and industry.B. Management acknowledges that the entity has had recurring operating losses.C. The CPA is unable to review the predecessor auditor's working papers.D. Management is unwilling to permit inquiry of its legal counsel.



Choice "d" is correct. If a prospective client is unwilling to permit inquiry of its legal counsel, the CPA must consider the implications of this refusal. Such refusal mayindicate a lack of cooperativeness on the part of management, or an attempt to be less than forthright with respect to litigation, claims, and assessments.Furthermore, a client's refusal to permit inquiry of its legal counsel ordinarily would result in a disclaimer of opinion. It would be unlikely that a CPA would accept anew engagement under these circumstances.Choice "a" is incorrect. An understanding of the client's operations and industry should be obtained during the planning stage of the audit. It does not necessarilyneed to be obtained before acceptance of the engagement.Choice "b" is incorrect. The fact that the entity has had recurring operating losses may increase the auditor's assessment of risk on the engagement, but it wouldnot preclude acceptance of the engagement.Choice "c" is incorrect. Although the predecessor's audit documentation provides some audit evidence with respect to opening balances, consistency of accountingprinciples, and other matters of continuing significance, alternative means of obtaining such evidence generally do exist.


QUESTION 120An auditor ordinarily uses a working trial balance resembling the financial statements without footnotes, but containing columns for:

A. Reclassifications and adjustments.B. Reconciliations and tickmarks.C. Accruals and deferrals.D. Expense and revenue summaries.



Choice "a" is correct. An auditor's working trial balance generally contains columns for reclassifications and adjustments.Choice "b" is incorrect. Reconciliations and tickmarks are included within audit documentation, but would not necessarily be shown in columns on the working trialbalance. Choice "c" is incorrect. Accruals and deferrals are included within audit documentation, but would not necessarily be shown in columns on the working trialbalance. Choice "d" is incorrect. Expense and revenue summaries are included within audit documentation, but would not necessarily be shown in columns on theworking trial balance.

QUESTION 121The audit documentation that makes up the current file most likely would include a copy of the:

A. Bank reconciliation.B. Pension plan contract.C. Articles of incorporation.D. Flowchart of the internal control.



Choice "a" is correct. The audit documentation that makes up the current file most likely would include a copy of the bank reconciliation.Choice "b" is incorrect. The audit documentation that makes up the permanent file would include a copy of the pension plan contract.

Choice "c" is incorrect. The audit documentation that makes up the permanent file would include a copy of the articles of incorporation.Choice "d" is incorrect. The audit documentation that makes up the permanent file would include a flowchart of the internal control.

QUESTION 122The third standard of fieldwork states that the auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basisfor an opinion regarding the financial statements under audit. The appropriate audit evidence required by this standard may be obtained, in part, through:

A. Flowcharting the internal control structure.B. Proper planning of the audit engagement.C. Analytical procedures.D. Audit documentation.



Choice "c" is correct. Analytical procedures are substantive tests that provide audit evidence used to assess the reasonableness of account balances.Choice "a" is incorrect. Flowcharting the internal control structure is used in obtaining an understanding of internal control, but it is not a procedure by which auditevidence is obtained. Choice "b" is incorrect. Audit evidence with respect to the year-end financial statement balances generally is not obtained as part of theplanning process. Choice "d" is incorrect. Audit documentation describes the procedures followed and results of testing. Since it is prepared by the auditor, it doesnot represent audit evidence by itself.

QUESTION 123In testing the existence assertion for an asset, an auditor ordinarily works from the:

A. Financial statements to the potentially unrecorded items.B. Potentially unrecorded items to the financial statements.C. Accounting records to the supporting evidence.D. Supporting evidence to the accounting records.



Choice "c" is correct. In testing the existence assertion for an asset, an auditor ordinarily works from the accounting records to the supporting evidence.Choice "a" is incorrect. If the auditor works from the financial statements, all items selected will have been recorded (i.e., because they are included in the financialstatements). Therefore, starting with the financial statements will not lead to any unrecorded items. Choice "b" is incorrect. Tracing potentially unrecorded items tothe financial statements tests for completeness, not existence.Choice "d" is incorrect. Tracing from supporting evidence to the accounting records tests for completeness, not existence.

QUESTION 124Auditors try to identify predictable relationships when using analytical procedures. Relationships involving transactions from which of the following accounts mostlikely would yield the highest level of evidence?

A. Accounts payable.B. Advertising expense.C. Accounts receivable.D. Payroll expense.



Choice "d" is correct. Auditors try to identify predictable relationships when using analytical review procedures. Payroll expense is predictable because it is based onobjective information (number of employees and pay rates). It can generally be computed directly by the auditor. Choices "a", "b", and "c" are incorrect. Theseaccount balances are less predictable because they are affected by other factors. Payable and receivable balances can be affected by cash payments or receipts;advertising expense is subject to management discretion.

QUESTION 125Which of the following statements concerning audit evidence is correct?

A. Reliable evidence supporting management's assertions should be conclusive rather than merely persuasive.B. An effective internal control structure contributes little to the reliability of the evidence created within the entity.C. The cost of obtaining evidence is not an important consideration to an auditor in deciding what evidence should be obtained.D. A client's accounting data cannot be considered sufficient audit evidence to support the financial statements.



Explanation:

Choice "d" is correct. Audit evidence consists of the underlying accounting data and all corroborating information available to the auditor. A client's accounting databy itself is not considered sufficient audit evidence to support the financial statements.Choice "a" is incorrect. Reliable evidence supporting management's assertions only needs to be corroborative or persuasive, not conclusive.Choice "b" is incorrect. An effective internal control structure contributes greatly to the reliability of the evidence created within the entity.Choice "c" is incorrect. The cost of obtaining evidence is an important consideration to an auditor in selecting appropriate audit procedures. The cost of a proceduremay be a valid reason for omitting that procedure, as long as an appropriate alternative procedure is available.

QUESTION 126An auditor's purpose in reviewing the renewal of a note payable shortly after the balance sheet date most likely is to obtain evidence concerning management'sassertions about:

A. Occurrence.B. Understandability and classification.C. Completeness.D. Valuation and accuracy.



Choice "b" is correct. An auditor's purpose in reviewing the renewal of a note payable shortly after the balance sheet date most likely is to obtain evidenceconcerning management's assertions about understandability and classification (i.e., classification of the note as current or noncurrent). Choice "a" is incorrect.Occurrence relates to whether recorded transactions have actually occurred during the given period. Since the renewal took place subsequent to year-end, theauditor would not be concerned about how the transaction was actually recorded until the next reporting period. Choice "c" is incorrect. Completeness relates towhether all transactions occurring in the period have been recorded. Since the renewal took place subsequent to year-end, it is not relevant to the completenessassertion for the year under audit.Choice "d" is incorrect. Valuation and accuracy pertains to the fair disclosure of financial and other information at appropriate amounts. The renewal of a notepayable shortly after year-end generally would not affect its valuation or its accuracy.

QUESTION 127Tests designed to detect credit sales made before the end of the year that have been recorded in the subsequent year provide assurance about management'sassertion regarding:

A. Classification.B. Cutoff.

C. Accuracy.D. Existence.



Choice "b" is correct. Cutoff tests are designed to determine whether transactions have been recorded in the proper period. Tests to detect credit sales madebefore the end of the year that have been (improperly) recorded in the subsequent year provide assurance about both cutoff and completeness (i.e., whether allcurrent year sales have been properly included). Choice "a" is incorrect. Cutoff tests do not determine whether the components of the financial statements areproperly presented, described and disclosed (classification). Choice "c" is incorrect. The cutoff testing described is designed to identify sales recorded in thesubsequent year that more properly belong in the current year. This relates to the timing of the entry, not to its accuracy.Choice "d" is incorrect. To test existence, the auditor would need to start with sales that were recorded in the current year, not those recorded in the subsequentyear.

QUESTION 128Inquiries of warehouse personnel concerning possible obsolete or slow-moving inventory items provide assurance about management's assertion of:

A. Completeness.B. Existence.C. Presentation.D. Valuation.



Choice "d" is correct. Inquiries of warehouse personnel concerning possible obsolete or slow-moving inventory items provide assurance about management'sassertion of valuation (i.e., has inventory been properly recorded at lower of cost or market?).Choice "a" is incorrect. Inquiries regarding obsolete or slow-moving inventory items provide little assurance regarding whether all transactions have been properlyincluded (completeness). Choice "b" is incorrect. Inquiries regarding obsolete or slow-moving inventory items provide little assurance regarding whether all recordedtransactions are real (existence). Choice "c" is incorrect. Inquiries regarding obsolete or slow-moving inventory items provide little assurance regarding whether alltransactions are properly presented, described, and disclosed.

QUESTION 129Which of the following statements is generally correct about the reliability of audit evidence?

A. The more effective the internal control structure, the more assurance it provides about the reliability of the accounting data and financial statements.B. Reliability of audit evidence refers to the amount of corroborative evidence obtained.C. Information obtained indirectly from independent outside sources is more persuasive than the auditor's direct personal knowledge obtained through observation

and inspection.D. Reliability of audit evidence refers to the audit evidence obtained from outside the entity.



Choice "a" is correct. The reliability of accounting data and financial statements is enhanced by a satisfactory system of internal control.Choice "b" is incorrect. The sufficiency (not reliability) of audit evidence refers to the amount of corroborative evidence obtained. Reliability refers to the quality ofevidence. Choice "c" is incorrect. The auditor's direct personal knowledge obtained through observation and inspection is more persuasive than informationobtained indirectly from independent outside sources. Choice "d" is incorrect. The reliability of audit evidence refers to its quality, and reliable audit evidence may beobtained from both inside and outside the entity.

QUESTION 130Which of the following audit procedures probably would provide the most reliable evidence concerning the entity's assertion of rights and obligations related toinventories?

A. Trace test counts noted during the entity's physical count to the entity's summarization of quantities.B. Inspect agreements to determine whether any inventory is pledged as collateral or subject to any liens.C. Select the last few shipping advices used before the physical count and determine whether the shipments were recorded as sales.D. Inspect the open purchase order file for significant commitments that should be considered for disclosure.



Choice "b" is correct. Inspecting agreements to determine whether any inventory is pledged as collateral or subject to liens provides the most reliable evidenceconcerning the entity's assertion of rights and obligations. These documents will probably verify ownership and show lenders' restrictions on the inventories.

Choice "a" is incorrect. Tracing from the auditor's test counts to the entity's summarization of quantities would provide evidence concerning the completenessassertion. Choice "c" is incorrect. Determining whether shipments were recorded as sales provides evidence about the completeness of recorded sales.Choice "d" is incorrect. Inspecting the open purchase order file for significant commitments that should be disclosed would provide evidence concerning theappropriate presentation, description, and disclosure of such items.

QUESTION 131An auditor most likely would analyze inventory turnover rates to obtain evidence concerning management's assertions about:

A. Existence.B. Rights and obligations.C. Understandability and classification.D. Valuation and allocation.



Choice "d" is correct. An auditor most likely would analyze inventory turnover rates to obtain evidence concerning management's assertions about valuation andallocation (i.e., if the inventory is becoming older, an obsolescence reserve might be required).Choice "a" is incorrect. The existence assertion addresses whether assets, liabilities, and equity interests exist. Analysis of inventory turnover would not provideevidence concerning this assertion. Choice "b" is incorrect. Rights and obligations pertain to ownership of assets and liabilities. Analysis of inventory turnover wouldnot provide evidence concerning this assertion. Choice "c" is incorrect. Understandability and classification deal with whether the components of the financialstatements are properly presented, described, and disclosed. Analysis of inventory turnover would not provide evidence concerning this assertion.

QUESTION 132Which of the following procedures would an auditor most likely perform to verify management's assertion of completeness?

A. Compare a sample of shipping documents to related sales invoices.B. Observe the client's distribution of payroll checks.C. Confirm a sample of recorded receivables by direct communication with the debtors.D. Review standard bank confirmations for indications of kiting.



Explanation:

Choice "a" is correct. In order to verify management's assertion of completeness, an auditor would most likely compare a sample of shipping documents to relatedsales invoices to determine that all goods shipped were properly included in sales.Choice "b" is incorrect. Observing the client's distribution of payroll checks would test management's assertion regarding existence of employees.Choice "c" is incorrect. Confirming a sample of recorded receivables by direct communication with the debtors (i.e., sending accounts receivable confirmations)would verify management's assertion of existence of the accounts receivable.Choice "d" is incorrect. Reviewing standard bank confirmations does not provide evidence of kiting. Kiting involves interbank transfers, and bank confirmations onlyshow year-end balances, not transfers between banks.

QUESTION 133Which of the following procedures would provide the most reliable audit evidence?

A. Inquiries of the client's internal audit staff held in private.B. Inspection of prenumbered client purchase orders filed in the vouchers payable department.C. Analytical procedures performed by the auditor on the entity's trial balance.D. Inspection of bank statements obtained directly from the client's financial institution.



Choice "d" is correct. External evidence, such as bank statements obtained directly from the client's financial institution, is more reliable than internal evidence.Choices "a", "b", and "c" are incorrect, which are all based on internally generated sources of evidence.

QUESTION 134In a credit sales and cash receipts system flowchart symbol X could represent:

A. Auditor's test data.B. Remittance advices.C. Error reports.D. Credit authorization forms.



Choice "b" is correct. Remittance advices (for customer payments) are the input document not identified in the credit sales and cash receipts system flowchart.Choice "a" is incorrect. The flowchart shows the client's processing of receipts, not the auditor's tests of controls.Choice "c" is incorrect. Error reports, also called exception reports, are generated after processing, not before.Choice "d" is incorrect. Credit authorization forms would not be an input used to create a transaction file, although they should be used prior to granting credit.

QUESTION 135Which of the following presumptions does not relate to the reliability of audit evidence?

A. The more effective the internal control structure, the more assurance it provides about the accounting data and financial statements.B. An auditor's opinion, to be economically useful, is formed within reasonable time and based on evidence obtained at a reasonable cost.C. Evidence obtained from independent sources outside the entity is more persuasive than evidence secured solely within the entity.D. The independent auditor's direct personal knowledge, obtained through observation and inspection, is more persuasive than information obtained indirectly.



Choice "b" is correct. The concept of cost-benefit is embodied in the auditor's opinion which, to be economically useful, is formed within reasonable time and basedon evidence obtained at a reasonable cost. The cost-benefit concept, however, bears no relationship to the reliability of audit evidence. Choice "a" is incorrect. Themore effective the internal control structure, the higher level of assurance it provides about the accounting data and financial statements, and the more reliable auditevidence will be.Choice "c" is incorrect. Evidence obtained from independent sources outside the entity is more persuasive, or reliable, than evidence secured solely within theentity. Choice "d" is incorrect. The independent auditor's direct personal knowledge, obtained through observation and inspection, is more persuasive (morereliable) than information obtained indirectly.

QUESTION 136An auditor concluded that no excessive costs for idle plant were charged to inventory. This conclusion most likely related to the auditor's objective to obtainevidence about the financial statement assertions regarding inventory, including understandability and classification, and:

A. Valuation and allocation.B. Completeness.C. Existence.D. Rights and obligations.



Choice "a" is correct. An auditor reviews the overhead allocation to determine that no excessive costs for idle plant were charged to inventory. This is one of theprocedures performed by an auditor to determine that the inventory balance is properly valued (assertion of valuation and allocation). Choice "b" is incorrect.Completeness relates to ensuring that all assets, liabilities, and equity interests are properly included in the financial statements. The allocation of overhead costs toinventory does not affect this assertion.

Choice "c" is incorrect. Existence relates to whether assets, liabilities, and equity interests exist. The allocation of overhead costs to inventory does not affect thisassertion. Choice "d" is incorrect. Rights and obligations pertain to ownership of assets and liabilities. The allocation of overhead costs to inventory does not affectthis assertion.

QUESTION 137An auditor selected items for test counts while observing a client's physical inventory. The auditor then traced the test counts to the client's inventory listing. Thisprocedure most likely obtained evidence concerning management's assertion of:

A. Rights and obligations.B. Completeness.C. Existence.D. Valuation.



Choice "b" is correct. When an auditor selects items for test counts and traces the test counts to the client's inventory listing, the auditor has obtained evidenceconcerning management's assertion of completeness (All inventory on hand has been properly included in the physical listing.) Choice "a" is incorrect. Theassertion of rights and obligations would be tested by examining paid vendor's invoices, consignment agreements, and contracts. Choice "c" is incorrect. Theassertion of existence would be supported by selecting from a sample of inventory items included in the physical listing and tracing to the floor to determine that theinventory was actually on hand. (Note how changing the direction of testing provides evidence for different assertions.)Choice "d" is incorrect. Valuation pertains to presentation of balances at their appropriate amounts, whereas tracing test counts to the client's inventory listingrelates to the testing of inventory quantities.

QUESTION 138

In testing plant and equipment balances, an auditor examines new additions listed on an analysis of plant and equipment. This procedure most likely obtainsevidence concerning management's assertionof:

A. Completeness.B. Existence.C. Understandability and classification.D. Valuation and allocation.



Choice "b" is correct. By examining the assets listed as new additions on an analysis of plant and equipment, an auditor obtains evidence concerningmanagement's assertion of existence. Choice "a" is incorrect. Examining new additions that are already listed on the analysis does not provide evidence ofcompleteness. The assertion of completeness relating to fixed assets might be tested by reviewing large repair and maintenance charges to determine if the costshould more properly have been capitalized (i.e., to evaluate whether fixed asset additions are complete). Choice "c" is incorrect. Understandability andclassification deals with whether the components of the financial statements are properly presented, described, and disclosed. Examination of new assets does notprovide evidence regarding this assertion.Choice "d" is incorrect. Valuation and allocation pertains to presentation of balances at their proper amounts. Examination of new assets does not provide evidenceregarding this assertion.

QUESTION 139Which of the following evidence provides the greatest assurance of reliability?

A. Bank statement.B. Bank reconciliation.C. Cash receipts journal.D. Cash disbursements journal.



Choice "a" is correct. External evidence is more reliable than internal evidence. A bank statement is external evidence.Choices "b", "c", and "d" are incorrect. Bank reconciliations, the cash receipts journal, and the cash disbursements journal are all internal evidence, which is not asreliable as external evidence.

QUESTION 140Which of the following evidence provides the least assurance of reliability?

A. Accounts receivable confirmation.B. Sales invoice.C. Vendor invoice.D. Bank statement.



Choice "b" is correct. Internal evidence is less reliable than external evidence. A sales invoice is internal evidence.Choices "a", "c", and "d" are incorrect. Accounts receivable confirmations, vendor invoices, and bank statements are all external evidence, which is more reliablethan internal evidence.

QUESTION 141Which of the following is not true about accounting estimates?

A. Accounting estimates measure the effects of past transactions or events that cannot be determined in a timely cost-effective manner.B. Accounting estimates measure the effects of the present status of an asset or liability.C. An accounting estimate is an approximation of an account pending the outcome of a future event.D. An accounting estimate is an approximation of past events that can be determined on a timely costeffective basis.



Choice "d" is correct. An accounting estimate pertains to determining the approximation of past events that cannot be determined on a timely, cost-effective basis. Ifthe effect of a past event can be determined on a timely, cost-effective basis, there would be no reason to make an estimate. Choices "a", "b", and "c" are incorrect.

Accounting estimates may:

A. Measure the effects of past transactions that cannot be determined in a timely cost-effective manner. B. Measure the effects of the present status of an asset orliability. C. Be used to approximate an account pending the outcome of a future event (e.g., uncollectible accounts receivable).

QUESTION 142An auditor should obtain sufficient knowledge of an entity's information system relevant to financial reporting to understand the:

A. Safeguards used to limit access to computer facilities.B. Process used to prepare significant accounting estimates.C. Procedures used to assure proper authorization of transactions.D. Policies used to detect the concealment of irregularities.



Choice "b" is correct. An auditor is responsible for evaluating the reasonableness of significant accounting estimates made by management. An entity's informationsystem may affect the quality of such estimates and therefore should be considered by the auditor. Choices "a", "c", and "d" are incorrect. Control activities such asthose designed to limit access, ensure proper authorization, and discover fraud are not directly related to the information system relevant to financial reporting.

QUESTION 143In evaluating an entity's accounting estimates, one of an auditor's objectives is to determine whether the estimates are:

A. Not subject to bias.B. Consistent with industry guidelines.C. Based on objective assumptions.D. Reasonable in the circumstances.



Choice "d" is correct. In evaluating an entity's accounting estimates, one of an auditor's objectives is to determine whether the estimates are reasonable in the

circumstances and in conformity with GAAP. Choice "a" is incorrect. Most estimates are subjective in nature and thus subject to bias. Choice "b" is incorrect.Industry guidelines generally do not determine the amount of an accounting estimate, which is developed in accordance with GAAP.Choice "c" is incorrect. Estimates are generally not based upon objective assumptions; rather, they are uncertain in nature, pending the outcome of future events.

QUESTION 144Which of the following is true about an auditor's responsibility with respect to accounting estimates?

A. The auditor is responsible for both preparing accounting estimates and evaluating their reasonableness.B. The auditor is responsible for preparing accounting estimates in accordance with generally accepted auditing standards.C. The auditor is responsible for evaluating the reasonableness of accounting estimates.D. The auditor has no responsibility with respect to accounting estimates.



Choice "c" is correct. The auditor is responsible for evaluating the reasonableness of accounting estimates.Choices "a" and "b" are incorrect. Management is responsible for establishing a process for preparing accounting estimates.Choice "d" is incorrect. The auditor must determine whether the accounting estimate is reasonable in the circumstances.

QUESTION 145Which of the following is not a reason justifying the use of accounting estimates?

A. The valuation or measurement of some accounts is uncertain pending the outcome of future events.B. Data about past events cannot be accumulated in a cost-effective manner.C. Data about future events cannot be accumulated in a cost-effective manner.D. Data about past events cannot be accumulated in a timely manner.



Choice "c" is correct. Accounting estimates are not used to measure future events. (Although, the measurement of some accounts may be uncertain pending theoutcome of future events.) Choice "a" is incorrect. Valuation of certain historical accounts is uncertain, and may be dependent upon the outcome of future events.

Accounting estimates are used in such situations to more properly reflect the account balance.Choices "b" and "d" are incorrect. If data about past events cannot be accumulated in a timely, costeffective manner, accounting estimates may be required.

QUESTION 146An auditor would be most likely to identify a contingent liability by obtaining a (an):

A. Accounts payable confirmation.B. Transfer agent confirmation.C. Standard bank confirmation.D. Related party transaction confirmation.



Choice "c" is correct. An auditor would be most likely to identify a contingent liability by obtaining a standard bank confirmation, which has an "exceptions andcomments" box that specifically discloses contingent liabilities as endorser of loans, for open letters of credit, etc. Choice "a" is incorrect. Confirmations of accountspayable relate to existing liabilities, not to contingent liabilities. They are not always performed and rarely disclose contingencies. Choice "b" is incorrect. Transferagent confirmations relate to purchase and sale of securities. They are not always used and rarely disclose contingencies.Choice "d" is incorrect. Confirmations of related party transactions relate to transactions that have already occurred. They are not always used and rarely disclosecontingencies.

QUESTION 147In evaluating the reasonableness of an accounting estimate, an auditor would be least likely to use which of the following approaches?

A. Review subsequent events or transactions occurring prior to audit completion.B. Develop an independent expectation of the estimate.C. Review and test the process used to develop the estimate.D. Review the minutes of board of directors and shareholder meetings for discussion of the estimate.



Choice "d" is correct. Even if estimates were discussed during board meetings and/or shareholder meetings, it is unlikely that review of such discussion wouldprovide evidence that the estimate is reasonable.Choices "a", "b", and "c" are incorrect. Reviewing subsequent events, developing an independent expectation, and reviewing and testing the process used todevelop the estimate are all appropriate methods used to evaluate the reasonableness of an accounting estimate.

QUESTION 148The sampling unit in a test of controls pertaining to the existence of payroll transactions ordinarily is a (an):

A. Clock card or time ticket.B. Employee Form W-2.C. Employee personnel record.D. Payroll register entry.



Choice "d" is correct. To test controls pertaining to the existence of payroll transactions, entries in the payroll register would be the population from which thesample is selecteD. (To test existence, the auditor needs to start with the accounting records and vouch backward to the source documents.) Choice "a" isincorrect. After the sample is taken from the payroll register, the selected samples are traced to clock cards or time tickets to verify that payroll transactions reallyexist/occurred. Choices "b" and "c" are incorrect. Sampling employee form W-2s and employee personnel records would test controls related to the completenessof recorded payroll, not existence of specific transactions.

QUESTION 149Which of the following procedures most likely would be considered a weakness in an entity's internal controls over payroll?

A. A voucher for the amount of the payroll is prepared in the general accounting department based on the payroll department's payroll summary.B. Payroll checks are prepared by the payroll department and signed by the treasurer.C. The employee who distributes payroll checks returns unclaimed payroll checks to the payroll department.D. The personnel department sends employees' termination notices to the payroll department.



Choice "c" is correct. If the employee who distributes payroll checks returns unclaimed checks to the payroll department, an unscrupulous payroll departmentemployee might be able to set up a fictitious employee and convert the checks once they are returned to the payroll department. Unclaimed checks should beturned over to the cashier in the treasurer's department. Choices "a", "b", and "d" are incorrect. All of the following procedures are good controls over the payrollsystem:

A. A voucher for the amount of the payroll is prepared in the general accounting department based on the payroll department's payroll summary.B. Payroll checks are prepared by the payroll department and signed by the treasurer. D. The personnel department sends employees' hire and termination noticesto the payroll department.

QUESTION 150An auditor most likely would perform substantive tests of details on payroll transactions and balances when:

A. Cutoff tests indicate a substantial amount of accrued payroll expense.B. The assessed level of control risk relative to payroll transactions is low.C. Analytical procedures indicate unusual fluctuations in recurring payroll entries.D. Accrued payroll expense consists primarily of unpaid commissions.



Choice "c" is correct. An auditor most likely would perform substantive tests of details on payroll transactions and balances when analytical procedures indicateunusual fluctuations in recurring payroll entries. Generally an auditor can audit the payroll accounts utilizing mostly analytical procedures; however if the results ofsuch procedures indicate unusual fluctuations, the auditor would employ more persuasive, substantive tests of details.Choice "a" is incorrect. A substantial amount of accrued payroll expense would not necessarily cause the auditor to perform substantive tests of details on payrolltransactions, since the balance may be effectively tested using analytical procedures.Choice "b" is incorrect. When the assessed level of control risk relative to payroll is low, the auditor would probably perform only analytical procedures to test therelated balances. If control risk rose to a high level, then substantive tests of details would probably be utilized. Choice "d" is incorrect. Unpaid commissions may betested effectively with analytical procedures.

QUESTION 151The purpose of segregating the duties of hiring personnel and distributing payroll checks is to separate the:

A. Human resources function from the controllership function.B. Administrative controls from the internal accounting controls.C. Authorization of transactions from the custody of related assets.

D. Operational responsibility from the recordkeeping responsibility.



Choice "c" is correct. The purpose of segregating the duties of hiring personnel (personnel department/human resources) and distributing payroll checks(treasurer's department) is to separate the authorization of transactions (hiring, pay rates, etC. are authorized by the personnel department/human resources) fromthe custody of related assets (cash or checks are held in the treasurer's department). Choice "a" is incorrect. Segregation of hiring personnel (human resources/personnel) from distribution of payroll checks (treasurer's department) does not involve the controllership function. Choice "b" is incorrect. Keeping administrativecontrols (management's directives) and accounting controls separate is not accomplished by segregating the hiring and distribution functions. Choice "d" isincorrect. Neither operational responsibility nor recordkeeping responsibility includes distributing checks or hiring personnel.

QUESTION 152An auditor most likely would extend substantive tests of payroll when:

A. Payroll is extensively audited by the state government.B. Payroll expense is substantially higher than in the prior year.C. Overpayments are discovered in performing tests of details.D. Employees complain to management about too much overtime.



Choice "c" is correct. An auditor most likely would extend (increase) substantive tests of payroll when significant errors, such as overpayments, are discovered inperforming the tests of details. Choice "a" is incorrect. The extensive auditing of payroll by the state government might serve to decrease substantive testing sincepresumably the extensive audit would have already flushed out any problem areas.Choice "b" is incorrect. A substantial increase in payroll expense would not necessarily increase the substantive tests of payroll if the increase is readily explainableand supportable with analytical review procedures.Choice "d" is incorrect. An increase in overtime would not necessarily cause the auditor to extend substantive tests of payroll, as long as the effect on payroll issupportable with analytical review procedures.

QUESTION 153An auditor vouched data for a sample of employees in a payroll register to approved clock card data to provide assurance that:

A. Payments to employees are computed at authorized rates.B. Employees work the number of hours for which they are paid.C. Segregation of duties exists between the preparation and distribution of the payroll.D. Internal controls relating to unclaimed payroll checks are operating effectively.



Choice "b" is correct. By vouching to time card data, the auditor is testing the existence assertion for hours worked.Choice "a" is incorrect. Vouching to approved time card data would provide evidence about hours worked, not pay rates. Pay rates would be tested by comparing topersonnel records. Choice "c" is incorrect. Vouching to approved time cards does not provide evidence about segregation of duties.Choice "d" is incorrect. Vouching to the approved time cards does not provide evidence about internal controls related to unclaimed paychecks. The auditor wouldneed to observe a payroll distribution to evaluate these controls.

QUESTION 154In a comparison of 20X2 to 20X1, Neir Co.'s inventory turnover ratio increased substantially although sales and inventory amounts were essentially unchanged.Which of the following statements explains the increased inventory turnover ratio?

A. Cost of goods sold decreased.B. Accounts receivable turnover increased.C. Total asset turnover increased.D. Gross profit percentage decreased.



Choice "d" is correct. Gross profit percentage decreased.

In order for the inventory turnover ratio to increase, either cost of sales must increase or average inventory must decrease. Since the question indicates thatinventory is unchanged, cost of sales must have increased.If the cost of sales increased and sales remained constant, the gross profit percentage would decrease. Choice "a" is incorrect. If cost of goods sold decreases, theinventory turnover ratio would also decrease.Choice "b" is incorrect. Accounts receivable turnover is calculated as sales divided by receivables. If sales remain the same while this ratio increases, receivableshave likely declined. This would have no impact on inventory turnover.Choice "c" is incorrect. Total asset turnover is calculated as sales divided by total assets. If sales remain the same while this ratio increases, total assets have likelydeclined. This would have no impact on inventory turnover.

QUESTION 155Confirmation is most likely to be a relevant form of evidence with regard to assertions about accounts receivable when the auditor has concerns about thereceivables:

A. Valuation.B. Classification.C. Existence.D. Completeness.



Choice "c" is correct. Confirmation of accounts receivable provides evidence that the customer and the receivable exist.Choice "a" is incorrect. Accounts receivable confirmations do not provide evidence regarding valuation, since they do not indicate whether customers have theintent or the ability to pay. Choice "b" is incorrect. Accounts receivable confirmations do not provide evidence regarding the appropriate classification of receivablesin the financial statements. Choice "d" is incorrect. Accounts receivable confirmations are sent to recorded customers, so they do not provide evidence regardingthe possible omission of valid accounts (i.e., completeness).

QUESTION 156Negative confirmation of accounts receivable is less effective than positive confirmation of accounts receivable because:

A. A majority of recipients usually lack the willingness to respond objectively.

B. Some recipients may report incorrect balances that require extensive follow-up.C. The auditor cannot infer that all nonrespondents have verified their account information.D. Negative confirmations do not produce audit evidence that is statistically quantifiable.



Choice "c" is correct. Negative confirmation of accounts receivable is less effective than positive confirmation of accounts receivable because the auditor cannotinfer that all nonrespondents have verified their account information.Choice "a" is incorrect. Both positive and negative confirmations are equally affected by recipients' lack of willingness to respond objectively.Choice "b" is incorrect. Both positive and negative confirms are equally affected by recipients' reporting of incorrect balances.Choice "d" is incorrect. Negative confirmations returned do produce information (e.g., errors noted in accounts) that can be statistically quantifiable.

QUESTION 157Auditor confirmation of accounts payable balances at the balance sheet date may be unnecessary because:

A. This is a duplication of cutoff tests.B. Accounts payable balances at the balance sheet date may not be paid before the audit is completed.C. Correspondence with the audit client's attorney will reveal all legal action by vendors for nonpayment.D. There is likely to be other reliable external evidence available to support the balances.



Choice "d" is correct. The documents available to support accounts payable balances come from external sources, which makes them more reliable.Choice "a" is incorrect. Confirmation of accounts payable is not a duplication of cutoff tests. Cutoff testing addresses questions about proper period (allocation)while confirmation of accounts payable balances generally tests for understated balances.Choice "b" is incorrect. If liabilities are not paid before the audit is completed, accounts payable confirmations would be more important, since there would be lessother evidence supporting the liability.Choice "c" is incorrect. Legal action usually takes a long time and correspondence with an attorney may not disclose all nonpayment problems. (Notice the all-inclusive word "all," usually the tip-off to a wrong answer.)

QUESTION 158Two assertions for which confirmation of accounts receivable balances provides primary evidence are:

A. Completeness and valuation.B. Valuation and rights and obligations.C. Rights and obligations and existence.D. Existence and completeness.



Choice "c" is correct. Two assertions for which the confirmation of accounts receivable balances provides primary evidence are rights and obligations (does theclient have a right to the receivable?) and existence (does the receivable really exist?).Choices "a", "b", and "d" are incorrect. Confirmation of receivables does not provide evidence about completeness, since the sample begins with recordedreceivables. (To test completeness, we would be looking for unrecorded receivables). In addition, confirmation of receivables does not necessarily provide evidencerelated to the valuation assertion. While the existence of the receivables is confirmed, their collectibility is not.

QUESTION 159The negative request form of accounts receivable confirmation is useful particularly when the:




Choice "a" is correct. The negative request form of accounts receivable confirmation is useful particularly when:

- the assessed level of control risk relating to receivables is low (if control risk is high, then positive confirmation requests would probably be sent),- there are many small balances (which would make it difficult to keep the number of positive confirmations to a reasonably low level), and- consideration of the confirmation by the recipient is likely (since the auditor is relying on the customers' consideration as the sole basis of support for theconfirmation). Choices "b", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 160Which of the following procedures would an auditor most likely perform for year-end accounts receivable confirmations when the auditor did not receive replies tosecond requests?

A. Review the cash receipts journal for the month prior to the year-end.B. Intensify the study of the internal control structure concerning the revenue cycle.C. Increase the assessed level of detection risk for the existence assertion.D. Inspect the shipping records documenting the merchandise sold to the debtors.



Choice "d" is correct. When an auditor does not receive replies to second requests on year-end accounts receivable confirmations, the auditor would most likelyperform alternate procedures to support the existence of the receivables. These procedures include inspection of the shipping records to determine that themerchandise was actually sold to the debtors. Choice "a" is incorrect. Alternate procedures would also include reviewing the cash receipts journal for the monthssubsequent to year-end. Reviewing the cash receipts journal for the month prior to year-end would provide no evidence regarding the existence of a year-endreceivable, which obviously had not been paid by year-end.Choice "b" is incorrect. Intensifying the study of the internal control structure concerning the revenue cycle would provide no additional evidence related to thespecific accounts receivable confirmations that were not returned.Choice "c" is incorrect. Increasing the assessed level of detection risk for the existence assertion would provide no additional evidence related to the specificaccounts receivable confirmations that were not returned by the customer. (By sending out confirmations, the auditor is already performing substantive tests).

QUESTION 161In which of the following circumstances would the use of the negative form of accounts receivable confirmation most likely be justified?

A. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major customers.B. A substantial number of accounts may be in dispute and the accounts receivable balance arises from sales to many customers with small balances.C. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to a few major customers.D. A small number of accounts may be in dispute and the accounts receivable balance arises from sales to many customers with small balances.



Choice "d" is correct. The use of negative confirmations most likely would be justified when there are a small number of accounts that may be in dispute and theaccounts receivable balance arises from sales to many customers with small balances (e.g., utility consumer customers). Choice "a" is incorrect. Positive (notnegative) confirmations should be used when a substantial number of accounts are expected to be in dispute, or if the accounts receivable balance is comprised ofaccounts from a few major customers.Choice "b" is incorrect. Positive (not negative) confirmations should be used when a substantial number of accounts are expected to be in dispute.Choice "c" is incorrect. Positive (not negative) confirmations should be used when the accounts receivable balance is comprised of accounts from a few majorcustomers.

QUESTION 162To reduce the risks associated with accepting fax responses to requests for confirmations of accounts receivable, an auditor most likely would:

A. Examine the shipping documents that provide evidence for the existence assertion.B. Verify the sources and contents of the faxes in telephone calls to the senders.C. Consider the faxes to be nonresponses and evaluate them as unadjusted differences.D. Inspect the faxes for forgeries or alterations and consider them to be acceptable if none are noted.



Choice "b" is correct. In order to validate the legitimacy of a faxed confirmation, the auditor is likely to call the senders to verify the sources and contents.Choice "a" is incorrect. Examining shipping documents is an alternative procedure that is more likely to be performed if the confirmation was not received at all.

Choice "c" is incorrect. Treating the faxes as non-responses would be to ignore an important source of audit evidence. Treating them as unadjusted differencesmay cause the auditor to conclude that the accounts receivable balance is misstated, when in fact it is not. Choice "d" is incorrect. Inspecting the faxes for forgeriesor alterations is beyond the professional capability of the CPA.

QUESTION 163Under which of the following circumstances would the use of the blank form of confirmations of accounts receivable most likely be preferable to positiveconfirmations?

A. The recipients are likely to sign the confirmations without devoting proper attention to them.B. Subsequent cash receipts are unusually difficult to verify.C. Analytical procedures indicate that few exceptions are expected.D. The combined assessed level of inherent risk and control risk is low.



Choice "a" is correct. If the recipients of confirmations are likely to sign them without devoting proper attention to them, it is possible that a misstatement in therelated receivable will not be discovered by the auditor (i.e., when the balance on the confirmation is incorrect and the recipient mistakenly signs it anyway). Use ofthe blank form of confirmation provides a greater degree of assurance in this situation because it forces the recipient to determine the receivable balance. Choice"b" is incorrect. Inability to verify subsequent cash receipts makes follow-up of unconfirmed accounts more difficult. Since blank forms may result in lower responserates (because they require additional effort), use of the blank form in this situation would be less likely. Choice "c" is incorrect. If few exceptions are expected, itwould be acceptable to use positive confirmations. (Blank confirmations may provide a greater degree of assurance, which would be more important if manyexceptions were expected.)Choice "d" is incorrect. In low risk situations, it would be acceptable to use positive confirmations. (Blank confirmations may provide a greater degree of assurance,which would be more important in high risk situations.)

QUESTION 164To establish the existence and ownership of a long-term investment in the common stock of a publiclytraded company, an auditor ordinarily performs a securitycount or:

A. Relies on the client's internal accounting controls if the auditor has reasonable assurance that the control activities are being applied as prescribed.B. Confirms the number of shares owned that are held by an independent custodian.C. Determines the market price per share at the balance sheet date from published quotations.D. Confirms the number of shares owned with the issuing company.

Correct Answer: B



Choice "b" is correct. Auditors obtain a confirmation (safekeeping list) indicating the number of shares of stocks held by an outside independent custodian.Choice "a" is incorrect. Even a good system of internal control does not necessarily provide sufficient evidence of existence and ownership.Choice "c" is incorrect. Verifying the market price doesn't provide evidence regarding ownership or existence.Choice "d" is incorrect. Confirmations are generally sent to the independent custodian, not to the issuing company.

QUESTION 165An auditor testing long-term investments would ordinarily use analytical review as the primary audit procedure to ascertain the reasonableness of the:

A. Valuation of marketable equity securities.B. Classification of gains and losses on the disposal of securities.C. Completeness of recorded investment income.D. Existence and ownership of investments.



Choice "c" is correct. Analytical review is generally used to ascertain the reasonableness of investment income in relationship to the amount invested.Choice "a" is incorrect. Valuation would be verified using listed prices (NYSE, etc.). Choice "b" is incorrect. Classification of gains or losses would be evaluatedbased upon appropriate accounting principles.Choice "d" is incorrect. Existence and ownership is generally evaluated by inspection of securities, review of brokerage statements, or confirmation with an outsideindependent custodian.

QUESTION 166An auditor would most likely verify the interest earned on bond investments by:

A. Vouching the receipt and deposit of interest checks.B. Confirming the bond interest rate with the issuer of the bonds.C. Recomputing the interest earned on the basis of face amount, interest rate, and period held.D. Testing the internal controls over cash receipts.



Choice "c" is correct. Recomputing the interest earned is the most likely method of auditing interest earned on bond investments.Choice "a" is incorrect. Vouching cash receipts would only verify the recording of checks received. This may not be the same as interest earned, since interest isaccrued between cash payment dates. Choice "b" is incorrect. Confirmation of the bond interest rate with the issuer is not sufficient, as the rate still needs to beapplied based on face amount and period held. Choice "d" is incorrect. Internal control testing of cash receipts would not provide evidence that earned interest wasproperly recorded, since interest is accrued between cash payment dates.

QUESTION 167Which of the following controls would be most effective in assuring that the proper custody of assets in the investing cycle is maintained?

A. Direct access to securities in the safety deposit box is limited to only one corporate officer.B. Personnel who post investment transactions to the general ledger are not permitted to update the investment subsidiary ledger.C. The purchase and sale of investments are executed on the specific authorization of the board of directors.D. The recorded balances in the investment subsidiary ledger are periodically compared with the contents of the safety deposit box by independent personnel.



Choice "d" is correct. An independent person comparing the contents of the safety deposit box with the recorded balances in the investment subsidiary ledger is aneffective control for assuring that the proper custody of assets in the investing cycle is maintained. Choice "a" is incorrect. Direct access to securities in the safetydeposit box being limited to only one corporate officer is a weakness in internal control since there is no independent verification of the box's contents. Good internalcontrol generally requires that two or more individuals be present when the safety deposit box is opened.Choice "b" is incorrect. While it is a good idea to have separate employees post investment transactions to the general and subsidiary ledgers (so they can later bereconciled), this control relates to recordkeeping, not to custody.Choice "c" is incorrect. Authorization of the purchase and sale of investments by the board of directors is a good control over the approval of investmenttransactions but does little to assure that proper custody of assets is maintained.

QUESTION 168To satisfy the valuation assertion when auditing an investment accounted for by the equity method, an auditor most likely would:

A. Inspect the stock certificates evidencing the investment.B. Examine the audited financial statements of the investee company.C. Review the broker's advice or canceled check for the investment's acquisition.D. Obtain market quotations from financial newspapers or periodicals.



Choice "b" is correct. To satisfy the valuation assertion when auditing an investment accounted for by the equity method, an auditor most likely would examine theaudited financial statements of the investee company, performing recalculations of prorata share of income/loss and analytical procedures to determine if theinvestment is carried at the lower of cost or market. Choices "a" and "c" are incorrect. Inspecting the stock certificates evidencing the investment or reviewing thebroker's advice or canceled check for the investment's acquisition are procedures that satisfy the existence assertion, not the valuation assertion. Choice "d" isincorrect. Obtaining market quotations from financial newspapers or periodicals would satisfy the valuation assertion for an investment accounted for by the costmethod.

QUESTION 169Which of the following controls would an entity most likely use in safeguarding against the loss of marketable securities?

A. An independent trust company that has no direct contact with the employees who have recordkeeping responsibilities has possession of the securities.B. The internal auditor verifies the marketable securities in the entity's safe each year on the balance sheet date.C. The independent auditor traces all purchases and sales of marketable securities through the subsidiary ledgers to the general ledger.D. A designated member of the board of directors controls the securities in a bank safe-deposit box.



Choice "a" is correct. The control most likely to be used by an entity in safeguarding against the loss of marketable securities is that an independent trust companythat has no direct contact with the employees who have recordkeeping responsibilities, has possession of the securities. For good internal control over thesafeguarding of any asset, the individual who has the recordkeeping responsibilities over that asset should never have access to it.Choice "b" is incorrect. Verifying the securities held in the entity's safe would detect that the loss occurred, but it would not prevent the loss.Choice "c" is incorrect. Tracing purchases and sales of marketable securities would verify that the transactions were properly recorded, but would not safeguardagainst loss. Choice "d" is incorrect. Having one person control the securities in a bank safe-deposit box is a weakness in internal control because that one person

can steal the securities. A better system requires that at least two employees have joint control over the securities in a bank safe-deposit box.

QUESTION 170Which of the following controls most likely would give the greatest assurance that securities held as investments are safeguarded?

A. There is no access to securities between the year-end and the date of the auditor's security count.B. Proceeds from the sale of investments are received by an employee who does not have access to securities.C. Investment acquisitions are authorized by a member of the Board of Directors before execution.D. Access to securities requires the signatures and presence of two designated officials.



Choice "d" is correct. Requiring the signatures and presence of two designated officials in order to gain access to securities is an internal control that providesassurance regarding the safeguarding of securities.Choice "a" is incorrect. Having no access to securities between the year-end and the date of the auditor's security count would assure that no securities are addedor taken away before the auditor counts them, but it would not ensure that securities are safeguarded for the entire year. Choice "b" is incorrect. Proceeds from thesale of investments should be received by an employee who does not have access to securities, but this control does not prevent the theft of investments that arenot sold.Choice "c" is incorrect. Requiring authorization from a member of the board of directors before execution assures that investment purchases are approved andconsistent with the financial philosophy of the organization (level of financial risk that the company is willing to accept), but this approval does not provide assurancethat the assets will be safeguarded.

QUESTION 171In testing long-term investments, an auditor ordinarily would use analytical procedures to ascertain the reasonableness of the:

A. Completeness of recorded investment income.B. Classification between balance sheet portfolios.C. Valuation of marketable equity securities.D. Existence of unrealized gains or losses in the portfolio.



Explanation:

Choice "a" is correct. In testing long-term investments, an auditor ordinarily would use analytical procedures to ascertain the reasonableness of the completeness ofrecorded investment income. These procedures would probably include a comparison of the recorded investment income with the expected amount (based uponthe related interest rate, dividends declared, etc.) and the income balance audited in the prior year.Choice "b" is incorrect. Classification between balance sheet portfolios would most likely be tested by confirming the terms of the investment and making inquiriesof management regarding how long they intend to hold the securities.Choice "c" is incorrect. To test the valuation of marketable equity securities an auditor would most likely compare to market quotations (cost method) or examinethe audited financial statements of the investee company (equity method).Choice "d" is incorrect. To identify and quantify the existence of unrealized gains and losses in the portfolio, an auditor would examine the trading prices in the WallStreet Journal (or other source) for those long-term investments carried under the cost method. For those carried under the equity method, an auditor would reviewthe audited financial statements of the investee company.

QUESTION 172Which of the following internal controls would an entity most likely use to assist in satisfying the completeness assertion related to long-term investments?

A. Senior management verifies that securities in the bank safe deposit box are registered in the entity's name.B. The internal auditor compares the securities in the bank safe deposit box with recorded investments.C. The treasurer vouches the acquisition of securities by comparing brokers' advices with canceled checks.D. The controller compares the current market prices of recorded investments with the brokers' advices on file.



Choice "b" is correct. Requiring the internal auditor to compare the securities in the bank safe deposit box with recorded investments is the procedure an entity mostlikely would use in satisfying the completeness assertion related to long-term investments. Choice "a" is incorrect. Verifying that securities in the bank safe depositbox are registered in the entity's name provides evidence regarding rights and obligations, not completeness. Choice "c" is incorrect. Vouching the acquisition ofsecurities by comparing brokers' advices with canceled checks provides evidence regarding rights and obligations, not completeness. Choice "d" is incorrect. Thecontroller comparing the current market prices of recorded investments with the broker advices on file provides assurance that the long-term investments areproperly valued, and that unrealized gains and losses are properly recognized.

QUESTION 173A client has a large and active investment portfolio that is kept in a bank safe deposit box. If the auditor is unable to count the securities at the balance sheet date,the auditor most likely will:

A. Request the bank to confirm to the auditor the contents of the safe deposit box at the balance sheet date.

B. Examine supporting evidence for transactions occurring during the year.C. Count the securities at a subsequent date and confirm with the bank whether securities were added or removed since the balance sheet date.D. Request the client to have the bank seal the safe deposit box until the auditor can count the securities at a subsequent date.



Choice "d" is correct. If the auditor is unable to count the securities at the balance sheet date the auditor should request the client to have the bank seal the safedeposit box until the auditor can count the securities.Choice "a" is incorrect. Bank employees are not present when items are put into or taken from the safety deposit box and do not keep records of safety deposit boxcontents. They would therefore be unable to provide any information to the auditors.Choice "b" is incorrect. Examining supporting evidence for the transactions occurring during the year is inefficient, as many of the securities purchased during theyear may have been sold before the balance sheet date. Counting securities is preferable as it provides direct external evidence of the securities on hand at year-end.Choice "c" is incorrect. Bank employees are not present when items are put into or taken from the safety deposit box and do not keep records of safety deposit boxcontents. They would therefore be unable to provide any information to the auditors.

QUESTION 174Property acquisitions that are misclassified as maintenance expense would most likely be detected by an internal accounting control system that provides for:

A. Investigation of variances within a formal budgeting system.B. Review and approval of the monthly depreciation entry by the plant supervisor.C. Segregation of duties of employees in the accounts payable department.D. Examination by the internal auditor of vendor invoices and canceled checks for property acquisitions.



Choice "a" is correct. Investigation of variances in a formal budget might show maintenance costs over budget or acquisition costs under budget, either of whichwould trigger an investigation. Choice "b" is incorrect. Review of journal entries relating to depreciation would not disclose acquisitions misclassified as maintenanceexpense, since no depreciation would be recorded for the misclassified items.Choice "c" is incorrect. Segregation of duties in the accounts payable department would have no effect on the account classification of an approved invoice.

Choice "d" is incorrect. Since the internal auditor would be looking at invoices and checks related to recorded property acquisitions, he or she would not be likely toidentify payments that were erroneously excluded from the property account.

QUESTION 175Which of the following controls is most likely to prevent the improper disposition of equipment?

A. A separation of duties between those authorized to dispose of equipment and those authorized to approve removal work orders.B. The use of serial numbers to identify equipment that could be sold.C. Periodic comparison of removal work orders to authorizing documentation.D. A periodic analysis of the scrap sales and the repairs and maintenance accounts.



Choice "a" is correct. Separation of duties between those authorized to dispose of equipment and those authorized to approve removal work orders is most likely toprevent the improper disposition of equipment.Choice "b" is incorrect. Serial number tracking is a good audit and control activity but it will not prevent improper dispositions of equipment.Choices "c" and "d" are incorrect. Periodic comparison of removal work orders to authorizing documentation and periodic analysis of scrap sales and the repairsand maintenance accounts may identify improper dispositions that have already occurred, but such procedures will not prevent improper dispositions.

QUESTION 176When auditing prepaid insurance, an auditor discovers that the original insurance policy on plant equipment is not available for inspection. The policy's absencemost likely indicates the possibility of a (an):

A. Insurance premium due but not recorded.B. Deficiency in the coinsurance provision.C. Lien on the plant equipment.D. Understatement of insurance expense.



Choice "c" is correct. If an auditor discovers that the original insurance policy on plant equipment is not available for inspection, this most likely indicates that there isa lien on the plant equipment, since the original policy would likely be in the possession of the lien holder. Choices "a", "b", and "d" are incorrect. The absence of theoriginal policy does not necessarily indicate that there is an insurance premium due but not recorded, that there is a deficiency in the coinsurance provision, or thatinsurance expense is understated, since the policy must be reviewed before any of these conclusions can be drawn.

QUESTION 177Which of the following combinations of procedures would an auditor most likely perform to obtain evidence about fixed asset additions?

A. Inspecting documents and physically examining assets.B. Recomputing calculations and obtaining written management representations.C. Observing operating activities and comparing balances to prior period balances.D. Confirming ownership and corroborating transactions through inquiries of client personnel.



Choice "a" is correct. In order to obtain evidence about fixed asset additions, an auditor would most likely inspect documents (e.g., purchase invoices) andphysically examine the new assets. Choice "b" is incorrect. Recomputing calculations might provide evidence about depreciation, and obtaining managementrepresentations might provide evidence about commitments with respect to fixed assets, but neither procedure provides specific evidence about fixed assetadditions. Choice "c" is incorrect. Observing operating activities and comparing balances to prior years might provide evidence that depreciation expense wasproperly recorded, but does not provide evidence supporting additions.Choice "d" is incorrect. Inquiry alone is not as persuasive as direct personal observation.

QUESTION 178Which of the following internal controls most likely would justify a reduced assessed level of control risk concerning plant and equipment acquisitions?

A. Periodic physical inspection of plant and equipment by the internal audit staff.B. Comparison of current-year plant and equipment account balances with prior-year actual balances.C. The review of prenumbered purchase orders to detect unrecorded trade-ins.D. Approval of periodic depreciation entries by a supervisor independent of the accounting department.



Explanation:

Choice "a" is correct. Periodic physical inspection of plant and equipment by the internal audit staff is an internal control that would most likely justify a reducedassessed level of control risk concerning plant and equipment acquisitions. Such inspections would provide assurance that recorded acquisitions are real (existenceassertion).Choice "b" is incorrect. The comparison of current-year plant and equipment account balances with prioryear actual balances might indicate that acquisitionsoccurred, but it would not justify a reduced assessed level of control risk, since the controls over the acquisition process are not tested. Choice "c" is incorrect. Areview of prenumbered purchase orders is unlikely to provide evidence regarding plant and equipment acquisitions. (Generally a special requisition form is used forsuch acquisitions.)Choice "d" is incorrect. Approval of depreciation entries has little bearing on the control risk relating to plant and equipment acquisitions.

QUESTION 179Equipment acquisitions that are misclassified as maintenance expense most likely would be detected by an internal control activity that provides for:

A. Segregation of duties of employees in the accounts payable department.B. Independent verification of invoices for disbursements recorded as equipment acquisitions.C. Investigation of variances within a formal budgeting system.D. Authorization by the board of directors of significant equipment acquisitions.



Choice "c" is correct. Equipment acquisitions that are misclassified as maintenance expense most likely would be detected by internal control procedures thatprovide for investigation of variances within a formal budgeting system.Choice "a" is incorrect. Segregation of duties of employees in the accounts payable department would not prevent the misclassification of equipment acquisitions asmaintenance expense. Choice "b" is incorrect. Verifying invoices for disbursements already recorded as equipment acquisitions would not include examininginvoices for disbursements recorded as maintenance expense. Choice "d" is incorrect. Since the authorization by the board of directors occurs before thedisbursement is recorded, this control would not prevent any misclassification.

QUESTION 180In testing for unrecorded retirements of equipment, an auditor most likely would:

A. Select items of equipment from the accounting records and then locate them during the plant tour.B. Compare depreciation journal entries with similar prior-year entries in search of fully depreciated equipment.C. Inspect items of equipment observed during the plant tour and then trace them to the equipment subsidiary ledger.D. Scan the general journal for unusual equipment additions and excessive debits to repairs and maintenance expense.



Choice "a" is correct. Tracing (old) equipment recorded in the books to the actual equipment during a plant tour is a control which tests for unrecorded retirements.Choice "b" is incorrect. Determining which assets are fully depreciated does not tell you which ones are retired, as fully depreciated assets may continue to be used.Choice "c" is incorrect. Selecting items from the plant tour and then tracing them to the equipment subsidiary ledger will provide evidence that all equipment isrecorded. It will not detect whether recorded equipment has been retired. (This step is backwards.) Choice "d" is incorrect. Scanning the general journal for unusualequipment additions and excessive debits to repairs and maintenance expense provides evidence regarding fixed asset additions, not retirements.

QUESTION 181An auditor ordinarily sends a standard confirmation request to all banks with which the client has done business during the year under audit, regardless of the year-end balance. A purpose of this procedure isto:

A. Provide the data necessary to prepare a proof of cash.B. Request a cutoff bank statement and related checks be sent to the auditor.C. Detect kiting activities that may otherwise not be discovered.D. Seek information about contingent liabilities and security agreements.



Choice "d" is correct. The standard confirmation request seeks information on contingent liabilities and security agreements in addition to information related todeposit account balances. Choice "a" is incorrect. The standard confirmation request does not provide all of the data necessary to prepare a "proof of cash" (i.e.,bank reconciliation), since it only confirms the balances at the end of a period, and does not provided information about the activity during the period under audit.Such information is necessary to perform a bank reconciliation and would be provided in a bank statement. Choice "b" is incorrect. A request for a cut-off statement,and not the standard bank confirmation form, is used to obtain a cut-off bank statement and related checks. Choice "c" is incorrect. The bank cut-off statement, notthe standard confirmation request, is used to detect kiting activities that may not otherwise be discovered.

QUESTION 182In an audit of contingent liabilities, which of the following procedures would be least effective?

A. Reviewing a bank confirmation letter.B. Examining customer confirmation replies.C. Examining invoices for professional services.D. Reading the minutes of the board of directors.


Explanation/Reference:Explanation:Choice "b" is correct. Customer confirmations relate to receivables, and would not be likely to disclose a contingent liability.Choice "a" is incorrect. A standard bank confirmation will most likely identify contingent liabilities because it contains confirmation of discounted drafts and/orguarantees of notes and/or other open letters of credit.Choice "c" is incorrect. Examining professional invoices may disclose a contingent liability. For example, invoices from attorneys may provide information regardinglitigation, claims, and assessments.Choice "d" is incorrect. Reviewing the board minutes may identify a contingent liability. For example, the board may discuss contingencies during one of itsmeetings. Other procedures that may be effective in an audit of contingent liabilities include:Discussing long-term purchase commitments with the purchasing agent.Reviewing long-term leases.Obtaining a client representation letter.

QUESTION 183The primary evidence regarding year-end cash balances in the financial statements is documented in the:

A. Standard bank confirmations.B. Bank reconciliations.C. Interbank transfer schedule.D. Bank deposit lead schedule.



Choice "b" is correct. The primary evidence regarding year-end cash balances in the financial statements is documented in the bank reconciliation, which reconcilesthe balance per the bank to that per the financial statements.Choice "a" is incorrect. The standard bank confirmation does not provide evidence about certain transactions that are necessary to compute the cash balance, such

as deposits in transit and outstanding checks.Choice "c" is incorrect. The interbank transfer schedule provides evidence about bank transfers over a period of time. It is used to detect kiting, not to support theyear-end cash balance. Choice "d" is incorrect. A "cash lead schedule" is a schedule that summarizes all the various balances that comprise cash. It is created bythe auditor and is not, in and of itself, evidence supporting cash.

QUESTION 184An auditor's program to examine long-term debt should include steps that require:

A. Examining bond trust indentures.B. Inspecting the accounts payable subsidiary ledger.C. Investigating credits to the bond interest income account.D. Verifying the existence of the bondholders.



Choice "a" is correct. Examination of bond trust indentures should be included in audit program of longterm debt to assure that the client was not in violation of anycovenants in the indentures. Choice "b" is incorrect. Inspecting the accounts payable subsidiary ledger relates to accounts payable, a current liability.Choice "c" is incorrect. Long-term debt generates interest expense, not interest income. Choice "d" is incorrect. Generally, the existence of the bondholders of debtis not verified.

QUESTION 185The scope of an audit is not restricted when an attorney's response to an auditor as a result of a client's letter of audit inquiry limits the response to:

A. Matters to which the attorney has given substantive attention in the form of legal representation.B. An evaluation of the likelihood of an unfavorable outcome of the matters disclosed by the entity.C. The attorney's opinion of the entity's historical experience in recent similar litigation.D. The probable outcome of asserted claims and pending or threatened litigation.



Choice "a" is correct. The scope of an audit is not restricted when an attorney's response is limited to matters to which the attorney has given substantive attentionin the form of legal representation. The attorney may also limit his or her response to matters that are considered individually or collectively to be material.Choices "b", "c", and "d" are incorrect. The scope of an audit may be restricted when an attorney's response is limited to:

1. An evaluation of the likelihood of an unfavorable outcome of the matter disclosed by the entity. (The attorney's response should also address the nature of theclaim, the progress to date, and the intended response.)2. The attorney's opinion of the entity's historical experience in recent similar litigation. (The attorney's response should address the current situation, which may notparallel historical experience).3. The probable outcome of asserted claims and pending or threatened litigation. (The attorney's response should also address the nature of the claim, theprogress to date, and the intended response, as well as unasserted claims).

QUESTION 186An auditor's plan to examine long-term debt most likely would include steps that require:

A. Comparing the carrying amount of the debt to its year-end market value.B. Correlating interest expense recorded for the period with outstanding debt.C. Verifying the existence of the holders of the debt by direct confirmation.D. Inspecting the accounts payable subsidiary ledger for unrecorded long-term debt.



Choice "b" is correct. An auditor's plan to examine long-term debt most likely would include steps that require correlating interest expense recorded for the periodwith outstanding debt. This is an analytical procedure that would provide evidence regarding the reasonableness of the interest expense balance. Choice "a" isincorrect. This question was released prior to the issuance of FAS 107, which requires disclosure of the fair values of financial instruments. Accordingly, the auditornow needs to audit the year-end market values of long-term debt. Choice "a" is still not the best answer, however, since the auditor would not need to compare thecarrying amount to the year-end market value. (Both values are shown, as FAS 107 does not require that debt securities be written down to (a lower) market value.)Choice "c" is incorrect. Generally the existence of the holders of the debt is not verified. Choice "d" is incorrect. Inspecting the accounts payable subsidiary ledgerwould be included in the audit of accounts payable, not long-term debt.

QUESTION 187Which of the following is not an audit procedure that the independent auditor would perform concerning litigation, claims, and assessments?

A. Obtain assurance from management that it has disclosed all unasserted claims that the lawyer has advised are probable of assertion and must be disclosed.B. Confirm directly with the client's lawyer that all claims have been recorded in the financial statements.C. Inquire of and discuss with management the controls adopted for identifying, evaluating, and accounting for litigation, claims, and assessments.

D. Obtain from management a description and evaluation of litigation, claims, and assessments existing at the balance sheet date.



Choice "b" is correct. The independent auditor would not confirm directly with the client's lawyer that all claims have been recorded in the financial statements.Management has the responsibility to include all claims in the financial statements, not the lawyers. The purpose of a legal letter is to obtain outside corroboration ofthe information furnished by management concerning litigation, claims, and assessments.Choice "a" is incorrect. The auditor should obtain assurance from management that it has disclosed all unasserted claims that the lawyer has advised are probableof assertion and must be disclosed. Choice "c" is incorrect. The auditor should inquire of and discuss with management the controls adopted for identifying,evaluating, and accounting for litigation, claims, and assessments. Choice "d" is incorrect. The auditor should obtain from management a description and evaluationof litigation, claims, and assessments existing at the balance sheet date.

QUESTION 188An auditor should request that an audit client send a letter of inquiry to those attorneys who have been consulted concerning litigation, claims, or assessments. Theprimary reason for this request is to provide:

A. The opinion of a specialist as to whether loss contingencies are possible, probable, or remote.B. A description of litigation, claims, and assessments that have a reasonable possibility of unfavorable outcomes.C. An objective appraisal of management's controls adopted for identifying and evaluating legal matters.D. The corroboration of the information furnished by management concerning litigation, claims, and assessments.



Choice "d" is correct. The primary reason for an auditor to request that the audit client send a letter of inquiry to its attorneys is to provide corroboration of theinformation furnished by management concerning litigation, claims and assessments.Choice "a" is incorrect. The letter of inquiry is used to corroborate information furnished by management.The likelihood of loss contingencies occurring is only one item addressed in this correspondence, but it is not the primary purpose of the request.Choice "b" is incorrect. The description of litigation, claims and assessments that have a reasonable possibility of unfavorable outcomes should be provided bymanagement, not the attorneys. Choice "c" is incorrect. The attorneys do not give an appraisal of management's controls adopted for identifying and evaluatinglegal matters.

QUESTION 189The most likely result of ineffective internal control policies and procedures in the revenue cycle is that:

A. Irregularities in recording transactions in the subsidiary accounts could result in a delay in goods shipped.B. Omission of shipping documents could go undetected, causing an understatement of inventory.C. Final authorization of credit memos by personnel in the sales department could permit an employee defalcation scheme.D. Fictitious transactions could be recorded, causing an understatement of revenues and overstatement of receivables.



Choice "c" is correct. The most likely result of ineffective internal control policies and procedures in the revenue cycle is that final authorization of credit memos bypersonnel in the sales department could permit a salesman to sell, collect, and pocket the collection, then cover it up by issuing a credit memo. Final authorizationof credit memos should be performed by an employee who is independent of the sales department such as the credit manager in the treasury department. Choice"a" is incorrect. The shipment of goods is an activity that takes place before the transaction is recorded. Irregularities in recording transactions in the subsidiaryaccounts therefore would have no impact on the timeliness of the goods being shipped.Choice "b" is incorrect. If shipping documents are omitted, then the inventory levels would be overstated since the reduction of inventory would not be recorded.Choice "d" is incorrect. If fictitious transactions in the revenue cycle are recorded, then the impact on revenues and receivables would be the same; either bothwould be overstated (the most likely case) or both would be understated.

QUESTION 190Which of the following questions would an auditor most likely include on an internal control questionnaire for notes payable?

A. Are assets that collateralize notes payable critically needed for the entity's continued existence?B. Are two or more authorized signatures required on checks that repay notes payable?C. Are the proceeds from notes payable used for the purchase of noncurrent assets?D. Are direct borrowings on notes payable authorized by the board of directors?



Choice "d" is correct. An internal control questionnaire for notes payable would likely ask if direct borrowings on notes payable are authorized by the board of

directors. Choice "a" is incorrect. Whether collateralized assets are critically needed for the entity's continued existence is not a part of the control environmentrelated to notes payable. Choice "b" is incorrect. The requirement for two authorized signatures is part of the disbursements internal control system, not the notespayable system. Choice "c" is incorrect. Whether the proceeds of notes payable are used for current or noncurrent assets is not a part of the notes payable internalcontrol system.

QUESTION 191In auditing accounts payable, an auditor's procedures most likely would focus primarily on management's assertion of:

A. Existence.B. Understandability and classification.C. Completeness.D. Valuation and allocation.


Explanation/Reference:Explanation:Choice "c" is correct. When testing liabilities, an auditor generally is concerned about understatement (as opposed to overstatement, for assets). Therefore, inauditing accounts payable, an auditor's procedures most likely would focus primarily on management's assertion of completeness (if accounts payable is notcomplete it would be understated).Choice "a" is incorrect. The assertion of existence is the primary focus of the auditor when auditing an asset account, not accounts payable.Choice "b" is incorrect. The understandability and classification assertion is not the primary focus in the audit of accounts payable.Choice "d" is incorrect. The assertion of valuation and allocation is not the main focus with respect to accounts payable. Good external evidence generally isavailable to support the amount, and allocation over more than one period generally is not required.

QUESTION 192Which of the following statements extracted from a client's lawyer's letters concerning litigation, claims, and assessments most likely would cause the auditor torequest clarification?

A. "I believe that the possible liability to the company is nominal in amount."B. "I believe that the action can be settled for less than the damages claimed."C. "I believe that the plaintiff's case against the company is without merit."D. "I believe that the company will be able to defend this action successfully."



Choice "b" is correct. The auditor is concerned with preventing an understatement of contingent liabilities. The auditor would therefore request clarification beforedetermining that a reduction in such liability (from damages claimed to some lesser amount) is reasonable. Choices "a", "c", and "d" are incorrect. When a lawyerasserts that a contingent liability is immaterial ("nominal") or improbable ("without merit" and "successful defense likely"), it is unlikely that the auditor would requirefurther clarification.

QUESTION 193An auditor should trace corporate stock issuances and treasury stock transactions to the:

A. Numbered stock certificates.B. Articles of incorporation.C. Transfer agent's records.D. Minutes of the board of directors.



Choice "d" is correct. The auditor should trace corporate stock issuances and treasury stock transactions to the minutes of the board of directors to make sure theywere authorized. Choice "a" is incorrect. Numbered stock certificates for shares that are issued and outstanding would be in the hands of the stockholders.Choice "b" is incorrect. Information about stock issuances and treasury stock transactions would not be included in the articles of incorporation. Generally only theshares authorized and their par value would be included therein.Choice "c" is incorrect. The transfer agent might confirm a transaction, but the auditor would not generally review the transfer agent's records.

QUESTION 194When a client company does not maintain its own stock records, the auditor should obtain written confirmation from the transfer agent and registrar concerning:

A. Restrictions on the payment of dividends.B. The number of shares issued and outstanding.C. Guarantees of preferred stock liquidation value.D. The number of shares subject to agreements to repurchase.



Choice "b" is correct. When a client company does not maintain its own stock records, the auditor should request the transfer agent and registrar to confirm thenumber of shares issued and outstanding. Choice "a" is incorrect. Restrictions on the payment of dividends should be in the board minutes, or possibly confirmedby the bank if the restrictions are due to outstanding loan(s). Choice "c" is incorrect. Guarantees of preferred stock liquidation value should be in the board minutesor the stock redemption agreement.Choice "d" is incorrect. The number of shares subject to agreements to repurchase should be in the board minutes and in any repurchase agreements.

QUESTION 195The primary responsibility of a bank acting as registrar of capital stock is to:

A. Ascertain that dividends declared do not exceed the statutory amount allowable in the state of incorporation.B. Account for stock certificates by comparing the total shares outstanding to the total in the shareholders subsidiary ledger.C. Act as an independent third party between the board of directors and outside investors concerning mergers, acquisitions, and the sale of treasury stock.D. Verify that stock is issued in accordance with the authorization of the board of directors and the articles of incorporation.


Explanation/Reference:Explanation:Choice "d" is correct. Large companies often use a registrar to provide registration services and maintain the stockholder list. The primary responsibility of theregistrar is to verify that stock is issued only with proper authorization.Choice "a" is incorrect. The company's board of directors bears responsibility for proper declaration of dividends, not the stock registrar.Choice "b" is incorrect. Since the company's management is responsible for maintaining accurate accounting records, a responsible company employee (not theregistrar) would periodically compare the recorded number of shares outstanding (per company records) with the total in the shareholders' subsidiary ledger (per theregistrar).Choice "c" is incorrect. A registrar does not have the described responsibility with respect to mergers, acquisitions, and the sale of treasury stock.

QUESTION 196In auditing a client's retained earnings account, an auditor should determine whether there are any restrictions on retained earnings that result from loans,agreements, or state law. This procedure is designed to corroborate management's financial statement assertions with respect to:

A. Transactions and events.B. Account balances.C. Presentation and disclosure.D. Audit risk and materiality.

Correct Answer: CSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "c" is correct. Restrictions on retained earnings should be shown as appropriations in the financial statements. An auditor attempts to determine whether anysuch restrictions exist to verify that proper disclosures (i.e., retained earnings appropriations) have been made. Choices "a" and "b" are incorrect. Retained earningsappropriations restrict the company from paying dividends in excess of the unappropriated portion of retained earnings. This relates to presentation and disclosure,not to transactions, events, or balances.Choice "d" is incorrect. Audit risk and materiality are not financial statement assertions.

QUESTION 197Which of the following audit procedures is best for identifying unrecorded trade accounts payable?

A. Examining unusual relationships between monthly accounts payable balances and recorded cash payments.B. Reconciling vendors' statements to the file of receiving reports to identify items received just prior to the balance sheet date.C. Reviewing cash disbursements recorded subsequent to the balance sheet date to determine whether the related payables apply to the prior period.D. Investigating payables recorded just prior to and just subsequent to the balance sheet date to determine whether they are supported by receiving reports.



Choice "c" is correct. Unrecorded trade accounts payable are best identified by reviewing cash disbursements recorded subsequent to the balance sheet date todetermine whether the related payables apply to the prior period.Choice "a" is incorrect. There is not usually a predictable relationship between accounts payable and cash payments, because management can pay cash or incuradditional liabilities at its discretion. Choice "b" is incorrect. Reconciling vendors' statements to the file of receiving reports would not identify unrecorded payables,as the vendor statement would still agree with the receiving report even if the payable were not recorded.Choice "d" is incorrect. Investigating payables already recorded would not help identify unrecorded trade payables.

QUESTION 198An entity's internal control requires for every check request that there be an approved voucher, supported by a prenumbered purchase order and a prenumberedreceiving report. To determine whether checks are being issued for unauthorized expenditures, an auditor most likely would select items for testing from thepopulation of all:

A. Purchase orders.B. Canceled checks.C. Receiving reports.D. Approved vouchers.

Correct Answer: BSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "b" is correct. To determine whether checks are being issued for unauthorized expenditures, the auditor is most likely to select from the population ofcanceled checks. For each check, the auditor would then look for evidence supporting the payment, such as a purchase order, a receiving report, and an approvedinvoice.Choice "a" is incorrect. If the auditor selected from the population of purchase orders, he or she would never find those check requests that were missing thepurchase orders. Without purchase orders, the expenditures would be considered unauthorized.Choice "c" is incorrect. If the auditor selected from the population of receiving reports, he or she would never find those check requests that were missing thereceiving reports. Without receiving reports, the expenditures would be considered unauthorized.Choice "d" is incorrect. If the auditor selected from the population of approved vouchers, he or she would never find those check requests that were missing theapproved vouchers. Without approved vouchers, the expenditures would be considered unauthorized.

QUESTION 199The primary purpose of sending a standard confirmation request to financial institutions with which the client has done business during the year is to:

A. Detect kiting activities that may otherwise not be discovered.B. Corroborate information regarding deposit and loan balances.C. Provide the data necessary to prepare a proof of cash.D. Request information about contingent liabilities and secured transactions.



Choice "b" is correct. The primary purpose of sending a standard confirmation request to financial institutions is to corroborate information regarding deposit andloan balances. Choice "a" is incorrect. The bank cut-off statement, not the standard bank confirmation form, is used to detect kiting activities that may otherwise notbe discovered. Choice "c" is incorrect. The standard confirmation does not provide all of the information necessary to prepare a proof of cash (i.e., bank

reconciliation) since it only confirms information at the end of a period, and not activity (e.g., deposits, checks, etc.) occurring during the period. Choice "d" isincorrect. The standard confirmation request seeks information on contingent liabilities and security agreements, but this is not the primary purpose of sending theconfirmation.

QUESTION 200To determine whether accounts payable are complete, an auditor performs a test to verify that all merchandise received is recorded. The population of documentsfor this test consists of all:

A. Payment vouchers.B. Receiving reports.C. Purchase requisitions.D. Vendor's invoices.



Choice "b" is correct. To determine whether accounts payable are complete, an auditor performs a test to verify that all merchandise received is recorded. This testconsists of tracing from receiving reports for inventory received before year-end to the accounts payable trial balance to determine whether the purchase has beenproperly recorded.Choice "a" is incorrect. In testing for completeness of payables, the auditor tries to determine whether there are payables that have not been recorded. If the auditorselects from payment vouchers, he or she may be unlikely to select an unrecorded payable, since unrecorded payables that have not yet been paid would not havecorresponding payment vouchers.Choice "c" is incorrect. Purchase requisitions do not indicate when the inventory was received, and therefore they are not useful for testing the completeness ofaccounts payable. Choice "d" is incorrect. Vendor's invoices do not generally indicate when the inventory was received, and therefore they are not useful for testingthe completeness of accounts payable.

QUESTION 201Which of the following procedures would an auditor most likely perform in searching for unrecorded payables?

A. Reconcile receiving reports with related cash payments made just prior to year-end.B. Contrast the ratio of accounts payable to purchases with the prior year's ratio.C. Vouch a sample of creditor balances to supporting invoices, receiving reports, and purchase orders.D. Compare cash payments occurring after the balance sheet date with the accounts payable trial balance.

Correct Answer: DSection: Auditing and Attestation (II) (Volume E)

Explanation


Choice "d" is correct. When performing a search for unrecorded payables, an auditor most likely would compare cash payments occurring after the balance sheetdate with the accounts payable trial balance to determine that disbursements that pertain to the prior year's business (year under audit) have been properly accrued.This procedure is commonly known as an "out-of-period-search." Choice "a" is incorrect. If the cash payment is made just prior to year-end, then the related liabilitywould have been paid/relieved as of the year-end balance sheet date. Choice "b" is incorrect. An analytical review procedure that contrasts the ratio of accountspayable to purchases with the prior year's ratio would not provide the best evidence, since payable balances are not predictable and may vary at management'sdiscretion. Choice "c" is incorrect. Vouching a sample of creditor balances already recorded does not provide any evidence concerning unrecorded payables.

QUESTION 202Which of the following audit procedures is best for identifying unrecorded trade accounts payable?

A. Reviewing cash disbursements recorded subsequent to the balance sheet date to determine whether the related payables apply to the prior period.B. Investigating payables recorded just prior to and just subsequent to the balance sheet date to determine whether they are supported by receiving reports.C. Examining unusual relationships between monthly accounts payable balances and recorded cash payments.D. Reconciling vendors' statements to the file of receiving reports to identify items received just prior to the balance sheet date.

Correct Answer: ASection: Auditing and Attestation (II) (Volume E)Explanation


Choice "a" is correct. When performing a search for unrecorded payables, an auditor most likely would examine cash disbursements recorded after the balancesheet date to determine whether the payables related to the prior period have been included in the accounts payable trial balance. Choice "b" is incorrect.Investigating payables already recorded does not provide any evidence concerning unrecorded payables.Choice "c" is incorrect. While a high level of cash payments compared with a low level of payable balances may be indicative of unrecorded payables, comparingthese amounts would not be the most effective method for identifying unrecorded payables.Choice "d" is incorrect. Comparing vendor statements to receiving reports is an audit step not involving the accounts payable balances; this step, therefore, providesno information about accounts payable.

QUESTION 203Proper authorization of write-offs of uncollectible accounts should be approved in which of the following departments?

A. Accounts receivable.B. Credit.

C. Accounts payable.D. Treasurer.

Correct Answer: DSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "d" is correct. Proper authorization of write-offs of uncollectible accounts are approved by the treasurer, who is not involved in the record-keeping function orthe initiation of the write-off. Choice "a" is incorrect. Proper segregation of duties requires that the authorization of the write-off be performed by individuals notinvolved with the accounts receivable department that records the original transactions.Choice "b" is incorrect. The credit department should grant credit and approve credit limits before the sale is made. If the credit department also approved the write-offs of accounts, there would be a lack of appropriate segregation of duties.Choice "c" is incorrect. Even though the accounts payable department is independent of the accounts receivable department, they are not particularlyknowledgeable regarding the customers and therefore would not be the best candidates for authorizing the write-offs of accounts receivable.

QUESTION 204An auditor would consider a cashier's job description to contain compatible duties if the cashier receives remittances from the mailroom and also prepares the:

A. Prelist of individual checks.B. Monthly bank reconciliation.C. Daily deposit slip.D. Remittance advices.



Choice "c" is correct. An auditor would consider a cashier's job description to contain compatible duties if the cashier receives remittances from the mailroom andalso prepares the daily deposit slip.(That is his or her job).Choice "a" is incorrect. The prelist of individual checks is prepared by a clerk in the mailroom upon opening the mail.Choice "b" is incorrect. The monthly bank reconciliation is prepared by an internal auditor or someone else that is independent of the cash receipts and cashdisbursements functions. Choice "d" is incorrect. The remittance advice is prepared by the customer and is mailed along with the check (remittance).

QUESTION 205If the objective of a test of details is to detect overstatements of sales, the auditor should trace transactions from the:

A. Cash receipts journal to the sales journal.B. Sales journal to the cash receipts journal.C. Source documents to the accounting records.D. Accounting records to the source documents.



Choice "d" is correct. If the objective of a test of details is to detect overstatements of sales (existence assertion), the auditor should trace transactions from theaccounting records (i.e., sales journal) to the source documents (e.g., customer order, sales order, shipping documents, etc.). Choices "a" and "c" are incorrect.Tracing from the supporting documents to the accounting records gives assurance as to the completeness assertion (all sales are properly included). Choice "b" isincorrect. Tracing from the sales journal to the cash receipts journal only shows whether cash has been received for the sale. Failure to find a related cash receiptmay indicate simply that the sale was made on account.

QUESTION 206Which of the following procedures most likely would not be an internal control procedure designed to reduce the risk of errors in the billing process?

A. Comparing control totals for shipping documents with corresponding totals for sales invoices.B. Using computer programmed controls on the pricing and mathematical accuracy of sales invoices.C. Matching shipping documents with approved sales orders before invoice preparation.D. Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger.



Choice "d" is correct. Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger would probably not reduce the risk of errors inthe billing process, since any errors in billing would likely be included in both the sales and accounts receivable balances. Choice "a" is incorrect. Comparing controltotals for shipping documents with corresponding totals for sales invoices is a procedure designed to determine that all shipments have been billed. Choice "b" isincorrect. Using computer-programmed controls on sales invoices would reduce the risk of errors in the billing process.

Choice "c" is incorrect. Matching shipping documents with approved sales orders before invoice preparation provides assurance that the quantity and terms of theinvoice are correct.

QUESTION 207An auditor should trace bank transfers for the last part of the audit period and first part of the subsequent period to detect whether:

A. The cash receipts journal was held open for a few days after the year-end.B. The last checks recorded before the year-end were actually mailed by the year-end.C. Cash balances were overstated because of kiting.D. Any unusual payments to or receipts from related parties occurred.



Choice "c" is correct. An auditor should trace bank transfers for the last part of the audit period and first part of the subsequent period (bank transfer test) to detectwhether cash balances were overstated because of kiting (concealing a cash shortage by depositing in one bank an unrecorded check of another disbursementbank, effectively recording the same funds in both bank accounts). Choice "a" is incorrect. If the cash receipts journal were held open for a few days after the year-end, cash receipts from the subsequent year would be erroneously included in the current year's accounting records. A bank transfer test is not typically used todetect this situation. Choice "b" is incorrect. If the last checks recorded before the year-end were actually mailed by the yearend, appropriate cut-off has occurred.Bank transfer tests would not be required to evaluate this situation.Choice "d" is incorrect. A bank transfer test is not generally used to detect unusual payments to or receipts from related parties.

QUESTION 208Which of the following most likely would be detected by an auditor's review of a client's sales cut-off?

A. Shipments lacking sales invoices and shipping documents.B. Excessive write-offs of accounts receivable.C. Unrecorded sales at year-end.D. Lapping of year-end accounts receivable.



Choice "c" is correct. A sales cut-off test is used to detect unrecorded sales (shipments where no invoice has been generated) or sales allocated to the wrongperiod (January sales included in December by "holding the books open").Choice "a" is incorrect. A sales cut-off test relies on shipping documents to test the "cut-off" of sales invoices. Shipping documents are selected and thecorresponding sale is examined to determine whether it was recorded in the proper period. A cut-off test is unlikely to detect the omission of shipping documents,since transactions without such documentation would have no chance of being selected for testing.Choices "b" and "d" are incorrect. Sales cut-off testing generally does not involve tests related to accounts receivable.

QUESTION 209The information below was taken from the bank transfer schedule prepared during the audit of Fox Co.'s financial statements for the year ended December 31,20X1. Assume all checks are dated and issued on December 30, 20X1.

Which of the following checks might indicate kiting?

A. #101 and #303.B. #202 and #404.C. #101 and #404.D. #202 and #303.

Correct Answer: B

Section: Auditing and Attestation (II) (Volume E)Explanation


Choice "b" is correct. Kiting is concealing a cash shortage by depositing in one bank an unrecorded check of another disbursement bank, so that the deposit isrecorded in both banks. An auditor would most likely detect kiting by reviewing the bank transfer schedule and following-up on all transfers for which the receipt dateper bank is recorded in the accounting period before the disbursement date. Checks #202 and #404 both meet this criterion and therefore might indicate kiting.Choices "a", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 210The information below was taken from the bank transfer schedule prepared during the audit of Fox Co.'s financial statements for the year ended December 31,20X1. Assume all checks are dated and issued on December 30, 20X1.

Which of the following checks illustrate deposits/transfers in transit at December 31, 20X1?

A. #101 and #202.B. #101 and #303.C. #202 and #404.D. #303 and #404.



Choice "b" is correct. A deposit in transit is a disbursement recorded in one accounting period with the receipt occurring in the subsequent period. Assuming allchecks were dated and issued on December 30, 20X1, any deposits with a receipt date in 20X2 would indicate a deposit in transit at December 31, 20X1. Checks#101 and #303 both meet this criterion and therefore illustrate deposits/transfers in transit at December 31, 20X1.Choices "a", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 211Tracing bills of lading to sales invoices provides evidence that:

A. Shipments to customers were recorded as sales.B. Recorded sales were shipped.C. Invoiced sales were shipped.D. Shipments to customers were invoiced.



Choice "d" is correct. Tracing from a population of bills of lading (shipping documents) to sales invoices provides evidence that shipments to customers wereinvoiced. Choice "a" is incorrect. Tracing bills of lading to the sales invoice provides assurance that shipments to customers were invoiced, not that they wererecorded as sales. Choice "b" is incorrect. Tracing from the sales journal to bills of lading provides evidence that recorded sales were shipped.Choice "c" is incorrect. Tracing from a population of sales invoices to the bills of lading provides evidence that invoiced sales were shipped.

QUESTION 212Which of the following controls most likely would be effective in offsetting the tendency of sales personnel to maximize sales volume at the expense of high baddebt write-offs?

A. Employees responsible for authorizing sales and bad debt write-offs are denied access to cash.B. Shipping documents and sales invoices are matched by an employee who does not have authority to write off bad debts.C. Employees involved in the credit-granting function are separated from the sales function.

D. Subsidiary accounts receivable records are reconciled to the control account by an employee independent of the authorization of credit.



Choice "c" is correct. Sales personnel will have a tendency to maximize sales volume by selling to customers that may not be creditworthy, thereby resulting in highbad debt write-offs. To prevent sales to customers that may not be creditworthy, employees involved in the credit-granting function are separated from the salesfunction.Choice "a" is incorrect. Employees responsible for authorizing sales and bad debt write-offs should be denied access to cash to prevent the embezzlement of cash,not to prevent them from maximizing sales volume at the expense of high bad debt write-offs.Choice "b" is incorrect. This control does not affect the sales department or the tendency to maximize sales volume at the expense of high bad debt write-offs.Choice "d" is incorrect. This control does not affect the sales department or the tendency to maximize sales volume at the expense of high bad debt write-offs.

QUESTION 213Which of the following controls most likely would help ensure that all credit sales transactions of an entity are recorded?

A. The billing department supervisor sends copies of approved sales orders to the credit department for comparison to authorized credit limits and currentcustomer account balances.

B. The accounting department supervisor independently reconciles the accounts receivable subsidiary ledger to the accounts receivable control account monthly.C. The accounting department supervisor controls the mailing of monthly statements to customers and investigates any differences reported by customers.D. The billing department supervisor matches prenumbered shipping documents with entries in the sales journal.



Choice "d" is correct. Selecting prenumbered shipping documents and matching them with entries in the sales journal is a control that would help ensure that allcredit sales transactions are recorded. (Shipping documents without corresponding sales journal entries might indicate unrecorded sales). Choice "a" is incorrect.Sending copies of approved sales orders to the credit department for comparison to authorized credit limits and current account balances before the sale is madecontrols the risk of bad debts, not the proper recording of credit sales transactions. Choice "b" is incorrect. Reconciling the accounts receivable subsidiary ledger tothe control account ensures that the accounts receivable balance in the general ledger is properly recorded, but would not necessarily identify unrecorded creditsales. (Unrecorded credit sales would be omitted from both places, and therefore the subsidiary ledger and control account would still agree). Choice "c" isincorrect. Controlling the mailing of monthly statements and investigating differences reported by the customers is not an effective control over the proper recordingof credit sales transactions, since it is possible that customers would not complain if they were not billed.

QUESTION 214An entity with a large volume of customer remittances by mail could most likely reduce the risk of employee misappropriation of cash by using:

A. Employee fidelity bonds.B. Independently prepared mailroom prelists.C. Daily check summaries.D. A bank lockbox system.



Choice "d" is correct. An entity with a large volume of customer remittances by mail could most likely reduce the risk of employee misappropriation of cash by usinga bank lockbox system. With this system the remittances are mailed directly to the bank where they are immediately deposited. The bank sends the remittancesand deposit detail to the entity on a daily basis. Most larger companies use a lockbox system.Choice "a" is incorrect. Employee fidelity bonds may cover some of the losses suffered by misappropriation, but they do nothing to prevent the embezzlement in thefirst place. Choices "b" and "c" are incorrect. Independently prepared mailroom prelists and daily check summaries are good controls over cash receipts, but theyare not as effective at reducing the risk of employee misappropriation as a lockbox system. With a lockbox system, employees have no access to cash receipts andtherefore no opportunity to misappropriate cash.

QUESTION 215Which of the following internal control procedures most likely would deter lapping of collections from customers?

A. Independent internal verification of dates of entry in the cash receipts journal with dates of daily cash summaries.B. Authorization of write-offs of uncollectible accounts by a supervisor independent of credit approval.C. Segregation of duties between receiving cash and posting the accounts receivable ledger.D. Supervisory comparison of the daily cash summary with the sum of the cash receipts journal entries.



Choice "c" is correct. Lapping is a defalcation in which a cash shortage is concealed by applying later customer remittances to a receivable account from which

money was stolen. Lapping can be deterred by appropriate segregation of duties between receiving cash and posting to the accounts receivable ledger.This makes it more difficult for the employee who is stealing the cash to cover it up through inappropriate remittance credits.Choice "a" is incorrect. Even with a lapping scheme, the dates of cash receipts journal entries and the dates of daily cash summaries would still agree, since thestolen funds would be excluded from both places and subsequent receipts would be included in both places. Choice "b" is incorrect. The authorization of write-offsof uncollectible accounts by a supervisor independent of credit approval would not deter lapping, since lapping schemes do not involve write- offs.Choice "d" is incorrect. Even with a lapping scheme, the daily cash summary would still agree with the sum of the cash receipts journal entries. Stolen funds wouldbe excluded from both places and subsequent receipts would be included in both places.

QUESTION 216Tracing shipping documents to prenumbered sales invoices provides evidence that:

A. No duplicate shipments or billings occurred.B. Shipments to customers were properly invoiced.C. All goods ordered by customers were shipped.D. All prenumbered sales invoices were accounted for.



Choice "b" is correct. Tracing from shipping documents (source documents) to sales invoices provides evidence that shipments to customers are properly invoiced.Choice "a" is incorrect. Tracing shipping documents to sales invoices wouldn't necessarily identify duplicate shipments or billings. Duplicate shipments or billingscould be identified by accounting for prenumbered shipping documents and sales invoices.Choice "c" is incorrect. The auditor would compare the signed purchase order to shipping documents to determine if all goods ordered by the customer wereshipped. Choice "d" is incorrect. To determine that all prenumbered sales invoices were accounted for, an auditor would review the consecutive numbering ofinvoices and then trace from the sales invoices into the sales journal.

QUESTION 217Which of the following procedures would an auditor most likely perform to test controls relating to management's assertion about the completeness of cash receiptsfor cash sales at a retail outlet?

A. Observe the consistency of the employees' use of cash registers and tapes.B. Inquire about employees' access to recorded but undeposited cash.C. Trace the deposits in the cash receipts journal to the cash balance in the general ledger.D. Compare the cash balance in the general ledger with the bank confirmation request.

Correct Answer: A



Choice "a" is correct. Observing the consistent use of cash registers and tapes by employees would provide evidence to the auditor regarding the controls over thecompleteness of cash receipts. Choices "b", "c", and "d" are incorrect. The completeness assertion relates to the recording of all transactions. Inquiries aboutaccess to recorded cash, tracing from the cash receipts journal, and testing the general ledger balance do not provide evidence regarding possible unrecordedtransactions.

QUESTION 218For effective internal accounting control, the accounts payable department should compare the information on each vendor's invoice with the:

A. Receiving report and the purchase order.B. Receiving report and the voucher.C. Vendor's packing slip and the purchase order.D. Vendor's packing slip and the voucher.


Explanation/Reference:Explanation:Choice "a" is correct. For effective internal accounting control, the accounts payable department should compare the information on each vendor's invoice with thereceiving report and the purchase order to assure that goods were received and that the purchase was properly authorized. Choices "b", "c", and "d" are incorrect.Vendor packing slips and internally generated vouchers do not provide assurance that goods were received and that the purchase was properly authorized.

QUESTION 219Which of the following is the most effective control activity to detect vouchers that were prepared for the payment of goods that were not received?

A. Count goods upon receipt in storeroom.B. Match purchase order, receiving report, and vendor's invoice for each voucher in accounts payable department.C. Compare goods received with goods requisitioned in receiving department.D. Verify vouchers for accuracy and approval in internal audit department.



Choice "b" is correct. The most effective control activity to detect vouchers that were prepared for the payment of goods that were not received is to match thepurchase order, receiving report, and vendor's invoice for each voucher in the accounts payable department. Choices "a" and "c" are incorrect. Controls that startwith goods received would not be effective at detecting a situation where vouchers are prepared for goods that were not received. Choice "d" is incorrect. Verifyingvouchers for accuracy and approval in the internal audit department might detect vouchers that were prepared for the payment of goods that were not received.However, this is not the most effective control, since it would likely occur subsequent to the processing of the transaction.

QUESTION 220For effective internal control purposes, the vouchers payable department generally should:

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



Choice "d" is correct. For effective internal control purposes, the vouchers payable department generally should establish the agreement of the vendor's invoice withthe receiving report and purchase order.Choice "a" is incorrect. The treasury or cash disbursement department should stamp, perforate, or otherwise cancel supporting documentation after payment ismailed. Choice "b" is incorrect. The purchasing department should verify that each requisition has been properly approved.Choice "c" is incorrect. The purchasing department should obliterate the "quantity ordered" on the receiving department copy of the purchase order.

QUESTION 221To determine whether accounts payable are complete, an auditor performs a test to verify that all merchandise received is recorded. The population of documentsfor this test consists of all:

A. Vendor's invoices.B. Purchase orders.C. Receiving reports.D. Canceled checks.



Choice "c" is correct. The auditor is looking for situations where merchandise has been received but was not recorded. Such situations may be identified byselecting receiving reports and then determining whether the related payable was recorded.Choice "a" is incorrect. Selecting from vendor's invoices might allow a purchase to be selected for which the goods have not yet been received.Choice "b" is incorrect. Selecting from purchase orders might allow a purchase to be selected for which the goods have not yet been received.Choice "d" is incorrect. Selecting from canceled checks will not result in testing of accounts payable, since the payable is eliminated once payment is made.

QUESTION 222Which of the following control activities is not usually performed in the vouchers payable department?

A. Determining the mathematical accuracy of the vendor's invoice.B. Having an authorized person approve the voucher.C. Controlling the mailing of the check and remittance advice.D. Matching the receiving report with the purchase order.



Choice "c" is correct. Internal control is enhanced if check mailing is performed by the treasury (cash disbursements) department.Choice "a" is incorrect. Mathematical accuracy of the vendor's invoice is usually verified in the vouchers payable department.Choice "b" is incorrect. Voucher approval by an authorized person is usually performed in the vouchers payable department.Choice "d" is incorrect. Matching the receiving report with the purchase order is usually performed in the vouchers payable department.

QUESTION 223Which of the following internal control procedures most likely addresses the completeness assertion for inventory?

A. Work in process account is periodically reconciled with subsidiary records.B. Employees responsible for custody of finished goods do not perform the receiving function.C. Receiving reports are prenumbered and periodically reconciled.D. There is a separation of duties between payroll department and inventory accounting personnel.



Choice "c" is correct. The internal control procedure of prenumbering receiving reports and periodically reconciling them to the inventory records most likelyaddresses the completeness assertion for inventory, because it allows the auditor to determine whether all goods received have been recorded as inventory.Choice "a" is incorrect. Reconciling the work in process account (per the general ledger) with subsidiary records (direct materials, direct labor, overhead) tests thatthose records are interfacing properly, but does not provide any information about the completeness assertion for inventory. Choice "b" is incorrect. Separation ofemployees responsible for custody of finished goods from the receiving function addresses the safeguarding of assets, not the completeness of the inventoryrecords. Choice "d" is incorrect. The separation of duties between the payroll department and inventory accounting personnel is related to the valuation (pricing) ofinventory, not its completeness.

QUESTION 224Which of the following controls would be most effective in assuring that recorded purchases are free of material errors?

A. The receiving department compares the quantity ordered on purchase orders with the quantity received on receiving reports.B. Vendor's invoices are compared with purchase orders by an employee who is independent of the receiving department.C. Receiving reports require the signature of the individual who authorized the purchase.D. Purchase orders, receiving reports, and vendor's invoices are independently matched in preparing vouchers.


Explanation/Reference:Explanation:Choice "d" is correct. The most effective control in assuring that recorded purchases are free of material errors is the independent matching of the purchase order,receiving report, and vendor's invoices in preparing the vouchers on which the disbursement check is based. Choice "a" is incorrect. The receiving departmentshould not have access to the quantity ordered on the purchase order. This forces receiving department employees to actually perform an independent count.Choice "b" is incorrect. It is not enough to compare only vendor invoices and purchase orders, as this will still allow payment for goods that were not received.Choice "c" is incorrect. Requiring that receiving reports be authorized by the individual who authorized the purchase does not ensure that the invoice and the relatedpayment will be properly recorded.

QUESTION 225Mailing disbursement checks and remittance advices should be controlled by the employee who:

A. Approves the vouchers for payment.B. Matches the receiving reports, purchase orders, and vendor's invoices.C. Maintains possession of the mechanical check-signing device.D. Signs the checks last.



Choice "d" is correct. Mailing disbursement checks and remittance advices should be controlled by the employee who signs the check last. This employee isgenerally in the treasury department. Choices "a" and "b" are incorrect. Approving the vouchers for payment and matching the receiving report, purchase orders,and vendor's invoices are functions of the vouchers payable department. Choice "c" is incorrect. When a mechanical check-signing device is used, there isgenerally dual control. One person maintains possession of the device itself, and the other controls the signature plates. The person with possession of the devicewould not mail disbursement checks, since mailing should be done by the last check signer.

QUESTION 226Which of the following questions would most likely be included in an internal control questionnaire concerning the completeness assertion for purchases?

A. Is an authorized purchase order required before the receiving department can accept a shipment or the vouchers payable department can record a voucher?B. Are purchase requisitions prenumbered and independently matched with vendor invoices?C. Is the unpaid voucher file periodically reconciled with inventory records by an employee who does not have access to purchase requisitions?D. Are purchase orders, receiving reports, and vouchers prenumbered and periodically accounted for?


Explanation/Reference:Explanation:Choice "d" is correct. A question related to whether purchase orders, receiving reports and vouchers are prenumbered and periodically accounted for would mostlikely be included in an internal control questionnaire concerning the completeness assertion for purchases. A gap in recorded purchase order numbers mightindicate an unrecorded purchase.Choice "a" is incorrect. Requiring an authorized purchase order before accepting a shipment would relate to whether the purchase was valid, not whether it wasproperly accounted for. Choice "b" is incorrect. Having prenumbered purchase requisitions independently matched with vendor invoices does not indicate whetherall purchases are accounted for since these documents do not show that the purchase has been recorded.Choice "c" is incorrect. Reconciling the unpaid voucher file with inventory records does not indicate whether all purchases are accounted for since these documentsdo not show that all purchases have been recorded.

QUESTION 227When the shipping department returns nonconforming goods to a vendor, the purchasing department should send to the accounting department the:

A. Unpaid voucher.B. Debit memo.C. Vendor invoice.D. Credit memo.



Choice "b" is correct. When nonconforming goods are returned to a vendor, the purchasing department should send a debit memo to the accounting department toensure that the accounts payable balance is reduced appropriately.Choice "a" is incorrect. The unpaid voucher is sent from the accounts payable department to the treasurer's department for payment when conforming goods arereceived. Choice "c" is incorrect. The vendor invoice is sent to the accounting department when conforming goods are received.Choice "d" is incorrect. A credit memo is generally used to reduce accounts receivable, not accounts payable.

QUESTION 228The authority to accept incoming goods in receiving should be based on a (an):

A. Vendor's invoice.B. Materials requisition.C. Bill of lading.D. Approved purchase order.


Explanation/Reference:Explanation:Choice "d" is correct. The authority to accept incoming goods in receiving should be based upon an approved purchase order.Choice "a" is incorrect. A vendor's invoice does not serve as an authority to accept incoming goods since it is generated by the vendor, not a responsible employeein the purchasing department. Choice "b" is incorrect. A materials requisition, which is prepared by the ultimate user of the goods, does not serve as an authority toaccept incoming goods since it has not been approved by the purchasing department.

Choice "c" is incorrect. A bill of lading does not serve as an authority to accept incoming goods since it is generated by the carrier, not a responsible employee in thepurchasing department.

QUESTION 229In a well designed internal control, employees in the same department most likely would approve purchase orders, and also:

A. Reconcile the open invoice file.B. Inspect goods upon receipt.C. Authorize requisitions of goods.D. Negotiate terms with vendors.



Choice "d" is correct. In a well designed internal control, employees in the purchasing department most likely would approve purchase orders and also negotiateterms with vendors. Choice "a" is incorrect. Personnel in the accounts payable department reconcile the open invoice file while the purchasing agent approvespurchase orders.Choice "b" is incorrect. Employees in the receiving department inspect goods upon receipt while the purchasing agent approves purchase orders.Choice "c" is incorrect. The stores department (personnel in the raw materials inventory area) authorize requisition of goods while the purchasing agent approvespurchase orders.

QUESTION 230An auditor's purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain evidence concerning management'sassertions about:

A. Understandability and classification.B. Existence.C. Rights and obligations.D. Valuation and allocation.



Choice "d" is correct. An auditor's purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain evidence concerningmanagement's assertions about valuation or allocation, which pertain to the presentation of assets, liabilities, and equity interests at appropriate amounts. Theauditor is concerned with the proper valuation of those receivables. Choice "a" is incorrect. Understandability and classification deals with whether the componentsof the financial statements are properly presented, described, and disclosed, not whether they are properly valued.Choice "b" is incorrect. Existence relates to whether assets, liabilities, and equity interests exist. Choice "c" is incorrect. Rights and obligations pertain to ownershipof assets and liabilities, not to the valuation of those accounts.

QUESTION 231An auditor most likely would review an entity's periodic accounting for the numerical sequence of shipping documents and invoices to support management'sfinancial statement assertion of:

A. Occurrence.B. Classification.C. Cutoff.D. Completeness.



Choice "d" is correct. An entity's periodic accounting for the numerical sequence of shipping documents and invoices supports management's financial statementassertion of completeness of sales. A gap in recorded sequence numbers might indicate an unrecorded sale. Choice "a" is incorrect. An auditor would trace fromthe sales invoices or sales journal (accounting records) to the shipping documents (source document) to support management's assertion of occurrence.Choice "b" is incorrect. An auditor would examine journal entries for a sample of shipping documents to determine whether the client has recorded the sales in theproper accounts. Choice "c" is incorrect. An auditor would review supporting documentation for shipping documents just before and just after year-end to determinewhether appropriate cutoff has been achieved.

QUESTION 232In evaluating the adequacy of the allowance for doubtful accounts, an auditor most likely reviews the entity's aging of receivables to support management's financialstatement assertion of:

A. Existence.B. Valuation and allocation.C. Completeness.D. Rights and obligations.

Correct Answer: B


Explanation/Reference:Explanation:Choice "b" is correct. In evaluating the adequacy of the allowance for doubtful accounts, an auditor most likely reviews the entity's aging of receivables to supportthe assertion of valuation and allocation (i.e., to determine whether the allowance for doubtful accounts properly adjusts the receivables balance to net realizablevalue).Choice "a" is incorrect. Evaluating the adequacy of the allowance for doubtful accounts does not pertain to existence. To support the assertion of existence, anauditor would most likely confirm accounts receivable.Choice "c" is incorrect. An auditor would trace from shipping records to the sales journal and the accounts receivable ledger to determine if all shipments wereproperly recorded as sales (completeness assertion).Choice "d" is incorrect. The assertion of rights and obligations relating to accounts receivable would be supported by examining appropriate supportingdocumentation, not by evaluating the allowance for doubtful accounts.

QUESTION 233Symbol A most likely represents:

A. Remittance advice file.B. Receiving report file.C. Accounts receivable master file.D. Cash disbursements transaction file.



Choice "c" is correct. The accounts receivable master file is the file most likely to be affected by sales and cash receipts transactions, as noted immediately abovesymbol "A" in the flowchart. Choice "a" is incorrect. Remittance advices are used to update the accounts receivable file, but a separate "remittance advice file"generally is not created. Choice "b" is incorrect. The inventory/purchase/cash disbursements cycle would include a receiving report file, not the revenue cycle.Choice "d" is incorrect. Cash disbursements are not part of the revenue cycle.

QUESTION 234Symbol B most likely represents:

A. Customer orders.B. Receiving reports.

C. Customer checks.D. Sales invoices.


Explanation/Reference:Explanation:Choice "d" is correct. The two documents most likely to be generated by the revenue cycle application are credit memos (already identified in the flowchart) andsales invoices. Choice "a" is incorrect. Customer orders are input at the beginning of the process, as noted in the flowchart. Customer orders are not generated bythe company's revenue cycle. Choice "b" is incorrect. Receiving reports are part of the inventory/purchasing/cash disbursements cycle.Choice "c" is incorrect. Customer checks and remittances are entered into the application at the top of the flowchart. Customer checks are not an output of therevenue cycle.

QUESTION 235This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.During our audit we discovered evidence of the company's failure to safeguard inventory from loss, damage, and misappropriation.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.



Choice "B" is correct. Failure to safeguard inventory from loss, damage, and misappropriation is a significant deficiency in the design or operation of internal controlthat could adversely affect the fairness of the financial statements.

QUESTION 236This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.The company considers the decline in value of equity securities classified as available-for-sale to be temporary.


Correct Answer: NSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "N" is correct. Management's discussion regarding the temporary nature of a decline in the value of equity securities provides information regardingrecognition, measurement, and disclosure, and would be included in the management representation letter.

QUESTION 237This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Was the difference of opinion on the accrued pension liabilities that existed between the engagement personnel and the actuarial specialist resolved in accordancewith firm policy and appropriately documented?


Correct Answer: MSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "M" is correct. The engagement partner has ultimate responsibility for the performance of the audit and the preparation of the report. He or she would

therefore want to ensure that any differences of opinion between engagement personnel and a specialist were resolved in accordance with firm policy and wereappropriately documented.

QUESTION 238This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Our audit is designed to provide reasonable assurance of detecting misstatements that, in our judgment, could have a material effect on the financial statementstaken as a whole. Consequently, our audit will not necessarily detect all misstatements that exist due to error, fraudulent financial reporting, or misappropriation ofassets.


Correct Answer: HSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "H" is correct. An understanding with the client should be established, and this understanding should be documented through an engagement letter. Theunderstanding, and the letter, should include the auditor's responsibilities, including the fact that an audit is designed to provide only reasonable assurance ofdetecting material misstatements, and therefore may not necessarily detect all misstatements that exist.

QUESTION 239This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.There have been no communications from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices.




Choice "N" is correct. Management's statement that there have been no communications from regulatory agencies concerning noncompliance with or deficienciesin financial reporting practices provides information regarding the completeness of information, and would be included in the management representation letter.

QUESTION 240This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.

Nothing came to our attention that caused us to believe that at October 31, 20XX, there was any change in the capital stock, increase in long-term debt, ordecrease in consolidated net current assets or stockholders' equity as compared with the amounts shown in the September 30, 20XX unaudited condensedconsolidated balance sheet.


Correct Answer: ISection: Auditing and Attestation (II) (Volume E)Explanation


Choice "I" is correct. In a comfort letter, negative assurance is provided with respect to changes in selected financial statement items during a period subsequent tothe date and period of the latest financial statements included in the registration statement.

QUESTION 241This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.It is our opinion that the possible liability to the company in this proceeding is nominal in amount.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.

B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.



Choice "D" is correct. In response to an audit inquiry letter, a lawyer would provide corroboration regarding the likelihood of an unfavorable outcome to pendinglitigation and an estimate of any potential loss.

QUESTION 242This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.As discussed in Note 4 to the financial statements, the company experienced a net loss for the year ended July 31, 20XX, and is currently in default undersubstantially all of its debt agreements. In addition, on September 25, 20XX, the company filed a prenegotiated voluntary petition for relief under Chapter 11 of theU.S. Bankruptcy Code. These matters raise substantial doubt about the company's ability to continue as a going concern.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.

D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.

Correct Answer: LSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "L" is correct. When there is substantial doubt about an entity's ability to continue as a going concern, the auditor would state his or her concerns in anexplanatory paragraph of the auditor's report.

QUESTION 243This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.During the year under audit, we were advised that management consulted with Better & Best, CPAs. The purpose of this consultation was to obtain another CPAfirm's opinion concerning the company's recognition of certain revenue that we believe should be deferred to future periods. Better & Best's opinion was consistentwith our opinion, so management did not recognize the revenue in the current year.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.

F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.

Correct Answer: FSection: Auditing and Attestation (II) (Volume E)Explanation

Explanation/Reference:Explanation:Choice "F" is correct. Unless all of those charged with governance are also involved with managing the entity, the auditor should discuss with those charged withgovernance significant accounting or auditing matters that were the subject of outside consultation.

QUESTION 244This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.The company believes that all material expenditures that have been deferred to future periods will be recoverable.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.

K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.



Choice "N" is correct. Management's discussion of its belief that all material expenditures that have been deferred to future periods will be recoverable providesinformation regarding recognition, measurement, and disclosure, and would be included in the management representation letter.

QUESTION 245This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Our use of professional judgment and the assessment of audit risk and materiality for the purpose of our audit mean that matters may have existed that would havebeen assessed differently by you. We make no representation as to the sufficiency or appropriateness of the information in our audit documentation for yourpurposes.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.

M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.

Correct Answer: PSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "P" is correct. An audit of a new client may be facilitated by review of the predecessor's audit documentation. The predecessor should make it clear that theyare not responsible for the sufficiency or appropriateness of the information in their audit documentation for the successor auditor's purposes.

QUESTION 246This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Indicate in the space provided below whether this information agrees with your records. If there are exceptions, please provide any information that will assist theauditor in reconciling the difference.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.

P. Predecessor auditor's communication with successor auditor.

Correct Answer: JSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "J" is correct. Receivable confirmations request customers of the client to confirm balances and identify discrepancies.

QUESTION 247This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Blank checks are maintained in an unlocked cabinet along with the check-signing machine. Blank checks and the check-signing machine should be locked inseparate locations to prevent the embezzlement of funds.



Explanation/Reference:Explanation:Choice "B" is correct. Failure to lock blank checks and the check-signing machine in separate locations is a significant deficiency in the design or operation ofinternal control that could adversely affect the fairness of the financial statements.

QUESTION 248This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Our audit cannot be relied upon to disclose significant deficiencies in the design or operation of internal control. Nevertheless, we will communicate to you all suchsignificant deficiencies and potential areas for improvement that we become aware of during the course of our audit.


Correct Answer: HSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "H" is correct. An understanding with the client should be established, and this understanding should be documented through an engagement letter. The

understanding, and the letter, should include limitations of the engagement, including the fact that an audit is not designed to provide assurance on internal controlor to identify significant deficiencies in internal control.

QUESTION 249This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.The timetable set by management to complete our audit was unreasonable considering the failure of the company's personnel to complete schedules on a timelybasis and delays in providing necessary information.


Correct Answer: FSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "F" is correct. The auditor should inform the audit committee of any serious difficulties encountered with management during the performance of the audit.

QUESTION 250This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent a

list of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.Several employees have disabled the anti-virus detection software on their PCs because the software slows the processing of data and occasionally rings falsealarms. The company should obtain anti-virus software that runs continuously at all system entry points and that cannot be disabled by unauthorized personnel.




Choice "B" is correct. The ability for unauthorized personnel to disable anti-virus detection software is a significant deficiency in the design or operation of internalcontrol that could adversely affect the fairness of the financial statements.

QUESTION 251This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.In connection with an audit of our financial statements, management has prepared, and furnished to our auditors, a description and evaluation of certaincontingencies.



Explanation/Reference:Explanation:Choice "C" is correct. In an audit inquiry letter to legal counsel, management states that they have furnished to the auditors a description and evaluation of pendingor threatened litigation and unasserted claims and assessments.

QUESTION 252This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.The company has no plans or intentions that may materially affect the carrying value or classification of assets and liabilities.

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.

E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.



Choice "N" is correct. Management's discussion of plans or intentions that may materially affect the carrying value or classification of assets and liabilities providesinformation regarding recognition, measurement, and disclosure, and would be included in the management representation letter.

QUESTION 253This question will represent a statement, question, excerpt, or comment taken from various parts of an auditor's documentation file. Letter choices A-P represent alist of the likely sources of the statement, question, excerpt, or comment. Select, as the best answer for each item, the most likely source. Select only one source foreach item.In planning the sampling application, was appropriate consideration given to the relationship of the sample to the audit objective and to preliminary judgments aboutmateriality levels?

A. Practitioner's report on management's assertion about an entity's compliance with specified requirements.B. Auditor's communications on significant deficiencies in internal control.C. Audit inquiry letter to legal counsel.D. Lawyer's response to audit inquiry letter.E. Communication from those charged with governance to the auditor.F. Auditor's communication to those charged with governance (other than with respect to significant deficiencies in internal control).G. Report on the application of accounting principles.

H. Auditor's engagement letter.I. Letter for underwriters.J. Accounts receivable confirmation request.K. Request for bank cutoff statement.L. Explanatory paragraph of an auditor's report on financial statements.M. Partner's engagement review notes.N. Management representation letter.O. Successor auditor's communication with predecessor auditor.P. Predecessor auditor's communication with successor auditor.

Correct Answer: MSection: Auditing and Attestation (II) (Volume E)Explanation


Choice "M" is correct. The engagement partner has ultimate responsibility for the performance of the audit and the preparation of the report. He or she wouldtherefore want to ensure that, in planning a sampling application, appropriate consideration was given to the relationship of the sample to the audit objective and topreliminary judgments about materiality levels.

QUESTION 254An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that:

A. Obsolete inventory has not yet been reduced to fair market value.B. There was an improper cutoff of sales at the end of the year.C. An unusually large receivable was written off near the end of the year.D. The aging of accounts receivable was improperly performed in both years.



Choice "b" is correct. Accounts receivable turnover is calculated as sales / receivables. A decline in this ratio may indicate that there was an improper cutoff of salesat the end of the year. For example, if sales made at the beginning of the subsequent year were inadvertently recorded in the current year, both sales and

receivables would be overstated by the same amount. This would generally result in a larger proportionate effect on receivables (since the receivables balance issmaller than sales for the year), and an overall decrease in the ratio.Choice "a" is incorrect. Failure to write down obsolete inventory would not affect sales or receivables, and so would have no effect on accounts receivable turnover.Choice "c" is incorrect. Write-off of an unusually large receivable would reduce the receivables balance without affecting sales. This in turn would cause an increasein accounts receivable turnover. Choice "d" is incorrect. The aging of accounts receivable does not affect the overall receivable balance, and therefore would haveno effect on accounts receivable turnover.

QUESTION 255To obtain assurance that all inventory items in a client's inventory listing are valid, an auditor most likely would trace:

A. Inventory tags noted during the auditor's observation to items listed in receiving reports and vendors' invoices.B. Items listed in receiving reports and vendors' invoices to the inventory listing.C. Inventory tags noted during the auditor's observation to items in the inventory listing.D. Items in the inventory listing to inventory tags and the auditor's recorded count sheets.



Choice "d" is correct. Tracing from the inventory listing to the inventory tags and the auditor's recorded count sheets verifies the validity (existence) of the items.Choice "a" is incorrect. Tracing inventory tags noted during the auditor's observation to items listed in receiving reports and vendors' invoices might be used to verifycompleteness of purchases or payables. Choice "b" is incorrect. Tracing from receiving reports and vendors' invoices to the inventory listing are cut-off proceduresused to verify completeness of the inventory listing. Choice "c" is incorrect. Tracing from inventory tags to the inventory listing schedule verifies the completeness ofthe schedule, not the existence (or validity) of the items.

Audit Sampling

QUESTION 256An audit partner is developing an office training program to familiarize his professional staff with statistical decision models applicable to the audit of dollar valuebalances. He wishes to demonstrate the relationship of sample sizes to population size and variability and the auditor's specifications as to tolerable misstatementand risk of incorrect acceptance. The partner prepared the following table to show comparative population characteristics and audit specifications of twopopulations.

You are to indicate for the specified case from the above table the required sample size to be selected from population 1 relative to the sample from population 2. Incase 1 the required sample size from population 1 is:

A. Larger than the required sample size from population 2.B. Equal to the required sample size from population 2.C. Smaller than the required sample size from population 2.D. Indeterminate relative to the required sample size from population 2.



Choice "a" is correct. A lower risk of incorrect acceptance requires a greater sample size. Choices "b", "c", and "d" are incorrect, based on the above Explanation: .

QUESTION 257An audit partner is developing an office training program to familiarize his professional staff with statistical decision models applicable to the audit of dollar valuebalances. He wishes to demonstrate the relationship of sample sizes to population size and variability and the auditor's specifications as to tolerable misstatementand risk of incorrect acceptance. The partner prepared the following table to show comparative population characteristics and audit specifications of two

populations.

You are to indicate for the specified case from the above table the required sample size to be selected from population 1 relative to the sample from population 2. Incase 2 the required sample size from population 1 is:

A. Larger than the required sample size from population 2.B. Equal to the required sample size from population 2.C. Smaller than the required sample size from population 2.D. Indeterminate relative to the required sample size from population 2.



Choice "d" is correct. The effect on sample size cannot be determined, because there is more than one change occurring. In this case, the increase in populationvariability results in an increase in sample size, whereas the larger tolerable misstatement results in a decrease in sample size. The overall effect on sample sizewill depend on which of the two effects is greater, but this cannot be determined from the information provided.Choices "a", "b", and "c" are incorrect, based on the above Explanation: .