Chapter 10

LO 10-1 to 10-2

100

Loan covenants are used for which of the following reasons? a) to protect the lender from the borrower's substantially weakening of the latter's financial position b) to protect he borrower from the lender's calling the loan early c) To protect the auditors from false information by the borrower d) to protect shareholders from management taking on too much

a) To protect the lender from the borrower's substantially weakening of the latter's financial position

200

A related party is a person or entity that a) has a family tie to a management member b) does business with the company c) can exert significant influence over or be influence by the company d) is a member of the company's management team or board of directors

c) The other answers are examples, but not complete definitions of a related party

300

The auditors should insist that a representative of the client be present during the inspection and count of securities to a) lend authority to the auditors' directives b) detect forged securities c) coordinate the return of all securities to proper locations d) Acknowledge the receipt of securities returned

d) A client representative should be present to acknowledge return so the auditor will not be accused of theft.

400

When the client holds a large amount of negotiable securities, auditors need to plan to guard against a) Unauthorized negotiation of the securities before they are counted b) Unrecorded sales of securities after they are counted c) Substitution of securities already counted for other securities that should be on hand but are not d) Substitution of authentic securities with counterfeit securities

c) The danger is that someone might move securities so the auditor counts them twice.

500

Which of the following approaches is most suitable for auditing the finance and investment cycle? a) Perform extensive tests of controls and limit substantive procedures to analytical procedures b) Ignore internal controls and perform extensive substantive procedures c) Gain an understanding of internal controls and perform extensive substantive procedures d) Ignore internal controls and limit substantive procedures to analytical procedures

c) Controls must be reviewed (and tested for public companies); however, a substantive approach is preferred.

LO 10-2 to 10-3

100

When independent stock transfer agents are not employed and the corporation issues its own stock and maintains stock records, canceled stock certificates should a) be defaced to prevent reissuance and attached to their corresponding stub b) Not be defaced but be segregated from other stock certificates and retained in a canceled certificates file c) Be destroyed to prevent fraudulent reissuance d) Be defaced and sent to the secretary of state

a) Stock certificates should be defaced but retained so the auditors can actually see the canceled certificate.

200

Which of the following questions would auditors most likely include in an internal 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 non-current assets? d) Are direct borrowings on notes payable authorized by the board of directors

d) Control is enhanced when different persons or departments authorize, record, and maintain custody of assets for a class of transactions. Authorization of notes payable transactions is best done by the board of directors.

300

Jones was engaged to examine the financial statements of Gamma Corp for the year ended June 30. Having completed an examination of the investment securities, which of the following is the best method of verifying the accuracy of recorded dividend income? a) Tracing the recorded dividend income to cash receipts records and validated deposit slips b) Performing analytical procedures and statistical sampling c) Comparing recorded dividends with amounts appearing on federal information form 1099 d) Comparing recorded dividends with a standard financial reporting service's record of dividends

d) Independent evidence from an outside dividend reporting service is the best evidence for existence, completeness, and valuation.

400

In connection with the audit of an issue of long-term bonds payable, the audit team should a) Determine whether bondholders are persons other than owners, directors, or officers of the company issuing the bond b) Calculate the effective interest rate to see whether it is substantially the same as the rates charged for similar issues c) Decide whether the bond issue was made without violating state or local laws or regulations d) Ascertain that the client has obtained the opinion of counsel on the legality of the issue

d) Among the choices available, obtaining an opinion from legal counsel is the best response. The legality of a bond issue is important although not the only important thing.

500

Which of the following is the most important audit consideration when examining the stockholders' equity section of a clients' balance sheet? a) Changes in the capital stock account are verified by an independent stock transfer agent b) Stock dividends and stock splits during the year under audit were approved by stockholders c) Stock dividends are capitalized at par or stated value on the dividend declaration date d) Entries in the capital stock account can be traced to resolutions in the minutes of meetings of the BOD

d) Capital stock transactions are important by definition, and the directors should have approved all of them.

LO 10-3

100

If the auditors discover that the carrying amount of a client's investments is overstated because of a loss in value that is other than a temporary decline in market value, they should insist that a) the approximate market value of the investments be shown in parenthesis on the face of the balance sheet b) The investments be classified as long term for balance sheet purposes with full disclosure in the footnotes c) The loss in value be recognized in the financial statements d) The equity section of the balance sheet separately show a charge equal to the amount of the loss

c) Losses on investment should be recorded in the accounts and shown in the financial statements. (Losses on trading securities in the income statement; loss on available-for-sale securities in the equity section.)

200

When a client company doesn't maintain its own capital stock records, the auditors should obtain written confirmation from the transfer agent and registrar concerning a) restrictions on the payments 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

b) The number of shares issued and outstanding is the record kept by the registrar/transfer agent.

300

All corporate capital stock transactions should ultimately be traced to the a) Minutes of the meetings of the BOD b) Cash receipts journal c) Cash disbursements journal d) Numbered stock certificates

a) Capital stock transactions are important by definition, and the directors should have approved all of them.

400

An audit plan for the examination of the retained earnings account should include a step that requires verification of the (choose two) a) market value used to charge retained earnings to account for a 2-for-1 stock split b) Approval of the adjustments to the beginning balance as a result of a write-down of account receivables c) Authorization for both cash and stock dividends declared and paid d) gain or loss resulting from disposition of treasury shares

c) These should be authorized by the board of directors. d) Gain or loss on treasury stock transactions should be audited

500

An audit team 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 internal controls relevant to cash receipts

c) The audit program for long-term investments includes making an independent computation of revenue (such as dividends and interest). For example, bond certificates contain information about interest rates, payment dates, issue date, and face amount that the auditor can use to recalculate bond interest earned, including amounts accrued but not collected, during the period the auditee has held the investment.

LO 10-3

100

A client has a large and active investment portfolio that is kept in a bank safe deposit box. If the auditors are unable to count securities at the balance sheet date, they will most likely a) request the bank to confirm to the auditors the contents of the safe deposit box at 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 auditors can count the securities at a subsequent date

d) Securities should be inspected simultaneously with the verification of cash and the count of other liquid assets to prevent transfers among asset categories for the purpose of concealing a shortage. If this procedure is not possible but the securities are kept by a custodian in a bank safe deposit box, the client may instruct the custodian that no one is to have access to the securities unless in the presence of the auditor. Thus, when finally inspecting the securities, the auditor may conclude that they represent what was on hand at the balance-sheet date

200

An audit team testing long-term investments would ordinarily use analytical procedures to ascertain the reasonableness of the a) existence of unrealized gains or losses b) completeness of recorded investment income c) classification as available for sale or trading securities d) valuation of trading securities

b) The auditor may develop expectations regarding the completeness assertion for unrecorded investment income from stocks by using dividend records published by standard investment advisory services to recompute dividends received. Interest income from bond investments can be calculated from interest rates and payment dates noted on the certificates. Income from equity-based investments can be estimated from audited financial statements of the investees. Thus, applying an expected rate of return to the net investment amount may be an effective means of estimating total investment income.

300

In auditing for unrecorded long-term bonds payable, an audit team most likely will 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

c) The recorded interest expense should reconcile with the outstanding bonds payable. If interest expense appears excessive relative to the recorded bonds payable, unrecorded long-term liabilities may exist.

400

An audit team's purpose in reviewing the documentation concerning the renewal of a note payable shortly after the balance-sheet date most likely is to obtain evidence concerning management's assertions about a) existence b) valuation c) completeness d) classification

d) Events such as the renewal of the note payable do not require adjustment of the financial statements but may require disclosure. Accordingly, the auditor should determine that the renewal had essentially the same terms and conditions as the recorded debt at year-end. A significant change may affect the presentation of notes payable such as a reclassification from short term to long term.

500

Which of the following audit procedures would NOT likely be performed for audits of investments? a) read BOD minutes for authorization of investment strategies b) confirm investments with registrar c) Confirm investments with broker or trustee d) compare valuation to published market prices

b) The registrar would have record of stock sold.

LO 10-3 to 10-4

100

The primary reason for preparing a reconciliation between interest-bearing obligation outstanding during the year and interest expense in the financial statements is to a) Evaluate internal control over securities b) Determine validity of prepaid interest expense c) Ascertain the reasonableness of imputed interest d) Detect unrecorded liabilities

d) “Detect unrecorded liabilities” is the best response, but remember that the procedure might be ineffective if the interest expense on an unrecorded liability is also unrecorded.

200

When 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) the trust company places the securities in a bank safe deposit vault under the custodian's exclusive control

a) To conceal fraud related to marketable securities, collusion between those responsible for record keeping and custody would be required. The possibility of collusion is reduced if no direct contact between responsible parties exists.

300

An audit plan to examine long-term debt most likely would include steps that require a) comparing the carrying amount of held-to-maturity securities with their year-end market values 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

b) By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to the long-term debt, unrecorded interest-bearing obligations may be outstanding.

400

Which of the following audit procedures would NOT likely be performed for audits of shareholders' equity a) Read BOD minutes for authorization of equity transactions b) Confirm outstanding common and preferred stock with stock registrar c) Compare valuation of stock to published market prices d) Obtain management representation about number of shares issued and outstanding

c) Market price is not important in valuing shareholder’s equity.

500

An audit plan to examine long-term debt most likely would include steps that require a) Comparing the carrying amount of held-to-maturity securities with their market values 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

b) By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to the long-term debt, unrecorded interest-bearing obligations may be outstanding.