Week 5 Homework Questions

Questions 1 and 2 were taken directly from the text and I am aware that the answers are available through an internet search.  I want to remind you that searching the internet for the answers and using those answers is a violation of UMUC academic integrity policies.  In addition, using any outside source without citation is plagiarism.  However, just gaining access to the answers will not satisfy the homework assignment because I have added the requirement that you explain your answers, which cannot be found on the internet and needs to be reasoned out from the material in the chapter.  In grading, I will place more emphasis you explanation than your selection of the correct alternative.

1)             The following are several multiple choice questions adapted from the CPA exam that cover the concept and application of materiality.  For each question, selected the best answer and then explain why it is better than all the alternatives.  Your explanations should address all the possible alternatives presented in the question.

a)              Which one of the following statements is correct concerning the concept of materiality?

i)               Materiality is determined by reference to guidelines established by the AICPA.

ii)             Materiality depends only on the dollar amount of an item relative to other items in the financial statements.

iii)           Materiality depends on the nature of an item rather than the dollar amount.

iv)           Materiality is a matter of professional judgment.

Answer: 

Explanation: 

b)             In considering materiality for planning purposes, an auditor believes that misstatements aggregating $10,000 will have a material effect on an entity’s income statement, but that misstatements will have to aggregate $20,000 to materially affect the balance sheet.  Ordinarily, it is appropriate to design audit procedures that are expected to detect misstatements that aggregate to

i)               $10,000

ii)             $15,000

iii)           $20,000

iv)           $30,000

Answer: 

Explanation: 

c)              A client decides not to record an auditor’s proposed adjustments that collectively are not material and wants the auditor to issue the report based on the unadjusted numbers.  Which of the following statements is correct regarding the financial statement presentation?

i)               The financial statements are free from material misstatement, and no disclosure is required in the notes to the financial statements.

ii)             The financial statements do not conform with generally accepted accounting principles (GAAP).

iii)           The financial statements contain unadjusted misstatements that should result in a qualified opinion.

iv)           The financial statements are free from material misstatement, but disclosure of the proposed adjustment is required in the notes to the financial statements.

Answer: 

Explanation: 

2)             The following are several multiple choice questions adapted from the CPA exam that cover audit risk.  For each question, selected the best answer and then explain why it is better than all the alternatives.  Your explanations should address all the possible alternatives presented in the question.

a)              Some account balances, such as those for pensions and leases, are the result of complex calculations. The susceptibility to material misstatements in these types of accounts is defined as

i)               audit risk.

ii)             detection risk.

iii)           inherent risk.

iv)           sampling risk.

Answer: 

Explanation: 

b)             As the acceptable level of detection risk decreases, the auditor may do one or more of the following except change the

i)               nature of audit procedures to more effective procedures.

ii)             timing of audit procedures, by perhaps performing them at year-end rather than an interim date.

iii)           extent of audit procedures, by perhaps using larger sample sizes.

iv)           assurances provided by audit procedures to a lower level.

Answer: 

Explanation: 

c)              Inherent risk and control risk differ from planned detection risk in that they

i)               arise from the misapplication of auditing procedures.

ii)             may be assessed in either quantitative or qualitative terms.

iii)           exist independently of the financial statement audit.

iv)           can be changed at the auditor’s discretion

Answer: 

Explanation: 

3)             For each of the following independent scenarios, state the effect, if any, on each component of the audit risk model and explain why you made each selection.  For your answer to the effect portion of the question, select from I = increase, D = decrease, or N = no effect.  I have included a table for each scenario to help you organize your answers and be complete.  This question was adapted from the text, but I have altered it to require explanations.  Also, I disagree with the text solutions manual on some of them but since the solutions manual doesn’t provide an explanation of their answers, I cannot determine how the authors arrived at their conclusions.  I will be grading based on my answers.  As I reminder, attempting to access the solutions manual to answer these questions is a violation of academic integrity. 

a)              In discussions with management, you conclude that management is planning to sell the business in the next few months.  Consequently several key accounting personnel have recently quit.  In addition, the firm’s gross profit margin has significantly increased since last year.

b)             The client began selling products online to customers through its web page during the year under audit.  The online ordering process has not been integrated with the firm’s accounting system.  The firm’s sales staff print out online orders and manually enter the information into the firms accounting system. 

c)              An account balance increased by a material amount from last year without any explanation.

d)             The firm’s management materially decreased long-term contractual debt from what is was last year.

e)              This is the second year of the engagement and there were few misstatements found in the prior year’s audit.  Consequently, the auditor has decided to increase reliance on internal controls.

4)             Read the following description of the Preview Company. 

Preview Company Case Description

Preview Company, a diversified manufacturer, has five divisions that operate throughout the United States and Mexico.  Preview has historically allowed its divisions to operate autonomously.  Corporate intervention occurred only when planned results were not obtained.  Corporate management has high integrity, but the board of directors and audit committee are not very active.  Preview has a policy of hiring competent people.  The company has a code of conduct, but there is little monitoring of compliance by employees.  Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance.  Preview Company does not have an internal audit department, and it relies on its external auditor to review the controls in each division. 

Chip Harris is the general manager of the Fabricator Division.  The Fabricator Division produces a variety of standardized parts for small appliances.  Harris has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division.  He is compensated based largely on the division’s profitability.  Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control activities over inventory. 

During the last year, a new competitor has entered Fabricator’s markets and has offered substantial price reductions in order to grab market share.  Harris has responded to the competitor’s actions by matching the price cuts in the hope of maintaining market share.  Harris is very concerned because he cannot see any other areas where costs can be reduced so that the division’s growth and profitability can be maintained.  If profitability is not maintained, his salary and bonus will be reduced. 

Harris has decided that one way to make the division more profitable is to manipulate inventory because it represents a large amount of the division’s balance sheet.  He also knows that controls over inventory are weak.  He views this inventory manipulation as a short-run solution to the profit decline due to the competitor’s price-cutting.  Harris is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements in inventory can be corrected with little impact on the bottom line. 

a)              The following table includes two columns.  Include a brief phrase or sentence in the first column that merely describes the strength or weakness.  In in second column, explain why each strength is a strength or why each weakness is weakness.  In addition, for each weakness you identify, suggest an improvement that would reduce that weakness.  Finally, include issues that affect financial reporting and not operational effectiveness.  While the overall definition of internal controls includes operational effectiveness, auditors primarily are concerned about the accuracy of the financial statements.  I have included one example for each category to help illustrate what I am looking for in your answers.