Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

213

Substantive Audit Testing: Financing and

Investing Cycle
MULTIPLE CHOICE:
1.

Which of the following expressions is least likely to be

included in a client's representation letter?
a.
No events have occurred subsequent to the balance sheet
date that require adjustment to, or disclosure in,
the financial statements.
b.
The company has complied with all aspects of
contractual agreements that would have a material
effect on the financial statements in the event of
noncompliance.
c.
Management acknowledges responsibility for illegal
actions committed by employees.
d.
Management has made available all financial statements
and related data.
ANSWER:

2.

When reviewing working papers, an audit supervisor will be

primarily concerned with determining whether the
a.
Audit programs have been carried out without deviation.
b.
Working papers adequately support the audit findings,
conclusions, and reports.
c.
Working papers reflect adherence to budget constraints.
d.
Auditing department's standard formats and tick marks
have been used consistently.
ANSWER:

3.

A written representation from a client's management which,

among other matters, acknowledges responsibility for the
fair presentation of financial statements, should
normally
be signed by the
a.
Chief executive officer and the chief financial
officer.
b.
Chief financial officer and the chairman of the
board of directors.
c.
Chairman of the audit committee of the board of
directors.
d.
Chief executive officer, and the chairman of the
board of directors, and the client's lawyer.
ANSWER:

214

4.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

Generally accepted auditing standards require the auditor to

apply analytical procedures in both the planning and review
stages of the audit. The major reason for applying
analytical procedures as part of audit review is
a.
To identify abnormalities that warrant audit attention.
b.
To assist the auditor in establishing materiality
thresholds.
c.
To ascertain that the auditor has gathered adequate
evidence to resolve suspicions arising during the
planning stages of the audit.
d.
To provide documentary evidence in the event of future
litigation.
ANSWER:

5.

The existence of a related party transaction may be

indicated when another entity
a.
Sells real estate to the corporation at a price that
is comparable to its appraised value.
b.
Absorbs expenses of the corporation.
c.
Borrows from the corporation at a rate of interest
which equals the current market rate.
d.
Lends to the corporation at a rate of interest which
equals the current market rate.
ANSWER:

6.

The main purpose of the auditor/client conference held at

the close of audit field work is to
a.
Discuss unresolved matters and audit fee arrangements.
b.
Review proposed audit adjustments, internal control
weaknesses, and needed disclosures, and agree on the
type of audit report to be rendered.
c.
Discuss areas of major audit risk and use of client
personnel to assist in high risk areas.
d.
Arrange for a meeting with outside legal counsel for
the purpose of discussing pending litigation.
ANSWER:

7.

After discovering that a related party transaction exists,

the auditor should be aware that the
a.
Substance of the transaction could be significantly
different from its form.
b.
Adequacy of disclosure of the transaction is secondary
to its legal form.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

c.
d.

Transaction is assumed to be outside the ordinary

course of business.
Financial statements should recognize the legal form
of the transaction rather than its substance.

ANSWER:
8.

An attorney is responding to an independent auditor as a

result of the audit client's letter of inquiry. The
attorney may appropriately limit the response to
a.
Asserted claims and litigation.
b.
Matters to which the attorney has given substantive
attention in the form of legal consultation or
representation.
c.
Asserted, overtly threatened, or pending claims and
litigation.
d.
Items which have an extremely high probability of
being resolved to the client's detriment.
ANSWER:

10.

Which of the following matters describes a "reportable

condition" that should be included in the auditor's
communication of the same?
a.
A significant audit adjustment was required because a
major year-end adjustment was inadvertently overlooked
by the client.
b.
The client's recently installed on-line real-time
computer system lacks necessary input editing features.
c.
A major customer of the client is verging on
bankruptcy.
d.
The auditors do not agree with the economic feasibility
of the client's proposed acquisition of a new
subsidiary.
ANSWER:

9.

215

An auditor is verifying a company's ownership of equipment

What is the best evidence of ownership?
a.
The current year's depreciation expense journal entry.
b.
A canceled check written to acquire the equipment.
c.
An interview with the equipment custodian verifying
company ownership.
d.
The presence of the equipment on the company's balance
sheet.
ANSWER:

216

11.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

If a lawyer refuses to furnish corroborating information

regarding litigation, claims, and assessments, the auditor
should
a.
Honor the confidentiality of the client-lawyer
relationship.
b.
Consider the refusal to be tantamount to a scope
limitation.
c.
Seek to obtain the corroborating information from
management.
d.
Disclose this fact in a footnote to the financial
statements.
ANSWER:

12.

In auditing investments for proper valuation, the auditor

should do all but the following:
a.
Confirm securities held in safekeeping off the client's
premises.
b.
Vouch purchases and sales of securities by tracing to
brokers' advices and canceled checks.
c.
Compare cost and market by reference to year end market
values for selected securities.
d.
Recalculate gain or loss on disposals.
ANSWER:

13.

When examining a client's statement of cash flows for audit

evidence, an auditor will rely primarily upon
a.
Determination of the amount of working capital at
year-end.
b.
Cross-referencing to balances and transactions reviewed
in connection with the examination of the other
financial statements.
c.
Analysis of significant ratios of prior years as
compared to the current year.
d.
The guidance provided by the APB Opinion on the
statement of cash flows.
ANSWER:

14.

A limitation on the scope of the auditor's examination

sufficient to preclude an unqualified opinion will always
result when management
a.
Prevents the auditor from reviewing the working papers
of the predecessor auditor.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

b.
c.
d.

Engages the auditor after the year-end physical

inventory count is completed.
Fails to correct a material internal control weakness
that had been identified during the prior year's audit.
Refuses to furnish a client representation letter to
the auditor.

ANSWER:
15.

Which of the following audit procedures provides the best

evidence about the collectability of notes receivable?
a.
Confirmation of note receivable balances with the
debtors.
b.
Examination of notes for appropriate debtors'
signatures.
c.
Examination of cash receipts records to determine
promptness of interest and principal payments.
d.
Reconciliation of the detail of notes receivable and
the provision for uncollectible amounts to the general
ledger control.
ANSWER:

17.

When an audit is made in accordance with generally accepted

auditing standards, the auditor should always
a.
Test control procedures by reprocessing a representative sample of completed transactions.
b.
Examine all negotiable and nonnegotiable securities,
regardless of location.
c.
Obtain certain written representations from management.
d.
Observe the taking of the physical inventory on the
balance sheet date.
ANSWER:

16.

217

An audit program for the examination of the retained

earnings account should include a step that requires
verification of the
a.
Market value used to charge retained earnings for a
two-for-one stock split.
b.
Approval of the adjustment to the beginning balance as
a result of a write-down of an account receivable.
c.
Authorization for both cash and stock dividends.
d.
Gain or loss resulting from disposition of treasury
shares.
ANSWER:

218

18.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

In testing the reasonableness of interest income, an auditor

could most effectively use analytical tests involving
a.
The beginning balance in the investments account for
fixed income securities.
b.
The average monthly balance in the investments account
for fixed income securities.
c.
The ending balance in the investments accounts for
fixed income securities.
d.
Documentary support of specific entries in the account.
ANSWER:

19.

Which of the following would provide the best form of

evidential matter pertaining to the annual valuation of a
long-term investment in which the independent auditor's
client owns a 30% voting interest?
a.
Market quotations of the investee company's stock.
b.
Current fair value of the investee company's assets.
c.
Historical cost of the investee company's assets.
d.
Audited financial statements of the investee company.
ANSWER:

20.

Which of the following is a "Type I" subsequent event?

a.
The client's Long Island warehouse was destroyed by
fire two weeks following the balance sheet date. The
warehouse and its contents were uninsured and
represented 15% of the client's total assets.
b.
As the result of an uninsured flood loss, one of the
client's major customers declared bankruptcy. The
client doesn't expect to recover more than 5% of the
outstanding receivable which accounts for 30% of total
accounts receivable. The flood and bankruptcy
declaration both occurred after the balance date but
before the release of the audit report. No additional
provision for loss had been made as of year end.
c.
Three weeks after the balance sheet date, a major
strike was called by the labor union representing 80%
of the client's work force.
d.
After the balance sheet date, but prior to release of
the audit report, a product liability judgment against
the client was rendered by a judge. The judgment
assessed damages and fines totaling 30% of audited net
income. The events giving rise to the judgment
occurred prior to the balance sheet date. The client
does not plan to appeal the decision.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

ANSWER:
21.

Which of the following matters should not be included in the

auditor's letter of communication with the client's audit
committee?
a.
An audit adjustment was required reducing inventory by
40%.
b.
Management was reluctant to answer the auditor's
questions concerning the economic substance of material
related party transactions.
c.
Contrary to a previous understanding, the client did
not have an adjusted trial balance completed prior to
the commencing of audit field work. Moreover, several
errors were detected by the audit team as a result of
significant weaknesses in internal control.
d.
An internal control weakness discovered during the
previous year's audit was corrected during the current
year.
ANSWER:

23.

Which of the following statements regarding the audit of

negotiable notes receivable is not correct?
a.
The auditor should confirm all notes receivable as of
the balance sheet date.
b.
Materiality of the amount involved is a factor
considered when selecting the accounts to be confirmed.
c.
Physical inspection of a note by the auditor does not
provide conclusive evidence.
d.
Notes receivable discounted with recourse need to be
confirmed.
ANSWER:

22.

219

Apex, Incorporated issued common stock to acquire another

company, in an acquisition that was accounted for as a
pooling of interests. The auditor examining this
transaction would be least interested in
a.
The net book value of the acquired company.
b.
The par value of the stock that was issued.
c.
Whether or not the acquisition was approved by the
board of directors of Apex, Incorporated.
d.
Whether the fair market value of the acquired assets
were independently appraised.
ANSWER:

220

24.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

An internal auditor discovered an error in a receivable due

from a major stockholder. The receivable's balance accounts
for less than one percent of the company's total
receivables. Would the auditor be likely to consider the
error material?
a.
Yes, if relative risk is low.
b.
No, if there will be further transactions with
this stockholder.
c.
Yes, because a related party is involved.
d.
No, because a small dollar amount is in error.
ANSWER:

25.

Two months before the year end, the bookkeeper erroneously

recorded the receipt of a long-term bank loan by a debit to
cash and a credit to sales. Which of the following is the
most effective procedure for detecting this type of error?
a.
Analyze the notes payable journal.
b.
Analyze bank confirmation information.
c.
Prepare a year-end bank reconciliation.
d.
Prepare a year-end bank transfer schedule.
ANSWER:

26.

Of the following statements regarding further analysis of

materiality thresholds during audit review, which one is
true?
a.
Audit adjustments reducing net income may suggest a
need to lower individual item and aggregate materiality
thresholds.
b.
Audit adjustments reducing net income may suggest a
need to lower the individual item threshold, but
should not affect aggregate materiality thresholds.
c.
Audit adjustments that increase net income may suggest
a need to lower aggregate materiality thresholds.
d.
An increase in the assessment of control risk suggests
a need to lower the individual item materiality
threshold.
ANSWER:

27.

A written understanding between the auditor and the client

concerning the auditor's responsibility for the discovery of
illegal acts is usually set forth in a(an)
a.
Client representation letter.
b.
Letter of audit inquiry.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

c.
d.

Management letter.
Engagement letter.

ANSWER:
28.

A letter from the company's attorney in response to

inquiries about possible litigation is best described as:
a.
Confirmation evidence.
b.
Analytical evidence.
c.
Documentary evidence.
d.
Physical evidence.
ANSWER:

29.

221

The auditor can best verify a client's bond sinking fund

transactions and year-end balance by
a.
Confirmation with individual holders of retired bonds.
b.
Confirmation with the bond trustee.
c.
Recomputation of interest expense, interest payable,
and amortization of bond discount or premium.
d.
Examination and count of the bonds retired during the
year.
ANSWER:

30.

Which of the following procedures would an auditor

ordinarily perform during the review of subsequent
events?
a.
An analysis of related party transactions for the
discovery of possible fraud.
b.
A review of the cut-off bank statements for the
period
after the year-end.
c.
An inquiry of the client's legal counsel concerning
litigation.
d.
An investigation of material weaknesses in internal
control previously communicated to the client.
ANSWER:
31.

Which of the following is not an audit procedure which the

independent auditor would perform with respect to
litigation, claims, and assessments.
a.
Inquire of and discuss with management the policies
and procedures adopted for identifying, evaluating, and
accounting for litigation, claims, and assessments.
b.
Obtain from management a description and evaluation
of litigation, claims, and assessments that

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Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

existed at
the balance sheet date.
c.
Obtain assurance from management that it has disclosed
all unasserted claims that the lawyer has advised are
probable of assertion and must be disclosed.
d.
Confirm directly with the client's lawyer that all
claims have been recorded in the financial statements.
ANSWER:
32.

The auditee has acquired another company by purchase. Which

of the following would be the best audit procedure to test
the appropriateness of the allocation of cost to tangible
assets?
a.
Determine whether assets have been recorded at their
book value at the date of purchase.
b.
Evaluate procedures used to estimate and record fair
market values for purchased assets.
c.
Evaluate the reasonableness of recorded values by use
of replacement cost data.
d.
Evaluate the reasonableness of recorded values by
discussion with operating personnel.
ANSWER:

33.

A CPA has received an attorney's letter in which no

significant disagreements with the client's assessments
of
contingent liabilities were noted. The resignation of
the
client's lawyer shortly after receipt of the letter
should
alert the auditor that
a.
Undisclosed unasserted claims may have arisen.
b.
The attorney was unable to form a conclusion with
respect to the significance of litigation, claims,
and
assessments.
c.
The auditor must begin a completely new examination of
contingent liabilities.
d.
An adverse opinion will be necessary
ANSWER:
34.

An audit procedure that provides evidence about proper

valuation of marketable securities arising from a
short-term
investment of excess cash is
a.
Comparison of carrying value with current market
quotations.
b.
Confirmation of securities held by broker.
c.
Recalculation of investment carrying value by applying
the equity method.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

d.

223

Calculation of premium or discount amortization.

ANSWER:

35.

Hall accepted an engagement to audit the 2002 financial

statements of XYZ Company. XYZ completed the preparation of
the 2002 financial statements on February 13, 2003, and Hall
began the field work on February 17, 2003. Hall completed
the field work on March 24, 2003, and completed the
report
on March 28, 2003. The client's representation
letter
normally would be dated
a.
February 13, 2003
b.
February 17, 2003
c.
March 24, 2003
d.
March 28, 2003
ANSWER:
36.

The auditee has just acquired another company by purchasing

all its assets. As a result of the purchase, "goodwill" has
been recorded on the auditee's books. Which of the
following comparisons would be the most appropriate audit
test for the amount of recorded goodwill?
a.
The purchase price and the book value of assets
purchased.
b.
The figure for goodwill specified in the contract for
purchase.
c.
Earnings in excess of 15% of net assets for the past
five years.
d.
The purchase price and the fair market value of assets
purchased.
ANSWER:

37.

All corporate capital stock transactions should ultimately

be traced to the
a.
Minutes of the Board of Directors.
b.
Cash receipts journal.
c.
Cash disbursements journal.
d.
Numbered stock certificates.
ANSWER:

38.

A logical substantive test for accrued interest receivable

would be to

224

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

a.
b.
c.
d.

Compare the interest income with published interestinvestment records.

Verify the interest income by a calculation based on
the face amount of notes and the nominal interest rate.
Verify the cost, carrying value, and market value of
notes receivable.
Recalculate interest earned and compare it to the
amounts received.

ANSWER:

39.

In verifying the amount of goodwill recorded by a client,

the most convincing evidence which an auditor can
obtain is
by comparing the recorded value of assets acquired
with the
a.
Assessed value as evidenced by tax bills.
b.
Seller's book value as evidenced by financial
statements.
c.
Insured value as evidenced by insurance policies.
d.
Appraised value as evidenced by independent appraisals.
ANSWER:

40.

An auditor who wishes to substantiate the gross balance of

the account "Trade Notes Receivable" is considering the
advisability of performing the four procedures listed
below.
Which pair of procedures is best suited to this
objective?
I.
Age the receivables.
II. Confirm the notes with the makers.
III. Inspect the notes.
IV. Trace a sample of postings from the sales journal to
the notes receivable ledger.
a.
I and III.
b.
I and IV.
c.
II and III.
d.
II and IV.
ANSWER:
41.

Jones was engaged to examine the financial statements of

Gamma Corporation for the year ended June 30, 2002.
Having
completed an examination of the investment securities, which
of the following is the best method of verifying the
accuracy of recorded dividend income?

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

a.
b.
c.
d.

Tracing recorded dividend income to cash receipts

records and validated deposit slips.
Utilizing analytical review techniques and statistical
sampling.
Comparing recorded dividends with amounts appearing on
federal information forms 1099.
Comparing recorded dividends with a standard financial
reporting service's record of dividends.

ANSWER:
42.

225

An auditor's program to examine long-term debt most likely

would include steps that require
a.
Comparing the carrying amount of the debt to its yearend 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.
ANSWER:

COMPLETION:
43.

Two alternative means for determining that recorded

securities exist are
and
.
ANSWER:

44.

INSPECTION (EXAMINATION), CONFIRMATION

When examining securities, the auditor should prepare a

workpaper (count sheet) that lists such data as serial
number of the securities certificate, registered owner, and
number of shares or par value. This workpaper should then
be compared with the client's investment record for
agreement. In this regard, the auditor tests for existence
of securities by tracing from
(investment
record or count sheet) to the
(investment
record or count sheet); and the auditor tests for
completeness by tracing from the
to
the
.

226

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

ANSWER:
INVESTMENT RECORD, COUNT SHEET, COUNT
SHEET, INVESTMENT RECORD

45.

Auditing intracompany transactions for consistency and

completeness is known as a test for
ANSWER:

46.

DISCLOSURE

An audit workpaper listing unresolved matters and the

ultimate disposition of these matters is commonly referred
to as a(n)
workpaper.
ANSWER:

50.

ACCRUALS, DISCLOSURES

Although a Type II subsequent event does not require

adjustment, it may require
.
ANSWER:

49.

AUDITED

Examining long-term debt agreements helps the auditor

identify necessary
and
.
ANSWER:

48.

ACCOUNTING SYMMETRY

If investments in unconsolidated subsidiaries are accounted

for under the equity method, the auditor may need to insist
that the financial statements of these subsidiaries be
.
ANSWER:

47.

OPEN ITEMS

The vehicle that is designed to make management more aware

of their primary responsibility for fairness of financial
presentation is known as the
.
ANSWER:

CLIENT REPRESENTATION LETTER

MATCHING:
51.

Match each of the listed objectives with the auditing

procedure that best meets the objective.
A. Examine securities and record serial numbers for later
comparison with recorded accountability.
B. Examine audited financial statements of 30% owned
subsidiary.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

227

C. Verify by reference to Standard & Poors or Moodys.

D. Inquire of management as to nature of investments and
reasons for holding them.
E. Obtain bank confirmations.
F. Examine minutes of board of directors meetings.
G. Recalculate on a test basis.
H. Examine loan agreements.
I. Examine copy of corporate charter in permanent file.
K. Trace from securities count sheets to investment ledger.
_____1.

Has dividend revenue been properly reflected in the

accounts?

_____2.

Are securities properly classified as to current or

noncurrent?

_____3.

Have liabilities and capital stock transactions been

properly authorized

_____4.

Have details relating to preferred and common stock been

adequately disclosed?

_____5.

Has unamortized discount on bonds payable been properly

determined and reflected in the financial statements?

_____6.

Are securities properly valued using the equity method?

_____7.

Have all securities examined been recorded?

_____8.

Do the securities purported to be owned by the client

exist?

_____9.

Have all loans been recorded?

_____10. Do any of the clients borrowing arrangements impose

restrictions on dividends or on additional
borrowing?
SOLUTION:
1.
2.
3.
4.
5.
6.

C
D
F
I
G
B

228

7.
8.
9.
10.

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

K
A
E
H

PROBLEM/ESSAY:
52. For each of the following situations, (1) identify the
financial statement effect(s) of the error or fraud, (2) describe
procedures enabling the auditor to detect the misstatement, and
(3) draft the audit adjustment(s) suggested by the procedures.
(a) An unsecured loan for $3.2 million was granted to Maria
Juarez, the chief executive officer of Compton, Inc., at the
beginning of 2002. On December 31, 2002, the company drew a
check for $3.2 million on Bank A for deposit in Bank B. The
transaction was recorded by a debit to cash in Bank B and a
credit to loans receivable-officers. The check was not listed
as outstanding on Bank A. It did appear as a credit on the
December 31 bank statement received from Bank B. On January 2,
2003, the company made a journal entry debiting loans
receivable-officers and crediting cash in Bank A for $3.2
million. The loan accounted for 35% of the entitys total assets.
(b) George Luminas, chief executive officer of Jako
Manufacturing, used a wholly-owned subsidiary to channel funds
for his personal use. To effect the transfer, he had the
subsidiary borrow money by issuing notes guaranteed by Jako to
various banks. The borrowed funds, $2,300,000, were then
transferred to Jako and Jako made cash advances of $1,200,000 to
the subsidiary which then transferred the funds to Luminas in the
form of unsecured loans. The transfers from the subsidiary to
Jako were recorded as customer deposits and the advances from
Jako to the subsidiary were debited to the customer deposits
account. To avoid auditor detection of the economic substance of
these transactions, Jako did not include the subsidiary in its
consolidated financial statements; nor did the company inform the
auditors of the existence of either the subsidiary or the loan
guarantee. These are the only transactions completed by the
subsidiary during the year under audit. The following balances
appear on the books of Jako and the wholly-owned subsidiary:
Jako:
Customer Deposits
$1,100,000 credit
Subsidiary: Notes Payable-Banks
$2,300,000 credit
Receivable from Parent
$2,300,000 debit
Payable to Parent
$1,200,000 credit
Receivable from Officers
$1,200,000 debit

229

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

SOLUTION:
(a)
(1) This set of journal entries is an example of fraudulent
misrepresentation in the form of kiting and the effect is to
overstate cash in bank and understate loans receivable.
(2) The auditors should detect the fraud by obtaining
cutoff bank statements from both banks and performing analysis of
interbank transfers for a few days before and after the balance
sheet date.
(3) Recommended audit adjustment:
Loans receivable-officers
Cash in Bank A

$3,200,000
$3,200,000

(b)
(1) In addition to misrepresenting Jakos financial
position, these transactions constitute misappropriation fraud by
the CEO, assuming Luminas has no intention of repaying the loans.
The effect is to understate loans payable to banks - given the
loan guarantee and the lack of subsidiary financial resources,
these are really loans made by the banks to Jako. Loans
receivable from officers is also understated.
(2) The following auditing procedures should identify the
related party and related party transactions:
a. Examination of directors minutes should reveal
authorization to establish the subsidiary.
b. Analysis of the customer deposits account and
confirmation of balances with customers should disclose the
substance of this account.
c. Bank confirmation letters expressly requesting
information regarding any existing loan guarantees should enable
the auditors to detect the loans.
(3)
Recommended audit adjustment:
Customer deposits
Receivable from officers
Notes payable-banks

$1,100,000
$1,200,000
$2,300,000

53. Assume that you are the audit manager in charge of the Gregs
Auto Parts audit, and that Sara Engles, the in-charge senior

230

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle

auditor, has presented you with an "open items" audit workpaper

describing the following unresolved issues:
1.
Gregs Auto Parts, as of March 31, 2003, its
fiscal year-end, had inventory on consignment in the
warehouse of its principal customer in Dallas awaiting
sale during the Spring buying season. Engles had the
client request the customer to confirm the existence
and ownership of the inventory, but a reply has not
been received as of the close of audit field work, May
17, 2003. The goods represent 11% of the total
finished goods inventory.
2.
Engles requested a copy of the debt restructuring
agreement that would permit reclassifying certain
current liabilities as short-term obligations expected
to be refinanced. The copy was not received as of the
close of audit field work. If not reclassified, Gregs
balance sheet will show a current ratio of 1:1 and a
quick ratio of 1:2.
3.
A loan to Ben Williams, Gregs Auto Parts chief
executive officer, is purportedly secured by collateral
consisting of negotiable securities. As of the close
of audit field work, Engles has yet to examine this
collateral. A request for brokers confirmation has
not been received. The loan is classified as a current
asset and represents 20% of total current assets.
Required:
a. For each of the open items described above, identify the
primary audit risk if the issue is not satisfactorily resolved.
b. How would you resolve each item (i.e., what audit
procedure(s) would you recommend?)
SOLUTION:
1.
RISK: If the inventory does not exist, or if it is not
owned by Gregs Auto Parts, ending inventory and net income will
be overstated.
AUDITING PROCEDURES: Ask the client to request the
customer to return the confirmation. Also arrange to have
correspondent auditors in Dallas inspect the inventory on a test
basis.
2.
RISK: If the debt has not been restructured, the
auditors, given the current and quick ratios, may need to add a

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paragraph to their audit report expressing doubt as to the

ability of Gregs Auto Parts to continue as a going concern.
AUDITING PROCEDURES: Ask the client to request the
creditor to confirm the existence of the agreement directly to
the auditors along with a signed copy of the agreement.
3.
RISK: If this is in reality an unsecured loan, and if
Williams is either unable or unwilling to repay it promptly, the
clients current debt paying ability becomes even more
precarious.
AUDITING PROCEDURES: Arrange for inspection of the
securities either by Engles or by correspondent auditors if the
broker is located some distance from the clients headquarters.