Learning Questions and Answers for Financial Accounting, Lesson 6.2 – Mastery Level

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1

Here is a list of essential questions covering Sections Three, Four, and Five of Chapter Six. If you have studied this material sufficiently, you may already be able to answer the questions below. Where that is not the case, study the answers that follow. Then, practice by going through the questions again.

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Repeat the process until you have a strong understanding of how each question should be addressed. The business world is not random. It works in a designed fashion. Learning something new always takes a bit of effort but knowledge is a worthy goal.

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(1) – The CPA firm of Abernethy and Chapman is auditing the financial statements of Lenoir Corporation. The goal is for the independent auditors to provide reasonable assurance that these statements are presented fairly according to U.S. GAAP. In other words, the statements contain no material misstatements. Why does the independent auditor only provide reasonable assurance and not perfect, or absolute, assurance?

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(2) – The Valdese Supply Company (VSC) buys and sells hammers. The accountant for VSC has produced a balance sheet that reports the company is holding 700 hammers at the end of the year having a cost of $20 each for a reported asset balance of $14,000. The CPA firm of Smith & Brown has been hired to perform an audit. The independent auditors are currently examining the inventory account with its $14,000 balance. What are some possible testing procedures that the auditing team might perform to gain evidence that no material misstatements exist in that reported figure?

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(3) – The Valdese Supply Company (VSC) makes sales and often receives cash. This money is counted at the end of each day and deposited in the local bank. The accountant then makes a journal entry debiting cash for the amount collected and crediting sales revenue. What is meant by the term internal controls?

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(4) – The Valdese Supply Company (VSC) is being audited by the CPA firm of Brandon, Wilson, and Ng. The firm is especially interested in the possibility of material misstatements in accounts receivable and in inventory because those two balances are particularly large. Early in the examination, the independent auditors spend time determining what internal controls existed in connection with each of these accounts and judged how well those controls were followed. Why did the auditors do this investigation?

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(5) – In (4), assume that the independent auditors spend 8 hours accumulating evidence to verify that the accounts receivable balance contains no material misstatements. In contrast, they spend nearly 30 hours gathering evidence about the inventory account. The balances are both large so their comparative size is not the reason for this difference in audit effort. Why might the independent auditors have spent so much more time investigating inventory?

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(6) – An independent audit firm performs an audit examination on a publicly-traded company. At the end of the examination, how are the audit results conveyed to interested parties?

(7) – An independent auditor is hired by a company to perform an audit of its financial statements. To whom is the audit report addressed?

(8) – Normally in an audit report, the independent auditor can provide either an unqualified opinion or a qualified opinion. In simple terms, what is the difference in these two types of audit reports?

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(9) – Typically, there are two types of qualified audit opinions. What are they?

(10) – An independent auditor is examining the financial statements of Ace Company and finds a misstatement that is viewed as material. The auditor then prepares a qualified audit report indicating the problem that was found. Why is this outcome not likely to happen?

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All of these questions describe the world of financial reporting that operates in the U.S. each day. This world has been designed to help decision makers have confidence that the financial information that they receive is free of material misstatements (according to the rules of U.S. GAAP) so that they will be comfortable making investing and lending decisions even for amounts of money that can be truly significant.

Read each of the following answers carefully, paying close attention to any that you might have missed.

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(1) – The CPA firm of Abernethy and Chapman is auditing the financial statements of Lenoir Corporation. The goal is for the independent auditors to provide reasonable assurance that these statements are presented fairly according to U.S. GAAP. In other words, the statements contain no material misstatements. Why does the independent auditor only provide reasonable assurance and not perfect, or absolute, assurance?

A number of practical reasons exist in an audit that make perfect assurance an unattainable goal. First, financial statements contain many estimates. Auditors have no way to ensure the exact accuracy of those numbers. No one can give perfect assurance about an estimate. Second, companies have an enormous number of transactions each year. It is not feasible that any auditor can verify the validity of each of those events. The time and cost would be prohibitive. Thus, some amount of testing is necessary where the auditor looks at only a representative sample of the transactions. With such testing, absolute assurance becomes impossible. The auditor could always miss something in the transactions that were not examined. Third, educated decision makers should understand the level of assurance they are getting and factor that uncertainty into their analysis. Reasonable assurance that the statements contain no material misstatements is the best they can expect to receive.

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(2) – The Valdese Supply Company (VSC) buys and sells hammers. The accountant for VSC has produced a balance sheet that reports the company is holding 700 hammers at the end of the year having a cost of $20 each for a reported asset balance of $14,000. The CPA firm of Smith & Brown has been hired to perform an audit. The independent auditors are currently examining the inventory account with its $14,000 balance. What are some possible testing procedures that the auditing team might perform to gain evidence that no material misstatements exist in that reported figure?

Even if you have never been on an audit, you should be able to come up with a few ways to verify that this balance is presented fairly. Auditing is not as mysterious as it might seem. In this audit, that might mean that an auditor does a test count of the inventory to make sure there really are 700 hammers. Another member of the audit team might look at purchase receipts to see if the hammers were actually bought for a cost of $20 each. One of the independent auditors might examine the hammers to make certain that they were not old or damaged and, thus, could not be sold while another person looks at sales documents to see if any of the hammers have already been sold and not yet delivered. There are many such tests that are normally performed. The independent audit team keeps working until the members believe they have gained sufficient evidence that enable them to provide reasonable assurance that the reported inventory balance of 700 hammers costing $20 each for a total of $14,000 does not contain any material misstatements.

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(3) – The Valdese Supply Company (VSC) makes sales and often receives cash. This money is counted at the end of each day and deposited in the local bank. The accountant then makes a journal entry debiting cash for the amount collected and crediting sales revenue. What is meant by the term internal controls?

Here, VSC has a system in place for its daily cash receipts. Internal controls are any policies or procedures that make sure the system works as intended. Perhaps, for example, two people count the money to make sure that one person alone cannot steal some of the cash. They might compare the amount of cash to a cash register tape or to sales receipts to be certain the correct amount of money is present. A third person might also check with the bank the following day to verify that the money was deposited appropriately. These extra requirements are not absolutely necessary. One person alone could count the money, assume it was the right amount, take it to the bank, and make the journal entry. Nevertheless, chances that the company’s cash is safeguarded and secure is increased by the presence of these extra policies and procedures. In addition, the accounting records are more likely to be accurate when a specific operating system has been well designed to include such internal controls and they are followed properly by the employees.

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(4) – The Valdese Supply Company (VSC) is being audited by the CPA firm of Brandon, Wilson, and Ng. The firm is especially interested in the possibility of material misstatements in accounts receivable and in inventory because those two balances are particularly large. Early in the examination, the independent auditors spend time determining what internal controls existed in connection with each of these accounts and judged how well those controls were followed. Why did the auditors do this investigation?

If the internal controls associated with an account are well designed and the employees are following those controls carefully, the possibility of a material misstatement is low and the amount of audit evidence that needs to be gathered can be reduced. In contrast, if internal control is poorly designed or if employees simply ignore the procedures and policies, the chance of a material misstatement is considerably higher. To compensate for that added risk, the auditors will need to gather more evidence to support the assertion that the reported numbers are presented fairly according to U.S. GAAP.

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(5) – In (4), assume that the independent auditors spend 8 hours accumulating evidence to verify that the accounts receivable balance contains no material misstatements. In contrast, they spend nearly 30 hours gathering evidence about the inventory account. The balances are both large so their comparative size is not the reason for this difference in audit effort. Why might the independent auditors have spent so much more time investigating inventory?

The easiest speculation here is that the internal controls surrounding accounts receivable were especially good. They were well designed and the employees involved understood them and followed them. The chance for a material misstatement was less. In contrast, the internal controls for inventory might have appeared weaker. Perhaps the system contains design flaws or the employees simply ignore the policies and procedures. To compensate for those internal control problems, the independent auditor apparently felt that a higher degree of testing was needed in order to provide reasonable assurance of no material misstatements.

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(6) – An independent audit firm performs an audit examination on a publicly-traded company. At the end of the examination, how are the audit results conveyed to interested parties?

Upon completion of the engagement, the independent auditor provides an audit report. This report is then attached to the financial statements so that any interested party can read the auditor’s opinion and take that into consideration when analyzing the information.

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(7) – An independent auditor is hired by a company to perform an audit of its financial statements. To whom is the audit report addressed?

Although the independent auditor is hired by the company, the audit report is normally addressed to the company’s board of directors. That group serves as the official representatives of the stockholders. The board members are elected to oversee the company and its management. In that role, they represent outside parties and are the initial recipients of the audit report.

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(8) – Normally in an audit report, the independent auditor can provide either an unqualified opinion or a qualified opinion. In simple terms, what is the difference in these two types of audit reports?

An unqualified opinion states that the independent auditor is providing reasonable assurance that the financial statements as a whole are presented fairly according to U.S. GAAP. That, as we know, means the auditor is providing reasonable assurance that the financial statements contain no material misstatements and can, therefore, be trusted by decision makers when making business decisions. A qualified opinion means that the auditor is not able to provide reasonable assurance that the financial statements as a whole are presented fairly according to U.S. GAAP. In those cases, the auditor must explain the problem that was encountered and the level of assurance that is provided.

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(9) – Typically, there are two types of qualified audit opinions. What are they?

First, the auditor might not have been able to gain sufficient evidence about some specific area of the financial statements. Some problem might have arisen to prevent the auditor from doing the necessary testing. In that case, the auditor gives reasonable assurance about the rest of the financial statements but provides no assurance about the element where sufficient evidence was not available. Second, the auditor might well have found a material misstatement in some area of the financial statements. In most cases, the auditor can still give reasonable assurance about the rest of the financial statements while spelling out the misstatement and indicating its effect.

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(10) – An independent auditor is examining the financial statements of Ace Company and finds a misstatement that is viewed as material. The auditor then prepares a qualified audit report indicating the problem that was found. Why is this outcome not likely to happen?

Receiving a qualified audit report because of a material misstatement is viewed so negatively by the public that the company is very likely to correct the problem and fix the misstatement. No company wants to issue financial statements that an expert (the independent auditor) has said are incorrect. The pressure on the company to alleviate the problem is enormous. The management of the reporting company will likely keep working until the financial statements no longer contain a material misstatement.

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This information might all be new to you. Many students have never been exposed to financial markets and how they are structured. However, there is an important difference between new knowledge and complicated knowledge. With a little thought, none of these questions is beyond your understanding. Yes, the information might be new but you certainly have the ability to answer these questions with some work and repetition.

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