Chapter 4 Audit Evidence and Audit Programs

36

Audit Evidence and Audit Programs

MULTIPLE CHOICE:
1.

The permanent file section of the working papers that is

kept for each audit client most likely contains
a.
Review notes pertaining to questions and comments
regarding the audit work performed.
b.
A schedule of time spent on the engagement by each
individual auditor.
c.
Correspondence with the client's legal counsel
concerning pending litigation.
d.
Narrative descriptions of the client's internal control
policies and procedures
ANSWER:

2.

Of the following procedures, which is not considered part of

obtaining an understanding of the clients environment?
a.
Examining trade publications to gain a better
understanding of the client's industry.
b.
Confirming customer accounts receivable for existence
and valuation.
c.
Touring the client's manufacturing and warehousing
facilities to gain a clearer understanding of
operations.
d.
Studying the internal controls over cash receipts and
disbursements.
ANSWER:

3.

If working papers are to have the characteristics that will

ensure that they achieve their primary purposes, which of
the following is the most important?
a.
Working papers must be of standard format and standard
content.
b.
Working papers must be properly indexed and crossreferenced to the draft audit report.
c.
Working papers must provide sufficient, competent, and
useful information to support the audit report.
d.
Working papers must be arranged in logical order
following the audit program sequence.
ANSWER:

37

4.

Chapter 4 Audit Evidence and Audit Programs

Which of the following is not an example of analytical
evidence?
a.
Compared inventory turnover by major class with the
prior year on a monthly and quarterly basis.
b.
Compared gross profit percentages by major product
classes with the prior year.
c.
Examined invoices for plant asset additions to
determine whether the client had erroneously recorded
ordinary repairs as plant assets.
d.
Examined monthly performance reports and investigated
significant variations from budgeted amounts.
ANSWER:

5.

Choose the best illustration of objective audit evidence

from the following
a.
The paid invoice file containing invoices matched with
receiving reports and purchase orders.
b.
Management's assertion that payment procedures require
matching of invoice with receiving report and purchase
order.
c.
Clerical staff assurances that management policy
regarding payment of invoices--matching of invoice with
receiving report and purchase order--is always
followed.
d.
The treasurer's statement of not remembering any
exceptions in which an invoice was submitted for
payment that was not accompanied by a matching
receiving report and purchase order.
ANSWER:

6.

An initial (first-time) audit requires more audit time to

complete than a recurring audit. One of the reasons for
this is that
a.
New auditors are usually assigned to an initial audit.
b.
Predecessor auditors need to be consulted.
c.
The client's business, industry, and internal control
are unfamiliar to the auditor and need to be carefully
studied.
d.
A larger proportion of customer accounts receivable
need to be confirmed on an initial audit.
ANSWER:

Chapter 4 Audit Evidence and Audit Programs

7.

Which of the following is a basic tool used by the auditor

to control the audit work and review the progress of the
audit?
a.
Time and expense summary.
b.
Engagement letter.
c.
Progress flowchart.
d.
Audit program.
ANSWER:

8.

Of the following audit procedures, which best supports the

valuation objective?
a.
Performing a lower of cost or market test of the
client's inventories.
b.
Reviewing a contingent liability footnote for proper
wording.
c.
Searching for unrecorded liabilities.
d.
Observing the client's year-end physical inventory
taking.
ANSWER:

11.

As part of audit planning, CPAs should design audit programs

for each individual audit and should include audit steps and
procedures to
a.
Detect and eliminate fraud.
b.
Increase the amount of management information
available.
c.
Provide assurances that the objectives of the audit are
met.
d.
Ensure that only material items are audited.
ANSWER:

10.

An auditor wants to develop an audit test to evaluate the

reasonableness of the quantity of scrap material resulting
from a certain production process compared to industry
standards.
Which would be the most competent type of
evidence available to satisfy this objective?
a.
Documentary.
b.
Hearsay.
c.
Physical.
d.
Analytical.
ANSWER:

9.

38

An assumption underlying analytical procedures is that

39

Chapter 4 Audit Evidence and Audit Programs

a.
b.
c.
d.

These procedures cannot replace tests of balances and

transactions.
Statistical tests of financial information may lead to
the discovery of material errors in the financial
statements.
The study of financial ratios is an acceptable
alternative to the investigation of unusual
fluctuations.
Relationships among data may reasonably be expected to
exist and continue in the absence of known conditions
to the contrary.

ANSWER:
12.

An auditor is examining accounts receivable. What is the

most competent type of evidence in this situation?
a.
Interviewing the personnel who record accounts
receivable.
b.
Verifying that postings to the receivable account from
journals have been made.
c.
Receipt by the auditor of a positive confirmation.
d.
No response received for a request for a negative
confirmation.
ANSWER:

13.

With respect to the auditor's planning of a year-end

examination, which of the following statements is always
true?
a.
An engagement should not be accepted after the fiscal
year-end.
b.
An inventory count must be observed at the balance
sheet date.
c.
The client's audit committee should not be told of the
specific audit procedures that will be performed.
d.
It is an acceptable practice to carry out substantial
parts of the examination at interim dates.
ANSWER:

14.

A letter to the auditor in response to an inquiry is an

example of
a.
Physical evidence.
b.
Confirmation evidence.
c.
Documentary evidence.
d.
Analytical evidence.

Chapter 4 Audit Evidence and Audit Programs

ANSWER:
15.

The procedures specifically outlined in an audit program are

primarily designed to
a.
Protect the auditor in the event of litigation.
b.
Detect errors or fraud.
c.
Test internal evidence.
d.
Gather evidence.
ANSWER:

18.

Which of the following factors is most important in

determining the competence of audit evidence?
a.
The reliability of the evidence in meeting the audit
objective.
b.
The objectivity of the auditor gathering the evidence.
c.
The quantity of the evidence obtained.
d.
The independence of the source of evidence.
ANSWER:

17.

Which of the following statements about working papers is

correct?
a.
Working papers are not permitted to be used as a
reference source by the client.
b.
The auditor should document the understanding of the
client's internal control obtained to plan the audit
c.
Working papers may be regarded as a substitute for
the client's accounting records.
d.
When reporting on comparative financial statements,
the independent auditor may discard working
papers after two years.
ANSWER:

16.

40

When reviewing audit working papers, the primary

responsibility of an audit supervisor is to determine
that:
a.
Each worksheet is properly identified with a
descriptive heading.
b.
Working papers are properly referenced and kept in
logical groupings.
c.
Standard departmental procedures are adhered to with
regard to work paper preparation and technique.
d.
Working papers adequately support the audit findings,
conclusions, and report.

41

Chapter 4 Audit Evidence and Audit Programs

ANSWER:

19.

Auditors apply analytical procedures to the client's

operations in order to identify
a.
Improper separation of accounting and other financial
duties.
b.
Weaknesses of a material nature in the client's
internal control.
c.
Unusual transactions.
d.
Noncompliance with prescribed control procedures.
ANSWER:

20.

The in-charge auditor decides that work papers are complete

a.
When satisfied that the audit objectives have been met
and the working papers support the conclusions.
b.
When working papers make reference to the steps
outlined in the audit program.
c.
Only after the auditor who prepared the working papers
has signed and dated them.
d.
When proper cross-references to other working papers
are noted.
ANSWER:

22.

Which of the following workpapers would one normally expect

to find in the permanent file?
a.
A copy of a long-term bond indenture.
b.
The working trial balance.
c.
An analysis of additions and disposals relating to
marketable securities.
d.
A workpaper analyzing customer replies to confirmation
requests.
ANSWER:

21.

Of the following procedures, which does not produce

analytical evidence?
a.
Compare revenue, cost of sales, and gross profit with
the prior year and investigate significant variations.
b.
Examine monthly performance reports and investigate
significant revenue and expense variances.
c.
Confirm customers' accounts receivable and clear all
material exceptions.
d.
Compare sales trends and profit margins with industry
averages and investigate significant differences.

42

Chapter 4 Audit Evidence and Audit Programs

ANSWER:
23.

Audit evidence can come in different forms with different

degrees of persuasiveness. Which of the following is the
least persuasive type of evidence?
a.
Documents mailed by outsiders to the auditor.
b.
Correspondence between the auditor and vendors.
c.
Sales invoices inspected by the auditor.
d.
Computations made by the auditor.
ANSWER:

24.

Analytical procedures are

a.
Substantive tests designed to evaluate a system of
internal control.
b.
Tests of control procedures designed to evaluate the
validity of management's representation letter.
c.
Substantive tests designed to evaluate the
reasonableness of financial information.
d.
Tests of control procedures designed to detect errors
in reported financial information.
ANSWER:

25. Which of the following statements relating to the

competence of evidential matter is always true?
a.
Evidential matter gathered by an auditor from
outside an enterprise is reliable.
b.
Accounting data developed under satisfactory conditions
of internal control are more relevant than data
developed under unsatisfactory internal control
conditions.
c.
Oral representations made by management are not valid
evidence.
d.
Evidence gathered by auditors must be both valid and
relevant to be considered competent.
ANSWER:
26.

An auditor test counted a batch of inventory.

example of what kind of evidence?
a.
Analytical.
b.
Documentary.
c.
Physical.
d.
Hearsay.
ANSWER:

This is an

43

27.

Chapter 4 Audit Evidence and Audit Programs

In evaluating the reasonableness of advertising expense,

which of the following would be the best evidence?
a.
Oral evidence obtained through discussions with company
marketing executives and representatives of the
advertising agency retained.
b.
Documentary evidence obtained by vouching charges to
the account and by retracing charges from source
documents to the account.
c.
Analytical evidence developed by comparing the ratio of
advertising expenses to sales with historical data for
the company and industry.
d.
Arithmetical evidence developed by re-computing charges
submitted by the advertising agency and paid by the
company.
ANSWER:

28.

Which of the following is not a consideration in the

development of audit programs?
a.
Internal control over the recording of plant asset
additions and repairs and maintenance expenditures is
found to be weak.
b.
The client constructed a major addition to its central
manufacturing facility during the year under audit.
c.
The client is a private university located in the
Midwest.
d.
The client's board or directors is elected by the
stockholders at the annual meeting.
ANSWER:

29.

Audit working papers are used to record the results of the

auditor's evidence-gathering procedures. When preparing
working papers, the auditor should remember that working
papers should be
a.
Kept on the client's premises so that the client can
have access to them for reference purposes.
b.
The primary support for the financial statements
being examined.
c.
Considered as a part of the client's accounting records
that are retained by the auditor.
d.
Designed to meet the circumstances and the auditor's
needs on each engagement.
ANSWER:

Chapter 4 Audit Evidence and Audit Programs

30.

The main advantage of properly indexed working papers is to

a.
Reduce the size of the file.
b.
Better organize the working papers.
c.
Allow division of labor within the audit team.
d.
Facilitate the efficient use of audit staff.
ANSWER:

31.

Which of the following is not a typical analytical

procedure?
a.
Study of relationships of financial information with
relevant nonfinancial information.
b.
Comparison of financial information with similar
information regarding the industry in which the entity
operates.
c.
Comparison of recorded amounts of major disbursements
with appropriate invoices.
d.
Comparison of recorded amounts of major disbursements
with budgeted amounts.
ANSWER:

32.

44

Which of the following is an example of inferential

evidence?
a.
The auditor observes the taking of the client's
physical inventory and performs test counts.
b.
The auditor inspects marketable securities for
existence.
c.
An auditor, who notes that customer accounts receivable
have increased significantly in the current year as a
percentage of sales, suspects that a larger proportion
of the accounts will prove uncollectible.
d.
The auditor counts cash on hand at year-end.
ANSWER:

33.

Which of the following would be least likely to be

comparable between similar corporations in the same
industry line of business?
a.
Earnings per share.
b.
Return on total assets before interest and taxes.
c.
Accounts receivable turnover.
d.
Operating cycle.
ANSWER:

45

34.

Chapter 4 Audit Evidence and Audit Programs

Which of the following is not an example of confirmation
evidence?
a.
Requesting the client's outside legal counsel to
evaluate the possible outcome of pending litigation.
b.
Questioning the client's employees about existing
internal control policies and procedures.
c.
Requesting the client's customers to verify year-end
accounts receivable balances.
d.
Requesting payees to respond in writing to the terms
contained in notes payable appearing in the client's
ledger.
ANSWER:

35.

A CPA, in performing an independent audit, would most likely

use recalculation as a substantive test for which of the
following expense-related accounts?
a.
Purchases of supplies.
b.
Interest expense.
c.
Advertising expense.
d.
Repairs and maintenance expense.
ANSWER:

36.

During the course of an audit engagement, an auditor

prepares and accumulates audit working papers. The
primary
purpose of the audit working papers is to
a.
Aid the auditor in adequately planning his work.
b.
Provide a point of reference for future audit
engagements.
c.
Support the underlying concepts included in the
preparation of the basic financial statements.
d.
Support the auditor's opinion.
ANSWER:
37.

Which of the following is not an appropriate auditing

procedure supporting fairness of financial presentation?
a.
Inspecting plant asset additions for existence.
b.
Recalculating accrued interest on notes payable.
c.
Examining invoices in support of legal fees recorded
during the fiscal year.
d.
Reviewing the client's production quality control
program.
ANSWER:

Chapter 4 Audit Evidence and Audit Programs

38.

Sales commissions as a percentage of sales declined

significantly during the year under audit. Of the following
possible causes, the most likely is
a.
Sales increased during the year.
b.
The sales force was reduced at the end of the year.
c.
Sales commission rates were increased at the beginning
of the year.
d.
Fictitious sales were recorded at year-end to inflate
earnings. Commissions were not recorded on these
sales.
ANSWER:

39.

Which of the following is responsible for the fairness of

the representations made in financial statements?
a.
Client's management.
b.
Independent auditor.
c.
Audit committee.
d.
AICPA.
ANSWER:

40.

46

An audit program provides proof that

a.
Sufficient competent evidential matter was obtained.
b.
The work was adequately planned.
c.
There was compliance with generally accepted standards
of reporting.
d.
There was a proper study and evaluation of internal
control.
ANSWER:

41. Which of the following ultimately determines the specific

audit procedures necessary to provide an independent
auditor with a reasonable basis for the expression of an
opinion?
a.
The audit program.
b.
The auditor's judgment.
c.
Generally accepted auditing standards.
d.
The auditor's working papers.
ANSWER:
42.

During the working paper review, an audit supervisor finds

that the auditor's reported findings are not adequately
cross-referenced to supporting documentation. The

47

Chapter 4 Audit Evidence and Audit Programs

supervisor will most likely instruct the auditor

to
a.
b.
c.
d.

Prepare a working paper to indicate that the full scope

of the audit was carried out.
Familiarize him/herself with the sequence of working
papers so that he(she) will be able to answer questions
about the conclusions stated in the report.
Eliminate any cross-references to other working papers
since the system is unclear.
Provide a workpaper indexing system that shows the
relationship between findings, conclusions, and the
related facts.

ANSWER:
43.

Which of the following would be the most relevant form of

evidence to evaluate the reasonableness of account balances?
a.
Analytical.
b.
Documentary.
c.
Physical.
d.
Hearsay.
ANSWER:

44.

Most of the independent auditor's work in formulating an

opinion on the financial statements consists of
a.
Studying and evaluating internal control.
b.
Obtaining and examining evidential matter.
c.
Examining cash transactions.
d.
Comparing recorded accountability with assets.
ANSWER:

46.

Generally, what source of evidence should most impact audit

conclusions?
a.
External
b.
Inquiry.
c.
Oral.
d.
Informal.
ANSWER:

45.

During an audit of the accounts receivable function, you

found that the accounts receivable turnover rate had
fallen
from 7.3 to 4.3 over the last three years. What is the
most
likely cause of the decrease in the turnover rate?

Chapter 4 Audit Evidence and Audit Programs

a.
b.
c.
d.

An increase in the discount offered for early payment.

A more liberal credit policy.
A change from net 30 to net 25.
Greater cash sales.

ANSWER:
47.

Which of the following does not describe one of the

functions of audit workpapers?
a.
Facilitates third-party reviews.
b.
Aids in the planning, performance, and review of
audits.
c.
Provides the principal evidential support for the
auditor's report.
d.
Aids in the professional development of the operating
staff.
ANSWER:

50.

To test for unsupported entries in the ledger, the

direction of audit testing should be from the
a.
Ledger entries.
b.
Journal entries.
c.
Externally generated documents.
d.
Original source documents.
ANSWER:

49.

Which of the following is generally included or shown in the

auditor's working papers?
a.
The procedures used by the auditor to verify the
personal financial status of members of the client's
management team.
b.
Analyses that are designed to be a part of, or a
substitute for, the client's accounting records.
c.
Excerpts from authoritative pronouncements that support
the underlying generally accepted accounting principles
used in preparing the financial statements.
d.
The manner in which exceptions and unusual matters
disclosed by the auditor's procedures were resolved or
treated.
ANSWER:

48.

48

The principal reason for developing a written audit program

is to help assure that the
a.
Audit work is properly supervised.

49

Chapter 4 Audit Evidence and Audit Programs

b.
c.
d.

Audit work is properly planned and documented.

Audit report contains only significant findings.
Work of different auditors is properly coordinated.

ANSWER:
51.

One of the primary roles of an audit program is to:

a.
Serve as a tool for planning, directing, and
controlling audit work.
b.
Document an auditor's understanding of the internal
control.
c.
Provide for a standardized approach to the audit
engagement.
d.
Delineate the audit risk accepted by the auditor.
ANSWER:

52.

Audit information is generally considered relevant when it

is:
a.
Derived through valid statistical sampling.
b.
Objective and unbiased.
c.
Factual, adequate, and convincing.
d.
Consistent with the audit objectives.
ANSWER:

54.

The principal purpose for cross-indexing audit working

papers is to
a.
Give the working papers a professional appearance.
b.
Explain the use of tick marks.
c.
Provide explanation of the audit steps performed.
d.
Provide a trail for the auditor and the reviewer.
ANSWER:

53.

External auditors often confirm assertions contained in the

organization's financial statements and accounting records
with third parties. Which of the following best
explains
why confirmation produces evidence of high
quality?
a.
Written assertions from knowledgeable third parties
provide sufficient evidence to achieve most audit
objectives.
b.
Confirmation by knowledgeable third parties is usually
the most relevant evidence available.
c.
Confirmation by knowledgeable third parties is usually
the least costly evidence available.

Chapter 4 Audit Evidence and Audit Programs

d.

50

Confirmation by knowledgeable third parties is highly

competent because of its independent source.

ANSWER:

55.

As a category of evidence, documents may be external or

internal. As an auditor reviewing your client's
accounts
receivable, which of the following is an example of internal
documentary evidence?
a.
The carrier's bill of lading.
b.
Sales invoice copies.
c.
A customer's purchase order.
d.
A vendor's month-end statement.
ANSWER:

COMPLETION:
56.

Audit programs can be developed only after the auditor has

completed the audit _______________ process.
ANSWER:

57.

PLANNING

An auditor who gathers increased quantities of evidence for

larger account balances is observing the standard relating
to
of audit evidence.
ANSWER: SUFFICIENCY

58.

An auditor who gathers increased amounts of external

evidence under conditions of weak internal control is
observing the standard of
of audit evidence.
ANSWER:

59.

In performing substantive audit tests, focusing on the

existence or occurrence objective helps locate misstatements
due to
while the completeness objective
directs audit attention to misstatements due to
.
ANSWER:

60.

COMPETENCE (VALIDITY)

COMMISSION, OMISSION

Evidence consisting of everything that can be counted,

examined, observed, or inspected is referred to as
_____________ evidence.

51

Chapter 4 Audit Evidence and Audit Programs

ANSWER:

61.

The audit trail consists of that stream of evidence that

enables the auditor to trace a transaction or event forward
from its inception to the appropriate ledger account, or
conversely, vouch a transaction backward from the ledger
account to the inception of the transaction or event. For
the audit trail to exist, transactions must be
.
ANSWER:

62.

of evidence
that auditors'
are often first
procedures.

COMPLETENESS

MATHEMATICAL

A group of related transactions affecting essentially the

same set of general ledger accounts is referred to as a
_________________
.
ANSWER:

65.

evidence may be the best form

the
objective, in
concerning errors of omission
the application of analytical

An auditor-prepared bank reconciliation is an example of

_______________ evidence.
ANSWER:

64.

DOCUMENTED

Analytical
supporting
suspicions
aroused by
ANSWER:

63.

PHYSICAL

TRANSACTION CYCLE

The focal point of the current file is the ____________

_______________ ______________ often referred to as a table
of contents.
ANSWER:

WORKING TRIAL BALANCE

MATCHING:
66. For each of the listed auditing procedures, indicate, by
letter, the type of evidence it represents.
a.
b.
c.
d.
e.
f.

Physical evidence
Confirmation evidence
Documentary evidence
Analytical evidence
Mathematical evidence
Hearsay evidence

52

Chapter 4 Audit Evidence and Audit Programs

____ 1. Audited client-prepared bank reconciliation
____ 2. Vouched debits to repairs accounts by examining
invoices

vendors

____ 3. Observed the clients year-end physical inventory

____ 4. Compared accounts receivable turnover with industry
average
____ 5. Prepared ten-year income summary expressing all
components as a percentage of sales
____ 6. Obtained letter from clients outside legal counsel
regarding pending litigation
____ 7. Inquired of corporate treasurer as to reason(s) for
acquiring marketable securities
____ 8. Calculated year-end interest accrual and compared
with general ledger balance
____ 9. Obtained replies directly from customers concerning
the correctness of clients recorded year-end accounts
receivable balances
____ 10.Examined securities purportedly owned by the client and
held by local brokers
____ 11.Compared operating cash flows with net income and
identified causes of significant disparities.
SOLUTION:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
67.

e
c
a
d
d
b
f
e
b
a
d

For each of the listed procedures, indicate, by letter, the

53

Chapter 4 Audit Evidence and Audit Programs

assertion(s) being tested.

a.
b.
c.
d.
e.

Existence or occurrence
Completeness
Rights and obligations
Valuation or allocation
Presentation and disclosure

____ 1. Confirmed customer accounts receivable

____ 2. Vouched property additions to underlying
documentation consisting of vendors invoices and
work orders
____ 3. Inquired of corporate treasurer as to reasons for
buying and holding securities
____ 4.

Selected a sample of bills of lading representing

shipments to customers and traced to sales invoices
to determine that all shipments have been billed to
customers

____ 5.

Examined vendors invoices recorded after year-end to

determine whether any of these invoices represent
liabilities of the client as of year-end

____ 6.

Obtained confirmation of marketable securities from

clients brokers

____ 7.

Evaluated the reasonableness of the clients

depreciation policy

____ 8.

Obtained letter from clients outside legal counsel

regarding pending litigation

____ 9.

Inspected recorded addition to client materials

handling facilities

____ 10. Investigated decrease in revenue from scrap sales as

revealed by the application of analytical
procedures
SOLUTION:
1.
2.
3.

a,d
d
e

Chapter 4 Audit Evidence and Audit Programs

4.
5.
6.
7.
8.
9.
10.

54

b
b,c
a,c,d
d
e
a
b

PROBLEM/ESSAY
68. For each of the following ledger accounts, give an example
of substance underlying the account balance:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Cash in bank
Sales revenue
Inventories
Accounts payable
Notes payable
Capital stock
Marketable securities
Operating expenses
Wages and salaries expense
Property, plant, and equipment

SOLUTION:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Bank statement, canceled checks, deposit tickets

Sales invoices, shipping documents, cash register tapes
Goods in warehouses, goods out on consignment
Vendors records of accounts receivable, vendors
invoices
Payees confirmation of amounts owed to them, copy of
note in clients files
Records maintained by registrar and transfer agent
Securities in vault or in safekeeping, brokers
advices, brokers confirmations
Vendors invoices, canceled checks, clients
workpapers supporting such charges as depreciation,
amortization, and product warranty
Payroll summaries, time cards, clock cards, canceled
checks, human resources records
Plant assets at various locations, vendors invoices

69. Audit evidence must be sufficient and competent. To be

competent, the evidence must be both valid and relevant.
Required:

55

Chapter 4 Audit Evidence and Audit Programs

a.
b.

What is meant by sufficient audit evidence?

Define the concepts of validity and relevance as they
relate to audit evidence.

SOLUTION:
a.
Sufficient audit evidence is evidence that is adequate
to support the auditors opinion on the financial statements. A
matter of audit judgment, sufficiency is usually based on
materiality and the adequacy of existing internal control.
b.
Validity of audit evidence is a function of three
qualities:
1) The independence and competence of the source of
the evidence (e.g., external evidence possesses
greater validity than internal evidence);
2) The conditions under which the evidence was
obtained (e.g., evidence produced by strong
internal control possesses greater validity
than evidence gathered under weak internal
control); and
3) The manner in which the evidence was obtained
(e.g., evidence obtained directly by the auditor
possesses greater validity than evidence obtained
indirectly).
Relevance means that the evidence pertains to specific audit
objectives. Observing the taking of the inventory, for example,
provides evidence concerning existence of the inventory, but is
not relevant to determining ownership.
70. The following operating data has been provided to Erica
Chavez by her audit client, Grimes Hardware. Sales commissions
average 6 percent of sales:
2002
Sales
$18,000
Cost of sales
10,000
Sales commissions
1,080
Gross profit
6,920
Operating expenses
3,200
Income before taxes
3,720
Income taxes
1,200
Net income
$2,520
=====
Required:

%
100%

2003

22,000
11,000
1 100
9,900
3,600
6,300
2,000
4,300
=====

100%

Change (%)
22%

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Chapter 4 Audit Evidence and Audit Programs

a. Complete the vertical and horizontal analysis by
calculating the correct percentages.

b.
Why are both vertical and horizontal analysis important
inputs to analytical procedures?
c.
Assuming sales commissions have been accurately
computed based on 2003 sales, what are the possible explanations
for any abnormalities produced by your percentage calculations?

SOLUTION:
a.
2002
Sales
$18,000
Cost of sales
10,000
Sales commissions
1,080
Gross profit
6,920
Operating expenses
3,200
Income before taxes
3,720
Income taxes
1,200
Net income
$2,520
=====

%
100%
56
6
38
17
21
7
14
==

2003

22,000
11,000
1,100
9,900
3,600
6,300
2,000
4,300
=====

100%
50
5
45
16
29
9
20
==

Change (%)
22%
10
2
43
13
69
67
71

b. Trend analysis (the Change column) examines changes in

data over time. Given the assumption that past trends may be
expected to continue into the future, significant changes warrant
further investigation. Vertical analysis (the first two
percentage columns), by expressing all components as percentages
of a common base (sales in this case), permits the auditors to
compare percentages with previously developed auditor
expectations. If, for example, the auditor has previously
determined that commissions average 6% of sales, he/she may wish
to investigate the lower rate reflected in 2003 results.
c.
If sales commissions are accurate and represent 6
percent of sales, the sales base must be overstated in order to
produce a commission rate of only 5 percent. Sales may have been
fabricated, or 2004 sales may have been recorded in 2003. The
material decline in cost of sales as a percentage of sales

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Chapter 4 Audit Evidence and Audit Programs

suggests that recorded sales transactions were not accompanied by

cost of sales entries.
71. The following financial data have been extracted from the
records of Blackwell Wholesale Tires:
2003

2002

Sales
$15,660
Cost of sales
7,800
Ending inventory
6,200
Accounts receivable-trade
2,200
Total current assets
12,300
Total current liabilities
7,300
Customer payment terms:
2/10;n/30
Industry averages:
Gross margin
51%
Current ratio
2:1
Inventory turnover
2.5
Accounts receivable turnover 11.0

14,980
7,400
4,300
1,300
10,100
4,980

Required:
Based on the above data, in which areas do you recommend
concentrating audit resources for the 2003 audit? Support your
answer by citing the relevant data.
SOLUTION:

Sales
Cost of sales
Gross margin

2003

2002

$15,660
7,800
7,860

14,980
7,400
5,580

50%

49%

Inventory and accounts receivable appear to warrant emphasis

for Blackwell Wholesale Tires. Although the gross margin has not
changed materially in 2003 relative to 2002 and approximates the
industry average for both years, inventory turnover has declined
significantly and is well below the industry average (1.25 v.
2.5). This suggests the possibility of inflated inventory
quantities, incorrect inventory prices, obsolete inventory, or
some combination of these. Accounts receivable turnover for 2002

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Chapter 4 Audit Evidence and Audit Programs

was approximately equal to the industry average; but for 2003

turnover has declined to approximately 7 times versus 11 times
for the industry. Given payment terms of 2/10;n/30, one would
expect a turnover between 11 and 12 times, or approximately 30
days sales in accounts receivable. A turnover of 7 times equates
with approximately 50 days sales in accounts receivable. Failure
to properly investigate customer credit, or weak collection
procedures, or inflated accounts receivable are possible
explanations for the decline in turnover. Although the current
ratio appears adequate when compared with the preceding year and
with the industry average, the quick ratio (current assets minus
inventory divided by current liabilities) has declined from 1.16
in 2002 to .84 in 2003. This suggests a short-term liquidity
problem, especially if inventories are overstated and/or customer
accounts receivable are delinquent.

71.

Identify the deficiencies in the following audit workpaper:

TRAMWAY ENTERPRISES
Bank Reconciliation
12/31/2003
Balance per bank
Add deposit in transit

$5,774 *
1,223 &
6,997

Deduct outstanding checks:

Adjusted balance

4455

$67 &

4477
4478
4479

180 &
1,023 &
33 &
1,303
$5,594

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Chapter 4 Audit Evidence and Audit Programs

Balance per ledger

Adjustment to correct
Adjusted balance as above

=====
$6,300
(706)
$5,594
======

SOLUTION:
1.
2.
3.
4.
5.

Initials of preparer and reviewer and dates of

preparation and review are missing.
Name of bank account being reconciled is omitted.
Subtraction error. Adjusted balance should be $5,694
rather than $5,594.
Audit adjustment of $706 not explained.
Audit legends not explained.