Chapter 19

Multiple-Choice Questions
1. easy a Which of the following accounts is associated with a transaction cycle other than acquisition and payment? a. Common stock. b. Property, plant and equipment. c. Accrued property taxes. d. Income tax expense. Property, plant, and equipment are assets that: a. have expected lives of more than one year. b. are used in the business. c. are not acquired for resale. d. meet all of the requirements stated above. Which of the following expenses is not typically evaluated as part of the audit of the acquisition and payment cycle? a. Depreciation expense. b. Insurance expense. c. Bad debts expense. d. Property tax expense. Debits to manufacturing equipment arise from which cycle(s)? a. Sales and collection b. Payroll c. Acquisition and disbursement d. Inventory and warehousing It should ordinarily be unnecessary to examine supporting documentation for each addition to property, plant, and equipment, but it is customary to verify: a. all large transactions. b. all unusual transactions. c. a representative sample of typical additions. d. all three of the above. The auditor must know the clients capitalization policies to determine whether acquisitions are: Recorded in accordance with GAAP Yes Yes No Yes Treated consistently with those of the preceding year Yes No No Yes Necessary Yes No No No

2. easy d

3. easy c

4. easy c

5. easy d

6. easy d

a. b. c. d. 7. easy d

To be capitalized as part of property, plant and equipment, assets must: a. have expected useful lives of more than one year. b. not be acquired for resale. c. be useful in multiple productive capacities within the organization. d. a and b, but not c. The primary accounting record for manufacturing equipment and other fixed assets is the:

8.

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easy b

a. b. c. d.

depreciation ledger. fixed asset master file. asset inventory. equipment roster.

9. easy b

Which of the following statements about the audit of fixed assets is not correct? a. The primary accounting record for manufacturing equipment and other property, plant and equipment is generally a fixed asset master file. b. Manufacturing equipment and current assets are normally audited in the same fashion regardless of the activity within a particular account. c. The emphasis on auditing fixed assets is on verification of current-period acquisitions. d. Failure to record the acquisition of a fixed asset affects the income statement until the assets is fully depreciated. During the audit of prepaid insurance, the auditor should keep in mind that the amount in insurance expense is based on: a. the beginning balance in prepaid insurance. b. the payment of premiums during the year. c. the ending balance in prepaid insurance. d. all three of the above. Which of the following is not a category of tests commonly associated with the audit of manufacturing equipment? a. Verification of depreciation expense. b. Analytical procedures. c. Verification of current-period disposals. d. Verification of the beginning balance in accumulated depreciation. The audit procedure that requires an auditor to foot the acquisition schedule relates to which balance-related audit objective? a. Classification. b. Detail tie-in. c. Existence. d. Cut-off. Which of the following audit objectives is not typically a major objective in the audit of current year fixed asset additions? a. Classification. b. Completeness. c. Existence. d. Accuracy. The extent to which auditors verify current period acquisitions of property, plant and equipment normally depends upon: a. assessed control risk for acquisitions. b. tolerable misstatement. c. Both a and b. d. Neither a nor b. Inadequate controls and misstatements discovered through tests of controls and substantive tests of transactions are an indication of the likelihood of misstatements in: a. the balance sheet. b. the income statement. c. the cash flow statement. d. both the income statement and the balance sheet.

10. easy d

11. easy d

12. easy b

13. easy c

14. easy c

15. easy d

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16. medium d

Failure to capitalize a fixed asset at the correct amount affects __________ until the company disposes of the asset. a. the balance sheet only b. the income statement only c. the cash flow statement only d. both the income statement and the balance sheet Which of the following tests are typically not necessary when auditing a clients schedule of recorded disposals? a. Footing the schedule. b. Tracing schedule totals to the general ledger. c. Tracing cost and accumulated depreciation of the disposals to the property master file. d. All of the above are necessary. Which of the following is not likely to be a test related to the audit of manufacturing equipment? a. Verify current year additions. b. Observe current year disposals. c. Verify depreciation expense. d. Perform analytical procedures. A set of records for each piece of equipment that includes descriptive information, date of acquisition, original cost, current year depreciation, and accumulated depreciation is the: a. acquisitions journal. b. depreciation schedule. c. fixed asset master file. d. file of purchase requisitions. In the audit of property, plant, and equipment, it is helpful to separate the tests into all but which one of the following categories? a. Verification of the beginning balance. b. Verification of current year acquisitions. c. Verification of current year disposals. d. Verification of the ending balance. Methods used to determine if there are legal encumbrances related to fixed assets include all but which of the following? a. Reading terms of loan and credit agreements. b. Reviewing loan confirmations received from banks. c. Inquiring of the client regarding possible legal encumbrances. d. All of the above may be used to identify legal encumbrances. The test of details of balances procedure which requires a recalculation of investment credit satisfies the audit objective of: a. classification. b. detail tie-in. c. existence. d. accuracy. The test of details of balances procedure to examine vendors invoices of closely related accounts such as repairs to uncover items that should be property, plant, and equipment satisfies the audit objective of: a. classification. b. detail tie-in. c. cutoff. d. existence.

17. medium d

18. medium b

19. medium c

20. medium a

21. medium d

22. medium d

23. medium a

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24. medium c

The auditors starting point for verifying disposals of property, plant, and equipment is the: a. equipment account in the general ledger. b. file of shipping documents. c. clients schedule of recorded disposals. d. equipment subsidiary ledger. Failure to capitalize a fixed asset at the correct amount will affect ___________ until the asset is fully depreciated. a. the balance sheet b. the income statement c. the cash flow statement d. both the income statement and the balance sheet Because the failure to record disposals of property, plant, and equipment can significantly affect the financial statements, the search for unrecorded disposals is essential. Which of the following is not a procedure used to verify disposals? a. Make inquiries of management and production personnel about the possibility of the disposal of assets. b. Review whether newly acquired assets replace existing assets. c. Test the valuation of fixed assets recorded in prior periods. d. Review plant modifications and changes in product line, taxes, or insurance coverage. In rare cases, the auditor may believe it is necessary that a complete physical inventory of fixed assets be taken to make sure they actually exist. If an inventory is taken, the auditor normally: a. takes the inventory. b. requires client to take the inventory and provide documentation to the auditor. c. observes the count. d. requires that it be done by an outside, independent third party. A major consideration in verifying the ending balance in fixed assets is the possibility of existing legal encumbrances. Tests to identify possible legal encumbrances would satisfy the audit objective of: a. existence. b. presentation and disclosure. c. detail tie-in. d. classification. When auditing depreciation expense, the two major concerns related to the accuracy audit objective are: a. consistent application of depreciation method and useful lives. b. consistent application of depreciation method and classification of assets. c. correctness of calculations and consistent application of depreciation method. d. cost of the fixed asset and useful lives. Which type of audit procedure is often sufficient for purposes of auditing prepaid expenses and deferred charges? a. Tests of controls. b. Tests of transactions. c. Tests of details of balances. d. Analytical procedures. Depreciation expense is one of the few expense accounts that is not verified as a part of: a. tests of controls. b. tests of transactions. c. test of details of balances.

25. medium d

26. medium c

27. medium c

28. medium b

29. medium c

30. medium d

31. medium d

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d. 32. medium a

a and b, but not c.

Changing circumstances may require a change in the useful life of an asset. When this occurs, it involves a change in: a. accounting estimate rather than a change in accounting principle. b. accounting principle rather than a change in accounting estimate. c. both accounting principle and accounting estimate. d. neither accounting principle nor accounting estimate. The auditor ___________ to test the accuracy or classification of fixed assets recorded in prior periods. a. normally needs b. never needs c. normally does not need d. is required The auditor normally does not need to test the accuracy or classification of fixed assets recorded in prior periods because: a. they are rarely material to the audit. b. they rarely contain misstatements. c. they are verified in previous audits. d. they dont affect the balance sheet. Internal controls for prepaid insurance are typically categorized into all but which of the following? a. Controls over the acquisition and recording of insurance. b. Controls over the insurance register. c. Controls over the charge-off of insurance expense. d. All of the above. A record of insurance policies in force and the due date of each policy is contained in the: a. voucher register. b. insurance register. c. insurance expense account. d. prepaid insurance account. Insurance expense for the period is a function of which of the following? a. The beginning prepaid balance, current premium payments and the ending prepaid balance. b. The beginning prepaid balance and the current period premium payments. c. The current period premium payments. d. The current period premium payments and the ending prepaid balance. Expense accounts analysis is closely related to tests of controls and substantive tests of transactions. The major difference is: a. the difference in the types of underlying documentation which is examined. b. the degree of concentration on an individual account. c. the use or nonuse of cutoff tests. d. that one emphasizes transactions and the other emphasizes amounts. In connection with a review of the prepaid insurance account, auditors would typically not perform which of the following procedures? a. Recompute the portion of the premium that expired during the year. b. Prepare excerpts of insurance policies for audit working papers. c. Confirm premium rates with an independent insurance broker. d. Examine support for premium payments.

33. medium c

34. medium c

35. medium d

36. medium b

37. medium a

38. medium b

39. medium c

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40. medium b

Which of the following audit procedures would be least likely to lead the auditor to find an unrecorded fixed asset disposal? a. Examination of insurance policies. b. Review of repairs and maintenance expense. c. Review of property tax files. d. Scanning of invoices for fixed asset additions. To achieve effective internal accounting control over fixed asset additions, a company should establish procedures that require: a. authorization and approval of major fixed asset additions. b. capitalization of the cost of fixed asset additions in excess of a specific dollar amount. c. classification, as investments, of those fixed asset additions that are not used in the business. d. performance of recurring fixed asset maintenance work solely by maintenance department employees. Which of the following is a customary audit procedure for the verification of the legal ownership of real property? a. Examination of correspondence with the corporate counsel concerning acquisition matters. b. Examination of ownership documents registered and on file at a public hall of records. c. Examination of corporate minutes and resolutions concerning the approval to acquire property, plant, and equipment. d. Examination of deeds and title guaranty policies on hand. Once the initial audit of a newly constructed industrial plant has been performed, with respect to consistency, which of the following is of least concern to the continuing auditor in the following year? a. Prior years capitalization policy. b. Prior years capitalization costs. c. Prior years depreciation methods. d. Prior years depreciable life. Controls over the acquisition and recording of insurance are a part of the ________. a. inventory and warehousing cycle b. capitalization cycle c. treasury cycle d. acquisition and payment cycle The approach used to verify manufacturing equipment is different than the one used to verify: a. current assets. b. patents. c. copyrights. d. all other types of property, plant, and equipment. Which balance-related audit objective is not relevant to an audit of prepaid expenses? a. Rights. b. Accuracy. c. Detail tie-in. d. Realizable value. The failure to capitalize a permanent asset, or the recording of an asset acquisition at the improper amount, affects the balance sheet: a. forever. b. for the current period.

41. medium a

42. medium d

43. medium b

44. medium d

45. challenging a

46. challenging d

47. challenging d

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c. d. 48. challenging b

for the depreciable life of the asset. until the firm disposes of the asset.

The failure to capitalize a permanent asset, or the recording of an asset acquisition at the improper amount, affects the income statement: a. for the current period. b. for the depreciable life of the asset. c. until the firm disposes of the asset. d. forever. ____________ both have the effect of simultaneously verifying balance sheet and income statement accounts. a. Analytical procedures and substantive tests of transactions b. Tests of controls and substantive tests of transactions c. Tests of details of balances and substantive tests of transactions d. Tests of controls and analytical procedures The tests of details of balances procedure for fixed assets which require the auditor to examine vendors invoices of closely related accounts such as repairs and maintenance to uncover items that should be fixed assets would satisfy the audit objective of: a. accuracy. b. existence. c. detail tie-in. d. completeness. The erroneous inclusion of transactions that should properly be recorded as assets into accounts such as repairs expense, lease expense, or supplies is a common client error. The auditor should evaluate the likelihood of these types of misclassifications in conjunction with: a. obtaining an understanding of internal control. b. the test of controls. c. the tests of transactions. d. the tests of details of balances. If the client fails to record disposals of property, plant, and equipment, both the original cost of the asset account and the net book value will be incorrect. a. Both will be overstated indefinitely. b. The original cost will be overstated indefinitely, and the net book value will be overstated until the asset is fully depreciated. c. The original cost will be overstated indefinitely, and the net book value will be understated indefinitely. d. The original cost will be overstated indefinitely, and the net book value will be understated until the asset is fully depreciated. Income statement accounts resulting from allocations are typically verified as a part of: a. tests of controls. b. substantive tests of transactions. c. analytical procedures. d. planning. Which of the following explanations might satisfy an auditor who discovers significant debits to an accumulated depreciation account? a. Extraordinary repairs have lengthened the life of an asset. b. Prior years depreciation charges were erroneously understated. c. A reserve for possible loss on retirement has been recorded. d. An asset has been recorded at its fair value. An auditor would be least likely to use confirmations in connection with the examination of:

49. challenging b

50. challenging d

51. challenging a

52. challenging b

53. challenging c

54. challenging a

55.

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challenging c

a. b. c. d.

inventories. long-term debt. property, plant, and equipment. stockholders equity.

56. challenging b

Which of the following is the most important internal control procedure over acquisitions of property, plant, and equipment? d. Requiring acquisitions to be made by user departments. b. Using a budget to forecast and control acquisitions and retirements. c. Analyzing monthly variances between authorized expenditures and actual costs. a. Establishing a written company policy distinguishing between capital and revenue expenditures. The auditor interviews the plant manager. The auditor is most likely to rely upon this interview as primary support for an audit conclusion on: a. capitalization vs. expensing policy. b. allocation of fixed and variable cost. c. the necessity to record a provision for deferred maintenance costs. d. the adequacy of the depreciation expense. The audit procedures used to verify accrued liabilities differ from those employed for the verification of accounts payable because: a. accrued liability balances are less material than accounts payable balances. b. accrued liabilities at year end will become accounts payable during the following year. c. evidence supporting accrued liabilities is non-existent, whereas evidence supporting accounts payable is readily available. d. accrued liabilities usually pertain to services of a continuing nature, whereas accounts payable are the result of completed transactions.

57. challenging c

58. challenging d

Essay Questions
59. easy Which type of audit procedure (tests of controls, tests of transactions, tests of details, or analytical procedures) is most often sufficient for the audit of prepaid expenses? Answer: Analytical procedures are often sufficient. 60. easy Why does the auditor not normally test the accuracy or classification of fixed assets recorded in prior periods? Answer: They are presumed to have been verified in prior years audits. 61. easy Auditors should be aware that the life of certain fixed assets might be reduced due to various circumstances. What circumstances might give rise to a reduction in the useful life of a fixed asset? Answer: The useful life a of fixed asset may be reduced by: a reduction in customer demand for products or services, unexpected physical deterioration of the asset, or a modification in operations. Arens/Elder/Beasley

62. easy

Describe the types of information that should be included in the schedule of prepaid insurance that is used by the auditor as the basis for auditing prepaid insurance. Answer: The schedule should include each insurance policy in force, policy number, insurance coverage for each policy, premium amount, premium period, insurance expense for the year, and prepaid insurance at the end of the year.

63. easy

Describe two ways the verification of existence and tests for omissions of the clients insurance policies in force can be performed. Answer: The verification of existence and tests for omissions of the insurance policies can be tested in one of two ways: by examining insurance invoices and policies in force or by obtaining a confirmation of insurance information from the companys insurance agent.

64. medium

What are several analytical procedures used in the audit of prepaid insurance and insurance expense? Answer: 1. Compare total prepaid insurance and insurance expense with previous years. 2. Compute the ratio of prepaid insurance to insurance expense and compare with previous years. 3. Compare the individual insurance policy coverage on the schedule of insurance obtained from the client with the preceding years schedule as a test of elimination of certain policies or a change in insurance coverage. 4. Compare the computed prepaid insurance balance for the current year on a policy-by-policy basis with that of the preceding year as a test of an error in the calculation.

65. medium

A major issue in verifying the ending balance in property, plant and equipment is the possibility of legal encumbrances. Describe the procedures that auditors may perform to obtain evidence about existing legal encumbrances. Answer: Auditors may obtain evidence about existing legal encumbrances by: reading the terms of loan and credit agreements, mailing loan confirmation requests to banks and other lending institutions, inquiring of the client, and sending letters of inquiry to the clients legal counsel.

66. medium

Describe the audit procedures used to verify the accuracy and detail tie-in objectives for prepaid insurance. Answer: The accuracy objective is tested by verifying the total amount of the insurance premium, the length of the policy period, and the allocation of the premium to unexpired insurance. The amount of the premium for a given policy and its time period can be verified

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simultaneously by examining the premium invoice or the confirmation from an insurance agent. Once these two have been verified, the clients calculations of unexpired insurance can be tested by recalculation. The schedule of prepaid insurance can then be footed and the totals traced to the general ledger to complete the detail tie-in tests.

67. medium

What are the auditors two main objectives in the audit of the ending balance in accumulated depreciation? Answer: 1. Accumulated depreciation as stated in the property master file must agree with the general ledger. This objective can be satisfied by test footing the accumulated depreciation or the property master file and tracing the total to the general ledger. 2. Accumulated depreciation in the master file must be correct.

68. medium

Explain allocation and why it is important to have accurate allocation within the financial statements. Answer: Allocation is the process of assigning a portion of the cost of an asset to a product or a period. For example, calculating and then recording depreciation expense is an allocation process. It is important to determine when an expenditure is an asset or a current period expense so that the financial statements are fairly stated.

69. challenging

Property, plant, and equipment is normally audited in a different manner than current asset accounts. State three reasons why this is so, and discuss the differences in how property, plant, and equipment is audited compared to current assets. Answer: There are usually fewer current period acquisitions of property, plant, and equipment than current assets. The amount of any given acquisition is often material. The equipment is likely to be kept and maintained in the accounting records for several years. Because of these three differences, the emphasis in auditing property, plant, and equipment is on the verification of current period acquisitions rather than on the balance in the account carried forward from the preceding year. In addition, the expected life of assets over one year requires depreciation and accumulated depreciation accounts, which are verified as a part of the audit of the assets.

70. challenging

State each of the seven specific balance-related audit objectives for property, plant, and equipment additions and, for each objective, describe one common test of details of balances. Answer:

Current-year acquisitions in the acquisitions schedule agree with related master file amounts, and the total agrees with the general ledger (detail tie-in). Foot the acquisitions schedule. Current-year acquisitions as listed exist (existence). Physically examine assets. Existing acquisitions are recorded (completeness). Examine vendors Arens/Elder/Beasley

invoices of closely related accounts such as repairs and maintenance to uncover items that should be property, plant, and equipment. Current-year acquisitions as listed are accurate (accuracy). Examine vendors invoices. Current-year acquisitions as listed are properly classified (classification). Examine rent and lease expense for capitalizable leases. Current-year acquisitions are recorded in the proper period (cutoff). Review transactions near the balance sheet date for proper period. The client has rights to current-year acquisitions (rights and obligations). Examine vendors invoices. 71. challenging Discuss the key internal controls related to the disposal of property, plant, and equipment. Answer: The most important internal control over the disposal of property, plant, and equipment is the existence of a formal method to inform management of the sale, trade-in, abandonment, or theft of recorded machinery and equipment. Another important control to protect assets from unauthorized disposal is a provision for authorization for the sale or other disposal of property, plant, and equipment. Finally, there should be adequate internal verification of recorded disposals to make sure that assets are correctly removed from the accounting records. 72. challenging When auditing disposals of property, plant, and equipment, the search for unrecorded disposals is essential. State the four audit procedures frequently used for verifying disposals. Answer: Review whether newly acquired assets replace existing assets. Analyze gains and losses on the disposal of assets and miscellaneous income for receipts from the disposal of assets. Review plant modifications and changes in product lines, taxes, or insurance coverage for indications of deletions of equipment. Make inquiries of management and production personnel about the possibility of the disposal of assets. 73. challenging Discuss the key internal controls over existing fixed assets that affect the auditors extent of testing of fixed assets acquired in prior years. Answer: Important controls include the use of a master file for individual fixed assets, adequate physical controls over assets that are easily movable, assignment of identification numbers to each plant asset, and periodic physical count of fixed assets and their reconciliation by accounting personnel. A formal method of informing the accounting department of all disposals of fixed assets is also an important control over the balance of assets carried forward into the current year. 74. challenging Discuss the key internal controls for prepaid insurance that affect the auditors extent of testing of the prepaid insurance account. Answer: Important controls include proper authorization for new insurance policies and payment of Arens/Elder/Beasley

insurance premiums consistent with the clients payment procedures. A record of insurance policies in force and the due date of each policy is an essential control to make sure that the company has adequate insurance at all times. The control should include a provision for periodic review of the adequacy of the insurance coverage by an independent qualified person. The detailed records of the information in the insurance register should be verified by someone independent of the person preparing them. A closely related control is the use of monthly standard journal entries for insurance expense.

Other Objective Answer Format Questions

75. easy a 76. easy b 77. easy a 78. easy b 79. easy b When an audit is a first-year engagement, some additional risk is involved and more audit work is required than in subsequent years. a. True b. False One of the auditors primary objectives when auditing manufacturing equipment is accuracy. a. True b. False Completeness and existence are the auditors primary objectives in auditing manufacturing equipment. a. True b. False Wages expense is normally considered to be associated with the acquisition and payment cycle. a. True b. False The primary characteristic that distinguishes property, plant, and equipment from inventory, prepaid expenses, and investments is the intention to use property, plant, and equipment as a part of the operations of the clients business and their expected life of approximately one year. a. True b. False The emphasis in auditing manufacturing equipment is on the verification of current-period disposals. a. True b. False The auditor should keep in mind that the amount in insurance expense is a residual amount. a. True b. False The realizable value audit objective is not applicable when auditing prepaid insurance or insurance expense. a. True b. False The starting point for the verification of current-year acquisitions of property, plant, and equipment is normally a client-prepared schedule of all acquisitions recorded in the general ledger during the year. a. True b. False

80. easy b 81. easy a 82. easy a 83. medium a

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84. medium b 85. medium a 86. medium a 87. medium a 88. medium a 89. medium a 90. medium b 91. medium a 92. medium a 93. medium a 94. medium b

The least common audit test to verify current period acquisitions of property, plant, and equipment is examining vendors invoices and receiving reports. a. True b. False Depreciation expense is normally verified as a part of tests of details of balances rather than as part of tests of controls or substantive tests of transactions. a. True b. False The most important audit objective for depreciation expense is accuracy. a. True b. False The audit of insurance expense is normally limited to analytical procedures and a brief test of whether charges to insurance expense arose from credits to prepaid insurance. a. True b. False Tests of the cutoff objective for prepaid insurance are rarely performed by auditors. a. True b. False In auditing the current year acquisitions of property, plant and equipment, all balance-related audit objectives except realizable value and disclosure are used as a frame of reference. a. True b. False While analytical procedures are commonly used when auditing balance sheet accounts, they are rarely used when auditing income statement accounts. a. True b. False Tests of controls provide an indication of the likelihood of misstatements in both the income statement and the balance sheet, simultaneously. a. True b. False The auditors review of current year acquisitions cutoff is normally done as part of accounts payable cutoff tests. a. True b. False The auditors tests for proper cutoff of current year acquisitions of property, plant, and equipment are usually done as part of accounts payable cutoff tests. a. True b. False In deciding the useful life of an asset, the companys policy is relatively unimportant. a. True b. False

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95. medium b 96. medium b 97. medium a 98. medium a 99. challenging b 100. challenging b 101. challenging a 102. challenging a 103. challenging a 104. challenging b

The audit procedure foot the schedule of fixed assets acquisitions and trace the total to the general ledger relates most closely to the accuracy objective for fixed assets acquisitions. a. True b. False Confirmations are commonly used to verify additions of property, plant, and equipment. a. True b. False When auditing insurance expense, auditors normally rely on analytical procedures and limited testing of the debits to ensure that they arose from credits to prepaid insurance. a. True b. False One very useful method of auditing depreciation is to use an analytical procedure to test for reasonableness. a. True b. False The approach to auditing patents and copyrights is more similar to that used for current assets than the approach used for property, plant, and equipment accounts. a. True b. False Recording an acquisition of a fixed asset at an improper amount affects the balance sheet until the company disposes of the asset, but the income statement is not affected. a. True b. False Ordinarily, it is unnecessary to test the accuracy objective or the classification objective for fixed assets acquired in prior years. a. True b. False In the audit of accrued property taxes, the two most important balance-related audit objectives are completeness and accuracy. a. True b. False Typically, analytical procedures are the primary means of verifying income statement accounts resulting from allocations. a. True b. False When auditing acquisitions of property, plant, and equipment, the auditors review of lease and rental agreements most closely relates to the cutoff objective. a. True b. False

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