CHAPTER 10

Multiple-Choice Questions
1.
easy
a

Which of the following parties is responsible for establishing an entitys internal controls?
a. Management.
c. Auditors.
b. Management and auditors.
d. Committee of Sponsoring Organizations.

2.
easy
d

Which of the following is not one of the three primary objectives of effective internal control?
a. Reliability of financial reporting
b. Efficiency and effectiveness of operations
c. Compliance with laws and regulations
d. Each of the above is a primary objective of effective internal control.

3. (Public)
easy
b

The PCAOB states that reasonable assurance allows for

a. a nominal likelihood of ineffective internal controls.
b. a remote likelihood that material misstatements will not be prevented or detected by
internal control.
c. a likelihood that material misstatements will not be prevented or detected by
internal control.
d. a high likelihood that material misstatements will not be prevented or detected by
internal control.

4.
easy
a

Internal controls can never be considered as absolutely effective because

a. their effectiveness is limited by the competency and dependability of employees.
b. controls always have inherent weaknesses that can be exploited.
c. controls are designed to prevent and detect only material misstatements.
d. none of the above.

5.

A major control available in a small company, which might not be feasible in a large company,
is
a. a wider segregation of duties.
b. a voucher system.
c. fewer transactions to process.
d. the owner-managers personal interest and close relationship with personnel.

easy
d

6.
easy
a

An act of two or more employees to steal assets or misstate records is frequently referred to as
a. collusion.
b. a material weakness.
c. a control deficiency.
d. Any of the above.

7.
easy
c

When the auditor attempts to understand the operation of the accounting system by tracing a
few transactions through the accounting system, this is referred to as
a. tracing.
b. vouching.
c. a walk-through.
d. tests of controls.

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8. (SOX)
easy
c

Which section of the Sarbanes-Oxley Act requires management to issue an internal control
report?
a. 202
b. 203
c. 404
d. 408

9. (SOX)
easy
a

Sarbanes-Oxley requires management to issue an internal control report that includes two
specific items. Which of the following is one of these two requirements?
a. A statement that management is responsible for establishing and maintaining an
adequate
internal control structure and procedures for financial reporting.
b. A statement that management and the board of directors are responsible for establishing
and maintaining an adequate internal control structure and procedures for financial
reporting.
c. A statement that management, the board of directors, and the external auditors for
establishing and maintaining an adequate internal control structure and procedures for
financial reporting.
d. None of the above is correct.

10. (Public)
easy
c

When management is evaluating the design of internal control, management evaluates whether
the control can do all but which of the following?
a. Prevent material misstatements.
b. Detect material misstatements.
c. Correct material misstatements.
d. None of the above is correct.

11. (Public)
easy
b

Internal control reports issued by public companies must identify the framework used to
evaluate the effectiveness of internal control. Which of the following is the most common
framework in the U.S.?
a. Effective Internal Control Framework - AICPA
b. Internal Control - Integrated Framework - COSO
c. Enterprise Internal Control - COSO
d. There is no single common framework used in the U.S.

12. (Public)
easy
d

Auditors tests of operating effectiveness of internal controls might include which of the
following types of procedures?
a. Inspection of relevant documentation
b. Inquiries of personnel
c. Reperformance of the application of controls
d. All of the above

13.
easy
b

With which one of managements concerns with respect to implementing internal controls is
the auditor primarily concerned?
a. Efficiency of operations.
b. Reliability of financial reporting.
c. Effectiveness of operations.
d. Compliance with applicable laws and regulations.

14.
easy
b

Which of the following activities would be least likely to strengthen a companys internal
control?
a. Separating accounting from other financial operations.
b. Maintaining insurance for fire and theft.
c. Fixing responsibility for the performance of employee duties.
d. Carefully selecting and training employees.
Management must disclose material weaknesses in internal control
a. whenever the weakness is deemed significant to a single class of transactions.
b. whenever the weakness is significant to overall financial reporting objectives.
c. even if just one weakness is found.

15. (Public)
easy
c

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d.

only if the auditor identifies the weakness as significant.

16.
easy
b

When auditing a nonpublic company, the auditor should obtain an understanding of internal
control sufficient
a. to provide reasonable protection against client fraud and defalcations by client employees.
b. to assess control risk.
c. to provide a basis for constructive suggestions to the client for improving the accounting
system.
d. to provide a method for safeguarding assets, checking the accuracy and reliability of
accounting data, promoting operational efficiency, and encouraging adherence to
prescribed managerial policies.

17.
easy
c

Which of the following audit tests would be regarded as a test of a control?

a. Tests of the specific items making up the balance in a given general ledger account.
b. Tests of the inventory pricing to vendors invoices.
c. Tests of the signatures on canceled checks to managements authorizations.
d. Tests of the additions to property, plant, and equipment by physical inspections.

18.
easy
d

During which part of an audit examination is the preparation of flowcharts most appropriate?
a. When performing preliminary analytical procedures.
b. When performing tests of controls.
c. When evaluating the system of administrative control.
d. When reviewing the system of internal control.

19.
easy
c

The ______ consists of the actions, policies, and procedures that reflect the overall attitudes of
top management.
a. control activities.
b. management philosophy.
c. control environment.
d. monitoring function.

20. (Public)
medium
b

An auditors primary emphasis is internal controls over

a. material account balances
b. classes of transactions
c. account balances and classes of transactions
d. immaterial and material account balances

21.
medium
b

The auditors study of a nonpublic clients internal control is

a. required by GAAP.
b. required by GAAS.
c. required by the IRS.
d. recommended by the AICPA.

22.
medium
d

Internal controls can never be regarded as completely effective. Even if company personnel
could design an ideal system, its effectiveness depends on the
a. adequacy of the computer system.
b. proper implementation by management.
c. ability of the internal audit staff to maintain it.
d. competency and dependability of the people using it.

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23.
medium
c

Even with the most effectively designed internal control, the auditor must obtain audit
evidence, beyond testing the controls, for every
a. transaction.
b. financial statement account.
c. material financial statement account.
d. financial statement account that will be relied upon by third parties.

24. (Public)
medium
a

To express an opinion on internal controls, an auditor obtains an understanding of and

performs tests of controls related to all but which of the following?
a. Account balances.
b. Significant account balances.
c. Classes of transactions.
d. Disclosures and related assertions in the financial statements.

25.
medium
d

The essence of an effectively controlled organization lies in the

a. effectiveness of its independent auditor.
b. effectiveness of its internal auditor.
c. attitude of its employees.
d. attitude of its management.

26. (Public)
medium
c

To issue a report on internal control over financial reporting for a public company, an auditor
must
a. evaluate managements assessment process.
b. independently assess the design and operating effectiveness of internal control.
c. evaluate managements assessment process and independently assess the design and
operating effectiveness of internal control.
d. test controls over significant account balances.

27. (Public)
medium
d

Which of the stock exchanges require listed companies to have an audit committee composed
entirely of independent directors?
a. AMEX and NYSE
b. NASDAQ only
c. AMEX and NASDAQ
d. AMEX, NASDAQ, and NYSE

28.
medium
d

Which of the following factors may increase risks to an organization?

a. Geographic dispersion of company operations.
b. Decreasing quality of personnel.
c. Presence of new information technologies.
d. All of the above.

29.
medium
b

Which of the following statements is correct with respect to separation of duties?

a. Employees should not have temporary and permanent custody of assets.
b. It is desirable to prevent employees who authorize transactions from having custody of
related assets.
c. It is permissible to allow an employee to open cash receipts and record those receipts.
d. None of the above is correct.

30.
medium
b

Authorizations can be either general or specific. Which of the following is not an example of a
general authorization?
a. Automatic reorder points for raw materials inventory.
b. A sales managers authorization for a sales return.
c. Credit limits for various classes of customers.
d. A sales price list for merchandise.
The most important type of protective measure for safeguarding assets and records is
a. adequate separation of duties among personnel.
b. proper authorization of transactions.
c. the use of physical precautions.

31.
medium
c

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d.

adequate documentation.

32.
medium
d

Which of the following statements is correct with respect to the design and use of business
documents?
a. Only documents used for internal purposes must be prenumbered.
b. Documents should be designed for single purposes only to avoid confusion in their use.
c. Documents should be designed to be understandable only to those responsible for their
use.
d. None of the above statements is correct.

33. (Public)

The SEC prohibits U.S. stock exchanges from listing securities if a companys audit committee
is
a. not comprised of solely independent directors.
b. inadequately funded.
c. not solely responsible for hiring and firing the companys auditors.
d. All of the above are correct.

medium
d

34.
medium
a

All of the following are substantive tests except

a. tests of controls.
b. tests of details of transactions.
c. tests of details of balances.
d. analytical procedures.

35.
medium
b

Most audits of a company are done annually by the same CPA firm. Except for initial
engagements, the auditor begins the audit with a great deal of information about the internal
controls developed in prior years. Because systems and controls usually do not change often,
a. the auditor can skip the evaluation of this area on repeat engagements.
b. this information can be updated and carried forward to the current years audit.
c. it eases the burden on the auditors requirement to do a complete study of the controls
this year.
d. it is sufficient for the auditor just to inquire of client whether the controls have been
changed since last year.

36.
medium
b

Narratives, flowcharts, and internal control questionnaires are three common methods of
a. testing the internal controls.
b. documenting the auditors understanding of internal controls.
c. designing the audit manual and procedures.
d. documenting the auditors understanding of a clients organizational structure.

37.
medium
d

Which of the following is not an element of a proper narrative of an accounting system and
related controls?
a. The origin of every document and record in the system should be stated.
b. All processing that takes place should be described.
c. The disposition of every document and record in the system should be stated.
d. There should be an indication of all controls affecting the applicable process.

38.
medium
c

Which of the following statements about the internal control questionnaire is not correct?
a. A questionnaire can lead to a piecemeal view of a clients control without providing an
overall view.
b. The questionnaire can be prepared reasonably quickly.
c. A questionnaire is usually applicable to a wide variety of companies, especially smaller
ones.
d. Each of the above statements is correct.

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39. (Public)
medium
c

Specific assessments must be made to arrive at the preliminary assessment of control risk.
Which of the following is not one of these assessments?
a. Is the entity auditable?
b. What is the expectation that internal controls will neither prevent material misstatements
from occurring nor detect and correct them if they have occurred?
c. Is management committed to internal control?
d. Each of the above is a required assessment.

40.
medium
a

Which of the following is not one of the levels of an absence of internal controls?
a. Internal control weakness.
b. Material weakness.
c. Significant deficiency.
d. None of the above.

41.
medium
a

Which of the following is the correct definition of control deficiency?

a. A control deficiency exists if the design or operation of controls does not permit company
personnel to prevent or detect misstatements on a timely basis.
b. A control deficiency exists if one or more deficiencies exist that adversely affect a
companys ability to prepare external financial statements reliably.
c. A control deficiency exists if the design or operation of controls results in a more than
remote likelihood that controls will not prevent or detect misstatements.
d. None of the above is a correct definition.

42.
medium
d

The purpose of an entitys accounting information and communication system is to ______.

a. initiate transactions.
b. record and process transactions.
c. monitor transactions.
d. a and b only.

43.
medium
b

A procedure that would most likely be used by an auditor in performing tests of control
procedures that involve segregation of functions and that leave no transaction trail is
a. inspection.
b. observation.
c. reperformance.
d. reconciliation.

44.
medium
b

Internal controls normally include procedures designed to provide reasonable assurance that
a. employees act with integrity when performing their assigned tasks.
b. transactions are executed in accordance with managements general or specific
authorization.
c. decision processes leading to managements authorization of transactions are sound.
d. collusive activities would be detected by segregation of employee duties.

45. (Public)
medium
d

Which of the following is not a common step used to identify internal control deficiencies?
a. Decide whether there is a significant deficiency or material weakness.
b. Identify existing controls.
c. Identify the absence of key controls.
d. Each of the above is a common step used to identify internal control deficiencies.

46.
medium
a

Which of the following is not a component of an entitys internal control?

a. Control risk.
b. Control procedures.
c. The accounting system.
d. The control environment.
Before making the final assessment of internal control at the end of an integrated audit, the
auditor must
a. test controls.
b. perform substantive tests of details.

47. (Public)
medium
d

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c.
d.

a only.
a and b.

48. (Public)
medium
c

Significant deficiencies and material weaknesses in internal control of a public company must
be reported to which of the following?
a. The Public Company Accounting Oversight Board.
b. Members of management who are responsible for the related area of the company.
c. Audit committee of the companys board of director.
d. None of the above.

49.
medium
d

Of the following statements about internal controls, which one is not valid?
a. No one person should be responsible for the custodial responsibility and the recording
responsibility for an asset.
b. Transactions must be properly authorized before such transactions are processed.
c. Because of the cost benefit relationship, a client may apply control procedures on a test
basis.
d. Control procedures reasonably ensure that collusion among employees cannot occur.

50.
medium
a

Which of the following best describes the inherent limitations that should be recognized by an
auditor when considering the potential effectiveness of internal control?
a. Procedures whose effectiveness depends on segregation of duties can be circumvented by
collusion.
b. The competence and integrity of client personnel provides an environment conducive to
accounting control and provides assurance that effective control will be achieved.
c. Procedures designed to assure the execution and recording of transactions in accordance
with proper authorizations are effective against irregularities perpetrated by management.
d. The benefits expected to be derived from effective internal accounting control usually do
not exceed the costs of such control.

51.
medium
c

Which of the following is not one of the subcomponents of the control environment?
a. Managements philosophy and operating style.
b. Organizational structure.
c. Adequate separation of duties.
d. Commitment to competence.

52.
medium
b

It is important for the CPA to consider the competence of the audit clients employees because
their competence bears directly and importantly upon the
a. cost/benefit relationship of the system of internal control.
b. achievement of the objectives of internal control.
c. comparison of recorded accountability with assets.
d. timing of the tests to be performed.

53.
medium
b

Effective internal control in a small company that has an insufficient number of employees to
permit proper division of responsibilities can best be enhanced by
a. employment of temporary personnel to aid in the separation of duties.
b. direct participation by the owner of the business in the record-keeping activities of the
business.
c. engaging a CPA to perform monthly write-up work.
d. delegation of full, clear-cut responsibility to each employee for the functions assigned to
each.

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54.
medium
a

Evidential matter concerning proper segregation of duties ordinarily is best obtained by

a. direct personal observation of the employee who applies control procedures.
b. making inquiries of co-workers about the employee who applies control procedures.
c. preparation of a flowchart of duties performed and available personnel.
d. inspection of third-party documents containing the initials of who applied control
procedures.

55.
medium
b

Proper segregation of functional responsibilities calls for separation of the functions of

a. authorization, execution, and payment.
b. authorization, recording, and custody.
c. custody, execution, and reporting.
d. authorization, payment, and recording.

56.
medium
d

When considering the objectivity of internal auditors, an independent auditor should

a. evaluate the quality control program in effect for the internal auditors.
b. examine documentary evidence of the work performed by the internal auditors.
c. test a sample of the transactions and balances that the internal auditors examined.
d. determine the organizational level to which the internal auditors report.

57.
medium
a

Internal controls are not designed to provide reasonable assurance that

a. all frauds will be eliminated.
b. transactions are executed in accordance with managements authorization.
c. access to assets is permitted only in accordance with managements authorization.
d. the recorded accountability for assets is compared with the existing assets at reasonable
intervals.

58.
medium
d

Which of the following statements regarding auditor documentation of the clients internal
controls is correct?
a. Documentation must include flow charts.
b. Documentation must include procedural write-ups.
c. No documentation is necessary although it is desirable.
d. No one particular form of documentation is necessary.

59.
medium
b

Significant deficiencies are matters that come to an auditors attention, which should be
communicated to an entitys audit committee because they represent
a. material frauds perpetrated by high-level management.
b. internal control deficiencies that could adversely affect a companys ability to initiate,
record, process, or report external financial statements reliably.
c. flagrant violations of the entitys documented conflict-of-interest policies.
d. intentional attempts by client personnel to limit the scope of the auditors field work.

60.
challenging
a

Which of the following statements, if any, is correct?

a. The NASDAQ market requires listed companies to have audit committees that have only
independent directors.
b. The NASDAQ market requires listed companies to have audit committees that have a
minority of the positions held by independent directors.
c. The NASDAQ market recommends, but does not require, listed companies to have audit
committees.
d. The NASDAQ market recommends, but does not require, listed companies to have audit
committees that have a minority of the positions held by independent directors.

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61.
challenging
d

Which of the following is not typically one of managements concerns in designing effective
internal controls?
a. Reliability of financial reporting.
b. Efficiency and effectiveness of operations.
c. Compliance with applicable laws and regulations.
d. Obtaining the best internal control possible.

62. (SOX)
challenging
a

The Sarbanes-Oxley Act requires

a. all public companies to issue an internal control report.
b. all public companies to define adequate internal controls.
c. the auditor of public companies to design effective internal controls over financial
reporting.
d. provides for all three of the above.

63.
challenging
d

When considering internal control, an auditor should be aware of the concept of reasonable
assurance, which recognizes that the
a. segregation of incompatible functions is necessary to ascertain that internal control is
effective.
b. employment of competent personnel provides assurance that the objectives of internal
control will be achieved.
c. establishment and maintenance of internal control is an important responsibility of the
management and not of the auditor.
d. costs of internal control should not exceed the benefits expected to be derived from
internal control.

64.
challenging
a

To comply with the second standard of fieldwork, the auditor need not be concerned with all
five areas of internal control that apply to management. The auditors primary concerns are
with the internal controls ability to
a. ensure reliability of financial reporting for external purposes.
b. provide reliable data and promote efficiency.
c. promote efficiency and encourage adherence to policy.
d. provide reliable data, safeguard assets, and comply with the Sarbanes-Oxley Act of 2002.

65.
challenging
a

The financial statements are not likely to correctly reflect generally accepted accounting
principles if
a. the controls affecting the reliability of financial reporting are inadequate.
b. the companys controls do not promote efficiency.
c. the companys controls do not promote effectiveness.
d. all three of the above are true.

66.
challenging
a

The primary emphasis by auditors is on controls over

a. classes of transactions.
b. account balances.
c. both a and b, because they are equally important.
d. both a and b, because they vary from client to client.

67.
challenging
c

The most important difference in a nonpublic company in assessing control risk is the ability to
assess control risk at _______ for any or all control-related objectives.
a. low
b. medium
c. high
d. none of the above

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68.
challenging
c

Having an audit committee composed of outside directors is a requirement of

a. all public and private companies.
b. all private companies.
c. all companies that are listed on the NYSE, AMEX, and NASDAQ.
d. all companies that are audited by members of the AICPA.

69.
challenging
c

An auditor should consider two key issues when obtaining an understanding of a clients
internal controls. These issues are
a. the effectiveness and efficiency of the controls.
b. the frequency and effectiveness of the controls.
c. the design and utilization of the controls.
d. none of the above.

70.
challenging
c

The independent auditor should acquire an understanding of the internal audit function as it
relates to the independent auditors study and evaluation of internal accounting control because
a. the audit programs, working papers, and reports of internal auditors can often be used as
a substitute for the work of the independent auditors staff.
b. the procedures performed by the internal audit staff may eliminate the independent
auditors need for an extensive study and evaluation of internal control.
c. the work performed by internal auditors may be a factor in determining the nature,
timing, and extent of the independent auditors procedures.
d. the understanding of the internal audit function is an important substantive test to be
performed by the independent auditor.

71.
challenging
d

Taylor Sales Corp. maintains a large full-time internal audit staff that reports directly to the
chief accountant. Audit reports prepared by the internal auditors indicate that the system is
functioning as it should and that the accounting records are reliable. The independent auditor
will probably
a. eliminate tests of controls.
b. increase the depth of the study and evaluation of administrative controls.
c. avoid duplicating the work performed by the internal audit staff.
d. place limited reliance on the work performed by the internal audit staff.

72.
challenging
c

When planning an audit, the auditors assessed level of control risk is

a. determined by using actuarial tables.
b. calculated by using the audit risk model.
c. an economic issue, trading off the costs of testing controls against the cost of testing
balances.
d. calculated by using the formulas provided in the AICPAs auditing standards.

73.
challenging
a

When a compensating control exists, the absence of a key control

a. is no longer a concern because there is no longer a significant deficiency or material
weakness.
b. is a slight concern to the auditor.
c. could cause a material loss, so it must be tested using substantive procedures.
d. is magnified and must be removed from the sampling process and examined in its
entirety.

74.
challenging
a

An internal control narrative indicates that an approved voucher is required to support every
check request for payment of merchandise. Which of the following procedures provides the
greatest assurance that this control is operating effectively?
a. Select and examine canceled checks and ascertain that the related vouchers are dated no
later than the checks.
b. Select and examine vouchers and ascertain that the related canceled checks are dated no
earlier than the vouchers.
c. Select and examine canceled checks and ascertain that the related vouchers are dated no
earlier than the checks.

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d.
75.
challenging
a

Select and examine vouchers and ascertain that the related canceled checks are dated no
later than the vouchers.

When obtaining an understanding of an entitys control environment, an auditor should

concentrate on the substance of managements policies and procedures rather than their form
because
a. management may establish appropriate policies and procedures but not act on them.
b. the board of directors may not be aware of managements attitude toward the control
environment.
c. the auditor may believe that the policies and procedures are inappropriate for that
particular entity.
d. the policies and procedures may be so weak that no reliance is contemplated by the
auditor.

Essay Questions
76.
easy

With which aspect of internal control are auditors primarily concerned?

77.
easy

An effective accounting information and communication system must satisfy six transactionrelated objectives. One of these objectives is that transactions are recorded on the correct dates
(timing). Identify the five remaining objectives.

Answer:
The aspect of internal control that auditors are primarily concerned with is the reliability
of financial reporting.

Answer:
The five remaining objectives are:
Recorded transactions exist (existence).
Existing transactions are recorded (completeness).
Recorded transactions are stated at the correct amounts (accuracy).
Transactions are properly classified (classification).
Recorded transactions are properly included in the master files and correctly
summarized (posting and summarization).
78. (Public)
medium

There are four steps in the auditors process of understanding internal control and assessing
control risk for a public company. Step one is obtain and document an understanding of
internal control: design and operation. What are the remaining three steps?
Answer:
The remaining three steps are:
Assess control risk.
Design, perform and evaluate tests of controls.
Decide planned detection risk and substantive tests.

79.
medium

Managements identification and analysis of risk is an ongoing process and is a critical

component of effective internal control. An important first step is for management to identify
factors that may increase risk. Identify at least five factors, observable by management, that
may lead to increased risk in a typical business organization.
Answer:
There are many factors that may lead to increased risk in an organization. Some
examples include:
failure to meet prior objectives.
decreasing quality of personnel.

10-11

80.
medium

increasing geographic dispersion of company operations.

increasing significance and complexity of core business processes.
introduction of new information technologies.
entrance of new competitors.

During a financial statement audit of a non-public company, three steps must be completed by
the auditor before he/she can conclude that control risk is low. Discuss these three steps.
Answer:
The three steps that must be completed by the auditor before he/she can conclude that
control risk is low are:
1. obtain an understanding of the control environment, risk assessment procedures,
accounting information and communication system, and monitoring methods at a
fairly detailed level;
2. identify specific controls that will reduce control risk and make an assessment of
control risk; and
3. test the controls for effectiveness.

81. (Public)
medium

In addition to understanding the design of internal control, the auditor must also evaluate
whether the designed controls are actually placed in operation. List four common methods
auditors use to fulfill this requirement during the audit of a public company.
Answer:
There are five common procedures listed below. Students were asked to list four common
methods:
Update and evaluate auditors previous experience with the entity.
Make inquiries of client personnel.
Examine documents and records.
Observe entity activities and operations.
Perform walkthroughs of the accounting system.
Read clients policy and systems manual

82.
medium

A proper narrative of an accounting system and related controls should possess several key
characteristics. What are three such characteristics?
Answer:
The characteristics are:
The origin of every document and record in the system.
All processing that takes place.
The disposition of every document and record in the system.
An indication of the controls relevant to the assessment of control risk.

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83.
medium

Describe three inherent limitations of internal control.

Answer:
The effectiveness of internal controls depends on the competency and dependability of the
people using it. Inherent limitations of internal control include:
employee carelessness,
lack of understanding,
management override, and
collusion.

84.
medium

The internal control framework developed by COSO includes five so-called components of
internal control. Discuss each of these five components.
Answer:
Five components of internal control are:
The control environment. The control environment consists of the actions, policies,
and procedures that reflect the overall attitudes of top management, directors and
owners, about internal control and its importance to the company.
Risk assessment. This is managements identification and analysis of risks relevant to
the preparation of financial statements in accordance with GAAP.
Information and communication. This is the set of manual and/or computerized
procedures that identifies, assembles, classifies, analyzes, records, and reports a
companys transactions and maintains accountability for the related assets.
Control activities. These are the policies and procedures that help ensure necessary
actions are taken to address risks in the achievement of the companys objectives.
Monitoring. This is managements ongoing and periodic assessment of the quality of
internal control performance to determine that controls are operating as intended and
modified when needed.

85.
medium

Discuss what is meant by the term control environment and identify four control
environment subcomponents that the auditor should consider.
Answer:
The control environment consists of the actions, policies, and procedures that reflect the
overall attitudes of top management, directors, and owners of an entity about control and
its importance to the entity. Subcomponents include:
Integrity and ethical values.
Commitment to competence.
Board of directors or audit committee participation.
Managements philosophy and operating style.
Organizational structure.
Assignment of authority and responsibility.
Human resource policies and practices.

86.
medium

Control activities, one of the five components of internal control, are defined as the policies
and procedures, in addition to those included in the other four components, that help ensure
necessary actions are taken to address risks in the achievement of the entitys objectives.
There are five categories of control activities. Please describe the five categories of control
activities.
Answer:
The five categories of control activities are:
Adequate separation of duties.
a. Custody of assets should be separated from accounting.
b. Authorizing transactions should be separated from custody of related assets.
c. Operational responsibility should be separated from record-keeping.
d. Duties within IT should be separated from user departments.

Proper authorization of transactions and activities.

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a.
b.

87.
medium

General authorization is given for transactions meeting established criteria.

Specific authorization is required for individual transactions that dont confirm
to the criteria.
Adequate document and records.
a. Documents should be prenumbered and simple to understand and use.
b. A chart of accounts should be available.
c. Systems manuals should be available.

Physical control over assets and records. These should include fireproof safes and
limited access storerooms.

Independent checks on performance by internal verification should be used.

Adequate documents and records are important for effective internal control. There are five
principles that dictate the proper design and use of documents and records. One principle is
that documents and records should be prenumbered consecutively to facilitate control over
missing documents, and as an aid in locating documents when they are needed at a later date.
Please discuss each of the other four principles of adequate documents and records.
Answer:
Documents and records should be:
Prepared at the time a transaction takes place, or as soon thereafter as possible.
Sufficiently simple to ensure that they are clearly understood.
Designed for multiple use whenever possible, to minimize the number of different
forms.
Constructed in a manner that encourages correct preparation, such as providing a
degree of internal check within the form or record.

88.
medium

Describe each of the three broad objectives management typically has for internal control.
Answer:
The three objectives are:
Reliability of financial reporting. Management has both a legal and professional
responsibility to be sure that the information is fairly presented in according with
reporting requirements such as GAAP.
Efficiency and effectiveness of operations. Controls within an organization are meant
to encourage efficient and effective use of its resources to optimize the companys
goals.
Compliance with laws and regulations. Public and non-public organizations are
required to follow many laws and regulations. Some relate to accounting only
indirectly, such as environmental protection and civil rights laws. Others are closely
related to accounting, such as income tax regulations and fraud.

89. (Public)
medium

Auditors of financial statements issued by a public company are required to report on internal
control over financial reporting. Briefly describe the auditors responsibility.
Answer:
The report on internal control over financial reporting must include the auditors opinion
as to whether managements assessment of the design and operating effectiveness of
internal control over financial reporting is fairly stated in all material respects. This
involves an evaluation of managements assessment process to determine whether
internal controls are effective and the auditors independent assessment of the internal
controls design and operating effectiveness.

90.
medium

What two specific assessments must be made to arrive at the preliminary assessment of control
risk during the audit of a public company?
Answer:
The two specific assessments are:

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91.
challenging

Assessment of whether the entity is auditable

Determine assessed control risk supported by the understanding obtained assuming
the controls are being followed

Adequate separation of duties is an important control activity. Please discuss the four general
guidelines for separation of duties to prevent both intentional and unintentional misstatements
that are of significance to auditors.
Answer:
The general guidelines are:
Custody of assets should be separated from accounting.
Authorizing transactions should be separated from custody of related assets.
Operational responsibility should be separated from record-keeping.
Duties within IT should be separated from user departments.

Other Objective Answer Format Questions

92.
medium

Match seven of the terms (a-i) with the definitions provided below (1-7):
a. Control environment
b. Control activities
c. Independent checks on performance
d. Internal control
e. Monitoring
f.
Separation of duties
g. General authorization
h. Specific authorization
i.
Risk assessment

1.

Managements ongoing and periodic assessment of the quality of internal

control performance to determine that controls are operating as intended and
modified when needed.

2.

Company-wide policies for the approval of all transactions within stated

limits.

3.

The actions, policies, and procedures that reflect the overall attitudes of top
management, directors, and owners of an entity about internal control and its
importance to the entity.

4.

Segregation of the following activities in an organization: custody of assets,

accounting, authorization, and operational responsibility.

5.

Managements identification and analysis of risks relevant to the preparation

of financial statements in accordance with generally accepted accounting
principles.

6.

Policies and procedures that help ensure necessary actions are taken to
address risks in the achievement of the entitys objectives.

7.

93.
easy
b

A process designed to provide reasonable assurance regarding the

achievement of managements objectives in the following categories: (1)
reliability of financial reporting, (2) effectiveness and efficiency of
operations, and (3) compliance with applicable laws and regulations.
If, when obtaining an understanding of control activities of a relatively small client, the auditor
identified no control activities, the auditor would probably set a low assessment of control risk.
a. True
b. False

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94.
easy
b

When internal controls are not effective, then substantive audit tests are less reliable; thus, the
extent of substantive tests should be reduced.
a. True
b. False

95.
easy
a

In an audit of a non-public company, the less control risk there is, the smaller the amount of
planned substantive evidence required.
a. True
b. False

96.
easy
b

As a clients information system becomes more complex, it is likely that an auditor will
decrease reliance on controls and increase substantive tests to support a control risk
assessment.
a. True
b. False

97.
easy
b

When a company designs and implements internal controls, cost of the controls is not a valid
consideration.
a. True
b. False

98. (Public)
easy
a

PCAOB Standard 2 requires auditors to perform walkthroughs to assist in understanding

internal control.
a. True
b. False

99.
easy
b

Adequate documents and records is a subcomponent of the control environment.

a. True
b. False

100.
easy
a

For proper internal control, there should be adequate separation of duties. However, the extent
of separation of duties considered adequate depends heavily on the size of the organization.
a. True
b. False

101.
easy
a

In an audit of a non-public company, the auditors assessment of control risk and the extent of
tests of controls are inversely related; that is, if the auditors assessment of control risk
decreases, more extensive tests of controls are applied.
a. True
b. False

102.
medium
b

Smaller companies usually have more extensive internal controls than larger companies which
result in fewer frauds being committed at small companies.
a. True
b. False

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103. (SOX)
medium
b

The Sarbanes-Oxley Act of 2002 requires that private and public companies issue an internal
control report.
a. True
b. False

104.
medium
b

The most important component of internal control is risk assessment.

a. True
b. False

105.
medium
b

The primary emphasis by auditors when evaluating and testing internal control is on controls
over account balances rather than controls over classes of transactions.
a. True
b. False

106.
medium
b

When internal controls over a given financial statement account are assessed by the auditor as
highly effective, the auditor need not obtain audit evidence for that account beyond testing the
controls.
a. True
b. False
The chart of accounts is a control and is closely related to the controls related to adequate
documents and records.
a. True
b. False

107.
medium
a
108.
medium
b

For proper internal control, the custodianship of cash, including receipts and disbursements,
should be the responsibility of the accounting department.
a. True
b. False

109.
medium
b

Auditing standards prohibit reliance on the work of internal auditors due to the lack of
independence of the internal auditors.
a. True
b. False

110.
medium
a

Procedures used to obtain an understanding of internal control are normally performed on

fewer transactions than procedures used to test controls.
a. True
b. False

111.
medium
a

For most uses, flowcharts are superior to narratives as a method of communicating the
characteristics of internal control.
a. True
b. False

112.
medium
b

When documenting their understanding of a clients internal controls, auditors are required to
use narratives.
a. True
b. False

113.
medium
b

The two primary determinants of an entitys auditability are the integrity of management and
the competency of personnel.
a. True
b. False

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