Inventory And Securities
Help Questions
CPA Auditing and Attestation (AUD) › Inventory And Securities
You are auditing a nonissuer and the entity holds $12 million of marketable equity securities at year-end, recorded at fair value. The securities are maintained in a brokerage account and management provided a year-end brokerage statement downloaded from the broker’s portal. Controls over investment recording are moderate, but you noted the controller has full access to initiate and record trades. What is the most appropriate method to confirm the existence of investment securities?
Obtain a direct confirmation from the broker/custodian of securities positions and account balance as of year-end
Inspect board minutes for authorization of the investment strategy and conclude existence is supported
Request management to provide a representation that the securities existed at year-end and treat it as sufficient evidence
Recompute the client’s fair value using public price quotes and conclude existence based on valuation accuracy
Explanation
AU-C Section 501 emphasizes obtaining reliable evidence for the existence of investment securities, particularly when held by third parties. Here, securities are in a brokerage account with moderate controls but potential override by the controller, making direct confirmation necessary. Obtaining a direct confirmation from the broker/custodian aligns with AU-C 330 as it provides external, reliable evidence of positions and balances. Choice A is incorrect because board minutes address authorization, not existence, per AU-C 500. Choice C is incorrect as recomputing fair value tests valuation, not existence, under AU-C 501, and choice D is incorrect because management representations are corroborative, not primary evidence, per AU-C 580. Auditors should prioritize external confirmations for existence when custody is with third parties. This decision rule mitigates risks of fictitious assets by ensuring independent verification.
In an audit of a nonissuer, the entity has investments in certificates of deposit (CDs) held at multiple banks, and management provided copies of CD statements. You also noted one CD is pledged as collateral for a loan. What is the most appropriate method to confirm the existence of investment securities?
Recalculate interest income for the year and conclude CDs exist if interest income appears reasonable
Confirm the CDs with the loan lender only, since they would know what is pledged
Send direct confirmations to each bank to confirm CD balances, terms, and any pledges or restrictions as of year-end
Inspect management’s copies of statements and conclude existence is verified because they are bank-generated
Explanation
AU-C Section 501 mandates external confirmations for investments like CDs to verify existence and rights. The CDs at multiple banks, with one pledged, require confirming balances, terms, and restrictions. Sending direct confirmations to each bank aligns with AU-C 330 as it obtains reliable evidence. Choice B is incorrect because internal copies are not independent per AU-C 500. Choice C is incorrect as lenders confirm only their interests, not full existence, under AU-C 501, and choice D is incorrect because interest recalculation tests income, not existence, per AU-C 520. Auditors should confirm details including encumbrances for restricted investments. This rule mitigates risks of overstatement or misclassification.
You are auditing a nonissuer investment holding company that owns a private equity investment accounted for at fair value. There are no quoted prices; management used a discounted cash flow model with significant unobservable inputs and engaged a valuation specialist. Controls include review of the specialist’s report, but reviewers lack valuation expertise and only check arithmetic. In the context of fair value measurement, which procedure is most appropriate?
Confirm the investment’s fair value directly with the investee company’s management because they know the business best
Rely on the specialist’s conclusion without further work because valuation is outside the auditor’s expertise
Perform only analytical procedures comparing current-year fair value to prior-year fair value and conclude reasonableness if change is small
Evaluate the competence and objectivity of management’s specialist, test significant assumptions (cash flows, discount rate) against external and internal evidence, and develop an independent range to assess reasonableness
Explanation
AU-C Section 540 requires testing assumptions and evaluating specialists in fair value measurements with unobservable inputs. The discounted cash flow model for private equity, with inadequate reviewer expertise, heightens estimation risk. Evaluating the specialist, testing assumptions, and developing an independent range aligns with AU-C 540 by assessing reasonableness. Choice B is incorrect because confirmations from investees are biased and insufficient per AU-C 500. Choice C is incorrect as auditors must perform procedures even if outside expertise per AU-C 620, and choice D is incorrect because analytics alone do not address complex estimates under AU-C 520. Auditors should integrate specialist work with independent verification. This framework reduces bias in Level 3 valuations through corroboration.
You are auditing a nonissuer with a portfolio of corporate bonds measured at fair value. At year-end, market volatility increased and bid-ask spreads widened; management selected the midpoint price from a pricing service without evaluating whether it represents an exit price. Internal controls do not require assessing market activity levels. In the context of fair value measurement, which procedure is most appropriate?
Perform only inquiry of management about their pricing policy and accept it if consistently applied
Use the prior-year fair value as the best evidence because volatility makes current pricing unreliable
Evaluate whether the market is active for the securities, assess the appropriateness of using midpoint pricing, and test fair value by corroborating prices to observable inputs and considering valuation adjustments when warranted
Confirm fair value with the bond issuers because they can validate the exit price
Explanation
AU-C Section 540 requires evaluating pricing appropriateness in volatile markets for fair value. The midpoint pricing without assessing market activity, amid widened spreads and weak controls, risks inaccurate exit prices. Assessing market activity, midpoint use, and corroborating prices aligns with AU-C 540 by ensuring reliable measurements. Choice B is incorrect because issuer confirmations are not market-based per AU-C 500. Choice C is incorrect as prior-year values ignore current conditions under AU-C 540, and choice D is incorrect because inquiry alone is insufficient evidence per AU-C 330. Auditors should test pricing adjustments in inactive markets. This decision rule promotes fair value accuracy through input validation.
During an audit of a nonissuer with significant work-in-process inventory, you note that production reports used to assign labor hours are prepared by production supervisors and are not reviewed, and the same supervisors’ bonuses are tied to reported efficiency. Inventory costing controls rely heavily on these reports. Which factor would most likely affect the auditor's assessment of inventory controls?
The auditor should assess control risk as low because supervisors are closest to the process and therefore most accurate
If labor is an immaterial component of inventory, the control deficiency can be ignored without further consideration
Incentive-based bias and lack of independent review over production reports increase the risk of misstatement in inventory valuation
Because production reports are operational, they do not affect financial reporting controls over inventory
Explanation
AU-C Section 315 highlights bias risks in controls when incentives exist, affecting inventory valuation. The unreviewed production reports tied to bonuses, relied upon for costing, create misstatement risk from manipulation. This factor increases control risk as it impacts accuracy per AU-C 315. Choice B is incorrect because operational reports influence financial assertions under AU-C 501. Choice C is incorrect as immateriality does not negate deficiencies per AU-C 315, and choice D is incorrect because proximity does not ensure accuracy amid bias per AU-C 240. Auditors should consider incentive-driven biases in assessments. This rule guides risk elevation for judgment-based controls.
In an audit of a nonissuer, you attended the year-end physical inventory count and observed that several high-value electronic components had bin tags showing quantities that differed from the count team’s sheets. The warehouse supervisor overrode the count team and instructed them to use the bin tag quantities. Controls over inventory counts include segregation of duties on paper, but you observed management influence over the count process. Based on the findings, which action should the auditor take?
Wait until after the audit report date to perform additional counts, because year-end counts cannot be reperformed
Communicate the issue only to the warehouse supervisor because it is an operational matter, not an audit matter
Expand test counts and perform independent recounts of the affected items, reconcile differences to the final inventory listing, and consider the need for additional procedures due to potential management override
Accept the bin tag quantities because they are part of the client’s perpetual records and proceed to pricing tests only
Explanation
AU-C Section 501 requires auditors to respond to observed irregularities during physical inventory counts by expanding procedures to ensure existence and completeness. The warehouse supervisor's override of count team quantities, despite segregation controls, indicates potential management influence and control deviations. Expanding test counts, performing independent recounts, and reconciling to the final listing aligns with AU-C 330 by addressing risks through additional substantive procedures. Choice A is incorrect because bin tags are not independent evidence and ignoring discrepancies violates AU-C 500. Choice C is incorrect as subsequent counts are not required if year-end procedures can be adjusted per AU-C 501, and choice D is incorrect because the issue is an audit matter requiring communication to those charged with governance under AU-C 260. Auditors should evaluate control deviations and expand testing when bias is observed. This framework promotes reliable inventory assertions by integrating observation with substantive verification.
During an audit of a nonissuer wholesaler, you note the company has a formal policy requiring independent approval of inventory write-offs, but in practice write-offs are processed by the warehouse manager without documentation or review. Additionally, write-offs increased significantly in the last quarter. Which factor would most likely affect the auditor's assessment of inventory controls?
The deviation from the documented approval control indicates the control is not operating effectively, increasing control risk over valuation and existence
Write-offs affect only the income statement and therefore do not impact inventory-related controls
A documented policy is sufficient evidence that the control is effective even if not performed
If write-offs increased, the auditor should lower assessed risk because management is being conservative
Explanation
AU-C Section 315 requires evaluating operating effectiveness in control risk assessment for inventory valuation and existence. The deviation from approval policy for write-offs, with increased activity, indicates ineffective operation and potential override. This factor increases control risk as it affects reliability per AU-C 315. Choice B is incorrect because documentation alone does not prove effectiveness under AU-C 330. Choice C is incorrect as write-offs impact balances directly, per AU-C 501, and choice D is incorrect because increased write-offs may not indicate conservatism if unauthorized per AU-C 240. Auditors should test actual performance beyond policies. This framework identifies deficiencies for adjusted audit responses.
You are auditing a nonissuer distributor and attended the physical inventory count. You observed that count teams skipped sealed pallets and used quantities printed on shipping labels without opening them, and several pallets were located in a staging area labeled “Ready to Ship.” Controls require opening pallets and counting contents, but the procedure was not followed. Based on the findings, which action should the auditor take?
Reduce substantive testing because controls are documented even if not performed consistently
Communicate the issue only to the shipping department and do not modify audit procedures because it is immaterial by nature
Accept the shipping label quantities because sealed pallets are presumed accurate and focus on price testing
Perform additional test counts of sealed pallets and items in the staging area, evaluate cutoff around shipments, and consider expanding procedures due to control deviations
Explanation
AU-C Section 501 requires auditors to address control deviations during inventory counts by expanding procedures for existence and cutoff. The failure to open sealed pallets and inconsistent application of controls, with items in staging areas, indicates risks of incomplete or inaccurate counts. Performing additional test counts, evaluating cutoff, and expanding procedures aligns with AU-C 330 by mitigating observed deficiencies. Choice B is incorrect because presuming accuracy without verification violates AU-C 500. Choice C is incorrect as documented controls do not reduce testing if ineffective per AU-C 315, and choice D is incorrect because the issue requires audit procedure modification under AU-C 501. Auditors should respond to deviations with targeted substantive testing. This rule ensures reliable inventory balances despite control weaknesses.
In an audit of a nonissuer, the entity holds $8 million of U.S. Treasury securities in book-entry form at a custodian bank. Management asserts the investments are unencumbered, but your preliminary risk assessment identified a new line of credit that may require pledged collateral. What is the most appropriate method to confirm the existence of investment securities?
Obtain a direct confirmation from the custodian/bank that includes securities held and any liens, pledges, or restrictions on the account
Confirm the securities with the U.S. Treasury to validate both existence and the absence of restrictions
Rely on management’s representation regarding unencumbered status because the securities are highly liquid
Inspect the entity’s general ledger detail for investment purchases and sales to confirm existence and rights
Explanation
AU-C Section 501 requires confirmation of securities held by third parties, including details on encumbrances. The Treasury securities at a custodian bank, with a potential pledge from a new credit line, necessitate verifying rights and obligations. Obtaining direct confirmation from the custodian including liens aligns with AU-C 330 as it provides comprehensive external evidence. Choice B is incorrect because ledger inspection is internal and insufficient per AU-C 500. Choice C is incorrect as the U.S. Treasury does not confirm individual holdings under AU-C 501, and choice D is incorrect because representations are not substitutive for confirmations per AU-C 580. Auditors should include inquiries about restrictions in confirmations for pledged assets. This framework safeguards against misstatements in rights assertions.
You are auditing an issuer in an audit engagement conducted under PCAOB standards. The company records inventory at standard cost and applies a variance analysis control to adjust to actual; however, you observed large unfavorable purchase price variances were not investigated and were instead allocated to ending inventory to meet gross margin targets. Controls exist but appear subject to management override. Which audit procedure should the auditor perform to verify inventory valuation?
Perform inquiry of the chief financial officer about the rationale for allocating variances to inventory and accept the response if consistent with prior year
Recalculate standard cost and variance allocations, test the investigation and disposition of significant variances, and evaluate whether allocations to inventory are appropriate given the risk of management override
Limit testing to observing the physical count because existence is the primary assertion for inventory in issuer audits
Test management’s variance analysis control only and, if documented, reduce substantive testing because PCAOB audits emphasize controls
Explanation
AS 2301 requires substantive procedures for inventory valuation in PCAOB audits, especially when variances are misallocated. The uninvestigated variances allocated to inventory to meet targets, with override risk, necessitates detailed testing. Recalculating standards and variances, testing investigations, and evaluating allocations aligns with AS 2301 by addressing risks. Choice A is incorrect as controls testing does not reduce substantives in high-risk areas per AS 2110. Choice C is incorrect because inquiry is insufficient under AS 2501, and choice D is incorrect as counts address existence, not valuation, per AS 2510. Auditors should test variance dispositions when override is possible. This framework ensures proper cost absorption in standard systems.