CPA Quiz: Inventory And Securities
20 questions · exam conditions
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Inventory And SecuritiesQuestion 1 of 20

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?

Inspect board minutes for authorization of the investment strategy and conclude existence is supported
Obtain a direct confirmation from the broker/custodian of securities positions and account balance as of year-end
Recompute the client's fair value using public price quotes and conclude existence based on valuation accuracy
Request management to provide a representation that the securities existed at year-end and treat it as sufficient evidence
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CPA Quiz

CPA Quiz: Inventory And Securities

Practice Inventory And Securities in CPA with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Inventory And Securities, giving you a quick way to practice the rules, question types, and explanations that matter most for CPA.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

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?

  1. Inspect board minutes for authorization of the investment strategy and conclude existence is supported
  2. Obtain a direct confirmation from the broker/custodian of securities positions and account balance as of year-end (correct answer)
  3. Recompute the client's fair value using public price quotes and conclude existence based on valuation accuracy
  4. Request management to provide a representation that the securities existed at year-end and treat it as sufficient evidence
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.

Question 2

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?

  1. Send direct confirmations to each bank to confirm CD balances, terms, and any pledges or restrictions as of year-end (correct answer)
  2. Inspect management's copies of statements and conclude existence is verified because they are bank-generated
  3. Confirm the CDs with the loan lender only, since they would know what is pledged
  4. Recalculate interest income for the year and conclude CDs exist if interest income appears reasonable
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.

Question 3

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?

  1. 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 (correct answer)
  2. Confirm the investment's fair value directly with the investee company's management because they know the business best
  3. Rely on the specialist's conclusion without further work because valuation is outside the auditor's expertise
  4. Perform only analytical procedures comparing current-year fair value to prior-year fair value and conclude reasonableness if change is small
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.

Question 4

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?

  1. 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 (correct answer)
  2. Confirm fair value with the bond issuers because they can validate the exit price
  3. Use the prior-year fair value as the best evidence because volatility makes current pricing unreliable
  4. Perform only inquiry of management about their pricing policy and accept it if consistently applied
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.

Question 5

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?

  1. Incentive-based bias and lack of independent review over production reports increase the risk of misstatement in inventory valuation (correct answer)
  2. Because production reports are operational, they do not affect financial reporting controls over inventory
  3. If labor is an immaterial component of inventory, the control deficiency can be ignored without further consideration
  4. The auditor should assess control risk as low because supervisors are closest to the process and therefore most accurate
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.

Question 6

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?

  1. Accept the bin tag quantities because they are part of the client's perpetual records and proceed to pricing tests only
  2. 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 (correct answer)
  3. Wait until after the audit report date to perform additional counts, because year-end counts cannot be reperformed
  4. Communicate the issue only to the warehouse supervisor because it is an operational matter, not an audit matter
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.

Question 7

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?

  1. The deviation from the documented approval control indicates the control is not operating effectively, increasing control risk over valuation and existence (correct answer)
  2. A documented policy is sufficient evidence that the control is effective even if not performed
  3. Write-offs affect only the income statement and therefore do not impact inventory-related controls
  4. 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.

Question 8

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?

  1. 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 (correct answer)
  2. Accept the shipping label quantities because sealed pallets are presumed accurate and focus on price testing
  3. Reduce substantive testing because controls are documented even if not performed consistently
  4. Communicate the issue only to the shipping department and do not modify audit procedures because it is immaterial by nature
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.

Question 9

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?

  1. Obtain a direct confirmation from the custodian/bank that includes securities held and any liens, pledges, or restrictions on the account (correct answer)
  2. Inspect the entity's general ledger detail for investment purchases and sales to confirm existence and rights
  3. Confirm the securities with the U.S. Treasury to validate both existence and the absence of restrictions
  4. Rely on management's representation regarding unencumbered status because the securities are highly liquid
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.

Question 10

While observing a client's physical inventory count, an auditor performs test counts. The auditor traces a sample of items from the physical inventory on the floor to the client's inventory listing. This procedure is designed to obtain evidence concerning management's assertion of:

  1. Existence.
  2. Rights and obligations.
  3. Valuation.
  4. Completeness. (correct answer)
Explanation: Tracing from the source (the physical inventory on the floor) to the accounting records (the inventory listing) is a test for completeness. This procedure ensures that all inventory that physically exists has been properly recorded in the client's records. A: The opposite procedure, vouching from the listing to the floor, tests for existence. B: Rights and obligations are tested by examining invoices and contracts. C: Valuation is tested by examining cost records and testing for obsolescence.

Question 11

A client uses a well-controlled perpetual inventory system and relies on cycle counts throughout the year rather than a single physical count at year-end. In this situation, the auditor's observation of inventory should be performed:

  1. At year-end to confirm the final perpetual balance.
  2. On a surprise basis for all counts during the year.
  3. During one or more of the cycle counts on a test basis. (correct answer)
  4. Only if analytical procedures indicate a high risk of misstatement.
Explanation: When a client uses cycle counts, the auditor can rely on this system if it is effective. The auditor tests the system by observing one or more of the cycle counts during the year. This allows the auditor to evaluate the client's procedures for counting and the accuracy of the perpetual records. A: Requiring a year-end count negates the benefit of the cycle count system. B: Observing all counts is not necessary. D: Observation of inventory is a generally accepted auditing procedure and cannot typically be replaced entirely by analytical procedures.

Question 12

A client conducted its physical inventory count on November 30, one month before its fiscal year-end. To obtain sufficient evidence about the year-end inventory balance, the auditor should test the client's records of transactions:

  1. From the beginning of the year to the physical count date.
  2. Occurring during the physical count to ensure they were excluded.
  3. For the entire fiscal year and compare them to the prior year.
  4. Between the physical count date and the fiscal year-end date. (correct answer)
Explanation: When the physical count is taken on a date other than the balance sheet date, the auditor must audit the intervening transactions to "roll forward" the balance from the count date to the year-end. This involves testing the purchases, sales, and other inventory movements that occurred during that period. A: Testing transactions before the count doesn't help validate the year-end balance. B: This is part of observing the count itself, not the roll-forward. D: This is a broad analytical procedure, not the specific test required for the roll-forward.

Question 13

An auditor is observing the client's inventory count. While test counting a sample of items selected from the client's inventory listing and locating them on the warehouse floor, the auditor also inspects the condition of the items for signs of damage.

This single audit procedure provides evidence primarily for which two financial statement assertions?

  1. Completeness and Rights.
  2. Rights and Valuation.
  3. Existence and Completeness.
  4. Existence and Valuation. (correct answer)
Explanation: Selecting items from the inventory listing and locating them on the floor (vouching) tests the existence assertion, ensuring that recorded items actually exist. Inspecting the physical condition of the items for damage or dust provides evidence for the valuation assertion, as damaged or obsolete items may need to be written down to their net realizable value. A, B, C: Completeness is tested by tracing from the floor to the list, and rights are tested by examining invoices, not by this procedure.

Question 14

The audit firm for a client with a significant portfolio of illiquid, alternative investments lacks the necessary in-house expertise to audit their valuation. The auditor's most appropriate response is to:

  1. Rely on the valuation provided by the client's management, as they have the most knowledge.
  2. Issue a qualified opinion due to the scope limitation imposed by the lack of expertise.
  3. Request that the client sell the investments to determine their market value.
  4. Engage an external, independent valuation specialist to assist in obtaining sufficient appropriate audit evidence. (correct answer)
Explanation: According to auditing standards, if the auditor does not possess the necessary skill and knowledge to audit a specific area (such as valuing complex financial instruments), the auditor should use the work of an auditor's specialist. The auditor remains responsible for the audit opinion but can use the specialist's work as audit evidence. A: Relying solely on management violates professional skepticism. B: A qualified opinion is a last resort; the auditor must first attempt to gather evidence. C: This is an unreasonable request and not a standard audit procedure.

Question 15

An auditor used nonstatistical sampling to test the pricing of a client's inventory. The sample of items had a book value of $200,000. The audit-determined value of the sample was $190,000. The total book value of the inventory population is $4,000,000.

Based on these results, the auditor's best estimate of the projected misstatement for the entire inventory population is:

  1. $10,000
  2. $190,000
  3. $200,000 (correct answer)
  4. $400,000
Explanation: The auditor can project the misstatement found in the sample to the entire population. The misstatement in the sample is $200,000 (book value) - $190,000 (audit value) = $10,000. The 'tainting' percentage is the misstatement divided by the book value of the sample: $10,000 / $200,000 = 5%. The projected misstatement is this percentage applied to the total population's book value: 5% * $4,000,000 = $200,000. A: This is the known misstatement in the sample only. B: This is the audited value of the sample. D: This represents a 10% misstatement rate, which is incorrect.

Question 16

A client holds a significant portfolio of complex, thinly-traded derivative instruments classified as Level 3 in the fair value hierarchy. The most appropriate audit procedure to test the valuation of these securities would be to:

  1. Confirm the original cost of the instruments with the counterparty.
  2. Obtain quoted market prices from an active exchange for similar, but not identical, assets.
  3. Evaluate the reasonableness of the valuation model and the assumptions used by management. (correct answer)
  4. Rely on a management representation letter stating the values are reasonable.
Explanation: For Level 3 fair value measurements, there are no observable inputs. Therefore, the auditor's primary procedure is to evaluate the valuation model used by management and test the reasonableness and appropriateness of the significant assumptions (inputs) to that model. This may involve using an auditor's specialist. A: Original cost is not relevant for fair value measurement. B: Using prices for similar assets relates to Level 2 inputs, not Level 3. D: A management representation letter provides corroborating evidence but is not sufficient on its own.

Question 17

When a client uses the LIFO (Last-In, First-Out) inventory method, it is important for the auditor's procedures to address the possibility of a LIFO liquidation. An auditor would be most concerned about an undisclosed LIFO liquidation if:

  1. The client's inventory quantities increased significantly during the year.
  2. The client's gross profit margin increased unexpectedly in a period of rising costs. (correct answer)
  3. The LIFO reserve decreased due to a decline in inventory costs.
  4. The client changed its inventory cost-flow assumption from FIFO to LIFO.
Explanation: A LIFO liquidation occurs when a company sells more inventory than it purchases, causing older, lower-cost inventory layers to be expensed as cost of goods sold. In a period of rising prices, this matches old, low costs against current, high revenues, resulting in an abnormally high gross profit. An unexpected increase in the gross profit margin is therefore a key indicator of a potential LIFO liquidation. A: A liquidation involves a decrease, not an increase, in quantities. C: A decrease in the reserve due to declining costs is a normal LIFO result. D: This relates to a change in accounting principle.

Question 18

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?

  1. Test management's variance analysis control only and, if documented, reduce substantive testing because PCAOB audits emphasize controls
  2. 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 (correct answer)
  3. Perform inquiry of the chief financial officer about the rationale for allocating variances to inventory and accept the response if consistent with prior year
  4. Limit testing to observing the physical count because existence is the primary assertion for inventory in issuer audits
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.

Question 19

During an audit of an issuer under PCAOB standards, you identify significant deficiencies in inventory controls: cycle counts are not performed, inventory adjustments lack approval, and there is no reconciliation between perpetual records and the general ledger. Management proposes that you perform more year-end substantive testing instead of remediating controls. Which factor would most likely affect the auditor's assessment of inventory controls?

  1. The control deficiencies indicate higher risk of material misstatement and may affect the auditor's ability to rely on controls, requiring a revised audit approach and consideration of control-related communications (correct answer)
  2. If substantive testing is increased, the auditor can assess control risk as low because the audit will detect misstatements
  3. Because the entity is an issuer, inventory controls are presumed effective unless fraud is identified
  4. The deficiencies affect only the timing of the audit and do not influence risk assessment or audit planning
Explanation: This question tests the auditor's responsibilities under PCAOB standards for assessing internal control deficiencies in an integrated audit of an issuer. The key facts include identified significant deficiencies in inventory controls, such as the absence of cycle counts, unapproved adjustments, and lack of reconciliations, coupled with management's proposal to increase substantive testing rather than remediate. Choice A is correct because PCAOB AS 2201 requires auditors to evaluate control deficiencies for their impact on the risk of material misstatement, which may limit reliance on controls, necessitate adjustments to the audit strategy, and trigger communications about significant deficiencies or material weaknesses. Choice B is incorrect because increasing substantive testing does not allow the auditor to assess control risk as low under PCAOB AS 2110, as control risk assessment is based on the operating effectiveness of controls, not on detection through substantive procedures. Choices C and D are incorrect because PCAOB standards do not presume controls are effective absent fraud and require deficiencies to influence overall risk assessment and audit planning per AS 2301, rather than merely affecting timing. In professional practice, auditors should apply judgment by first classifying deficiencies as significant or material weaknesses based on likelihood and magnitude, then adjusting the nature, timing, and extent of substantive procedures accordingly. This framework ensures the audit addresses both financial statement and internal control opinions in an integrated audit of issuers.

Question 20

You are auditing a nonissuer that holds a structured note measured at fair value with no active market. Management obtained a broker quote that is labeled "indicative" and is based on internal models. Controls require obtaining two independent quotes, but only one was obtained due to time constraints. In the context of fair value measurement, which procedure is most appropriate?

  1. Assess the reliability of the indicative quote, obtain additional corroborating evidence (such as a second independent quote or independent valuation), and evaluate key assumptions used in the pricing (correct answer)
  2. Accept the indicative quote as sufficient because it was provided by a broker and therefore is objective
  3. Confirm the fair value with the structured note issuer because the issuer can provide the market exit price
  4. Perform only tests of controls over quote retention and conclude fair value is reasonable if documentation exists
Explanation: AU-C Section 540 requires assessing reliability and corroborating indicative quotes for Level 3 fair values. The single indicative quote based on models, deviating from dual-quote controls, increases estimation uncertainty. Evaluating the quote, obtaining corroboration, and testing assumptions aligns with AU-C 540 by ensuring appropriateness. Choice B is incorrect because indicative quotes are not necessarily objective per AU-C 500. Choice C is incorrect as issuers provide biased data under AU-C 540, and choice D is incorrect because controls testing does not replace substantive procedures per AU-C 330. Auditors should seek multiple sources for non-market quotes. This framework enhances valuation credibility amid limited data.