Auditing, Attestation, and Assurance

1. The single feature that most clearly distinguishes Which of the following is not a distinguishing feature of
auditing, attestation, and assurance is risk-based auditing?
a. Type of service. a. Identifying areas posing the highest risk of financial
b. Training required to perform the service. statement errors.
c. Scope of services. b. Analysis of internal control.
d. CPAs approach to the service. c. Collecting and evaluating evidence.
d. Concentrating audit resources in those areas
ANSWER: C presenting the highest risk of financial statement
errors.
2. The primary goal of the CPA in performing the attest
function is to ANSWER: C
a. Detect fraud.
b. Examine individual transactions so that the 8. To maximize independence, the director of internal
auditor may certify as to their validity. auditing should report to the
c. Determine whether the client's assertions are a.Audit committee.
fairly stated. b. Controller.
d. Assure the consistent application of correct c. Chief financial officer.
accounting procedures. d. Director of information systems.

ANSWER: C ANSWER: A

3. Internal auditing often extends beyond examinations 9. The auditor communicates the results of his or her
leading to the expression of an opinion on the fairness work through the medium of the
of financial presentation and includes audits of a. Engagement letter.
efficiency, effectiveness, and b. Management letter.
a. Internal control. c. Audit report.
b. Evaluation. d. Financial statements.
c. Accuracy.
d. Compliance. ANSWER: C

ANSWER: D 10. The best description of the scope of internal auditing is

4. Which of the following best describes the operational audit?
a. It requires the constant review by internal auditors
of the administrative controls as they relate to
operations of the company.
b. It concentrates on implementing financial and
accounting control in a newly organized company.
c. It attempts and is designed to verify the fair
presentation of a company's results of operations.
d. It concentrates on seeking out aspects of
operations in which waste would be reduced by the
introduction of controls.
ANSWER: D
5. The auditor's judgment concerning the overall fairness
of the presentation of financial position, results of
operations, and changes in financial position is applied
within the framework of
a. Generally accepted accounting principles.
b. Generally accepted auditing standards.
c. Internal control.
d. Information systems control.
ANSWER: A
6. Which of the following is not considered an assertion
as formulated by the Auditing Standards Board?
a. Valuation or allocation.
b. Mathematical accuracy.
c. Rights and obligations.
d. Presentation and disclosure.
that it encompasses
a. Primarily operational auditing.
b. Both financial and operational auditing.
c. Primarily the safeguarding of assets and verifying
the existence of such assets.
d. Primarily financial auditing.
ANSWER: B
11. A typical objective of an operational audit is to
determine whether an entity's
a. Financial statements fairly present financial position
and cash flows.
b. Financial statements present fairly the results of
operations.
c. Financial statements fairly present financial position,
results of operations, and cash flows.
d. Specific operating units are functioning efficiently
and effectively.
ANSWER: D
12. The scope and nature of an auditor's contractual
obligation to a client is ordinarily set forth in the
a. Scope paragraph of the auditors report.
b. Opinion paragraph of the auditors report.
c. Management letter.
d. Engagement letter.
ANSWER: D

ANSWER: B
13. The four major steps in conducting an audit are:
a. Testing internal controls d. The internal auditor's span of coverage goes beyond
b. Audit report financial auditing to encompass operational and performance
c. Planning auditing.
d. Testing transactions and balances
ANSWER: B
The proper sequence in applying the above steps is:
a. cadb 17. Which of the following best describes the purpose of
b. cdab the engagement letter?
c. bcda a. The engagement letter relieves the auditor of some
d. adcb responsibility for the exercise of due care.
b. By clearly defining the nature of the engagement,
ANSWER: A the engagement letter helps to avoid and
resolve misunderstandings between CPA and
13. Which of the following statements is not true client regarding the precise nature of the work
regarding the competence of audit evidence? to be performed and the type of report to be
a.Relevance is enhanced by an effective issued.
information system. c. The engagement letter conveys to management the
b.To be competent, evidence must be both valid detailed steps to be applied in the audit
and relevant. process.
c.Validity is related to the quality of the clients d. The engagement letter should be signed by both the
information system. client and the CPA and should be used only
d.Relevance must always relate to audit objectives. for independent audits.

ANSWER: A ANSWER: B

15. As used in auditing, which of the following statements
best describes "assertions"?
a. Assertions are the representations of management
as to the reliability of the information system.
b.Assertions are the auditor's findings to be
communicated in the audit report.
c.Assertions are the representations of management
as to the fairness of the financial statements.
d.Assertions are found only in the footnotes to the
financial statements.
18. In assessing audit risk, the CPA needs to do all of the
following except
a.Gather audit evidence in support of recorded
transactions.
b.Obtain an understanding of the client's system of
internal control.
c. Understand the economic substance of significant
transactions completed by the client.
d. Understand the entity and the industry in which it
operates.

ANSWER: C ANSWER: A

16. Which of the following statements is not a distinction 19. Which of the following tasks should be performed prior to the
between independent auditing and internal auditing? final audit?
a. Independent auditors represent third party users a. Determining the fairness of property, plant, and
external to the auditee entity, whereas internal equipment.
auditors report directly to management. b. Confirming accounts receivable.
b.Although independent auditors strive for both validity c. Testing internal control.
and relevance of evidence, internal auditors d. Collecting and evaluating evidence supporting the
are concerned almost exclusively with validity. fairness of inventory values.
c.Internal auditors are employees of the auditee,
whereas independent auditors are ANSWER: C
independent contractors.

COMPLETION

20. An audit approach that attempts to identify areas posing the highest probability of financial statement errors and allocate audit
resources to those areas is known as _________ - ___________ auditing.

ANSWER: RISK-BASED

21. Because is the standard for measuring fairness, independent auditors must be expert in accounting matters.

ANSWER: GAAP

22. Independent auditing is considered necessary because managers and stockholders have attitudes toward financial
reporting.

ANSWER: DIVERGENT (CONFLICTING)

23. The most important characteristics contributing to effective auditing are the ability of the auditor to exercise and

ANSWER: DUE CARE, SOUND JUDGMENT

24. The assertion stating that no assets, equities, or transactions have been omitted from the financial statements is known as the
____________ assertion.

ANSWER: COMPLETENESS

MATCHING:

25. Match each of the listed procedures with the primary assertion that is satisfied by the procedure

a. existence or occurrence
b. completeness
c. rights and obligations
d. valuation or allocation
e. presentation and disclosure

____ 1. Calculated depreciation expense for the year

____ 2. Test counted clients year end inventory of materials

and finished goods

____ 3. Examined vehicle title applicable to new truck purchased during the current year

____ 4. Considered need for a footnote describing a lawsuit pending against the client

____ 5. Conducted a search for unrecorded liabilities

____ 6. Advised client of the need to reclassify the current portion of a long term mortgage note

____ 7. Performed tests to determine that overhead had been properly applied to ending inventory and cost of sales

____ 8. Reconciled clients bank accounts as of year end

____ 9. Examined appraisal reports applicable to land donated by the city

____ 10. Obtained written confirmation from customers regarding year end balances in selected accounts receivable

SOLUTION:

1. d
2. a
3. c
4. e
5. b
6. e
7. d
8. d
9. d
10.d
Problem/Essay

26. George & Washington, CPAs, has just accepted an engagement to audit Ginger and Cinnamon, a small
manufacturer of spice products. Julia Jenkins has been selected as the in-charge auditor for the engagement, and Josh
Lukins will be her assistant. In planning the audit field work, Jenkins makes the following assignments of audit tasks:

Julia Jenkins Josh Lukins

Interim Audit

Test internal control over cash Audit property, plant, and

receipts equipment balances
Audit accounts receivable Test internal control over
balances cash disbursements

Final Audit

Test internal control over Audit cash balances

sales
Obtain signed copy of engagement Audit inventory balances
letter

Required:
a. Identify the steps to be followed in completing an audit.
b. What is meant by the term "systematic process" as
contained in the definition of auditing?
c. Explain the strengths and weaknesses in Jenkins audit
planning.

SOLUTION:
a. Audit planning; interim audit; final audit; audit report.
b. Systematic auditing means that the auditor studies and tests the system of internal control before testing
the substance of transactions and balances. Strong internal control increases the level of confidence and
decreases the extent of transaction and balance testing.
c. Strengths: The auditors tested internal control over cash receipts and disbursements before auditing
cash balances.
Weaknesses: 1. Jenkins and Lukins audited property, plant, and equipment balances
and accounts receivable balances during the interim audit. These procedures are typically applied on the
final audit. Moreover, internal controls over sales and property transactions were not tested and
evaluated prior to auditing the balances. 2. Either Jenkins or Lukins should have tested internal controls
over both cash receipts and disbursements transactions. Dividing these duties was inappropriate and
failed to maximize efficiency and effectiveness. 3. Internal control over sales transactions should have
been performed during the interim audit. 4. A signed copy of the engagement letter should have been
obtained as a first step in the acceptance process prior to conducting any of the audit field work. 5.
There is no indication that internal controls over property or inventory transactions were ever tested. 6.
Internal control over sales should have been tested on the interim, rather than on the final audit.
 Auditing Theory 10. Fraudulent financial reporting is often called
a. Management fraud c. Defalcation
1. A control which relates to all parts of the EDP system is b. Theft of assets d. Employee fraud
called a(n)
a. Systems control c. Applications control 11. The most important general ledger account included in
b. General control d. Universal control and affecting several cycles is the
a. General cash account
2. Which of the following is not an output control? b. Inventory accounts
a. Proper authorization of transaction c. Income tax expense ad liability accounts
b. Control totals d. Retained earnings account
c. Check digits
d. Adequate documents 12. In testing for cut-off , the objective is to determine
a. Whether all of the current periods transactions are
3. Should the auditor feel, after obtaining an recorded
understanding of the EDP internal control structure, b. That no transactions from the prior period are
that control risk cannot be reduced, he or she will included in the current periods balances
a. Issue a disclaimer c. That no transactions of the curret period have
b. Issue an adverse opinion been delayed and recorded in the future period.
c. Increase the sample size for tests of controls d. Whether transactions are recorded in the proper
d. Expand the substantive testing portion of the audit period.

4. The real-time feature normally would be least useful 13. The primary difference between an audit of the balance
when applied to accounting for a firms sheet and an audit of the income statement lies in the
a. Bank-account balances fact that the audit of the income statement deals with
b. Property and depreciation the verification of
c. Customer accounts receivable a. Transactions c. Costs
d. Merchandise inventory b. Authorization d. Cutoffs

5. A sample in which the characteristics in the sample 14. Documentation is a form of evidence
are the same as those of the population is a a. Used in every financial statement audit
a. Random sample c. Attributes sample b. Used in most financial statement audit
b. Variables sample d. Representative sample c. Used o the rate occasions when it is both readily
available ad less costly than other procedures
6. Establishing a route through the random number table d. Used when nothing is available that is more
a. Is an arbitrary decision competent
b. Needs to be done in advance of choosing the
numbers 15. The current file of the auditors working papers
c. Is essential and the route must be followed generally should include
consistently a. a flowchart of internal controls
d. Requires that all three of the above is true b. organization charts
c. a copy of the financial statements
7. When an auditor goes through a population and d. copies of bond and note indentures
selects items for the sample without regard to their
size, source, or other distinguishing characteristics, it is 16. An audit working paper that reflects the major
called components of an amount reported in the financial
a. Block selection statements is referred to as(an)
b. Haphazard selection a. Lead schedule c. Audit control schedule
c. Systematic selection b. Supporting schedule d. Working trial balance
d. Statistical selection
17. The major reason an independent auditor gathers audit
8. Which of the following may be used to reduce the risk evidence is to
of non sampling errors? a. Form an opinion on the financial statements
a. Increasing the size of audit samples b. Detect fraud
b. Stratifying audit samples c. Evaluate management
c. Adequately planning audit samples d. Evaluate internal control
d. Using statistical sampling techniques
18. An auditor most likely would analyze inventory turnover
9. A number of factors influences the sample size for a rates to obtain evidence concerning managements
substantive test of details of an account balance. All assertions about
other factors being equal, which of the following would a. Existence or occurrence
lead to larger sample size? b. Rights and obligations
a. Greater reliance on internal control c. Presentation and disclosure
b. d. Valuation and allocation
c. Smaller reliance o analytical procedures
d. Smaller measures of tolerable misstatement 19. To which type of the following matters would materiality
limits not apply when obtaining client representations?
a. Losses from sales commitments.
b. Unasserted claims and assessments
 c. Irregularities involving management
d. Noncompliance with contractual agreements
20. Which of the following procedures is more likely to be
performed i a review engagement of a non-public entity
that i n a compilation engagement?
a. Gaining an understading of the entitys business
transactions
b. Making a preliminary assessment of control risk
c. Obtaining a representation letter from the chief
executive officer
d. Assisting the entity i adjusting the accounting
records
28. The general cash account is considered significant in
almost all audits
a. Where the ending balance is material
b. Where either the beginning balance is material
c. Even when the ending balance is immaterial
d. Except those of not-for-profit organizations
29. Sales order form and invoice blanks should be
controlled in the
a. Sales order section of the sales department
b. Billing clerk in the accounting department
c. Credit manager in the credit department
d. Sales manager in the sales department

30. Which of the following is a substantive test of

21. In auditing accounts payable, an auditors procedures transactions
most likely would focus primarily o managements a. Review personnel policies
assertion of b. Account for a sequence of payroll checks
a. Existence or occurrence c. Reconcile the disbursements i the payroll journal
b. Presentation and disclosure with the disbursements on the payroll bank
c. Completeness statement
d. Valuation or allocation d. Examine printouts of transactions rejected by the
computer as having invalid employee numbers
22. Before goods are shipped on account, a properly
authorized person must 31. The information typically needed to prepare a
a. Prepare the sales invoice production order would not include a
b. Approve the journal entry a. Sales forecast c. Inventory plan
c. Approve credit b. Production plan d. Bill of materials
d. Verify that the unit price is accurate
32. The substantive test which requires the auditor to
23. Which of the following is not a auditors concern about trace from a file of receiving reports to the acquisitions
a key authorization point in the sales/collection cycle journal satisfies the objective of
a. The receiving room must have authorization a. Validity c. Completeness
before releasing items to inventory control b. Authorization d. Valuation
b. Credit must be authorized before sale
c. Goods must be shipped after the authorization 33. An auditor usually examines receiving reports to
d. Prices must be authorized support entries in the
a. Voucher register and sales return journal
24. Whenever footing ad comparisons are restricted to b. Sales journal and sales return journal
journals, master file records, and ledgers, the process c. Voucher register and sales journal
is d. Check register and sales journal
a. Valuation c. Cutoff
b. Summarization d. Completeness 34. The inventory and warehousing cycle can be thought
of as comprising two separate but closely related
25. The most significant effect of the results of the tests of systems, one involving the actual physical flow of
controls substantive tests of transactions in tha sales goods, and the other the
and collection cycle is on a. internal control over those goods
a. Allowance for uncollectible accounts b. related costs
b. Bad debts expense account c. storing of the goods
c. Confirmation of accounts receivable d. prevention of wastes, obsolenscence, and theft
d. Income tax payable
35. In planning an audit engagement, which of the
26. There is a difference between internal control following is a factor that affects the independent
objectives and audit objectives. Which of the following auditors judgement as to the quantity, type, and
is not an audit objective? content of working papers?
a. Validity c. a. The estimated occurrence rate of attributes
Valuation b. The preliminary evaluation based upon initial
b. Completeness d. substantive testing
Authorization c. The content of the clients representation letter
d. The anticipated nature of the auditors report
27. For effective internal control, employees maintaining
the accounts receivable subsidiary ledger should not 36. A listing of all the things which the auditor will use to
also approve gather sufficient, competent evidence is the
a. Employee overtime wages a. audit procedure
b. Credit granted to customers b. audit plan
c. Write-offs of customer accounts c. audit program
d. Cash disbursement d. audit risk model
37. The primary emphasis in most tests of details of
balances is on the
a. balance sheet accounts
b. income statement accounts
c. cash flow statement accounts
d. three statements above
38. Tracing recorded sales transactions in the sales journal
to the shipping documents (bills of lading) provides
evidence about the
a. Completeness of recording of sales transactions
b. Occurrence of sales transactions
c. billing of all sales transactions
d. presentation of payables
39. Which of the following is the best audit procedure for
the detection of lapping?
a. Comparison of postings of cash receipts to
accounts with the details of cash deposits
b. Confirmation of the cash balance
c. Reconciliation of the cash account balances
d. Preparing a proof of cash
40. To gather evidence regarding the balance per bank in
the bank reconciliation, an auditor could examine all of
the following except
a. Cut-off bank statement
b. year-end bank statement
c. bank confirmation
d. general ledger
46. The use of negative assurances in audit reports of
historical financial statements is
a. a violation of the standards of reporting
b. encouraged by the Philippine Institute of CPAs
c. a help in clarifying the degree of responsibility by
being assumed by the auditor
d. properly located in the opinion paragraph of the
unqualified report
47. Unqualified financial statements for the prior year
presented in comparative form with audited financial
statements for the current year should be clearly
marked to indicate their status and
I.The report on the prior period should be reissued to
accompany the current period report
II.The report on the current period should include as
a separate paragraph description of the responsibility
assumed for the prior periods financial statements
a. I only
b. II only
c. Both I and II
d. Either I or II
48. Compilation services are intended to enable a CPA firm
to compete with
a. Management advisory service firms
b. Tax preparation businesses
c. Computer service business
d. Bookkeeping firms

41. The confirmation of accounts receivable is most closely 49. A modification of the CPAs report on a review of the
associated with interim financial statements of a publicly-held company
a. business risk would be necessitated by which of the following?
b. detection risk a. An uncertainty
c. inherent risk b. Lack of consistency
d. relative risk c. Reference to another accountant
d. Inadequate disclosure
42. The clients physical count of inventories is lower than
the inventory quantities in the perpetual records. This 50. Comfort letters ordinarily are signed by the clients
could be the result of a failure to record a. independent auditor
a. purchases b. underwriter of securities
b. purchases discounts c. audit committee
c. sales d. senior management
d. sales discounts
ANSWER KEY
43. The most likely technique for the current year audit of
goodwill which was not acquired three years ago by a
continuing audit client. 1-5 BBDBD
a. Confirmation 6-10 DBCDA
b. Observation 11-15 ADAAC
c. Recomputation 16-20 DADCC
d. Inquiry 21-25 CCABD
26-30 DDDAC
44. The auditor will most likely perform extensive tests for 31-35 DCABD
possible understatement of 36-40 DABAD
a. revenues 41-45 BDCCA
b. assets 46-50 ADDAA
c. liabilities
d. capital

45. If the auditor is determined to lack independence, a

disclaimer of opinion must be issued
a. in all cases
b. only if it is highly material
c. only if it is material
d. if the client requests it
 Defining Professional Responsibility Quality Standards and Ethics
1.Which of the following did not result at least partially due to
the alleged audit failures of the 1980s and 1990s?
a. The Treadway Report.
b. An SAS further defining the auditors responsibility for
fraud detection.
c. Formation of the AICPA Fraud Commission.
d. Formation of the Independence Standards Board.
ANSWER: C
2. Competence as a certified public accountant includes all of
the following except
a. Having the technical qualifications to perform an
engagement.
b. Possessing the ability to supervise and evaluate the
quality of staff work.
c. Warranting the infallibility of the work performed.
d. Consulting others if additional technical information
is needed.
ANSWER: C
3. Which of the following is mandatory if the auditor is to
comply with generally accepted auditing standards?
a. Possession by the auditor of adequate technical
training.
b. Use of analytical review on audit engagements.
c. Use of statistical sampling whenever feasible on an
audit engagement.
d. Confirmation by the auditor of material accounts
receivable balances.
ANSWER: A
4. As a guidance for measuring the quality of the performance
of an auditor, the auditor should refer to
a. Statements of the Financial Accounting Standards
Board.
b. Generally Accepted Auditing Standards.
c. Interpretations of the Statements on Auditing
Standards.
d. Statements on Quality Control Standards.
ANSWER: B
5. In addition to auditing, CPAs perform other services for
their clients. Standards governing the quality of these
services are covered in the attestation standards
generally, and performance requirements are more
explicitly defined in sets of statements relating to each
type of service. Which of the following is not such a
set?
a. Statements on Standards for Consulting Services.
b. Statements on Responsibilities in University Audits.
c. Statements on Standards for Accounting and Review
Services.
d. Statements on Responsibilities in Tax Practice.
ANSWER: B
6. Which of the following is a violation of Rule 301
(Confidential Client Information) of the Code of
Professional Conduct?
a. The CPA, in response to a court subpoena, submits
auditor-prepared workpapers as evidence of
possible illegal acts perpetrated by the client.
b. The CPA discloses to the board of directors a
scheme concocted by top management to
intentionally inflate earnings.
c. The CPA warns Client B as to the inadvisability of
acquiring Client A. The CPA bases this
warning on knowledge of Client A's financial
condition and a belief that the management of
Client A lacks integrity. This knowledge was
obtained by the CPA as a result of auditing
Client A during the past several years.
d. The CPA, when questioned in court, admits to
knowledge of certain illegal acts perpetrated
by the client.
ANSWER: C
7. Which of the following statements best describes why the
CPA profession has deemed it essential to promulgate
ethical standards and to establish means for ensuring
their observance?
a. A requirement for a profession is the establishment
of ethical standards that stress primarily a responsibility to
clients and colleagues.
b. A requirement of most state laws calls for the profession to
establish a code of ethics.
c. An essential means of self-protection for the profession is the
establishment of flexible ethical standards by the profession.
d. A distinguishing mark of a profession is its acceptance of
responsibility to the public.
ANSWER: D
8. Which of the following best describes what is meant by
generally accepted auditing standards?
a. Audit objectives generally determined on audit
engagements.
b. Acts to be performed by the auditor.
c. Measures of the quality of the auditor's performance.
d. Procedures to be used to gather evidence to support
financial statements.
ANSWER: C
9. Which of the following best describes what is meant by
generally accepted auditing standards?
a. Pronouncements issued by the Auditing Standards Board.
b. Procedures to be used to gather evidence to support
financial statements.
c. Rules acknowledged by the accounting profession because
of their universal compliance.
d. Measures of the quality of the auditor's performance.
ANSWER: D
10.Under which of the following circumstances may a CPA
agree with a departure from an accounting principle
promulgated by that body designated by AICPA Council
to formulate such principles?
a.When the principle was one formulated by the
Accounting Principles Board inasmuch as the APB is
no longer the body so designated by Council.
b.When the CPA can demonstrate that application of
the principle in question would make the financial
statements materially misleading.
c.When the disputed principle is contrary to industry
practice. 15.
d.When adoption of the principle would cause the
financial statements to be inconsistent with prior years.
ANSWER: B every
11. Pursuant to the AICPA rules of conduct, the auditor's
responsibility to the profession is defined by
experience
a. The AICPA Code of Professional Conduct.
b. Federal laws governing licensed professionals who
are involved in interstate commerce.
c. Statements on Auditing Standards. 16.
d. The Bylaws of the AICPA.
ANSWER: A
12. An auditor who accepts an audit engagement and does not
possess the industry expertise of the business entity, should
a. Engage financial experts familiar with the nature of
the business entity.
b. Obtain a knowledge of matters that relate to the
nature of the entity's business.
c. Refer a substantial portion of the audit to another
CPA who will act as the principal auditor.
d. First inform management that an unqualified opinion 17.
cannot be issued.
ANSWER: B
13.Which of the following factors is most important concerning
an auditor's responsibility to detect errors and fraud?
a. The susceptibility of the accounting records to
intentional manipulations, alterations, and the
misapplication of accounting principles.
b. The probability that unreasonable accounting
estimates result from unintentional bias or
intentional attempts to misstate the financial 18. The first general standard recognizes that regardless of
statements.
c. The possibility that management fraud, defalcations,
and misappropriation of assets may indicate the
existence of illegal acts.
d. The risk that mistakes, falsifications, and omissions
may cause the financial statements to contain
material misstatements.
ANSWER: D
14. The standard of due audit care requires the auditor to
a. Apply judgment in a conscientious manner,
carefully weighing the relevant factors before
reaching a decision.
b. Ensure that the financial statements are free
from error.
c. Make perfect judgment decisions in all cases.
d. Possess skills clearly above the average for
the profession.
ANSWER: A
The exercise of due professional care requires that an
auditor
a. Examine all available corroborating evidence.
b. Critically review the judgment exercised at
level of supervision.
c. Reduce control risk below the maximum.
d. Attain the proper balance of professional
and formal education.
ANSWER: B
A CPA who has never audited a commercial bank
a. May not accept such an engagement.
b. May accept the engagement only if the
accounting firm specializes in the audit of
commercial banks.
c. May accept the engagement after attaining a
suitable level of understanding of the
transactions and accounting practices unique
to commercial banking.
d. May accept the engagement because training
as a CPA transcends unique industry
characteristics.
ANSWER: C
The first general standard requires that a person or
persons have adequate technical training and
proficiency as an auditor. This standard is met by
a. An understanding of the field of business and
finance.
b. Education and experience in the field of auditing.
c. Continuing professional education.
d. A thorough knowledge of the Statements on
Auditing Standards.
ANSWER: B
how capable an individual may be in other fields, the
individual cannot meet the requirements of the auditing
standards without the proper
a.Business and finance courses.
b.Quality control and peer review.
c.Education and experience in auditing.
d.Supervision and review skills.
ANSWER: C
19. In determining estimates of fees, an auditor may take into
account each of the following, except the
a. Value of the service to the client.
b. Degree of responsibility assumed by undertaking
the engagement.
c. Skills required to perform the service.
d. Attainment of specific findings.
ANSWER: D
20. A CPA, while performing an audit, strives to achieve
independence in appearance in order to
21.
a. Reduce risk and liability.
b. Comply with the generally accepted standards of
field work.
c.Become independent in fact.
d. Maintain public confidence in the profession.
d. To provide the corporate owners with an opportunity to
voice their opinion concerning the quality of the
auditing firm selected by the directors.
ANSWER: B
22. Which of the following is not required by the generally
accepted auditing standard that states that due
professional care is to be exercised in the
performance of the examination?
a. Observance of the standards of field work and
reporting.
b. Critical review of the audit work performed at every
level of supervision.
c. Degree of skill commonly possessed by others in
the profession.
d. Responsibility for losses because of errors of
judgment.
ANSWER: D

ANSWER: D
23. The third general standard states that due care is to be
exercised in the performance of the examination. This
21. Which of the following best describes why publicly standard means that a CPA who undertakes an
traded corporations follow the practice of having the engagement assumes a duty to perform each audit
outside auditor appointed by the board of directors or
elected by the stockholders?
a. As a professional possessing the degree of skill
commonly possessed by others in the field.
a. To comply with the regulations of the Financial b. In conformity with generally accepted accounting
Accounting Standards Board. principles.
b. To emphasize auditor independence from the management c. With reasonable diligence and without fault or error.
of the corporation. d. To the satisfaction of governmental agencies and
c. To encourage a policy of rotation of the independent investors who rely upon the audit.
auditors.
ANSWER: A

COMPLETION:

24. Client outsourcing of certain accounting functions, such as internal auditing, to the national accounting firms may cause
financial statement users to question ___________ _______________.

ANSWER: AUDITOR INDEPENDENCE (OR INDEPENDENCE OF THE AUDITOR)

25. Through the , the AICPA has provided a framework for defining the acceptable quality of independent
audits and other services rendered by CPAs.

ANSWER: CODE OF PROFESSIONAL CONDUCT

26. Proper study and evaluation of internal accounting control is needed because virtually all independent audits are
.

ANSWER: TEST BASED

27. The generally accepted auditing standards, as promulgated by the American Institute of Certified Public Accountants, define
the ______________ of independent auditing.

ANSWER: QUALITY
28. The general standards relate to the and of the auditor.

ANSWER: CHARACTER, COMPETENCE

29. The field work standards are concerned with the process.

ANSWER: AUDIT

30. The reporting standards relate to the function.

ANSWER: ATTEST

MATCHING:

31. Match each of the following actions with the Code of Conduct rule violated by the action. No rule is used more than once.
Briefly explain why the action is a violation of the rule cited.

a. Rule 101: Independence

b. Rule 102: Integrity and objectivity
c. Rule 201: General standards
d. Rule 202: Compliance with standards
e. Rule 203: Accounting principles
f. Rule 301: Confidential client information
g. Rule 302: Contingent fees
h. Rule 501: Acts discreditable
i. Rule 502: Advertising and other forms of solicitation
j. Rule 503: Commissions and referral fees
k. Rule 505: Form of practice and name

____1. Juanita Garcia, CPA, refused to be associated with a clients financial statements after the client declined to correct a material
misstatement. Garcia later contacted James Jordan, CPA, retained by the client to replace Garcia, and informed Jordan of the
misstatement.

____2. Brianna Lopez, CPA, agreed to review loan applications for First Charter Bank, an audit client. The bank granted or denied the
loans on the basis of Lopez recommendations.

____3. In defense of a lawsuit alleging negligence, Melissa Franklin, CPA, explained that she was not an expert in commodities trading
and therefore did not detect the accounting fraud perpetrated by her client, a commodities broker.

____4. Rudy Boesch, CPA, accepted an audit engagement for a fixed fee of $27,000 plus 1% of audited net assets.

____5. In reviewing the corporate tax return for Eager Turnstiles, Inc., Abba Shah, CPA, discovered that Eagers controller had
incorrectly reported a $500,000 purchase of painting equipment as repairs expense. When Shah informed the controller of the
tax code violation, she refused to correct the return. Shah signed the return as preparer

____6. Ben Williams, CPA, issued an unqualified opinion on a set of financial statements, even though he felt uncomfortable about an
accounting practice applied by the client. Although the practice in question was in accordance with GAAP, it increased net
income significantly above a level that Williams considered reasonable.

____7. Jones Transfer Company wishes to defer charging certain research and development expenditures to current income on the
basis that the expenditures are virtually certain to benefit future operations. For this reason, Jack Risher, CPA and Jones
auditor, agrees with the proposed accounting treatment.

SOLUTION:

1. f: This is a violation of client confidence. Had Garcia been contacted by Jordan, with her former clients permission, she
could have informed Jordan of the disagreement.
 2.a: The independence rule prohibits a member from being associated with an audit client in any capacity equivalent to that of
a member of management. Making loan recommendations casts Lopez in that capacity.

3.c: Rule 201 (A) Permits a member to undertake only those engagements that the member or the members firm can
complete with professional competence. Before accepting this engagement, therefore, Franklin should have received
training in commodities trading and related accounting practices.

4.g: A member is not permitted to perform an attest engagement on a contingent fee basis. In this case, the higher the
audited net income, the higher will be the audited net assets, and the higher will be the audit fee. Such
arrangements impair auditor objectivity.

5.d: Rule 202 requires members to comply with all of the standards governing the practice of public accounting as set by
those AICPA bodies responsible for promulgating them. One of these sets of standards is the Statements on
Responsibilities in Tax Practice, which prohibits members from being associated with tax returns known to contain
material errors.

6.b: Rule 102 states that a member shall not knowingly misrepresent facts or subordinate his or her judgment to others. In
this case, Williams, in agreeing to the questionable practice, subordinated his judgment to that of management,
thereby failing to adequately represent the interests of the stockholders.

7.e:A member may not agree to a departure from an accounting principle promulgated by the body designated by Council to
establish such principles unless the departure is necessary in order not to make the financial statements materially
misleading. In the present case, inasmuch as the R & D expenditures are not directly reimbursable, they must be
charged to expense in the current period; and, therefore, Risher is wrong in agreeing to the departure from GAAP.

Problem/Essay

33. John Block, CPA, has been approached by a prospective new audit client, Snappy Enterprises, Inc. Snappy had previously
been audited by another CPA. Before accepting the engagement, Block discussed several matters with Snappys controller and (with
Snappys permission) the other CPA. As a result of these discussions, the following information was obtained.
Incorporated in 1992, Snappys primary business is buying, developing, selling, and leasing commercial real estate.
Apartment complexes, shopping malls, and industrial parks make up the major portion of the companys business. Starting out in
Albuquerque, New Mexico and the surrounding area, Snappy gradually expanded its operations to include most of southwestern United
States, including the Phoenix--Scottsdale--Mesa area of Arizona.
After two years of losses, the company reported its first earnings in 1994. From 1995 to 2000, revenues and earnings
increased dramatically. Earnings for 2001 and 2002, however
declined from earlier levels. For the current year, 2003, unaudited net income has rebounded to the 2000 level.
Block has learned from discussions with Snappys controller that, as of 12/31/03, the end of the current year, the company was
in the process of completing a major mall project. The company currently owns several apartment complexes and leases its completed
shopping malls to numerous retail establishments. After having been developed, industrial properties are sold either to municipalities or
to companies locating in the complexes.
In discussing past audits with the CPA formerly engaged by Snappy, Block learned that several disagreements had arisen over
the years, many of which had not been resolved to the satisfaction of the former auditors. The disagreements related to accounting
matters as well as to the substance of certain transactions with lessees.

Required:

a. In deciding whether to accept this engagement, what factors should Block consider?
b. If he decides to accept the engagement, in what areas should he concentrate his audit resources?

SOLUTION:

a. Factors Block should consider are the following:

1. Seriousness of disagreements with the prior auditor and their potential impact on the financial statements
2. Whether the disagreements demonstrate lack of management integrity
3. Competence of Block to satisfactorily perform the audit
b. The increase in unaudited earnings suggests possible overstatement of revenues or understatement of
expenses. For this reason, Block should focus on the following areas:
1.Cost allocations to the uncompleted mall project. Operating expenses may have been inappropriately
allocated to the project and reflected as assets
2. Adequacy of provisions for uncollectible lease rentals
3.Whether financing leases have been incorrectly treated as sales type leases
4.Whether revenues or gains have been improperly recognized as a result of transactions with
lessees (related parties)
 Maintaining Professional Responsibility: Regulation and Legal Liability

1933. Mane & Co., CPAs, rendered an unqualified opinion

1.A CPA firm studies its personnel advancement experience to on the financial statements of Salem which
ascertain whether individuals meeting stated criteria are were included in
assigned increased degrees of responsibility. This is Salem's registration statement filed with the SEC on
evidence of the firm's adherence to prescribed standards of March 1, 2002 Kent has commenced an action
against Mane based on the Securities Act of 1933
a. Supervision and review. provisions dealing with omissions of facts required to
b. Continuing professional education. be stated in the registration
c. Professional development. statement. Which of the following elements of a cause
d. Quality control. of action under the Securities Act of 1933 must be
proved by Kent?
ANSWER: D a. Kent relied upon Mane's opinion.
b. Kent was the initial purchaser of the
2. Which one of the following, if present, would support a stock and gave value for it.
finding of constructive fraud on the part of a c. Mane's omission was material.
CPA? d. Mane acted negligently or fraudulently.
a. Privity of contract.
b. Intent to deceive. ANSWER: A
c. Reckless disregard.
d. Ordinary negligence. 6. The limitation of auditor liability under contract law is
known as
ANSWER: C
a. Privity of contract.
3. The CPA firm of Knox and Knox has been subpoenaed b. Contributory liability.
to testify and produce its correspondence and c. Statutory liability.
workpapers in connection with a lawsuit brought by a d. Common law liability.
third party against one of their clients. Knox
considers the subpoenaed documents to be ANSWER: A
privileged communication and therefore seeks to avoid
admission of such evidence in the lawsuit. Which of 7. Under the Securities Act of 1933, the registration of
the following is correct? securities which are offered to the public in interstate
a. Federal law recognizes such a commerce is
privilege if the accountant is a a. Directed toward preventing the marketing of securities
Certified Public Accountant. which pose serious financial risks to the
b. The privilege is available regarding prospective investor.
the workpapers since the CPA is b. Not required unless the issuer is a
deemed to own them. corporation. c. Mandatory unless the cost to the
c. The privileged communication rule as it issuer is "prohibitive" as
applies to a CPA/client relationship is the same defined in the SEC regulations. d. Required
as that of attorney-client. unless there is an applicable exemption.
d. In the absence of a specific statutory
provision, the law does not recognize the ANSWER: D
existence of the privileged communication
rule between a CPA and his client. 8. The auditor's defense of contributory negligence is
ANSWER: D most likely to prevail when

4. Of the following statements, which best distinguishes
ordinary negligence from gross negligence?
a. Failure to detect material errors, whether
internal control is strong or weak, suggests
gross negligence.
b. Failure to exercise reasonable care denotes
ordinary negligence, whereas failure to
exercise minimal care indicates gross
negligence.
c. Gross negligence is most probable when the
auditor fails to detect errors that occurred
under conditions of strong internal control.
d. The more material the undetected error the
greater the likelihood of ordinary negligence.
ANSWER: B
5. On July 1, 2002, Kent purchased common stock of
Salem Corp. in an offering subject to the Securities Act of
a. Third party injury has been minimal.
b. The auditor fails to detect fraud resulting from
management override of the control structure.
c. The client is privately held as contrasted with
a public company.
d. Undetected errors have resulted in materially
misleading financial statements.
ANSWER: B
9. The objective of quality control mandates that a public
accounting firm should establish policies and
procedures for professional development which provide
reasonable assurance that all entry-level personnel
a. Prepare working papers which are
standardized in form and content.
b. Have the knowledge required to
enable them to fulfill responsibilities
assigned.
 c. Will advance within the organization. statement filed with the SEC included the financial
d. Develop specialties in specific areas of public statements. Gold is being sued by Egan under
accounting. Section 11 of the Securities Act of 1933 for the
ANSWER: B misstatements contained in the financial statements.
To prevail, Egan must prove
10. A plaintiff wishes to recover damages from the issuer
for Scienter Reliance
losses resulting from material misstatements in a a. No No
securities b. No Yes
registration statement. In order to be successful, one of c. Yes No
the elements the plaintiff must prove is that the d. Yes Yes
a. Plaintiff was in privity of contract with
the issuer or that the issuer knew of ANSWER: A
the plaintiff.
b. Plaintiff acquired the securities. 15. The Rusch Factors and Rhode Island Hospital Trust
c. Issuer acted negligently. cases further defined the doctrine of privity by stating
d. Issuer acted fraudulently. that

ANSWER: B a. Stockholders, as owners of the company, are

also parties to the contract between auditor
11. A basic objective of a CPA firm is to provide and client.
professional services that conform with professional b. Privity extends to primary third party
standards. Reasonable assurance of achieving this basic beneficiaries known by the auditor to be
objective is provided through relying on the financial statements.
a. A system of peer review. c. The doctrine of privity is broken when
b. Continuing professional education. management intentionally misrepresents
c. A system of quality control. financial position and/or results of operations.
d. Compliance with generally accepted reporting d. Privity extends to third parties only in cases
standards. involving auditor negligence.

ANSWER: C ANSWER: B

12. Mix and Associates, CPAs, issued an unqualified 16. In connection with the element of professional
opinion on development, a CPA firm's system of quality control should
the financial statements of Glass Corp. for the year ended ordinarily provide that all personnel
December 31, 2002. It was determined later that Glass'
treasurer had embezzled $300,000 from Glass during a. Have the knowledge required to
2002. Glass sued Mix because of Mix's failure to enable them to fulfill
discover the embezzlement. Mix was unaware of responsibilities assigned.
the embezzlement. Which of the following is b. Possess judgment, motivation, and adequate
Mix's best defense? experience. c. Seek assistance from persons
a. The audit was performed in accordance with having appropriate level
GAAS. b. The treasurer was Glass' agent and, of knowledge, judgment, and authority.
therefore, Glass was responsible for d. Demonstrate compliance with peer review
preventing the embezzlement. c. The financial directives.
statements were presented in conformity with
GAAP. ANSWER: A
d. Mix had no actual knowledge of the embezzlement.
17. In the case of Fischer v. Kletz (Yale Express), the
ANSWER: A auditors were charged with fraud for failing to inform
users of nonexistent accounts receivable. Although the
13. Which of the following is not a condition for case was settled out of court, it did encourage the
membership in the Division for CPA Firms? profession to issue a Statement on Auditing Standards
a. Participating in peer review. relating to
a. Employing only CPAs.
b. Conforming to specified continuing a. Related party transactions.
professional b. Auditor responsibility for detecting illegal acts.
education requirements. c. Audit risk assessment.
c. Maintaining adequate levels of d. Subsequent discovery of facts existing at the
liability date of the audit report.
insurance.
ANSWER: D
ANSWER: B
18. Accounting firms should establish quality control
14. Gold, CPA, rendered an unqualified opinion on the procedures for professional development in order to
2000 financial statements of Eastern Power Co. provide reasonable assurance that
Egan purchased Eastern bonds in a public offering d. Persons promoted possess the
subject to the Securities Act of 1933. The registration appropriate
 characteristics to perform competently. Provide the CPA with evidence and documentation which
b. Personnel will have the knowledge required to may be helpful in the event of a lawsuit.
fulfill responsibilities assigned. d. Establish a continuity of relationship with the
c. The extent of supervision and review in a client whereby indiscriminate replacement of CPAs
given is discouraged.
instance will be appropriate.
d. Association with a client whose management ANSWER: C
lacks integrity will be minimized.
23. Mead Corp. orally engaged Dex & Co., CPAs, to audit
ANSWER: B its financial statements. The management of
Mead informed Dex that it suspected that the
19. The factor that distinguishes constructive fraud from accounts receivable were materially
actual fraud is overstated. Although the financial statements
a. Materiality. audited by Dex did, in fact, include a materially
b. Quality of internal control. overstated accounts receivable balance, Dex issued an
c. Type of error or irregularity. unqualified opinion. Mead relied on the financial
d. Intent. statements in deciding to obtain a loan from City Bank
to expand its operations. City relied on the financial
ANSWER: D statements in making the loan to Mead. As a result
of the overstated accounts receivable balance, Mead
20. Gleam is contemplating a common law action against has defaulted on the loan and has incurred a
Moore & Co. CPAs, based upon fraud. Gleam substantial loss. If Mead sues Dex for negligence in
loaned money to Lilly & Co. relying upon Lilly's failing to discover the overstatement, Dex's best
financial statements which were audited by Moore. defense would be that
Gleam's action will fail if a. No engagement letter had been signed by
a. Gleam shows only that Moore failed Dex. b. The audit was performed by Dex in
to meticulously follow GAAS. accordance with generally accepted auditing
b. Moore can establish that they fully standards.
complied with the statute of frauds. c. Dex was not in privity of contract with Mead.
c. The alleged fraud was in part committed by d. Dex did not perform the audit recklessly or
oral misrepresentations and Moore with an intent to deceive.
pleads the parol evidence rule.
d. Gleam is not a third party beneficiary in light ANSWER: B
of the absence of privity.
24. Dickens, a CPA firm's personnel partner, periodically
ANSWER: A studies the CPA firm's personnel
advancement experience to
21. In the Continental Vending Machine Corporation case, ascertain whether individuals meeting stated
the court argued that a footnote appearing in the criteria are assigned increased degrees of
company's responsibility. This is evidence of the CPA firm's
annual report was confusing and misleading. As a adherence to prescribed
result, the accounting profession a. Standards of due professional care.
a. Encouraged practitioners to carry adequate b. Quality control standards.
liability insurance. c. Supervision and review standards.
b. Issued a Statement on Auditing Standards d. Reporting standards.
defining related party transactions and
assigning auditor responsibility for detecting ANSWER: B
material related party transactions and
determining that the economic substance of 25. West & Co., CPAs, was engaged by Sand Corp. to
such transactions is properly reflected in the audit its financial statements. West issued an
financial statements. unqualified opinion on Sand's financial statements. Sand
c. Issued a Statement on Auditing Standards has been accused of making negligent
requiring auditor presence at the client's misrepresentations in the financial
physical inventory taking and auditor statements, which Reed relied upon when purchasing Sand
confirmation of customer accounts receivable. stock. West was not aware of the misrepresentations
d. More clearly defined "privity of contract" nor was it negligent in performing the audit. If Reed sues West
between auditor and client. for damages based upon Section 10(b) and rule 10b-5 of
the Securities Exchange Act of 1934, West will
ANSWER: B a. Lose, because Reed relied upon the financial
22. Working papers prepared by a CPA in connection with statements.
an audit engagement are owned by the CPA, b. Lose, because the statements contained negligent
subject to certain limitations. The rationale for this misrepresentations. c.
rule is to Prevail, because some element of scienter
a. Protect the working papers from being must be proved.
subpoenaed. b. Provide the basis for d. Prevail, because Reed was not in privity of
excluding admission of the contract with West.
working papers as evidence because of the privileged
communication rule. c. ANSWER: C
26. A CPA establishes quality control policies and ANSWER: D
procedures
for deciding whether to accept a new client or continue 30. Tulip Corp. is a registered and reporting corporation
to perform services for a current client. The primary under the Securities Exchange Act of 1934. As such it
purpose for establishing such policies and procedures a. Can offer and sell its securities to the
is public without the necessity of
a. To enable the auditor to attest to the registering its securities pursuant to
integrity or reliability of a client. the Securities Act of 1933.
b. To comply with the quality control standards b. Cannot make a tender offer for the
established by regulatory bodies. equity securities of another
c. To lessen the exposure to litigation resulting registered and reporting corporation
from failure to detect irregularities in client financial without the consent of the SEC.
statements. c. Must file annual reports (Form 10-K) with the
d. To minimize the likelihood of association with clients SEC. d. Must distribute a copy of the annual
whose management lacks integrity. report (Form 10-K) to each of its shareholders.

ANSWER: D ANSWER: C

27. Which of the following statements is correct concerning 31. A CPA firm issues an unqualified opinion on financial
corporations subject to the reporting requirements of statements not prepared in accordance with
the Securities Exchange Act of 1934? GAAP. The CPA firm will have acted with scienter in
a. The annual report (form 10-K) need all the following circumstances except where the firm
not include audited financial a. Intentionally disregards the truth.
statements. b. Has actual knowledge of fraud.
b. The annual report (form 10-K) must c. Negligently performs auditing
be filed with the SEC within 20 procedures.
days of the end of the corporation's d. Intends to gain monetarily by concealing the
fiscal year. fraud.
c. A quarterly report (form 10-Q) need only be
filed with the SEC by those corporations that ANSWER: C
are also subject to the registration
requirements of the Securities Act of 1933. 32. Which of the following conditions suggests auditor
d. A monthly report (form 8-K) must be filed with negligence?
the SEC after the end of any month in which a
materially important event occurs. a. Failure to detect material errors under
conditions of weak internal control.
ANSWER: D b. Failure to detect collusive fraud perpetrated
by members of middle management.
28. In a common law action against an accountant, the c. Failure to detect collusive fraud perpetrated
lack of by members of top management.
privity is a viable defense if the plaintiff d. Failure to detect errors occurring outside the
a. Bases his action upon fraud. internal control structure.
b. Is the accountant's client.
c. Is a creditor of the client who sues the ANSWER: A
accountant for negligence.
d. Can prove the presence of gross negligence 33. The registration of a security under the Securities Act
which amounts to a reckless of 1933 provides an investor with
disregard for the truth. a. A guarantee by the SEC that the
facts contained in the registration
ANSWER: C statement are accurate.
b. An assurance against loss resulting from
29. Donn & Co. is considering the sale of $11 million of its purchasing the security.
common stock to the public in interstate c. Information on the principal purposes for
commerce. In this connection, Donn has been correctly which the offering's proceeds will be used.
advised that registration of the d. Information on the issuing corporation's trade
securities with the SEC is secrets.
a. Not required if the states in which the
securities are to be sold have securities acts ANSWER: C
modeled after the federal act and
Donn files in those states. b. Required 34. The principal purpose of the registration requirements
in that it is necessary for the SEC to approve of the Securities Act of 1933 is to
the merits of the securities offered. a. Prevent public offerings of securities in which
c. Not required if the securities are to management fraud or unethical conduct is
be sold through a suspected. b. Provide the SEC with the information
registered brokerage firm. necessary to determine the accuracy of the facts
d. Required and must include audited financial presented in the financial statements.
statements as an integral part of its registration.
 c. Assure that investors have adequate information necessary to evaluate the
information upon which to base investment financial merits of the securities being offered.
decisions. d. Provide the SEC with the
ANSWER: C

COMPLETION:

35. A committee formed in 1999 to focus on the problem of managed earnings, cookie-jar reserves, purchased R&D
write-offs, and abuse of the materiality concept is known as the __________ __ _______ _____________.

ANSWER: PANEL ON AUDIT EFFECTIVENESS

36. A disparity between users' and CPAs' perceptions of auditor responsibility is referred to as the .

ANSWER: EXPECTATION GAP

37. Ultimate authority to set accounting and auditing standards rests with the .

ANSWER: SECURITIES AND EXCHANGE COMMISSION

38. is defined as negligence so flagrant as to border on deceit.

ANSWER: CONSTRUCTIVE FRAUD

39. The primary difference between contractual liability to clients and civil liability to third parties is that, under civil liability, the
auditor is not liable to third parties for .

ANSWER: ORDINARY NEGLIGENCE

40. Given the Securities Exchange Act of 1934 and the concept of "integrated disclosure", information may be ____________ ___
in Form 10-K.

ANSWER: INCORPORATED BY REFERENCE

41. The legal term for "intent to deceive" is .

ANSWER: SCIENTER

42. Auditor liability under the Securities acts is referred to as liability.

ANSWER: STATUTORY

43. In responding to an underwriter's request for a __________

_________, the auditor will likely apply certain limited procedures to the financial data arising subsequent to the most recent
audit.

ANSWER: COMFORT LETTER

44. In the Ernst and Ernst v. Hochfelder case, the U.S. Supreme Court held that auditors are not liable for under Rule 10B-5
of the Securities Exchange Act of 1934, but only for .

ANSWER: NEGLIGENCE, SCIENTER (FRAUD)

MATCHING:

45. Match each of the responsibilities enumerated below with the bodies charged with that responsibility.

a. State board of accountancy

b. SEC Practice Section
c. Public Oversight Board
d. Securities and Exchange Commission
e. AICPA Quality Control Standards Board
f. Independence Standards Board
g. Emerging Issues Task Force
h. Panel on Audit Effectiveness
____ 1. Oversee peer review for public companies.

____ 2. Issue a guideline for reviewing accounting firm

personnel for promotion.

____ 3. Issue recommendations directed toward improving the

quality of independent audits.

____ 4. Recommend that the executive committee of the SEC

Practice Section sanction a member for failing to
comply with the Sections peer review standards.

____ 5. Issue a standard prohibiting an accounting firm from

accepting an accounting service engagement from an
audit client on the basis that performing both types
of service might impair objectivity.

____ 6. Review prospectus and registration statement of

company contemplating an initial public offering.

____ 7. Revoke license of member for committing a

discreditable act.

____ 8. Monitor FASB deliberations concerning the proper

accounting treatment to be applied to derivatives.

SOLUTION:
1. b
2. e
3. h
4. c
5. f
6. d
7. a
8. g

ESSAY

46.An auditor is sued for negligence by the stockholders of an audit client. The auditor had issued an unqualified opinion on the clients
financial statements. It was later determined that the statements were materially distorted due to errors and fraud.

Required:
a. Under what conditions, in common law may an auditor be held liable to third parties for negligence?

b. Describe two approaches for differentiating between ordinary negligence and gross negligence. Cite examples to
support your approaches.

c. Who will prevail in the present case?

SOLUTION:

a. The doctrine of privity states that auditors are liable to third parties for fraud but not for negligence. Subsequent court
decisions, such as Ultramares v. Touche, however, have construed gross negligence as constructive fraud. Auditors, therefore, may be
held liable to injured third parties for gross negligence, but not for ordinary negligence. In addition, privity may extend to specifically
identified third parties known by the auditor to be relying on the audited financial statements.

b. Two approaches to distinguishing ordinary negligence from gross negligence are materiality and internal control.
Performing an audit with due care should permit the auditor to detect a material misstatement not cleverly concealed. For example, an
inventory extension error (price x quantity) that overstates the ending inventory by 25 percent and results in a material overstatement of
net income should be detected in the ordinary course of the audit.
Errors or fraud perpetrated because of weak internal controls are more likely to be detected by the auditor than errors or fraud
perpetrated outside the existing system of internal control. For example, material misstatements caused by classification errors related
to repairs and maintenance expenditures versus property, plant, and equipment additions may occur because the persons charged with
determining the appropriate accounts to be debited have not been adequately trained. This constitutes an internal control weakness;
and the auditors should have detected the weakness and modified their substantive audit testing accordingly.
 Contrast this with a material misstatement caused by management intentionally overriding existing internal control for the
purpose of inflating earnings. As part of the scheme, documentation supporting fictitious sales may have been fabricated. Under these
conditions, the prudent auditor is less likely to detect the fraud.

c. To prevail in the present case, the plaintiffs must demonstrate that the auditor was grossly negligent and must also
prove that the plaintiffs were injured by the auditors negligence.

47. A. How does the level of quality maintenance within the accounting profession impact the expectations gap? Cite examples in
your answer.
B. What is the alternative to self-regulation? Cite two measures the profession has taken in recent years to meet the
challenges posed by the threat of a widening expectations gap?

SOLUTION:

The goal of self-regulation within the accounting profession is to maintain the quality of accounting services at a level that will
satisfy the users of these services. The expectations gap is the disparity between users and CPAs perceptions of the quality of these
services. Therefore, a decline in either the quality of services rendered by CPAs or users perceptions of quality causes a widening of
the expectations gap. Such diminishments occur, for example, when courts find auditors negligent in the performance of audits or when
the financial press reports incidents of alleged audit failures. Cases involving Phar Mor, Lincoln Savings and Loan, Crazy Eddie, and
Miniscribe can be cited as illustrations. CPA consulting services for audit clients impair the appearance of independence, and is
another means for widening the expectations gap and undermining the perceived effectiveness of self-regulation.
The alternative to self-regulation is external regulation by the SEC or a similar public body. One must remember that the SEC
already has the authority granted by the securities acts to regulate the accounting profession, but has declined to fully exercise that
authority. If the expectations gap were to widen significantly, however, and self-regulation is perceived to be ineffective, the SEC may
well decide to actively pursue its regulatory powers.
To meet the challenges posed the threat of a widening expectations gap and more external regulation, the profession, in
recent years, has:
1. Assigned the auditor responsibility for planning the audit to provide reasonable assurance of detecting material
financial statement errors and fraud;
2. Required auditors to evaluate the ability of each audit client to continue as a going concern;
3. Encouraged clients to appoint audit committees to monitor internal control and arbitrate disputes between
management and the external auditors;
4. Issued a new SAS that provides more explicit guidance to auditors for detecting fraud and communicating the
findings to management and the board of directors;
5. Created an Independence Standards Board to actively pursue issues involving auditor independence

48. For each of the following capsule cases, determine the outcome and provide the rationale to support your conclusion.

1. A group of stockholders is suing a CPA for failing to detect a material misappropriation of customer cash receipts by
the controller of a company in which the group has invested. The fraud occurred because the controller had access to cash as well as
the accounting records. The fraud was concealed by not recording the receipts. To conceal the overstatement of accounts receivable,
the controller inflated sales returns and allowances and wrote off some of the accounts as uncollectible. The CPA failed to detect the
fraud in the course of the audit.

2. The management of a large manufacturer of exercise equipment inflated net assets and net earnings by 1)recording
fictitious sales and fabricating the underlying documentation; 2)debiting operating expenses to several construction projects in progress;
and 3) inflating inventories by not recording sales returns and including the inventory at full cost, and inflating various inventory unit
costs. These frauds were detected by IRS auditors after the companys check for payment of income taxes bounced. The
independent auditors did not discover the misrepresentation, and the new management is now suing them for failure to detect the fraud.

3. A CPA failed to detect a misrepresentation fraud perpetrated by an audit client. The fraud was material in its impact
on the financial statements and was effected by debiting operating expenses and manufacturing overhead to work orders for various
construction projects underway. The projects did not exist and the CPA examined a client-prepared analysis of the work orders rather
than the work orders themselves. Moreover, the CPA did not ask to inspect any of the projects.
An action alleging negligence was brought against the CPA by the bank that granted a loan to the company on the basis of the
audited financial statements. The inflated earnings figure resulting from the misrepresentation was an integral part of the decision to
grant the loan.
The CPA had rendered an unqualified opinion on the financial statements. This was the first year the company had been
audited. In past years, the CPA had performed only a review of the companys financial statements; but this year the company
requested an audit as part of the banks conditions for processing the loan application.

SOLUTION:

1. The stockholders need to prove gross negligence by the CPA, inasmuch as they are not privy to the contract between
the CPA and the client. The CPA appears to have been grossly negligent in this case. First, the fraud was facilitated by internal control
weaknesses - the controller had access to cash as well as to accounting records. The CPA should have noted the weakness in
assessing internal control and modified substantive audit programs accordingly. Further investigation of the accounts receivable write-
offs, including contacting customers whose accounts had been written off, should have enabled the auditor to detect the fraud. In
summary, this is a material fraud perpetrated within the system of internal control, and failure to detect is evidence of gross negligence.

2. The auditors appear not to be negligent in this case. Like Cenco v. Seidman & Seidman, the fraud was perpetrated
by top management, was cleverly concealed, and was effected by overriding internal control. As the court stated in that case, auditors
cannot be expected to detect misstatements when management has turned the entity into an engine of fraud.

3. The CPA will probably lose in this case. Although not grossly negligent, privity will likely be extended to the bank
because the CPA knew the bank was the primary beneficiary of the audited financial statements. Negligence may be inferred by the
fact that the auditor did not examine the work orders and did not inspect any of the additions.