CHAPTER 2

MULTIPLE CHOICE

a. 1. Due professional care requires

a. A critical review of the work done at every level of supervision.
b. The examination of all corroborating evidence available.
c. The exercise of error-free judgment.
d. A consideration of internal control structure that includes tests of controls.
(AICPA ADAPTED)

c 2. The first general standard requires that the audit of financial statements be performed by a person
or persons having adequate technical training and
a. Independence with respect to the financial statements and supplementary disclosures.
b. Exercising professional care as judged by peer reviewers.
c. Proficiency as an auditor, which likely has been acquired from previous experience.
d. Objectivity as an auditor, as verified by proper supervision. (AICPA ADAPTED)

d 3. An auditor, while performing an audit, strives to achieve the appearance of independence in order
to
a. Reduce risk and liability.
b. Comply with the generally accepted standards of fieldwork.
c. Become independent in fact.
d. Maintain public confidence in the profession. (AICPA ADAPTED)

d 4. Adequate technical training and proficiency as an auditor encompasses an ability to understand a

computer system sufficiently to identify and evaluate
a. The processing and imparting of information.
b. Essential accounting control features.
c. All control procedures.
d. The degree to which programming conforms to the application of generally accepted
accounting principles. (AICPA ADAPTED)

c 5. 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. (AICPA ADAPTED)

a 6. Ultimately, the decision about whether or not an auditor is independent must be made by the
a. Auditor.
b. Client.
c. Audit committee.
d. Public. (AICPA ADAPTED)

7
 c 7. Madison Corporation has a few large accounts receivable that total $1,000,000. Nassau
Corporation has a great number of small accounts receivable that also total $1,000,000. The
importance of an error in any one account is, therefore, greater for Madison than for Nassau. This
is an example of the auditor's concept of
a. Account bias.
b. Audit risk.
c. Materiality.
d. Reasonable assurance. (AICPA ADAPTED)

b 8. Which of the following best describes what is meant by generally accepted auditing standards?
a. Acts to be performed by the auditor.
b. Measures of the quality of an auditor's performance.
c. Procedures used to gather evidence to support financial statements.
d. Audit objectives generally determined on audit engagements. (AICPA ADAPTED)

b 9. There is an inverse relationship between the effectiveness of an entity's internal control structure
and the
a. Reliability of financial statements.
b. Extent of detailed audit tests required.
c. Degree of staff supervision required in the performance of an audit.
d. Fairness of management assertions in the financial statements.

a 10. Which of the following best describes the character of the three generally accepted auditing
standards classified as general standards?
a. Criteria for competence, independence, and professional care of individuals performing the audit.
b. Criteria for the content of the financial statements and related footnote disclosures.
c. Criteria for the content of the auditor's report.
d. The requirements for planning and supervision. (AICPA ADAPTED)

c 11. The generally accepted standards of fieldwork relate to

a. The competence, independence, and professional care of persons performing the audit.
b. Criteria for the content of the auditor's report on financial statements.
c. Audit planning and evidence gathering.
d. The need to maintain independence in mental attitude. (AICPA ADAPTED)

d 12. Which of the following statements is correct concerning the concept of materiality?
a. Materiality is determined by reference to AICPA guidelines.
b. Materiality depends only on the dollar amount involved.
c. Materiality depends on the nature of an item rather than on the dollar amount.
d. Materiality is a matter of professional judgment. (AICPA ADAPTED)

a 13. The generally accepted standards of reporting encompass all of the following except
a. Consideration of an entity's internal control structure.
b. Consistent application of accounting principles.
c. Informative disclosures.
d. Conformity of financial statements with GAAP.
c 14. An objective of the fourth generally accepted standard of reporting, relating to the expression of
an opinion, is to
a. Prohibit the auditor from issuing a report that does not include an opinion on the
financial statements taken as a whole.
b. Inform users that the financial statements and related notes are the joint responsibility of
the auditor and management.
c. Prevent users of financial statements from misinterpreting the degree of responsibility
assumed by the auditor.
d. Ensure adequate informative disclosures in the financial statements.

d 15. The least important evidence of a public accounting firm's evaluation of its system of quality
controls would concern the firm's policies and procedures with respect to
a. Employment (hiring).
b. Confidentiality of audit engagements.
c. Assigning personnel to audit engagements.
d. Determination of audit fees. (AICPA ADAPTED)

a 16. Which of the following is not an element of quality control?

a. Documentation.
b. Inspection.
c. Supervision.
d. Consultation. (AICPA ADAPTED)

d 17. Williams & Co., a large international public accounting firm, is due to have a peer review. The
peer review will most likely be performed by
a. Employees and partners of Williams & Co. who are not associated with the particular audit being
reviewed.
b. Audit review staff of the Securities and Exchange Commission.
c. Audit review staff of the AICPA.
d. Employees and partners of another firm. (AICPA ADAPTED)

b 18. In a financial statement audit, audit risk represents the probability that
a. Internal control fails and the failure is not detected by the auditor's procedures.
b. The auditor unknowingly fails to modify an opinion on materially misstated financial statements.
c. Inherent and control risk cause errors that could be material to the financial statements.
d. The auditor is not retained to conduct a financial statement audit in the succeeding year.

a 19. In a financial statement audit, inherent risk represents

a. The susceptibility of an account balance to error that could be material.
b. The risk that error could occur and not be prevented or detected by the internal control structure.
c. The risk that error could occur and not be detected by the auditor's procedures.
d. The risk that the auditor fails to modify materially misstated financial statements.

d 20. What is the magnitude of audit risk if inherent risk is .50, control risk .40, and detection risk .10?
a. .20.
b. .10.
c. .04.
d. Not determinable from the facts given.
c 21. The "hallmark" of auditing is
a. Available audit technology.
b. Generally accepted auditing standards.
c. Professional judgment.
d. Materiality and audit risk.

d 22. An auditor is most likely to refer to one or more of the three general auditing standards in
determining
a. The nature of a report qualification.
b. The scope of auditing procedures.
c. Requirements for the consideration of internal control.
d. Whether the auditor should undertake an audit engagement. (AICPA ADAPTED)

a 23. Which of the following is mandatory if the auditor is to comply with the general standards of the
AICPA’s generally accepted auditing standards?
a. Adequate technical training
b. Use analytical procedures.
c. Use statistical sampling when feasible on an audit engagement.
d. Confirmation of material accounts receivable balances. (AICPA ADAPTED)

b 24. 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. Understanding business and finance.
b. Education and experience in auditing.
c. Continuing professional education.
d. Knowledge of Statements of Auditing Standards. (AICPA ADAPTED)

a 25. What is the meaning of the generally accepted auditing standard that requires that the auditor be
independent?
a. The auditor must be without bias with respect to the client audited.
b. The auditor must adopt a critical attitude during the audit.
c. The auditor's sole obligation is to third parties.
d. The auditor may have a direct ownership interest in the client's business if it is not material.
(AICPA ADAPTED)

d 26. The third general standard states that due care is to be exercised in the performance of an audit,
and should be interpreted to mean that an auditor who undertakes an engagement assumes a duty
to perform
a. With reasonable diligence and without fault or error.
b. As a professional who will assume responsibility for losses consequent upon error of judgment.
c. To the satisfaction of the client and third parties.
d. As a professional possessing the degree of skill commonly possessed by others in the field.
(AICPA ADAPTED)

10
 a 27. The first standard of fieldwork, which states that the work is to be adequately planned, and
assistants, if any, are to be properly supervised, recognizes that
a. Early appointment of the auditor is advantageous both to the auditor and to the client.
b. Acceptance of an audit engagement after the close of the client's fiscal year is generally
not permissible.
c. Appointment of the auditor subsequent to the physical count of inventories requires a
disclaimer of opinion.
d. Performance of substantial parts of the engagement is necessary at interim dates.
(AICPA ADAPTED)

b 28. In connection with the third generally accepted auditing standard of fieldwork, an auditor
examines corroborating evidential matter that includes all of the following except
a. Client accounting manuals.
b. Written client representations.
c. Vendor invoices.
d. Minutes of board meetings. (AICPA ADAPTED)

a 29. Which of the following underlies the application of generally accepted auditing standards,
particularly the standards of fieldwork and reporting?
a. The elements of materiality and risk.
b. The element of internal control.
c. The element of corroborating evidence.
d. The element of reasonable assurance. (AICPA ADAPTED)

c 30. The fourth generally accepted auditing standard of reporting requires an auditor to render a report
whenever an auditor's name is associated with financial statements. The overall purpose of the
fourth standard of reporting is to require that reports
a. Assure that the auditor is independent with respect to the financial statements audited.
b. State that the audit has been conducted in accordance with generally accepted auditing standards.
c. Indicate the character of the engagement and the degree of responsibility assumed by the auditor.
d. Express whether the accounting principles used in preparing the financial statements have
been applied consistently in the period audited. (AICPA ADAPTED)

d 31. The auditor's judgment concerning the overall fairness of the presentation of financial positions,
results of operations, and cash flows is applied within the framework of
a. Quality control.
b. Generally accepted auditing standards that include the concept of materiality.
c. The auditor's evaluation of the audited company's internal controls.
d. Generally accepted accounting principles. (AICPA ADAPTED)

d 32. The concept of materiality would be least important to an auditor in determining

a. Transactions that should be reviewed.
b. The need for disclosing a particular transaction or event.
c. The extent of audit work planned for particular accounts.
d. The effects of an auditor's direct financial interest in a client. (AICPA ADAPTED)
 b 33. The objective of quality control mandates that a public accounting firm should establish policies
and procedures for professional development that provide reasonable assurance that all entry-
level personnel
a. Prepare working papers that are standardized in form and content.
b. Have the knowledge required to enable them to fulfill responsibilities assigned.
c. Will advance within the organization.
d. Develop specialties in specific areas of public accounting. (AICPA ADAPTED)

b 34. In pursuing its quality control objectives with respect to assigning personnel to engagements, a
public accounting firm may use policies and procedures such as
a. Rotating employees from assignment to assignment on a random basis to aid in the staff
training effort.
b. Requiring timely identification of the staffing requirements of specific engagements so
that enough qualified personnel can be made available.
c. Allowing staff to select the assignments of their choice to promote better client relationships.
d. Assigning a number of employees to each engagement in excess of the number required so as
not to overburden the staff and interfere with the quality of the audit work performed.
(AICPA ADAPTED)

d 35. A public accounting firm studies its personnel advancement experience to determine whether
individuals meeting stated criteria are assigned increased degrees of responsibility. This is
evidence of the firm's adherence to
a. Generally accepted auditing standards.
b. Attestation standards.
c. Supervision and review.
d. Quality control standards. (AICPA ADAPTED)

d 36. Which of the following statements best describes the primary purpose of Statements on Auditing
Standards?
a. Guides intended to set forth auditing procedures that are applicable to a variety of situations.
b. Outlines intended to narrow the areas of inconsistency and divergence of auditor opinion.
c. Authoritative statements, enforced through the code of professional conduct, and intended to
limit the degree of auditor judgment.
d. Interpretations intended to clarify the meaning of generally accepted auditing standards.
(AICPA ADAPTED)

SHORT ANSWER

1. Describe what is meant by planned detection risk and what effect planned detection risk
would have on evidence.

Answer:
Detection risk is the likelihood that error could occur and not be detected by the auditor’s
procedures. Detection risk is inversely related to the amount of audit evidence an auditor would
plan to gather. As detection risk goes up, the amount of evidence gathered goes down.
2. Define inherent risk and name two examples of factors that may increase inherent risk.

Answer:
Inherent risk is the susceptibility of an account balance to error that could be material assuming there
are no related internal controls. Examples will vary among students, including: the client's business
or industry, management's predisposition to manage earnings, and insights obtained from prior
engagements.

3. What is the importance of internal controls to an auditor in an audit engagement?

Answer:
The second standard of fieldwork within GAAS, requires that an auditor obtain an understanding of
an entity's internal controls to help in planning the audit and designing audit tests.

4. What is the demand for due care within an audit or attestation engagement?

Answer:
Competent professional staff should plan attestation and audit engagements, and the work of all
assistants assigned to the engagement should be supervised.

5. Differentiate between independence in fact and independence in appearance.

Answer:
Independence of fact is a state of mind, an attitude of impartiality, which underlies both an attestation
standard and a GAAS. Independence in appearance is the ability to demonstrate independence by
remaining free of any overt interest in a client that would damage the appearance of independence.

CHAPTER 3

MULTIPLE CHOICE

c 1. An auditor's report contains the following sentences:

We did not audit the financial statements of B Company, a consolidated subsidiary, which
statements reflect total assets and revenues constituting 20 percent and 22 percent, respectively,
of the related consolidated totals. These statements were audited by other auditors, whose report
has been furnished to us, and our opinion, insofar as it relates to the amounts included for B
Company, is based solely upon the report of the other auditors.

These sentences
a. Disclaim an opinion.
b. Qualify the opinion.
c. Divide responsibility.
d. Should not be part of the audit report. (AICPA ADAPTED)

c 2. In which of the following situations would the auditor appropriately issue a standard unqualified
15
 report with no explanatory paragraph concerning consistency?
a. A change in the method of accounting for specific subsidiaries that comprise the group of
companies for which consolidated statements are presented.
b. A change from an accounting principle that is not generally accepted to one that is generally
accepted.
c. A change in the percentage used to calculate the provision for warranty expense.
d. Correction of a mistake in the application of a generally accepted accounting principle.
(AICPA ADAPTED)

b 3. When financial statements are presented that are not in conformity with generally accepted
accounting principles, an auditor may issue a(n)

Qualified Adverse
opinion opinion
a. Yes No
b. Yes Yes
c. No Yes
d. No No (AICPA ADAPTED)

a 4. The management of a client company believes that the statement of cash flow is not a useful
document and refuses to include one in the annual report to stockholders. As a result, the
auditor's opinion should be
a. Qualified due to inadequate disclosure.
b. Qualified due to a scope limitation.
c. Adverse.
d. Unqualified. (AICPA ADAPTED)

16
 d 5. An auditor would issue an adverse opinion if
a. The audit was begun by other independent auditors who withdrew from the engagement.
b. A qualified opinion cannot be given because the auditor lacks independence.
c. The restriction on the scope of the audit was significant.
d. The statements taken as a whole do not fairly present the financial position, results of
operations, and cash flows of the company. (AICPA ADAPTED)

d 6. The fourth reporting standard requires that the auditor's report contain either an expression of
opinion regarding the financial statements taken as a whole or an assertion that an opinion cannot
be expressed. The objective of the fourth standard is to prevent
a. An auditor from reporting on one basic financial statement and not the others.
b. An auditor from expressing different opinions on each of the basic financial statements.
c. Management from reducing its responsibility for the basic financial statements.
d. Misinterpretations about the degree of responsibility the auditor assumes.
(AICPA ADAPTED)

d 7. An auditor's opinion reads as follows: "In our opinion, except for the above-mentioned limitation
on the scope of our audit...” This is an example of a(n)
a. Review opinion.
b. Emphasis on a matter.
c. Qualified opinion.
d. Unacceptable reporting practice. (AICPA ADAPTED)

c 8. An auditor's report includes a statement that "the financial statements do not present fairly the
financial position in conformity with generally accepted accounting principles." This auditor's
report was probably issued in connection with financial statements that were
a. Prepared on a comprehensive basis for accounting other than GAAP.
b. Restricted for use by management.
c. Misleading.
d. Condensed. (AICPA ADAPTED)

c 9. If the auditor believes there is minimal likelihood that resolution of an uncertainty will have a
material effect on the financial statements, the auditor would issue a(n)
a. Qualified opinion.
b. Adverse opinion.
c. Unqualified opinion.
d. Disclaimer of opinion. (AICPA ADAPTED)

b 10. If an accounting change has no material effect on the financial statements in the current year but
the change is reasonably certain to have a material effect in later years, the change should be
a. Treated as a consistency modification in the auditor's report for the current year.
b. Disclosed in the notes to the financial statements of the current year.
c. Disclosed in the notes to the financial statements and referred to in the auditor's report for
the current year.
d. Treated as a subsequent event. (AICPA ADAPTED)
 c 11. When comparative financial statements are presented, the fourth reporting standard, which refers
to financial statements "taken as a whole," should be considered to apply to the financial
statement of the
a. Periods presented plus one preceding period.
b. Current period only.
c. Current period and those of the other periods presented.
d. Current and immediately preceding period only. (AICPA ADAPTED)

b 12. An auditor's standard report expresses an unqualified opinion and includes an explanatory
paragraph that emphasizes a matter included in the notes to the financial statements. The
auditor's report would be deficient if the explanatory paragraph states that the entity
a. Is a component of a larger business enterprise.
b. Has changed from the completed contract method to the percentage of completion method
to account for long-term construction contracts.
c. Has had a significant subsequent event.
d. Has accounting reclassifications that enhance the comparability between years.
(AICPA ADAPTED)

d 13. Raider, Inc., uses the last-in, first-out method to value half of its inventory and the first-in, first-
out method to value the other half. Assuming the auditor is satisfied in all other respects, under
these circumstances the auditor will issue a(n)
a. Opinion modified due to inconsistency.
b. Unqualified opinion with an explanatory middle paragraph.
c. Qualified or adverse opinion, depending on materiality.
d. Unqualified opinion. (AICPA ADAPTED)

d 14. Under which of the following sets of circumstances might an auditor disclaim an opinion?
a. The financial statements contain a departure from GAAP, the effect of which is material.
b. The principal auditor decides to make reference to the report of another auditor who audited
a subsidiary.
c. There has been a material change between periods in the method of the application of
accounting principles.
d. There were significant limitations on the scope of the audit.

a 15. An auditor includes an explanatory paragraph in an otherwise unqualified report in order to

emphasize that the entity being reported on is a subsidiary of another business enterprise. The
inclusion of this paragraph
a. Is appropriate and would not negate the unqualified opinion.
b. Is a qualification.
c. Is a violation of generally accepted reporting standards if this information is disclosed
in footnotes to the financial statements.
d. Necessitates a revision of the opinion paragraph to include the phrase "with the
foregoing explanation."
c 16. In which of the following circumstances would an adverse opinion be appropriate?
a. The auditor is not independent with respect to the enterprise being audited.
b. An uncertainty prevents the issuance of an unqualified report.
c. The statements are not in conformity with authoritative statements regarding accounting
for pension plans.
d. A client-imposed scope limitation prevents the auditor from complying with generally accepted
auditing standards.

b 17. An audit report should be dated as of

a. the date the report is delivered to the entity audited.
b. the date of the last day of fieldwork.
c. the balance sheet date of the latest period reported on.
d. the date a letter of audit inquiry is received from the entity's attorney of record.

d 18. An auditor completed fieldwork on February 10, 2005 for a December 31, 2004 year-end client.
A significant subsequent event occurred on February 22, 2005. In this case, which of the
following report dates would not be appropriate?
a. February 10, 2005.
b. February 10, except Note 1, February 22, 2005.
c. February 22, 2005.
d. December 31, 2004.

d 19. Which of the following statements indicates a qualified opinion?

a. The financial statements do not present fairly in all material respects the financial position,
results of operations, and cash flows in conformity with GAAP.
b. The auditor does not express an opinion on the financial statements.
c. The financial statements present fairly in all material respects the financial position, results
of operations, and cash flows in conformity with GAAP.
d. Except for the effects of a matter, the financial statements present fairly in all material respects
the financial position, results of operations, and cash flows in conformity with GAAP.

b 20. Under Statement on Auditing Standards No. 59, "The Auditor's Consideration of an Entity's
Ability to Continue as a Going Concern," an independent auditor is responsible to
a. Predict whether the entity will be in business one year from the balance sheet date.
b. Evaluate whether there is substantial doubt about the entity's ability to continue as a
going concern.
c. Weigh mitigating factors against contrary information about the entity's ability to continue as a
going concern.
d. Report the entity's ability to continue as a going concern to senior management and to the
board of directors.

c 21. Does an auditor make the following representations explicitly or implicitly in a standard audit
report on comparative financial statements?

Consistent application Examination of

of accounting principles evidence on a test basis
a. Explicitly Explicitly
b. Implicitly Implicitly
c. Implicitly Explicitly
d. Explicitly Implicitly (AICPA ADAPTED)
a 22. An auditor is unable to determine the amounts associated with illegal acts committed by a client.
The auditor would most likely
a. Issue either a qualified opinion or a disclaimer of opinion.
b. Issue an adverse opinion.
c. Issue either a qualified opinion or an adverse opinion.
d. Issue a disclaimer of opinion. (AICPA ADAPTED)

b 23. A principal auditor is satisfied both with the independence and professional reputation of another
auditor who audited a subsidiary, but wants to share responsibility with the other auditor in the
audit report. The principal auditor should
a. Modify the scope and opinion paragraphs of the report.
b. Modify the introductory and opinion paragraphs of the report.
c. Not modify the report except for including an explanatory paragraph.
d. Modify the opinion paragraph of the report. (AICPA ADAPTED)

a 24. An auditor may issue a qualified opinion for

Inadequate Scope
Disclosure Limitation
a. Yes Yes
b. Yes No
c. No Yes
d. No No (AICPA ADAPTED)

a 25. An explanatory paragraph following an opinion paragraph describes an uncertainty as follows:

As discussed in Note X to the financial statements, the company is a defendant in a lawsuit

alleging infringement of certain patent rights and claiming damages. Discovery proceedings
are in progress. The ultimate outcome of the litigation cannot presently be determined.
Accordingly, no provision for any liability that may result upon adjudication has been made in
the accompanying financial statements.

What type of opinion should the auditor express in this circumstance?

a. Unqualified.
b. Qualified.
c. Disclaimer.
d. Adverse. (AICPA ADAPTED)

d 26. An auditor's report that refers to a departure from generally accepted accounting principles
includes the language, “In our opinion, with the foregoing explanation, the financial
statements referred to above present fairly ...” This is a/an
a. Adverse opinion.
b. Qualified opinion.
c. Unqualified opinion with an explanatory paragraph.
d. Example of inappropriate reporting. (AICPA ADAPTED)
b 27. When management prepares financial statements on the basis of a going concern and the auditor
believes the company may not continue as a going concern, the auditor should issue
a. A qualified opinion.
b. An unqualified opinion with an explanatory paragraph.
c. A disclaimer of opinion.
d. An adverse opinion. (AICPA ADAPTED)

b 28. An auditor concludes that there is substantial doubt about an entity's ability to continue as a going
concern. If the entity's disclosures about continued existence are adequate, the audit report may
include

A disclaimer of opinion A qualified opinion

a. Yes Yes
b. No No
c. No Yes
d. Yes No (AICPA ADAPTED)

a 29. Keller, CPA, was about to issue an unqualified opinion on the financial statements of Lupton
Television Broadcasting Company when a letter was received from Lupton's independent
counsel. The letter stated that the Federal Communications Commission has notified Lupton that
its broadcasting license will not be renewed because of alleged irregularities in its broadcasting
practices. Lupton cannot continue to operate without the license. Keller has also learned that
Lupton and its independent counsel plan to take all necessary legal action to retain the license.
The letter from independent counsel, however, states that a favorable outcome of any legal action
is highly uncertain. On the basis of this information, what action should Keller take?
a. Issue an unqualified opinion, with an explanatory paragraph that describes the matter--giving
rise to the uncertainty.
b. Issue an unqualified opinion if full disclosure is made of the matter in a note to the
financial statements.
c. Issue an adverse opinion and disclose all reasons why.
d. Issue a piecemeal opinion with full disclosure made of the license dispute in a note to the
financial statements. (AICPA ADAPTED)

d 30. If the auditor believes that required disclosures are omitted from the financial statements, the
auditor should decide between issuing
a. A qualified opinion or an adverse opinion.
b. A disclaimer of opinion or a qualified opinion.
c. An adverse opinion or a disclaimer of opinion.
d. An unqualified opinion or a qualified opinion. (AICPA ADAPTED)

b 31. An auditor's report on comparative financial statements should be dated as of the date the
a. Report is issued.
b. Auditor's fieldwork is completed.
c. Fiscal year ends.
d. Last subsequent event occurred. (AICPA ADAPTED)

20
b 32. An auditor is confronted with an exception sufficiently material to warrant departing from the
standard wording of an unqualified report. If the exception relates to a departure from
generally accepted accounting principles, the auditor must decide between
a. An adverse opinion and an unqualified opinion.
b. An adverse opinion and a qualified opinion.
c. An adverse opinion and a disclaimer of opinion.
d. A disclaimer of opinion and a qualified opinion. (AICPA ADAPTED)

a 33. An auditor had expressed a qualified opinion on the financial statements of a prior period because
the client's financial statements departed from generally accepted accounting principles. The
prior period statements are restated in the current period to conform with generally accepted
accounting principles. The auditor's updated report on the prior period statements should
a. Express an unqualified opinion about the restated financial statements.
b. Be accompanied by the auditor's original report on the prior period.
c. Bear the same date as the auditor's original report on the prior period.
d. Qualify the opinion concerning the restated financial statements because of a change in
accounting principles. (AICPA ADAPTED)

SHORT ANSWER

1. When would an auditor issue an adverse opinion?

Answer:
Adverse opinions are issued when financial statements depart from GAAP, or when management
is unable to justify an accounting change (and the effect of the departure or change is so highly
material that a qualified opinion is unwarranted.)

2. When the client limits the scope of an audit engagement and the auditor believes this limitation
of scope to be material in nature, what is the action to be taken by the auditor?

Answer:
The auditor must issue a disclaimer of opinion, as the auditor does not have sufficient evidence to
reach an opinion.

3. When an opinion is based upon the work of separate auditors, as is the case with subsidiary
companies, in compiling the work of both audits and expressing an opinion on the
combined statements, how is the principle auditor determined?

Answer:
AU Sec. 543 requires that the following factors be considered:
 The materiality of the financial statements audited by each auditor,
 The extent of each auditor's knowledge of the overall financial statements, and
 The significance of the financial statements audited in relation to the combined
entity taken as a whole.

4. What type of audit opinion would be issued to reflect a material departure from GAAP?
Also explain the modifications needed to be made to the audit report.
 Answer:
A qualified opinion is required unless the auditor can demonstrate that owing to rare and unusual
circumstances, complying with the pronouncement would cause the financial statements to be
misleading. A qualified opinion for a material departure from GAAP requires an explanatory
paragraph to disclose the misstatement and a modified opinion paragraph.

PROBLEMS

1. As the independent auditor for Jansin Company, you completed the audit engagement for the year
ended August 31, 2005 on October 1, 2005. Jansin Company’s audit revealed no irregularities in
the accounting system and you have concluded that management’s financial statements are
presented fairly in all material respects in conformity with GAAP.

Required:
Produce an audit report for this client addressed to the Board of Directors and company
shareholders.

Answer:

Independent Auditor’s Report

To the Board of Directors and Shareholders of The Jansin Company

We have audited the accompanying balance sheets of the Jansin Company as of August 31, 2005
and the related statements of earnings, retained earnings, and cash flows for the period ended
August 31, 2005. These financial statements are the responsibility of the companies’
management. Our responsibility is to express an opinion on these financial statements based on
our audit.

We conducted our audit in accordance with U.S. generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of the company at August 31, 2005, and the results of operations and cash
flows for the period ended August 31, 2005, in conformity with U.S. generally accepted
accounting principles.

Student’s Company Name

October 1, 2005

2. Based upon information given determine for each of the ten companies:
a. Which type of audit report will be issued
b. Which (in any) paragraphs of the audit report would require modification
c. Would a explanatory paragraph by deemed necessary
 Company Circumstance Level of
Materiality
Company A Departure from GAAP Material
Company B Lack of Independence Highly
Material
Company C Scope Limitation Material
Company D Opinion based partly on another auditor’s Material
work
Company E Going Concern Material
Company F Emphasize a Matter Highly
Material
Company G Departure from GAAP Highly
Material
Company H Going Concern Highly
Material
Company I Opinion based partly on another auditor’s Highly
work Material
Company J Inconsistency that management can Material
justify

Answer:

Company (a) Form of Audit (b) Paragraph(s) (c)

Report Modified Explanatory
Paragraph
Necessary
Company A Qualified Opinion Yes
Company B Disclaimer Omit Introductory, Yes
Scope,
Opinion
Company C Qualified Scope/ Yes
Opinion
Company D Unqualified Introductory/Opinion No
Company E Unqualified N/A Yes
Company F Unqualified N/A Yes
Company G Adverse Opinion Yes
Company H Unqualified N/A Yes
Company I Unqualified Introductory/Opinion Yes
Company J Unqualified N/A Yes
 CHAPTER 4 MULTIPLE CHOICE

c 1. Of the following, which is the least persuasive type of audit evidence?

a. Documents mailed by outsiders to the auditor.
b. Correspondence between auditor and vendors.
c. Copies of sales invoices inspected by the auditor.
c d. Computations
2. Analytical made by
procedures arethe auditor. (AICPA ADAPTED)
a. Substantive tests designed to evaluate a system of internal control.
b. Tests of controls designed to evaluate the validity of management's representation letter.
c. Substantive tests designed to evaluate the reasonableness of financial information.
d. Tests of controls designed to evaluate the reasonableness of financial information.
(AICPA ADAPTED)

c 3. Which of the following best describes the primary purpose of audit procedures?
a. To detect errors or irregularities.
b. To comply with generally accepted accounting principles.
c. To gather corroborative evidence.
d. To verify the accuracy of account balances. (AICPA ADAPTED)

d 4. The procedures specifically outlined in an audit program are primarily designed to

a. Protect the auditor in the event of litigation.
b. Detect errors or irregularities.
c. Test internal control structure.
d. Gather evidence. (AICPA ADAPTED)

b 5. Which of the following is ordinarily designed to detect possible material dollar errors on the
financial statements?
a. Tests of controls.
b. Analytical procedures.
c. Computer controls.
d. Post audit working paper review. (AICPA ADAPTED)

d 6. Which of the following statements relating to the competence of evidential matter is always true?
a. Evidential matter gathered by an auditor from outside an enterprise is reliable.
b. Accounting data developed under satisfactory conditions of internal control are more
relevant than data developed under unsatisfactory conditions.
c. Oral representations made by management are not valid.
d. Evidence gathered by auditors must be both valid and relevant to be considered competent.
(AICPA ADAPTED)

c 7. In the context of an audit of financial statements, substantive tests are audit procedures that
a. May be eliminated under certain conditions.
b. Are designed to discover significant subsequent events.
c. May be either tests of transactions, direct tests of financial balances, or analytical tests.
d. Will increase proportionately with the auditor's assessment of control risk.
(AICPA ADAPTED)

25
a 8. Which of the following elements ultimately determines the specific auditing procedures that are
necessary in the circumstances to afford a reasonable basis for an opinion?
a. Auditor judgment.
b. Materiality.
c. Relative risk.
d. Reasonable assurance. (AICPA ADAPTED)

d 9. Which of the following factors will least affect the independent auditor's judgment as to the
quantity, type, and content of the working papers desirable for a particular engagement?
a. Nature of the auditor's report.
b. Nature of the financial statements, schedules, or other information upon which the auditor
is reporting.
c. Need for supervision and review.
d. Number of personnel assigned to the audit. (AICPA ADAPTED)

a 10. An auditor's working papers will generally be least likely to include documentation showing how
the
a. Client's schedules were prepared.
b. Engagement had been planned.
c. Client's internal control structure had been reviewed and evaluated.
d. Unusual matters were resolved. (AICPA ADAPTED)

c 11. Which of the following is not a primary purpose of audit working papers?
a. To coordinate the examination.
b. To assist in preparation of the audit report.
c. To support the financial statements.
d. To provide evidence of the audit work performed. (AICPA ADAPTED)

b 12. The understanding between the client and the auditor as to the degree of responsibility to be
assumed by each is normally set forth in a(n)
a. Representation letter.
b. Engagement letter.
c. Management letter.
d. Comfort letter. (AICPA ADAPTED)

b 13. Audit evidence takes different forms and varies in persuasiveness. Which of the following is the
least persuasive type of evidence?
a. Vendor's invoice.
b. Bank statement obtained from the client.
c. Computations made by the auditor.
d. Canceled checks. (AICPA ADAPTED)

b 14. The following statements were made in a discussion of audit evidence by two independent
auditors. Which statement is untrue?
a. “I am seldom convinced beyond all doubt about all aspects of the financial statements
being audited.”
b. “I would not undertake that procedure because, at best, the results would only be persuasive
and I'm looking for convincing evidence.”
c. “I evaluate the degree of risk involved in deciding the kind of evidence I will gather.”
d. “I evaluate the usefulness of the evidence I can obtain against the cost to obtain it.”
(AICPA ADAPTED)
 b 15. As the acceptable level of detection risk decreases, an auditor may change the
a. Timing of substantive tests by performing them at an interim date rather than at year-end.
b. Nature of substantive tests from a less effective to a more effective procedure.
c. Timing of tests of controls by performing them at several dates rather than at one time.
d. Assessed level of inherent risk to a higher amount. (AICPA ADAPTED)

d 16. When an independent auditor is approached to perform an audit for the first time, he or she
should make inquiries of the predecessor auditor. Inquiries are necessary because the predecessor
may be able to provide the successor with information that will assist the successor in
determining whether
a. The predecessor's work should be used.
b. The company rotates auditors.
c. Control risk is low, in the predecessor’s opinion.
d. The engagement should be accepted. (AICPA ADAPTED)

b 17. The purpose of tests of controls is to provide reasonable assurance that

a. The extent of substantive testing is minimized.
b. Evidence will be obtained to determine an assessed level of control risk.
c. Errors and irregularities are prevented or detected in a timely manner.
d. The auditor has an understanding of the control environment. (AICPA ADAPTED)

c 18. An auditor's working papers should

a. Not be permitted to serve as a reference source for the client.
b. Not contain comments critical of management.
c. Show that the accounting records agree or reconcile with the financial statements.
d. Be considered the primary support for the financial statements being audited.
(AICPA ADAPTED)

c 19. Which of the following is not a factor affecting the independent auditor's judgment about the
quantity, type, and content of audit working papers?
a. The needs for supervision and review of the work performed by assistants.
b. The nature and condition of the client's records and internal controls.
c. The expertise of client personnel and their participation in preparing schedules.
d. The type of the financial statements, schedules, or other information on which the auditor is
reporting. (AICPA ADAPTED)

c 20. During an audit engagement, data are compiled and included in the audit working papers. The
working papers are
a. A client-owned record of conclusions reached by the auditors who performed the engagement.
b. Evidence supporting financial statements.
c. Support for the auditor's compliance with generally accepted auditing standards.
d. A record to be used as a basis for the following year's engagement. (AICPA ADAPTED)

c 21. The current file of the auditor's working papers generally should include
a. A flowchart of the internal controls.
b. Organization charts.
c. A copy of the financial statements.
d. Copies of bond and note indentures. (AICPA ADAPTED)
 b 22. Using laptop computers in auditing may affect the methods used to review the work of staff
assistants because
a. Supervisory personnel may not have an understanding of the capabilities and limitations
of computers.
b. Working paper documentation may not contain readily observable details of calculations.
c. The audit field work standards for supervision may differ.
d. Documenting the supervisory review may require assistance of management services personnel.
(AICPA ADAPTED)

c 23. Which of the following persons is not a specialist upon whose work an auditor may rely?
a. Actuary.
b. Appraiser.
c. Internal auditor.
d. Engineer. (AICPA ADAPTED)

b 24. In which of the following instances would an auditor be least likely to require the assistance of a
specialist?
a. Assessing the value of inventories of works of art.
b. Determining the quantities of materials stored in piles.
c. Determining the value of unlisted securities.
d. Determining the assessed value of fixed assets. (AICPA ADAPTED)

SHORT ANSWER

1. Evidential matter consists of the accounting data that underlies management’s financial
statements and the information that supports the accounting data. Please compare
underlying accounting data with corroborating information.

Answer:
Underlying accounting data includes records of original entry (e.g., journals), general and
subsidiary ledgers, data files, and spreadsheets that capture the details summarized in financial
statements. Corroborating information includes checks, records of electronic fund transfers,
invoices, contracts, minutes of meetings, and other documents; written representations from
vendors, attorneys, banks, and other third parties; and information obtained by questioning
management or by observing a client’s employees at work.

2. List the two control activities that audit clients use in practice.

Answer:
a. Controls that create documentation (leave an audit trail).
b. Controls that do not create documentation.

3. How do tests of controls and tests of details differ from one another?

Answer:
Tests of controls provide evidence about whether misstatement is likely (a means to assess control
risk), and substantive tests of details provide evidence about whether misstatement actually exists
(a means to control detection risk).
 4. List and define the four categories of ratios used in ratio analysis.

Answer:
1. Activity ratios – measure management’s effectiveness in managing available resources,
among them total assets, inventory and receivables.
2. Profitability ratios – measure management’s effectiveness in turning a profit on their
investment in assets and on shareholders’ investments in the company, and can be more
comprehensive than income statements.
3. Liquidity ratios – compare short-term assets to short-term liabilities, and
measure management’s ability to meet current obligations.
4. Solvency ratios – measure management’s long-term financial dexterity in one of two
ways: effectiveness in managing borrowed funds or in generating income on
borrowed funds.

5. Describe the evidence normally included in working papers.

Answer:
 Evidence that work was adequately planned, supervised, and reviewed.
 Evidence that internal control was considered as a basis for planning substantive tests.
 Evidence that sufficient competent evidential matter was obtained.

PROBLEMS

1. Analytical procedures allow the auditor to reach conclusions about the details in an account by
testing aggregated data. Well-designed analytical procedures offer an alternative to tests of details
especially in low-risk accounts.

Required:
(a) List two ratios from each category of ratios: activity ratios, profitability ratios, liquidity
ratios, and solvency ratios.
(b) Present the method of calculating the ratios.

Answer:
Student’s answers will vary but will contain ratios and calculation methods from the following
list:

Ratio Method of Calculation

Activity Ratios
Asset Turnover Net Sales/Total Assets
Inventory Turnover Cost of Sales/Average Inventory
Number of Days Supply in Inventory 360 Days/ Inventory Turnover
Accounts Receivable Turnover Net Sales/Average Accounts Receivable
Number of Days Sales in Receivables 360 Days/Accounts Receivable Turnover
Profitability Ratios
Return on Assets Operating Income Before Interest and Taxes
/Average Total Assets
Return on Equity Operating Income Before Interest and Taxes
/Average Shareholders Equity
Operating Margin Operating Income Before Interest and Taxes
/Net Sales
Liquidity Ratios
Current Ratio Current Assets/Current Liabilities
Quick Ratio Cash, Marketable Securities, and Receivables
/Current Liabilities
Solvency Ratios
Debt to Equity Ratio Long-Term Debt/Shareholders Equity
Times Interest Earned Income Before Interest and Taxes/Interest Expense
Asset Leverage Total Assets/Shareholders Equity

2. (a) Name and define the five financial statement assertions

(b) Relate each of the financial statement assertions to a Balance Sheet specific account.

Answer:
Answers will vary in the Balance Sheet account example. Presented is the answer as it pertains to
the asset account - Inventory

Assertion Definition Balance Sheet Account

Existence or Occurrence
Completeness
Rights and Obligations
Valuation or Allocation
Presentation and Disclosure
Example (Inventory)
All recorded assets, liabilities, Inventory physically exists.
and equities exist, and all
recorded transactions occurred.
All transactions and accounts Inventory includes all products
that should be presented in the on hand.
financial statements are
presented.
Assets are the rights, and The entity has legal title or
liabilities are the obligations, of similar rights of ownership.
the entity.
Assets, liabilities, equities, Inventory is properly stated at
revenues, and expenses are the lower of cost or market.
included in the financial
statements at appropriate
amounts; revenues, costs, and
expenses are allocated to the
proper accounting periods.
Financial statement components Inventory is properly classified
are properly classified, as a current asset.
described, and disclosed.

CHAPTER 17

MULTIPLE CHOICE

d 1. Which of the following is generally more important in a review than in a compilation?

a. Determining the accounting basis on which the financial statements are to be presented.
b. Gaining familiarity with industry accounting principles and practices.
c. Obtaining a signed engagement letter.
d. Obtaining a signed representation letter. (AICPA ADAPTED)

d 2. Which of the following procedures is not included in a review engagement on a nonpublic entity?
a. Inquiries of management.
b. Inquiries regarding events subsequent to the balance sheet date.
 c. Any procedures designed to identify relationships among data that appear to be unusual.
d. A study and evaluation of internal control structure. (AICPA ADAPTED)

c 3. When auditing a public entity's financial statements that include segment information, the auditor
should
a. Make certain the segment information is labeled "unaudited" and determine that the information
is consistent with audited information.
b. Make certain the segment information is labeled "unaudited" and perform only analytical review
procedures on the segment information.
c. Audit the segment information and, if the information is adequate and in conformity with GAAP,
do not make reference to the segment information in the auditor's report.
d. Audit the segment information and, if the information is adequate and in conformity with GAAP,
refer to the segment information in the auditor's report. (AICPA ADAPTED)

a 4. If management chooses to place supplementary information required by the FASB in footnotes

attached to the financial statements, this information should be clearly marked as
a. Unaudited.
b. Supplementary information required by the FASB.
c. Disclosures required by the FASB.
d. Audited financial data required by GAAP. (AICPA ADAPTED)

b 5. Which of the following best describes the auditor's responsibility for "other information" included
in the annual report to stockholders, which contains financial statements and the auditor's report?
a. The auditor has no obligation to read the "other information."
b. The auditor has no obligation to corroborate the "other information" but should read the "other
information" to determine whether it is materially inconsistent with the financial statements.
c. The auditor should extend the examination to the extent necessary to verify the "other
information."
d. The auditor must modify the auditor's report to state that the "other information is unaudited" or
"not covered by the auditor's report." (AICPA ADAPTED)

d 6. When an independent audit report is incorporated by reference in a SEC registration statement, a

prospectus that includes a statement about the independent accountant's involvement should refer to
the independent accountant as
a. Auditor of the financial reports.
b. Management's designate before the SEC.
c. Certified preparer of the report.
d. Expert in auditing and accounting. (AICPA ADAPTED)
 c 7. If information accompanying the basic financial statements in an auditor-submitted document has
been subjected to auditing procedures, the auditor may express an opinion which states that the
accompanying information is fairly stated in
a. Conformity with generally accepted accounting principles.
b. Terms of negative assurance.
c. All material respects in relation to the basic financial statements taken as a whole.
d. Conformity with principles for presenting accompanying information. (AICPA ADAPTED)

b 8. The auditor's inquiries of management regarding supplementary information on the effects of

price level changes should be directed to the judgments made concerning
a. Relevance and validity.
b. Measurement and presentation.
c. Accuracy and objectivity.
d. Rights and obligations. (AICPA ADAPTED)

a 9. Comfort letters are ordinarily signed by the

a. Independent auditor.
b. Client.
c. Client's lawyer.
d. Internal auditor. (AICPA ADAPTED)

c 10. When an auditor submits a document containing audited financial statements to a client, the
auditor has the responsibility to report on
a. Only the basic financial statements included in the document.
b. The basic financial statements and only that additional information required to be presented
in accordance with provisions of the FASB.
c. All of the information included in the document.
d. Only that portion of the document which was audited. (AICPA ADAPTED)

b 11. An accountant's compilation report should be dated as of the date of

a. Completion of fieldwork.
b. Completion of the engagement.
c. Transmittal of the compilation report.
d. The latest subsequent event referred to in the notes to the financial statements.
(AICPA ADAPTED)

b 12. A CPA has been engaged to compile financial statements for a nonpublic client. Which of the
following statements best describes this engagement?
a. The CPA must perform the basic accepted auditing procedures necessary to determine that the
statements are in conformity with GAAP.
b. The CPA is performing an accounting service rather than an examination of financial statements.
c. The financial statements are representations of both management and the CPA.
d. The CPA may prepare the statements from the books but may not assist in adjusting and closing
the books. (AICPA ADAPTED)

120
 a 13. Which of the following would not be included in an accountant's review report on the financial
statements of a nonpublic entity?
a. A statement that the review was made in accordance with generally accepted auditing standards.
b. A statement that all information included in the financial statements is the representation of
management.
c. A statement describing the principal procedures performed.
d. A statement describing the auditor's conclusions based on the results of the review.
(AICPA ADAPTED)

a 14. An accountant who is not independent may issue a

a. Compilation report.
b. Review report.
c. Comfort letter.
d. Qualified opinion. (AICPA ADAPTED)

c 15. The objective of a review of the interim financial information of a public company is to
a. Provide the accountant with a basis for expressing of an opinion.
b. Estimate the accuracy of financial statements from limited tests of accounting records.
c. Provide the accountant with a basis for reporting to the board of directors or shareholders.
d. Obtain corroborating evidence through inspection, observation, and confirmation.
(AICPA ADAPTED)

b 16. An auditor's report would be designated as a special report when it is issued in connection with
which of the following financial statements?
a. Financial statements for an interim period that are subjected to a limited review.
b. Financial statements that are prepared in accordance with a comprehensive basis of
accounting other than GAAP.
c. Financial statements that purport to be in accordance with GAAP but do not include a statement
of cash flows.
d. Financial statements that are unaudited and are prepared from a client's accounting records.
(AICPA ADAPTED)

a 17. An auditor has been engaged to audit financial statements that were prepared on a cash basis. The
auditor
a. Must ascertain that there is proper disclosure of the fact that the cash basis has been used,
the general nature of material items omitted, and the net effect of the omissions.
b. May not be associated with statements that are not in accordance with GAAP.
c. Must render a qualified report explaining the departure from GAAP in the opinion paragraph.
d. Must restate the financial statements on an accrual basis and then issue the standard report.
(AICPA ADAPTED)

d 18. When issuing a comfort letter to underwriters, the accountant should

a. File a copy with the SEC.
b. Disclaim an opinion.
c. Avoid any reference to the accountant's independence.
d. Express negative assurance. (AICPA ADAPTED)

121
a 19. An auditor should not issue a report on
a. The achievability of forecasts.
b. Internal control.
c. Management performance.
d. Quarterly financial information. (AICPA ADAPTED)

b 20. Under which of the following circumstances may audited financial statements contain a note
disclosing a subsequent event that is labeled unaudited?
a. When the subsequent event does not require adjustment of the financial statements.
b. When the event occurs after completion of fieldwork and before issuance of the auditor's report.
c. When audit procedures with respect to the subsequent event were not performed by the auditor.
d. When the event occurs between the date of the auditor's original report and the date of the
reissuance of the report. (AICPA ADAPTED)

d 21. Auditors often request that the audit client send a letter of inquiry to those attorneys who have
been consulted with respect to litigation, claims, or assessments. The primary reason for this
request is to provide the auditor with
a. An estimate of the dollar amount of the probable loss.
b. An opinion about whether the loss is possible, probable, or remote.
c. Information concerning the progress of cases to date.
d. Corroborative evidential matter. (AICPA ADAPTED)

a 22. A lawyer's response to an auditor's request for information concerning litigation, claims, and
assessments will ordinarily contain which of the following information?
a. An explanation for limitations on the scope of the response.
b. A statement of concurrence with the client's determination of which unasserted possible claims
warrant specification.
c. Confidential information that would be prejudicial to the client's defense if publicized.
d. An assertion that the list of possible unasserted claims identified by the client represents all
claims of which the lawyer may be aware. (AICPA ADAPTED)

c 23. A lawyer's response to a letter of audit inquiry may be limited to matters that are considered
individually or collectively material to the financial statements if
a. The auditor has instructed the lawyer about the limits of materiality in financial statements.
b. The client and the auditor have agreed on the limits of materiality and the lawyer has
been notified.
c. The lawyer and auditor have reached an understanding about the limits of materiality.
d. The lawyer's response to the inquiry explains the legal meaning of materiality limits and
establishes quantitative parameters. (AICPA ADAPTED)

b 24. An attorney is responding to an independent auditor as a result of the audit client's letter of
inquiry. The attorney may appropriately limit the response to
a. Asserted claims and litigation.
b. Matters to which the attorney has given substantive attention in the form of legal consultation
or representation.
c. Asserted, overtly threatened, or pending claims and litigation.
d. Items that have an extremely high probability of being resolved to the client's detriment.
(AICPA ADAPTED)
 SHORT ANSWER

1. Compare and contrast a review engagement and a compilation engagement.

Answer:
In a review engagement, an attestation service, the independent accountant performs analytical
procedures, makes inquiries of management, and issues a report that provides negative assurance,
using language that states the accountant is “not aware of any material modifications that should
be made to the financial statements in order for them to be conformity with GAAP.” In a
compilation engagement, the accountant compiles financial statements from management’s
unaudited and unreviewed accounts, and issues a report that provides literally no assurance.

2. Describe what is involved in a review of financial statements.

Answer:
A review of financial statements consists of “performing inquiry and analytical procedures that
provide the accountant with a reasonable basis for expressing negative assurance that there are no
material modifications that should be made to the statements in order for them to be in conformity
with GAAP, or if applicable, with another comprehensive basis of accounting.”

3. When an entity’s financial statements are presented in a generally accepted comprehensive basis
other than GAAP, what should be included in an accountant’s report?

Answer:
 A title that includes the word independent, and
 Separate paragraphs stating the:
 Statements were audited and are management’s responsibility,
 Audit compiled with GAAS,
 Comprehensive basis of accounting, and
 Auditor’s opinion on whether the financial statements conform to the
comprehensive basis of accounting.

4. In general what does SAS No. 72, “Letters for Underwriters and Certain Other
Requesting Parties,” state should be included in the comfort letter?

Answer:
In general, the letter reports:
 An opinion on whether the latest audited financial statements comply with the
Security Act of 1933’s accounting requirements, and
 Negative assurance on unaudited interim financial information for the period
between the date of the latest audited financial statements and the date of the
registration statement.

5. Describe the scope of a compilation of prospective financial statements.

Answer:
A compilation of prospective financial statements involves:
 Assembling prospective financial statements based on management’s assumptions,
and
 Performing compilation procedures, including comparing the prospective
financial statements with the summaries of significant assumptions and
accounting policies.
 PROBLEMS

1. When performing a review of interim financial information under SAS No. 71, describe the
analytical procedures and inquiries that are made by the auditor.

Answer:
Analytical procedures that may identify unusual matters, including:
 Comparing interim financial information with the immediate preceding
interim period and with corresponding prior periods.
 Considering plausible relationships between both financial state and
nonfinancial data.
 Comparing recorded amounts, or ratios calculated from recorded amounts,
to budgets, forecasts, and industry gross margin information.
 Inquiries about internal control, including significant changes.
 Reading the minutes of shareholders’ and directors’ meetings to identify actions that
may affect the interim financial information.
 Considering whether the interim financial information conforms with GAAP.
 Obtaining reports from other accountants engaged to review a subsidiary’s financial
information.
 Inquiries of personnel responsible for financial and accounting matters concerning:
o Whether the interim financial information has been prepared in
accordance with GAAP.
o Changes in business activities and accounting principles.
o Matters about which questions have arisen.
o Events subsequent to the date interim financial information that would have
a material effect on the information.
 Obtaining a written representation from management.

2. Prepare a compilation report for Otis Company. Otis Company has entered into negotiations with
First U.S. Bank to obtain a plant expansion loan. Your firm has been retained to complete a
compilation engagement to prepare projected financial statements that will be used in the
negotiations. The compilation engagement covers the financial statements for year ended
December 31, 2006
 CHAPTER 18

MULTIPLE CHOICE

d 1. In addition to assessing the fairness of the entity's financial statements, a governmental financial
statement audit is concerned with evaluating
a. Internal control.
b. Efficiency.
c. Accuracy.
d. Compliance.

b 2. Statement on Auditing Standards No. 74, "Compliance Auditing Applicable to Governmental

Entities and to Other Recipients of Governmental Financial Assistance," describes an
independent auditor's responsibilities for all but which of the following?
a. Laws and regulations under generally accepted auditing standards.
b. Laws and regulations in conjunction with a regulatory agency's criteria.
c. The GAO's government auditing standards.
d. The Single Audit Act.

a 3. Under generally accepted auditing standards, an auditor's responsibility to detect and report
violations of laws and regulations is to
a. Assess the risk that violations of laws and regulations may cause materially misstated
financial statements and to design the audit accordingly.
b. Report all violations of laws and regulations to the U.S. GAO.
c. Detect all violations of laws and regulations, including those that are neither direct nor material.
d. Coordinate the search for violations of laws and regulations with all agencies from which
the entity has received financial assistance.

c 4. In assessing whether management has overlooked relevant laws and regulations, the auditor
would perform all of the following except
a. Obtain written representations from management.
b. Review relevant portions of grant and loan agreements.
c. Confirm grant arrangements with granting agencies.
d. Discuss laws and regulations with the entity's chief financial officer and legal counsel.

a 5. Program audits performed for governmental entities include

a. Determining the extent to which the desired results or benefits established by the legislature
are being achieved.
b. Determining whether the entity is acquiring resources economically and efficiently.
c. Determining whether the financial statements are presented fairly.
d. Determining whether the entity has adhered with specific financial compliance requirements.

127
 d 6. In a governmental financial audit, the auditor is required to test an entity's compliance with
applicable laws and regulations and to prepare a written report that provides all of the
following except
a. Positive assurance on items tested.
b. Negative assurance on items not tested.
c. A description of material instances of noncompliance for items tested.
d. A description of the entity's performance on major financial assistance programs.

c 7. Under government auditing standards issued by the U.S. GAO, a report on internal control should
address all of the following except
a. The entity's internal control categories.
b. The scope of the work performed in obtaining an understanding of the entity's internal controls.
c. The auditor's opinion on the appropriateness of the internal control in complying with
future grants.
d. Deficiencies in internal control not significant enough to be considered reportable conditions
under SAS No. 60, "Communication of Internal Control Structure Related Matters Noted in
an Audit."

a 8. In which of the following circumstances would a governmental entity have the option of not
complying with the Single Audit Act?
a. Governmental entities receiving less than $25,000 per year.
b. Governmental entities receiving over $1,000,000 per year.
c. Governmental entities receiving over $500,000 per year.
d. Governmental entities receiving over $100,000 per year.

c 9. In an audit of a governmental entity under the Single Audit Act, which of the following questions
are not appropriate?
a. Are the costs reasonable and necessary?
b. Do the costs conform to applicable grant requirements?
c. Are the costs the result of purchases made by competitive bid?
d. Are the costs net of applicable credits such as purchase discounts?

c 10. To provide for the greatest degree of independence in performing internal auditing functions, an
internal auditor most likely should report to the
a. Financial vice-president.
b. Corporate controller.
c. Board of directors.
d. Corporate stockholders.

b 11. An independent auditor might consider the procedures performed by the internal auditors because
a. They are employees whose work must be reviewed during substantive testing.
b. They are employees of the client, but their work might be relied on.
c. Their work impacts upon the cost-benefit tradeoff in evaluating inherent limitations.
d. Their degree of independence may be inferred by the nature of their work.
(AICPA ADAPTED)

128
d 12. Taylor Sales Corp. maintains a large full-time internal audit staff, which reports directly to the
chief accountant. Audit reports prepared by the internal auditors indicate that the system is
functioning as it should and that control risk is low. The independent auditor will probably
a. Eliminate compliance testing.
b. Increase tests of controls.
c. Avoid duplicating the work performed by the internal audit staff.
d. Place limited reliance on the work performed by the internal audit staff. (AICPA ADAPTED)

a 13. When an independent auditor decides that the work performed by internal auditors may have a
bearing on the nature, timing, and extent of contemplated audit procedures, the independent
auditor should plan to evaluate the objectivity of the internal auditors. Relative to objectivity, the
independent auditor should
a. Consider the organization level to which internal auditors report the results of their work.
b. Review the quality control program in effect for the internal audit staff.
c. Examine the quality of the internal audit reports.
d. Consider the qualifications of the internal audit staff. (AICPA ADAPTED)

b 14. In connection with the audit of financial statements by an independent auditor, the client suggests
that members of the internal audit staff be utilized to minimize audit costs. Which of the
following tasks could most appropriately be delegated to the internal audit staff?
a. Selection of accounts receivable for confirmation, based on the internal auditor's judgment as
to how many accounts and which accounts will provide sufficient coverage.
b. Preparation of schedules for negative accounts receivable responses.
c. Evaluation of the internal control for accounts receivable and sales.
d. Determination of the adequacy of the allowance for doubtful accounts. (AICPA ADAPTED)

c 15. Which of the following activities is typically associated with operational auditing?
a. Determining whether the financial statements are an accurate representation of the
entity's operations.
b. Evaluating the feasibility of attaining the entity's operational objectives.
c. Making recommendations for improving performance.
d. Reporting on the entity's relative success in meeting profitability goals.

b 16. The overall objective of internal auditing is to

a. Design and implement an effective internal control structure.
b. Assist the independent auditors in gathering evidence needed to form an opinion on the
fairness of the financial statements.
c. Ensure that assets are properly accounted for and protected from loss or misuse.
d. Provide information about any phase of business activity to assist members of management
in discharging their responsibilities.

d 17. Usually, an operational audit is performed

a. By independent external auditors.
b. By a team consisting of an equal number of external and internal auditors.
c. Only when an operating division is experiencing declines in productivity or profitability.
d. By internal auditors at the request of top management or the board of directors.
b 18. For an internal auditor to render impartial and unbiased judgments, he or she must be independent
of the entity's
a. Stockholders.
b. Personnel and operating activities.
c. Independent (external) auditors.
d. Board of directors.

c 19. In a financial statement audit, the independent auditor would not rely on the work of an internal
auditor in
a. Obtaining an understanding of the internal control structure.
b. Assessing risk.
c. Determining a preliminary estimate of materiality.
d. Performing substantive tests.

SHORT ANSWER

1. Explain the purpose of economy and efficiency audits.

Answer:
Economy and efficiency audits determine:
 Whether an entity acquires, protects, and uses resources economically and efficiently,
 The causes of diseconomies or inefficiencies, and
 Whether the entity has complied with laws and regulations that bear on economy
and efficiency.

2. Explain the purpose of program audits.

Answer:
Program audits determine:
 The extent to which a program achieves the results or benefits established by
the granting legislature or authorizing body,
 The effectiveness of an organization, program, activity, or function,
 Whether the entity complies with laws and regulations applicable to the program.

3. Explain the purpose of the Single Audit Act of 1984.

Answer:
Congress enacted the Single Audit Act of 1984 which was intended to improve the financial
management of state and local governments receiving federal funds, establish uniform audit
requirements for federal grant recipients, promote efficient and effective use of audit resources,
and ensure that federal departments and agencies rely on one audit report only: the single audit
report. In 1996, the Single Audit Act Amendment amended the Act.

4. An internal auditor and his/her staff attempt to familiarize themselves with the specific activity
to be reviewed. Describe the preliminary considerations for familiarizations.

130
 Answer:
 Review the internal audit working paper files and reports from prior
operational audits.
 Discuss and coordinate the timing and scope of the review with the manager of
the activity to be audited.
 Coordinate staff requirements with the director of internal auditing to assure that
the operational audit can be completed on time.

5. An internal auditor’s documented evidence should be examined on a test basis to provide an

independent auditor with a basis for judging the adequacy and appropriateness of the
internal auditor’s competency and objectivity in what areas of internal audit work?

Answer:
 The scope of internal audit work
 Audit programs
 Working paper documentation
 Conclusion reached
 Any reports prepared

PROBLEMS

1. Complete the following chart with information relating to financial statement auditing,
compliance auditing, and internal auditing. Information needed to complete the chart will
include the type of audits completed for each area of auditing and also the standards that govern
the different areas of auditing.
Answer:

Area of Auditing Type of Audits Standards

Financial Statement Auditing Financial Statement Audit Audit AICPA: Generally
Accepted Auditing Standards
Compliance Auditing Financial Audit GAO: Government Auditing
Standards
Compliance Auditing Performance Audit GAO: Government Auditing
Standards
Operational Audit IIA: Standards for the
Internal Auditing Professional Practice of Internal
Auditing

2. Complete the operational audit function that relates to each scientific method listed below.

Scientific Method Operational Audit Function

Observe and recognize a problem

Formulate hypothesis

Gather relevant verifiable evidence to test

hypothesis

Evaluate evidence

Develop conclusions

Answer:

Scientific Method Operational Audit Function

Observe and recognize a problem Management requests an operational audit
familiarization with the operational activity to be
reviewed.
Formulate hypothesis Overall hypothesis: The accounting, financial, or
operating control is operating properly and relevant
to the control’s objective.
Gather relevant verifiable evidence to test Select appropriate operational audit procedures and
hypothesis gather sufficient competent evidential matter.

Evaluate evidence Evaluate evidential matter to determine if the

hypothesis is supported, refuted, or inconclusive.
Develop conclusions Report to the appropriate organizational level.

133
 CHAPTER 19

MULTIPLE CHOICE

c 1. A client company has not paid its 2004 audit fees. According to the AICPA Code of Professional
Conduct, for the auditor to be considered independent with respect to the 2005 audit, the 2004
audit fees must be paid before the
a. 2004 report is issued.
b. 2005 fieldwork is started.
c. 2005 report is issued.
d. 2006 fieldwork is started. (AICPA ADAPTED)

d 2. Inclusion of which of the following in a promotional brochure published by a public accounting

firm would be most likely to result in a violation of the AICPA rules of conduct?
a. Reprints of newspaper articles that praise the firm's expertise.
b. Services offered and fees for such services, including hourly rates and fixed fees.
c. Educational and professional attainments of partners.
d. Testimonials and endorsements. (AICPA ADAPTED)

a 3. According to the AICPA Code of Professional Conduct, a member who has a financial interest in
a partnership that invests in a potential client is considered to have
a. An indirect financial interest in the client.
b. A direct financial interest in the client.
c. No financial interest in the client.
d. A partial financial interest in the client. (AICPA ADAPTED)

a 4. The AICPA Rules of Conduct will ordinarily be considered to have been violated when the
member represents that specific consulting services will be performed for a stated fee and it
is apparent at the time of the representation that the
a. Actual fee would be substantially higher.
b. Actual fee would be substantially lower than the fees charged by other members for comparable
services.
c. Fee was a competitive bid.
d. Member would not be independent. (AICPA ADAPTED)

d 5. In which of the following instances would the independence of the CPA not be considered to be
impaired? The CPA has been retained as the auditor of a brokerage firm
a. Which owes the CPA audit fees for more than one year.
b. In which the CPA has a large active margin account.
c. In which the CPA's brother is the controller.
d. Which owes the CPA audit fees for services in the current year and has just filed a petition for
bankruptcy. (AICPA ADAPTED)

a 6. Pursuant to the AICPA rules of conduct, the auditor's responsibility to the profession is defined
by
a. The AICPA Code of Professional Conduct.
b. Federal laws governing licensed professionals who are involved in interstate commerce.
c. Statements on Auditing Standards.
d. The Bylaws of the AICPA. (AICPA ADAPTED)

134
a 7. In performing an audit, Jackson, CPA, discovers that the professional competence necessary for
the engagement is lacking. Jackson informs management of the situation and recommends
another local firm, and management engages this other firm. Under these circumstances
a. Jackson may request compensation from the other firm for any professional services rendered
to it in connection with the engagement.
b. Jackson may accept a referral fee from the other firm.
c. Jackson has violated the AICPA Code of Professional Conduct because of nonfulfillment of the
duty of performance.
d. Jackson's lack of competence should be construed to be a violation of generally accepted
auditing standards. (AICPA ADAPTED)

c 8. In which of the following instances would the independence of the CPA not be considered to be
impaired? The CPA has been retained as the auditor of a
a. Charitable organization in which an employee of the CPA serves as treasurer.
b. Municipality in which the CPA owns $25,000 of the $2,500,000 indebtedness of the municipality.
c. Cooperative apartment house in which the CPA owns an apartment and is not part of the
management.
d. Company in which the CPA's investment club owns a one-tenth interest. (AICPA ADAPTED)

d 9. The AICPA Code of Professional Conduct recognizes that the reliance of the public, the
government, and the financial community on sound financial reporting imposes
particular obligations on CPAs. The Code derives its authority from
a. Public laws enacted over the years.
b. General acceptance of the Code by the financial community.
c. Requirements of governmental regulatory agencies, such as the SEC.
d. Bylaws of the AICPA. (AICPA ADAPTED)

c 10. Which of the following most completely describes how independence has been defined by the
profession?
a. Performing an audit from the viewpoint of the public.
b. Avoiding the appearance of significant interests in the affairs of an audit client.
c. Possessing the ability to act with integrity and objectivity.
d. Accepting responsibility to act professionally and in accordance with a professional code of
ethics. (AICPA ADAPTED)

c 11. The appearance of independence of a CPA, or that CPA's firm, could be impaired if the CPA
a. Owns a unit in a cooperative apartment house where each unit has a vote in the cooperative,
and the CPA, who does not participate in the management, has been retained as the auditor for
the cooperative.
b. Joins a trade association that is a client and serves in a nonmanagement capacity.
c. Accepts a gift from a client.
d. None of the above. (AICPA ADAPTED)
 c 12. An audit independence issue might be raised by the auditor's participation in management
advisory services engagements. Which of the following statements is most consistent with the
profession's attitude toward this issue?
a. Information obtained as a result of a consulting engagement is confidential to that
engagement and should not influence performance of the attest function.
b. The decision as to loss of independence must be made by the client based on the facts of
the particular case.
c. The auditor should not make management decisions for an audit client.
d. The auditor who is asked to review management decisions is also competent to make these
decisions and can do so without loss of independence. (AICPA ADAPTED)

a 13. The AICPA Code of Professional Conduct states, in part, that a CPA should maintain integrity
and objectivity. Objectivity in the Code refers to a CPA's ability
a. To maintain an impartial attitude on all matters that come under the CPA's review.
b. To independently distinguish between accounting practices that are acceptable and those that are
not.
c. To be unyielding in all matters dealing with auditing procedures.
d. To independently choose between alternate accounting principles and auditing standards.
(AICPA ADAPTED)

c 14. The AICPA Code of Professional Conduct states that a CPA shall not disclose any confidential
information obtained in the course of a professional engagement except with the consent of his or
her client. In which of the situations that follow would disclosure by a CPA be in violation of the
Code?
a. Disclosing confidential information to properly discharge the CPA's responsibilities in
accordance with the profession's standards.
b. Disclosing confidential information in compliance with a subpoena issued by a court.
c. Disclosing confidential information to another accountant interested in purchasing the CPA's
practice.
d. Disclosing confidential information in a review of the CPA's professional practice by a peer
review team. (AICPA ADAPTED)

a 15. Which of the following fee arrangements is in violation of the AICPA Code of Professional
Conduct?
a. A fee based on whether the CPA's report on the client's financial statements results in the
approval of a bank loan.
b. A fee based on the outcome of a bankruptcy proceeding.
c. A fee based on the nature of the service rendered and the CPA's particular expertise instead of the
actual time spent on the engagement.
d. A fee based on the fee charged by the prior auditor. (AICPA ADAPTED)

a 16. Which of the following is prohibited by the AICPA Code of Professional Conduct?
a. Use of a firm name that indicates specialization.
b. Practice of public accounting in the form of a professional corporation.
c. Use of the partnership name for a limited period by one of the partners in a public
accounting firm after the death or withdrawal of all other partners.
d. Holding 10 of 1,000 outstanding shares as an investment in a commercial corporation that
performs bookkeeping services. (AICPA ADAPTED)
b 17. Which organizations operate to enforce ethical conduct among certified public accountants?
a. The SEC and state boards of accountancy.
b. The AICPA, state societies of CPAs, and state boards of accountancy.
c. The AICPA, state societies of CPAs, and the SEC.
d. The National Association of State Boards of Accountancy.

a 18. Cases involving ethical misconduct reach the Joint Trial Board if
a. Both the AICPA or state society of CPAs concur on their findings, but do not issue a joint
administrative reprimand.
b. The AICPA refers the case owing to its own backlog of ethics cases.
c. The state board of accountancy disagrees with a ruling by either the AICPA or the state society of
CPAs.
d. The case has national implications.

d 19. The Principles of the AICPA's Code of Professional Conduct

a. Are enforceable on AICPA members.
b. Derive their authority from state boards of accountancy.
c. Include the Code's Rules of Conduct.
d. Express each member's responsibilities to the public, to clients, and to colleagues in
the profession.

d 20. Which of the following describes most completely how the profession defines independence?
a. Performing an audit from the public's point of view.
b. Avoiding the appearance of a significant interest in an audit client's interests.
c. Resisting a client’s reluctance to reveal evidence.
d. Accepting responsibility to act professionally and in accordance with a professional Code
of Conduct.

b 21. Which of the following publications does not qualify as a statement of generally accepted
accounting principles under the Code of Professional Conduct?
a. Accounting interpretations issued by the FASB.
b. Accounting interpretations issued by the AICPA.
c. AICPA Accounting Research Bulletins.
d. Statements of Financial Accounting Standards issued by the FASB.

c 22. Which of the following is required for a firm's letterhead to include “Member of the American
Institute of Certified Public Accountants?”
a. At least one of the partners must be a member.
b. The partners whose names appear in the firm name must be members.
c. All partners must be members.
d. The firm must be a dues paying member.

b 23. In which of the following circumstances would a CPA be bound to refrain from disclosing
confidential information obtained during a professional engagement?
a. The CPA is issued a summons enforceable by a court order that orders the CPA to present
confidential information.
b. A major stockholder of a client company seeks accounting information from the CPA after
management declined to disclose the information.
c. Confidential client information is made available as part of a quality review of the CPA's practice
by a review team authorized by the AICPA.
d. An inquiry by a disciplinary body of a state CPA society requests confidential client information.
 b 24. Richard, CPA, performs accounting services for Norton Corporation. Norton wishes to offer
shares to the public and asks Richard to audit the financial statements. Richard refers Norton to
Cruz, CPA, who is more competent in the area of registration statements. Cruz performs the audit
of Norton's financial statements and subsequently thanks Richard for the referral by giving
Richard a portion of the audit fee. Richard accepts the fee. Who, if anyone, has violated
professional ethics?
a. Only Richard.
b. Both Richard and Cruz.
c. Only Cruz.
d. Neither Richard nor Cruz.

d 25. The AICPA Code of Professional Conduct would be violated if a member accepted a fee for
services and the fee was
a. Fixed by a public authority.
b. Based on a price quotation submitted in competitive bidding.
c. Based on the result of judicial proceedings.
d. Payable after a specified finding was attained.

d 26. Inclusion of which of the following statements in a CPA's advertisement is not acceptable under
the AICPA Code of Professional Conduct?
a. Paul Fall
Certified Public Accountant
Fluency in Spanish and French
b. Paul Fall
Certified Public Accountant
Tax Specialist
c. Paul Fall
Certified Public Accountant
Free Consultation
d. Paul Fall
Certified Public Accountant
Endorsed by the AICPA

a 27. Which of the following is prohibited by the AICPA Code of Professional Conduct?
a. A firm that designates itself “Members of the AICPA” when one partner has been expelled from
the AICPA.
b. Practice of public accounting in the form of a professional corporation.
c. Use of the partnership name for a limited period by one of the partners in a public
accounting firm after the death or withdrawal of all other partners.
d. Holding as an investment 10 of 1,000 outstanding shares in a commercial corporation
that performs bookkeeping services.

SHORT ANSWER

1. Name the four instances in which litigation would impair auditor independence.

Answer:
 Litigation by management alleging deficiencies in audit work.
 Litigation by the auditor alleging management fraud or deceit.
  An expressed intent by management to commence litigation alleging deficiencies
in audit work.
 Litigation unrelated to audit work but material nevertheless either to the firm’s or to
the client’s financial statements.

2. Address the ways that the SEC judges independence in a relationship or service.

Answer:

To judge independence, the SEC considers four general issues. Whether a relationship or a
service:
 Creates a mutual or conflicting interest.
 Places the auditor in the position of auditing his or her own work.
 Results in the auditor acting as a client’s management or employee.
 Places the auditor in the position of acting as the client’s advocate.

3. Describe the purpose of Rule 302 as it pertains to AICPA members.

Answer:
Rule 302 prohibits fee arrangements with audit and attest clients whereby no fee is paid unless a
particular outcome is attained or the fee is contingent upon a particular outcome, the intent being
to remove AICPA members from potentially compromising conflicts of interest. Rule 302 offers
several opportunities for AICPA members to enter into contingent fee arrangements with
nonattest service clients.

4. Compare and contrast the successor auditor and the predecessor auditor.

Answer:
A successor auditor is one who has accepted an engagement or been invited to submit a proposal,
and places the burden on the successor to initiate communication with the predecessor auditor,
the auditor precedes the successor auditor.

5. Describe the two methods of self-regulation that is used to monitor public accounting firm’s
standards of quality control and quality review.

Answer:
Today, self-regulation is achieved through two means:
 Quality control – the internal policies and procedures a firm designs to assure
consistent performance and achievement across engagements.
 Peer review/Quality review – an independent outside review of a firm’s quality
control performed by practitioners not otherwise employed by the firm
reviewed.

PROBLEMS

1. For each of the following five elements of quality control you are required to define the
element of quality control and also to give one example of quality control policies.

a. Independence, Integrity, and Objectivity

b. Personnel Management
c. Acceptance and Continuance of Clients
 d. Engagement Performance
e. Monitoring

Answer:
Note - examples may vary among students.

a. Independence, Integrity, and Objectivity – Establish policies to provide reasonable

assurance that all staff are independent of attest clients to the extent required by the
AICPA Code of Professional Conduct.
 Example – Require that all staff identify attest clients in which they own securities.
b. Personnel Management – Establish policies for hiring, advancement, assigning
personnel to engagements, and professional development.
 Example – Designate a staff member to assign personnel to engagements. Base
assignments on engagement needs and on staff career development.
c. Acceptance and Continuance of Clients – Establish policies to preclude accepting
or continuing services for managements that lack integrity.
 Example – Outsource background checks for all proposed clients’ management.
d. Engagement Performance – Establish polices for planning, performing,
supervising, reviewing, documenting, and communicating the results of each
engagement.
 Example – Assign staff to review planning memos, working papers, and reports, and
designate a consulting partner for each industry the firm serves.
e. Monitoring – Establish policies for monitoring compliance with the firm’s quality
control policies and procedures.
 Example – Assign an assessment director to document quality control compliance.

2. Name and define the six Principles of Professional Conduct.

Answer:

a. Responsibilities – In carrying out their responsibilities as professional, members should

exercise sensitive professional and moral judgment in all other activities.
b. The Public Interest – Members should accept the obligation to act in a way that will
serve the public interest, honor the public trust, and demonstrate commitment to
professionalism.
c. Integrity – To maintain and broaden public confidence, members should perform all
professional responsibilities with the highest sense of integrity.
d. Objectivity and Independence – A member should maintain objectivity and be free of
conflicts of interest in discharging professional responsibilities. A member in public
practice should be independent in fact and appearance when providing auditing and
other attestation services.
e. Due Care – A member should observe the profession’s technical and ethical standards,
strive continually to improve competence and the quality of services, and discharge
professional responsibility to the best of the member’s ability.
f. Scope and Nature of Services – A member in public practice should observe the Code
of Professional Conduct in determining the scope and nature of services to be
provided.
 CHAPTER 20 MULTIPLE

CHOICE

c 1. Which of the following best describes a trend in litigation involving CPAs?

a. A CPA cannot render an opinion on a company unless the CPA has audited all affiliates of that company.
b. A CPA may successfully assert as a defense that the CPA had no motive to be part of a fraud.
c. A CPA may be exposed to criminal as well as civil liability.
d. A CPA is primarily responsible for a client's footnotes in an annual report filed with the SEC.
(AICPA ADAPTED)

c 2. As a consequence of failure to adhere to generally accepted auditing standards in the course of an audit of the Lamp
Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's
controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses
attributable to the theft?
a. No liability since the ordinary examination cannot be relied on to detect defalcations.
b. No liability because privity of contract is lacking.
c. Liable for losses attributable to her or his negligence.
d. Liable only if it could be proved that he or she was grossly negligent. (AICPA ADAPTED)

b 3. The Apex Surety Company wrote a general fidelity bond covering defalcations by the employees of Watson, Inc.
Thereafter, Grand, an employee of Watson, embezzled $18,999 of company funds. When his activities were
discovered, Apex paid Watson the full amount in accordance with the terms of the fidelity bond and then
sought recovery against Watson's auditors, Kane & Dobbs, CPAs. Which of the following would be Kane &
Dobbs' best defense?
a. Apex is not in privity of contract.
b. The shortages were the result of clever forgeries and collusive fraud that would not be detected by an
examination made in accordance with generally accepted auditing standards.
c. Kane & Dobbs were not guilty of either gross negligence or fraud.
d. Kane & Dobbs were not aware of the Apex-Watson surety relationship. (AICPA ADAPTED)

b 4. Martin Corporation orally engaged Humm & Dawson to audit its year-end financial statements. The engagement
was to be completed within two months after the close of Martin's fiscal year for a fixed fee of $2,500. Under
these circumstances, what obligation is assumed by Humm & Dawson?
a. None. The contract is unenforceable since it is not in writing.
b. An implied promise to exercise reasonable standards of competence and care.
c. An implied obligation to take extraordinary steps to discover all defalcations.
d. The obligation of an insurer of its work, which is liable without fault. (AICPA ADAPTED)

a 5. One of the most significant aspects of the Continental Vending case was that it
a. Created a more general awareness of the auditor's exposure to criminal prosecution.
b. Extended the auditor's responsibility for financial statements of subsidiaries.
c. Extended the auditor's responsibility for events after the end of the audit period.
d. Defined the auditor's common-law responsibilities to third parties. (AICPA ADAPTED)

141
 b 6. The 1136 Tenants case was chiefly important because of its emphasis on the legal liability of the
CPA when
a. Performing a review of financial statements.
b. An engagement letter is not obtained.
c. An audit results in a disclaimer of opinion.
d. Preparing letters for underwriters. (AICPA ADAPTED)

d 7. In which of the following statements about a public accounting firm's action is scienter or its
equivalent absent?
a. Reckless disregard for the truth.
b. Actual knowledge of fraud.
c. Intent to gain monetarily by concealing fraud.
d. Performance of substandard auditing procedures. (AICPA ADAPTED)

c 8. Doe and Co., CPAs, issued an unqualified opinion on the 2005 financial statements of Marx
Corp. These financial statements were included in Marx's annual report and form 10K filed with
the SEC. Doe did not detect material misstatements in the financial statements as a result of
negligence in the performance of the audit. Based on the financial statements, Fitch purchased
stock in Marx. Shortly thereafter, Marx became insolvent, causing the price of the stock to
decline drastically. Fitch has commenced legal action against Doe for damages based on Section
10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Doe's best defense to such an
action would be that
a. Fitch lacks privity to sue.
b. The engagement letter specifically disclaimed all liability to third parties.
c. There is no proof of scienter.
d. There has been no subsequent sale for which a loss can be computed. (AICPA ADAPTED)

b 9. Hall purchased bonds for Eon Corp. in a public offering subject to the Securities Act of 1933.
Kosson and Co., CPAs, rendered an unqualified opinion on Eon's financial statements, which
were included in Eon's registration statement. Kosson is being sued by Hall based on
misstatements contained in the financial statements. In order to be successful, Hall must prove
materiality of Kosson's

Damages Misstatement Scienter

a. Yes Yes Yes
b. Yes Yes No
c. Yes No No
d. ADAPTED)
(AICPA No Yes Yes

b 10. Lewis & Clark, CPAs, rendered an unqualified opinion on the financial statements of a company
that sold common stock in a public offering subject to the Securities Act of 1933. Based on a false
statement in the financial statements, Lewis & Clark are being sued by an investor who purchased
shares of this public offering. Which of the following represents a viable defense?
a. The investor has not met the burden of proving fraud or negligence by Lewis & Clark.
b. The investor did not actually rely on the false statement.
c. Detection of the false statement by Lewis & Clark occurred after their examination date.
d. The false statement is immaterial in the overall context of the financial statements.
(AICPA ADAPTED)
 c 11. Gibson is suing Simpson & Sloan, CPAs, to recover losses incurred in connection with Gibson's
transactions in Zebra Corporation securities. Zebra's Annual Form 10-K Report contained
material false and misleading statements in the financial statements audited by Simpson & Sloan.
To recover under the Securities and Exchange Act of 1934, Gibson must, among other things,
establish that
a. All of his past transactions in Zebra securities, both before and after the auditors' report
date, resulted in net losses.
b. The transaction in Zebra securities that resulted in a loss occurred within 90 days of the
auditors' report date.
c. He relied on the financial statements in his decision to purchase or sell Zebra securities.
d. The market price of the stock dropped significantly after Zebra issued corrected financial
statements. (AICPA ADAPTED)

b 12. Humm & Dawson had been engaged to audit the Martin Corporation's financial statements.
Although an engagement letter was not prepared, Martin agreed orally to a fixed fee of $2,500.
Which of the following best describes the obligation assumed by Humm & Dawson?
a. None; the agreement is not in writing.
b. An implied promise to exercise due care.
c. An implied obligation to detect all fraud.
d. An implied obligation to detect all illegal acts. (AICPA ADAPTED)

d 13. Winslow Manufacturing, Inc. sought a $200,000 loan from National Lending Corporation.
National Lending insisted that audited financial statements be submitted before granting credit.
Winslow agreed. An audit was performed by an independent auditor who submitted an audit
report to Winslow that was to be used solely for the purpose of negotiating a loan from National.
National, upon reading the audited financial statements, decided in good faith not to extend the
credit desired. Certain ratios, used routinely by National in reaching credit decisions, were
judged insufficient. Winslow used copies of the audited financial statements to obtain credit
elsewhere. Despite complying with generally accepted auditing standards, the independent
auditor failed to discover a sophisticated embezzlement scheme perpetrated by Winslow's chief
financial officer.
The auditor is liable to
a. Third parties who relied on the audited financial statements to extend credit.
b. Winslow to repay the audit fee because National did not extend credit.
c. Winslow for any losses Winslow suffered as a result of failing to discover the embezzlement.
d. None of the parties. (AICPA ADAPTED)

b 14. Which of the following ultimately determines the specific audit procedures necessary to provide
an independent auditor with a reasonable basis for the expression of an opinion?
a. The audit program.
b. The auditor's judgment.
c. Generally accepted auditing standards.
d. The auditor's working papers. (AICPA ADAPTED)

b 15. An auditor who believes that a material irregularity may exist should initially
a. Discuss the matter with those believed to be involved in the perpetration of the
material irregularity.
b. Discuss the matter with a higher level of management.
c. Withdraw from the engagement.
d. Consult legal counsel. (AICPA ADAPTED)
 c 16. Which of the following, if material, would be an irregularity?
a. Mistakes in the application of accounting principles.
b. Clerical mistakes in the accounting data underlying the financial statements.
c. Misappropriation of an asset or groups of assets.
d. Misinterpretations of facts that existed when the financial statements were prepared.
(AICPA ADAPTED)

d 17. When unable to determine the amounts associated with certain illegal acts committed by a client,
the auditor would most likely issue
a. A review opinion with a separate explanatory paragraph.
b. Only an adverse opinion.
c. Either a qualified opinion or an adverse opinion.
d. Either a qualified opinion or a disclaimer of opinion. (AICPA ADAPTED)

c 18. The auditor is most likely to presume that a high risk of irregularities exists if
a. The client is a multinational company that does business in numerous foreign countries.
b. The client does business with several related parties.
c. Inadequate segregation of duties places an employee in a position to perpetrate and conceal thefts.
d. Inadequate employee training results in lengthy EDP exception reports each month.
(AICPA ADAPTED)

a 19. An auditor who finds that the client has committed an illegal act would be most likely to
withdraw from the engagement when the
a. Illegal act affects the auditor's ability to rely on management representations.
b. Illegal act has material financial statement implications.
c. Illegal act has received widespread publicity.
d. Auditor cannot reasonably estimate the effect of the illegal act on the financial statements.
(AICPA ADAPTED)

c 20. The Foreign Corrupt Practices Act requires that

a. Auditors engaged to examine the financial statements of publicly held companies report all
illegal payments to the SEC.
b. Privately held companies devise and maintain an adequate internal control structure.
c. Publicly held companies devise and maintain an adequate internal control structure.
d. U.S. firms doing business abroad report sizable payments to non-U.S. citizens to the Justice
Department. (AICPA ADAPTED)

a 21. Donalds & Company, CPAs, audited the financial statements included in the annual report
submitted by Markum Industries, Inc. to the Securities and Exchange Commission. The audit was
deficient in several respects. Markum is now insolvent and unable to satisfy shareholders' claims.
The shareholders have taken legal action against Donalds under Section 10b and Rule 10b-5 of
the Securities Exchange Act of 1934. Which of the following is Donalds' best defense?
a. Donalds did not intend to deceive, manipulate, or defraud Markum's shareholders.
b. Section 10b does not apply.
c. Donalds was not in privity to the shareholders.
d. The engagement letter specifically disclaimed liability to any third party. (AICPA ADAPTED)
 a 22. A third party sues a public accounting firm for negligence under common law on the basis of
materially false financial statements. Which of the following is the firm's defense?
a. Lack of privity.
b. Lack of reliance.
c. Lack of intent.
d. Contributory negligence. (AICPA ADAPTED)

c 23. Purchasers of securities have brought suit against an independent auditor under the Securities Act
of 1933. The firm will prevail in the suit, even though the firm issued an unqualified opinion on
materially misstated financial statements, if
a. The firm was unaware of the material misstatements.
b. The purchasers had no direct dealings with the auditor.
c. The firm can show that the purchasers did not rely on the financial statements.
d. The firm can show that there was no intent to deceive or manipulate the purchasers.
(AICPA ADAPTED)

a 24. When seeking to recover stock market losses from a public accounting firm on the basis of an
unqualified opinion that accompanied a registration statement, an investor must establish that
a. The audited financial statements were materially misstated.
b. He or she relied on the financial statements.
c. The firm did not act in good faith.
d. If the firm had exercised due care, the material misstatement would have been discovered.
(AICPA ADAPTED)

c 25. An auditor is subject to criminal liability if he or she

a. Refuses to return a client's working papers.
b. Performs an audit negligently.
c. Willfully omits a material fact required to be stated in a registration statement.
d. Willfully breaches a contract with a client. (AICPA ADAPTED)

a 26. If an independent auditor believes that material errors or fraud exist, he or she should
a. Consider the implications and discuss the matter with appropriate levels of management.
b. Make the investigation necessary to determine whether the errors or fraud have, in fact, occurred.
c. Request that management investigate whether the errors or fraud have, in fact, occurred.
d. Consider whether the errors or fraud were the result of a failure by employees to comply with
existing internal controls. (AICPA ADAPTED)

d 27. With respect to errors and fraud, which of the following should be part of an auditor's planning of
the audit engagement?
a. Plan to search for errors or fraud that would have a material or immaterial effect on the
financial statements.
b. Plan to discover errors or fraud that are either material or immaterial.
c. Plan to discover errors or fraud that are material.
d. Plan to consider factors affecting the risk of material misstatement both at the financial
statement and the account balance level. (AICPA ADAPTED)
 d 28. An audit conducted in accordance with generally accepted auditing standards generally should
a. Be expected to provide assurance that illegal acts will be detected when internal control
is effective.
b. Be relied on to disclose violations of truth in lending laws.
c. Include a plan to actively search for illegal acts.
d. Not be relied on to provide assurance that illegal acts will be detected. (AICPA ADAPTED)

c 29. If an auditor believes a client may have committed illegal acts, which of the following actions
should the auditor take?
a. Consult with the client's counsel and the auditor's counsel to determine how the suspected
illegal acts will be communicated to stockholders.
b. Extend auditing procedures to determine whether the suspected illegal acts have a material
effect on the financial statements.
c. Make inquiries of the client's management and obtain an understanding of the
circumstances underlying the acts and of other evidence to determine the effects of the acts
on the financial statements.
d. Notify each member of the audit committee of the board of directors about nature of the acts
and request that they advise an approach to be taken by the auditor. (AICPA ADAPTED)

d 30. If an illegal act is discovered during the audit of a publicly held company, the auditor should
a. Notify the regulatory authorities.
b. Determine who was responsible for the act.
c. Modify the extent of auditing procedures.
d. Report the act to high-level personnel within the client's organization. (AICPA ADAPTED)

d 31. An audit client's board of directors and audit committee refused to take action about an
immaterial illegal act that was brought to their attention by the auditor. Because of their failure to
act, the auditor withdrew from the engagement. The auditor's decision to withdraw was primarily
due to doubts concerning
a. Inadequate financial statement disclosures.
b. Compliance with the Foreign Corrupt Practices Act.
c. Scope limitations resulting from the inaction.
d. Reliance on management's representations. (AICPA ADAPTED)

b 32. Which of the following statements correctly describes the unlawful influence provision of the
Foreign Corrupt Practices Act? The Act applies
a. Only to multinational corporations.
b. To all domestic corporations engaged in interstate commerce.
c. To corporations whose securities are registered under the Securities Exchange Act of 1934.
d. To corporations engaged in foreign commerce. (AICPA ADAPTED)

SHORT ANSWER

1. Compare and contrast common law with statutory law.

Answer:
The source of common law is the written opinions of prior courts within a state (legal precedent),
each state having its own common law. Common law is based in the doctrine of stare decisis,
which is the handing down precedent-setting principles of law to succeeding cases.
 Statutory law refers to written statutes established by Congress at the federal level and by state
legislatures at the state level. Federal (and state) courts are bound by federal (state) statutes,
unless the statue violates the U.S. (state) constitution.

2. Under common law, clients may bring action against an auditor for breach of contract or for tort.
Explain these two violations of common law.

Answer:
Clients may sue for breach of contract because clients are parties (they are in privity) to an
express or implied contract for audit services. Suits for breach of contract usually allege that an
auditor violated either GAAS or the auditor–client confidential relationship.
A tort is a wrongful act, other than breach of contract, which results in injury to another person.
Suits in tort usually allege negligence, gross negligence, or fraud.

3. Explain the difference between (a) primary beneficiaries, (b) foreseen third parties,
(c) foreseeable third parties.

Answer:
Primary beneficiaries are specifically identified to auditors as the beneficiaries of audit services
– the auditor would not have been engaged were it not for the primary beneficiary.
Foreseen third parties are not specifically identified as beneficiaries of audit services, although
the auditor knows their general identity and specific purpose of an audit report.
Foreseeable third parties are parties who have a reasonable need to rely on an entity’s financial
statements but, because they’re the furthest removed from a contractual agreement for audit
services, generally enjoy the least favorable position in auditor liability cases.

4. Compare ordinary negligence, gross negligence, and fraud as it pertains to the audit process.

Answer:
Ordinary negligence means a lack of reasonable care when performing services, such as a
departure from one of the generally accepted auditing standards. When used alone, the term
negligence is generally understood to mean ordinary negligence.
Gross negligence is a lack of even minimum care when performing services, such as a reckless
departure from GAAS.
Fraud is an intentional misstatement or omission of a material fact or a theft that results in
another party being deceived and then injured. The operative word is intentional.

5. The extent of an independent auditor’s liability under either common or statutory law rests
on four essential points. Name and describe the four essential points.

Answer:
 The plaintiff sustained a damage or loss.
 The audited financial statements were materially misstated.
 The plaintiff relied on the financial statements.
 The auditor’s conduct was deficient.

PROBLEMS
1. Complete the chart below illustrating the minimum basis for potential auditor liability and
the burden of proof placed upon the plaintiff as it pertains to specified Securities acts and
rules.
Answer:

Plaintiff/Act/Rules Minimum Basis For Describe The

Potential Auditor Burden of Proof
Liability Placed Upon Plaintiff

Under 1933 Act Section 11: Damage or loss

Security Purchaser Ordinary Negligence
Financial statements
misstated or erroneous
advice

Damage or loss
Under 1934 Act Section
10(b): Rule 10b-5: Gross Negligence or Fraud Financial statements
Security Purchaser or misstated or erroneous
Seller advice

Reliance

Auditor conduct deficient

Damage or loss
Under 1934 Act Section 18:
Security Purchaser or Gross Negligence Financial statements
Seller misstated or erroneous
advice

Reliance
2. Complete the chart below illustrating the minimum basis for potential auditor liability and the
burden of proof placed upon the defendant as it pertains to specified Securities acts and rules.

Answer:

Plaintiff/Act/Rules Minimum Basis For Describe The

Potential Auditor Burden of Proof
Liability Placed Upon Defendant

Under 1933 Act Section 11: Lack of reliance or auditor

Security Purchaser Ordinary Negligence conduct not deficient (due
diligence)

Under 1934 Act Section

10(b): Rule 10b-5: Gross Negligence or Fraud No defendant
Security Purchaser or burden of proof
Seller

Under 1934 Act Section 18: Auditor conduct not

Security Purchaser or Gross Negligence deficient (due diligence)
Seller