MULTIPLE CHOICE:

1. A CPA firm studies its personnel advancement experience to ascertain whether individuals meeting stated
criteria are assigned increased degrees of responsibility. This is

evidence of the firm's adherence to prescribed standards of

a. Supervision and review.

b. Continuing professional education.

c. Professional development.

d. Quality control.

ANSWER: D

2. Which one of the following, if present, would support a finding of constructive fraud on the part of a CPA?

a. Privity of contract. b. Intent to deceive.

c. Reckless disregard.

d. Ordinary negligence.

ANSWER: C

3. The CPA firm of Knox and Knox has been subpoenaed to testify and produce its correspondence and
workpapers in connection with a lawsuit brought by a third party against one of their clients. Knox
considers the subpoenaed documents to be privileged communication and therefore seeks to
avoid admission of such evidence in the lawsuit. Which of the following is correct?

a. Federal law recognizes such a privilege if the accountant is a Certified Public Accountant.

b. The privilege is available regarding the workpapers since the CPA is deemed to own them.

c. The privileged communication rule as it applies to a CPA/client relationship is the same as that
of attorney-client. d. In the absence of a specific statutory provision, the law does not recognize the
existence of the privileged communication rule between a CPA and his client.

ANSWER: D

4. Of the following statements, which best distinguishes ordinary negligence from gross negligence?

a. Failure to detect material errors, whether internal control is strong or weak, suggests gross
negligence.

b. Failure to exercise reasonable care denotes ordinary negligence, whereas failure to exercise
minimal care indicates gross negligence.

c. Gross negligence is most probable when the auditor fails to detect errors that occurred under
conditions of strong internal control.

d. The more material the undetected error the greater the likelihood of ordinary negligence.

ANSWER: B

5. On July 1, 2002, Kent purchased common stock of Salem Corp. in an offering subject to the Securities Act
of 1933. Mane & Co., CPAs, rendered an unqualified opinion on the financial statements of Salem which were
included in

Salem's registration statement filed with the SEC on March 1, 2002 Kent has commenced an action
against Mane based on the Securities Act of 1933 provisions dealing with omissions of facts required
to be stated in the registration

statement. Which of the following elements of a cause of action under the Securities Act of 1933
must be proved by Kent?

a. Kent relied upon Mane's opinion.

b. Kent was the initial purchaser of the stock and gave value for it.

c. Mane's omission was material.

d. Mane acted negligently or fraudulently.

ANSWER: A

6. The limitation of auditor liability under contract law is known as

a. Privity of contract.

b. Contributory liability.

c. Statutory liability.

d. Common law liability.

ANSWER: A

7. Under the Securities Act of 1933, the registration of securities which are offered to the public in
interstate commerce is

a. Directed toward preventing the marketing of securities which pose serious financial risks to the
prospective investor. b. Not required unless the issuer is a corporation. c. Mandatory unless the cost to the
issuer is"prohibitive" as defined in the SEC regulations. d. Required unless there is an applicable exemption.

ANSWER: D

8. The auditor's defense of contributory negligence is most likely to prevail when

a. Third party injury has been minimal.

b. The auditor fails to detect fraud resulting from management override of the control structure.

c. The client is privately held as contrasted with a public company.

d. Undetected errors have resulted in materially misleading financial statements.

ANSWER: B

9. The objective of quality control mandates that a public accounting firm should establish policies and
procedures for professional development which provide reasonable assurance that all entry-level personnel

a. Prepare working papers which are standardized in form and content.

b. Have the knowledge required to enable them to fulfillresponsibilities assigned.

c. Will advance within the organization.

d. Develop specialties in specific areas of public accounting.

ANSWER: B

10. A plaintiff wishes to recover damages from the issuer for

losses resulting from material misstatements in a securities

registration statement. In order to be successful, one of

the elements the plaintiff must prove is that the

a. Plaintiff was in privity of contract with the issuer or that the issuer knew of the plaintiff.

b. Plaintiff acquired the securities.

c. Issuer acted negligently.

d. Issuer acted fraudulently.

ANSWER: B

11. A basic objective of a CPA firm is to provide professional services that conform with professional
standards. Reasonable assurance of achieving this basic objective is provided through

a. A system of peer review.

b. Continuing professional education.

c. A system of quality control.

d. Compliance with generally accepted reporting standards.

ANSWER: C

12. Mix and Associates, CPAs, issued an unqualified opinion on

the financial statements of Glass Corp. for the year ended

December 31, 2002. It was determined later that Glass' treasurer had embezzled $300,000 from Glass
during 2002. Glass sued Mix because of Mix's failure to discover the embezzlement. Mix was unaware of the
embezzlement. Which of the following is Mix's best defense?

a. The audit was performed in accordance with GAAS. b. The treasurer was Glass' agent and, therefore,
Glass was responsible for preventing the embezzlement. c. The financial statements were presented in
conformity with GAAP.

d. Mix had no actual knowledge of the embezzlement.

ANSWER: A

13. Which of the following is not a condition for membership in the Division for CPA Firms?

a. Participating in peer review.

a. Employing only CPAs.

b. Conforming to specified continuing professional

education requirements.

c. Maintaining adequate levels of liability

insurance.

ANSWER: B

14. Gold, CPA, rendered an unqualified opinion on the 2000 financial statements of Eastern Power Co. Egan
purchased Eastern bonds in a public offering subject to the Securities Act of 1933. The registration
statement filed with the SEC included the financial statements. Gold is being sued by Egan under Section 11
of the Securities Act of 1933 for the

misstatements contained in the financial statements. To prevail, Egan must prove

Scienter Reliance

a. No No

b. No Yes

c. Yes No

d. Yes Yes

ANSWER: A

15. The Rusch Factors and Rhode Island Hospital Trust cases further defined the doctrine of privity by stating
that

a. Stockholders, as owners of the company, are also parties to the contract between auditor and
client.

b. Privity extends to primary third party beneficiaries known by the auditor to be relying on
the financial statements.

c. The doctrine of privity is broken when management intentionally misrepresents financial position
and/or results of operations.

d. Privity extends to third parties only in cases involving auditor negligence.

ANSWER: B

16. In connection with the element of professional development, a CPA firm's system of quality control
should ordinarily provide that all personnel

a. Have the knowledge required to enable them to fulfillresponsibilities assigned.

b. Possess judgment, motivation, and adequate experience. c.Seek assistance from persons having
appropriate level

of knowledge, judgment, and authority.

d. Demonstrate compliance with peer review directives.

ANSWER: A

17. In the case of Fischer v. Kletz (Yale Express), the auditors were charged with fraud for failing to inform
users of nonexistent accounts receivable. Although the case was settled out of court, it did
encourage the profession to issue a Statement on Auditing Standards relating to

a. Related party transactions.

b. Auditor responsibility for detecting illegal acts.

c. Audit risk assessment.

d. Subsequent discovery of facts existing at the date of the audit report.

ANSWER: D

18. Accounting firms should establish quality control

procedures for professional development in order to provide reasonable assurance that

d. Persons promoted possess the appropriate

characteristics to perform competently. b. Personnel will have the knowledge required to

fulfill responsibilities assigned.

c. The extent of supervision and review in a given

instance will be appropriate.

d. Association with a client whose management lacks integrity will be minimized.

ANSWER: B

19. The factor that distinguishes constructive fraud from actual fraud is

a. Materiality.

b. Quality of internal control.

c. Type of error or irregularity.

d. Intent.

ANSWER: D

20. Gleam is contemplating a common law action against Moore & Co. CPAs, based upon fraud. Gleam
loaned money to Lilly & Co. relying upon Lilly's financial statements which were audited by Moore. Gleam's
action will fail if

a. Gleam shows only that Moore failed to meticulously follow GAAS.

b. Moore can establish that they fully complied with the statute of frauds.

c. The alleged fraud was in part committed by oralmisrepresentations and Moore pleads the parol
evidence rule. d.Gleam is not a third party beneficiary in light of the absence of privity.

ANSWER: A

21. In the Continental Vending Machine Corporation case, the court argued that a footnote appearing in the
company's

annual report was confusing and misleading. As a result, the accounting profession

a. Encouraged practitioners to carry adequate liability insurance.

b. Issued a Statement on Auditing Standards defining related party transactions and assigning
auditor responsibility for detecting material related party transactions and determining that

the economic substance of such transactions is properly reflected in the financial

statements.

c. Issued a Statement on Auditing Standards requiring auditor presence at the client's physical
inventory taking and auditor confirmation of customer accounts receivable.

d. More clearly defined "privity of contract" between auditor and client.

ANSWER: B

22. Working papers prepared by a CPA in connection with an auditengagement are owned by the CPA,
subject to certainlimitations. The rationale for this rule is to

a. Protect the working papers from being subpoenaed. b. Provide the basis for excluding admission of
the working papers as evidence because of the privileged communication rule. c. Provide the CPA with
evidence and documentation which may be helpful in the event of a lawsuit. d.Establish a continuity of
relationship with the client whereby indiscriminate replacement of CPAs is discouraged.

ANSWER: C

23. Mead Corp. orally engaged Dex & Co., CPAs, to audit its financial statements. The management of Mead
informed Dex that it suspected that the accounts receivable were materially overstated. Although the
financial statements audited by Dex did, in fact, include a materially

overstated accounts receivable balance, Dex issued an

unqualified opinion. Mead relied on the financial

statements in deciding to obtain a loan from City Bank to expand its operations. City relied on the
financial

statements in making the loan to Mead. As a result of the overstated accounts receivable balance,
Mead has defaulted on the loan and has incurred a substantial loss. If Mead sues Dex for negligence
in failing to discover the overstatement, Dex's best defense would be that

a. No engagement letter had been signed by Dex. b. The audit was performed by Dex in accordance
with generally accepted auditing standards.

c. Dex was not in privity of contract with Mead. d. Dex did not perform the audit recklessly or with an intent
to deceive.

ANSWER: B

24. Dickens, a CPA firm's personnel partner, periodically studies the CPA firm's personnel advancement
experience to

ascertain whether individuals meeting stated criteria are assigned increased degrees of responsibility. This
is evidence of the CPA firm's adherence to prescribed

a. Standards of due professional care.

b. Quality control standards.

c. Supervision and review standards.

d. Reporting standards.

ANSWER: B

25. West & Co., CPAs, was engaged by Sand Corp. to audit its financial statements. West issued an
unqualified opinion on Sand's financial statements. Sand has been accused of making negligent
misrepresentations in the financial statements, which Reed relied upon when purchasing Sand stock. West
was not aware of the misrepresentations nor was it negligent in performing the audit. If Reed sues West
for damages based upon Section 10(b) and rule 10b-5 of theSecurities Exchange Act of 1934, West will

a. Lose, because Reed relied upon the financial statements.

b. Lose, because the statements contained negligent misrepresentations.c. Prevail, because some element
of scienter must be proved. d.Prevail, because Reed was not in privity of contract with West.

ANSWER: C

26. A CPA establishes quality control policies and procedures

for deciding whether to accept a new client or continue to perform services for a current client. The primary
purpose for establishing such policies and procedures is

a. To enable the auditor to attest to the integrity or reliability of a client.

b. To comply with the quality control standards

established by regulatory bodies.

c. To lessen the exposure to litigation resulting from failure to detect irregularities in client
financial statements. d. To minimize the likelihood of association with clients whose management lacks
integrity.

ANSWER: D

27. Which of the following statements is correct concerning corporations subject to the reporting
requirements of the Securities Exchange Act of 1934?

a. The annual report (form 10-K) need not include auditedfinancial statements.

b. The annual report (form 10-K) must be filed with the SEC within 20 days of the end of the
corporation's fiscal year.

c. A quarterly report (form 10-Q) need only be filed with the SEC by those corporations that are also
subject to the registration requirements of the Securities Act of 1933. d. A monthly report (form 8K) must be filed with the SEC after the end of any month in which a materially important event
occurs.

ANSWER: D

28. In a common law action against an accountant, the lack of

privity is a viable defense if the plaintiff

a. Bases his action upon fraud.

b. Is the accountant's client.

c. Is a creditor of the client who sues the accountant fornegligence. d. Can prove the presence of
gross negligence whichamounts to a reckless disregard for the truth.

ANSWER: C

29. Donn & Co. is considering the sale of $11 million of its common stock to the public in interstate
commerce. In this connection, Donn has been correctly advised that registration of the securities with the
SEC is

a. Not required if the states in which the securities are to be sold have securities acts modeled after
the federal act and Donn files in those states. b. Required in that it is necessary for the SEC to approve the
merits of the securities offered.

c. Not required if the securities are to be sold through a

registered brokerage firm.

d. Required and must include audited financial statements as an integral part of its registration.

ANSWER: D

30. Tulip Corp. is a registered and reporting corporation under the Securities Exchange Act of 1934. As such
it

a. Can offer and sell its securities to the public without the necessity of registering its securities
pursuant to the Securities Act of 1933.

b. Cannot make a tender offer for the equity securities ofanother registered and reporting
corporation without the consent of the SEC.

c. Must file annual reports (Form 10-K) with the SEC. d. Must distribute a copy of the annual report
(Form 10-K) to each of its shareholders.

ANSWER: C

31. A CPA firm issues an unqualified opinion on financial statements not prepared in accordance with
GAAP. The CPA firm will have acted with scienter in all the following circumstances except where the firm

a. Intentionally disregards the truth.

b. Has actual knowledge of fraud.

c. Negligently performs auditing procedures.

d. Intends to gain monetarily by concealing the fraud.

ANSWER: C

32. Which of the following conditions suggests auditor negligence?

a. Failure to detect material errors under conditions of weak internal control.

b. Failure to detect collusive fraud perpetrated by members of middle management.

c. Failure to detect collusive fraud perpetrated by members of top management.

d. Failure to detect errors occurring outside the internal control structure.

ANSWER: A

33. The registration of a security under the Securities Act of 1933 provides an investor with

a. A guarantee by the SEC that the facts contained in theregistration statement are accurate.

b. An assurance against loss resulting from purchasing thesecurity. c. Information on the principal
purposes for which theoffering's proceeds will be used.

d. Information on the issuing corporation's trade secrets.

ANSWER: C

34. The principal purpose of the registration requirements of the Securities Act of 1933 is to

a. Prevent public offerings of securities in which management fraud or unethical conduct is

suspected. b. Provide the SEC with the information necessary to determine the accuracy of the facts
presented in thefinancial statements.

c. Assure that investors have adequate information upon which to base investment decisions. d. Provide the
SEC with the information necessary to evaluate the financial merits of the securities being offered.

ANSWER: C

COMPLETION:

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

ANSWER: PANEL ON AUDIT EFFECTIVENESS

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

ANSWER: EXPECTATION GAP

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

ANSWER: SECURITIES AND EXCHANGE COMMISSION

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

ANSWER: CONSTRUCTIVE FRAUD

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

ANSWER: ORDINARY NEGLIGENCE

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

in Form 10-K.

ANSWER: INCORPORATED BY REFERENCE

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

ANSWER: SCIENTER

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

ANSWER: STATUTORY

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

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

ANSWER: COMFORT LETTER

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

ANSWER: NEGLIGENCE, SCIENTER (FRAUD)

MATCHING:

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

a. State board of accountancy

b. SEC Practice Section

c. Public Oversight Board

d. Securities and Exchange Commission

e. AICPA Quality Control Standards Board

f. Independence Standards Board

g. Emerging Issues Task Force

h. Panel on Audit Effectiveness

____ 1. Oversee peer review for public companies.

____ 2. Issue a guideline for reviewing accounting firm

personnel for promotion.

____ 3. Issue recommendations directed toward improving the

quality of independent audits.

____ 4. Recommend that the executive committee of the SEC

Practice Section sanction a member for failing to

comply with the Sections peer review standards.

____ 5. Issue a standard prohibiting an accounting firm from

accepting an accounting service engagement from an

audit client on the basis that performing both types

of service might impair objectivity.

____ 6. Review prospectus and registration statement of

company contemplating an initial public offering.

____ 7. Revoke license of member for committing a

discreditable act.

____ 8. Monitor FASB deliberations concerning the proper

accounting treatment to be applied to derivatives.

SOLUTION:

1. b

2. e

3. h

4. c

5. f

6. d

7. a

8. g

ESSAY

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

Required:

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

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

c. Who will prevail in the present case?

SOLUTION:

a. The doctrine of privity states that auditors are liable to third parties for fraud but
not for negligence.Subsequent court decisions, such as Ultramares v. Touche, however, have
construed gross negligence as constructive fraud. Auditors, therefore, may be held liable

to injured third parties for gross negligence, but not for ordinary negligence. In
addition, privity may extend to specifically identified third parties known by the auditor
to be relying on the audited financial statements.

b. Two approaches to distinguishing ordinary negligence from gross negligence are

materiality and internal control.Performing an audit with due care should permit the
auditor to detect a material misstatement not cleverly concealed.For example, an inventory
extension error (price x quantity) that overstates the ending inventory by 25 percent and
results in a material overstatement of net income should be detected in the ordinary course
of the audit.

Errors or fraud perpetrated because of weak internal controls are more likely to be
detected by the auditor than errors or fraud perpetrated outside the existing system of
internal control. For example, material misstatements caused by classification errors
related to repairs and maintenance expenditures versus property, plant, and equipment
additions may occur because the persons charged with determining the appropriate accounts
to be debited have not been adequately trained. This constitutes an internal control
weakness; and the auditors should have detected the weakness and modified their substantive
audit testing accordingly.

Contrast this with a material misstatement caused by management intentionally overriding

existing internal control for the purpose of inflating earnings. As part of the scheme,
documentation supporting fictitious sales may have been fabricated. Under these conditions,
the prudent auditor is less likely to detect the fraud.

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

47. A. How does the level of quality maintenance within the accounting profession impact
the expectations gap? Cite examples in your answer.

B. What is the alternative to self-regulation? Cite two measures the profession has taken
in recent years to meet the challenges posed by the threat of a widening expectations gap?

SOLUTION:

The goal of self-regulation within the accounting profession is to maintain the quality of
accounting services at a level that will satisfy the users of these services. The
expectations gap is the disparity between users and CPAs perceptions of the quality of
these services. Therefore, a decline in either the quality of services rendered by CPAs or
users perceptions of quality causes a widening of the expectations gap. Such diminishments
occur, for example, when courts find auditors negligent in the performance of audits or
when the financial press reports incidents of alleged audit failures. Cases involving Phar
Mor, Lincoln Savings and Loan, Crazy Eddie, and Miniscribe can be cited as
illustrations. CPA consulting services for audit clients impair the appearance of
independence, and is another means for widening the expectations gap and undermining the
perceived effectiveness of self-regulation.

The alternative to self-regulation is external regulation by the SEC or a similar public

body. One must remember that the SEC already has the authority granted by the securities
acts to regulate the accounting profession, but has declined to fully exercise that
authority. If the expectations gap were to widen significantly, however, and selfregulation is perceived to be ineffective, the SEC may well decide to actively pursue its
regulatory powers.

To meet the challenges posed the threat of a widening expectations gap and more external
regulation, the profession, in recent years, has:

1. Assigned the auditor responsibility for planning the audit to provide reasonable
assurance of detecting material financial statement errors and fraud;

2. Required auditors to evaluate the ability of each audit client to continue as a going
concern;

3. Encouraged clients to appoint audit committees to monitor internal control and arbitrate
disputes between management and the external auditors;

4. Issued a new SAS that provides more explicit guidance to auditors for detecting fraud
and communicating the findings to management and the board of directors;

5. Created an Independence Standards Board to actively pursue issues involving auditor

independence

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

1. A group of stockholders is suing a CPA for failing to detect a material misappropriation

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

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

3. A CPA failed to detect a misrepresentation fraud perpetrated by an audit client. The

fraud was material in its impact on the financial statements and was effected by debiting
operating expenses and manufacturing overhead to work orders for various construction
projects underway. The projects did not exist and the CPA examined a client-prepared
analysis of the work orders rather than the work orders themselves. Moreover, the CPA did
not ask to inspect any of the projects.

An action alleging negligence was brought against the CPA by the bank that granted a loan
to the company on the basis of the audited financial statements. The inflated earnings
figure resulting from the misrepresentation was an integral part of the decision to grant
the loan.

The CPA had rendered an unqualified opinion on the financial statements. This was the first
year the company had been audited. In past years, the CPA had performed only a review of
the companys financial statements; but this year the company requested an audit as part of
the banks conditions for processing the loan application.

SOLUTION:

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

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

3. The CPA will probably lose in this case. Although not grossly negligent, privity will
likely be extended to the bank because the CPA knew the bank was the primary beneficiary of
the audited financial statements. Negligence may be inferred by the fact that the auditor
did not examine the work orders and did not inspect any of the additions.
posted by padelacrz at 9:25 pm

no comments:
Post a Comment

Newer PostOlder PostHome

Subscribe to: Post Comments (Atom)

blog archive

2010 (15)
November (15)

AUDITING THEORY QUIZZER

Other Assurance Services

Audit Reports

Substantive Audit Testing: Expenditure Cycle

Substantive Audit Testing: Revenue Cycle

Statistical Sampling for Substantive Testing

Statistical Sampling for Testing Control Procedure...

Internal Control and Computer Based Information Sy...

Audit Planning (Reviewer in Auditing Theory)

Internal Control: Concepts (Reviewer in Auditing ...

Audit Risk and Materiality (Reviewer in Auditing T...

Audit Evidence and Audit Programs (Reviewer in Aud...

Maintaining Professional Responsibility: Regulati...

Defining Professional Responsibility: Quality Stan...

Auditing, Attestation, and Assurance (Reviewer in ...

about me

padelacrz
View my complete profile