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ACC 450

External Auditing
Spring 2016
Dr. Jordan Lowe

Exercises
Exercise
2-1
Hide It

Hide It (HI), a family-owned business, based in Tombstone, Arizona, builds custom homes with
special features, such as hidden rooms and hidden wall safes. Hide-It has been an audit client for
three years.

You are about to sign off on a "clean" opinion on HI's current annual financial statements when Art
Hyde, the VP-Finance, calls to tell you that the Arizona Department of Revenue has seized control
of a Hide-It bank account that includes about $450,000 of company funds; the account is not
currently recorded in the accounting system and you had been unaware of it. In response to your
questions about the origin of the funds, Art assures you that the funds, though not recorded as
revenue, had been obtained legitimately. He explains that all of the money came from separately
billed but unrecorded change orders to items in contracts completed before you became HI's auditor,
and before he or any members of current management became involved with the company. You
subsequently determine that there is insufficient evidence to allow you to reconstruct the nature of
these cash transactions, although the following analysis is available from the Arizona Department of
Revenue:
Deposits 1/17/X3--12/3/X5 $455,000
Interest earned 1/2/X3 -- 12/31/X9 95,000
Withdrawals 2/12/X4--4/7/X8 (100,000)
Balance 12/31/X9 $450,000

Art also informs you that HI has agreed to pay a combined tax and penalty of 12% on the total funds
deposited within 120 days as required by a recently enacted rule that provides amnesty for tax
evaders. Furthermore, he states that negotiations with the Internal Revenue Service are in process.

Required:

a. The professional standards define errors as unintentional misstatements or omissions of amounts


or disclosures in the financial statements? Is the situation described an error?

b. The professional standards state that fraud relates to intentional misstatements or omissions of
amounts or disclosures in the financial statements. Misstatements due to fraud may occur due to
either (a) fraudulent financial reporting or (b) misappropriation of assets. Does the situation
appear to be fraud? If so, is it fraudulent financial reporting, misappropriation of assets, or
both?

c. The professional standards outline certain responsibilities relating to noncompliance with laws,
and distinguish between "direct effect" and those acts related to other laws. Is the situation
described herein a situation involving noncompliance with laws as discussed within the auditing
standards? If so, is it "direct"?

d. Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional
information would you desire before deciding?
Exercise
5-1
Analytical ProceduresExplaining Changes

Analytical procedures are evaluations of financial information made by a study of plausible


relationships among financial and nonfinancial data. Understanding and evaluating such
relationships are essential to the audit process.

The following financial statements were prepared by Holiday Manufacturing Co. for the year
ended December 31, 20X1. Sales represent net credit sales.

Holiday Manufacturing Co.


BALANCE SHEET
December 31, 20X1
Assets Liabilities and Capital
Cash $ 240,000 Accounts payable $ 160,000
Receivables 400,000 Notes payable 100,000
Inventory 600,000 Other current liabilities 140,000
Total current assets $1,240,000 Total current liabilities $ 400,000
Plant and equipment--net 760,000 Long-term debt 350,000
Common stock 750,000
Retained earnings 500,000
Total assets $2,000,000 Total liabilities and
capital $2,000,000

Holiday Manufacturing Co.


INCOME STATEMENT
Year Ended December 31, 20X1
Sales $3,000,000
Cost of goods sold
Material $800,000
Labor 700,000
Overhead 300,000 1,800,000
Gross margin $1,200,000
Selling expenses $240,000
General and administrative exp. 300,000 540,000
Operating income $ 660,000
Less interest expense 40,000
Income before taxes $ 620,000
Less federal income taxes 220,000
Net income $ 400,000
Exercise
5-2
1. Times interest earned increased.

Times interest Operating income


=
earned Interest expense

Explanation May Explain


Change
Explanation (Client and Other)
Yes No
a. The company bought back shares of its common *
stock using proceeds from a new long term loan
b. Sales remained constant in absolute dollar terms *
while cost of goods sold increased
c. Short term debt stayed the same in total, but its *
interest rate now changes with changes in the prime
rate.

2. The inventory turnover decreased.

Cost of Good Sold


Inventory

Explanation May Explain


Change
Explanation (Client and Other)
Yes No
a. A number of expense items were erroneously *
included in cost of goods sold (but not in ending
inventory)
b. Times are good, sales are up; relatively, a higher *
percentage of customers are paying their accounts
c. Although sales for the year were the same as in the *
preceding year, inventory is a bit higher than normal
because Decembers sales were lower than expected.
Exercise
5-3
3. Operating income increased but the company was less profitable.

Explanation May Explain


Change
Explanation (Client and Other)
Yes No
a. Sales stayed constant, while cost of goods sold *
increased
b. The tax rate on income increased. *
c. Selling expenses and general and administrative *
expenses increased
d. Short-term borrowing was refinanced on a long-term *
basis at a higher interest rate.

4. Accounts receivable turnover increased for this year.

AR = Credit Sales
Turnover AR

Explanation May Explain


Change
Explanation (Client and Other)
Yes No
a. The company has increased sales by selling goods *
for lower prices, but shortening the length of credit
terms from 30 days to 20 days.
b. A major fraudulent credit sale was recorded on *
December 31, representing 20% of the years total
sales
Exercise
5-4
Audit Team Disagreements

Bill Small is a new audit associate in his first year with the public accounting firm of Foot, Tick,
and Tie. Small is currently engaged in the audit of Raider Manufacturing Company. The audit
is being supervised by Pauline Big, an audit senior with five years' experience. During the
course of the audit, Small takes exception to the client's justification for a change in the method
of computing depreciation. Big, on the other hand, sees no problem with the client's justification
and indicated to Small that further discussion of the matter would damage the good client
relations she has worked so hard to develop over the past few years. Small points out the fact
that SFAS 154 (Accounting Changes and Error Corrections) discusses the justification for a
change in accounting principle. Big states that she is aware of the requirements of SFAS 154
and wants the matter dropped immediately. Small agrees to drop the matter, but he continues to
have reservations about the justification for the change.

How should the disagreement be resolved?


Exercise
6-1
Budget Situations

1. Assume that you have worked for a public accounting firm for approximately six months, and
you were recently assigned to the audit of a small manufacturing company. The senior auditor on
the job assigned you the task of extracting financial information about comparable companies
from several financial databases on the Internet. She indicated that the work must be completed
by Monday morning. While you had hoped to complete the assignment on Friday, things didn't
work out and you had to come to work on Saturday.

On Saturday, your expectation that it would take only a couple hours to complete the task faded
and you didn't finish until 4 p.m., after eight hours of work. Although you completed the task,
you exceeded the budgeted hours for the task by six hours. Because of the circumstances
(inefficient work and the blown budget) you are tempted to underreport the number of hours that
you actually worked. While your firm has an informal policy that encourages employees to
report all hours worked, you are aware that the policy is often ignored by other audit associates.
In addition, you are aware that your evaluation on this audit will be based not only on the quality
of your work, but also on your ability to meet time budgets. You have been criticized on your
evaluations on previous engagements for taking too long to perform certain tasks.

Since you are paid a straight monthly salary and a year-end bonus based on performance, your
pay will not be directly affected by underreporting the hours worked. You could even argue that
not reporting the hours might improve your evaluation and lead to a bigger bonus.

NoteThe E&Y global code of conduct states, We require actual hours worked and expenses incurred to be reported.

Is underreporting hours in your best interest as an audit associate? audit senior? partner?

2. Today you had lunch with your friend Sarah Teasdale. Sarah has worked with Zaird &
Associates, CPAs for about 2 years. Youve been with Zaird for only nine months. You
discussed with her your difficulties in getting jobs done in the budgeted number of hours. Sarah
said, yes, that a problem. Youll get quicker with experience, butdont tell anyone I told you
thissome of those audit programs are pretty awful and include some pretty outdated and even
some stupid procedures. Sometimes I just sign the program, but skip doing the procedure. I
dont do this often, but sometimes the procedure isnt capable of detecting anything. You said
little to her after this, but are now thinking about whether you need to become more practical
about how you perform you work. Discuss this issue.
Exercise
6-2
Directional Testing Questions

1. Assume that the auditors are concerned about source documents that reflect valid
transactions that have not been recorded in the journals. Which procedure would be most
effective?

a. Trace from source documents to journals.


b. Vouch from journals to source documents.
c. Either a or b.

2. Assume that the auditors are concerned about transactions that have been recorded in the
journals (and subsequently in the ledgers) that are not valid--that is a transaction is
recorded, but it did not actually occur (e.g., a fraudulent overstatement of sales). Which
procedure would be most effective?

a. Trace from source documents to journals.


b. Vouch from journals to source documents.
c. Either a or b.

3. Assume that the auditors are concerned about transactions that have been recorded for
improper amounts. Which procedure would be most effective?

a. Trace from source documents to journals.


b. Vouch from journals to source documents.
c. Either a or b.

4. Tracing from source documents to journals most directly tests

a. completeness (understatements)
b. existence (overstatements)

5. Vouching from journals (or ledgers) to source documents most directly tests

a. completeness (understatements)
b. existence (overstatements)
Exercise
6-3
Chapter 6 Review Questions

1. When is a successor auditor required to attempt communication with a predecessor


auditor?Before accepting engagement, after accepting engagement, or both?

2. What types of questions are asked before accepting the engagement?

3. What is an engagement letter? Is it required on all audits?

4. Present and briefly describe the two materiality concepts. Discuss whether each is largely
quantitative and/or qualitative (nonquantitative).

5. If existence of acquisitions of inventory is the main risk (that is, overstatement) would one
test (a) from purchases journal to support; or
(b) from support to purchase journal
(support would include items such as purchase orders, vendors invoices, receiving report)

6. What are the two types of fraud included in SAS 99?

7. When fraud is identified, who should it be reported to?


Exercise
7-1
Internal Control Review Questions

1. For what two purposes do auditors consider internal control?

2. For controls, what is the difference between implemented (placed in operation) and operating
effectiveness?

3. In planning an audit, the auditor uses knowledge of internal control to:

a. Identify types of potential misstatements.


b. Consider factors that affect the risk of material misstatement.
c. Design tests of control, when applicable.
d. Design substantive tests.

4. What are the three control risks?

5. What is necessary to assess the level of control risk below the maximum.

6. Give three circumstances in which control risk may be assessed at the maximum level.

7. What types of control deficiencies need to be reported to management and regulators?

8. When doing an audit of internal control for public companies, what types of opinions are
given based on what circumstances?
Exercise
7-2
More Internal Control Questions

1. Internal control is primarily established within a company to do which of the following?

A. Prevent fraud
B. Provide reasonable assurance that the companys objectives will be achieved.
C. Catch all errors that may occur in the company.
D. Aid in the effective auditing of the company.

2. Which of the following is considered a control environment factor by the definition of


internal control?

A. Control objectives.
B. Integrity and ethical values.
C. Reasonable assurance.
D. Risk assessment.

3. Xiaotong Zhang is responsible for custody of the finished goods in the warehouse. If her
company wishes to maintain strong internal control, which of the following
responsibilities are incompatible with her primary job?

A. She is also responsible for the companys fixed asset control ledger.
B. She is responsible for receiving of goods into the warehouse.
C. She is responsible for the accounting records for all receipts and shipments of goods
from the warehouse.
D. She is responsible for issuing goods for shipment.

4. Which of the following describes the function of a fidelity bond?

A. An insurance policy that covers theft by a bonded employee.


B. A short term investment that is secured by a bank.
C. It is a procedure to separate the duties of employees.
D. A contract between parents and their children to remain celibate.

5. Tests of controls are used to test whether controls are

A. Operating effectively.
B. Implemented (placed in operation)
C. Properly accumulated into balance sheet totals.
D. Properly documented by the client.
Exercise
7-3
6. Tests of controls are least likely to include:

A. Inquiries of appropriate client vendors.


B. Reperformance of a control.
C. Observation of the application of an accounting procedure.
D. Inspection of documents.

7. Which of the following is most likely to be considered an inherent limitation of a clients


internal control?

A. Complexity of the information system.


B. Human errors.
C. Managements interest in a profitable enterprise.
D. An ineffective audit committee.

8. Which of the following is one of the most fundamental and effective controls?

A. Increased use of computers for recording accounting transactions.


B. Increased reliance of internal auditors to monitor accounting systems.
C. Segregation of incompatible duties across several people.
D. Having internal auditors report only to the Board of Directors.

9. Control risk is most likely to be assessed at a level below the maximum when?

A. No tests of controls have been performed.


B. Tests of controls have been performed.
C. Externally generated evidence supports managements contentions relating to internal
control.
D. The results of the consideration of internal control suggest that controls are not
operating effectively.

10. The results of the consideration of internal control are least likely to affect the auditors
decisions pertaining to:

A. The use of analytical procedures.


B. The assessment of control risk.
C. The assessment of inherent risk.
D. Detailed tests of ending balance.
Exercise
7-4

11. Which of the following is not considered one of the five major components of internal
control?

A. Risk assessment
B. Segregation of duties
C. Control activities
D. Monitoring

12. After documenting the client's prescribed internal control, the auditors will often
perform a walk-through of each transaction cycle. An objective of a walk-through is to:

A. Verify that the controls have been implemented (placed in operation)


B. Replace tests of controls
C. Evaluate the major strengths and weaknesses in the client's internal control
D. Identify weaknesses to be communicated to management in the management letter

13. Which of the following audit tests would be regarded as a test of a control?

A. Tests of the specific items making up the balance in a given general ledger account.
B. Tests confirming receivables.
C. Tests of the signatures on canceled checks to determine whether there are two
signatures on each check.
D. Tests of the additions to property, plant, and equipment by physical inspection.
Exercise
7-5
Control Risk Assessment

Lowe CPA Firm has hired you as a new audit associate. One of your first tasks is to make
assessments of control risk. For Cases A, B, and C, assume the client is a non-public client. For
Case D, assume the client is a public client.

Case A: Controls, as described by management, appear strong, and Lowe wishes to test them to
the extent possible. In this case he realizes that the results of the tests of controls may
differ. Accordingly, Case A has three subcases:

A(1) Controls are found to be strong and operate effectively. Inherent risk is assessed at
a moderate level.

A(2) Controls are found to operating ineffectively. Inherent risk is assessed at a low
level.

A(3) Controls, despite managements description, are found to be operating only


moderately effectively. Inherent risk is assessed at the maximum level.

Case B: Controls, as described by management, appear strong, but Lowe wishes to use his old
approach of not testing them. Inherent risk is assessed at the moderate level.

Case C: Controls, as described by management, appear weak. Inherent risk is assessed at a low
level.

Case D: Controls, as described by management, appear weak. Inherent risk is assessed at the
maximum level.

To assist the audit associates with their risk assessments, the firm uses the following chart:

Allowable Levels of Detection Risk,


Given Assessed Levels of Inherent Risk and Control Risk
Assessed Level of Control Risk
Inherent Risk Low Moderate Maximum

Low Highest Allowable Detection High Detection Risk (Low Moderate Detection Risk
Risk (Lowest Allowable Scope of Scope of Substantive (Moderate Scope of Substantive
Substantive Procedures) Procedures) Procedures)

Moderate High Detection Risk (Low Scope Moderate Detection Risk Low Detection Risk (High
of Substantive Procedures) (Moderate Scope of Scope of Substantive
Substantive Procedures) Procedures)

Moderate Detection Risk Low Detection Risk (High Lowest Detection Risk (Highest
Maximum
(Moderate Scope of Substantive Scope of Substantive Scope of Substantive
Procedures) Procedures) Procedures)
Exercise
7-6
On the following pages you will be given several questions to answer. Please use the following
reply options:

QUESTION REPLY OPTIONS


1. At what level is the planned Low
assessed level of control risk? Moderate
Maximum
2. Describe the scope of tests of None
control that will be performed Tests performed
3. At what level is the assessed Low
level of control risk? Moderate
Maximum
4. What is the (a) acceptable level a. Acceptable b. Scope of substantive tests
of detection risk and (b) the level of detection
resulting scope of substantive risk
tests?
Lowest Highest scope--Heavy emphasis on
externally generated evidence,
performed at year-end, and/or using
larger samples
Low
High scope--Emphasis on externally
generated evidence, performed at year-
end, and/or using larger samples
Moderate
Moderate
High
Low scope--Emphasis on internally
generated evidence, performed at interim
dates, and/or using smaller samples
Highest
Lowest scope--Heavy emphasis on
internally generated evidence, performed
at interim dates, and/or using smaller
samples
Exercise
7-7
Case A(1) Controls appear strong, auditor decides to test controls to extent possible.
Inherent risk is assessed at a moderate level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

[Results of Tests of ControlsControls Strong (Operating Effectively)]

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
7-8
Case A(2) Controls appear strong, auditor decides to test controls to extent possible.
Inherent risk is assessed at a low level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

[Results of Tests of ControlsControls Operating Ineffectively]

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
7-9
Case A(3)Controls appear strong, auditor decides to test controls to extent possible.
Inherent risk is assessed at the maximum level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

[Results of Tests of ControlsControls Operating Moderately Effectively]

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
7-10
Case BControls appear strong but auditor does not test.
Inherent risk is assessed at a moderate level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
7-11
Case CControls appear weak. Inherent risk is assessed at a low level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
7-12
Case DAssume you are now auditing a PUBLIC company. Controls appear weak.
Inherent risk is assessed at the maximum level.

1. At what level is the planned assessed level of control risk?

2. Describe the scope of tests of controls that will be performed?

[Results of Tests of ControlsControls Operating Ineffectively]

3. At what level is the assessed level of control risk?

4a. What is the acceptable level of detection risk?

4b. Describe the scope (nature, timing, and extent) of substantive procedures?
Exercise
9-1
Wong Attributes Sampling Problem

Wong CPA, wants you to test the effectiveness of Ingo Corporation's control of manually
approving all purchases of over $25,000. During the year Ingo Corporation has made 1,000,000
purchases, of which 300,000 were for over $25,000. He has asked you to use a tolerable
deviation rate of 5%, although he expects the rate to only be approximately .50 percent (i.e., 1/2
of 1%).

A. If Wong is a believer in the AICPA's table on page 345 of the text (and reproduced
below), what is the planned assessed level of control risk here?

(Planned) Assessed Level of Control Risk Tolerable Deviation Rate


Low 2-7%
Moderate 6-12%
Slightly below the maximum 11-20%
Maximum (wasnt worth testing)

B. Determine the proper sample size using Figure 9-4.

C. Use Figure 9-5 to calculate the achieved upper deviation rate, the sampling risk and then
the AICPA table to calculate the assessed level of control risk.

Circumstance Achieved Upper Sampling Risk Assessed level of


Deviation Rate Control Risk
1. Assume no deviations were
included in the sample.

2. Assume 3 deviations were


included in the sample.

3. Assume 4 deviations were


included in the sample.
Exercise
9-2
Note: Parts D and E in essence require you to rework the problem using ACL.

D. Use ACL and open up any project that has a table. Then to determine the proper sample
size use Sampling, Calculate Sample Size. Then select Record, Confidence=95,
Population = 300000

NOTE: No commas in numbers or decimal point by the 95; there is a decimal


point for the 1/2 of 1% (key in .5)

What is the proper sample size?

E. Use ACL to calculate the achieved upper deviation rate, the sampling risk and then the
AICPA table to calculate the assessed level of control risk (noteyou will get
differences here because of approximations above).

Circumstance Achieved Upper Sampling Risk Assessed level of


Deviation Rate Control Risk
1. Assume no deviations were
included in the sample.

2. Assume 3 deviations were


included in the sample.

3. Assume 4 deviations were


included in the sample.
Exercise
9-3
Smith, Inc.

The auditors wish to use mean-per-unit sampling to evaluate the reasonableness of the book
value of the accounts receivable of Smith, Inc. Smith has 10,000 receivable accounts with a total
book value of $1,500,000. The auditors estimate the population's standard deviation to be equal
to $25. After examining the overall audit plan, the auditors believe that the account's tolerable
misstatement is $60,000, and that a risk of incorrect rejection of 5 percent and a risk of incorrect
acceptance of 10 percent are appropriate.

Required:

a. Calculate the required sample size.

b. Assuming the following results:


Average audited value = $146
Standard deviation of sample = $ 28

Use the mean-per-unit method to:

(1) Calculate the estimated total audit value?

(2) Calculate the projected misstatement for the population.

(3) Calculate the adjusted allowance for sampling risk.

(4) State the auditors' conclusion in this situation.

Assume the average book value of the items in the sample is $149

c. Use the ratio method to calculate:

(1) Projected misstatement.

(2) Estimated total audited value.

d. Use the difference estimation method to calculate:

(1) Projected misstatement.

(2) Estimated total audited value.


Exercise
9-4
Potomac Mills

In the audit of Potomac Mills, the auditors wish to test the costs assigned to manufactured goods.
During the year, the company has produced 2,000 production lots with a total recorded cost of
$5.9 million. The auditors select a sample of 200 production lots with an aggregate book value of
$600,000 and vouch the assigned costs to the supporting documentation. Their examination
discloses misstatements in the cost of 52 of the 200 production lots; after adjustment for these
misstatements, the audited value of the sample is $582,000.

Required:
Compute an estimate of the total cost of production lots manufactured during the year using each
of the following sampling plans. (Do not compute the allowance for sampling risk or the risk of
incorrect acceptance of the estimates.)

(1) Mean-per-unit estimation.


(2) Ratio estimation.
(3) Difference estimation.

First Set it up as the outlines presented the material

Book Value Audited Value Book Value Audited Value


A1
A2
:
:
:
A200 __________ ___________ __________ __________

TOTAL

MEAN
VALUE

(1) Mean Per Unit

(2) Ratio

(3) Difference
Exercise
9-5
Attributes Sampling and Classical Variables Sampling Questions

1. For tests of controls, is attributes or variables sampling ordinarily most appropriate?

2. Distinguish between sampling and nonsampling risk.

3. If you accept a greater risk of incorrect acceptance, what does this do to sample size?

4. Which is considered the bigger problemrisk of incorrect acceptance or risk of incorrect


rejection? Why?

Assume the following:


Avg. population book value $100
Avg. sample book value 99
Avg. sample audited value 97
Number in population 20,000

5. What is the book value of the population?


$2,000,000

6. Calculate the projected misstatement using mean per unit sampling.


97(20,000)= $1,940,000
$60,000
7. Same as 6 using ratio estimation
(97/99)(2,000,000)= $1,959,596
$40,404
8. Same as 6 using difference estimation.
(99-97)(20,000)=$40,000
auditors: ETAV $1,960,000
9. What is the estimated total audited value using difference estimation?
Exercise
9-6
Laughlin

Below is the information from the PPS example that we did manually in class.

The auditors wish to test the valuation of accounts receivable in the audit of Desert Enterprises of
Laughlin. The client has $600,000 of total recorded receivables, composed of 1000 accounts.
The auditors have determined the following:

Tolerable misstatement $30,000


Risk of incorrect acceptance 5%
Expected misstatement $2,500

Assume that the auditors have tested the sample and discovered three misstatements:

Book Value Audited Value


$ 75 $ 71
600 550
7,900 7,500

Required: Work this problem using ACL. Note the following differences:

TEXT ACL
PPS sampling Monetary
Risk of incorrect Confidence
acceptance
Tolerable misstatement Materiality
Expected misstatement Expected Total Errors
Sampling interval Interval

Open up any project that has a table. Input the proper information into ACL. Then copy and
paste your ACL output into your WORD file that you are submitting.

Then calculate and document the:

(1) Required sample size.


(2) Sampling interval.
(3) Projected misstatement.
(4) Basic precision.
(5) Incremental allowance.
(6) Upper limit on misstatement.
Exercise
9-7
Edwards

Edwards has decided to use probability-proportional-to-size (PPS) sampling in the audit of a


client's accounts receivable balance. Few, if any, misstatements of the account balance are
expected.

Required:

a. Identify the advantages of using PPS sampling over classical variables sampling.

b. Use ACL to calculate the sampling interval and the sample size using the following
information:

Tolerable misstatement $15,000


Risk of incorrect acceptance 5%
Estimated misstatement $0
Recorded amount of accounts receivable $300,000

c. Use ACL to calculate results, given the following three errors were discovered in a PPS
sample:

Misstatement Book Value Audited Value


1. $ 400 $ 320
2. 500 0
3. 6,000 5,000

NOTICE: If you use an estimated misstatement of zero, if you find any misstatements, you will
always reject, since the basic precision equals the tolerable misstatement.
Exercise
9-8
ACL PPS Exercise

You have used ACL to perform PPS sampling. In addition to the "printout" below, assume the
account has a book value of $2,400,000 and a tolerable misstatement of $280,000.

@ EVALUATE MONETARY CONFIDENCE 95 ERRORLIMIT 85000, 412,1000, 1000,750,


40 INTERVAL 80000 TO SCREEN
Confidence: 95, Interval: 80000

Item Error Most Likely Error Upper Error Limit

Basic Precision: 240,000.00


1,000.00 1,000.00 80,000.00 140,000.00
750.00 40.00 4,266.67 6,613.34
85,000.00 412.00 412.00 412.00

Totals: 84,678.67 387,025.34

1. Present the projected misstatement (calculate if necessary).

2. Based on the sample results, would one "accept" or "reject" the population as being
materially correct? Explain.

3. What was the planned sample size?

4. The second misstatement (book value = $750) has a misstatement of $40. Show details
of the calculation performed by ACL to arrive at "most likely error" of $4,266.67.

5. Calculate the "Incremental Allowance."

6 Calculate the Allowance for Sampling Risk.

7. Given these results, if the procedure was applied properly, is it possible that the sample
size was different than that planned? Explain.
Exercise
10-1
Sales Cutoff Illustration

An improper cutoff of transactions around year-end occurs when journal entries are recorded in
the wrong year. In this case you are to determine the effects of various cutoff misstatements
relating to recording cash receipts received on accounts receivable and the recording of credit
sales. To effectively consider the effects of an improper cutoff, it is helpful to consider the
underlying journal entries.

Type of Transaction Proper Journal Entry (Entries)


Cash receipt on an account receivable Cash 3,000
Accounts Receivable 3,000
Credit sale periodic inventory system Accounts Receivable 2,000
Sales 2,000
Credit sale perpetual inventory system Accounts Receivable 2,000
Sales 2,000

Cost of Goods Sold 1,300


Inventory 1,300

An example of a possible improper cutoff is to close the cash receipts journal on December 30
and include December 31 sales in the subsequent year (e.g., the entry is dated January 1 rather
than December 31). As a result, cash is understated by $3,000, while accounts receivable is
overstated by $3,000 for the year just ended. The effects of closing the sales journal depend upon
whether a periodic inventory or perpetual inventory system is in use. The effects of leaving
open journals past year-end and dating January entries as of December may be determined in a
similar manner.

Required: Assume that the client made the following actual credit sales and received cash
receipts as follows after 12/29/20X8.

Cash Receipts
Sales Cost of Goods Sold (Receivables Collected)
12/30/X8 $ 1,000 $ 600 $ 4,000
12/31/X8 2,000 1,300 3,000
1/1/X9 3,500 2,200 2,500
1/2/X9 4,000 2,900 3,200
Exercise
10-2
Determine the overstatements and understatements that would result from the following situations. Assume that each situation is
independent of one another. As an illustration, situation 1 has been solved for you. To simplify the problem, in the case of a perpetual
inventory, assume that the year-end inventory count did not identify and correct the misstatement(s).

Situation Cash Acct. Rec. Inventory COGS Sales Income


1. Zhang Inc. left the cash receipts journal open $2,500 (o) $2,500 (u)
after year-end for an extra day and included
January 1 cash receipts in the December 31 totals.
The company uses a periodic inventory system.
What effect would this have on 20X8?
2. Zhang Inc. closed the cash receipts journal at
12/29 and reported the last two days of cash
receipts in January of 20X9. The company uses a
periodic inventory system. What effect would this
have on 20X8?
3. Zhang Inc. left the sales journal open after year-
end for an extra day ad included January 1 sales in
the December 31 totals. The company uses a
periodic inventory system. What effect would this
have on 20X8?
4. Same as 3, but the company uses a perpetual
inventory system.
5. Zhang Inc. closed the sales journal at 12/29 and
reported the two last days sales in January of
20X9. The company uses a perpetual inventory
system. What effect would this have on 2008?
6. Zhang Inc. left both the sales journal and the
cash receipts journal open through January 2 and
reported the first two days transactions in
December of 20X8. The company uses a periodic
inventory system. What effect would this have on
20X8?
Exercise
10-3

Assume Customers are saying they owe a smaller amount than that on the confirmation? This is
consistent with:

a. Cash receipts journal held open after year end?


b. Sales journal closed prior to year end?
c. Sales journal held open after year-end

How else could the situation occur?


Exercise
10-4
Bank Reconciliation Audit Perspective

You received the client prepared bank reconciliation presented below and are auditing Simply Soups Incs cash; control
risk over cash is assessed at the maximum level. For each item select the one or more procedures she could perform to
gather evidence in support of it. Note that since many of the procedures are redundant with one another, they would
not all necessarily be included in one particular audit program. For purposes of this problem you may assume:
Information provided by the bank is correct.
The client has only this one bank account.
The bank issues credit memos (which increase cash) and debit memos (which decrease cash) for transactions other
than ordinary deposits and disbursements.
Of the reconciling items, only Check # 517 was not returned with the cutoff statement (the others items cleared in
a reasonable period of time).
Bank Reconciliation
American NorthWest Bank (relates to Simply Soups, Inc.)
Milwaukee
December 31, 20X2

1 (select 3 Balance per bank $121,987.00


procedures)

2 (select 4 Deposits in transit


procedures 12/30 $121,200.00
12/31 31,600.57 152,800.57

3 (select 4 Outstanding checks


procedures) 517 $78,212.30
2455 7,911.15
2456 200.00
2457 23.54
2458 42,345.35
2459 2,375.23
2460 600.00 (131,667.57)

4 (select 4 Error: Check 2444 for $2,300 was 900.00


procedures) erroneously charged by bank for $3,200
on 12/23/X2; $900 credit received on
1/4/X3

5 (select 1 Balance per books $144.020.00


procedure)
Procedures
A. Trace to cash receipts journal.
B. Trace to cash disbursements journal.
C. Compare to 12/31/X2 general ledger.
D. Confirm directly with bank on standard form
E. Determine item and amount are on 12/31/X2 bank statement.
F. Compare to 1/10/X3 cutoff statement.
G. Use cutoff statement to determine that no relevant items have been omitted from bank reconciliation.
H. Inspect bank issued credit memo.
I. Inspect bank issued debit memo.
J. Inspect bank issued deposit receipt.
K. Inspect supporting documents for reconciling item not appearing on cutoff statement.
Exercise
10-5

Wilco

This exercise involves evaluating the sufficiency of audit evidence and reviewing working papers.
You are the senior auditor on the Wilco Inc. audit at 12/31/X1. James Adler is the audit associate
assigned to work on cash. He has completed the cash working papers on this, his first engagement,
and has given them to you for your review. James is a U of A graduate.

Review the schedules presented, noting any errors, missing indexes or cross references, lack of
sufficient evidence, unclear explanations, etc. Make a list of "audit points" to summarize
your review.

Note on cutoff statements A cutoff statement (not included in these materials, but referred to), is a
bank statement for a period less than a month. For example, in this case the auditors received a
cutoff statement directly from the bank for the period from January 1 through January 10, 20X2 (the
process is that the client requests the bank to send it directly to the auditor); a cutoff statement
includes canceled checks, deposit receipts, etc. Auditors use a cutoff statement to examine whether
year end reconciling items on the bank statements are properly handled. For example, if the clients
books show a 12/31 deposit that is not shown on the 12/31 bank statement, the deposit should be
included early in January on the cutoff statement.

Finally, schedule A-1-1 is a standard form used by auditors to confirm both the cash and debt with a
financial institution.

The referencing is as follows:

A Cash lead schedule


A-1 Bank reconciliation
A-1-1 Bank confirmation
A-1-2 Deposit in transit information
A-1-3 Schedule of 12/31 outstanding checks
Exercise
10-6
Wilco Inc.
Cash Lead Schedule
12/31/X1

A/C Description Prior Unadj. Adj.


Year 12/31/X1 Dr. Cr. 12/31/X1

101 Petty Cash $ 50.00 $ 50.00 $ 50.00

103 Genl. Acct. $90,328.00 $ 26,200.14 A-1 26,200.14

104 CD 0.00 $ 75,000.00 A-1-1 75,000.00

TOTAL $90,378.00 $101,250.14 --- --- $101.250.14


f f f

f Column footed.

Counted petty cash on January 2, 20X2. Fund was not replenished at year end and included
$39.29 of cash, a receipt for $5.80 for stamps, and one for $4.91 for other supplies. Both had
been purchased prior to year-end. Pass adjustment due to immateriality.

A
Exercise
10-7
Wilco Inc.
Bank Reconciliation--General Account
12/31/X1

Balance per Bank @ 12/31/X1--per A-1-1 $12,002.22

Deposit in Transit--per A-1-2 8,010.50

CC Deposits in Transit 7,200.00

Outstanding Checks--per A-1-3 (6,022.08)

Other--Note Collected by Bank 5,000.00

Bank Service Charge 9.50

Balance per Books @12/31/X1 $26,200.14


f

f Column footed.

Amount agrees to amount recorded as a deposit on the bank statement as of 12/31/X1. This
cash was recorded in the cash receipts journal on 12/30/X1.

Amount agrees to 12/31/X1 bank statement and charge slip enclosed with that statement. Client
recorded charge on 1/7/X2 after reconciling bank account. Pass year-end adjustment as amount
involved is immaterial.

Represents December 30-31 credit card sales (Entry recorded is to debit Cash and to credit
Credit Card Sales). Cash is ordinarily wired to account 2-3 days after sale as the company uses
a batch process to runs the transactions every 2-3 days.

Agreed to general ledger.

A-1
Exercise
10-8
Wilco Inc.
Standard Bank Confirmation
12/31/X1
STANDARD FORM TO CONFIRM ACCOUNT
BALANCE INFORMATION WITH FINANCIAL INSTITUTION

Wilco Inc._________
ORIGINAL CUSTOMER NAME
To be mailed to accountant
Financial Institutions Name We have provided to our accountants the following information as of
and Address the close of business on ___12/31, X1_ _ , regarding our deposit
Bank of Arizona and loan balances. Please confirm the accuracy of the information,
Tempe Branch noting any exceptions to the information provided. If the balances
1601 E. Broadway have been left blank, please complete this form by furnishing the
Tempe, AZ 85282 balance in the appropriate space below. Although we do not request
nor expect you to conduct a comprehensive, detailed search of your
records, if during the process of completing this confirmation additional
information about other deposit and loan accounts we may have with
you comes to your attention, please include such information below.

1. At the close of business on the date listed above, our records indicated the following deposit balance(s):

ACCOUNT NAME ACCOUNT NO. INTEREST RATE BALANCE

GENERAL 0044-9834 -0- $12,002.22 A-1

2. We were directly liable to the financial institution for loans at the close of business on the date listed above as follows:

ACCOUNT NO./ BALANCE DATE DUE INTEREST RATE DATE THROUGH WHICH DESCRIPTION OF
DESCRIPTION INTEREST IS PAID COLLATERAL
A-1
37-353-23-56 $75,500 6/30/X3 8% 11/1/X1 1st mortgage on building

Brian Dyman 12/29/X1


(Customers Authorized Signature) (Date)

The information presented above by the customer is in agreement with our records. Although we have not conducted a comprehensive, detailed
search of our records, no other deposit or loan accounts have come to our attention except as noted below.

Will Clarke 1/5/X2


(Financial Institution Authorized Signature) (Date)

Assistant Controller
(Title)
EXCEPTIONS AND/OR COMMENTS

Please return this form directly to our accountants:


Gill & Co, CPAs
2552 E. Camelback Road
Phoenix, AZ 85002

Ordinarily, balances are intentionally left blank if they are not available at the time the form is prepared.

A-1-1
Exercise
10-9
Wilco Inc.
Deposit in Transit
12/31/X1

Copy of Deposit Slip for Deposit in Transit

DEPOSIT SLIP

Wilco Inc. Currency 7510.00


PO Box 2833353 Coin 500.50
Tempe, AZ 85282 Checks

Date: 12/31, 20X1


Total From
DEPOSITS MAY NOT BE Other Side
AVAILABLE FOR IMMEDIATE
WITHDRAWAL
DEPOSIT TICKET
TOTAL USE OTHER SIDE FOR ADDITIONAL
LISTINGS
Less Cash
TOTAL ITEMS
NET
DEPOSIT 8010.50
A-1 BE SURE EACH ITEM IS PROPERLY
ENDORSED.
f
Bank of Arizona
Tempe Branch
1601 E. Broadway Avenue
Tempe, AZ 85282 21133544: 933..50023333

The client saved a copy of the deposit slip that is filled out. This is a copy of it. Per client, the
cash represents cash sales on 12/31/X1. I agreed totals to the Cash Receipts Journal on
12/31/X1. Properly posted on cutoff bank statement as having been received by bank on 1/9/X2.

A-1-2

CP
Exercise
10-10
Wilco Inc.
Outstanding Checks--General Account
12/31/X1

Check # Date Amount

217 1/ 6/X1 $2,000.00


222 1/22/X1 2.50
1021 12/15/X1 1,000.00
1024 12/22/X1 1,110.32
1025 12/24/X1 1,147.04
1028 12/29/X1 40.00
1030 12/30/X1 22.22
1034 12/31/X1 900.00
1035 12/31/X1 350.00
1036 12/31/X1 450.00
$6,022.08

Traced and agreed to canceled check included in 1/10/X2 cutoff statement sent directly to us.
Amount and date agreed.

Check not returned with cutoff statement. Traced to cash disbursements journal (payee,
amount, date, and number). No exceptions noted. Pass further analysis since amount is
immaterial.

Per client, these checks have not been cashed. Controller believes payee may have lost them and
wishes to "leave sleeping dogs lie."

Per client, check written (to pay account payable) before year-end, but not mailed until 1/2/X2
because on 12/31/X1 the last office mail was picked up at 3 PM due to year-end party of mail
room employees at Durant's.

NOTE: Also included with the cutoff statement were two checks #s 1038 and 1039, for $2,000 and
$3,000 respectively, dated 12/31/X1. I discussed this with controller and he showed me
where they had been properly recorded in the cash disbursements journal on December
31, 20X1.

A-1-3
Exercise
10-11
Johnson Co.

The auditors of Johnson Co., decided to study the cash receipts and disbursements for the month
of July of the current year under audit. They obtained the bank reconciliations and the cash
journals prepared by the company accountants, which revealed the following:

BANK BOOKS
June 30 Balance $355,001 June 30 Balance $399,210
Deposits in July $835,846 Cash Receipts in July $650,187
Disbursements in July $684,747 Cash Disbursements in July $565,397
July 31 Balance $506,100 July 31 Balance $484,000

Deposits in Transit: June 30 $86,899


July 31 $51,240

Outstanding Checks: June 30 $42,690


July 31 $73,340

Johnson Co.
Proof of Cash for July, 200X

Balance Balance
6/30/0X Deposits Checks 7/31/0X

Per bank statement $355,001 $835,846 $684,747 $506,100

Deposits in transit:
At 6/30/9X 86,899
At 7/31/9X 51,240

Outstanding checks:
At 6/30/9X (42,690)
At 7/31/9X (73,340)

Per Books $399,210 $650,187 $565,397 $484,000


Exercise
10-12
Reliable Auto Parts

You are the senior auditor-in-charge of the July 31, 20X0, audit of Reliable Auto Parts, Inc. Your newly
hired audit associate reports to you that she is unable to complete the four-column proof of cash for the
month of April 20X0, which you instructed her to do as part of the consideration of internal control over
cash.

Your assistant shows you the working paper that she has prepared. Your review of your assistants work
reveals that the dollar amounts of all the items in her working paper are correct. You learn that the
accountant for Reliable Auto Parts, Inc., making no journal entries for bank service charges or note
collections until the month following the banks recording of the item. In addition, Reliables accountant
makes no journal entries whatsoever for NSF checks that are redeposited and cleared. Your assistants
working paper appears on below.

Required: prepare a corrected four-column proof of cash in good form for Reliable Auto Parts, Inc., for
the month of April 20X0.

RELIABLE AUTO PARTS, INC.


Proof of Cash for April 20X0
July 31, 20X0
Balance Deposits Checks Balance
3/31/X0 4/30/X0
Per bank statement $71682.84 $61488.19 $68199.40 $65051.63
Deposits in transit:
At 3/31/X0 2118.18 (2118.18)
At 4/30/X0 4918.16 4918.16
Outstanding checks:
At 3/31/X0 (14888.16) 14888.16
At 4/30/X0 (22914.70) 22914.70
Bank service charges:
March 20X0 (22.18) 22.18
April 20X0 (19.14) 19.14
Note receivable collected
by bank 4/30/X0 18180.00 18180.00
NSF check of customer
L.G. Waite, charged
back by bank 3/31/X0,
redeposited and
cleared 4/3/X0 (418.19) 418.19
Balances as computed 58472.49 85004.54 60095.90 108964.45
Balances per book 59353.23 45689.98 76148.98 28894.23
Unlocated difference $(880.74) $39314.56 $(16053.08) $80071.22
Exercise
10-13
RELIABLE AUTO PARTS, INC.
Corrected Proof of Cash for April, 200X
July 31, 200X

Balance Checks Balance


3/31/9X Deposits and Debits 4/30/9X

Per bank statement $ 71,682.84 $ 61,488.19 $68,119.40 $65,051.63


Deposits in transit:
At 3/31/9X 2,118.18 ( 2,118.18)
At 4/30/9X 4,918.16 4 ,918.16
Outstanding checks:
At 3/31/9X (14,888.16) (14,888.16)
At 4/30/9X 22,914.70 (22,914.70)

Bank service charges:


March, 200X 22.18 22.18
April, 200X (19.14) 19.14

Note receivable collected


by bank 4/30/9X (18,180.00) (18,180.00)

NSF check of customer L. G.


Waite, charged back by
bank 3/31/9X, redeposited
and cleared 4/3/9X 418.19 (418.19) _________ _________
Per Books $59,353.23 $45,689.98 $76,148.98 $28,894.23
Exercise
10-14
Errors & Fraud / Audit Procedures

Items 1 through 10 represent possible misstatements due to errors and/or fraud. The
accompanying list of auditing procedures (A through R) represents procedures that the auditor
would consider performing to gather evidence concerning possible errors and fraud. For each
item, select one procedure (two procedures for item #7) that the auditor would most likely
perform to gather evidence in support of that item. The procedures on the list may be selected
once, more than once, or not at all.

Possible Misstatements Due to Errors and Fraud

1. The auditor suspects that a lapping scheme exists because an accounting department
employee who has access to cash receipts also maintains the accounts receivable ledger
and refuses to take any vacation or sick days. (answer is C)
2. The auditor suspects that the entity is inappropriately increasing the cash reported on its
balance sheet by drawing a check on one account and not recording it as an outstanding
check on that account and simultaneously recording it as a deposit in a second account.
3. The auditor suspects that the entitys controller has overstated sales and accounts
receivable by recording fictitious sales to regular customers in the entitys books.
4. The auditor is examining the entitys bank reconciliation and needs to corroborate the
cash balance per the entitys books.
5. An auditor suspects that the controller wrote several checks and recorded the cash
disbursements just before year-end but did not mail the checks until after the first week of
the subsequent year.
6. The entity borrowed funds from a financial institution. Although the transaction was
properly recorded, the auditor suspects that the loan created a lien on the entitys real
estate that is not disclosed in the financial statements.
7. The auditor discovered an unusually large receivable from one of the entitys new
customers. The auditor suspects that the receivable may be fictitious because the auditor
has never heard of the customer and because the auditors initial attempt to confirm the
receivable has been ignored by the customer (2 procedures).
8. The entitys cash receipts of the first few days of the subsequent year were properly
deposited in its general operating account after the year-end. However, the auditor
suspects that the entity recorded the cash receipts in its books during the last week of the
year under audit.
9. The auditor suspects that vouchers were prepared and processed by an accounting dept.
employee for merchandise that was neither ordered nor received by the entity.
10. The details of invoices for equipment repairs were not clearly identified or explained to
the accounting department employees. The auditor suspects that the bookkeeper
incorrectly recorded the repairs as fixed assets.
Exercise
10-15

List of Auditing Procedures

A. Sign off on the procedure (without performing it) and hope nobody finds out.
B. Treat your audit senior to lunch and ask him or her what to do.
C. Compare the details of the cash receipts journal entries with the details of the
corresponding daily deposit slips.
D. Scan the debits to the fixed asset accounts and vouch selected amounts to vendors
invoices and managements authorization.
E. Obtain the cutoff bank statement and compare the cleared checks to the year-end bank
reconciliation.
F. Prepare a bank transfer schedule.
G. Inspect the entitys deeds to its real estate.
H. Make inquiries of the entitys attorney concerning the details of the real estate
transactions.
I. Confirm the terms of borrowing arrangements with the lender.
J. Examine selected equipment repair orders and supporting documentation to determine the
propriety of the charges.
K. Send a second request for confirmation of the receivable to the customer and make
inquiries of a reputable credit agency concerning the customers creditworthiness.
L. Examine the entitys shipping documents to verify that the merchandise that produced the
receivable was actually sent to the customer.
M. Inspect the entitys correspondence files for indications of customer disputes for evidence
that certain shipments were on consignment.
N. Inspect the file of prenumbered vouchers for consecutive numbering and proper approval
by an appropriate employee.
O. Determine that the details of the selected prenumbered vouchers match the related
vendors invoices.
P. Examine the supporting purchase orders and receiving reports for selected paid vouchers.
Q. Compare to the year-end general ledger.
R. Confirm directly with the bank.
Exercise
11-1
Brief Example of Revenue Cycle

Sale

Customer
Purchase Sales Shipping
Order Order Documents
:
:
:
Sales Sales General
Invoice Journal Ledger

Cash Receipt

Check and Cash General


Remittance Receipts Ledger
Advice Journal

1. When vouching (tracing back) debit entries in accounts receivable subsidiary ledger back to
supporting sales invoices, what is being tested?

a. Sales invoices represent bona fide sales.


b. All sales have been recorded
c. All sales invoices have been properly posted to customer accounts.
d. Debit entries in the accounts receivable sub ledger are properly supported by sales
invoices.

2. How would you test credit sales for understatements?

3. How would you test credit sales for overstatements?


Exercise
11-2
Suncraft Appliance Corporation

On October 21, Rand & Brink, a CPA firm, was retained by Suncraft Appliance Corporation to perform
an audit for the year ended December 31. A month later, James Minor, president of the corporation,
invited the CPA firm's partners, George Rand and Alice Brink, to attend a meeting of all officers of the
corporation. Mr. Minor opened the meeting with the following statement: All of you know that we are
not in a very liquid position, and our October 31 balance sheet shows it. We need to raise some outside
capital in January, and our December 31 financial statements (both balance sheet and income statement)
must look reasonably good if we're going to make a favorable impression upon lenders or investors. I
want every officer of this company to do everything possible during the next month to ensure that, at
December 31, our financial statements look as strong as possible, especially our current position and our
earnings. "I have invited our auditors to attend this meeting so they will understand the reason for some
year-end transactions that might be unusual. It is essential that our financial statements carry the auditors'
approval, or we'll never be able to get the financing we need. What suggestions can you offer?"

(1) The vice president in charge of production commented: "We can ship every order we have now and
every order we get during December before the close of business on December 31. We'll have to pay
some overtime in our shipping department, but we'll try not to have a single unshipped order on hand at
year-end.

(2) Also, we could overship some orders, and the customers wouldn't make returns until January."

(3) The controller spoke next: "If there are late December orders from customers that we can't actually
ship, we can just label the merchandise as sold and bill the customers with December 31 sales invoices.

(4) Also, there are always some checks from customers dated December 31 that don't reach us until
Januarysome as late as January 10. We can record all those customers' checks bearing dates of late
December as part of our December 31 cash balance."

(5) The treasurer offered the following suggestions: "I owe the company $50,000 on a call note I issued to
buy some of our stock. I can borrow $50,000 from my mother-in-law about Christmas time and repay my
note to the company. However, I'll have to borrow the money from the company again early in January,
because my mother-in-law is buying an apartment building and will need the $50,000 back by January 15.

(6) The vice president of production made two final suggestions: "Some of our inventory, which we had
tentatively identified as obsolete, does not represent an open-and-shut case of being unsaleable. We could
defer any write-down until next year.

(7) Another item is some machinery we have ordered for delivery in December. We could instruct the
manufacturer not to ship the machines and not to bill us before January."

(8) Another thing we can do to improve our current ratio is to write checks on December 31 to pay most
of our current liabilities. We might even wait to mail the checks for a few days or mail them to the wrong
addresses. That will give time for the January cash receipts to cover the December 31 checks.
Exercise
11-3
Accounts Receivable Confirmations

You are involved with the audit of of Jelco Company for year 1 and have been asked to consider
the confirmation reply results indicated below. For each confirmation reply as to the proper
action to be taken from the following:

(1) Exception; propose and adjustment.


(2) Send a second confirmation request to the customer.
(3) Examine shipping documents and/or subsequent cash receipts.
(4) Verify whether the additional invoices noted on the confirmation reply pertain to the year
under audit or the subsequent year.
(5) Not an exception, no further audit work is necessary.

Customer Reply (and any audit action already taken) Proper Action
a We mailed the check for this on December 31.

b We returned those goods on December 2. You


have been able to determine that the goods were
received by the client on December 29, but not
recorded until January 2.

c We also owe for two more invoices for purchase


we made around year-end, Im not sure of the
exact date.

d We are very satisfied with Jelco and plan to


purchase from them in the future.

e While thats what we owe, we didnt owe it on


December 31 since we didnt receive the goods
until January 2 of year 2.

f You received no reply to a negative confirmation


requests to Adams Co.

g You received no reply to a positive confirmation


request to Blake Co. Subsequently you recalled
that Blake Co. has a policy of not responding to
confirmationin writing or orally.
Exercise
11-4
Lapping Example

DATE SITUATION JOURNAL ENTRY


1/2 Abbott pays $750 on account

Crane pays $1,035 on account

Bookkeeper steals and cashes check


from Abbott

1/22 Barstow pays $750 on account

White pays $130 on account

2/1 Crawford pays $1,575 on account


Miller pays $400 on account

Bookkeeper steals $825 from deposit

Possible conclusionsall on 2/15

SITUATION JOURNAL ENTRY


a. Write-off account

b. Bookkeeper comes up with another


plan (bury it in miscellaneous
expense).

c. Bookkeeper feels moderately guilty


(or fears he will be caught) and repays
Exercise
12-1

Inventory Assertions and Procedures

Zimmermann, CPA, knows that while audit objectives relating to inventories may be stated in
terms of the assertions as presented in this chapter, they may also be stated in a more detailed
manner as specific audit objectives. He has chosen to do so and has prepared the second column
of the following table.

Financial
statement Audit
assertion Specific audit objective procedure
D 1. The entity has legal title to inventories J
E 2. Inventories are reduced, when appropriate, to G
replacement cost or net realizable value.
E 3. Cost of inventories is properly calculated. J
C 4. The major categories of inventories and their basis H
of valuation are adequately reported in the
financial statements.
A 5. Recorded inventory quantities include all products I
on hand.

Required:
Assume that Zimmermann's client, a retail department store, does no production. For each
specific inventory audit objective listed above, select the most closely related financial statement
assertion and the most appropriate audit procedure from the following. Financial statement
assertions and audit procedures may be selected once, more than once, or not at all. However,
only one letter should be placed in each box.

Financial Statement Assertion Audit procedure


A. Completeness G. Examine current vendor's price lists.
B. Existence or occurrence H. Review drafts of the financial statements.
C. Presentation and disclosure I. Select a sample of items during the physical
D. Rights and obligations inventory count and determine that they
E. Valuation or allocation have been included on count sheets.
F. Cutoff J. Select a sample of recorded items and
examine supporting vendors' invoices, and
contracts.
K. Select a sample of recorded items on count
sheets during the physical inventory count
and determine that items are on hand.
L. Tests reasonableness of direct labor rates.
Exercise
12-2
Brief Example of Disbursement Cycle

Purchase

Purchase Purchase
Requisition Order

Receiving Purchases General


Report Journal Ledger

Vendor's
Invoice

Cash Disbursement

Check and Cash


Remittance Disbursements General
Advice Journal Ledger

1. Which documents need to be present before payment is approved?

2. How can a firm control disbursements so that if a duplicate invoice is sent by the supplier the
payment will not be made a second time?

3. What audit test could be used to determine whether recorded purchases represent valid business
expenses?

4. What audit procedure would test whether actual purchases are recorded?
Exercise
16-1
Keystone Computers & Networks (KCN), Inc

The auditors of Adams, Barnes & Co. (ABC), CPAs, reported the following audit findings in
their audit of Keystone Computers & Networks (KCN), Inc.:

1. Unrecorded liabilities in the amount of $6,440 for purchases of inventory. These inventory
items were counted and included in the year-end total. (Note Given that the inventory
count is greater than the inventory totals on the books, the bookkeeper has adjusted the
books by debiting inventory and crediting COGS.)

2. Projected misstatement for inventory of $9,510 overstatement.

3. The auditors of ABC believes that the amount of KCN's allowance for uncollectible
accounts should be increased by $5,000.

In addition, the auditors have decided that for evaluating a material misstatement of the financial
statements the following guidelines should be used:

Current assets$50,000
Noncurrent assets$75,000
Current liabilities$50,000
Noncurrent liabilities$75,000 Total owners' equity$100,000
Net income before taxes$65,000

Required:

a. Complete the schedule on the following page, assuming that KCN's marginal tax rate is 25
percent.

b. Decide whether the results indicate that there is a sufficiently low risk of material
misstatement to justify ABC's audit opinion.
Exercise
16-2

Keystone Computers & Networks, Inc.


Total Likely Misstatement
December 31, 20X5
Overstatement (Understatement)

W/P Current Noncurren Current Noncurrent Owners' Inc. Before Tax


ref. Assets t Liabilities Liabilities Equity Taxes Expense
Assets
Uncorrected Known
Misstatements
1. Unrecorded liabilities ($6,440) $6,440 $ 6,440
1,610 (1,610) $1,610

Projected Misstatements

2. Overstatement of inventory
(price tests) 9,510 9,510 9,510
2,378 (2,378) 2,378
Other Estimated Misstatements
3. Understatement of allowance 5,000 5,000 5,000
for uncollectible accounts 1,250 (1,250) 1,250

Total Likely Misstatements $14,510 ------- ($ 1202) -------- $15,712 $20,950 $ 5238
Amount Considered Material $50,000 $75,000 $ 50,000 $75,000 $100,000 $65,000 ----------
Exercise
17-1
Audit Report Review Questions

1. What type of report(s) arises due to a scope limitation?

Qualify; Disclaimer

2. What circumstance(s) result in a disclaimer of opinion?

Scope limitation; Uncertainties;

3. What are the types of audit reports for uncertainties?

Unqualified opinion with emphasis of mater or Disclaimer;

4. Under what circumstance(s) is an adverse opinion issued?

A large part of gap;

5. What types of reports are issued when "component auditors" are involved?

6. What's the difference between "component auditors" and a "predecessor auditor"?

Component auditors:
Predecessor auditor:

7. What date is ordinarily used to date an audit report?

8. Which additional paragraphs added to audit reports must follow the opinion paragraph?

Emphasis of matter.

9. Which additional paragraphs added to audit reports must precede the opinion paragraph?

10. In a "going concern modification" an auditor evaluates whether there is "substantial doubt"
about an entity's ability to continue as a going concern for a reasonable period of time. How
long is this reasonable period of time?
Exercise
17-2

Audit Report Multiple Choice Questions

1. In which of the following circumstances would an auditor not be likely to express an


unmodified opinion?

a. There has been a material change between periods in accounting principles


b. The company is a component of a larger business enterprise.
c. The auditor wishes to emphasize an unusually important subsequent event.
d. The auditor is unable to obtain audited financial statements of a consolidated investee.

2. Under which of the following circumstances would a disclaimer of opinion not be


appropriate?

a. The auditor is unable to determine the amounts associated with an employee fraud scheme.
b. Management does not provide reasonable justification for a change in accounting
principles.
c. The client refuses to permit the auditor to confirm certain accounts receivable or apply
alternative procedures to verify their balances.
d. The chief executive office is unwilling to sign the management

3. In which of the following circumstances would an auditor most likely add an emphasis of
matter paragraph to the audit report while not affecting the auditors unmodified opinion?

a. The auditor is asked to report on the balance sheet and income statement, but the client will
not prepare a statement of cash flow.
b. An unusually important significant event, properly disclosed in the financial statements, is
referred to by the auditor.
c. Managements estimates of the effects of future events are unreasonable.
d. Certain transactions cannot be tested because of managements records retention policy.

4. An auditor may not issue a qualified opinion when

a. An accounting principle at variance with GAAP is used.


b. The auditor lacks independence with respect to the audited entity.
c. A scope limitation prevents the auditor from completing an important audit procedure.
d. The auditors report refers to the work of a specialist.
Exercise
17-3
Sample Audit Reports

For each of the next 7 audit reports indicate:

1. Whether the report is for a public or nonpublic company.

2. The type of opinionunmodified, modified (qualified, adverse, or disclaimer)

3. The circumstance involved (e.g., going concern, scope limitation, GAAP departure).

To keep things somewhat manageable, all audit reports are on only one year, even though public
company audit reports would be on multiple years. Wording of reports gets very bulky when, for
example, the balance sheet for 20X1 has a departure from GAAP while the balance sheet for
20X0 does not. At this point, we are just trying to get an overall understanding of audit reports.
Exercise
17-4
Independent Auditors Report
To the Board of Directors and Stockholders of ABC Company
We have audited the accompanying consolidated financial statements of ABC Company and its
subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related
consolidated statements of income, changes in stockholders equity and cash flows for the year then
ended, and the related notes to the financial statements.
Managements Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial
statements in accordance with accounting principles generally accepted in the United States of America;
this includes the design, implementation and maintenance of internal control relevant to the preparation
and fair presentation of consolidated financial statements that are free from material misstatement,
whether due to fraud or error.
Auditors Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the
consolidated financial statement. The procedures selected depend on the auditors judgment, including the
assessment of the risks of material misstatement of the consolidated financial statements, whether due to
fraud or error. In making those risk assessments, the auditor considers internal control relevant to the
entitys preparation and fair presentation of the consolidated financial statements in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on
the effectiveness of the entitys internal control. Accordingly, we express no such opinion. An audit also
includes evaluating the appropriateness of accounting policies used and the reasonableness of significant
accounting estimates made by management, as well as evaluating the overall presentation of the
consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for
our audit opinion.
Opinion
In our opinion, the consolidated financial statements referred to above present fairly, in all material
respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1, and the
results of their operations and their cash flows for the year then ended in accordance with accounting
principles generally accepted in the United States of America.
Emphasis of Matter
As discussed in Note 5 to the consolidated financial statements, the Company adopted Statement of
Financial Accounting Standards Update No. XXY, Leases: New Requirements, as of December 31, 20X1.
Our opinion is not modified with respect to this matter.
Phoenix Arizona Williams & Co., LLP
February 5, 20X2
Exercise
17-5
Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders


DEF Co.
We have audited the accompanying consolidated balance sheet of DEF Co. as of December 31, 20X1 and
20X8, and the related consolidated statements of income, stockholders equity, and cash flows for the
year ended December 31, 20X1. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements based on our
audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). 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 audit
provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
consolidated financial position of DEF Co. at December 31, 20X1, and the consolidated results of its
operations and its cash flows for the year ended December 31, 20X1, in conformity with U.S. generally
accepted accounting principles.
As discussed in Note 5 to the consolidated financial statements, the Company adopted Statement of
Financial Accounting Standards Update No. XXY, Leases: New Requirements, as of December 31,
20X1.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), DEF Co.s internal control over financial reporting as of December 31, 20X1,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission and our report dated January 29, 20X2 expressed
an unmodified opinion thereon.
Abbott & Olde LLP
Dallas, Texas
January 29, 20X2
Exercise
17-6
Independent Auditors Report
To the Board of Directors and Stockholders of ABC Company
We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries,
which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated
statements of income, changes in stockholders equity and cash flows for the year then ended, and the related
notes to the financial statements.
Managements Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial statements
in accordance with accounting principles generally accepted in the United States of America; this includes the
design, implementation and maintenance of internal control relevant to the preparation and fair presentation of
consolidated financial statements that are free from material misstatement, whether due to fraud or error.
Auditors Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We
conducted our audit in accordance with auditing standards generally accepted in the United States of America.
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the
consolidated financial statement. The procedures selected depend on the auditors judgment, including the
assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud
or error. In making those risk assessments, the auditor considers internal control relevant to the entitys
preparation and fair presentation of the consolidated financial statements in order to design audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
entitys internal control. Accordingly, we express no such opinion. An audit also includes evaluating the
appropriateness of accounting policies used and the reasonableness of significant accounting estimates made
by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our
audit opinion.
Basis for Qualified Opinion
The company has excluded from property and debt in the accompanying balance sheet certain lease obligations that
in our opinion, should be capitalized in order to conform with accounting principles generally accepted in the
United States of America. If these lease obligations were capitalized, property would be increased by
$15,000,000, long-term debt by $14,500,000, and retained earnings by $500,000 as of December 31, 20X8.
Additionally, net income would be increased by $500,000 and earnings per share would be increased by $1.22
for the year then ended.
Qualified Opinion
In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the Basis for
Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the
financial position of Wend Company as of December 31,20X8, and the results of its operations and its cash flows
for the year then ended in conformity with accounting principles generally accepted in the United States of
America.
Phoenix Arizona Williams & Co., LLP
February 5, 20X2
Exercise
17-7
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholders
DEF Co.
We have audited the accompanying consolidated balance sheet of DEF Co. as of December 31, 20X1 and
20X8, and the related consolidated statements of income, stockholders equity, and cash flows for the
year ended December 31, 20X1. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements based on our
audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). 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 audit
provide a reasonable basis for our opinion.
The company has excluded from property and debt in the accompanying balance sheet certain lease obligations
that in our opinion, should be capitalized in order to conform with accounting principles generally accepted
in the United States of America. If these lease obligations were capitalized, property would be increased by
$15,000,000, long-term debt by $14,500,000, and retained earnings by $500,000 as of December 31,
20X8. Additionally, net income would be increased by $500,000 and earnings per share would be
increased by $1.22 for the year then ended.
In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the
preceding paragraph, the financial statements referred to above present fairly, in all material respects, the
consolidated financial position of DEF Co. at December 31, 20X1, and the consolidated results of its
operations and its cash flows for the year then ended in conformity with accounting principles generally
accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), DEF Co.s internal control over financial reporting as of December 31, 20X1,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission and our report dated January 29, 20X2 expressed
an unmodified opinion thereon.
Abbott & Olde LLP
Dallas, Texas
January 29, 20X2
Exercise
17-8
Independent Auditors Report

To the Board of Directors and Stockholders of ABC Company


We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries,
which comprise the consolidated balance sheet as of December 31, 20X1, and the related consolidated
statements of income, changes in stockholders equity and cash flows for the year then ended, and the related
notes to the financial statements.
Managements Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial statements
in accordance with accounting principles generally accepted in the United States of America; this includes the
design, implementation and maintenance of internal control relevant to the preparation and fair presentation of
consolidated financial statements that are free from material misstatement, whether due to fraud or error.
Auditors Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We
conducted our audit in accordance with auditing standards generally accepted in the United States of America.
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the
consolidated financial statement. The procedures selected depend on the auditors judgment, including the
assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud
or error. In making those risk assessments, the auditor considers internal control relevant to the entitys
preparation and fair presentation of the consolidated financial statements in order to design audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
entitys internal control. Accordingly, we express no such opinion. An audit also includes evaluating the
appropriateness of accounting policies used and the reasonableness of significant accounting estimates made
by management, as well as evaluating the overall presentation of the consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our
audit opinion.
Basis for Adverse Opinion
The company has excluded from property and debt in the accompanying balance sheet certain lease obligations that
in our opinion, should be capitalized in order to conform with accounting principles generally accepted in the
United States of America. If these lease obligations were capitalized, property would be increased by
$15,000,000, long-term debt by $14,500,000, and retained earnings by $500,000 as of December 31, 20X8.
Additionally, net income would be increased by $500,000 and earnings per share would be increased by $1.22
for the year then ended.
Adverse Opinion
In our opinion, because of the effects of not capitalizing certain lease obligations as discussed in the Basis for
Adverse Opinion paragraph, the financial statements referred to above do not present fairly the financial position
of Wend Company as of December 31,20X8, and the results of its operations and its cash flows for the year then
ended in conformity with accounting principles generally accepted in the United States of America.
Phoenix Arizona Williams & Co., LLP
February 5, 20X2
Exercise
17-9
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholders
DEF Co.
We have audited the accompanying consolidated balance sheet of DEF Co. as of December 31, 20X1 and
2008, and the related consolidated statements of income, stockholders equity, and cash flows for the year
ended December 31, 20X1. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements based on our
audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). 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 audit
provide a reasonable basis for our opinion.
The company has excluded from property and debt in the accompanying balance sheet certain lease obligations
that in our opinion, should be capitalized in order to conform with accounting principles generally accepted
in the United States of America. If these lease obligations were capitalized, property would be increased by
$15,000,000, long-term debt by $14,500,000, and retained earnings by $500,000 as of December 31,
20X8. Additionally, net income would be increased by $500,000 and earnings per share would be
increased by $1.22 for the year then ended.
In our opinion, because of the effects of not capitalizing certain lease obligations as discussed in the
preceding paragraph, the financial statements referred to above do not present fairly, in conformity with
accounting principles generally accepted in the United States of America, the consolidated financial
position of DEF Co. at December 31, 20X1, and the consolidated results of its operations and its cash
flows for the year then ended.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), DEF Co.s internal control over financial reporting as of December 31, 20X1,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission and our report dated January 29, 20X2 expressed
an unmodified opinion thereon.
Abbott & Olde LLP
Dallas, Texas
January 29, 20X2
Exercise
17-10
Independent Auditors Report

To the Board of Directors and Stockholders of ABC Company

We have audited the accompanying consolidated financial statements of ABC Company and its
subsidiaries, which comprise the consolidated balance sheet as of December 31, 20X1, and the related
consolidated statements of income, changes in stockholders equity and cash flows for the year then
ended, and the related notes to the financial statements.
Managements Responsibility for the Financial Statement
Management is responsible for the preparation and fair presentation of these consolidated financial
statements in accordance with accounting principles generally accepted in the United States of America;
this includes the design, implementation and maintenance of internal control relevant to the preparation
and fair presentation of consolidated financial statements that are free from material misstatement,
whether due to fraud or error.
Auditors Responsibility
Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of
America. Because of the matter described in the Basis for Disclaimer of Opinion paragraph, however, we
were not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion.
Basis for Disclaimer of Opinion
We were unable to obtain audited financial statements supporting the Company's investment in a foreign
affiliate stated at $20,500,000, or its equity in earnings of that affiliate of $6,250,450, which is included in
net income, as described in Note 8 to the financial statements; nor were we able to satisfy ourselves as to
the carrying value of the investment in the foreign affiliate or the equity in earnings by other auditing
procedures.
Disclaimer of Opinion
Because of the significance of the matter described in the Basis for Disclaimer of Opinion paragraph, we have
not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion.
Accordingly, we do not express an opinion on these financial statements.
Phoenix Arizona Williams & Co., LLP
February 5, 20X2
Exercise
17-11

Various Reporting Situations

For each of the following brief scenarios assume that you are reporting on a client's financial statements.
Reply as to the type(s) of opinion (per below) possible for the scenario.

Unless stated otherwise, assume the matter involved is material. If the problem doesnt tell you whether
a misstatement pervasively misstatements the financial statements or doesnt list a characteristic that
indicates pervasiveness, two reports may be possible (i.e., replies 6 to 9).

Do not read more into the circumstance than what is presented.

Do not consider an auditor discretionary circumstance for modification of the audit report unless the
situation explicitly suggests that the auditor wishes emphasize a particular matter.

Types of Opinion
1. Standard unmodified
2. Unmodified with an emphasis of matter paragraph
3. Qualified
4. Adverse
5. Disclaimer
6. Unmodified with an emphasis of matter paragraph or disclaimer
7. Qualified or adverse
8. Qualified or disclaimer
9. Adverse or disclaimer
10. Other

Situation Report
1. A component auditor has audited a subsidiary of your client as a part of a group audit.
You have decided to rely upon the component auditors work.
2. A client omits a note disclosure related to significant accounting policies that the auditor 4
believes to be fundamental to users understanding of the financial statements.
3. A company has not followed generally accepted accounting principles in the recording of its 7
leases.
4. A company has not followed generally accepted accounting principles in the recording of its 1
leases. The amounts involved are immaterial.
5. A client does not count its year-end inventory. The auditors are unable to obtain
sufficient appropriate audit evidence related to inventory and they consider inventory as
representing an extremely substantial proportion of the financial statements.
6. Due to recurring operating losses and working capital deficiencies, you have substantial
doubt about an entitys ability to continue as a going concern for a reasonable period of
time. The notes to the financial statements adequately disclose the substantial doubt
situation.
7. An auditor was hired after year-end and was unable to observe the counting of the year-end
inventory. She is unable to apply other procedures to determine whether ending inventory and
related information is properly stated.
Exercise
17-12
8. An auditor was hired after year-end and was unable to observe the counting of the year-end
inventory. However, she was able to apply other procedures and determined that ending
inventory and related information is properly stated.
9. An auditor reporting on group financial statements decides to take responsibility for the
work of a component auditor who audited a 70% owned subsidiary and issued an unmodified
opinion. The total assets and revenues of the subsidiary are 5% and 8%, respectively, of the
total assets and revenues of the entity being audited.
10. An auditor reporting on group financial statements decides not to take responsibility for
the work of a component auditor who audited a 70% owned subsidiary and issued an
unqualified opinion. The total assets and revenues of the subsidiary are 5% and 8%,
respectively, of the total assets and revenues of the entity being audited.
11. In auditing the long-term investments account of a new client, an auditor finds that a large
contingent liability exists that is material to the consolidated company. It is probable that this
contingent liability will be resolved with a material loss in the future, but the amount is not
estimable. Although no adjusting entry has been made, the client has provided a note to the
financial statements that describes the matter in detail.
12. In auditing the long-term investments account of a new client, an auditor finds that a large
contingent liability exists that is material to the consolidated company. It is probable that this
contingent liability will be resolved with a material loss in the future, and this amount is
reasonably estimable as $2,000,000. Although no adjusting entry has been made, the client has
provided a note to the financial statements that describes the matter in detail and includes the
$2,000,000 estimate in that note.
13. A client changed its depreciation method for production equipment from the straight- 2
line method to the units-of-production method based on hours of utilization. The auditor
concurs with the change.
14. A client changed its depreciation method for production equipment from the straight- 7
line to a units-of-production method based on hours of utilization. The auditor does not
concur with the change.
15. A client's financial statements follow GAAP, but the auditor wishes to emphasize in his
audit report a significant related-party transaction that is adequately described in the notes to
the financial statements.
16. A client's financial statements follow GAAP except that they do not include a note on a
significant related party transaction.
17. A client uses the specific identification method of accounting for valuable items in
inventory, and LIFO for less valuable items. The auditor concurs that this is a reasonable
practice.
18. Due to recurring operating losses and working capital deficiencies, an auditor has
substantial doubt about an entity's ability to continue as a going concern for a reasonable
period of time. The notes to the financial statements adequately disclose the situation.
19. A company valued its inventory at current replacement cost. While the auditor believes 7
that the inventory costs do approximate replacement costs, these costs do not approximate any
GAAP inventory valuation method.
Exercise
17-13
20. An auditor discovered that a client made illegal political payoffs to a candidate for
president of the United States. The auditor was unable to determine that amounts associated
with the payoffs because of the client's inadequate record retention policies. The client has
added a note to the financial statements to describe the illegal payments and has stated that the
amounts of the payments are not determinable.
21. An auditor discovered that a client made illegal political payoffs to a candidate for
president of the United States. The auditor was unable to determine that amounts associated
with the payoffs because of the client's inadequate record retention policies, although there is
no likelihood that the financial statements are pervasively misstated, they may be materially
misstated. The client refuses to disclose the payoffs in a note to the financial statements.
22. A client changed the depreciable life of certain assets from 10 years to 12 years. The
auditor concurs with the change.
23. A client changed the depreciable life of certain assets from 10 years to 12 years. The
auditor does not concur with the change. Confined to fixed assets and accumulated
depreciation, the misstatement is not considered pervasive.
24. A client changed from the method it uses to calculate post employment benefits from one
acceptable method to another one. The effect of the change is immaterial this year, but
expected to be material in the future.
25. A client changed the salvage value of certain assets from 5% to 10% of original cost.
The auditor concurs with the change.
26. A client is issuing 2 years of comparative financial statements. The first year was audited
by another auditor who is not being asked to reissue her audit report. (Reply as to the
successor auditors report.)
27. A client is issuing 2 years of comparative financial statements. The first year was audited
by another auditor who is being asked to reissue her audit report. (Reply as to the successor
auditors report.)
28. Due to recurring operating losses and working capital deficiencies, an auditor has
substantial doubt about an entity's ability to continue as a going concern for a reasonable
period of time. The notes to the financial statements do not adequately disclose the
substantial doubt situation and the auditor believes the omission fundamentally affects the
users understanding of the financial statements.
Exercise
3-1
Leanne Walker, Audit Associate

Leanne Walker graduated from a major state university in the spring of 20X1 with a bachelor's
degree in accounting. During her college career, Walker earned a 3.9 grade point average and
participated in many extracurricular activities, including several student business organizations.
Her closest friends often teased her about the busy schedule she maintained and the fact that she
was, at times, a little too "intense." During the fall of 20X0, Walker interviewed with several
public accounting firms and large corporations and received five job offers. After considering
those offers, she decided to accept an entry-level position as an audit associate of a "Big 4"
accounting firm.

Walker spent the first two weeks on her new job at her firm's regional audit training school. On
returning to her local office in early September 20X1, she was assigned to work on the audit of
Saint Andrew's Hospital. Walker's immediate superior on the Saint Andrew's engagement was
Jennifer Vaughn, a third-year senior. On her first day on the Saint Andrew's audit, Walker
learned that she would audit the hospital's cash accounts and assist with accounts receivable.
Walker was excited about her first client assignment and pleased that she would be working for
Vaughn. Vaughn had a reputation as being a demanding supervisor, having an excellent rapport
with her clients, a thorough knowledge of technical standards, and for being fair and
straightforward with her subordinates.

Like many newly hired audit associates, Walker was apprehensive about her new job. She
understood the purpose of independent audits and was familiar with the work performed by
auditors but doubted that her two-week audit-training seminar and one auditing course had
adequately prepared her for her new work role. After being assigned to work under Vaughn's
supervision, Walker was relieved. She sensed that although Vaughn was demanding, the senior
would be patient and understanding with a new audit associate. More importantly, she believed
that she could learn a great deal from working with Vaughn. Walker resolved that she would
work hard to impress Vaughn.

Early in Walker's second week on the Saint Andrew's engagement, Jennifer Vaughn casually
asked over lunch one day whether she had taken any sections of the CPA examination. After a
brief pause, Walker replied that she had NOT taken any sections yet but planned to take the
Financial Accounting and Reporting (FAR) section during the next few months.

In fact, Walker had taken the FAR section a week ago. However, she didnt feel that she passed
this section and decided not to tell her coworkers that she had taken any parts of the exam. She
realized that most of her peers would not pass all sections of the CPA exam on their first attempt.
Nevertheless, Walker wanted to avoid the self-imposed embarrassment of admitting that she
didnt pass a section on her first try.

Walker continued to work on the Saint Andrew's engagement throughout the fall. She completed
the cash audit within budget, thoroughly documenting her work. Vaughn was pleased with
Walker's work and frequently complimented and encouraged her.
Exercise
3-2

As the engagement was winding down, Walker received her grades on the audit section of the
CPA exam in the mail one Friday evening. To her surprise, she had passed the FAR section. She
hurriedly called Vaughn to tell her the good news and was disappointed by her senior's less than
enthusiastic response. Oddly, Vaughn seemed irritated if not disturbed by Walker's call. Walker
then recalled having earlier told Vaughn that she had not taken any sections of the CPA exam.
Walker immediately apologized and explained why she had chosen not to disclose that she had
taken the FAR section. Following her explanation, Vaughn still seemed annoyed, so Walker
decided to drop the subject and pursue it later in person.

The following week, Vaughn spent Monday through Wednesday with another client, while
Walker and the other auditors assigned to the Saint Andrew's engagement continued to wrap up
the hospital audit. On Wednesday morning, Walker received a call from Don Roberts, the office
managing partner and Saint Andrew's audit engagement partner. Roberts asked Walker to meet
with him late that afternoon in his office. She assumed that Roberts simply wanted to
congratulate her on passing the FAR section of the CPA exam.

The usually upbeat Roberts was in a serious mood when Walker stepped into his office that
afternoon. After she was seated, Roberts informed her that he had spoken with Jennifer Vaughn
several times during the past few days and that he had consulted with the three other audit
partners in the office regarding a situation involving Walker. Roberts explained that Vaughn was
very concerned about Walker's having lied to her regarding the CPA exam. Vaughn told Roberts
that she did not want Walker assigned to any future engagements of hers, since she could not
trusted. Vaughn had also suggested that Walker be dismissed from the firm because of the lack
of integrity that she had demonstrated.

After a brief silence, Roberts told a stunned Walker that he and the other audit partners agreed
with Vaughn. He informed Walker that she would be given 60 days to find another job. Roberts
also told Walker that he and the other partners would not disclose that she had been "counseled
out" of the firm if contacted by employers interested in hiring her.

QUESTIONS

1. In your opinion, did Vaughn overreact to Walker's admission that she had been untruthful
regarding the CPA exam?

2. How would you have dealt with the situation if you had been in Vaughn's position?

3. How would you have dealt with the situation if you had been in Roberts' position?
Exercise
3-3
Moore and Reed

Case 1: Don Moore, a partner in the firm, has recently moved into a condominium which he
shares with his girlfriend, Joan Scott. Moore owns the condominium and pays all of the expenses
relating to its maintenance. Otherwise, the two are self-supporting. Scott is a stockbroker, and
recently she has started acquiring shares in one of the audit clients of this office of the CPA firm.
The shares are held in Scott's name. At present, the shares are not material in relation to her net
worth.

Case 2: Mary Reed, a new audit associate with no managerial responsibilities in the firm, has
recently separated from her husband. Mary has filed for divorce, but the divorce cannot become
final for at least five months. The property settlement is being bitterly contested. Mary's husband
has always resented her professional career and has just used community property to acquire one
share of common stock in each of the publicly owned companies audited by the office in which
Mary works.

Keep Mary off the audits, go to a different office, another state


Exercise
3-4
Ethics Review Questions

1. Sandy Schultz, CPA, has been working on the audit of McKay Co. While doing this audit,
she made recommendations which ultimately resulted in McKay Co. purchasing a computer
manufactured by the AMZ Computer Corporation. Shortly thereafter, Ms. Schultz was
surprised when she received a $1000 unsolicited commission from AMZ Computer
Corporation. Would acceptance of this commission violate the AICPA Code of Professional
Conduct?

2. Arthur Brown is a CPA who often serves as an expert witness in court cases. Is it proper for
Brown to receive compensation in a damage suit based on the amount awarded to the
plaintiff (this is a contingent fee)?

3. Which of the following is most likely to be a violation of the AICPA rules of conduct by Bill
Jones, a sole practitioner with no other employees?

A. Jones performs consulting services for a percentage of the clients savings; these are the
only services provided for the client.
B. Jones names his firm Jones and Smith CPAs.
C. Jones advertises the services he provides in an Internet set of telephone yellow pages.
D. Jones, without client consent, makes available working papers for purposes of a peer
review of his practice.

4. According to the AICPAs ethical standards, an auditor would be considered independent in


which of the following situations?

A. The auditors checking account which is fully insured by the FDIC, is held at a audit
clients financial institution.
B. A managerial employee of the auditor donates service as a vice president of a charitable
organization that is the audit client.
C. The audit client owes that auditor fees for this and last years audit.
D. A covered members five year old son owns stock in the client

5. A audit associate in a firm has an immaterial direct financial interest in a prospective audit
client of the firm. Would the firm be precluded from expressing an opinion on the clients
financial statements?
Exercise
3-5
6. In which of the following situations would a public accounting firm have violated the AICPA
Code of Professional Conduct?

A. A fee is based on whether or not the public accounting firms audit report leads to the
approval of the clients application for bank financing.
B. A fee is to be established at a later date by the Bankruptcy Court.
C. A fee is based upon the nature of the engagement rather than upon the actual time spent
on the engagement.
D. A fee is based on the fee charged by the clients former auditors.

7. The firm of McGraw and West, CPAs, has two offices, one in Phoenix and one in San Diego.
The firm has audited the Cameron Corporation out of its Phoenix office for the past five
years. For each of the following independent cases which occurred during the year under
audit, indicate whether the independence of either (a) the CPA involved or (b) the firm would
be impaired.

A. Jim West is the father of Will West, a Phoenix partner. Jim West has a material
investment in Cameron. Will West is unaware of his father's investment, but does
participate in the engagement.

B. Brittney Johnson, a senior in the San Diego office, has a material investment in the
capital stock of Cameron. She does not participate in the engagement.

C. Bill Adams, a senior in the Phoenix office, does not work on the Cameron audit, but
owns 9% of the stock of Camerons stock.

Is CPA Independent? Is Firm Independent?


A

C
Exercise
3-6
8. The firm of Bell & Greer, CPAs, has been asked to perform attest services for Trek
Corporation (a nonpublic company) for the year ended December 31, Year 5. Bell & Greer
has two offices: one in Los Angeles and the other in Newport Beach. Trek Corporation
would be audited by the Los Angeles office. For each of the following independent cases,
indicate whether Bell & Greer would be independent with respect to the CPA and to Trek
Corporation.

A. A manager in the Newport Beach office of Bell & Greer has a father who is the treasurer
of Trek Corporation.

B. A partner in the Newport office of Bell & Greer jointly owns a cattle ranch in Montana
with one of the directors of Trek Corporation. The value of the investment is material to
both parties.

C. The former controller of Trek Corporation became a partner in the Newport Beach office
of Bell & Greer on March 15, Year 5, resigning from Trek Corporation on that date.

Is CPA Independent? Is Firm Independent?

C
Exercise
3-7
Westerman Corporation

Donald Westerman is president of Westerman Corporation, a nonpublic manufacturer of kitchen


cabinets. He has been approached by Darlene Zabish, a partner with Zabish and Co., CPAs, who
suggests that her firm can design a payroll system for Westerman that will either save his
corporation money, or be free. More specifically, Ms. Zabish proposes to design a payroll system
for Westerman on a contingent fee basis. She suggests that her firm's fee will be 25 percent of
the savings in payroll for each of the next four years. After four years Westerman will be able to
keep all future savings. Westerman Corporation's payroll system costs currently are
approximately $200,000 annually, and the corporation has not previously been a client of Zabish.

Westerman discussed this offer with his current CPA, Bill Zabrinski, whose firm annually audits
Westerman Corporation's financial statements. Zabrinski states that this is a relatively simple
task, and that he would be willing to provide the service for $30,000.

Required:

a. Would either Zabish or Zabrinski violate the AICPA Code of Professional Conduct by
offering to provide these services? Explain.

b. Now assume that Westerman has indicated to Zabrinski that he was leaning toward accepting
Zabish's offer. Zabrinski then offered to provide the service for 15 percent of Westerman's
savings for the next three years. Would performing the engagement in accordance with the
terms of this offer violate the AICPA Code of Professional Conduct? Explain.
Exercise
3-8
James Daleiden, CPA

James Daleiden, CPA, is interested in expanding his practice through acquisition of new clients.
For each of the following independent cases, indicate whether Daleiden would violate the
AICPA Code of Professional Conduct by engaging in the suggested practice and explain why. If
more information is needed to arrive at a final determination, indicate the nature of such
information.

a. Daleiden wishes to form a professional corporation and use the name AAAAAAAA the
CPA, to obtain the first ad in the internet version of the yellow pages of the telephone
book.

b. Daleiden wishes to prepare a one-page flyer which he will have his son stuff on the
windshields of each car at the Pleasant Valley shopping mall. The flyer will outline the
services provided by Daleidens firm and will include a $50-off coupon for services
provided on the first visit.

c. Daleiden has a thorough knowledge of the tax law. He has a number of acquaintances who
prepare their own tax returns. He proposes to offer to review these returns before they are
filed with the Internal Revenue Service. For this review, he will charge no fee unless he is
able to identify legal tax savings opportunities. He proposes to charge each individual one-
third of the tax savings he is able to identify.

d. Daleiden wishes to advertise that if he is hired to perform the audit, he will discount his
fees on tax services (he does intend to grant a discount).
Exercise
3-9
Range Rover

Six months ago the managing partner of your firm retired, and the remaining partners divided up
his responsibilities. One of his responsibilities was handling consultations on independence and
ethics matters. For some reason, none of your partners wanted that responsibility, so you grabbed
it, since researching these issues is now much easier using the online version of the revised
AICPA Code of Professional Conduct (the code) (pub.aicpa.org/codeofconduct).

Because yours is a small, one-office firm, your policies and procedures are pretty informal. One
procedure youve put in place is performing an ethics and independence check before the firm
can issue a bid for services, attest or nonattest.
Its Monday morning, and you receive an excited call from one of your partners indicating that
this past weekend, he met someone who was looking for a new auditor. The bid is due in a week,
so he needs your clearance ASAP. He provides you the prospective clients name and tells you
that it is a holding company that owns a small privately held bank and, interestingly enough, a
used car dealership. He believes that the holding company is the sole owner of these entities and
that each has its own auditors.

Even though your firm wont be performing any services for the bank, or the used car dealership,
you are confident the firm will need to remain independent of them under the new affiliate rules
(see AICPA Code of Professional Conduct Resources)

Next you email the partners and professional staff to determine if they have relationships with
any of the entities. Bruce, a tax partner, emailed you back and said that he had leased a
Range Rover from the used car dealership for his 18-year-old daughter, Katrina.

You go to pub.aicpa.org/codeofconduct, click login, and type lease in the search bar. After
drilling down into the search (see sidebar, Bruces Independence), you determine that there are
two interpretations that may contain the guidance you are looking for: 1.260.040, Leases, and
1.260.020, Loans and Leases With Lending Institutions. You scroll through the interpretations
and find that 1.260.020 is right on point: As long as Bruce got the car lease under the
dealerships normal lending procedures, terms, and requirements; he complies with the terms of
the lease (i.e., he makes his payments on time); and the car is the collateral for the lease, the
lease shouldnt present a problem to the firms independence. You send Bruce an email to
confirm these facts.
Exercise
3-10
Bruces Independence

Step 1. Go to pub.aicpa.org/codeofconduct.

Step 2. Type Lease in the search bar and hit search.

Step 3. Your search results (shown below) indicate there is one place in the Preface, five places
in Part 1, Members in Public Practice, and one place in Appendix D, Mapping Document, that
the term lease or a variation of it appears. Determine which location is the most appropriate to
begin refining your search and select.
Preface: Applicable to All Members. . . . . . . . . . . . . . .1
Part 1Members in Public Practice. . . . . . . . . . . . . . 5
Appendix DMapping Document. . . . . . . . . . . . . . . . 1
The Preface contains the defined terms and other more conceptual items, so you decide to start
by selecting Part 1Members in Public Practice because you are a firm looking for guidance.

Step 4. Your refined search results (shown below) indicate four places in 1.200, Independence,
and one place in 1.800, Form of Organization and Name, where the term lease or a variation of
it appears. Determine which location is the most appropriate to begin refining your search and
select.
1.200, Independence. . . . . . . . . . . . . . . . . . . . . . . . . .4
1.800, Form of Organization and Name. . . . . . . . . . . . .1
Because you are looking for guidance on independence issues that the prospective engagement
could present your firm, you select 1.200, Independence.

Step 5. Your refined search results (shown below) indicate there are four places in the
Independence topic where the term lease or a variation of it appears. Determine which
subtopic is the most appropriate given your issue and select.
1.220, Accounting Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
1.260, Loans, Leases, and Guarantees . . . . . . . . . . . . . . . . . . . . . . . . .1
1.277, Former Employment or Association With an Attest Client . . . . .. . .1
1.280, Memberships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Because you are looking for guidance on whether having a lease from a client is problematic,
you select subtopic 1.260, Loans, Leases, and Guarantees.

Step 6. Your refined search result takes you to the Loans, Leases, and Guarantees section, where
using the Next button at the top right-hand corner of the screen, you quickly scroll through
your search hits until you land on the seventh hit where you find the guidance that is on point in
paragraph .04a of the Loans and Leases With Lending Institutions interpretation [1.260.020].
Exercise
4-1
Geiger Co.

The following appeared in a brief article in a major business newspaper:

A local court is in the process of ruling on whether the public accounting firm of James Willis and Co. CPA,
PC should be required to pay all or part of $16 million in damages relating to Geiger Co. for failing to detect
a scheme to defraud the company, a former audit client.

Geiger Co., an SEC registrant, charges that Willis was negligent in failing to discover fraud committed by the
companys controller and wants Willis to foot the bill for all $16 million in claims by and against the
company. The company claims that if it had known about the fraud, it could have stopped it and recovered
financially. The bank involved claims that it granted the loan based on misstated financial statements. The
shareholders involved claim that they purchased the stock on the American Stock Exchange at an inflated
price due to the misstated financial statements. They acknowledged that while stock had been outstanding
and traded for many years (10) prior to the fraud, they made their investment decisions relying upon the
misstated financial statements.

Williss general counsel said, We anxiously await a decision that will show that accountants are not
guarantors for everything that goes on in the company. Geiger Co.s lawyer said that she anxiously awaited
a decision because it will clearly show that CPAs are liable for finding fraud."

Assume that Willis performed that audit with ordinary negligence and this ordinary negligence is the reason
that the defalcation was not discovered and recovered. Further, assume that the $16,000,000 of loss is
properly distributed as follows:

Company itself $8,000,000


Bank that gave a commercial loan 5,000,000
Shareholders 3,000,000

Reply from the perspective that the only issues involved here are whether the plaintiffs involved may recover
from a CPA that has performed the engagement with this degree of negligence--assume the situation
described above and that other elements of proof (e.g., loss, proximate cause) are not at issue. Assume
that each context (a, b, and c) are independent situations.

a. Assume that the case is brought under common law, and that the state in which Geiger Co. is
headquartered follows the Ultramares Approach for third party legal liability.

1. Should Willis be found liable to the company, Geiger Co., itself? Explain.

2. Should Willis be found liable if sued by a bank that used the financial statements as a basis for providing
a loan and, due to the misstatement, lost $5,000,000 on the loan? Explain.

3. Should Willis be found liable if sued by shareholders who invested in the stock of the company. Assume
these investors invested relying upon the misstated financial statements and as a result thereof lost
$3,000,000? Explain.
Exercise
4-2

b. Assume that the case is brought under the Securities Act of 1933. Answer the following from the
perspective of CPA liability under that act.

1. Should Willis be found liable to the company, Geiger Co., itself? Explain.

2. Should Willis be found liable if sued by a bank that used the financial statements as a basis for providing
a loan and, due to the misstatement, lost $5,000,000 on the loan? Explain.

3. Should Willis be found liable if sued by the original (IPO) shareholders who invested in the stock of the
company. Assume these investors invested relying upon the misstated financial statements and as a result
thereof lost $3,000,000? Explain.

4. Should Willis be found liable if sued by the current shareholders who invested in the stock of the
company. Assume these investors invested relying upon the misstated financial statements and as a result
thereof lost $3,000,000? Explain.

c. Assume that the case is brought under the Securities Exchange Act of 1934. Answer the following
from the perspective of CPA liability under that act.

1. Should Willis be found liable to the company, Geiger Co., itself? Explain.

2. Should Willis be found liable if sued by a bank that used the financial statements as a basis for providing
a loan and, due to the misstatement, lost $5,000,000 on the loan? Explain.

3. Should Willis be found liable if sued by shareholders who invested in the stock of the company (not the
original shareholders). Assume these investors invested relying upon the misstated financial statements
and as a result thereof lost $3,000,000? Explain.
Exercise
4-3
Multiple Choice Questions:

1. Which statement best expresses the factors that purchasers of securities registered under the
Securities Act of 1933 need prove to recover losses from the auditors?

a. The purchasers of securities must prove ordinary negligence by the auditors and reliance on
the audited financial statements.
b. The purchasers of securities must prove that the financial statements were misleading and
that they relied on them to purchase the securities.
c. The purchasers of securities must prove that the financial statements were misleading, then,
the burden of proof is shifted to the auditors to show that the audit was performed with due
diligence.
d. The purchasers of securities must prove that the financial statements were misleading and
the auditors were negligent.

2. Under which common law approach is an unidentified third-party least likely to be able to
recover damages from a CPA who is guilty of ordinary negligence?

a. Due Diligence Approach.


b. Ultramares Approach.
c. Restatement of Torts Approach.
d. Rosenblum Approach.

3. A common stock investors burden of proof relating to a CPAs deficiency of performance


under the 1933 Securities Act, when compared to the 1934 Securities Exchange Act, is:

a. Greater
b. Less
c. Equal
d. Undeterminable

4. A CPA issued 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
misstatement in the financial statements, the CPA is 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 proven CPA negligence.
b. The investor did not rely upon the financial statement.
c. The CPA detected the misstatement after the audit report date.
d. The misstatement is immaterial in the overall context of the financial statements.
Exercise
4-4
5. A case by a client against its CPA firm alleging negligence would be brought under:

a. The Securities Act of 1933.


b. The Securities Exchange Act of 1934.
c. The state blue sky laws.
d. Common law.

6. An auditor knew that the purpose of her audit was to render reasonable assurance on
financial statements that were to be used for the application for a loan; the auditor did not
know the identity of the bank that would eventually give the loan. Under the foreseeable
third party approach the auditor is generally liable to the bank which subsequently grants
the loan for:

a. Lack of due diligence.


b. Lack of good faith.
c. Gross negligence, but not ordinary negligence.
d. Either ordinary or gross negligence.