Multiple Choice: Select the Best Answer 1. To be proficient as an auditor, a person must first be able to accomplish which of these tasks in a decision-making process: a. Identify audit evidence relevant to the verification of assertions management makes in its unaudited financial statements and notes b. Formulate evidence-gathering procedures (audit program) designed to obtain sufficient, competent evidence about assertions management makes in financial statements and notes c. Recognize the financial assertions made in management's financial statements and footnotes d. Evaluate the evidence produced by the performance of procedures and decide whether management's assertions conform to generally accepted accounting principles and reality 2. CPA Krogstad is the executive in charge of the Omaha office of the audit firm. He is responsible for the practice in all areas of audit, tax, and consulting, but he does not serve as a field audit partner or a reviewer. CPA Ward is the partner in charge of the Dodger, Inc. audit (an SEC filing). The audit firm's independence is impaired if: a. Krogstad owns Dodger common stock b. Krogstad's brother owns 10 shares of Dodger common stock c. Ward's sister-in-law is a sales representative with a territory in California d. Ward's fellow partner CPA Felix in the Omaha office has a wife who owns Dodger stock through a mutual fund held in her own employer's employee benefit plan 3. Elliot Corp. is interested in buying Roger Corp. Prior to the purchase Elliot hired Adam & Co. to audit the financial statements of Roger. During the audit, Adam & Co. failed to discover a fraud that resulted in a material misstatement on Roger's financial statements. After the merger, the fraud was discovered and Elliot Corp. suffered substantial losses. If Elliot sues Adam & Co., Elliot must prove that Adam & Co: a. Acted recklessly or with lack of reasonable grounds for belief b. Knew of the instances of fraud c. Failed to exercise the appropriate level of professional care d. Demonstrated gross negligence 4. At the request of James Company's management, E.G. audited James Company's financial statements and was aware that James' management intended to deliver the financial statements to its 25 shareholders for the purpose of repurchasing their shares for $50 (the investors had originally purchased the shares for $5 per share). The audit was conducted in accordance with generally accepted auditing standards and the financial statements were prepared in accordance with generally accepted accounting principles. Later, the shareholders sued the auditors, claiming that if they fully realized the significance of disclosures about the market value of the assets, they could have received $75 per share from James Company. The shareholders' lawsuit will probably fail because: a. The shareholders did not suffer a loss b. The shareholders were not primary beneficiaries of the audit engagement and they have no standing to sue c. The shareholders failed to prove lack of appropriate professional care on the part of auditors d. The shareholders did not rely properly on the financial statements 5. When an entity will not permit inquiry of outside legal counsel, the auditors' report on the entity's financial statements will ordinarily contain a (an) a. Disclaimer of opinion b. "Except for" qualified opinion regarding a departure from generally accepted accounting principles c. Unqualified opinion with a separate explanatory paragraph d. Adverse opinion 6. The auditors conclude that there is a material inconsistency in the "other information" in an annual report to shareholders containing audited financial statements. If the auditors conclude that the financial statements do not require revision, but the entity refuses to revise or eliminate the material inconsistency, the auditors may a. Issue an "except for" qualified opinion on the entity's financial statements, citing a departure from generally accepted accounting principles b. Consider the matter closed since the other information is not in the audited financial statements c. Issue an adverse opinion on the entity's financial statements due to inadequate disclosure d. Revise the report on the entity's financial statements to include a separate explanatory paragraph describing the material inconsistency 7. Restrictions imposed by an entity prohibited the observation of physical inventories, which accounted for 35% of all assets. Alternative auditing procedures were not feasible, although the auditors were able to examine satisfactory evidence for all other items in the financial statements. The auditors should express a. An "except for" qualified opinion on the entity's financial statements, referring to a departure from generally accepted accounting principles b. A disclaimer of opinion on the entity's financial statements c. An unqualified opinion on the entity's financial statements with a separate explanatory paragraph d. An unqualified opinion on the entity's financial statements with an explanation in the scope paragraph 8. The major emphasis in GAAS related to consideration of fraud in a financial statement audit (SAS 99) is on: a. Employee misappropriation of assets b. Management fraud c. Client fraud on customers d. Employee embezzlement 9. 13. If control risk increases, and all other risks in the audit risk model stay constant except the one referred to below, which of the following statements is correct? a. Detection risk will decrease b. Inherent risk will increase c. Audit risk will decrease d. Detection risk will increase 10. Which of the following situations would not indicate an incentive or pressure related to fraudulent financial reporting? a. The company?s financial stability or profitability is threatened b. Physical assets are not adequately protected c. There is excessive pressure on management to meet third party expectations d. Management?s (or the Board?s) personal financial situation is threatened based on the entity?s financial performance 11. Which of the following situations would not indicate an opportunity related to fraudulent financial reporting? a. The nature of the entity?s operations is such that there are often significant transactions involving estimates, subjective judgments, unusual situations, or uncertainties in determining the appropriate accounting treatment b. Management is not effectively monitored c. There are significant deficiencies in internal controls related to the accumulation of financial information d. There is excessive pressure on management or company personnel to meet financial targets 12. Which of the following situations would not indicate a fraud risk factor related to misappropriation of assets? a. Management disregards the need for protection of physical assets by overriding existing controls b. There is an adversarial relationship between the entity and its employees c. The organizational structure is complex or unstable d. Management or employees are subject to overwhelming personal financial obligations 13. Hill, CPA, has been retained to audit the financial statements of Monday Co. Monday's predecessor auditor was Post, CPA, who has been notified by Monday that Post's services have been terminated. Under these circumstances, which party should initiate the communications between Hill and Post? a. Hill, the successor auditor b. Post, the predecessor auditor c. Monday's controller or CFO d. The chair of Monday's board of directors 14. Assume that application of analytical procedures revealed significant unexplained differences between recorded amounts and the expectations (estimates) developed by the auditor. If management is unable to provide an acceptable explanation, the auditor should a. Consider the matter a scope limitation b. Perform additional audit procedures to investigate the matter further c. Intensify the audit with the expectation of detecting management fraud d. Withdraw from the engagement 15. Which of the following procedures would an auditor most likely perform in planning a financial statement audit? a. Inquiring of the client's legal counsel concerning pending litigation b. Comparing the financial statements to anticipated results c. Examining computer-generated exception reports to verify the effectiveness of internal controls d. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities 16. Which of the following accounts tends to be most predictable for purposes of analytical procedures? a. Accounts receivable b. Travel and entertainment expense c. Interest expense d. Income taxes payable 17. Paula performed the audit of the financial statements of Abdul Company (a privately- held company currently not subject to filing requirements under the Securities Act of 1933 or Securities Exchange Act of 1934). Abdul Company is currently considering several alternatives for raising capital, including seeking financing from area banks or an initial public offering of its securities. Which of the following parties would have the lowest likelihood of successfully bringing suit for ordinary negligence against Paula? a. Abdul Company b. Purchasers of Abdul Company's securities in an initial public offering c. First State Bank, a bank with whom Abdul Company has not previously done business d. Simon Whitaker, a private investor who is considering acquiring Abdul Company 18. Under the liability provisions of section 11 of the Securities Act of 1933, auditors may be liable to any purchaser of a security for certifying materially misstated financial statements that are included in the registration statement. Under section 11, auditors usually will not be liable to the purchaser a. If auditors can show contributory negligence on the part of the purchaser b. If auditors can demonstrate due diligence c. Unless the purchaser can prove privity with auditors d. Unless the purchaser can prove scienter on the part of auditors Problems: Answer as Indicated 1. On January 15, Year 2, Lawrence and Rigoli, CPAs, are hired to audit the December 31, Year 1, financial statements of KeepWell, Inc., a health care provider. Lawrence and Rigoli have only a limited time in which to complete the audit, due to pre-existing client obligations. There are two staff people available to work on the audit, Roger, a new staff accountant and Lisa, an experienced audit senior. The firm has never audited a company in the health care field. Which auditing standard, if any, is being violated in the following situations? Select as many options as apply, but no more than three for each situation. Key: 1. Professional care 2. Planning 3. Supervision 4. Internal control, entity, and environment 5. Consistency 6. Disclosure 7. No standard violated A. The firm accepts the engagement despite the fact that it has never audited a company in the health care field. B. Due to time constraints, there is no opportunity to learn much about the health care field, so a standard audit plan from another industry is used. C. In the interest of being fair, Rigoli and Lawrence devote an equal amount of time to overseeing the work performed by Roger and the work performed by Lisa. D. Lisa is currently overseeing two other audit engagements. E. Lisa audits the more complicated areas, such as pensions and leases, while Roger audits cash and receivables. Each staff member is responsible for setting the scope of the audits in their areas. F. Roger drafts the initial report, and indicates that accounting principles have been consistently applied, but fails to state that disclosures are adequate. G. Lisa modifies the report to indicate that disclosures are adequate. H. Lisa has an excellent track record in the firm, so Rigoli and Lawrence do not review her work. 2. Explain the technique the company is using that may constitute a financial shenanigan. Indicate both the technique used and how the auditor should react. A. Highlinetime Inc., was about to report lower earnings than expected for 2010. The shortfall would be about $10,000,000. Before year end, the company contracts with Bogus Insurance, Inc., which insures corporate earnings. Under the contract, Highlinetime will receive an insurance payment of $10,000,000 at year end 2010, in exchange for a premium due at the end of 2011 in the amount of $10,000,000. The insurance payment in 2010 will enable Highlinetime, Inc. to meet its earnings expectations. B. Hamlich, Inc. sold computer equipment to three universities at year end 2010. The universities accepted the equipment and needed to use funds to be obtained from a National Institutes of Health grant. All three universities are awaiting approval of the grants, which is expected in early 2011. Hamlich books the revenues from the sales in 2010 income. C. Martin?s Corporation has decided that a substantial portion of its plant, property, and equipment are being depreciated over too short a period of time. It revises the depreciation period from 15 years to 25 years. D. Newco?s bad debt expenses are been cut in half, a material reduction. The company indicates it has tightened up on its credit standards. At the same time, the company?s sales revenues have increased by 10%, which is in line with the previous 5 years. E. Oldco has had some difficulty moving its inventory in 2010. The company?s accountants have reviewed Oldco?s overhead allocation process and has increased the factory overhead it allocates to inventory (as opposed to period costs). 3. For each situation (1-5), identify the most applicable AICPA rule of conduct and whether there is a violation or no violation of the rule (Please use the following key (e.g., ?A?) for your answers: A-F). Do not copy the rule itself into your student answer packet. A. Rule 101: Independence; no violation B. Rule 101: Independence; violation C. Rule 102: Integrity and Objectivity; no violation D. Rule 102: Integrity and Objectivity; violation E. Rule 203: Accounting Principles; no violation F. Rule 203: Accounting Principles; violation ___ 1. Sterling Stevens, CPA, was auditing Global Services Company. Global Services used an accounting principle that was not in conformity with GAAP. Nevertheless, Stevens rendered a standard unqualified audit report. ___ 2. Christina Hall, CPA, provided expert testimony for a plaintiff. The defendant in the case was a client of Hall's. ___ 3. Sam Miller, CPA, owned 100 shares of Johnson Drilling, Inc., his audit client. ___ 4. Dewey Wise, CPA, obtained a loan from an insurance company using the cash value of the insurance policy as collateral. The loan is for less money than the cash value of the policy. ___ 5. Stella Steinbeck, CPA, was auditing Good Services Company. Good Services used an accounting principle that was not in conformity with GAAP. Good Services believed, and Steinbeck concurred, that using a generally accepted method would cause the financial statements to be misleading. Therefore, Steinbeck rendered a standard unqualified audit report. 4. A manager is explaining to a staff auditor how various situations might affect the audit opinion. For each of the following scenarios, identify the appropriate reporting option by double-clicking on a shaded cell and selecting he appropriate option from the list provided. Assume that any financial statement effect is material and that U.S. auditing standards are followed. (Please use the following key (e.g., ?A?) for your answers: A-H). Do not copy the rule itself into your student answer packet. Select from the options provided: A = Standard unqualified opinion B = Unqualified opinion with explanatory language C = Qualified opinion D = Qualified opinion or adverse opinion E = Qualified opinion or disclaimer of opinion F = Adverse opinion G = Adverse opinion or disclaimer of opinion H = Disclaimer of opinion 1. The scope of the auditor?s examination is affected by conditions that preclude the application of a necessary auditing procedure. 2. The auditor decides to make reference to the report of another auditor as a bsis, in part, for expressing an opinion. 3. The financial statements are affected by an alternative accounting treatment that is a departure from GAAP. The use of GAAP would cause the financial statements to be misleading. 4. The company changed its method of accounting for long-term construction contracts, but management was justified in making the change. The new method is acceptable under GAAP and the change was properly accounted for retrospectively. 5. Doubt about the company?s ability to continue as a going concern is fully disclosed in the notes to the financial statements. 6. The financial statements are subject to an uncertainty that will likely result in a material loss. Management has been unable to estimate the amount of potential loss, but has properly disclosed the details of the situation. 7. The company changed its method of valuing inventory, but management did not have appropriate justification for the change. The change is properly disclosed in the financial statements. 8. A predecessor auditor?s unqualified opinion for a prior year?s report on comparative financial statements is not presented. 9. Required supplementary information is omitted from the financial statements. 10. The auditor wishes to emphasize the acquisition of newly acquired companies. 5. Items 1 through 6 represent an auditor's observed changes in certain financial statement ratios or amounts from the prior year's ratios or amounts. For each observed change, select the most likely explanation or explanations from the list of explanations provided. Answers on the list may be selected once, more than once, or not at all. (Please use the following key (e.g., ?A?) for your answers: A-F). Do not copy the rule itself into your student answer packet. Auditor's observed changes (independent of each other). A. Inventory turnover increased substantially from the prior year. (Select 3 explanations) B. Accounts receivable turnover decreased substantially from the prior year. (Select 3 explanations) C. Allowance for doubtful accounts increased from the prior year, but allowance for doubtful accounts as a percentage of accounts receivable decreased from the prior year. (Select 3 explanations) D. Long term debt increased from the prior year, but interest expense increased a larger than proportionate amount than long term debt. (Select 1 explanation) E. Operating income increased from the prior year although the entity was less profitable than in the prior year. (Select 2 explanations) F. Gross margin percentage was unchanged from the prior year although gross margin increased from the prior year. (Select 1 explanation) Explanations (Please use these numbers for the explanations for A-F above when responding to this problem): (1) Items shipped on consignment during the last month of the year were recorded as sales. (2) A significant number of credit memos for returned merchandise that were issued during the last month of the year were not recorded. (3) Yearend purchases of inventory were overstated by incorrectly including items received in the first month of the subsequent year. (4) Yearend purchases of inventory were understated by incorrectly excluding items received before the year-end. (5) A larger percentage of sales occurred during the last month of the year, as compared to the prior year. (6) A smaller percentage of sales occurred during the last month of the year, as compared to the prior year. (7) The same percentage of sales occurred during the last month of the year, as compared to the prior year. (8) Sales increased at the same percentage as cost of goods sold, as compared to the prior year. (9) Sales increased at a greater percentage than cost of goods sold increased, as compared to the prior year. (10) Sales increased at a lower percentage than cost of goods sold increased, as compared to the prior year. (11) Interest expense decreased, as compared to the prior year. (12) The effective income tax rate increased, as compared to the prior year. (13) The effective income tax rate decreased, as compared to the prior year. (14) Short term borrowing was refinanced on a long-term basis at the same interest rate. (15) Short term borrowing was refinanced on a long-term basis at lower interest rates. (16) Short term borrowing was refinanced on a long-term basis at higher interest rates.
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