Audit Theory exam 1 (ch 1-5)

Categories of Audit Reports

- Standard Unmodified Opinion - Unmodified Opinion with Emphasis-of-matter Explanatory Paragraph or - Qualified - Adverse or Disclaimer

Providing quantitative information that management and others can use to make decisions is the function of a. management information systems. b. auditing. c. finance. d. accounting.

d accounting

If an auditor of a public company cannot find guidance issued by the PCAOB, where should (s)he look for guidance?

The ASB which is issued by the AICPA

What is acceptable in terms of advertising?

advertisements cannot be false, misleading or deceptive

Prudent person concept

o The standard of due care to which the auditor is expected to be held, is often called the prudent person concept.

8. The Public Company Accounting Oversight Board does not: a. perform inspections of the quality controls at audit firms that audit public companies. b. establish auditing standards that must be followed by all CPAs. c. oversee auditors of public companies. d. perform any of the above functions.

b. establish auditing standards that must be followed by all CPAs.

.To do an audit, it is necessary for information to be in a verifiable form and some criteria by which the auditor can evaluate the information. (A) What information and criteria would an independent CPA firm use when auditing a company's historical financial statements? (B) What information and criteria would an Internal Revenue Service auditor use when auditing that same company's tax return? (C) What information and criteria would an internal auditor use when performing an operational audit to evaluate whether the company's computerized payroll processing system is operating efficiently and effectively?

(A) The information used by a CPA firm in a financial statement audit is the financial information in the company's financial statements. The most commonly used criteria are accounting principles generally accepted in the United States. (B) The information used by an IRS auditor is the financial information in the company's federal tax return. The criteria are the internal revenue code and interpretations. (C) The information used by an internal auditor when performing an operational audit of the payroll system could include various items such as the number of errors made, costs incurred by the payroll department, and number of payroll records processed each month. The criteria would consist of company standards for departmental efficiency and effectiveness.

Principles of Professional Conduct

1) Responsibilities- In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. 2) The Public Interest- Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate a commitment to professionalism. 3) Integrity- To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. 4) Objectivity and Independence- A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. 5) Due Care- A member should observe the profession's technical and ethical standards, strive continually to improve competence and quality of services, and discharge professional responsibility to the best of the member's ability. 6) Scope and Nature of Services- A member in public practice should observe the principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.

How does materiality affect the type of report issued?

1. amounts are immaterial; unqualified report 2. Amounts are material but do not overshadow financial statements; qualified opinion(except for) 3. Amounts are highly material; disclaimer or adverse

When a standard unmodified report can be issued

1. All statements are included 2. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagement in a manner that enables him to conclude that the audit was conducted in accordance of auditing standards 3. The fin statements are presented fairly in all material respects in accordance with GAAP 4. There are no explanatory paragraph of modified wording necessary THE MOST COMMON REPORT

When should an unqualified report with explanatory paragraph should be issued?

1. Lack of consistent application of GAAP a) the paragraph discusses nature of the change b) the explanatory paragraph should refer to the footnote that discusses that change 2.Substantial doubt about going concern a)auditor is responsible under SAS 59 to eval whether the company is likely to continue as a going concern b) concern factors: significant recurring operating loss inability to pay obligation in time loss of major customers legal proceedings, legislation c)concern is the client will fail to continue for one year d) disclaimer can be used; not needed 3. Auditor agrees with a departure from promulgated accounting principles 4.Emphasis of other matters a) auditor emphasize matter of fin state -existence of significant related party transactions -important event occurring subsequent to balance sheet date -accounting matters affecting comparability of fin states -material uncertainties disclosed in footnotes

What are the conditions that require departure form unqualified opinion?

1. Scope limitation 2. Fin states have not been prepared in accordance with GAAP 3. Auditor is not independent

Who is a third party beneficiary?

A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. A common example is a bank that has a large loan outstanding at the balance sheet date and requires an audit as a part of its loan agreement.

The effect of the financial interests direct and indirect on the independence

AICPA prohibits covered members from owning any stock of direct investment in clients Indirect investments, such as ownership in clients company by an auditor's grandparent are prohibited if the amount is material to the auditor

An auditor's legal defense under which the auditor contends that the damages claimed by the client were not brought about by any act of the auditor.

Absense of causal connection

Independence rule

A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council

covered members

An individual on the attest engagement team An individual in a position to influence the attest engagement, such as people who supervise or eval the engagement partner A partner or manager who provides nonattest services to the attest entity beginning once he or she provides 10 hours of nonattest services in a fiscal year A partner in the office of the partner responsible for the attest engagement The firm, including the firm's employee benefits plan An entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described above or by two or more such individuals or entities operating together

Distinguish between constructive fraud and fraud.

Constructive fraud is the existence of extreme or unusual negligence with no intent to deceive or do harm. In contrast, fraud involves both knowledge and intent to deceive.

An auditor's legal defense under which the auditor claims that the client failed to perform certain obligations and that it is the client's failure to perform those obligations that brought about the claimed damages.

Contributory negligence

Explain what each of the following terms means: (1) Business failure. (2) Audit failure. (3) Audit risk.

Answer: (1) Business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions. The extreme case of business failure is filing for bankruptcy. (2) Audit failure occurs when the auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of generally accepted auditing standards. (3) Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

PCAOB (Public Company Accounting Oversight Board)

Established by the Sarbanes-Oxley Act and overseen and appointed by the SEC -provides oversight for auditors of public companies(originally done by the AICPA) -establishes auditing and quality control standards for public company audits -performs inspection of quality control at audit firms performing those audits

1The "unqualified report with explanatory paragraph" and the "unqualified report with modified wording": a. arise as a result of an incomplete audit. b. arise when the financial statements are not "presented fairly." c. meet the criteria of a complete audit with satisfactory results. d. meet the criteria of a complete audit but with unsatisfactory results.

C. meet the criteria of a complete audit with satisfactory results.

A federal statute that makes it illegal to offer a bribe to an official of a foreign country.

Foreign Corrupt Practices Act

A disclaimer of opinion may be issued in which of the following instances? a. The auditor has doubts related to an entity's ability to continue as a going concern. b. There are highly material misstatements in the financial statements. c. The auditor's scope has been restricted due to circumstances beyond the client's control. d. A disclaimer may be issued for circumstances discussed in a and c.

D, A disclaimer may be issued for circumstances discussed in a and c.

. In the context of auditing, explain what is meant by an independent mental attitude. Discuss how internal auditors can have an independent mental attitude when they are employed by the company they audit.

Independent mental attitude refers to a state of mind in which the CPA is totally unbiased with respect to the client and the financial information under audit. Although internal auditors are employees of the organization for which their audits are performed, internal auditors should be independent of the function being examined and should report their findings to a level high enough in the organization to allow the auditor to be free from influence by the party, or parties, being examined.

How to demonstrate the lack of duty to perform certain service

Lack of duty to perform the service a. It means that the CPA firm claims that there was no implied or expressed contract. For example, the CPA firm might claim that misstatements were not uncovered because the firm did a review service, not an audit. The CPA's use of an engagement letter provides a basis to demonstrate a lack of duty to perform.

An auditor's legal defense under which the auditor claims that the audit was performed in accordance with generally accepted auditing standards.

Nonnegligent performance

The differences between operational audit, compliance audit, financial statements audit

Operational audits- the objective of improving processes and improving effectiveness and efficiency. Compliance audit- determine whether the auditee is following specific procedures, rules, or regulations set by some higher authority. EX: • Determine whether accounting personnel are following the procedures prescribed by the company controller. • Review wage rates for compliance with minimum wage laws. Financial Statements audit- to determine whether the financial statements (the information being verified) are stated in accordance with specified criteria

. Distinguish between ordinary negligence and gross negligence.

Ordinary negligence is the absence of reasonable care, whereas gross negligence is the absence of even slight care that can be expected of a person in a set of circumstances.

What are the parts of the code of professional conduct?

Preface- all members, the principles of professional conduct Part 1 is the Code includes rules for members in public practice Part 2 includes rules for members in business Part 3 includes rules for all other members

What is accounting?

Process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of information

The AICPA principles and subcategories

Purpose of the audit: -provide an opinion about the financial statements Responsibilities: -Possess appropriate competence & capabilities -comply with ethical requirements -maintain professional skepticism and exercise professional judgment Performances -obtain reasonable assurance about whether the financial statements are free of material misstatements -Plan work and supervise assistants -Determine and apply materiality level -Identify & assess risks of material misstatement -Obtain sufficient appropriate audit evidence Reporting -Express opinion on financial statements in a written report -state whether of not financial statements were presented fairly in accordance with financial reporting framework

When should an unqualified report with modified wording should be issued?

Reports involving other auditors -if the work of other auditors is material and the principle auditor is willing to asume responsibility for the work done by the other auditor, an unqualified shared report is issued

The role of the SEC

SEC is an agency that assists in providing investors with reliable information -Security act of 1933; requirements for new securities security act of 1934; requirements for public companies disclosure such as: S-1, for new security 8-K, for significant events, such as acquisition 10-K, annual 10-Q, quarterly

A federal statute dealing with companies that trade securities on national and over-the-counter exchanges. Auditors are involved because the annual reporting requirements include audited financial statements.

Securities Exchange Act of 1934

A federal statute designed to cause class-action securities lawsuits to be addressed in federal district courts.

Securities Litigation Uniform Standards Act of 1998

Organizational structures for a CPA firm

Sole proprietorship- One owner, unlimited liability General partnership- multiple owners, unlimited liability General Corporation- liability is limited to investments, however most states prohibit CPA firms to use this method Professional Corporation- provides professional services and is owned by one or more shareholders. PC laws in some states offer personal liability protection similar to that of general corporations, whereas the protection in other states is minimal. making it difficult for a CPA firm with clients in different states to operate as a PC LLC- structured and taxed like a partnership, but owners have limited liability like a general corporation LLP-Structured and taxed like a general partnership, but partners of personally liable for partnership's debts and obligations, and acts of others under their supervision

Audit report parts

Standard Unmodified 1 report title a. "Independent Auditor's Report" 2 Audit report address a. Usually addressed to the company, stockholds, board of directors 3 Intro paragraph a. The CPA firm has performed the audit b. Lists the financial statements that are audited c. The wording of the fin statements in the report should be indentical to the titles used by the management on the financial statements 4. Management responsibility paragraph a. The responsibility includes selecting the appropriate accounting principles and maintaining internal control over financial reporting 5. Auditor's responsibility(3 paragraphs)- a) auditor's responsibility is to express an opinion and to conduct the audit in accordance with GAAS. also to design the audit to obtain reasonable assurance that the fin statements are free from material misstatements b) describes the scope of the audit & evidence accumulated. It also indicates that the auditor considers internal control, but no for the purpose of expressing an opinion on its effectiveness c)indicates that auditor believes that sufficient appropriate evidence has been obtained to support the auditor's opinion 6.Opinion paragraph - the final paragraph in the standard report states that the auditor's conclusions based on the results of the audit. It is stated as an opinion rather than a statement of fact 7 Signature and address of the CPA firm 8 Audit report date

What are the SASs and their purpose

Statements on Auditing Standards issued by the AICPA the PCAOB issues the ASs(auditing standards) provide more meaningful guidance on the auditing principles and framework

The difference between independent in fact (in mind) and in appearance

The AICPA codes of professional conduct defines independence as consisting of two components: independence of mind and appearance Independence of mind: reflects the auditor's state of mind that permits the audit to be performed with an unbiased attitude. (aka independence in fact) Independence in appearance: the result of others' interpretations of independence. If auditors are independent in fact but users believe them to be advocates for the client, most of the value of the audit function is lost

Defenses available for lawsuits from clients and third parties

The CPA firm normally uses one or a combination of four defenses when there are legal claims by clients: 1. Lack of duty to perform the service a. It means that the CPA firm claims that there was no implied or expressed contract. 2. Nonnegligent performance a. The CPA firm claims that the audit was performed in accordance with auditing standards. Even if there were undiscovered misstatements, the auditor is not responsible if the audit was conducted properly. 3. Contribu¬tory negligence a. A defense of contributory negligence exists when the client's own actions either resulted in the loss that is the basis for damages or interfered with the con¬duct of the audit in such a way that prevented the auditor from discovering the cause of the loss. 4. Absence of causal connection. a. To succeed in an action against the auditor, the client must be able to show that there is a close causal connection between the auditor's breach of the standard of due care and the damages suffered by the client. • Contributory negligence is ordinarily not available because a third party is not in a position to contribute to misstated financial statements. • The preferred defense in third-party suits is nonnegligent performance. If the auditor conducted the audit in accordance with GAAS, the other defenses are unnecessary. On the other hand, nonnegligent performance is difficult to demonstrate to a court, especially if it is a jury trial and the jury is made up of laypeople.

The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). What are the PCAOB's primary functions? Who performed these functions prior to the PCAOB?

The PCAOB has responsibility for providing oversight auditors of public companies, establishing auditing and quality control standards for public company audits and performing inspections of the quality controls at audit firms performing those audits. These functions were formerly the responsibility of the American Institute of Certified Public Accountants.

What is the difference between standard unqualified report and combined report on financial statements and internal controls

The combined report adresses both the fin statements and management report on internal control over financial reporting -Modifications are made to the intro, scope, and opinion paragraphs to include reference to managements report on internal control over financial reporting and the scope of the auditor's work and opinion on the internal control -includes paragraph after the scope paragraph to define internal control over financial reporting

An audit of historical financial statements most commonly includes the: a. balance sheet, the income statement, and the statement of cash flows. b. income statement, the statement of cash flows, and the statement of net working capital. c. statement of cash flows, the balance sheet, and the retained earnings statement. d. balance sheet, the income statement, and the statement of cash flows.

a. balance sheet, the income statement, and the statement of cash flows.

A situation in which the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards.

audit failure

Attestation services fall into five categories. What are these categories?

The five categories of attestation services include: • audits of historical financial statements, • attestation on internal control over financial reporting, • reviews of historical financial statements, • attestation services on information technology, and • other attestation services that may be applied to a broad range of subject matter.

There are four conditions that must be met before an auditor can issue a standard unmodified report for the audit of a private company. Please discuss each of these four conditions.

The four conditions that justify issuing a standard unqualified report are: • All statements—balance sheet, income statement, statement of retained earnings, and statement of cash flows—are included in the financial statements. • Sufficient appropriate audit evidence has been accumulated and the auditor can conclude that the three fieldwork standards have been followed. • The financial statements are presented in accordance with GAAP. • There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report.

Privy of Contract

The relationship that exists between the promisor and the promisee of a contract.

. Discuss the AICPA's Code of Professional Conduct rule on advertising and solicitation. Give two examples of permitted advertising or solicitation, and two examples of prohibited advertising or solicitation.

The rule on advertising and solicitation prohibits members in public practice from advertising in a manner that is false, misleading, or deceptive. It also prohibits solicitation by the use of coercion, over-reaching, or harassment. Examples of permitted advertising include the use of television, radio, newspapers, and billboards to communicate truthful information about the CPA. Examples of prohibited advertising identified by the AICPA's Code of Professional Conduct include any advertisement that creates a false or unjustified expectation of favorable results, and any advertisement that contains statements that would be likely to cause a reasonable person to be deceived.

A common-law approach to third-party liability in which ordinary negligence is insufficient for liability to third parties, because of the lack of privity of contract between the third party and the auditor unless the third party is a primary beneficiary.

Ultramares doctrine

Each of the following situations involves a possible violation of the rule on independence. For each situation, (1) decide whether the Code of Professional Conduct has been violated, and (2) briefly explain how the situation violates (or does not violate) the Code of Professional Conduct. a. Harry Brown is a partner in the Topeka office of Hedley & Co., CPAs. Harry's brother is employed in an audit-sensitive position by Jensen Appliances, a publicly held company in Kansas. Jensen Appliances is one of Hedley & Co.'s audit clients. Neither Harry nor personnel from the Topeka office is involved in the audit of Jensen . b. John Woods is an audit manager with Calden & Co., CPAs, a one-office CPA firm. John owns 100 shares of common stock in one of the firm's audit clients, but he does not provide any audit or non-audit services to the company. c. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Fine & Herman also performs the annual audit of Henderson Corporation. d. Bob Shelton CPA, is the auditor of Cafe Ecko. A couple of weeks ago, Cafe Ecko's management expressed an intention to commence litigation against Bob, alleging he was negligent in last year's audit. Bob believes there is a strong possibility that management will proceed with the litigation. However, Cafe Ecko has not fired Bob as its auditor, and he is now working on the current year's audit. e. Hamilton Appliance has not paid Karen Linwood, CPA, her audit fee for the past two years. Karen is starting work on the current year's audit of Hamilton.

a) No violation. Although partners in a CPA firm are not allowed to have close relatives employed in a position of significant influence by a client, it is acceptable to have a close relative employed in an audit-sensitive position (with no significant influence), as long as the partner does not participate in the engagement. b) No violation. John is not a covered member with respect to the audit client as he has no responsibility for the engagement and is not in a position to influence the engagement. c) No violation. The AICPA does not prohibit CPA firms from providing bookkeeping, tax, and audit services to the same non-public client. d. Violation. When there is a lawsuit or intent to start a lawsuit between a CPA and an audit client's management related to audit services, independence is impaired. e. Violation. Independence is impaired if fees remain unpaid for services provided more than one year prior to the date of the report.

28. The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation, (1) determine the applicable rule number or name from the Code, (2) decide whether or not the Code has been violated, and (3) briefly explain how the situation violates (or does not violate) the Code. a. In 2004, Freeman and Johnson, both CPAs, decided to form a CPA practice. In 2007, Freeman and Johnson approached Bill Delaney, a physician and medical expert, and asked him to assist them with their growing medical consulting practice. Delaney agreed, but only after he was given an ownership interest in the firm. Delaney does not intend to quit his private medical practice. b. Brian DePalie has a successful dentistry practice in Charleston. Brian has recommended one of his patients to Katie Walton, CPA. To show gratitude for the referral, Katie has agreed to pay Brian a token gift of $50. Katie discloses the payment arrangement to her new clients. c. The accounting firm of Bayer & Peng, CPAs, is negotiating a fee with a new audit client. They agree the client will pay $50,000 if Bayer & Peng issues a clean, unqualified opinion, $40,000 if a qualified opinion is issued, and only $20,000 if an adverse opinion is issued. d. Don Smith, CPA, is a member of the engagement team that performs the audit of Shaw Corporation. Don's five-year-old daughter, Precious, received ten shares of Shaw Corporation's common stock for her fifth birthday. The stock was a gift from Precious's grandmother. e. Jennifer Harris, CPA, is a partner in the CPA firm that audits Alltech, Inc., a closely held corporation. Jennifer's sister-in-law is the chief financial officer at Alltech, Inc.

a) Violation. Non-CPA ownership of firms is allowable, however, a non-CPA owner must actively provide services to the firm's clients as their principal occupation. b) No violation. A CPA may pay a referral fee to a non-CPA as long as the payment is disclosed to the client. c) Violation. This is a contingent fee agreement and is prohibited. d) Violation of Independence Rule. Don is a covered member. Because his daughter is a dependent, her ownership interest in Shaw is treated as a direct financial interest of her father. e) No violation. A sister-in-law is not considered to be a close relative.

Interpretations of independence rule regarding a "direct financial interest" have presumed that a violation exists in which of the following circumstances, unless other circumstances offset such a presumption? a. When close relatives such as nondependent children, brothers, and sisters have a significant financial interest in the client. b. When close relatives such as nondependent children, brothers, and sisters have any financial interest in the client. c. When the CPA owns shares in a mutual fund that has an ownership interest in the client. d. When close relatives such as brother, sister, or in-laws are employed by client.

a. When close relatives such as nondependent children, brothers, and sisters have a significant financial interest in the client.

24. The AICPA's Code of Professional Conduct requires independence for all: a. attestation engagements. b. services performed by accountants in public practice. c. accounting and auditing services performed. d. professional work performed by CPAs.

a. attestation engagements.

Audit risk is the risk there will be an audit failure for a given audit engagement. a. True b. False

b False

Which of the following can be significantly affected by an audit? a. Business risk. b. Information risk. c. The risk-free interest rate. d. All of these are correct.

b Information risk

Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor's involvement with the: a. 8-K form. b. 10-K form. c. 10-Q form. d. S-1 form.

b. 10-K form.

Which of the auditor's defenses is ordinarily not available when lawsuits are filed by a third party? a. Absence of causal connections. b. Contributory negligence. c. Non-negligent performance. d. Lack of duty.

b. Contributory negligence.

.Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units. a. True b. False

b. False

Which of the following is the least likely form of business for a CPA firm? a. General partnership b. General corporation c. Limited liability company

b. General corporation

When a qualified or adverse opinion is issued, the qualifying paragraph is inserted: a. between the introductory and scope paragraphs. b. between the scope and opinion paragraphs. c. after the opinion paragraph, as a fourth paragraph. d. immediately after the address, as the first paragraph.

b. between the scope and opinion paragraphs.

Which of the following statements is true when the CPA has been engaged to do an attestation engagement? a. The CPA firm is engaged and paid by the client; therefore, the firm has primary responsibility to be an advocate for the client. b. The CPA firm is engaged and paid by the client, but the primary beneficiaries of the audit are those who rely on the financial statements. c. Should a situation arise where there is no convincing authoritative standard available, and there is a choice of actions which could impact a client's financial statements, the CPA is free to endorse the choice which is in the investors' interests. d. None of the above is true.

b. The CPA firm is engaged and paid by the client, but the primary beneficiaries of the audit are those who rely on the financial statements.

Any service that requires a CPA firm to issue a report about the reliability of an assertion that is made by another party is a(n): a. accounting and bookkeeping service. b. attestation service. c. assurance service. d. tax service.

b. attestation service.

Statements on Auditing Standards issued by the AICPA's Auditing Standards Board are: a. part of the generally accepted auditing standards under the AICPA Code of Professional Conduct. b. interpretations of generally accepted auditing standards and departures from such statements must be justified. c. interpretations of generally accepted auditing standards and such standards must be followed in every engagement. d. generally accepted auditing procedures that are not covered by the AICPA Code of Professional Conduct.

b. interpretations of generally accepted auditing standards and departures from such statements must be justified.

All of the following are causes for the addition of an explanatory paragraph under both AICPA and PCAOB standards except for: a. emphasis of a matter. b. reports involving other auditors. c. lack of consistent application of generally accepted accounting principles. d. auditor agrees with a departure from promulgated accounting principles..

b. reports involving other auditors.

The use of the title Certified Public Accountant (CPA) is regulated by a. the federal government through the licensing department of the Commerce Department. b. state law through a licensing department/agency of each state. c. the American Institute of Certified Public Accountants (AICPA) through the licensing departments of the tax and auditing committees. d. the Securities and Exchange Commission (SEC).

b. state law through a licensing department/agency of each state.

The dollar amount of some misstatements cannot be accurately measured. For example, if the client were unwilling to disclose an existing lawsuit, the auditor must estimate the likely effect on: a. net income. b. users of the financial statements. c. the auditor's exposure to lawsuits. d. management's future decisions.

b. users of the financial statements.

The Sarbanes-Oxley Act applies to which of the following companies? a. All companies. b. Privately held companies. c. Public companies. d. All public companies and privately held companies with assets greater than $500 million.

c Public companies

1. The ___________ rate may be defined as approximately the rate a bank could earn by investing in U.S. treasury notes for the same length as the length of a business loan. a. nominal b. stated c. risk-free d. prevailing

c risk-free

Which of the following is an element of the CPA's quality control system that should be considered in establishing its quality control policies and procedures? a. Considering audit risk and materiality b. Using statistical sampling techniques c. Assigning personnel to engagements d. Complying with laws and regulations

c. Assigning personnel to engagements

2. An audit of historical financial statements is most often performed to determine whether the: a. organization is operating efficiently and effectively. b. entity is following specific procedures or rules set down by some higher authority. c. management team is fulfilling its fiduciary responsibilities to shareholders. d. none of these choices.

d none of these choices

The leading precedent-setting auditing case in third-party liability is: a. Escott et al. v. Bar Chris Construction Corp. b. Hochfelder v. Ernst & Ernst. c. Ultramares Corporation v. Touche. d. United States v. Simon.

c. Ultramares Corporation v. Touche.

A member in public practice may not perform for a contingent fee any professional services for a client for whom the member or member's firm performs: a. an audit. b. a review. c. either an audit or review. d. any professional service regardless of the specific nature of the service.

c. either an audit or review.

William Gregory, CPA, is the principal auditor for a multi-national corporation. Another CPA has examined and reported on the financial statements of a significant subsidiary of the corporation. Gregory is satisfied with the independence and professional reputation of the other auditor, as well as the quality of the other auditor's examination. With respect to his report on the consolidated financial statements, taken as a whole, Gregory: a. must not refer to the examination of the other auditor. b. must refer to the examination of the other auditor. c. may refer to the examination of the other auditor. d. must refer to the examination of the other auditors along with the percentage off consolidated assets and revenue that they audited.

c. may refer to the examination of the other auditor.

9. Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) should be looked upon by practitioners as: a. ideals to work towards, but which are not achievable. b. maximum standards that denote excellent work. c. minimum standards of performance that must be achieved on each audit engagement. d. benchmarks to be used on all audits, reviews, and compilations.

c. minimum standards of performance that must be achieved on each audit engagement.

The 1136 Tenants case and its results

civil case concerning a CPA's failure to uncover fraud as a part of unaudited financial statements. The tenants recovered approximately $235,000. A CPA firm was engaged by a real estate management agent for $600 per year to prepare financial statements, a tax return, and a schedule showing the apportionment of real estate taxes for the 1136 Tenants Corporation, a cooperative apartment house. The statements were sent periodically to the tenants. The statements included the words unaudited, and there was a cover letter stating that ''the statement was prepared from the books and records of the cooperative and no independent verifications were taken thereon.'' During the period of the engagement, from 1963 to 1965, the manager of the management firm embezzled significant funds from the tenants of the cooperative. The tenants sued the CPA firm for negligence and breach of contract for failure to find the fraud. There were two central issues in the case. Was the CPA firm engaged to do an audit instead of only accounting, and was there negligence on the part of the CPA firm? The court answered yes on both counts. The reasoning for the court's conclusion that an audit had taken place was the performance of ''some audit procedures'' by the CPA firm, including the preparation of a worksheet entitled ''missing invoices.'' Had the CPA followed up on these, the fraud would likely have been uncovered. Most important, the court concluded that even if the engagement had not been considered an audit, the CPA had a duty to follow up on any potential significant exceptions uncovered during an engagement. As a result of this case: • Engagement letters were required. • The Accounting and Review Services Committee was formed to set forth guidelines for unaudited financial statements for nonpublic companies

The difference between compilation, review, and audit services

compliation: helping client prepare financial statements without assurance review: auditor provides only moderate assurance and are less costly than audits audits: auditor provides high level of assurance, making sure the statements are in accordance with GAAP or the appropriate framework

Which of the following is least likely to impair a CPA firm's independence with respect to an audit client in the Oklahoma City office of a national CPA firm? a. A partner in the Oklahoma City office owns an immaterial amount of stock in the client. b. A partner in the Jersey City office owns 25% of the client's stock. c. A partner in the Oklahoma City office, who does not work on the audit engagement, previously served as controller for the audit client. d. A partner in the Chicago office previously served as vice president of finance for the audit client.

d. A partner in the Chicago office previously served as vice president of finance for the audit client.

A company has changed its method of inventory valuation from an unacceptable one to one in conformity with generally accepted accounting principles. The auditor's report on the financial statements of the year of the change should include: a. no reference to consistency. b. a reference to a prior period adjustment in the opinion paragraph. c. an explanatory paragraph that justifies the change and explains the impact of the change on reported net income. d. an explanatory paragraph explaining the change.

d. an explanatory paragraph explaining the change.

8. The trait that distinguishes auditors from accountants is the a. auditor's ability to interpret accounting principles generally accepted in the United States. b. auditor's education beyond the Bachelor's degree. c. auditor's ability to interpret FASB Statements. d. auditor's accumulation and interpretation of evidence related to a company's financial statements.

d. auditor's accumulation and interpretation of evidence related to a company's financial statements.

A group not typically included as "third parties" in common law is: a. actual and potential stockholders. b. bankers and other creditors of client. c. employees of client. d. none of the above; that is, all would be included.

d. none of the above; that is, all would be included.

An audit of historical financial statements is most often performed to determine whether the: a. organization is operating efficiently and effectively. b. entity is following specific procedures or rules set down by some higher authority. c. management team is fulfilling its fiduciary responsibilities to shareholders. d. none of these choices.

d. none of these choices.

The difference between information and business risk

information risk: reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements. Business risk: This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions, such as a recession, poor management decisions, or unexpected competition in the industry AUDITING HAS A MAJOR EFFECT ON INFORMATION RISK

AICPA (American Institute of Certified Public Accountants)

issues standards and rules for auditors of private companies ASB(Audit standards board)-responsible for issuing pronouncements on auditing matters for all private companies ARSC(Accounting and Review Servie Committee)-issues standards for CPA's associated with financial statements of private companies that are not audited. Statements on standards for accounting and review services (SSARS)

The difference between negligence, gross negligence, constructive fraud, and fraud

negligence: Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation. • Gross negligence: Lack of even slight care that can be expected of a person. • Constructive fraud: Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness. • Fraud: Occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive.

The responsibilities of auditors under 1934 act

o The liability of auditors under the 1934 Act often centers on the audited financial statements issued to the public in annual reports or submitted to the SEC as a part of annual Form 10-K reports. o Every company with securities traded on national and over-the-counter exchanges is required to submit audited statements annually. o In addition to annual audited financial statements, there is potential legal exposure to auditors for quarterly information (Form 10-Q) or other reporting information filed with the SEC, such as Form 8-K.

What are the parts of the Code of Professional Conduct?

responsibilities- members should exercise sensitive professional and moral judgments in all their activities

Qualified opinion

results from scope limitation or failure to follow GAAP can take form of qualification of both the scope and opinion, or of the opinion alone the term except for in the opinion paragraph should be used

What is attestation?

service in which the CPA firm issues a report about the reliability of an assertion made by another party

What is auditing?

the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria Auditing should be done by a competent, independent person

Consulting bookkeeping and other non-attest services

• CPA firms offer many other services to attest clients that may potentially impair independence. Such activities are permissible as long as the member does not perform management functions or make management decisions. • For example, a CPA firm may assist in the installation of a client's information system as long as the client makes necessary management decisions about the design of the system. • Subject to some restrictions, CPA firms may also provide internal auditing and other extended audit¬ing services to their clients as long as management maintains responsibility for the direction and oversight of the internal audit function.

Scope Limitation

the auditor was unable to acquire significant evidence due to: a) restrictions imposed by the client b) restrictions caused by circumstances beyond the auditor's and client's control

What are the services that can't be provided to a public client?

these 9 services are prohibited by auditors: 1 Bookkeeping and other accounting services 2 fin info systems design & implementation 3 appraisal or valuation services 4 actuarial services 5 Internal audit outsourcing 6 management or human resource 7 broker or dealer or investment advisor or investment banker services 8 legal & expert services unrelated to the audit 9 any other service that the PCAOB determines by regulation is impermissible

contingent fees

to maintain objectivity, basing fees on the outcome of engagements is prohibited

The responsibilities of auditors under 1933 Act

· The auditor has the burden of demonstrating as a defense that · (1) an adequate audit was conducted in the circumstances or (2) all or a portion of the plaintiff's loss was caused by factors other than the misleading finan¬cial statements. The 1933 act is the only common or statutory law where the burden of proof is on the defendant. · Furthermore, the auditor has responsibility for making sure that the financial state¬ments were fairly stated beyond the date of issuance, up to the date the registration state¬ment became effective, which could be several months later. · Although the burden may appear harsh to auditors, there have been relatively few cases tried under the 1933 act.

The difference between audit risk, audit failure and business risk

• Business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions, such as a recession, poor management decisions, or unexpected competition in the industry. The extreme case of business failure is filing for bankruptcy. • Audit failure occurs when the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards (GAAS). • Audit risk represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated. • It depends on whether the auditor exercised due care. • If the auditor failed to use due care in the conduct of the audit, there is an audit failure. In such cases, the law often allows parties who suffered losses to recover some or all of the losses proximately caused by the audit failure. • It is difficult in practice to determine when the auditor has failed to use due care because of the complexity of auditing.

The difference between separate and proportionate liability and joint and several liability

• Joint and several liability: The assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay. • Separate and proportionate liability: The assessment against a defendant of that portion of the damage caused by the defendant's negligence. For example, if the courts determine that an auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage would be assessed to the CPA firm.

Section 10-5b of 1934 Act (the antifraud provision)

• The principal focus on CPA liability litigation under the 1934 act has been Rule 10b-5, which prohibits any fraudulent activities. • Generally, accountants can be held liable under Section 10 and Rule 10b -5 if they intentionally or recklessly mis-represent information intended for third-party use.

There are three conditions requiring a departure from an unqualified audit report. Discuss each of these three conditions and state the appropriate audit report for each condition.

• a scope restriction imposed by the client or by circumstances beyond the auditor's or client's control which prevents the auditor from accumulating sufficient evidence to reach a conclusion regarding whether financial statements are stated in accordance with GAAP. In this condition, the auditor would issue either a qualified scope and opinion report, or a disclaimer of opinion. • the financial statements were not prepared in accordance with GAAP. In this condition, the auditor would issue a qualified opinion if the GAAP violation were moderately material, or an adverse opinion if the GAAP violation were highly material. • the auditor is not independent. In this condition, the auditor must issue a disclaimer of opinion.