Exam 1 Review Sheet

This review does not cover every thing. You need to study your text book, notes, and
other handouts.
You need to know:

1. What is accounting
2. What is auditing
3. What is attestation
4. The roles SEC, PCAOB, AICPA and ASB
5. The differences between operational audit, compliance audit, financial statements audit
6. The difference between information and business risk
7. The difference between Webtrust and Systrust services
8. The AICPA principles and their subcategories
9. What are the SASs and their purpose
10. The difference between S-1, 8-K, 10-K, and 10 Q
11. If an auditor of a public company cannot find guidance issued by the PCAOB, where should
(s)he look for guidance
12. Possible organizational structures for CPA firms
13. The difference between compilation, review, and audit services
14. The audit report parts
15. The purpose and characteristics of each paragraph on the audit report
16. When a standard unqualified report can be issued
17. What is going to happened if there is a scope limitation
18. What is the difference between standard unqualified report and combined report on financial
statements and internal controls
19. When should an unqualified report with explanatory paragraph should be issued
20. When should an unqualified report with modified wording should be issued
21. What are the conditions that require departure form unqualified opinion
22. and how does materiality affect the type of report issued
23. The cases where qualified, adverse, or a disclaimer is issued
24. Independence
25. The difference between independent in fact and in appearance
26. What are the factors that affect the CPA firm’s independence
27. The effect of the financial interests direct and indirect on the independence
28. The contingent fees
29. What is acceptable in terms of advertising
30. What are the services that can and con not be provided to a client public and a private client
31. What are the parts of the Code of Professional Conduct
32. The employment of a CPA and the independence
33. What is the effect of materiality of the investments on the independence
34. Interpretations of the rule that prohibits covered members from owning any stock or other direct
investment in audit clients. Who are the covered members
35. The difference between audit risk, audit failure and business risk
36. How to demonstrate the lack of duty to perform certain service
37. prudent person concept
38. who is a third party beneficiary
39. What privity of contract is
40. The difference between separate and proportionate liability and joint and several liability
41. The difference between negligence, gross negligence, constructive fraud, and fraud
42. Defenses available for lawsuits from clients and third parties
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 43. The responsibilities of auditors under 1933 Act and 1934 Act
44. The 1136 Tenants case and its results
45. Section 10-5b of 1934 Act (the antifraud provision)

Questions and exercises

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

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.

3. Attestation services on information technology include WebTrust services and SysTrust

services. Which of the following statements most accurately describes SysTrust services?
a. SysTrust services provide assurance on business processes, transaction integrity and
information processes.
b. SysTrust services provide assurance on system reliability in critical areas such as security
and data integrity.
c. Neither of the above statements accurately describes SysTrust services.
d. Either of the above accurately describes SysTrust services.

4. 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?
Answer:
(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.

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5. Attestation services fall into five categories. What are these categories?
Answer:
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.

6. 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.

7. 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
d. Limited liability partnership

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.

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.

10. 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
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procedures?
a. Considering audit risk and materiality
b. Using statistical sampling techniques
c. Assigning personnel to engagements
d. Complying with laws and regulations

11. 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.

Answer:
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.

12. 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?

Answer:
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.

13. 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..

14. 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.
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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.

15. 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.
Answer: C

16. 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.

17. 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

18. 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.

19. The “unqualified report with explanatory paragraph” and the “unqualified report with
modified wording”:
a. arise as a result of an incomplete audit.

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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.

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

Answer:
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.

20. 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.

Answer:
The three conditions requiring a departure from an unqualified report are:
 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.

21.Oehlers, CPA, is a staff auditor participating in the engagement of Capital

Trust, Inc. Which of the following circumstances impairs Oehlers
independence?
a. Oehlers' sister is an internal auditor employed by Capital Trust.
b. Oehlers' friend, and employee of another local accounting firm, prepares
the tax return of Capital Trust's CEO.
c. Oehlers and Capital Trust's 401K plan own stock with the same
corporation.
d. During the period of professional engagement, Capital Trust and Oehlers
discussed business over lunch at a first-class restaurant.

22. 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:
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a. an audit.
b. a review.
c. either an audit or review.
d. any professional service regardless of the specific nature of the service.

23. 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

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.

25. Interpretations of Rule 101 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.

26. 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.
Answer: D

27. 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
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 Hedley & Co.’s audit clients. Neither Harry nor personnel from the Topeka
office is involved in the audit of Jensen .

Violation? Yes No
Explanation:

Answer:
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. 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.

Violation? Yes No
Explanation:

Answer:
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. 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.

Violation? Yes No
Explanation:

Answer:
No violation. The AICPA does not prohibit CPA firms from providing bookkeeping, tax,
and audit services to the same non-public client.

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.

Violation? Yes No
Explanation:

Answer:
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. 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.
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 Violation? Yes No
Explanation:

Answer:
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.

Rule: __________ Violation? Yes No

Explanation:

Answer:
Violation of Rule #505-Form of Organization and Name. 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. 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.

Rule: __________ Violation? Yes No

Explanation:

Answer:
No violation of Rule #503-Commissions and Referral Fees. A CPA may pay a referral fee
to a non-CPA as long as the payment is disclosed to the client.

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.

Rule: __________ Violation? Yes No

Explanation:

Answer:
Violation of Rule #302-Contingent Fees. This is a contingent fee agreement and is
prohibited by Rule 302.

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.

Rule: __________ Violation? Yes No

Explanation:

Answer:

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 Violation of Rule #101-Independence. Don is a covered member for purposes of Rule 101.
Because his daughter is a dependent, her ownership interest in Shaw is treated as a direct
financial interest of her father.

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.

Rule # __________ Violation? Yes No

Explanation:

Answer:
No violation of Rule #101. According to the Code a close relative is defined as a parent,
sibling, or nondependent child. Thus, a sister-in-law is not considered to be a close
relative.

29. 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.

Answer:
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 Interpretation 502-2 of 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.

30. 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.

31. 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.

32. 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
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33. 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.

34. Distinguish between ordinary negligence and gross negligence.

Answer:
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.

35. Distinguish between constructive fraud and fraud.

Answer:
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.

36. 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.

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37. Match eight of the following terms (a-n) with the definitions provided below (1-8):

a. Foreign Corrupt Practices Act

b. Securities Exchange Act of 1934
c. Securities Litigation Uniform Standards Act of 1998
d. Securities Act of 1933
e. Ultramares doctrine
f. Audit risk
g. Audit failure
h. Standards failure
i. Business failure
j. Absence of causal connection
k. Contributory negligence
l. Lack of duty to perform
m. Private Securities Litigation Reform Act
n. Nonnegligent performance

G 1. 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.

B 2. 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.

K 3. 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.

A 4. A federal statute that makes it illegal to offer a bribe to an official of a foreign

country.

E 5. 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.

C 6. A federal statute designed to cause class-action securities lawsuits to be

addressed in federal district courts.

N 7. An auditor’s legal defense under which the auditor claims that the audit was
performed in accordance with generally accepted auditing standards.

J 8. 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.

38. 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

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

b
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