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Auditing and Assurance Services, 17e (Arens/Elder/Beasley) Chapter 1 The Demand for Audit and Other Assurance Services 1.1 Learning Objective 1-1 1) In the auditing process, A) the types and amounts of evidence remain constant from audit to audit. B) the criteria for evaluating information will not vary depending on the information being audited. C) the audit report communicates the auditor's findings to users. D) records are gathered by the auditor to determine whether the audited information is stated in accordance with SEC standards. Answer: C Terms: Audit process Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 2) Which of the following is considered audit evidence? A) Oral statements Written Auditor made by management Communications Observations Y N N B) Oral statements made by management N

Written Communications Y

Auditor Observations Y

Written Communications Y

Auditor Observations Y

Written Communications N

Auditor Observations Y

C) Oral statements made by management Y D) Oral statements made by management N

Answer: C Terms: Audit evidence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking

3) Which of the following can be used as a criterion for evaluating information being audited? A) International Financial Reporting Standards (IFRS) B) Generally Accepted Accounting Principles (GAAP) C) Internal Revenue Code (IRC) D) all of the above Answer: D Terms: Criteria by which an auditor evaluates information Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 4) Auditors do not provide which of the following? A) assurance on financial statements B) assurance on the effectiveness of internal controls over financial reporting C) assurance on corporate sustainability reports D) absolute assurance on the financial statements including assuming responsibility for them Answer: D Terms: Nature of Objectives of Auditing Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 5) The accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and some established criteria is defined as A) accounting. B) financial reporting. C) tax reporting. D) auditing. Answer: D Terms: Definition of auditing Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 6) The criteria by which an auditor evaluates the information under audit may vary with the information being audited. Answer: TRUE Terms: Criteria by which an auditor evaluates information Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking

7) One criterion used by an external auditor to evaluate published financial statements is known as generally accepted auditing standards. Answer: FALSE Terms: Criteria used by external auditor to evaluate published financial statements Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 8) Auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports. Answer: TRUE Terms: Independence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 9) To perform an audit, there must be information in a verifiable form and some criteria by which the auditor can evaluate the information. Answer: TRUE Terms: Independence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 10) An auditor must be competent and have an independent mental attitude. Answer: TRUE Terms: Criteria used by external auditor to evaluate published financial statements Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 11) Auditors are not allowed and should not audit subjective information like the effectiveness of computer controls or the efficiency of manufacturing-related operations. Answer: FALSE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 12) In an audit of internal controls over financial reporting, the auditor may rely upon Internal Control - Integrated Framework issued by COSO. Answer: TRUE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 3 Copyright © 2020 Pearson Education, Inc.

13) In circumstances where the auditor is being asked to audit subjective types of information, typically, the auditor and the entities being audited should agree in writing about the criteria being audited after the audit starts. Answer: FALSE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 14) Evidence is paramount to audit and attestation engagements. List the four basic types of audit evidence. Answer: The four types of audit and attestation evidence include 1. Electronic and documentary data about transactions 2. Written and electronic communications with outsiders 3. Observations by the auditor 4. Oral testimony of the auditee (client) Terms: Basic types of audit evidence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 1.2 Learning Objective 1-2 1) Recording, classifying, and summarizing economic events in a logical manner for the purpose of providing financial information for decision making is commonly called A) finance. B) auditing. C) accounting. D) economics. Answer: C Terms: Recording, classifying, and summarizing economic events Difficulty: Easy Objective: LO 1-2 AACSB: Reflective thinking 2) An accountant A) must possess expertise in the accumulation of audit evidence. B) must decide the number and types of items to test. C) must have an understanding of the principles and rules that provide the basis for preparing the accounting information. D) must be a CPA. Answer: C Terms: Distinguishes auditors from accountants Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 4 Copyright © 2020 Pearson Education, Inc.

3) When auditing accounting data, auditors focus on A) determining whether recorded information properly reflects the economic events that occurred during the accounting period. B) determining if fraud has occurred. C) determining if taxable income has been calculated correctly. D) analyzing the financial information to be sure that it complies with government requirements. Answer: A Terms: Auditing financial accounting data primary concern Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 4) 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 expertise in the accumulation and the interpretation of audit evidence. Answer: D Terms: Distinguishes auditors from accountants Difficulty: Challenging Objective: LO 1-2 AACSB: Reflective thinking 5) Auditors focus on determining whether recorded information properly reflects the economic events that occurred during the accounting period. Answer: TRUE Terms: Roles of accountants and auditors Difficulty: Easy Objective: LO 1-2 AACSB: Reflective thinking 6) Both accountants and auditors must possess expertise in the accumulation and interpretation of audit evidence. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 7) Accountants are not directly responsible for developing a system that ensures the entity's economic events are properly recorded on a timely basis and at a reasonable cost. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 5 Copyright © 2020 Pearson Education, Inc.

8) Financial statement users do not confuse auditing with accounting any longer. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 9) Discuss the differences and similarities between the roles of accountants and auditors. What additional expertise must an auditor possess beyond that of an accountant? Answer: The role of accountants is to record, classify, and summarize economic events in a logical manner for the purpose of providing financial information for decision making. To provide relevant information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the accounting information. In addition, accountants must develop a system to ensure that the entity's economic events are properly recorded on a timely basis and at a reasonable cost. The role of auditors is to determine whether the recorded information prepared by accountants properly reflects the economic events that occurred during the accounting period. Because U.S. or international accounting standards provide the criteria for evaluating whether financial information is properly recorded, auditors must thoroughly understand those accounting standards. In addition to understanding accounting, the auditor must possess expertise in the accumulation and interpretation of audit evidence. It is this expertise that distinguishes auditors from accountants. Determining the proper audit procedures, deciding the number and types of items to test, and evaluating the results are unique to the auditor. Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 1.3 Learning Objective 1-3 1) ________ risk reflects the possibility that the information upon which the business decision was made was inaccurate. A) Client acceptance B) Information C) Business D) Control Answer: B Terms: Risk that reflects the possibility that information upon which business risk decision was made Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking

2) The possibility that a business may not be able to repay a bank loan because of an economic downturn is referred to as A) materiality risk. B) information risk. C) interest rate risk. D) business risk. Answer: D Terms: Business risk Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 3) A bank loan officer is trying to decide whether the bank should make a loan to a particular company. The interest rate the bank will charge the company is determined by many factors. Which of the following factors is influenced by the auditor's report? A) the risk-free interest rate risk B) information risk C) the business risk for/of the customer D) All of the above are influenced by the auditor's report. Answer: B Terms: Interest rate risk/factor influenced by auditor's report Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 4) Auditing can have a significant effect on both information risk and business risk. Answer: FALSE Terms: Business risk and information risk Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 1.4 Learning Objective 1-4 1) A correct relationship among the auditor, the client, and the external users is A) management of a public company hires the independent auditor. B) the audit committee of a private company hires the independent auditor. C) the client provides capital to the external users. D) the external users can rely upon the auditor's report to reduce information risk. Answer: D Terms: Relationships among auditor, client, and external users Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking

2) The most common way for users to obtain reliable information is to A) have an internal audit. B) have an independent audit. C) verify all information individually. D) verify the information with management. Answer: B Terms: Obtain reliable information Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 3) External users of the financial statements A) value the auditor's report because of the auditor's independence from the client. B) look to the auditor's report as an indication of the statements' reliability. C) use the audited information on the assumption that it is reasonably complete, accurate, and unbiased. D) all of the above. Answer: D Terms: Relationships among auditor, client, and external users Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 4) Which of the following is not a cause of information risk? A) Society, today, is not as complex as it used to be. B) Remoteness of information. C) The volume and the complexity of data and exchange transactions. D) The biases and the motives of the information provider. Answer: A Terms: Causes of Information Risk Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 5) Large businesses, especially, have the ability to reduce information risk. Which of the following is not a way for a large business to reduce information risk? A) Paying higher interest rates on loans. B) The user verifies the information they need by any possible means. C) The user of information shares information risk with management. D) Having an independent audit performed of the financial statements. Answer: A Terms: Causes of Information Risk Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking

6) As society becomes more complex, decision makers are more likely to receive reliable information. Answer: FALSE Terms: Reducing information risk Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 7) Management is required by GAAP to reduce information risk, even if the costs outweigh the benefits. Answer: FALSE Terms: Reducing information risk Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 8) Explain what is meant by information risk, and list the four causes of this risk. Answer: Information risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. Four causes of information risk are • remoteness of information, • biases and motives of the provider, • voluminous data, and • complex exchange transactions. Terms: Information risk definition and causes Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 1.5 Learning Objective 1-5 1) In the audit of historical financial statements, management asserts that the financial statements are fairly stated in accordance with what standards? A) regulatory accounting principles B) applicable international accounting standards C) applicable U.S. accounting standards D) B and C Answer: D Terms: Audit of historical financial statements Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

2) 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. Answer: B Terms: Assurance services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 3) Three common types of attestation services are A) audits of historical financial statements, reviews of historical financial statements, and audits of internal control over financial reporting. B) audits of historical financial information, verifications of historical financial information, and attestations regarding internal controls. C) reviews of historical financial information, verifications of future financial information, and attestations regarding internal controls. D) audits of historical financial information, reviews of controls related to investments, and verifications of historical financial information. Answer: A Terms: Types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 4) Which of the following services provides the lowest level of assurance on a financial statement? A) review B) audit C) Neither service provides assurance on financial statements. D) Each service provides the same level of assurance on financial statements. Answer: A Terms: Service provides lowest level of assurance on a financial statement Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking

5) Which of the following is an accurate statement regarding assurance services? A) Assurance services must be performed by a CPA. B) An attestation service is not a type of assurance service. C) Assurance services improve the quality of information for decision makers. D) Assurance services can only be performed on financial data. Answer: C Terms: Assurance services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 6) Audits A) are an assurance service, but not an attestation service. B) are designed to provide absolute assurance that the financial statements are free of material misstatement. C) are required for publicly traded companies in the United States. D) do not require the auditor to express their opinion in a written report. Answer: C Terms: Audit assurance Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 7) A high, but not absolute, level of assurance is called A) probable assurance. B) reasonable assurance. C) limited assurance. D) incomplete assurance. Answer: B Terms: Reasonable assurance Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 8) Which of the following is an accurate statement regarding the various types of other assurance services? A) Assurance services must be about the reliability of another party's assertion about compliance with specified criteria. B) Other assurance services must meet the definition of an attestation service. C) The primary purpose of a management consulting engagement is to improve the quality of information. D) The market for other forms of assurance services is open to non-CPA competitors. Answer: D Terms: Assurance services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 11 Copyright © 2020 Pearson Education, Inc.

9) CPA firms are never allowed to provide bookkeeping services for clients. Answer: FALSE Terms: CPA services provided to clients Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 10) Section 404 of the Sarbanes-Oxley Act requires public companies to have an external auditor attest to their internal control over financial reporting. Answer: TRUE Terms: Section 404 of the Sarbanes-Oxley Act Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 11) Most public companies' audited financial statements are available on the SEC's EDGAR database. Answer: TRUE Terms: Public companies' audited financial statements: SEC's EDGAR database Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 12) The primary purpose of a management consulting engagement is to generate a recommendation to management. Answer: TRUE Terms: Nonassurance services provided by CPAs; management consulting Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 13) The primary purpose of a management consulting engagement is to generate a recommendation to management. Answer: TRUE Terms: Nonassurance services provided by CPAs; management consulting Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 14) Audits and some types of attestation services are no longer limited by regulation to licensed CPAs. Answer: FALSE Terms: Who can provide audits and certain types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 12 Copyright © 2020 Pearson Education, Inc.

15) Evaluating internal controls at third-party service providers, such as cloud computing suppliers, is not an attestation type of service which a CPA is allowed to perform today. Answer: FALSE Terms: Who can provide other types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 16) It is increasingly important for companies to ask their third-party service provider of services, including payroll and other types of transaction processing, for attestation reports covering a review of the effectiveness of internal controls in place at the third-party service provider. Answer: TRUE Terms: Who can provide other types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 17) Two types of attestation services provided by CPA firms are audits and reviews. Discuss the similarities and differences between these two types of attestation services. Which type provides the least assurance? Answer: In both the review and audit of the historical financial statements, management asserts that the statements are fairly stated in accordance with accounting standards. The CPA provides a lower level of assurance for reviews of financial statements compared to the high level for audits, therefore less evidence is needed. A review is often adequate to meet financial statement users' needs. It can be provided by a CPA firm at a much lower fee than an audit because less evidence is needed. An audit is the most common assurance service provided by CPA firms. Publicly traded companies in the U.S. are required to have audits under the federal securities acts. Many nonpublic companies have a review to limit audit fees. Terms: Attestation services; Audits and reviews of historical financial statements Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking

18) What is an audit of internal control over financial reporting? Answer: For an audit of internal control over financial reporting, management asserts that internal controls have been developed and implemented following well established criteria. Section 404 of the Sarbanes-Oxley Act requires public companies to report management's assessment of the effectiveness of internal control. The Act also requires auditors for larger public companies to attest to the effectiveness of internal control over financial reporting. This evaluation, which is integrated with the audit of financial statements, increases user confidence about future financial reporting, because effective internal controls reduce the likelihood of future misstatements in the financial statements. Terms: Engagement to attest on internal control over financial reporting Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 19) What are the four categories of attestation services? Answer: The four categories of attestation services include • Audit of historical financial statements • Audit of internal control over financial reporting • Review of historical financial statements • Other attestation services that may be applied to a broad range of subject matter. Terms: Categories of attestation services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 20) CPA firms perform numerous services that generally fall outside the scope of assurance services. Give three examples of such services. Answer: Three specific examples of services performed by CPAs that generally fall outside the scope of assurance services are • accounting and bookkeeping services • tax services • management and consulting services. Terms: Nonassurance services provided by CPAs Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

1.6 Learning Objective 1-6 1) One objective of an operational audit is to A) determine whether the financial statements fairly present the entity's operations. B) determine if the auditee is in compliance with GAAP. C) make recommendations for improving performance. D) report on the entity's relative success in attaining profit maximization. Answer: C Terms: Objective of operational audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 2) An examination of part of an organization's procedures and methods for the purpose of evaluating efficiency and effectiveness is what type of audit? A) operational audit B) compliance audit C) financial statement audit D) production audit Answer: A Terms: Examination of part of an organization's procedures and method to evaluate efficiency and effectiveness Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 3) An audit to determine whether an entity is following specific procedures or rules set down by some higher authority is classified as a(n) A) audit of financial statements. B) compliance audit. C) operational audit. D) production audit. Answer: B Terms: Audit to determine whether entity followed specific procedures or rules Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

4) Which one of the following is more difficult to evaluate objectively? A) presentation of financial statements in accordance with generally accepted accounting principles B) compliance with government regulations C) efficiency and effectiveness of operations D) All three of the above are equally difficult. Answer: C Terms: Most difficult to evaluate objectively Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking 5) Which of the following audits can be regarded as generally being a compliance audit? A) IRS agents' examinations of taxpayer returns B) GAO auditor's evaluation of the computer operations of governmental units C) an internal auditor's review of a company's payroll authorization procedures D) a CPA firm's audit of a public company Answer: A Terms: Compliance audit Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking

6) Which of the following are required to have a written report regarding the assertion of another party? A) Financial Statement Operational Compliance Attestation Assurance Audit Audit Audit Engagement Engagement Y Y Y Y Y B) Financial Statement Audit Y

Operational Audit Y

Compliance Audit Y

Attestation Engagement Y

Assurance Engagement N

C) Financial Statement Audit Y

Operational Audit Y

Compliance Audit Y

Attestation Engagement N

Assurance Engagement N

Operational Audit

Compliance Audit

Attestation Engagement

Assurance Engagement

D) Financial Statement Audit N

Answer: B Terms: Required to have a written report Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking 7) In a financial statement audit, the auditor A) gathers evidence to determine whether the statements contain material errors or other misstatements. B) must have a thorough understanding of the entity and its environment. C) determines whether the financial statements are stated in accordance with specified criteria. D) all of the above. Answer: D Terms: Audit of historical financial statements Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

8) Which of the following is not an example of a compliance audit? A) The accounting personnel at the Chinese subsidiary following the financial statement preparation procedures prescribed in writing by the corporate controller. B) Is the company paying the minimum wage rates required by state laws? C) Determine if a company is meeting the financial covenants of a loan agreement with its lenders. D) Is the computerized processing of payroll at the Indian subsidiary operating effectively and efficiently? Answer: D Terms: Examples of compliance audits Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 9) The primary purpose of a compliance audit is to determine whether the financial statements are prepared in compliance with generally accepted accounting principles. Answer: FALSE Terms: Compliance audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 10) Results of compliance audits are typically reported to the company's management rather than to a broad spectrum of outside users. Answer: TRUE Terms: Compliance audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 11) An integrated approach to auditing considers both the risk of misstatements and operating controls intended to prevent misstatements. Answer: TRUE Terms: Audit of historical financial statements; integrated approach Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

12) Discuss the similarities and differences between financial statement audits, operational audits, and compliance audits. Give an example of each type. Answer: Financial statement audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria and/or procedures, rules, or regulations. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. A financial statement audit is conducted to determine whether financial statements are stated in accordance with specified criteria, normally the U.S. or international standards. Auditors not only focus on accounting transactions, but also focus on an integrated approach in which both the risk of misstatements and the operating controls are considered. The auditor must have a thorough understanding of the entity and its environment. An operational audit evaluates the efficiency and effectiveness of any part of an organization's operating procedures and methods. At completion of an operational audit, management normally expects recommendations for improving operations. In operational auditing, the reviews are not limited to accounting. It is more difficult to objectively evaluate whether the efficiency and effectiveness of operations meets established criteria than it is for compliance and financial statement audits. Also, establishing criteria for evaluating the information in an operational audit is extremely subjective. Thus, operational auditing is more like management consulting than what is usually considered auditing. A compliance audit is conducted to determine whether the auditee is following specific procedures, rules, or regulations set by some higher authority. Results of compliance audits are typically reported to management, like in the operational audits, rather than to outside users as is done with financial statement audits. An example of a financial statement audit would be the annual audit of IBM Corporation, in which the external auditors examine IBM's financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor's evaluation of whether the company's computerized payroll-processing system is operating efficiently and effectively. An example of a compliance audit would be an IRS auditor's examination of an entity's federal tax return to determine the degree of compliance with the Internal Revenue Code. Terms: Financial statement audits, operational audits and compliance audits Difficulty: Challenging Objective: LO 1-6 AACSB: Analytic thinking

13) To perform an audit, it is necessary for the information to be in a verifiable form and there must be some criteria by which the auditor can evaluate the information. Detail the information and criteria that would be used when (A) an independent CPA firm audits a company's historical financial statements. (B) an Internal Revenue Service auditor audits that same company's tax return. (C) an internal auditor performs 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 applicable U.S. or international accounting standards. (B) The information used by an IRS auditor is the financial information in the company's federal tax return. The criteria used 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. Terms: Information and criteria used by CPA firm, Internal Revenue Service auditor, and internal auditor Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 1.7 Learning Objective 1-7 1) Internal auditors A) must be independent of the entity that employs them. B) report to the accounting department. C) are employed by all types of organizations. D) must be CPAs. Answer: C Terms: Internal audit Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 2) Which type of auditor audits the financial information prepared by various federal government agencies before it is submitted to Congress? A) internal auditor B) revenue agent C) independent auditor D) GAO auditor Answer: D Terms: Types of auditors Difficulty: Easy Objective: LO 1-7 AACSB: Reflective thinking 20 Copyright © 2020 Pearson Education, Inc.

3) The primary role of the United States General Accounting Office is the enforcement of the Federal tax laws as defined by Congress and interpreted by the courts. Answer: FALSE Terms: Primary role of United States General Accounting Office Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 4) CPA firms are often called and thought of by outsiders as external auditors, independent auditors, or internal auditors. Answer: FALSE Terms: Primary role of CPA firms Difficulty: Easy Objective: LO 1-7 AACSB: Reflective thinking 5) Compliance is a secondary objective of audits performed by the GAO of the financial information prepared by the various Federal government agencies before that information is submitted to Congress. Answer: FALSE Terms: Primary role of the GAO Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 6) The GAO reports to the Public Company Accounting Oversight Board, which reports to the Securities and Exchange Commission. Answer: FALSE Terms: GAO reports to and is responsible only to Congress Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking

7) Match the engagement described to the (A) type of audit and (B) auditor that would most likely perform the engagement. Each engagement will have an answer from List-A and List-B. An answer can be used once, more than once, or not at all. List A - Type of Audit: a. Financial Statement b. Compliance c. Operational

List B - Type of Auditor: d. Internal e. External f. Government g. IRS

Engagement: 1. Evaluate a company's payroll processing for economy of scale. 2. Evaluate/determine if bank covenants are being met. 3. Evaluate financial statements that are to be submitted to a bank. 4. Evaluate the promptness of materials inspection in a manufacturer's receiving department. 5. Determine if Medicare reimbursements are in accordance with the Healthcare Financing Administration (HCFA). 6. Determine if the tax return of a multinational corporation is in accordance with the tax code. 7. Determine if a public school is properly applying their reimbursement for the payment-in-kind program. 8. Determine the effectiveness of a Department of Defense project. Answer: 1. c, d 2. b, d 3. a, e 4. c, d 5. b, f 6. b, g 7. b, e 8. c, f Terms: Financial statement audit; Compliance audit; Operational audit; Types of auditors Difficulty: Challenging Objective: LO 1-7 AACSB: Analytic thinking

8) Discuss the similarities and differences between the roles of independent auditors, GAO auditors, internal revenue agents, and internal auditors. Answer: The roles of all four types of auditors are similar in that they involve the accumulation and evaluation of evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences in their roles center around the information audited and the criteria used to evaluate that information. Independent auditors primarily audit companies' financial statements. GAO auditors' primary responsibility is to perform the audit function for Congress. IRS auditors are responsible for the enforcement of federal tax laws. Internal auditors primarily perform operational and compliance audits for their employing company. Terms: Roles of independent auditors, GAO auditors, internal revenue agents and internal auditors Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 1.8 Learning Objective 1-8 1) The three requirements for becoming a CPA include all but which of the following? A) uniform CPA examination requirement B) education requirements C) character requirements D) experience requirement Answer: C Terms: Requirements for becoming a CPA Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking 2) The use of the Certified Public Accountant title is regulated by A) the federal government. B) state law through the licensing departments of each state. C) the American Institute of Certified Public Accountants through the licensing departments of the tax and auditing committees. D) the Securities and Exchange Commission. Answer: B Terms: Certified Public Accountant title Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking

3) The AICPA completed a significant revision of the CPA examination effective April 1, 2017. In total, the CPA Examination has four sections, and the total number of hours these four sections involve when taking the Examination is A) 16 hours, 4 hours for each section. B) 20 hours, 5 hours for each section. C) 16 hours, 5 hours each for two of the sections, 3 hours for the other two sections. D) 20 hours, 6 hours for two of the sections, 4 hours for the other two sections. Answer: A Terms: Structure of the CPA Examination Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking 4) List and discuss the three primary requirements to become a CPA. Answer: The three primary requirements for becoming a CPA are: • Educational requirement. Normally, an undergraduate degree or a graduate degree with a major in accounting, including a minimum number of accounting credits is required. Most states now require 150 semester hours for licensure. Some states require fewer credits before taking the examination, but require 150 semester credits before receiving the CPA certificate. • Uniform CPA examination requirement. This is a four-part, computer-based examination with components on auditing and attestation, financial accounting and reporting, regulation, and business environment and concepts. Some states also require a separate ethics requirement. • Experience requirement. The experience requirement varies from state to state with some states requiring no experience, while other states require up to two years of audit experience. Terms: Primary requirements to become CPA Difficulty: Easy Objective: LO 1-8 AACSB: Reflective thinking

Auditing and Assurance Services, 17e (Arens/Elder/Beasley) Chapter 2 The CPA Profession 2.1 Learning Objective 2-1 1) The legal right to perform audits is granted to a CPA firm by regulation of A) each state. B) the Financial Accounting Standards Board (FASB). C) the American Institute of Certified Public Accountants (AICPA). D) the Auditing Standards Board. Answer: A Terms: Legal rights to perform audits Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 2) Which of the following is not a characteristic of a small local CPA firm? A) Most small firms have fewer than 25 professionals. B) Small firms perform audits on small and not-for-profit businesses. C) Tax services are more important than auditing services to the small firm. D) Small firms are prohibited by the SEC from auditing publicly traded companies. Answer: D Terms: Characteristics of a small firm Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 3) Sarbanes-Oxley and the Securities and Exchange Commission restrict auditors from providing many consulting services to their publicly traded audit clients. Which of the following is true for auditors of publicly traded companies? I. They are restricted from providing consulting services to privately held companies. II. There is no restriction on providing consulting services to non-audit clients. A) I only B) II only C) I and II D) Neither I nor II Answer: B Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking

4) Which of the following does not describe a size category for a CPA firm? A) Big Four national firms B) Big Four international firms C) local firms D) national and regional firms Answer: A Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 5) ________ is one of the Big Four international CPA firms. A) Deloitte B) KPMG C) Ernst & Young D) All of the above are classified as Big Four international CPA firms. Answer: D Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 6) In which type of service does the CPA assemble the financial statements but provide no assurance to third parties? A) audit B) compilation C) review D) bookkeeping Answer: B Terms: Compilation Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 7) ________ is not one of the National/Regional CPA Firms. A) PwC B) BDO USA C) Grant Thornton D) RSM US. Answer: A Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking

8) Which of the following is not an accurate definition or description of a local CPA firm? A) Some local CPA firms have several offices. B) Local CPA firms do not compete for clients with the Big Four CPA firms. C) Some local CPA firms are affiliated with other CPA firms to share resources. D) Many local CPA firms provide primarily accounting and tax services to their clients only. Answer: B Terms: Three categories for describing size of audit firms Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 9) Many small, local accounting firms perform audits as their primary service to their clients. Answer: FALSE Terms: Small accounting firms do not perform audits as their primary service to their clients Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 10) Sarbanes-Oxley and the Securities and Exchange Commission restrict auditors from providing many consulting services to their publicly traded audit clients. Answer: TRUE Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 11) Small local CPA Firms are allowed under Sarbanes-Oxley and the Securities and Exchange Commission a special exemption to perform audits of publicly-listed firms. Answer: FALSE Terms: Sarbanes-Oxley and Securities and Exchange Commission restrictions Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 12) In addition to attestation and assurance services, CPA firms provide other services to their clients. List three of these services. Answer: Other services performed by a CPA firm include: • accounting and bookkeeping services • tax services • management consulting and risk advisory services. Terms: Activities of CPA firms Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking

2.2 Learning Objective 2-2 1) Which of the following statements is true as it relates to limited liability partnerships? A) Only senior partners are liable for the partnership's debts. B) Partners have no liability in a limited liability partnership arrangement. C) Partners are personally liable for the acts of those under their supervision. D) All partners must be AICPA members. Answer: C Terms: Limited liability partnerships Difficulty: Challenging Objective: LO 2-2 AACSB: Reflective thinking 2) Which staff level in a CPA firm performs most of the detailed audit work? A) partner B) staff assistant C) senior auditor D) senior manager Answer: B Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 3) Which staff level in a CPA firm manages the overall relationship with the client and manages the audit, in general? A) the audit partner B) the audit staff assistant C) the senior or in-charge auditor with 2-5 years' experience D) the audit manager Answer: D Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 4) All of the Big Four accounting firms and many of the smaller CPA firms now operate as limited liability partnerships. Answer: TRUE Terms: Limited liability partnerships Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking

5) Limited liability companies are structured and taxed like a general partnership, but their owners have limited personal liability similar to that of a general corporation. Answer: TRUE Terms: Limited liability companies Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking 6) In a CPA firm, the audit partner coordinates the performance of audit procedures. Answer: FALSE Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 7) In a CPA firm, the audit senior or the in-charge auditor performs most of the detailed audit work. Answer: FALSE Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 8) List and describe the three factors that influence the organizational structure of all CPA firms. What are the most common forms of CPA firm organization? Answer: The three factors that influence the organization of a CPA firm include: 1. The need for independence from clients. Independence permits auditors to remain unbiased in drawing conclusions about the financial statements. 2. The importance of a structure to encourage competence. Competency permits auditors to conduct audits and perform other services effectively and efficiently. 3. The increased litigation risk faced by auditors. Audit firms continue to experience increases in litigation-related costs. Some organizational structures afford a degree of protection to individual firm members. Common forms of audit firm organization include: • Proprietorship • General Partnership • General Corporation • Professional Corporation • Limited Liability Company • Limited Liability Partnership Terms: Factors that influence the organizational structure of CPA firms Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking 5 Copyright © 2020 Pearson Education, Inc.

9) List and describe the six organizational structures available to CPA firms. Answer: CPA firms can take one of six organizational forms: • Proprietorship. This form is limited to firms with only one owner. • General partnership. This form is similar to a proprietorship, except that it applies to multiple owners. • General corporation. Shareholders in a general corporation are liable only to the extent of their investment in the corporation. Many states prohibit CPA firms from organizing as a general corporation. • Professional corporation. A professional corporation provides professional services and is owned by one or more shareholders. Personal liability protection for shareholders in professional corporations varies widely from state to state. • Limited liability company. This form combines the most favorable attributes of a general corporation and a general partnership. LLCs are typically structured and taxed like a general partnership, but its owners have limited personal liability similar to that of a general corporation. • Limited liability partnership. An LLP is owned by one or more partners. It is structured and taxed like a general partnership. However, the personal liability protection of an LLP is less than that of a general corporation or an LLC, but it is greater than a general partnership. Many accounting firms now operate as LLPs. Terms: Organizational structures available to CPA firms Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking 2.3 Learning Objective 2-3 1) The organization that is responsible for providing oversight for auditors of public companies is called the A) Auditing Standards Board. B) American Institute of Certified Public Accountants. C) Public Oversight Board. D) Public Company Accounting Oversight Board. Answer: D Terms: Organization responsible for providing oversight for auditors of public companies Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking

2) Members of the Public Company Accounting Oversight Board are appointed and overseen by the A) U.S. Congress. B) American Institute of Certified Public Accountants. C) Auditing Standards Board. D) Securities and Exchange Commission. Answer: D Terms: Members of Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking 3) The Public Company Accounting Oversight Board A) performs inspections of the quality controls of firms that audit public companies. B) establishes auditing standards that must be followed by CPAs on all audits. C) oversees auditors of private companies. D) performs all of the above functions. Answer: A Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking

4) Assume the Public Company Accounting Oversight Board (PCAOB) identifies a violation during its inspection of a registered accounting firm. The PCAOB A) can enforce report the matter to suspend the license to disciplinary action the Securities and practice of the CPA against the Exchange guilty of the violation accounting firm Commission Yes Yes Yes B) can enforce disciplinary action against the accounting firm Yes

report the matter to the Securities and Exchange Commission Yes

suspend the license to practice of the CPA guilty of the violation

report the matter to the Securities and Exchange Commission No

suspend the license to practice of the CPA guilty of the violation

report the matter to the Securities and Exchange Commission No

suspend the license to practice of the CPA guilty of the violation

C) can enforce disciplinary action against the accounting firm Yes

D) can enforce disciplinary action against the accounting firm No

Answer: B Terms: Public Company Accounting Oversight Board inspection violations Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking

5) Has audit quality improved since the passage of Sarbanes-Oxley Act (SOX)? Which of the following statements is true with regards to audit quality since the passage of SOX? A) The frequency of financial statement restatements has increased since SOX. B) PCAOB audit engagement findings continue to document a high level of audit deficiencies. C) Finally, the auditing professions agrees on the definition of audit quality. D) No progress has been made on the definition of what are called "Audit Quality Indicators" since SOX. Answer: B Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 6) The Public Company Accounting Oversight Board (PCAOB) provides oversight to auditors of publicly traded and private companies. Answer: FALSE Terms: Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking 7) The PCAOB requires annual inspections of accounting firms that audit more than ten public companies. Answer: FALSE Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 8) The PCAOB requires annual inspections of other registered accounting firms that audit less than 100 publicly listed companies at least once every 3 years. Answer: TRUE Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 9) The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). What are the PCAOB's primary functions? Answer: The PCAOB provides oversight for auditors of public companies; establishes auditing, attestation, and quality control standards for public company audits; and performs inspections of audit engagements as well as the quality controls at audit firms performing those audits. Terms: Sarbanes-Oxley Act; Public Company Accounting Oversight Board primary functions Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 9 Copyright © 2020 Pearson Education, Inc.

2.4 Learning Objective 2-4 1) The form that must be completed and filed with the Securities and Exchange Commission whenever a company experiences a significant event that is of interest to public investors is the A) Form S-1. B) Form 8-K. C) Form 10-K. D) Form 10-Q. Answer: B Terms: SEC Form 8-K, reporting significant events Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 2) The form that must be filed with the Securities and Exchange Commission whenever a company plans to issue new securities to the public is the A) Form S-1. B) Form 8-K. C) Form 10-K. D) Form 10-Q. Answer: A Terms: Form must be completed and filed with Securities and Exchange Commission when company plans to issue new securities Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 3) Which of the following is a correct statement regarding the SEC? A) The Securities Act of 1934 requires most companies planning to issue new securities to the public to submit a registration statement to the SEC for approval. B) All public companies must file monthly statements with the SEC. C) The Form 10-K must be filed within 30 days after the close of the fiscal year. D) The SEC has the power to establish rules for any CPA associated with audited financial statements submitted to the commission. Answer: D Terms: Securities and Exchange Commission Difficulty: Challenging Objective: LO 2-4 AACSB: Reflective thinking

4) With respect to the SEC, A) the attitude of the SEC is generally considered in any major change proposed by the FASB. B) the SEC is the sole agency responsible for setting generally accepted accounting principles. C) the SEC requirements of greatest interest to CPAs are set forth in their enforcement regulations. D) the SEC has the power to establish rules for all CPAs. Answer: A Terms: Securities and Exchange Commission influence on setting generally accepted accounting principles Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 5) Which of the following is not a publication issued by the Securities and Exchange Commission? A) Accounting and Auditing Enforcement Actions B) Accounting Series Releases C) Regulation S-X D) State Board of Accountancy Enforcement Actions Answer: D Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 6) The difference between the Securities Act of 1933 and the Securities Act of 1934 is that only the 1934 Act requires audited financial statements. Answer: FALSE Terms: Securities Acts of 1933 and 1934 Difficulty: Easy Objective: LO 2-4 AACSB: Reflective thinking 7) Form 10-K must be filed with the SEC whenever a public company experiences a significant event. Answer: FALSE Terms: Form 10-K; SEC Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking

8) The overall purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions. Answer: TRUE Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 9) Form 10-Q must be filed monthly with the Securities and Exchange Commission by every publicly held company. Answer: FALSE Terms: Form 10-Q; SEC Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 10) Discuss the purpose of the Securities and Exchange Commission and its influence on setting generally accepted accounting principles. Answer: The SEC, an agency of the federal government, assists in providing investors with reliable information upon which to make investment decisions. The SEC has considerable influence in setting generally accepted accounting principles (GAAP) and disclosure requirements for financial statements as a result of its authority for specifying reporting requirements considered necessary for fair disclosure to investors. The SEC has the power to establish rules for any CPA associated with audited financial statements submitted to the commission. The attitude of the SEC is generally considered in any major change proposed by the Financial Accounting Standards Board (FASB), the independent organization that establishes U.S. GAAP. Terms: Securities and Exchange Commission influence on setting generally accepted accounting principles Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 2.5 Learning Objective 2-5 1) Statements on Standards for Accounting and Review Services (SSARS) are issued by the A) Accounting and Review Services Committee. B) Professional Ethics Executive Committee. C) Securities and Exchange Commission. D) Financial Accounting Standards Board. Answer: A Terms: Statements on Standards for Accounting and Review Services (SSARS) Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking

2) The American Institute of Certified Public Accountants (AICPA) A) is responsible for issuing licenses to new CPAs. B) restricts its membership to CPAs who are independent auditors. C) sets auditing standards for both public and private companies. D) sets rules of conduct that CPAs are required to meet. Answer: D Terms: AICPA has authority to establish standards and rules Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking 3) In 2017, the American Institute of CPAs joined with which of the following to form the Association of International Certified Public Accountants? A) the Chartered Institute of Management Accountants B) the Securities and Exchange Commission C) the Public Accounting Oversight Board D) the Japanese Institute of Certified Public Accountants Answer: A Terms: AICPA joins with the CIMA (Chartered Institute of Management Accountants) Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking 4) Membership in the AICPA is restricted to CPAs who are currently practicing as independent auditors. Answer: FALSE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 5) Membership in the AICPA is mandatory for all licensed practicing CPAs. Answer: FALSE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 6) A CPA must meet continuing education requirements to maintain their license to practice. Answer: TRUE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking

7) The Auditing Standards Board (ASB) of the AICPA is responsible for issuing pronouncements on auditing matters in the U.S. for the audits of every type of entity. Answer: TRUE Terms: AICPA Standards and Rules Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 8) What are the major functions of the AICPA? Answer: Major functions of the AICPA include: • Setting standards and rules that all members and other practicing CPAs must follow. These standards consist of auditing standards for auditors of private companies, compilation and review standards, other attestation standards, and the Code of Professional Conduct. • Research and publication on many different subjects related to accounting, auditing, attestation and assurance services, management consulting services, and taxes. AICPA publications include the Journal of Accountancy, industry audit guides for several industries, periodic updates of the Codification of Statements on Auditing Standards, and the Code of Professional Conduct. • Promoting the accounting profession through organizing national advertising campaigns • Promoting new assurance services • Developing specialist certifications to help market and ensure the quality of services in specialized practice areas • Writing and grading the uniform CPA examination • Providing continuing education seminars for its members Terms: Major functions of AICPA Difficulty: Challenging Objective: LO 2-5 AACSB: Reflective thinking

2.6 Learning Objective 2-6 1) Which of the following are audit standards used in professional practice by audit firms? A) International AICPA Auditing PCAOB Auditing Standards on Standards Standards Auditing Yes No No B) International Standards on Auditing Yes

AICPA Auditing Standards

PCAOB Auditing Standards

Yes

International Standards on Auditing Yes

AICPA Auditing Standards

PCAOB Auditing Standards

Yes

International Standards on Auditing No

AICPA Auditing Standards

PCAOB Auditing Standards

Yes

Answer: C Terms: Standards used in professional practice Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 2) Who is responsible for establishing auditing standards for privately held companies? A) Securities and Exchange Commission B) Public Company Accounting Oversight Board C) Auditing Standards Board D) National Association of Accounting Answer: C Terms: Establishing auditing standards for privately held companies Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking

3) Standards issued by the Public Company Accounting Oversight Board must be followed by CPAs who audit A) both private and public companies. B) public companies only. C) private companies, public companies, and nonprofit entities. D) private companies only. Answer: B Terms: Public Company Accounting Oversight Board Standards Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 4) The International Standards on Auditing (ISA) A) are issued by the AICPA. B) override a country's regulations governing the audit of a company. C) has many of the same standards as the Auditing Standards Board (ASB). D) must be followed by companies whose stock is traded in the U.S. Answer: C Terms: International Standards on Auditing; International Auditing and Assurance Standards Board Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 5) ________ are referred to as U.S. generally accepted auditing standards (GAAS). A) AICPA auditing standards B) SEC auditing standards C) PCAOB auditing standards D) Sarbanes-Oxley standards Answer: A Terms: Auditing standards of the United States Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 6) Which of the following is a true statement regarding auditing standards? A) Prior to the passage of Sarbanes-Oxley, the FASB established auditing principles for U.S. public companies. B) PCAOB auditing standards are applicable to entities outside the U.S. C) There are no similarities between PCAOB standards and International Standards on Auditing. D) The Auditing Standards Board has revised most of its standards to converge with the international standards. Answer: D Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 16 Copyright © 2020 Pearson Education, Inc.

7) Which of the following is true with regards to the various auditing standards? A) Statements on Auditing Standards (SASs) are issued by the PCAOB. B) The ASB Clarity Project was intended to make the U.S. auditing standards easier to read, understand, and apply. C) The ASB redrafted existing AICPA auditing standards to align them with respective International Standards on Auditing (ISA's). D) Both B and C are correct. Answer: D Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Challenging Objective: LO 2-6 AACSB: Reflective thinking 8) Which of the following is not one of the main sets of auditing standards around the world today? A) AICPA Auditing Standards B) International Standards on Auditing C) PCAOB Auditing Standards D) Securities and Exchange Commission Auditing Standards Answer: D Terms: Auditing standards of the United States and International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 9) The PCAOB considers International Standards on Auditing (ISA) when developing its standards. Answer: TRUE Terms: Public Company Accounting Oversight Board Standards Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 10) International Standards on Auditing are issued by the International Auditing and Assurance Standards Board (IAASB). Answer: TRUE Terms: International Standards on Auditing; International Auditing and Assurance Standards Board Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking

11) The ASB has revised its audit standards to converge with international standards. Answer: TRUE Terms: Auditing standards of the United States and International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 12) International Standards on Auditing (ISAs) override a country's regulations governing the audit of financial or other information. Answer: FALSE Terms: International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 2.7 Learning Objective 2-7 1) Historically, auditing standards have been organized into three categories, including A) standards of field work. B) purpose of an audit. C) responsibilities of the auditor. D) proper planning and supervision. Answer: A Terms: GAAS, general standards Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 2) The "Principles Underlying an Audit in Accordance with Generally Accepted Auditing Principles" provide a framework to help auditors A) understand the ten GAAS standards. B) obtain complete assurance that the financial statements are free from any error. C) report on the financial statements. D) prevent fraud. Answer: C Terms: GAAS; New principles underlying GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking

3) Which of the following is not one of the responsibilities of an auditor under the principles underlying an audit of financial statements? A) possess appropriate competence and capabilities B) comply with relevant ethical requirements C) plan work and supervise assistants D) maintain professional skepticism and exercise professional judgment Answer: C Terms: Principles underlying an audit performed in accordance with GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 4) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, the auditor must fulfill several performance responsibilities, including A) verifying that all audit work is performed by a CPA with a minimum of three years' experience. B) obtaining sufficient, appropriate audit evidence. C) exercising professional judgment. D) providing an opinion on the financial statements. Answer: B Terms: GAAS- New principles underlying GAAS; Purpose of an audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 5) The Statements on Auditing Standards issued by the Auditing Standards Board A) are regarded as authoritative literature. B) mandate the amount of evidence that must be obtained. C) must be followed in all situations. D) are optional guidelines which an auditor may choose to follow or not follow when conducting an audit. Answer: A Terms: Generally Accepted Auditing Standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

6) An auditor need not abide by a particular auditing standard if the auditor believes that A) the issue in question is immaterial in amount. B) more expertise is needed to fulfill the requirement. C) the requirement of the standard has not been addressed by the PCAOB. D) fraud is involved. Answer: A Terms: Auditor need not abide by a particular auditing standard Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 7) When assessing the risk of material misstatements in the financial statements, A) inadequate internal control procedures will mitigate client business risk. B) GAAS specifies in detail how much and what types of evidence the auditor needs to obtain. C) company management is responsible for determining materiality levels. D) the auditor must understand the client's business and industry. Answer: D Terms: Generally Accepted Auditing Standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 8) In order to properly plan and perform an audit, an important fact for both the auditor and the client to understand is that A) the internal control policies and procedures are developed by the auditors. B) the purpose of an audit is to prevent fraud. C) management is responsible for the preparation of the financial statements. D) management can restrict the auditor's access to important information relevant to the financial statements. Answer: C Terms: GAAS- New principles underlying GAAS; Purpose of an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 9) The principles underlying an audit A) contain the procedures that must be followed during an audit. B) carry the same authority as AICPA auditing standards. C) only apply to the audits of public companies. D) provide structure for the clarified Codification. Answer: D Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

10) The AICPA principles underlying an audit are organized around four principles. Which of the following is not one of those principles? A) fairness B) responsibilities C) reporting D) performance Answer: A Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 11) Which of the following statements about Generally Accepted Audit Standards are true? I. They serve as broad guidelines to auditors for conducting an audit engagement. II. They are sufficiently specific to provide a meaningful guide to practitioners. III. They represent a framework upon which the AICPA can provide interpretations. A) I and II B) I and III C) II and III D) I, II and III Answer: B Terms: Generally Accepted Auditing Standards Difficulty: Challenging Objective: LO 2-7 AACSB: Reflective thinking 12) The AICPA principles and the auditing standards should be viewed 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. Answer: C Terms: Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) Difficulty: Challenging Objective: LO 2-7 AACSB: Reflective thinking

13) Which of the following is an accurate statement regarding principles and auditing standards? A) The principles underlying an audit give specific guidance to an auditor when a problem arises in an audit. B) The principles underlying an audit state that the only objective of an audit is to provide financial statement users with an opinion. C) All auditing standards issued by the PCAOB are given two classification numbers. D) The Statement on Auditing Standard (SAS) number identifies the order in which it was issued in relation to other SASs. Answer: D Terms: Principles underlying an audit versus auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 14) ________ is an attitude that includes a questioning mind, being alert to conditions that might indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence. A) Reasonableness B) Diligence C) Professional skepticism D) Competence Answer: C Terms: Professional skepticism Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 15) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, the auditor fulfills several performance responsibilities, including A) complying with the AICPA Code of Professional Conduct. B) issuing a written report on the financial statements. C) determining and applying materiality levels. D) having the appropriate competence to perform the audit. Answer: C Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

16) Which of the following is not true regarding the purpose of an audit performed on a set of financial statements in accordance with generally accepted auditing standards? A) to provide users of the financial statements with an opinion on the financial statements B) to provide users of the financial statements with absolute assurance that the financial statements contain no errors in them C) to provide financial statement users with an opinion on whether the financial statements are presented fairly or not D) to provide financial statement users with an opinion in accordance with the applicable financial reporting framework Answer: B Terms: Purpose of a GAAS audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 17) In situations in which the CPA or the CPA's assistants are not qualified to perform the audit work, which of the following is not an option the CPA or the CPA firm has? A) The CPA and the CPA's assistants have a professional obligation to acquire the required knowledge and skills. B) The CPA and the CPA's assistants should simply rely more upon the client's representations when performing the audit. C) The CPA should suggest someone else or another CPA firm which is qualified to perform the work. D) The CPA should decline the audit engagement. Answer: B Terms: Auditor's Responsibilities: Competence and Capabilities Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 18) Professional skepticism must be maintained only if the auditor suspects fraud. Answer: FALSE Terms: Generally Accepted Auditing Standards; Responsibilities Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 19) Statements on Auditing Standards (SASs) are issued by the Public Company Accounting Oversight Board. Answer: FALSE Terms: Statements on Auditing Standards (SAS); Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking

20) The AU-C number identifies the order in which it was issued in relation to all other codified auditing standards. Answer: FALSE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 21) Similar to the Financial Accounting Standards Board (FASB) Codification, the AICPA has codified the Statement of Auditing Standards. Answer: TRUE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 22) The PCAOB website includes a reference tool that identifies the analogous AICPA and IAASB auditing standards for each PCAOB standard. Answer: TRUE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 23) An auditor should accept the fact that management of an audit client may restrict access to persons within the entity from whom the auditor may need to obtain audit evidence due to client confidentiality. Answer: FALSE Terms: Purpose of an Audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 24) List the four principles underlying an audit. Answer: • Purpose of an audit • Responsibilities • Performance • Reporting Terms: GAAS; New principles underlying GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking

25) Principles related to the auditor's responsibilities in the audit stress three important personal qualities that the auditor should possess. List and discuss these three qualities. Answer: 1. Appropriate competence and capabilities. The auditor is required to have formal education in auditing and accounting, adequate practical experience for the work being performed, and continuing professional education. 2. Comply with relevant ethical requirements. The AICPA Code of Professional Conduct outlines the ethical requirements for CPAs who practice in accounting firms or work in organizations as part of management. The Code and auditing standards stress the need for independence in audit engagements. 3. Maintain professional skepticism and exercise professional judgment. Professional skepticism is an attitude that includes a questioning mind, being alert to conditions that might indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence. In making judgments about the presence of a material misstatement, auditors are responsible for applying relevant training, knowledge, and experience in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 26) Performance is one of the principles underlying an audit. List three performance responsibilities. Answer: Performance responsibilities include: • obtain reasonable assurance about whether financial statements are free of material misstatement • plan work and supervise assistants • determine and apply materiality level(s) • identify and assess risks of material misstatements based on understanding of the entity and its environment, including internal controls • obtain sufficient appropriate audit evidence Terms: Principles underlying an audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking

2.8 Learning Objective 2-8 1) Quality control for a CPA firm A) includes the organizational structure of the firm and the procedures it establishes. B) is tailored to each specific audit engagement. C) is a guarantee that auditing standards are followed. D) is required only for firms auditing SEC companies. Answer: A Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 2) The method used by a CPA firm to ensure that the firm meets its professional responsibilities to clients and others is A) continuing professional education. B) compliance with generally accepted reporting standards. C) quality control. D) peer review. Answer: C Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 3) Within the context of quality control, the primary purpose of continuing professional education and training activities is to enable a CPA firm to provide its personnel with A) technical training that assures proficiency as a valuation expert. B) professional education that is required in order to perform with due professional care. C) knowledge required to fulfill assigned responsibilities. D) knowledge required to perform a peer review. Answer: C Terms: Quality control; Continuing professional education and training activities Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

4) The purpose of establishing quality control policies and procedures to accept or continue a client relationship is to A) provide reasonable assurance that personnel are adequately trained to fulfill their responsibilities. B) monitor the risk factors concerning misstatements that arise from the misappropriation of assets. C) document objective criteria for the CPA firm's peer review. D) minimize the likelihood of associating with a client whose management may lack integrity. Answer: D Terms: Purpose of quality control policies and procedures to accept or continue client relationship Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 5) 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 appropriately experienced personnel to engagements D) complying with laws and regulations Answer: C Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 6) Which of the following is not an essential component of quality control? A) policies and procedures to ensure that firm personnel are actively engaged in marketing strategies B) policies and procedures to ensure that the work performed by firm personnel meet applicable professional standards C) policies to ensure that personnel maintain their independence in fact and in appearance D) policies that ensure that monitoring activities are effectively applied Answer: A Terms: Component of quality control Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

7) Which one of the following is not true regarding the American Institute of Certified Public Accountants peer review requirement? A) A CPA firm must develop and adhere to quality control standards. B) Peer reviews are mandatory. C) A CPA firm will lose AICPA eligibility if a peer review is not performed. D) Firms required to be registered with and inspected by the PCAOB are exempt. Answer: D Terms: AICPA peer review Difficulty: Challenging Objective: LO 2-8 AACSB: Reflective thinking 8) How often is the AICPA Peer Review Program performed of an AICPA member CPA firm administered by a State CPA Society under the overall direction of the AICPA Peer Review Board? A) every year B) every 2 years C) every 3 years D) every 5 years Answer: C Terms: AICPA CPA Firm Member Peer Review Requirement Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 9) Which of the following is not a purpose of the Center for Audit Quality which is affiliated with the AICPA? A) to serve the capital markets B) to serve public company auditors C) to serve investors D) to serve the International Accounting Standards Board (IASB) Answer: D Terms: Audit Practice and Quality Centers Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 10) Quality controls are established for the entire CPA firm whereas auditing standards are applicable to the individual engagement. Answer: TRUE Terms: Quality controls and auditing standards Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

11) In order to be eligible for membership in the AICPA, public accounting firms must be enrolled in an AICPA-approved practice monitoring program. Members of the firm can still be eligible for AICPA membership even if their firms are not enrolled in an AICPA-approved practice monitoring program. Answer: FALSE Terms: Peer review requirements Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 12) Discuss the relationship between quality control and generally accepted auditing standards. Answer: For a CPA firm, quality control comprises the methods used to ensure that the firm meets its professional responsibilities to clients and others. Quality control is closely related to but distinct from auditing standards. The standards recognize that a quality control system can provide only reasonable assurance, not a guarantee that auditing standards are followed. A CPA firm must make sure that auditing standards are followed on every audit. Quality controls are the procedures used by the entire CPA firm to ensure that the principles in auditing standards are followed on every audit. Quality controls are established for the entire CPA firm, whereas auditing standards are applicable to individual engagements. Terms: Relationship between quality control and generally accepted auditing standards Difficulty: Easy Objective: LO 2-8 AACSB: Reflective thinking

13) List and describe the six elements of quality control. Who establishes the standards for quality control? Answer: • Leadership responsibilities for quality within the firm – The firm should promote a culture that quality is essential in performing engagements and should establish policies and procedures that support that culture. • Relevant ethical requirements – All personnel on engagements should maintain independence in mind and in appearance, perform all professional responsibilities with integrity and maintain objectivity in performing their professional responsibilities. • Acceptance and continuation of client relationships and engagements – Policies and procedures should be established for deciding whether to accept or continue a client relationship or specific engagement. These policies and procedures should minimize the risk of associating with a client whose management lacks integrity. The firm should also only undertake engagements that can be completed with professional competence. • Human resources – Policies and procedures should be established to provide the firm with reasonable assurance that all new personnel are qualified to perform their work competently, work is assigned to personnel who have adequate technical training and proficiency, all personnel should participate in continuing professional education and professional development activities that enable them to fulfill their assigned responsibilities, and personnel selected for advancement should have the qualifications necessary for the fulfillment of their assigned responsibilities. • Engagement performance – Policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional standards, legal and regulatory requirements, and the firm's standards of quality. • Monitoring – Policies and procedures should exist to ensure that the other quality control elements are being effectively applied. Quality control standards are established by the Auditing Standards Board for auditors of private companies and by the Public Company Accounting Oversight Board for auditors of public companies. Terms: Elements of quality controls Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

14) Listed below are policies or procedures that the Crystal Cove audit firm has in place. For each identified policy or procedure state if it is an auditing standard or a quality control standard. Audit firm Policy or Procedure Standards Category 1. Determination on whether to accept or a. auditing standard reject a new client. b. quality control standard 2. A client evaluation form. 3. All personnel participate in continuing professional education. 4. Conducting the audit with professional skepticism. 5. Answering an independence questionnaire. 6. Determine and apply materiality levels. 7. Audit staff workpapers are reviewed by audit seniors, then managers. 8. Plan work and supervise assistants. Answer: 1. b 2. b 3. b 4. a 5. b 6. a 7. b 8. a Terms: Auditing standards and quality control standards Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

15) The following are definitions of terms that are listed on the right. Match the definition with its associated term. Each term can be used once, more than once or not at all. Definition Audit Term 1. an organizational structure where professional a. AICPA services are provided by one or more shareholders b. PCAOB 2. the grantor of the right to practice public c. Securities Exchange Commission accounting d. Form 10-K 3. a report filed to indicate a significant event e. IAASB 4. sets professional standards and rules for f. Form S-1 members g. due professional care 5. oversees accounting firms who audit public h. limited liability partnership companies i. professional corporation 6. an organizational structure where the owners are j. limited liability company taxed like a partnership and have limited personal k. peer review liability l. 1933 Securities Act 7. a report that is filed when a company wishes to m. 1934 Securities Act issue new securities n. Form 8-K 8. the methods used to ensure the firm meets its o. state regulation professional responsibilities to clients and others p. Code of Professional Conduct 9. assists in providing investors with reliable q. quality control standards information r. auditing standards 10. requires annual inspections of accounting firms auditing more than 100 public companies 11. practice monitoring by a CPA firm for another CPA firm 12. fulfilling duties diligently and carefully 13. requires a registration statement Answer: 1. i, 2. o, 3. n, 4. a, 5. b, 6. j, 7. f, 8. q, 9. c, 10. b, 11. k, 12. g, 13. l Terms: AICPA; PCAOB; Securities Exchange Commission; Form S-1; Form 8-K; Due professional care; Professional Corporation; Limited Liability Company; Peer review; 1933 Securities Act; State Regulation; Quality Control Standards Difficulty: Moderate Objective: LO 2-1, LO 2-3, LO 2-4, LO 2-5, and LO 2-8 AACSB: Reflective thinking

Auditing and Assurance Services, 17e (Arens/Elder/Beasley) Chapter 3 Audit Reports 3.1 Learning Objective 3-1 1) Which of the following is a correct statement regarding the standard unmodified opinion audit report? A) The format of the audit report for public and nonpublic entities are identical. B) The auditor's responsibility paragraph includes a statement that the auditors are responsible for selecting the appropriate accounting principles. C) The audit report includes the name of the lead partner on the audit. D) The auditor's responsibilities paragraph includes a statement that the auditor considers internal controls when designing the audit procedures performed. Answer: D Terms: Parts of standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 2) Auditing standards require that the audit report must be titled and that the title must A) include the word "independent." B) indicate if the auditor is a CPA. C) indicate if the auditor is a proprietorship, partnership, or corporation. D) indicate the type of audit opinion issued. Answer: A Terms: Auditing standards require audit report title Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

3) To emphasize the fact that the auditor is independent, a typical addressee of the audit report could be A) Company Controller Shareholders Board of Directors No Yes Yes B) Company Controller No

Shareholders No

Board of Directors Yes

C) Company Controller Yes

Shareholders Yes

Board of Directors No

D) Company Controller Yes

Shareholders No

Board of Directors No

Answer: A Terms: Audit report addressee Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 4) The auditor's responsibilities section of the standard unmodified opinion audit report states that the audit is designed to A) discover all errors and/or irregularities. B) discover material errors and/or irregularities. C) conform to generally accepted accounting principles. D) obtain reasonable assurance whether the statements are free of material misstatement. Answer: D Terms: Auditor's responsibilities paragraph of the standard unqualified audit report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

5) The audit report date on a standard unmodified opinion audit report indicates A) the last day of the fiscal period. B) the date on which the financial statements were filed with the Securities and Exchange Commission. C) the last date on which users may institute a lawsuit against either the client or the auditor. D) the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements. Answer: D Terms: Audit report date on standard unqualified report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 6) The standard audit report for nonpublic entities refers to GAAS and GAAP in which sections? A) GAAS GAAP Auditor's Responsibilities Auditor's Responsibilities paragraph paragraph B) GAAS Auditor's Responsibilities paragraph

GAAP Auditor's Opinion paragraph

C) GAAS Management's Responsibilities and Auditor's Opinion paragraphs

GAAP Management's Responsibilities and Auditor's Opinion paragraphs

GAAS

GAAP Management's Responsibilities and Auditor's Opinion paragraphs

D) Auditor's responsibilities and Basis for Opinion paragraphs

Answer: D Terms: Standard unqualified audit report for nonpublic entities; GAAS and GAAP Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking

7) Which of the following is not explicitly stated in the standard unmodified opinion audit report? A) The financial statements are the responsibility of management. B) The audit was conducted in accordance with generally accepted accounting principles. C) The auditors believe that the audit evidence provides a reasonable basis for their opinion. D) An audit includes assessing the accounting estimates used. Answer: B Terms: Standard unmodified opinion audit report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 8) The standard unmodified opinion audit report for a nonpublic entity must A) have a report title that includes the word "CPA." B) be addressed to the company's stockholders and creditors. C) be dated. D) include an explanatory paragraph. Answer: C Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 9) The management's responsibilities section of the standard unmodified opinion audit report for a nonpublic company states that the financial statements are A) the responsibility of the auditor. B) the responsibility of management. C) the joint responsibility of management and the auditor. D) none of the above. Answer: B Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

10) The first paragraph of the standard unmodified opinion audit report for a nonpublic company effective for audits of financial statements for fiscal years ending on or after June 15, 2019 performs which of the following functions? I. Presents the auditors' opinion, first. II. Provides additional information related to the responsibilities of management for preparing the financial statements. III. Provides additional information regarding the responsibilities of the auditor in conducting the audit. A) I only B) I and II C) II and III D) I and III Answer: D Terms: First paragraph of unmodified opinion audit report for a U.S. nonpublic company Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 11) Which of the following statements are true for the standard unmodified opinion audit report of a nonpublic entity for fiscal years ending on or after June 15, 2019? I. The management's responsibilities paragraph states that management is responsible for the preparation and the fair presentation of the financial statements. II. The opinion paragraph is stated as a statement of absolute fact and a guarantee by the auditor. A) I only B) II only C) I and II D) Neither I nor II Answer: A Terms: Standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 12) The auditor's responsibilities section of the standard unmodified opinion audit report states that the auditor is A) responsible for the financial statements and the opinion on them. B) responsible for the financial statements. C) exercising professional judgment throughout the audit. D) expressing an opinion on the effectiveness of internal controls. Answer: C Terms: Standard unqualified audit report for a nonpublic entity Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

13) If the balance sheet of a private company is dated December 31, 2018, the audit report is dated February 8, 2019, and both are released on February 15, 2019, this indicates that the auditor has searched for subsequent events that occurred up to A) December 31, 2018. B) January 1, 2019. C) February 8, 2019. D) February 15, 2019. Answer: C Terms: Audit report subsequent event dating Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 14) The appropriate audit report date for a standard unmodified opinion audit report for a nonpublic entity should be A) the date the financial statements are given to the Board of Directors. B) the date of the financial statements. C) the date the auditor completed the auditing procedures in the field. D) 60 days after the date of the financial statements as required by the SEC. Answer: C Terms: Standard unqualified audit report for a nonpublic entity Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 15) Most auditors believe that financial statements are "presented fairly" when the statements are in accordance with GAAP, and that it is also necessary to A) determine that they are not in violation of FASB statements. B) examine the substance of transactions and balances for possible misinformation. C) review the statements using the accounting principles promulgated by the SEC. D) assure investors that net income reported this year will be exceeded in the future. Answer: B Terms: Financial statements are presented fairly in accordance with GAAP Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking 16) An audit provides a guarantee that a material misstatement will not exist in the financial statements. Answer: FALSE Terms: Audit and reasonable assurance Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking

17) AICPA auditing standards provide uniform wording for the auditor's report to enable users of the financial statements to understand the audit report. Answer: TRUE Terms: Uniform wording for auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 18) Users of the financial statements rely on the auditor's report because of the absolute assurance the report provides. Answer: FALSE Terms: Users of financial statements rely on auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 19) The auditor's opinion paragraph of the auditor's report states that the auditor is responsible for the preparation, presentation and opinion on the financial statements. Answer: FALSE Terms: Auditor's opinion paragraph of auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 20) The audit report date is the date the auditor completed audit procedures in the field. Answer: TRUE Terms: Audit report date Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 21) The basis of opinion section of the audit report issued for financial statements of a nonpublic company should refer to auditing standards generally accepted in the United States of America. Answer: TRUE Terms: Audit reports issued for financial statements of private company; Basis for opinion paragraph; Generally accepted auditing standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

22) In the auditor's responsibilities paragraph of the audit report issued for financial statements of a nonpublic company, the auditor expresses an opinion about the internal controls of the company. Answer: FALSE Terms: Audit reports issued for financial statements of private company; Auditor's responsibilities paragraph; Generally accepted auditing standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 23) The audit report is normally addressed to the company's president or chief executive officer. Answer: FALSE Terms: Audit report normally addressed Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 24) The phrase "accounting principles generally accepted in the United States of America" can be found in the auditor's opinion paragraph of a standard unmodified opinion report. Answer: TRUE Terms: Generally accepted accounting principles; Opinion paragraph of the standard unqualified report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 25) The date of the auditor's report is indicative of the last day of the auditor's responsibility for the review of significant events occurring after the balance sheet date. Answer: TRUE Terms: Date of auditor's report indicates auditor's responsibility Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 26) The phrase "auditing standards generally accepted in the United States of America" can be found in the auditor's opinion paragraph of a standard unmodified opinion report for a nonpublic company. Answer: FALSE Terms: Auditing standards generally accepted in the United States; Opinion and basis of opinion paragraphs in standard unqualified report for public company Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking

27) The phrase "Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material error" is included in the auditor's opinion section of an audit report. Answer: FALSE Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 28) The European Union has not yet implemented requirements for mandatory audit rendering and auditor rotation despite many years of debate on this subject. Answer: FALSE Terms: Mandatory auditor rotation and audit rendering Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 29) The Auditing Standards Board (ASB) sets auditing standards in the U.S. for nonpublic entities. Answer: TRUE Terms: Setting of Auditing Standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 30) The PCAOB and the AICPA recently adopted new auditor reporting standards which are designed to make the standard audit report less informative for users. Answer: FALSE Terms: Standard Audit Report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

31) Describe the standard unmodified opinion audit report to be issued for an audit of a private company issued for fiscal years ending on or after June 15, 2019. Begin by specifying the eight parts of the report, and then discuss the contents of each part. Answer: The parts of the standard unmodified opinion audit report are as follows: • Report title. The title must include the word "independent." Examples of appropriate titles are "independent accountant's opinion," or "report of independent auditor." • Audit Report address. The report is usually addressed to the company's stockholders or the company's board of directors or the company. It should not be addressed to company management. • Auditor's Opinion section. The opinion section, which states the auditor's conclusions based upon the results of the audit, is presented first due to its importance and must include the heading "Opinion." This paragraph states that an audit was performed to distinguish the report from a compilation or review report. It also lists the financial statements that were audited, including the notes to the financial statements as well as the balance sheet dates and the accounting periods for the income statement and statement of cash flows. The wording of the financial statements in the report should be identical to the titles used by management on the financial statements. • Basis for Opinion section. The basis for opinion paragraph states the audit was conducted in accordance with auditing standards generally accepted in the United States of America and references additional responsibilities as detailed in the auditor's responsibilities section of the report. The auditor also provides an affirmative statement that they are independent of the company and that they have fulfilled their professional ethical obligations. The final sentence indicates the auditor believes that sufficient appropriate evidence has been obtained to support the auditor's opinion. • Management's Responsibility section. The report must include the heading: Responsibilities of Management and Those Charged with Governance for the Financial Statements, and a paragraph that describes management's responsibility for the financial statements. This responsibility includes selecting the appropriate accounting principles and maintaining internal control over financial reporting sufficient for preparation of financial statements that are free of material misstatements due to fraud or error. This section references management's responsibility under accounting standards to assess the ability of the company to continue as a going concern and also references the responsibility of those charged with governance (e.g., the board of directors) to oversee the financial reporting process. • Auditor's Responsibilities section. This section must include the heading "Auditor's Responsibilities for the Audit of the Financial Statements" followed by three paragraphs that describe the auditor's responsibility. The first paragraph notes that the audit is designed to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to fraud or error. The inclusion of the word material conveys that auditors are only responsible to search for significant misstatements, not minor misstatements that do not affect users' decisions. The use of the term reasonable assurance is intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the financial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee.

The second paragraph describes the scope of the audit and the evidence accumulated about the amounts and disclosures in the financial statements. This paragraph starts with the statement that the auditor exercised professional judgment and maintain professional skepticism throughout the audit in accordance with GAAS. This paragraph indicates that the procedures depend on the auditor's professional judgment and includes an assessment of the risk of material misstatements in the financial statements. It also indicates that the auditor considers internal control relevant to the preparation and fair presentation of the financial statements in designing the audit procedures performed, but this assessment of internal control is not for the purpose of and is not sufficient to express an opinion on the effectiveness of the entity's internal control. The last two bullet points of this paragraph indicate that the audit includes evaluating the appropriateness of accounting policies selected, the reasonableness of accounting estimates, the overall financial statement presentation, and the ability of the company to continue as a going concern. Finally, the third paragraph indicates the auditor communicates to those charged with governance the planned scope and timing of the audit as well as any significant findings, including significant deficiencies and material weaknesses in internal control. • Signature and Address of Audit Firm. The signature identifies the CPA firm or practitioner who performed the audit. Typically, the firm's name is used because the entire CPA firm has the legal and professional responsibility to ensure that the quality of the audit meets professional standards. The city and state of the audit firm should also be indicated. • Audit Report Date. The appropriate date for the report is the one on which the auditor completed the auditing procedures needed to obtain sufficient appropriate audit evidence. This date is important to users because it indicates the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements. Terms: Standard unqualified audit report for a nonpublic entity effective for fiscal years ending on or after June 15, 2019; eight distinct parts of the report. Terms: Standard unqualified audit report for a nonpublic entity effective for fiscal years ending on or after June 15, 2019; eight distinct parts of the report Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking 32) EPM, Inc., is a publicly listed manufacturing company with a calendar year-end. Their financial statements include a balance sheet, a statement of income, statement of cash flows, and statement of stockholders' equity. For the most recent audit, Harrington and Perry, LLP, from Denver, Colorado, audited the 2018 and 2019 financial statements. The auditors completed all significant fieldwork on March 5, 2020 and issued the audit report on March 16, 2020. Required: Consider all the facts given and write the PCAOBs new standard unmodified opinion audit report.

Answer: Audit Report Address

To the shareholders and the board of directors of EPM, Inc.

Opinion on the Financial Statements

Opinion on the Financial Statements We have audited the accompanying balance sheets of EPM, Inc. (the "Company") as of December 31, 2019 and 2018, the related statements of income, cash flows, and stockholders' equity, for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the EPM, Inc. at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with generally accepted accounting principles.

Basis for Opinion Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. We conducted our audits in accordance with auditing standards generally accepted in the United States of America (GAAS). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

Critical Audit Matters

Critical Audit Matters [if applicable] The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. [Include critical audit matters]

Signature and Address of Audit Firm

Harrington and Perry, LLP Denver, Colorado We have served as the Company's auditor since [year]. March 5, 2020

Terms: Example of PCAOB's New Standard Unqualified Audit Report - Report of Independent Registered Public Accounting Firm Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking 3.2 Learning Objective 3-2 1) What category of audit report will be issued if the auditor concludes that the financial statements are not fairly presented? A) disclaimer B) qualified C) standard unmodified opinion D) adverse Answer: D Terms: Audit reports in various situations Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking

2) The standard unmodified audit report A) is sometimes called a clean opinion. B) can be issued only with an explanatory paragraph. C) can be issued if only a balance sheet and income statement are included in the financial statements. D) is sometimes called a disclaimer report. Answer: A Terms: Conditions for standard unmodified audit report Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking 3) An audit of historical financial statements most commonly includes the A) balance sheet, statement of retained earnings, 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, balance sheet, and the statement of retained earnings. D) balance sheet, income statement, statement of cash flows, and the statement of changes in stockholders' equity. Answer: D Terms: Audit of historical financial statements Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking 4) When analyzing the various types of audit reports, A) the unmodified opinion with an emphasis-of-matter paragraph is the most common type of report. B) companies will generally make the appropriate changes to their accounting records to avoid a qualification by the auditor. C) management is more concerned about a qualified report than a disclaimer report. D) an adverse report is issued when the auditor is unable to form an opinion on the financial statements. Answer: B Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking 5) Financial statement users are normally much more concerned about a disclaimer than an unmodified opinion audit report that contains an additional emphasis-of-matter paragraph. Answer: TRUE Terms: Audit reports in various situations Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking

6) An auditor will issue a disclaimer when he or she concludes that the financial statements are not fairly presented. Answer: FALSE Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking 7) There are four conditions that must be met before an auditor can issue a standard unmodified opinion audit report for the audit of a private company. Please discuss each of these four conditions. Answer: The four conditions that justify issuing a standard unmodified report are: • All statements—balance sheet, income statement, statement of changes in stockholder's equity, and statement of cash flows—are included in the financial statements. • Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagement in a manner that enables him or her to conclude that the audit was performed in accordance with auditing standards. • The financial statements are presented fairly in all material respects in accordance with U.S. generally accepted accounting principles or other appropriate accounting framework. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. • There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report. Terms: Conditions for standard unqualified report for audit of private company Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking 3.3 Learning Objective 3-3 1) Whenever an auditor issues an audit report for a public company, the auditor can choose to issue a report in which of the following forms? I. A combined report on financial statements and internal control over financial reporting II. Separate reports on financial statements and internal control over financial reporting A) I only B) II only C) either I or II D) neither I nor II Answer: C Terms: Combined report on financial statements and internal control over financial reporting Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking

2) The unqualified opinion audit report for public entities includes which of the following sections and/or paragraphs? A) report title, address, and opinion B) basis for opinion and discussion of critical audit areas C) auditor information and date D) All of the above are included. Answer: D Terms: Standard unqualified audit report for public entities Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 3) Auditing standards for public companies are established by the A) SEC. B) FASB. C) PCAOB. D) IRS. Answer: C Terms: Audit standards for public companies; PCAOB Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 4) Under PCAOB standards, A) the standard unmodified opinion audit report is referred to as an unqualified opinion audit report. B) the scope paragraph states that the financial statements are the responsibility of management. C) internal controls of a public company must be audited every five years. D) the scope paragraph is the same as the scope paragraph for private companies. Answer: A Terms: Public Company Accounting Oversight Board Standards Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 5) The separate report on internal control over financial reporting A) cannot contain a cross-reference to the auditor's report on the financial statements. B) includes a paragraph that addresses the inherent limitations of internal controls. C) is addressed to the PCAOB. D) includes a scope paragraph which refers to the framework used to evaluate internal controls. Answer: B Terms: Separate report on internal control Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking

6) Section 404(b) of the Sarbanes Oxley Act requires that the auditor of a public company attest to management's report on the efficiency of internal controls over financial reporting. Answer: FALSE Terms: Section 404(b) of Sarbanes-Oxley Act; Internal controls over financial reporting Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 7) Auditors of public company financial statements must issue separate reports on internal control over financial reporting. Answer: FALSE Terms: Separate report on internal control Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 8) PCAOB standards use the term "unqualified opinion" to refer to the standard unmodified opinion audit report. Answer: TRUE Terms: Public Company Accounting Oversight Board Standards Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 9) If the auditor also issues a separate report on internal control over financial reporting for a public company, the additional paragraph following the opinion paragraph is included to reference the audit report on internal control. Answer: TRUE Terms: Separate report on internal control Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 10) The basis for opinion paragraph of the audit report for a public company is worded exactly the same as the basis for opinion section for a U.S. nonpublic company. Answer: FALSE Terms: Basis of opinion paragraph for public companies Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking

11) Similar to AICPA standards, the new PCAOB standard requires the auditor to disclose critical audit matters in the auditor's report. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 12) The critical audit matters section of the auditor's report notes that this communication of critical audit matters alters the auditor's opinion on the financial statements. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 13) PCAOB audit report requirements require the auditor to include the auditor's signature, tenure, city and state where the audit firm is located, as well as the audit report date. Answer: TRUE Terms: Disclosure of year in which auditor began serving the entity Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 14) The PCAOB expects that in most audits, the auditor will determine that at least one matter involved especially challenging, subjective, or complex auditor judgment. Answer: TRUE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 15) If the auditor concludes there are no critical audit matters, the auditor is not required to disclose this fact in the audit report. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking

16) The critical audit matters section of the audit report is required for audits of fiscal years ending on or after June 30, 2019 for large companies, and fiscal years ending on or after December 31, 2020 for all other audits to which these requirements apply. Answer: TRUE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 17) PCAOB auditing standards require the disclosure of the audit engagement partner's name and other accounting firms participating in the audit engagement in the audit report. Answer: FALSE Terms: Disclosure of engagement partner and other audit participants Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 18) With regards to critical audit matters as defined by the PCAOB, the auditor would likely consider what type(s) of issues that involved "especially challenging, subjective, or complex auditor judgment" matters? Name at least three specific matters. Answer: • the auditor's assessment of the risks of material misstatement, including significant risks • the degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty • the nature and timing of significant unusual transactions and the extent of audit effort and judgment related to those transactions • the degree of auditor subjectivity in applying audit procedures to address the matter or in evaluation the results of those procedures • the nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter Terms: Critical audit matters Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking

3.4 Learning Objective 3-4 1) Examples of unmodified opinions which contain modified wording (without adding an emphasis-of-matter paragraph) include A) reports involving other auditors. B) the lack of consistent application of generally accepted accounting principles. C) substantial doubt about the audited company (or the entity) continuing as a going concern. D) lack of consistent application of GAAP. Answer: A Terms: Modified unqualified opinion without adding an emphasis of matter paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 2) A CPA may wish to emphasize specific matters regarding the financial statements even though an unqualified opinion will be issued. Normally, such explanatory information is A) included in the scope paragraph. B) included in the opinion paragraph. C) included in a separate paragraph in the report. D) included in the introductory paragraph. Answer: C Terms: Unmodified opinion with emphasis on specific matters regarding the financial statements Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 3) All of the following are causes for the addition of an emphasis of a matter 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. Answer: B Terms: Unqualified opinion with addition of emphasis of matter paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking

4) The term "explanatory paragraph" was replaced in the AICPA auditing standards with A) going concern paragraph. B) emphasis-of-matter paragraph. C) departure from principles paragraph. D) consistency paragraph. Answer: B Terms: Unqualified opinion with modified wording Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 5) Which of the following are changes that affect the comparability of financial statements but not the consistency and therefore, do not have to be included in the auditor's report? A) error corrections not involving principles B) changes in accounting estimates C) variations in the format and presentation of financial information D) all of the above Answer: D Terms: Changes that affect the comparability of financial statements Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 6) Which of the following is least likely to cause uncertainty about the ability of an entity to continue as a going concern? A) The entity is suing a competitor for a minor patent infringement. B) The entity has lost a major customer. C) The entity has significant recurring operating losses. D) The entity has working capital deficiencies. Answer: A Terms: Going concern Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

7) When there is uncertainty about a company's ability to continue as a going concern, the auditor's concern is the possibility that the client may not be able to continue its operations or meet its obligations for a "reasonable period of time." For this purpose, a reasonable period of time is considered not to exceed A) six months from the date of the financial statements. B) one year from the date of the financial statements. C) six months from the date of the audit report. D) one year from the date of the audit report. Answer: B Terms: Going concern; time period Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 8) When the auditor concludes that there is substantial doubt about the entity's ability to continue as a going concern, the appropriate audit report could be I. an unmodified opinion audit report with an explanatory paragraph. II. a disclaimer of opinion. A) I only B) II only C) I or II D) Neither I nor II Answer: C Terms: Auditor concludes substantial doubt about entity's ability to continue as going concern Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 9) When a company's financial statements contain a departure from GAAP with which the auditor concurs, the departure should be explained in A) the scope paragraph. B) an introductory paragraph. C) the opinion paragraph. D) a separate paragraph. Answer: D Terms: Justified Departure Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

10) William Gregory, CPA, is the principal auditor for an international 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 of consolidated assets and revenue that they audited. Answer: C Terms: Reports involving other auditors Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 11) 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. Answer: D Terms: Consistency modifications Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 12) Which of the following modifications of the auditor's report does not include an explanatory paragraph? A) A qualified report is due to a GAAP departure. B) The report includes an emphasis of a matter. C) There is a very material scope limitation. D) A principal auditor accepts the work of another auditor. Answer: D Terms: Shared opinions Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

13) No reference is made in the auditor's report to other auditors who perform a portion of the audit when I. the other auditor audited an immaterial portion of the audit. II. the other auditor is well known or closely supervised by the principle auditor. III. the principle auditor has thoroughly reviewed the work of the other auditor. A) I and II B) I and III C) II and III D) I, II and III Answer: D Terms: Shared opinions Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 14) When an auditor is trying to determine how changes can affect consistency and/or comparability, he or she should keep in mind that A) changes that affect comparability but not consistency require an explanatory paragraph. B) items that materially affect the comparability of financial statements requires a disclaimer of opinion. C) changes that affect consistency require an explanatory paragraph if they are material. D) changes that involve either comparability or consistency only need to be mentioned in the footnotes. Answer: C Terms: Standard audit report; explanatory paragraph; consistency and comparability Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 15) All of the following would require an emphasis of matter paragraph except for A) the existence of material related party transactions. B) the lack of auditor independence. C) important events occurring subsequent to the balance sheet date. D) material uncertainties disclosed in the footnotes. Answer: B Terms: Unmodified opinion with emphasis on specific matters regarding the financial statements Difficulty: Easy Objective: LO 3-4 AACSB: Analytic thinking

16) Under AICPA auditing standards, the primary auditor issuing the opinion on the financial statements is called the A) component auditor. B) principal auditor. C) group engagement partner. D) majority auditor. Answer: C Terms: Reports involving other auditors Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 17) Which of the following is false concerning the principal CPA firm's alternatives when issuing a report when another CPA firm performs part of the audit? A) Issue a joint report signed by both CPA firms. B) Make no reference to the other CPA firm in the audit report, and issue the standard unqualified opinion. C) Make reference to the other auditor in the report by using modified wording (a shared opinion or report). D) A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor. Answer: A Terms: Shared opinions Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking 18) Which of the following requires recognition in the auditor's opinion as to consistency? A) the correction of an error in the prior year's financial statements resulting from a mathematical mistake in capitalizing interest B) a change in the estimate of provisions for warranty costs C) the change from the cost method to the equity method of accounting for investments in common stock D) a change in depreciation method which has no effect on current year's financial statements but is certain to affect future years Answer: C Terms: Consistency Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking

19) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Correction of an error by changing from Change from LIFO to FIFO an accounting principle that is not generally acceptable to one that is generally acceptable Yes Yes B) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable No C) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Yes D) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable No

Change from LIFO to FIFO

No Change from LIFO to FIFO

Yes

Answer: A Terms: Changes that require explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

20) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Change in the estimated life Variation in the format of the of an asset financial statements Yes Yes B) Change in the estimated life Variation in the format of the of an asset financial statements No No C) Change in the estimated life Variation in the format of the of an asset financial statements Yes No D) Change in the estimated life Variation in the format of the of an asset financial statements No Yes Answer: B Terms: Changes that require explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

21) Indicate which change(s) would require an explanatory paragraph in the audit report. A) The CPA concludes there is Change from FIFO to LIFO substantial doubt about the entity's ability to continue as a going concern. Yes Yes B) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. No

Change from FIFO to LIFO

C) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. Yes

Change from FIFO to LIFO

D) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. No

Change from FIFO to LIFO

Yes

Answer: A Terms: Changes that would require an explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

22) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Changes in reporting entities, Make reference to the work of such as the inclusion of an another auditor to indicate additional company in the shared responsibility in an combined financial statements unqualified opinion. Yes Yes B) Changes in reporting entities, such as the inclusion of an additional company in the combined financial statements No

Make reference to the work of another auditor to indicate shared responsibility in an unqualified opinion. No

C) Changes in reporting entities, such as the inclusion of an additional company in the combined financial statements Yes

Make reference to the work of another auditor to indicate shared responsibility in an unqualified opinion. No

D) Changes in reporting entities, such as the inclusion of an additional company in the combined financial statements No

Make reference to the work of another auditor to indicate shared responsibility in an unqualified opinion. Yes

Answer: C Terms: Changes that would require an explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 23) When there is a lack of consistent application in accounting principles, A) the nature and impact of the change should be adequately disclosed. B) the auditor should discuss the nature of the change and point the reader to the footnote that discusses the change. C) the materiality of the change is evaluated based on the current year effect of the change. D) all of the above. Answer: D Terms: Lack of consistent application of GAAP; auditing standards Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 29 Copyright © 2020 Pearson Education, Inc.

24) Under PCOAB auditing standards, the primary auditor issuing the opinion on the financial statements is called the A) component auditor. B) principal auditor. C) group engagement partner. D) majority auditor. Answer: B Terms: Reports involving other auditors Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 25) An unmodified opinion audit report with an emphasis-of-matter paragraph is issued when the auditor believes the financials are fairly stated but also believes additional information should be provided. Answer: TRUE Terms: Modified unqualified audit report Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 26) Changes in accounting estimates requires the auditor to issue a modified audit report with a consistency paragraph inserted after the opinion paragraph. Answer: FALSE Terms: Changes of accounting estimates; Modified unqualified audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 27) The only unmodified opinion audit report that does not include an explanatory paragraph is when other auditors are involved. In this case only the introductory paragraph is modified. Answer: FALSE Terms: Modified unqualified opinion Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 28) Items that materially affect the comparability of the financial statements generally require disclosure in the footnotes. Answer: TRUE Terms: Items that materially affect comparability of financial statements Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

29) Changes in an estimate, such as a change in the estimated useful life of an asset for depreciation purposes, affect consistency but not comparability, and therefore require an explanatory paragraph in the audit report. Answer: FALSE Terms: Comparability and consistency Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 30) Changes in reporting entities, such as the inclusion of an additional company in combined financial statements, affect comparability but not consistency, and therefore do not require an explanatory paragraph in the audit report. Answer: FALSE Terms: Comparability and consistency Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking 31) When an auditor relies upon a different CPA firm to perform part of the audit and chooses to issue a shared opinion, only the auditor's responsibility paragraph should be modified. Answer: FALSE Terms: Auditor reliance on different CPA firm to perform part of audit; Shared opinion Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 32) When other auditors are involved in the audit and they qualify their portion of the audit, the principal auditor must decide if the amount in question is material to the financial statements as a whole. Answer: TRUE Terms: Shared responsibility Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking 33) The unmodified opinion audit report with emphasis-of-matter paragraph does not meet the criteria of a complete audit with satisfactory results. Answer: FALSE Terms: Unmodified opinion audit report with emphasis-of-matter-explanatory paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking

34) When there is a lack of consistent application of GAAP due to a new accounting pronouncement, no explanatory paragraph is required. Answer: FALSE Terms: Lack of consistent application of GAAP; auditing standards Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 35) Discuss each of the five circumstances when an auditor would issue an unmodified opinion audit report with an emphasis-of-matter paragraph or nonstandard report wording. Answer: An unmodified opinion audit report with an emphasis-of-matter paragraph or nonstandard report wordings appropriate in the following circumstances: • Lack of consistent application of GAAP. When the client has not followed generally accepted accounting principles consistently in the current period in relation to the preceding period, an unmodified opinion audit report with an explanatory paragraph following the opinion paragraph is appropriate. • Substantial doubt about continuing as a going concern. When an auditor concludes there is substantial doubt about the client's ability to continue as a going concern, an unmodified opinion audit report with an explanatory paragraph following the opinion paragraph is appropriate. The auditor also has the option of issuing a disclaimer of opinion. • A departure from GAAP with which the auditor concurs. If adherence to GAAP would result in misleading financial statements, an unmodified opinion audit report with an explanatory paragraph is appropriate. • Emphasis of a matter. If the auditor wants to emphasize specific matters in the audit report, an explanatory paragraph discussing those matters may be added to an unmodified report. • Reports involving other auditors. When an auditor relies upon a different CPA firm to perform part of the audit, the auditor can indicate that responsibility for the audit is shared with another CPA firm by modifying the wording of an unmodified report. Terms: Circumstances where an auditor will issue modified unqualified report with explanatory paragraph or modified wording Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

3.5 Learning Objective 3-5 1) As a result of management's refusal to permit the auditor to physically examine inventory, the auditor must depart from the unmodified opinion audit report because A) the financial statements have not been prepared in accordance with GAAP. B) the scope of the audit has been restricted by circumstances beyond either the client's or auditor's control. C) the financial statements have not been audited in accordance with GAAS. D) the scope of the audit has been restricted. Answer: D Terms: Auditor must depart from unmodified opinion audit report; Management refusal to permit the auditor to physically examine inventory Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking 2) An adverse opinion is issued when the auditor believes A) some parts of the financial statements are materially misstated or misleading. B) the financial statements would be found to be materially misstated if an investigation were performed. C) the auditor is not independent. D) the overall financial statements are so materially misstated that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP. Answer: D Terms: Adverse opinion Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking

3) An auditor can express a qualified opinion due to a A) Departure from Lack of Consistency Lack of Sufficient GAAP Evidence Yes No No B) Departure from GAAP No

Lack of Consistency

Departure from GAAP Yes

Lack of Consistency

Departure from GAAP Yes

Lack of Consistency

Yes

Lack of Sufficient Evidence No

C) No

Lack of Sufficient Evidence Yes

D) Yes

Lack of Sufficient Evidence Yes

Answer: C Terms: Qualified opinion Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking

4) An auditor determines the financial statements include at least a material departure from GAAP. Which type of opinion may be issued? A) Disclaimer Qualified Adverse Yes No No B) Disclaimer No

Qualified Yes

Adverse No

Disclaimer Yes

Qualified No

Adverse Yes

Disclaimer No

Qualified Yes

Adverse Yes

Answer: D Terms: Opinion, GAAP departure Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 5) A qualified opinion can be issued for which of the following? I. When a limitation on the scope of the audit has occurred II. When the auditor lacks independence III. When generally accepted accounting principles have not been used A) I and II B) I and III C) II and III D) I, II and III Answer: B Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

6) In which situation would the auditor be choosing between "except for" qualified opinion and an adverse opinion? A) The auditor lacks independence. B) A client-imposed scope limitation C) A circumstance-imposed scope limitation D) Lack of full disclosure within the footnotes Answer: D Terms: Qualified opinion and adverse opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 7) When the auditor determines that the financial statements are fairly stated, but there is a nonindependent relationship between the auditor and the client, the auditor should issue A) an adverse opinion. B) a disclaimer of opinion. C) either a qualified opinion or an adverse opinion. D) either a qualified opinion or an unqualified opinion with modified wording. Answer: B Terms: Audit report when auditor not independent Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 8) If the auditor lacks independence, a disclaimer of opinion must be issued A) if the client requests it. B) only if it is highly material. C) only if it is material but not pervasive. D) in all cases. Answer: D Terms: Disclaimer when auditor lacks independence Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 9) If the phrase "except for" is present in the opinion paragraph of the audit report, the auditor has issued a(n) A) adverse opinion. B) disclaimer of opinion. C) unqualified opinion. D) qualified opinion. Answer: D Terms: Departure from unqualified audit report Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 36 Copyright © 2020 Pearson Education, Inc.

10) When analyzing the various types of opinions that the auditor can issue, A) an adverse opinion must contain the phrase "except for" in the opinion paragraph. B) an adverse opinion can only be issued when there is a lack of knowledge by the auditor. C) a disclaimer of opinion can be issued for material or immaterial misstatements. D) a qualified opinion report can be used only when the auditor concludes that the overall financial statements are fairly stated. Answer: D Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 11) Items that materially affect the comparability of financial statements generally require disclosure in the footnotes. If the client refuses to properly disclose the item, the auditor will most likely issue A) a disclaimer. B) an unqualified opinion. C) a qualified opinion. D) an adverse opinion. Answer: C Terms: Disclosure and comparability Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 12) Which of the following scenarios does not result in a qualified opinion? A) A scope limitation prevents the auditor from completing an important audit procedure. B) Circumstances exist that prevent the auditor from conducting a complete audit. C) The auditor lacks independence with respect to the audited entity. D) An accounting principle at variance with GAAP is used. Answer: C Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

13) Whenever the client imposes restrictions on the scope of the audit, the auditor should be concerned that management may be trying to prevent discovery of misstatements. In such cases, the auditor will likely issue a A) disclaimer of opinion in all cases. B) qualification of both scope and opinion in all cases. C) disclaimer of opinion whenever materiality is in question. D) qualification of both scope and opinion whenever materiality is in question. Answer: C Terms: Client imposed restrictions on scope of audit Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 14) In which of the following circumstances would an auditor most likely express an adverse opinion? A) The CEO refuses to let the auditor have access to the board of director meeting minutes. B) The financial statements are not in conformity with the FASB statement on loss contingencies. C) Information comes to the auditor's attention that raises substantial doubt about the ability for the client to continue as a going concern. D) Tests of controls show that the internal control structure is so poor that the auditor has to assess control risk at the maximum. Answer: B Terms: Adverse opinion circumstances Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 15) Which of the following statements is true? I. The auditor is required to issue a disclaimer of opinion in the event of a material uncertainty. II. The auditor is required to issue a disclaimer of opinion in the event of a going concern problem. A) I only B) II only C) I and II D) Neither I nor II Answer: D Terms: Disclaimer of opinion Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking

16) The most common case in which conditions beyond the client's and auditor's control cause a scope restriction in an engagement is when the A) auditor is not appointed until after the client's year-end. B) client won't allow the auditor to confirm receivables for fear of offending its customers. C) auditor doesn't have enough staff to satisfactorily audit all of the client's foreign subsidiaries. D) client is going through Chapter 11 bankruptcy. Answer: A Terms: Scope restriction beyond client and auditor control Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 17) When the client fails to make adequate disclosure in the body of the statements or in the related footnotes, it is the responsibility of the auditor to A) inform the reader that disclosure is not adequate, and to issue an adverse opinion. B) inform the reader that disclosure is not adequate, and to issue a qualified opinion. C) present the information in the audit report and issue an unqualified or qualified opinion. D) present the information in the audit report and to issue a qualified or an adverse opinion. Answer: D Terms: Inadequate disclosure Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 18) A qualified opinion audit report is issued when all auditing conditions have been met, no significant misstatements have been discovered, and it is the auditor's opinion that the financial statements are fairly stated in accordance with GAAP. Answer: FALSE Terms: Qualified opinion audit report Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking 19) Auditors should issue a disclaimer of opinion when there is a highly material client-imposed scope restriction. Answer: TRUE Terms: Disclaimer of opinion; Client-imposed scope restriction Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

20) Whenever an auditor issues a qualified report, he or she must use the term "except for " in the opinion paragraph. Answer: TRUE Terms: Qualified report; Except for in opinion paragraph Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 21) A qualified report can take the form of a qualification of both the scope and the opinion or of the opinion alone. Answer: TRUE Terms: Qualified report; Scope limitation Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 22) When an auditor discovers a highly material GAAP violation in the financial statements and the client refuses to correct it, the auditor should issue a disclaimer of opinion. Answer: FALSE Terms: Disclaimer of opinion; Highly material GAAP violation in the financial statements and client refuses to correct it Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 23) Client imposed restrictions on the audit always require a disclaimer of opinion. Answer: FALSE Terms: Disclaimer of opinion; Client-imposed restrictions on audit Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 24) An auditor should issue a qualified opinion with an explanatory paragraph whenever there is a material uncertainty affecting the financial statements. Answer: FALSE Terms: Qualified opinion with explanatory paragraph Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

25) There are three conditions necessitating a departure from an unqualified audit report. Name, discuss and state the appropriate audit report for each of these three conditions. Answer: The three conditions requiring a departure from an unqualified report are: • Scope Restrictions. A scope restriction can be imposed by the client or due to circumstances beyond the auditor's or client's control. In either case the scope restriction prevents the auditor from accumulating sufficient evidence to reach a conclusion regarding whether financial statements are stated in accordance with GAAP. The type of opinion, depending upon materiality, would be either a qualified or a disclaimer of opinion report. • GAAP Departures. In this situation the financial statements are not prepared in accordance with GAAP. Accordingly, 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. • Auditor lacks independence. Independence is ordinarily determined by the AICPA Code of Professional Conduct. When the auditor is not independent, the only report the auditor can issue is a disclaimer of opinion. Terms: Conditions necessitating a departure from an unqualified audit report Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 3.6 Learning Objective 3-6 1) A misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of A) the PCAOB. B) a reasonable user of the financial statements. C) an accountant. D) the SEC. Answer: B Terms: Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 2) Misstatements must be compared with some measurement base before a decision can be made about materiality. A commonly accepted measurement base includes A) net income. B) total assets. C) working capital. D) all of the above. Answer: D Terms: Misstatements and materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

3) When comparing misstatements with a measurement base, the auditor must consider the pervasiveness of the misstatement. Of the following examples, the most pervasive misstatement is a(n) A) understatement of inventory. B) understatement of retained earnings caused by a miscalculation of dividends payable. C) misclassification of notes payable as a long-term liability when it should be current. D) misclassification of salary expense as a selling expense. Answer: A Terms: Pervasive misstatements Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 4) 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. Answer: B Terms: Misstatements accurately measured Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 5) If most or all users' decisions that are based on the financial statements are likely to be significantly affected, the materiality level is A) unrestricted. B) material. C) pervasive. D) risky. Answer: C Terms: Materiality qualifications Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

6) When a client fails to follow GAAP, the audit report can be unmodified, qualified, or adverse depending on the materiality. What factors affect materiality that an auditor should consider? A) the dollar amount in comparison to a base B) if the misstatement can be measured C) the nature of the item D) All the above are factors an auditor should consider regarding materiality. Answer: D Terms: Client fails to follow GAAP; Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 7) Which of the following is a correct statement regarding materiality? A) There are well-defined guidelines that enable auditors to determine if something is material. B) Misstatements must be compared with some benchmark before a decision can be made about the materiality level of the failure of a company to follow GAAP. C) Pervasiveness is not considered when comparing potential misstatements with a base or benchmark. D) To evaluate overall materiality, the auditor does not combine all unadjusted misstatements. Answer: B Terms: Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 8) Management has recorded prepaid insurance as an asset in the previous year. This year, to reduce record-keeping costs, it expenses insurance. If the amount is immaterial to the financial statements, A) a disclaimer opinion is issued. B) a qualified opinion is issued. C) a standard unmodified opinion audit report is issued. D) no audit report can be issued. Answer: C Terms: Standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

9) The highest level of materiality exists when A) users are likely to make incorrect decisions if they rely on the overall financial statements. B) there has been a departure from GAAP. C) amounts are material but do not overshadow the financial statements as a whole. D) a scope limitation has been imposed. Answer: A Terms: Materiality levels Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 10) Materiality is essential when an auditor considers his/her determination of the appropriate report for a given set of circumstances. Answer: TRUE Terms: Materiality; Appropriate report Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking 11) A pervasive exception is one that affects different parts of the financial statements. Answer: TRUE Terms: Pervasive exception Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking 12) An item with a "psychological" effect (e.g., where the item maintains an increasing earnings trend) is a qualitative factor that may affect the auditor's decision regarding materiality. Answer: TRUE Terms: Psychological effect; Materiality Difficulty: Challenging Objective: LO 3-6 AACSB: Reflective thinking 13) As misstatements become more pervasive, the likelihood of issuing a disclaimer rather than a qualified opinion increases. Answer: FALSE Terms: Materiality level and type of opinion Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

14) It is typically more difficult to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. Answer: TRUE Terms: Materiality level and type of opinion Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 15) Discuss how materiality affects audit reporting decisions. Answer: When determining the appropriate audit report to issue, the auditor considers three levels of materiality for a given condition. These three levels are (1) immaterial, (2) material without overshadowing the financial statements as a whole, and (3) so material and so pervasive that overall fairness of the statements is in question. For conditions involving a GAAP violation, the materiality level of the violation influences whether an unmodified, qualified, or adverse opinion is issued. For conditions involving a scope restriction, the materiality of the restriction influences whether a standard unmodified opinion report, a report with a qualified scope and opinion, or a disclaimer report is issued. Terms: Materiality effect on audit reporting decisions Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking 3.7 Learning Objective 3-7 1) A restriction on the scope of the auditor's examination requires A) a qualifying paragraph to be included in the introduction. B) a qualifying paragraph preceding the opinion paragraph. C) a disclaimer opinion. D) a basis for a qualified opinion paragraph. Answer: B Terms: Scope limitation and type of audit report Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

2) An auditor who issues a qualified opinion because sufficient appropriate evidence was not obtained should describe the limitations in an explanatory paragraph. The auditor should also modify the A) Scope paragraph Opinion paragraph Notes to the financial statements Yes No Yes B) Scope paragraph No C) Scope paragraph No D) Scope paragraph Yes

Opinion paragraph Notes to the financial statements Yes Yes Opinion paragraph Notes to the financial statements Yes No Opinion paragraph Notes to the financial statements Yes No

Answer: D Terms: Qualified opinion insufficient evidence Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking

3) When an auditor issues a qualified report due to a scope limitation an explanatory paragraph is normally added. Which, if any, of the following paragraphs are also modified? A) Introductory Scope Opinion Yes Yes Yes B) Introductory Yes

Scope Yes

Opinion No

Introductory No

Scope Yes

Opinion No

Introductory No

Scope Yes

Opinion Yes

Answer: D Terms: Qualified report due to scope restriction; Paragraphs modified Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 4) 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. Answer: B Terms: Qualified or adverse opinion paragraph placement Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 5) When the client fails to include information that is necessary for the fair presentation of financial statements in the body of the statements or in the footnotes, A) it is the auditor's responsibility to present the information in the audit report. B) the auditor should issue a qualified or an adverse opinion. C) the qualification is put in an added paragraph preceding the opinion. D) all of the above. Answer: D Terms: Type of audit opinion when statements are not in conformity with GAAP Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 47 Copyright © 2020 Pearson Education, Inc.

6) If the financial statements include an income statement and a balance sheet but exclude the statement of cash flows, the auditors A) can issue an unqualified report. B) should issue a qualified opinion due to the departure from GAAP. C) should issue a qualified opinion because the missing statement of cash flows constitutes a scope limitation. D) should include the statement of cash flows, modify the report, and issue an unqualified opinion. Answer: B Terms: Report when financial statements exclude statement of cash flows Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 7) Which of the following is incorrect concerning scope limitations? A) If client imposed, the auditor should be concerned about the client trying to prevent discovery of a material misstatement. B) An unqualified opinion can result if auditors can perform alternative procedures and are satisfied that the information is fairly stated. C) The most common circumstance-imposed scope restriction is due to the client changing their auditors. D) The most common circumstance-imposed scope limitation is when the auditor is appointed after the balance sheet date. Answer: C Terms: Scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 8) When dealing with materiality and scope limitation conditions, A) a disclaimer of opinion must be issued. B) it is easier to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. C) scope limitations imposed by the client are always considered material. D) an unqualified opinion may still be issued depending on the materiality of the scope limitation. Answer: D Terms: Scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

9) When a pervasive scope limitation exists, A) a disclaimer of opinion rather than a qualified opinion is generally required. B) the auditor's responsibility paragraph is modified to indicate that the auditor was not able to obtain sufficient appropriate evidence to express an audit opinion. C) sections of the auditor's responsibility paragraph are eliminated to avoid stating anything that might lead readers to believe that other parts of the financial statements might be fairly stated. D) all of the above. Answer: D Terms: Pervasive scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 10) When there is a scope restriction, what type of audit report can be issued? A) unmodified opinion B) qualification of scope and opinion C) disclaimer of opinion D) any of the above Answer: D Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 11) Subsequent to the close of Spacely Sprockets fiscal year ending October 31, 2019, a major debtor has declared bankruptcy due to a series of events. The receivable is significantly material in relation to the financial statements, and recovery is doubtful. The debtor had confirmed the full amount due to Spacely Sprocket at the balance sheet date. Because the account was confirmed at the balance sheet date, Spacely refuses to disclose any information in relation to this subsequent event. The CPA believes that all other accounts were stated fairly at the balance sheet date. In addition, Spacely changed their method of inventory valuation from FIFO to LIFO. This change was disclosed in Note X to the financial statements. Accordingly, what type of opinion should be expressed? A) unqualified with an explanatory paragraph B) qualified due to a GAAP departure C) qualified due to a scope limitation D) a combination of B and C Answer: B Terms: Audit report when client has subsequent event and change in inventory valuation Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking

12) For the report containing a disclaimer for lack of independence, the disclaimer is in the A) second or scope paragraph. B) third or opinion paragraph. C) first and only paragraph. D) fourth or explanatory paragraph. Answer: C Terms: Disclaimer in which report paragraph Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 13) When an adverse opinion is issued, a scope paragraph would be A) qualified. B) unchanged. C) deleted. D) expanded to identify the additional procedures which the auditor performed. Answer: B Terms: Adverse opinion and scope paragraph Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 14) After the balance sheet date but prior to issuance of the auditor's report the auditor learns that the client's facility in a foreign country has been expropriated. Management refuses to disclose this information in a financial statement footnote or present pro-forma data as to the effect of the event. The auditor should A) add a footnote to the financial statements. B) disclaim an opinion due to the client-imposed scope limitation. C) provide the information in the report and modify the opinion. D) issue an unqualified opinion but provide the information in the auditor report. Answer: C Terms: Material subsequent event management refusal to disclose Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 15) Financial statement users are typically more concerned with an unmodified report with explanatory paragraphs than they are with a disclaimer of opinion. Answer: FALSE Terms: Financial statement users; Unqualified report with explanatory paragraphs; Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

16) A lack of independence will override any other scope limitations and requires a disclaimer of opinion. Answer: TRUE Terms: Lack of independence; Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 17) When a qualified opinion is issued, an explanatory paragraph is added immediately after the opinion paragraph to explain the nature of the qualification that affects the opinion. Answer: FALSE Terms: Qualified opinion explanatory paragraph and opinion paragraph Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 18) In the case of a disclaimer due to lack of independence, the entire scope paragraph is excluded from the report. Answer: TRUE Terms: Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

19) The following is a portion of an adverse audit report issued for a public company. (Note: A separate report was issued on the effectiveness of internal control over financial reporting.) Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Wallace Corporation We have audited the accompanying balance sheet of Wallace Corporation as of December 31, 2019, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. The company has excluded from property and debt in the accompanying balance sheet certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $14,500,000, long-term debt by $13,200,000, and retained earnings by $1,300,000 as of December 31, 2019, and net income and earnings per share would be increased by $1,300,000 and $2.25, respectively, for the year then ended. Required: Complete the above adverse audit report by preparing the opinion paragraph. Do not date or sign the report. Answer: In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the financial statements referred to above do not present fairly the financial position of Wallace Corporation as of December 31, 2019, or the results of its operations and its cash flows for the year then ended. Terms: Adverse audit report Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

20) The following is the introductory paragraph, and the Basis for Qualified Opinion paragraph for Fast Times Corporation, a nonpublic company. Independent Auditor's Report To the shareholders and the board of directors of Fast Times Corporation We have audited the accompanying balance sheet of Fast Times Corporation as of September 30, 2019, and the related statements of income, retained earnings, and cash flows for the year then ended, and the related notes to the financial statements. Basis for Qualified Opinion We were unable to obtain audited financial statements supporting the company's investment in a foreign affiliate stated at $1,040,000, or its equity in earnings of that affiliate of $501,000, which is included in net income, as described in Note 14 to the financial statements. Because of the nature of the company's records, we were unable to satisfy ourselves as to the carrying value of the investment or the equity in its earnings by means of other auditing procedures. Required: Prepare the opinion paragraph for the above audit report. Do not date or sign the report. Answer: In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Fast Times Corporation as of September 30, 2019, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Terms: Qualified scope and opinion report Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking 21) Your CPA firm has completed the fieldwork for the 2019 audit of Sharp Corporation, a private company with an October year-end. You were preparing to draft a standard, unqualified audit report when you discovered that the audit manager on the Sharp engagement owns 10 shares of Sharp's common stock. Prepare the appropriate report. Answer: We are not independent with respect to Sharp Corporation, and the accompanying balance sheet as of October 31, 2019, and the related statements of income, retained earnings, and cash flows for the year then ended were not audited by us. Accordingly, we do not express an opinion on them. Note: There is no report title when the auditor issues a disclaimer due to a lack of independence. Terms: Audit report with lack of independence Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 53 Copyright © 2020 Pearson Education, Inc.

22) Assume you are the partner in charge of the 2019 audit of Becker Corporation, a private company. The audit report has not yet been prepared. In each independent situation following (1-8), indicate the appropriate action (a-g) to be taken. The possible actions are as follows: a. Issue an unmodified opinion audit report. b. Qualify both the scope and opinion paragraphs. c. Qualify the opinion paragraph. d. Issue an unmodified opinion with an explanatory paragraph. e. Issue an unmodified opinion with revised wording (no explanatory paragraph). f. Issue an adverse opinion. g. Disclaim an opinion. The situations are as follows: ________ 1. Becker Corporation carries its property, plant, and equipment accounts at current market values. Current market values exceed historical cost by a highly material amount, and the effects are pervasive throughout the financial statements. ________ 2. Management of Becker Corporation refuses to allow you to observe, or make, any counts of inventory. The recorded book value of inventory is highly material. ________ 3. You were unable to confirm accounts receivable with Becker's customers. However, because of detailed sales and cash receipts records, you were able to perform reliable alternative audit procedures. ________ 4. One week before the end of fieldwork, you discover that the audit manager on the Becker engagement owns a material amount of Becker's common stock. ________ 5. You relied upon another CPA firm to perform part of the audit. Although you were the principal auditor, the other firm audited a material portion of the financial statements. You wish to refer to (but not name) the other firm in your report. ________ 6. You have substantial doubt about Becker's ability to continue as a going concern. ________ 7. Becker Corporation changed its method of computing depreciation in 2019. You concur with the change and the change is properly disclosed in the financial statement footnotes. ________ 8. Ten days after the balance sheet date, one of Becker's buildings was destroyed by a fire. Becker refuses to disclose this information in a footnote to the financial statements, but you believe disclosure is required to conform with GAAP. The amount of the uninsured loss was material, but not highly material. Answer: 1. f, 2. g, 3. a, 4. g, 5. e, 6. d or g, 7. d, 8. c Terms: Audit reports in various situations Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking 54 Copyright © 2020 Pearson Education, Inc.

23) Smith and Jones, CPAs, audited the consolidated financial statements of Concord Inc. and all but one of its subsidiaries for the year ended September 30, 2019 and are expressing an unqualified opinion on the financials presented as a whole. Smith, the engagement partner, instructed Mary, an assistant on the engagement, to draft the auditor's report on November 4, 2019, the date of fieldwork completion. In drafting the report, Mary considered the following: • In preparing its financial statements, Concord changed its method of accounting for research and development costs and properly expensed these amounts. Management described the change in principle in Note 10 to the consolidated financial statements. • Ball & Brown, CPAs, audited the financial statements of Biotherm, Inc., a consolidated subsidiary of Concord for the year ended September 30, 2019. The subsidiary's financial statements reflect total assets of 22% and total revenues of 20% of the consolidated totals. Ball & Brown expressed an unqualified opinion and furnished to Smith & Jones a copy of their auditor report. Smith & Jones have decided not to assume responsibility for the work of Ball & Brown insofar as it relates to the expression of an opinion on the consolidated financial statements taken as a whole because of the materiality of Biotherm's financial statements to the consolidated whole. Ball & Brown's report will not be presented together with that of Smith & Jones. • Concord is the subject of a grand jury investigation into possible violations of federal antitrust laws and possible related crimes. Related civil class actions are pending. Concord's management has adequately disclosed in Note 12 to their consolidated financial statements. Because of the early stage of the investigation, the ultimate outcome of these matters cannot be determined at this time. Therefore, no provision for any liability that may result has been recorded. • Concord experienced a net loss in 2019 and is currently in default under substantially all of its debt agreements. Management's plans in regard to these matters are adequately disclosed in Note 14 to Concord's consolidated financial statements. The financials do not include any adjustments that might result from the outcome of this uncertainty. These matters raise substantial doubt about Concord's ability to continue as a going concern.

Ball reviewed Mary's draft and indicated in his review notes that there were many deficiencies in Mary's Draft. The audit report that Mary drafted follows. Independent Auditor's Report We have audited the consolidated financial statements of Concord, Inc., and subsidiaries as of September 30, 2019, and the related consolidated statements of income, changes in stockholder's equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Biotherm, Inc., a wholly-owned subsidiary, which statements reflect total assets and revenues constituting 22% and 20% respectively at September 30, 2019 of the consolidated totals. Those statements were audited by Ball & Brown, CPAs, whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included for Biotherm, Inc. is based solely on their report. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used, as well as assessing control risk. We believe our audits provide a reasonable basis for our opinion. In our opinion, based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Concord Inc., as of September 30, 2019 in conformity with generally accepted accounting principles, except for the uncertainty, which is discussed in Note 12 to the consolidated financials. The accompanying consolidated financial statements have been prepared assuming that the Company will continue in existence for a reasonable period of time. As discussed in Note 14 to the consolidated financial statements, the Company suffered a net loss and is currently in default under substantially all of its debt agreements. Management's plans in regard to these matters are also described in Note 14. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Smith & Jones, CPAs November 4, 2019

Required: The following items present some of the deficiencies in the drafted audit report noted by Smith. For each deficiency, indicate whether: S. Smith's review note is correct M. Mary's draft is correct B. Both Smith's review note and Mary's draft are incorrect Smith's Review Notes 1. An explanatory paragraph is required between the scope and opinion paragraphs for the change in accounting principles referring the reader to Note 10. 2. The names of the other auditors do not need to be explicitly stated in the introductory paragraph. Only that "other auditors" performed the audit and provided their report. 3. The opinion paragraph should extend the auditor's opinion beyond financial position to include the results of Concord's operations and flows. 4. The reference to the uncertainty in the opinion paragraph is incomplete. It should describe the nature of the uncertainty as pertaining to the grand jury investigation into possible violations of federal antitrust laws. 5. The explanatory paragraph following the opinion paragraph does not include the terms "substantial doubt" and "going concern". These terms are required to be used in this paragraph. The explanatory paragraph following the opinion paragraph includes an inappropriate statement that "the consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty." This statement is misleading and should be omitted. Answer: 1. B 2. S 3. S 4. B 5. S 6. M Terms: Deficiencies in audit reports Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

24) In auditing the long-term investments account, Arens, CPA, is unable to obtain audited financial statements for an investee located in a foreign country. Levine concludes sufficient appropriate audit evidence regarding this investment cannot be obtained. For each of the following situations below, identify the appropriate opinion type and report modification by selecting a choice from the appropriate tables below. Situation 1. Assume the potential effect on the financial statements is immaterial. 2. Assume the potential effect on the financial statements is moderate. 3. Assume the potential effect on the financial statements is high. Opinion Type U Unmodified Q Qualified A Adverse D Disclaimer

Opinion Type

Intro

Scope Opinion Exp1

Standard Paragraph Choice Explanatory Paragraph O Omit 0 None required N No change + Insert before opinion M Modify - Insert after opinion

Answer: Situation 1. Assume the potential effect on the financial statements is immaterial. 2. Assume the potential effect on the financial statements is moderate. 3. Assume the potential effect on the financial statements is high.

Opinion Type

Intro

Scope Opinion Exp1

Terms: Circumstances and required audit reports Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

25) Audit situations 1 through 10 present various independent factual situations an auditor might encounter in conducting an audit. List A represents the types of opinions the auditor ordinarily would issue, and List B represents the report modifications (if any) that would be necessary. For each situation, select one response from List A and one from List B. Select, as the best answer for each item, the action the auditor normally would take. Items from either list may be selected once, more than once, or not at all. Assume the following: • The auditor is independent • The auditor previously expressed an unmodified opinion on the prior-year financial statements unless otherwise noted • Only single-year (not comparative) statements are presented for the current year (unless otherwise stated) • The conditions for an unmodified opinion exist unless contradicted in the factual scenario • The conditions stated in the factual scenario are material • No report modifications are to be made except in response to the factual scenario Factual Scenario 1. The financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with GAAP. 2. In auditing the Long-Term Investments account, an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditor concludes that sufficient competent evidential matter regarding this investment cannot be obtained but it is not pervasive to the financials as a whole. 3. Due to recurring operating losses and working capital deficiencies the auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. However, the financial statement disclosures are adequate. 4. The principal auditor decides to refer to the work of another auditor, who audited a wholly owned subsidiary of the entity and issued an unqualified opinion. 5. An entity issues financial statements that present financial position and results of operations but omits the related statement of cash flows. Management discloses in the notes to the financial statements that it does not believe the statement of cash flows to be useful. 6. An entity changes its depreciation method for production equipment from straight-line to units of production based on hours of utilization. The auditor concurs with the change, although it has a material effect on the comparability of the entity's financial statements. 7. An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, management cannot reasonably estimate the ultimate outcome of the litigation. The auditor believes that there is a reasonable possibility of a significant material loss, but the lawsuit is adequately disclosed in the notes to the financial statements. 8. An entity discloses certain lease obligations in the notes to the financial statements. The auditor believes that the failure to capitalize these leases is a departure from GAAP. 9. The entity wishes to show comparative financial statements and include the prior year. However, the prior year financial statements contained a qualification due to an inappropriate method of GAAP. Accordingly, management corrected the prior year GAAP deficiency and included the updated numbers in the comparative financials for the current year.

10. The entity wishes to show comparative financial statements and include the prior year. However, the prior year financial statements were audited by another auditor who refuses to reissue his opinion. List A Opinion Choices

A Qualified B Unmodified

C Adverse

D Disclaimer

E Either Qualified or Adverse

F Either Disclaimer or Adverse G Either Qualified or Disclaimer

List B Report Modification Choices H Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph w/o modifying the three standard paragraphs. I Describe the circumstances in the opinion paragraph w/o adding an emphasis-of-matter paragraph. J Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph and modify the opinion paragraph. K Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the opinion paragraph. L Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph and modify the scope & opinion paragraph. M Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the scope & opinion paragraph. N Describe the circumstances in the scope paragraph w/o adding an emphasis-of-matter paragraph. O Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph w/o modifying the three standard paragraphs. P Describe the circumstances in the introductory paragraph w/o adding an emphasis-of-matter paragraph. Q Describe the circumstances in the introductory paragraph w/o adding an emphasis-of-matter paragraph, and modify the scope & opinion paragraphs. R Issue the standard auditor's report w/o modification. S None of the above.

Answer: 1. B, R 2. A, L 3. B, I 4. B, Q 5. A, J 6. B, I 7. B, R 8. E, J 9. B, H 10. B, R Terms: Audit situations and required reports with modifications Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking 3.8 Learning Objective 3-8 1) When accounting principles are not consistently applied, and the materiality level is immaterial, the auditor will issue a(n) A) standard unmodified opinion. B) unmodified opinion with an explanatory paragraph. C) adverse opinion. D) disclaimer opinion. Answer: A Terms: Audit report and different levels of materiality Difficulty: Moderate Objective: LO 3-8 AACSB: Analytic thinking 2) The first step to be followed when deciding the appropriate audit report in a given set of circumstances is to A) decide the appropriate type of report for the condition. B) write the report. C) determine whether any conditions exist requiring a departure from a standard unmodified opinion audit report. D) decide the materiality for each condition. Answer: C Terms: Auditor's decision process for audit reports Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

3) In most audits, the auditor issues a(n) A) modified opinion audit report. B) standard unmodified opinion audit report. C) scope limited audit report. D) adverse audit report. Answer: B Terms: Standard unmodified opinion audit report Difficulty: Challenging Objective: LO 3-8 AACSB: Reflective thinking 4) More than one modification should be included in the audit report when A) the auditor is not independent and the auditor knows that the company has not followed generally accepted accounting principles. B) there is substantial doubt about the going concern of the company and information about the causes of the uncertainties is not adequately disclosed in the footnotes. C) there is a scope limitation and there is substantial doubt about the company's ability to continue as a going concern. D) all of the above. Answer: D Terms: Standard report; More than one condition requiring a departure or modification Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 5) When there is a justified departure from GAAP which is considered material, the auditor should issue a(n) A) standard unmodified opinion. B) disclaimer of opinion. C) unmodified opinion with an explanatory paragraph. D) adverse opinion. Answer: C Terms: Audit report and different levels of materiality Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

6) If there is a deviation in the statements' preparation in accordance with GAAP and another accounting principle was applied on a basis that was not consistent with that of the preceding year, A) the auditor must choose which modification to include in the audit report. B) only the most material modification can be disclosed. C) more than one modification should be included in the report. D) none of the above. Answer: C Terms: Standard report; More than one condition requiring a departure or modification Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 7) After the auditor determines whether any conditions exist which require a departure from a standard unmodified opinion audit report, the next step in the decision process is to A) write the report. B) decide the materiality for each condition. C) decide the appropriate type of report for the condition. D) discuss the report with management. Answer: B Terms: Auditor's decision process for audit reports Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking 8) For departures from GAAP or scope restrictions, the auditor must decide if the potential effect on the financial statements is A) immaterial. B) material. C) highly material. D) any of the above. Answer: D Terms: Auditor's best defense when existing material misstatements in the financial statements Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

9) If the scope restriction imposed by the client is so material that the overall fairness of the financial statements is in question, the auditor should issue a(n) A) standard unmodified opinion. B) disclaimer of opinion. C) adverse opinion. D) unmodified opinion with revised wording in the scope paragraph. Answer: B Terms: Disclaimer of opinion; Client-imposed scope restriction Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 10) The final step in the auditor's decision process for audit reports is to write the audit report. Answer: TRUE Terms: Auditor's decision process for audit reports Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking 11) Auditors usually make the materiality judgment by referring to a standard checklist. Answer: FALSE Terms: Materiality levels Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking 3.9 Learning Objective 3-9 1) Which of the following is correct regarding IFRS? A) Companies that are required to file their financial statements with the SEC must follow IFRS starting in 2018. B) Recent developments suggest that the SEC may be slowing down its efforts towards adopting IFRS any time soon. C) When an auditor is engaged to report on financial statements prepared in accordance with IFRS, they must issue a qualified opinion. D) The introductory paragraph of the audit report is modified to indicate that the audit was conducted in accordance with International Standards on Auditing. Answer: B Terms: International accounting and auditing standards Difficulty: Moderate Objective: LO 3-9 AACSB: Reflective thinking

2) Auditing standards in the United States allow an auditor to perform an audit of a nonpublic U.S. entity in accordance with both generally accepted auditing standards in the U.S. and the ISAs. Answer: TRUE Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Moderate Objective: LO 3-9 AACSB: Reflective thinking

Auditing and Assurance Services, 17e (Arens/Elder/Beasley) Chapter 4 Professional Ethics 4.1 Learning Objective 4-1 1) Ethics are A) needed in the professions, but is not needed for society in general. B) a set of moral principles or values. C) not formed by life experiences. D) always incorporated in laws. Answer: B Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 2) ________ means that a person acts according to conscience, regardless of the situation. A) Caring B) Fairness C) Integrity D) Respect Answer: C Terms: Ethical principles and integrity Difficulty: Moderate Objective: LO 4-1 AACSB: Ethical understanding and reasoning 3) Which of the following is a prescribed set of moral principles or values? A) codes of business ethics for professional groups B) laws and regulations C) codes of conduct within an organization D) all of the above Answer: D Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 4) One of the main reasons people act unethically is that they choose to act selfishly. Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning

5) Most people define unethical behavior as conduct that differs from what they believe is appropriate given the circumstances. Answer: TRUE Terms: Unethical behavior Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 6) PCAOB inspections, especially information related to future inspections which will be made by the PCAOB staff and personnel of public company audits, is publicly available information. Answer: FALSE Terms: Ethical Principles and Confidential Information Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 7) Ethical values such as caring have been incorporated into the laws, as caring now been defined enough to be legally enforceable. Answer: FALSE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 4.2 Learning Objective 4-2 1) A six-step approach is often used to resolve an ethical dilemma. The first step in this process is to A) identify the alternative actions available. B) identify the ethical issues from the facts. C) determine who will be affected by the outcome of the dilemma. D) obtain the relevant facts. Answer: D Terms: Ethical dilemma Difficulty: Moderate Objective: LO 4-2 AACSB: Ethical understanding and reasoning 2) Ethical frameworks help identify the ethical issues and will always lead to the appropriate course of action. Answer: FALSE Terms: Ethical Frameworks Difficulty: Moderate Objective: LO 4-2 AACSB: Ethical understanding and reasoning

3) A rationalization method that can easily result in unethical behavior is the argument that "everybody does it." Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 4) If an action is considered legal, it must also be considered ethical. Answer: FALSE Terms: Ethical dilemma Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 5) The likelihood of discovery and the consequences of unethical conduct can easily result in unethical conduct. Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 6) Auditors and accountants do not face many ethical dilemmas during their respective business careers. Answer: FALSE Terms: Ethical dilemma Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning

7) Describe an ethical dilemma that an auditor or an accountant might face in his or her business career, then illustrate how the auditor or accountant might use the six-step approach presented in the text to resolve that dilemma. Be specific. Answer: An ethical dilemma is a situation a person faces in which a decision must be made about an appropriate behavior. Although students' answers will vary depending on the dilemma, their answer should list the following six steps, along with a discussion of how each step relates to their particular dilemma: 1. Obtain the relevant facts. Students should list the key facts from their dilemma. 2. Identify the ethical issues from the facts. Students should identify the key ethical issue(s) in their dilemma. 3. Determine who is affected by the outcome of the dilemma and how each person or group is affected. Students should identify who is involved and how each person is affected by the dilemma. 4. Identify the alternatives available to the person who must resolve the dilemma. Students should list the alternatives available to the auditor or accountant. 5. Identify the likely consequence of each alternative. Students should identify both the shortterm and long-term effects of each alternative. 6. Decide the appropriate action. Terms: Ethical dilemma Difficulty: Challenging Objective: LO 4-2 AACSB: Ethical understanding and reasoning 4.3 Learning Objective 4-3 1) The underlying reason for a code of professional conduct for any profession is A) the need for public confidence in the quality of service of the profession. B) it provides a safeguard to keep unscrupulous people out. C) it is required by federal legislation. D) it allows licensing agencies to have a yardstick to measure deficient behavior. Answer: A Terms: Reason for code of professional conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning

2) Which of the following statements is true when the CPA has been engaged to perform an audit of financial statements? 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) The CPA firm has primary responsibility to the FASB. Answer: B Terms: CPA engaged to perform audit of financial statements Difficulty: Moderate Objective: LO 4-3 AACSB: Ethical understanding and reasoning 3) The ________ is a standard of conduct for all members of the AICPA. A) IESBA Code of Conduct B) SEC Code of Conduct C) PCAOB Code of Professional Conduct D) AICPA Code of Professional Conduct Answer: D Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 4) Professionals are expected to conduct themselves at a higher level than most other members of society. Answer: TRUE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 5) CPA firms have a similar relationship with the users of financial statements which they audit compared to the relationship other professionals have with their customers. Answer: FALSE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning

6) Users of financial statements believe that CPA firms reduce the information risk associated with financial statements. Answer: TRUE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 7) Users of financial statements have the time and the ability to evaluate the audit performance of a CPA firm. Answer: FALSE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 8) Explain why there is a special need for ethical conduct in the auditing profession. Answer: The reason for an expectation of a high level of professional conduct by any profession is the need for public confidence in the quality of service by the profession, regardless of the individual providing it. It is not practical for most customers to evaluate the quality of the performance of professional services because of their complexity. Therefore, since the users (e.g., the general public) of services provided by an auditor generally cannot evaluate the quality of the auditor's performance, it is critical to the auditing profession that the public have a high degree of confidence in the quality of the services provided by the auditor. Public confidence in the quality of professional services is enhanced when the profession encourages high standards of performance and ethical conduct by all its members. If users of auditing services were to lack confidence in the quality of those services, then the value of CPA firms' audits would be diminished, as would the demand for audits. It is essential that the users regard CPA firms as competent and unbiased. Terms: Need for ethical conduct in auditing profession Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning

4.4 Learning Objective 4-4 1) Which of the following is(are) true concerning the Ethical Principles of the Code of Professional Conduct? I. They identify ideal conduct. II. They are general ideals and are not enforceable. A) I only B) II only C) I and II D) Neither I nor II Answer: C Terms: Ethical principles of the Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 2) Which of the following is not one of the major parts of the AICPA's Code of Professional Conduct? A) principles B) rules C) interpretations D) definitions Answer: D Terms: AICPA Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning

3) One of the AICPA's Ethical Principles deals with the public interest. It states that members should accept the obligation to act in a way that will A) Honor the public trust Serve the client's interest Yes Yes B) Honor the public trust No

Serve the client's interest No

Honor the public trust Yes

Serve the client's interest No

Honor the public trust No

Serve the client's interest Yes

Answer: C Terms: Ethical Principles; Public interest; Obligations Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 4) A CPA performs bookkeeping services for a client and then performs an audit of those financial statements. This is an example of a ________ threat. A) familiarity B) self-interest C) self-review D) management participation Answer: C Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 5) Since the rules cannot address all circumstances, the Code includes a conceptual framework approach for members to use to evaluate threats to compliance. Using this framework, A) the first step is to discuss the threat with the client's management team. B) all threats must be completely eliminated. C) safeguards can be used to eliminate any threat. D) more than one safeguard may be necessary. Answer: D Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 8 Copyright © 2020 Pearson Education, Inc.

6) Which part of the AICPA's Code of Professional Conduct is enforceable? A) ethical rulings B) rules of conduct C) principles D) interpretations Answer: B Terms: AICPA Code of Professional Conduct; Enforceable Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 7) Interpretations of the rules of conduct A) are enforceable. B) are finalized after being approved by the FASB. C) are issued as exposure drafts to the profession and others for comments. D) do not apply to members in business. Answer: C Terms: Interpretations of AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 8) 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. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 9) When a member observes the profession's technical and ethical standards and strives to continually improve her competence and quality of services, she is exercising A) due care. B) integrity. C) independence. D) objectivity. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

10) Four of the six Ethical Principles in the AICPA's Code of Professional Conduct are equally applicable to all members of the AICPA. Which of the following principles applies only to members in public practice? A) Scope and Nature of Services B) Integrity C) Due Care D) The Public Interest Answer: A Terms: Ethical Principles apply only to members in public practice Difficulty: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning 11) The Code of Professional Conduct is established by the membership of the AICPA, and the Interpretations of the Rules of Conduct are prepared by the A) Financial Accounting Standards Board. B) Securities and Exchange Commission. C) CPA licensing agencies within each state. D) Professional Ethics Executive Committee of the AICPA. Answer: D Terms: Code of Professional Conduct; Interpretations of Rules of Conduct Difficulty: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning 12) Due to a shortage of personnel, the client asks a member firm to assist with the authorization of accounting transactions. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) self-review D) undue influence Answer: A Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

13) It becomes obvious that a member of a CPA firm has developed a close relationship with an attest client. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) familiarity C) self-review D) undue influence Answer: B Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 14) An officer participates in litigation against the CPA firm. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) adverse interest B) self-interest C) self-review D) undue influence Answer: A Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 15) A member actively endorses an attest client's products or services. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) advocacy D) undue influence Answer: C Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

16) An attest client threatens the member with not awarding future additional engagements to the firm if the firm does not agree with the client on a particular accounting matter. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) self-review D) undue influence Answer: D Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 17) An advantage of specific rules in the Code of Professional Conduct is the enforceability of minimum behavior and performance standards. Answer: TRUE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 18) It is a violation of the rules of conduct if someone does something on behalf of a member that is a violation if the member does it. Answer: TRUE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 19) An advantage of the principles of professional conduct in the Code of Professional Conduct is that they are more easily enforced than are the specific rules of conduct. Answer: FALSE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 20) Safeguards can always reduce the threat to an acceptable level. Answer: FALSE Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

21) Interpretations of rules of conduct in the Code of Professional Conduct are not officially enforceable and practitioners need not justify departure from them. Answer: FALSE Terms: AICPA Code of Professional Conduct; Interpretation of rules Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 22) Adverse interest is the threat that a member will not act with objectivity because their interests are opposed to the client's interests. Answer: TRUE Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 23) In the AICPA's Code of Professional Conduct, the second principle of professional conduct, entitled "The Public Interest," applies only to members of the AICPA in public practice and not to members who work as accountants in business, government, or education. Answer: FALSE Terms: AICPA Code of Professional Conduct; Public Interest principle Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 24) In the AICPA's Code of Professional Conduct, the sixth principle of professional conduct, entitled "Scope and Nature of Services," applies to members of the AICPA who work in public practice, business, government, or education. Answer: FALSE Terms: AICPA Code of Professional Conduct; Scope and nature of services principle Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 25) The Conceptual Framework for AICPA Independence Standards can be used when making decisions on ethical matters not explicitly addressed in the Code. Answer: TRUE Terms: AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

26) Each state also has rules of conduct that are required for licensing by the state. Answer: TRUE Terms: AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 27) Threats to compliance with the AICPA's Code of Professional Conduct fall into seven broad categories. List and explain three of these categories. Answer: Threats to compliance include: • Adverse interest. The threat that a member will not act with objectivity because the member's interests are opposed to the client's interests. • Advocacy. The threat that a member will promote a client's interest or position to the point that their objectivity or independence is compromised. • Familiarity. The threat that, due to a long or close relationship with a client, a member will become too sympathetic to the client's interest or too accepting of the client's work or product. • Management participation. The threat that a member will take on the role of client management or otherwise assume management responsibilities. • Self-interest. The threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, a client or persons associated with the client. • Self-review. The threat that a member will not appropriately evaluate the results of a previous judgment or service performed or supervised by the member or an individual in the member's firm and that the member will rely on that service in forming a judgment as part of another service. • Undue influence. The threat that a member will subordinate their judgment to an individual associated with a client or any relevant third party due to that individual's reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member. NOTE: The student only had to list and explain three of the above threats. Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 28) The AICPA Code of Conduct includes a conceptual framework approach for the member to evaluate threats to compliance with the Code. List the three steps necessary to evaluate the threats. Answer: The three steps to evaluate the threats to compliance with the Code are: 1. Identify the threats. 2. Evaluate the significance of the threat. 3. Identify and apply safeguards. Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 14 Copyright © 2020 Pearson Education, Inc.

29) What are the six Ethical Principles stated in the Code of Professional Conduct? Briefly discuss each principle. Are these principles enforceable? Answer: The six Ethical Principles of the Code of Professional Conduct are: 1. Responsibilities. Members should exercise sensitive professional and moral judgments. 2. The Public Interest. Members should demonstrate commitment to professionalism by serving the public interest and honoring the public trust. 3. Integrity. Members should perform all professional responsibilities with the highest sense of integrity. 4. Objectivity and Independence. Members should maintain objectivity and remain free of conflicts of interest. A member in public practice should be independent in both fact and appearance when providing auditing and other attestation services. 5. Due Care. Members should observe the profession's technical and ethical standards, strive continually to improve competence and quality of services, and discharge professional responsibilities to the best of their 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. The Ethical Principles are not enforceable. Terms: Ethical Principles Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 4.5 Learning Objective 4-5 1) For which of the following professional services must CPAs be independent? A) management advisory services B) audits of financial statements C) preparation of tax returns D) all of the above Answer: B Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 2) "Independence" in auditing means A) maintaining an indirect financial interest. B) not being financially dependent on a client. C) taking an unbiased viewpoint. D) being an advocate for a client. Answer: C Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

3) When CPAs are able to maintain their actual independence, it is referred to as independence in A) conduct. B) appearance. C) fact. D) total. Answer: C Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 4) The Sarbanes-Oxley Act ________ a CPA firm from doing both bookkeeping and auditing services for the same public company client. A) encourages B) prohibits C) allows D) allows on a case-by-case basis Answer: B Terms: Sarbanes-Oxley; non-audit services Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

5) Interpretations of the independence rule of the AICPA Code prohibit covered members from owning any stock or other direct investment in audit clients. Covered members would include which of the following? A) All partners in the Individuals on the attest The firm and its employee engagement office even if engagement benefit plans they have no engagement responsibility Yes Yes Yes B) All partners in the engagement office even if they have no engagement responsibility Yes

Individuals on the attest engagement

The firm and its employee benefit plans

Individuals on the attest engagement

The firm and its employee benefit plans

Yes

Individuals on the attest engagement

The firm and its employee benefit plans

C) All partners in the engagement office even if they have no engagement responsibility No D) All partners in the engagement office even if they have no engagement responsibility No

Answer: A Terms: Independence Rule; Direct investment; Covered members Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

6) The financial interests of a CPA's family members can affect the CPA's independence. Which of the following parties would not be included as a "direct financial interest" of the CPA? A) spouse B) dependent child C) relative supported by the CPA D) sibling living in the same city as the CPA Answer: D Terms: Independence; Direct financial interest Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 7) Interpretations of the rules regarding independence allow an auditor to serve as A) a director or officer of an audit client. B) an underwriter for the sale of a client's securities. C) a trustee of a client's pension fund. D) an honorary director for a not-for-profit charitable or religious organization. Answer: D Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 8) Independence is required of a CPA when performing A) management advisory services. B) all attestation services. C) all attestation and tax services. D) all professional services. Answer: B Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 9) CPAs may provide bookkeeping services to their private company audit clients, but there are a number of conditions that must be met if the auditor is to maintain independence. Which of the following conditions is not necessary? A) The CPA must not assume a management role or function. B) The client must hire an external CPA to approve all of the journal entries prepared by the auditor. C) The auditor must comply with GAAS when auditing work prepared by his/her firm. D) The client must accept responsibility for the financial statements. Answer: B Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 18 Copyright © 2020 Pearson Education, Inc.

10) An example of an "indirect financial interest in a client" would be A) ownership of less than 10% of the client's stock by the covered members spouse. B) an ownership of less than 10% of the client's stock by a staff member who is not involved in the audit. C) the covered member's ownership of a mutual fund that has an investment in the client. D) All of the above are examples of an indirect financial interest in a client. Answer: C Terms: Indirect financial interest in a client Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 11) When determining whether independence is impaired because of an ownership interest in a client company, materiality will affect ownership A) in all circumstances. B) only for direct ownership. C) only for indirect ownership. D) under no circumstances. Answer: C Terms: Independence; Materiality Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 12) A direct financial interest violates independence in which of the following circumstances? 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 a brother, sister, or in-laws are employed by the client in their engineering department Answer: A Terms: Direct financial interest, independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

13) A CPA sole practitioner purchased stock in a client corporation and placed it in a trust as an educational fund for the CPA's minor child. The trust securities were not material to the CPA but were material to the child's personal net worth. Would the independence of the CPA be considered to be impaired with respect to the client? A) Yes, because the stock is a direct financial interest. B) Yes, because the stock is an indirect financial interest that is material to the CPA's child. C) No, because the CPA does not have a direct financial interest in the client. D) No, because the CPA does not have a material indirect financial interest in the client. Answer: A Terms: Financial interest and independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 14) Julie and Lisa are sisters. Julie is a CPA auditing the company where Lisa works. Julie's independence is impaired if A) Lisa is the controller. B) Lisa owns 2% of the company. C) Lisa is the marketing manager. D) all of the above. Answer: A Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 15) 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, an employee of another local accounting firm, prepares the tax return of Capital Trust's CEO. C) Oehlers' and Capital Trust's 401K plans 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. Answer: A Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

16) An auditor's independence is considered impaired if the auditor has A) an immaterial, indirect financial interest in a client. B) an outstanding $8,000 balance on a credit card issued by a client. C) an automobile loan from a client bank, collateralized by the automobile. D) a joint, closely held business investment with the client that is material to the auditor's net worth. Answer: D Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 17) According to the profession's ethical standards, an auditor would be considered independent in which of the following instances? A) The auditor's checking account, which is fully insured by a federal agency, is held at a client financial institution. B) The auditor is also an attorney who advises the client as its general counsel. C) An employee of the auditor serves as treasurer of a charitable organization that is a client. D) The client owes the auditor fees for two consecutive annual audits. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 18) Which of the following loans would be prohibited between a CPA firm or its members and an audit client? A) automobile loans B) loans fully collateralized by cash deposits at the same financial institution C) new home mortgage loans D) unpaid credit card balances not exceeding $10,000 in total Answer: C Terms: Independence; Loan exceptions Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

19) Under the AICPA independence rules, the auditor A) is prohibited from performing a company's audit and installing and designing the client's new information system. B) does not need to document the understanding and willingness of the client to perform all management functions associated with the nonaudit service. C) is prohibited from doing any bookkeeping services for the client if performing the audit. D) must follow the more restrictive SEC independence rules when dealing with a public company. Answer: D Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 20) The Code of Conduct rule on independence indicates that materiality must be considered when A) Evaluating direct Evaluating indirect investments made by the ownership investments CPA Yes Yes B) Evaluating direct investments made by the CPA No

Evaluating indirect ownership investments No

C) Evaluating direct investments made by the CPA Yes

Evaluating indirect ownership investments No

D) Evaluating direct investments made by the CPA No

Evaluating indirect ownership investments Yes

Answer: D Terms: Independence; Direct and indirect ownership investments Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

21) Which of the following instances would impair a CPA's independence when they have been retained as the auditor? I. A charitable organization where the CPA serves as treasurer II. A municipality where the CPA owns $250,000 of the $25 million outstanding bonds of the municipality III. A company that the CPA's investment club owns a 10% investment interest A) I and II B) I and III C) II and III D) I, II, and III Answer: D Terms: Impair independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 22) Under the AICPA independence rules, independence can be considered impaired when A) billed fees remain unpaid for professional services for more than ninety days. B) a client in bankruptcy has unpaid fees for more than one year. C) there is litigation by the client related to the auditor's tax or other nonaudit services for an immaterial amount. D) there is a lawsuit by the client claiming deficiencies in the previous year's audit. Answer: D Terms: Independence; Ramifications on auditor and CPA firm Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 23) 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 Terms: Independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

24) A CPA's financial interests in nonclients may have an effect on independence if the nonclients are investors in or investees of the client. Which situation would not impair a CPA's independence? A) The client has an immaterial investment in a nonclient investee in which the CPA has an immaterial investment. B) The CPA has a material indirect financial interest in a nonclient in which the client has a material investment. C) The client investor has a nonmaterial investment in the nonclient investee in which the CPA has a material investment. D) The CPA has a joint closely held investment with the client in a nonclient that is material to the client as well as the CPA. Answer: A Terms: Impair CPA independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 25) The CPA firm will lose its independence if A) a staff auditor providing audit services to the client acquires stock in that client. B) a staff tax preparer who provides 15 hours of non-audit services to the client acquires stock in that client. C) an audit manager in an office different than the office providing audit services has a direct, immaterial financial interest in the audit client. D) a covered member has an indirect, immaterial financial interest in an audit client. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 26) Interpretations to the Rules of Conduct permit a CPA firm to do both bookkeeping and auditing for the same private company client if three criteria are met. Which of the following is not one of those criteria? A) The client must accept full responsibility for the financial statements. B) The client is required to file an annual report, including audited financial statements, with the Securities and Exchange Commission. C) The CPA must not assume the role of employee or of manager. D) The CPA must follow applicable auditing standards. Answer: B Terms: SEC and allowed services Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

27) Which of the following circumstances impairs an auditor's independence? I. Litigation by a client against an audit firm claiming a deficiency in the previous audit II. Litigation by a client against an audit firm for a material amount related to tax services III. Litigation by an audit firm against a client claiming management fraud or deceit A) I and II B) I and III C) II and III D) I, II, and III Answer: B Terms: Impair auditor independence Difficulty: Challenging Objective: LO 4-5 AACSB: Reflective thinking 28) A CPA firm should decline an offer to perform consulting services engagement if A) the proposed engagement is not accounting related. B) recommendations made by the CPA firm are to be subject to review by the client. C) acceptance would require the CPA firm to make management decisions for an audit client. D) any of the above is true. Answer: C Terms: CPA firm should decline to perform consulting services Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 29) Interpretations of the AICPA's Code of Professional Conduct are dominated by the concept of A) independence. B) compliance with standards. C) accounting. D) acts discreditable to the profession. Answer: A Terms: Interpretations of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 30) Both SEC rules and the Sarbanes-Oxley Act prohibit auditors from providing bookkeeping services to their public company audit clients. Answer: TRUE Terms: SEC and allowed services Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

31) Under the interpretations to the AICPA Code, independence is considered to be impaired if fees remain unpaid for professional services provided more than six months before the date of the current year's report. Answer: FALSE Terms: Independence and unpaid fees Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 32) Auditors are allowed to have an indirect financial interest in an audit client, such as ownership of stock in a client's company by the auditor's brother, as long as the amount of the financial interest is immaterial to the brother. Answer: TRUE Terms: Indirect financial interest; Immaterial Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 33) CPA firms are required to be independent when performing any professional service. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 34) The prohibition on direct financial interests applies to covered members in a position to influence an engagement. Answer: TRUE Terms: Independence and financial interests Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 35) All litigation by a client related to tax or other nonaudit services will impair independence. Answer: FALSE Terms: Litigation and auditor independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 36) Some CPA firms do not permit any ownership by staff of a client's stock regardless of which office serves that particular client. Answer: TRUE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 26 Copyright © 2020 Pearson Education, Inc.

37) A staff member in a national CPA firm is not allowed to own stock in a client corporation even if the staff member is not involved in the client corporation's audit engagement under the AICPA's independence rule. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 38) A partner of a CPA firm performing the audit of the Red Cross may be an honorary director of the Red Cross and also vote and participate in management functions at the Red Cross. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 39) Audit firms frequently merge with other audit firms or form professional associations to enhance their capabilities to provide professional services. In these situations, it is not required for the network firm to be independent of audit and review clients of the other network firms for a period of 5 years. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

40) 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. Violation? Yes No Explanation: 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: 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: d. Bob Shelton, CPA, is the auditor of Cafe Ecko. A couple of weeks ago, Cafe Ecko's management commenced litigation against Bob, alleging he was negligent in last year's audit. Violation? Yes No Explanation: 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. Violation? Yes No Explanation:

Answer: 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 and is not in an office that participates on 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 nonpublic 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. Terms: Violation of rule on independence; AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 41) Don Crosby, a partner in a national CPA firm, has just learned that his self-sufficient daughter has accepted a position as the CFO of Sunglasses, Inc., a current client within the office with which he is employed. Explain the independence ramifications on 1) Don's independence, 2) his office, and 3) the firm's independence. Answer: 1. Don's non-dependent daughter is considered a close relative. Because she has a key position for the client, Don's independence is impaired. 2. Because Don is considered a covered member any office in which he is employed cannot be independent. 3. The firm will not be considered independent. However, the firm can maintain its independence if they either move: a. Don to an office that does not participate on the engagement or b. the audit engagement is assigned to an office in which Don is not employed. Terms: Independence; Ramifications on auditor and CPA firm Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

4.6 Learning Objective 4-6 1) Under the Sarbanes-Oxley Act, the audit committee of a public company A) must meet on a monthly basis. B) must be comprised entirely of financial experts. C) is responsible for the oversight of the work of the independent auditor. D) should have at least one independent member. Answer: C Terms: Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 2) The Sarbanes-Oxley Act requires which employees of an accounting firm to rotate off the engagement every five years? A) In-Charge Auditor Lead audit partner Yes Yes B) In-Charge Auditor No

Lead audit partner No

In-Charge Auditor Yes

Lead audit partner No

In-Charge Auditor No

Lead audit partner Yes

Answer: D Terms: Sarbanes-Oxley Act; Partner rotation Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 3) Which of the following statements is true with respect to audit committees? A) Audit committee members should consist of members of the company's management. B) All members of the audit committee must be financial experts. C) The audit committee of a public company is responsible for hiring the auditor. D) Audit committees must have a minimum of ten members. Answer: C Terms: Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 30 Copyright © 2020 Pearson Education, Inc.

4) The provisions of the Sarbanes-Oxley Act are most likely to allow which of the following non-audit services for audit clients? A) appraisal or valuation services (e.g., pension, post-employment benefit liabilities) B) financial information systems design and implementation C) internal audit outsourcing D) tax consulting Answer: D Terms: Sarbanes-Oxley Act; Allowed nonaudit services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 5) Which of the following services are allowed by the SEC whenever a CPA also audits the company? A) internal audit outsourcing B) legal services unrelated to the audit C) appraisal or valuation services D) services related to assessing the effectiveness of internal control over financial reporting Answer: D Terms: SEC and allowed services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 6) Which of the following services is not prohibited by the SEC whenever a CPA also audits the company? A) actuarial services B) assisting the company in preparing certain SEC registration statements (e.g., 10-Q, 10-K) C) investment banker services D) bookkeeping services Answer: B Terms: SEC and allowed services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 7) The members of a client's "audit committee" should be A) members of management. B) directors who are not a part of company management. C) non-directors and non-managers. D) directors and managers. Answer: B Terms: Members of audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 31 Copyright © 2020 Pearson Education, Inc.

8) The Sarbanes-Oxley Act requires a cooling off period of ________ before a member of an audit team can work for a client in a key management position. A) one year B) eighteen months C) three years D) five years Answer: A Terms: Sarbanes-Oxley Act; Cooling off period Difficulty: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning 9) Which of the following is an accurate statement? A) Auditing standards detail the requirements that a CPA firm must follow when it is requested to provide an opinion on the application of accounting principles for a client of another CPA firm. B) SEC rules prohibit ownership in audit clients by those persons who can influence the audit. C) PCAOB rules require a CPA firm, before its selection as the company's auditor, to document all relationships between the firm and the company. D) All of the above are accurate statements. Answer: D Terms: Auditor independence Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 10) Companies are required to disclose in their proxy statement or annual filings with the SEC the total amount of audit and non-audit fees paid to the audit firm for the two most recent years. Which of the following is not one of the categories of fees that must be disclosed? A) tax fees B) consulting fees C) audit-related fees D) all other fees Answer: B Terms: Annual SEC filings; Audit and non-audit fees Difficulty: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning

11) Which of the following is not an example of an audit-related fee required to be included in the audit-related fees category related to fees disclosed in the annual proxy statement? A) comfort letters B) reviews of SEC filings C) reviews of SEC inquiry letters D) tax avoidance planning services Answer: D Terms: Proxy audit and nonaudit fee disclosure requirements Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 12) The European Commission has a rule that generally requires, with some exceptions, audit firm rotation after how many years? A) 5 B) 10 C) 12 D) 15 Answer: B Terms: Mandatory European Commission audit firm rotation rule Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 13) A public company may obtain internal audit services from their financial statement auditor if it is approved by the company's audit committee. Answer: FALSE Terms: Public company; Non-audit services purchased Difficulty: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning 14) For a public company, the Sarbanes-Oxley Act requires audit committee approval of all nonaudit services prior to their performance by the company's external auditor. Answer: TRUE Terms: Sarbanes-Oxley Act; Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 15) Under certain circumstances, a CPA firm can offer legal and expert services unrelated to the audit to publicly held audit clients. Answer: FALSE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 33 Copyright © 2020 Pearson Education, Inc.

16) SEC and PCAOB rules allow CPAs to provide tax services for audit clients, including tax services for company executives which oversee financial reporting. Answer: FALSE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 17) Nonaudit services provided that are not prohibited by the Sarbanes-Oxley Act and SEC rules must be preapproved by the company's audit committee. Answer: TRUE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 4.7 Learning Objective 4-7 1) The CPA must not subordinate his or her professional judgment to that of others in any A) engagement. B) audit engagement. C) engagement excluding tax services. D) engagement where the opinion of a specialist is used. Answer: A Terms: CPA subordinate professional judgment Difficulty: Easy Objective: LO 4-7 AACSB: Ethical understanding and reasoning 2) Under the rules and interpretations of the AICPA Code, A) a CPA can be a client advocate during an audit, but not while performing tax or management services. B) staff auditors should always defer to the judgment of their immediate supervisor. C) a conflict of interest is a relationship that might interfere with objectivity or integrity. D) even if a conflict of interest is disclosed to the member's client or employer, it is still considered a violation of the rules of conduct. Answer: C Terms: Integrity, objectivity, and conflicts of interest Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

3) Several months after an unqualified audit report was issued, the auditor discovers the financial statements were materially misstated. The client's CEO agrees that there are misstatements, but refuses to correct them. The CEO claims that "confidentiality" prevents the CPA from informing anyone. Which of the following statements is correct? A) The CEO is correct and the auditor must maintain confidentiality. B) The CEO is incorrect, but since the audit report has been issued, it is too late to correct the report. C) The CEO is correct, but to be ethically correct, the auditor should violate the confidentiality rule and disclose the error. D) The CEO is incorrect, and the auditor has an obligation to issue a revised audit report, even if the CEO will not correct the financial statements. Answer: D Terms: Confidentiality on audit Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 4) A CPA firm may charge a contingent fee for A) an audit. B) consulting services for a client for which they do not perform any attestation services. C) the preparation of an original tax return for a client for which they do not perform any attestation services. D) the preparation of an amended tax return. Answer: B Terms: Contingent fees Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

5) A member in public practice shall neither receive from, nor pay to, a client a commission when the member or member's firm also performs certain services for that client. Commissions are allowed if the CPA performs A) A compilation that will be An audit of prospective used by a third party financial information Yes Yes B) A compilation that will be used by a third party No

An audit of prospective financial information No

C) A compilation that will be used by a third party Yes

An audit of prospective financial information No

D) A compilation that will be used by a third party No

An audit of prospective financial information Yes

Answer: B Terms: Commissions Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 6) The AICPA's Code of Professional Conduct states that a CPA should maintain integrity and objectivity. The term "objectivity" in the Code refers to a CPA's ability to A) choose independently between alternate accounting principles and auditing standards. B) distinguish between accounting practices that are acceptable and those that are not. C) be unyielding in all matters dealing with auditing procedures. D) maintain an impartial attitude on matters that come under the CPA's review. Answer: D Terms: AICPA Code of Professional Conduct; Objectivity Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

7) Which of the following is required for a firm to designate itself "Member of the American Institute of Certified Public Accountants" on its letterhead? A) At least one of the owners must be a member of the AICPA. B) All CPA owners must be members of the AICPA. C) The CPA owners whose names appear in the firm name must be members of the AICPA. D) A majority of the owners must be members of the AICPA. Answer: B Terms: Members of the AICPA requirements Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 8) CPAs are prohibited from which of the following forms of advertising? A) self-laudatory advertising B) celebrity endorsement advertising C) use of trade names, such as "Awesome Auditors" D) use of phrases, such as "Guaranteed largest tax refunds in town!" Answer: D Terms: Prohibited forms of advertising Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning 9) Which of the following would be considered a violation of the AICPA's Code of Professional Conduct? A) The CPA makes the audit files available to the client's bank without the permission of the client. B) The CPA firm charges a contingent fee for nonattestation services to a client for whom he or she does not perform any attestation services. C) The CPA firm takes a prospective client to lunch to discuss auditing services. D) A CPA firm uses the name San Diego Tax Specialists. Answer: A Terms: Code of ethics Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

10) The AICPA's Code of Professional Conduct requires CPAs to maintain the confidentiality of client information. This rule would be violated if a CPA disclosed information without a client's consent as a result of a A) subpoena or summons. B) peer review. C) complaint filed with the trial board of the Institute. D) request by a client's largest stockholder. Answer: D Terms: Confidentiality Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 11) Which one of the following statements is false? A) Confidentiality is broken when an auditor is presented with a subpoena concerning an audit client. B) Information that a CPA obtains from a client is generally not privileged. C) When a CPA firm conducts an AICPA-authorized peer review of the quality controls of another CPA firm, permission of the client is not needed to examine audit documentation. D) A CPA firm which observes substandard audit documentation of another firm during a peer review can initiate a complaint to the AICPA. Answer: A Terms: Confidentiality Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 12) A CPA firm A) can sell securities to a client for whom they perform an attestation service. B) can receive a commission for a client that they are engaged to perform an attestation service for. C) cannot receive a referral fee for recommending the services of another CPA. D) can receive a commission from a nonattestation client as long as the situation is disclosed. Answer: D Terms: Commissions and Referral Fees Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

13) Which of the following represents all of the ways a CPA firm can be organized? A) proprietorships and partnerships B) proprietorships, partnerships, and professional corporations C) proprietorships, general partnerships, general corporations, professional corporations, limited liability companies, and limited liability partnerships if permitted by state law D) single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations Answer: C Terms: AICPA Code of Professional Conduct; CPA firm form of organization Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 14) In which of the following circumstances would a CPA be ethically bound to refrain from disclosing any confidential client information? A) The CPA is issued a summons enforceable by a court order which orders the CPA to present confidential information. B) A major stockholder of a client company seeks accounting information from the CPA after management declined to disclose the requested information. C) The confidential client information is made available as part of a quality review of the CPA's practice by a peer review team authorized by the AICPA. D) An inquiry by a disciplinary body of a state CPA society requests confidential client information. Answer: B Terms: Confidential client information Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 15) Which of the following fee arrangements is not a violation of the AICPA's Code of Professional Conduct? A) basing fees as an expert witness on the amount awarded to the plaintiff, even though the CPA performs a compilation for client use B) basing consulting fees on a percentage of a bond issue, even though the CPA performs a review of the client's financial statements C) basing fees for a tax service on the amount of the refund that the client will receive D) basing consulting fees on a percentage of a bond issue, even though the CPA performs an audit of the client's financial statements Answer: A Terms: Fee arrangements not a violation of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning

16) Which of the following is not defined as an act discreditable in either the Rules or the Interpretations of the AICPA's Code of Professional Conduct? A) The CPA firm's partner in charge failed to file his tax return for the past year. B) The CPA firm discriminates in its hiring practices based on the age of the applicant. C) The CPA retains the client's books and records to enforce past-due payment of the CPA's bill, even after the client has demanded they be returned. D) The CPA firm's partner-in-charge was a passenger in a car driven by his wife. On the way home from the firm's Christmas party, she was charged with "driving while intoxicated." Answer: D Terms: Act discreditable Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning 17) Freedom from ________ means the absence of relationships that might interfere with objectivity or integrity. A) independence B) acts discreditable C) impartiality D) conflicts of interest Answer: D Terms: Conflicts of interest Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 18) Membership in the AICPA can be terminated without a hearing for A) a crime punishable by imprisonment for more than one year. B) the filing of a fraudulent income tax return on a client's behalf. C) the willful failure of a CPA to file their own personal tax return. D) all of the above. Answer: D Terms: Membership in AICPA terminated for discreditable acts Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 19) Which of the following activities is allowed for a CPA firm's attestation clients? A) contingent fees fixed by a court B) commissions for referring a review client to an insurance agency for insurance coverage C) preparation of tax returns for which fees are based upon client refunds D) Each of the above is allowed. Answer: A Terms: Activities allowed for CPA firm's attestation clients Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 40 Copyright © 2020 Pearson Education, Inc.

20) Imprisonment for a period of six months or longer will result in automatic expulsion from the AICPA. Answer: FALSE Terms: Imprisonment; Expulsion Difficulty: Easy Objective: LO 4-7 AACSB: Ethical understanding and reasoning 21) Under the Form of Organization and Name rule, a CPA firm is prohibited from practicing as a limited liability partnership. Answer: FALSE Terms: Form of Organization and Name rule Difficulty: Easy Objective: LO 4-7 AACSB: Reflective thinking 22) A CPA firm may use any name as long as it is not misleading. Answer: TRUE Terms: Form of Organization and Name rule Difficulty: Easy Objective: LO 4-7 AACSB: Reflective thinking; Analytic thinking 23) A CPA firm may practice public accounting only in a form of organization permitted by federal law or regulation. Answer: FALSE Terms: Form of Organization Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 24) Under the Confidential Client Information rule, permission is not required from the client to use the audit documentation relating to that client during an AICPA authorized peer review program with another CPA firm. Answer: TRUE Terms: Confidential Client Information Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 25) Information obtained by a CPA from a client is legally privileged in federal court. Answer: FALSE Terms: Legally privileged information Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 41 Copyright © 2020 Pearson Education, Inc.

26) Members of the AICPA in public practice are prohibited from performing comparative advertising. Answer: FALSE Terms: Advertising and Other Forms of Solicitation Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 27) Under the Form of Organization and Name rule, a CPA firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless a majority of its owners are members of the Institute. Answer: FALSE Terms: Form of Organization and Name rule Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 28) Under the AICPA's Code of Professional Conduct, CPAs are prohibited from offering audit clients a discount for referring a prospective client even if they are disclosed. Answer: FALSE Terms: AICPA Code of Professional Conduct; Offer audit clients a discount Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 29) All owners of a CPA firm must be CPAs who are qualified to practice. Answer: FALSE Terms: CPA qualified to practice Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 30) Audit assistants should be allowed to document situations during the audit where they disagreed with a conclusion made by their superior(s) involving a significant audit matter. Answer: TRUE Terms: Integrity and Objectivity Rules Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 31) It is allowable for an auditor who is also an attorney to represent a client in legal matters. Answer: FALSE Terms: Integrity and Objectivity Rules Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 42 Copyright © 2020 Pearson Education, Inc.

32) The AICPA recently issued a new interpretation of the Code of Professional Conduct which addresses a number of suggested safeguards in situations where a member faces pressure from a colleague or a superior to report misleading financial results. Answer: TRUE Terms: Integrity and Objective Rules — Resisting Pressure Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 33) Discuss the Confidential Client Information Rule, including the four exceptions to the rule. Answer: The Confidential Client Information Rule prohibits a member from disclosing any confidential client information without the specific consent from the client. However, there are four conditions when client permission is not required: • Obligations related to technical standards; the rule makes it clear that the auditor's responsibility to discharge professional standards is greater than that for confidentiality. • In response to a valid subpoena or summons and compliance with laws and regulations. • A peer review authorized by the AICPA, state CPA Society, or State Board of Accountancy. • The CPA is initiating or responding to an inquiry from a recognized investigative body or the professional ethics division. Terms: Confidential Client Information and exceptions Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

34) The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation, (1) determine the applicable rule 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 2014, Freeman and Johnson, both CPAs, decided to form a CPA practice. In 2016, 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: ________ Explanation:

Violation? Yes No

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: ________ Explanation:

Violation? Yes No

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, unmodified opinion, $40,000 if a qualified opinion is issued, and only $20,000 if an adverse opinion is issued. Rule: ________ Explanation:

Violation? Yes No

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: ________ Explanation:

Violation? Yes No

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: ________ Explanation:

Violation? Yes No

Answer: a. Violation of the rule on Form of Organization and Name. Non-CPA ownership of firms is allowable; however, non-CPA owners must actively provide services to the firm's clients as their principal occupation. b. No violation of the Commissions and Referral Fees rule. A CPA may pay a referral fee to a non-CPA as long as the payment is disclosed to the client. c. Violation of the Contingent Fees rule. Charging a contingent fee for attestation services is prohibited. d. Violation of the Independence rule. Don is a covered member for purposes of the independence rule. Because his daughter is a dependent, her ownership interest in Shaw is treated as a direct financial interest of her father. e. No violation of the Independence rule. 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. Terms: Violations of Rules of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5, LO 4-6, and LO 4-7 AACSB: Ethical understanding and reasoning

35) The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation, (1) determine the applicable rule 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. Howard Cunningham & Co., CPAs, designates its firm as "Members of the American Institute of Certified Public Accountants." All of the partners of the firm are CPAs. However, one of the partners has recently chosen to allow her membership to lapse because of personal reasons. Rule: ________ Explanation:

Violation? Yes No

b. Brad Long, CPA, was traveling from Orlando to Miami, Florida when he was pulled over by a police officer on suspicion of driving under the influence. He was convicted in court of driving while under the influence of alcohol. Because of past convictions, Brad was sentenced to 5 years in prison. Rule: ________ Explanation:

Violation? Yes No

c. Kelley Brent, CPA, is a partner in a one-office CPA firm that audits Dane, Inc., a closely held corporation. Kelley's sister was recently appointed as the chief financial officer for Dane, Inc. Rule: ________ Explanation:

Violation? Yes No

d. Sarah Martin, CPA, is a senior auditor in the San Francisco office of Cooper & Howell, CPAs. Sarah's father is employed as the controller of Line Electronics, a public company in Detroit, Michigan. Line Electronics is one of the firm's audit clients. Neither Sarah nor the San Francisco office is involved in the audit of Line Electronics. Rule: ________ Explanation:

Violation? Yes No

e. On August 20, 20x9, Min Lee, CPA and partner, was offered and accepted the engagement to audit the annual financial statements of Jernigan Corporation for the year ended December 31, 20x7. Preliminary work began on the audit on September 15, 20x7 and the engagement ended on March 7, 20x8. Jernigan is regulated by the SEC. Min served as controller of Jernigan Corporation from December 1, 20x2, until April 10, 20x7, at which time she terminated her employment with Jernigan. Rule: ________ Explanation:

Violation? Yes No

Answer: a. Violation of the Form of Organization and Name rule (Rule 505). A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its owners are members of the Institute. b. Violation of the Acts Discreditable rule (Rule 501). Felonies are considered acts discreditable. c. Violation of the Independence rule (Rule 101). According to the Code, Kelly's sister is a "close relative" and she occupies a key position at an audit client. Because Kelly is a partner in the office that provides the audit services to Dane, the firm is not independent. d. No violation of the Independence rule (Rule 101). While Sarah's father occupies a key position with an audit client of the firm, there is no independence violation as long as Sarah is not a member of the engagement team. The firm may provide the audit services. e. Violation of the Independence rule (Rule 101). Since Min had an employment relationship with the client during part of the period covered by the financial statements, her independence is impaired. Terms: Violations of Rules of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5, LO 4-6, and LO 4-7 AACSB: Ethical understanding and reasoning

36) The scenarios below all involve a possible violation of the AICPA's Code of Professional Conduct. 1. Using the list below, indicate which of the Code of Conduct Rules applies to the scenario. a. Independence b. Integrity and Objectivity c. Contingent Fees d. Acts Discreditable e. Commissions and Referral Fees f. Form of Organization and Name 2. State if the scenario is a violation of the Code. Scenario: 1. Margaret Henry is a partner in the Tupelo office of Jenkins & Thorn, CPAs. Margaret's father is the controller at Markrich Sporting Supplies, Inc., a publicly held company in Tupelo. Markrich is one of Jenkins & Thorn's audit clients. Margaret is not involved in the audit of Markrich. 2. Jason Alexander is an audit manager with Reese & Co., CPAs. Jason 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. 3. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Mr. Herman also performs the annual audit of Henderson Corporation. 4. Elaine Cooper, CPA, is the auditor of Paula's Pizza. Toward the end of the audit, Paula gave Elaine her estimate of receivable collectability and Elaine accepted it without any testing. 5. Charley Ray, CPA, is a member of the engagement team that performs the audit of Desiree Corporation. Charley's five-year-old daughter, Becky, received ten shares of Desiree common stock for her fifth birthday in a trust fund established by Becky's grandmother. 6. Freeman and Johnson formed a successful CPA practice ten years ago. In the current year, they approached Adam Sawtooth, a surgeon and medical expert, and asked him to assist them with their growing medical consulting practice. Sawtooth agreed, but only after he was given an ownership interest in the firm. Sawtooth does intend to reduce his private practice hours and spend 40% of his working hours devoted to the Freeman & Johnson practice. 7. Sally Preen has a successful computer network consulting business. Sally has recommended one of her clients to Sam Walton, CPA. To show gratitude for the referral, Sam has agreed to pay Sally a token gift of $50. Sam has not disclosed the payment arrangement to his new clients. 8. The accounting firm of Smith & Black, CPAs, is negotiating a fee with a new audit client where the client will pay $50,000 if the client obtains the line of credit needed for working capital purposes. Otherwise, the fee will be $40,000. 48 Copyright © 2020 Pearson Education, Inc.

9. Brad Barns, CPA, was traveling from Las Vegas to the Grand Canyon when he was pulled over by a police officer for suspicion of driving under the influence. He was convicted in court of driving under the influence of alcohol and received six months' probation. 10. Manuel Lopez, CPA, is a senior in a small, local, CPA firm that audits Childress, Inc., a closely held corporation. Manuel's sister was recently appointed as the controller for Childress, Inc. Answer: Part 1: 1. a 6. f 2. a 7. e 3. a 8. c 4. b 9. d 5. a 10. a Part 2: 1. Yes 6. Yes 2. No 7. Yes 3. No 8. Yes 4. Yes 9. No 5. Yes 10. Yes Terms: AICPA Code of Professional Conduct; Ethical rulings; Interpretations of rules Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning 4.8 Learning Objective 4-8 1) If the board of accountancy in the state in which a CPA firm is licensed has rules that are different than the AICPA's rules, the CPA firm must follow A) whichever rules are less restrictive. B) whichever rules are more restrictive. C) the rules of the AICPA. D) the rules of the state's board of accountancy. Answer: B Terms: State rules which differ from AICPA rules Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking

2) Which of the following is a true statement regarding the enforcement mechanism for CPA conduct? A) The PCAOB has the authority to investigate and discipline registered public accounting firms. B) All disciplinary action by the AICPA must go through the Joint Trial Board. C) Disciplinary actions taken by the AICPA are not disclosed to the public. D) Only a few states have adopted the AICPA rules of conduct. Answer: A Terms: Enforceability of Interpretations of the Rules of Conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Ethical understanding and reasoning 3) Which of the following is a true statement regarding an action which the PCAOB can take if it finds a public accounting firm or an individual has violated the SEC rules governing the audit of a public company? A) The PCAOB cannot impose appropriate sanctions—only the respective state Board of Accountancy is allowed impose sanctions. B) The PCAOB cannot suspend or revoke the firm's registration allowing it to audit public companies. C) The PCAOB can suspend or impose appropriate sanctions on the firm and on the individual. D) The PCAOB cannot impose any type of monetary penalties. Answer: C Terms: PCAOB Enforcement Actions Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking 4) Expulsion from the AICPA for failing to follow the rules of conduct is, by itself, sufficient to prevent a CPA from practicing public accounting. Answer: FALSE Terms: Expulsion from AICPA for failing to follow rules of conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking 5) Describe the methods used by the AICPA and State Boards of Accountancy to enforce the rules of conduct. Answer: The AICPA uses two levels of disciplinary action. For less serious, and probably unintentional, violations of Rules of Conduct, the division limits the discipline to a requirement of remedial or corrective action. For more serious violations, the level of disciplinary action goes before the Joint Trial Board. The violator may be suspended or expelled from membership in the AICPA. Violation of a State Board's rules of conduct is punishable by loss of the violator's CPA certificate and license to practice. Terms: Methods to enforce the rules conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking 50 Copyright © 2020 Pearson Education, Inc.

Auditing and Assurance Services, 17e (Arens/Elder/Beasley) Chapter 5 Legal Liability 5.1 Learning Objective 5-1 1) Which of the following factors does not contribute to the number of lawsuits against auditors? A) large civil court judgments against CPA firms awarded in a few cases B) growing awareness of the responsibilities of public accountants by users of financial statements C) the simplicity of auditing and accounting functions D) an increased consciousness by the SEC for its responsibility for protecting investors' interests Answer: C Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 2) Which of the following does not contain provisions that may serve as a basis for legal actions against auditors? A) the Sarbanes-Oxley Act of 2002 B) the Securities Act of 1933 C) the Securities Act of 1934 D) the Dodd-Frank Wall Street Reform and Consumer Protection Act Answer: D Terms: Government legislation serving as a basis for legal actions against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 3) Which of the following factors does not explain why the number of lawsuits and the sizes of awards to plaintiffs in cases involving CPA firms remains high even today? A) Attorneys are willing to take these types of lawsuits on a contingent-fee basis. B) Economic changes often result in an increase in the number of business failures. C) the deep-pocket concept of liability D) All of the above explain why the number of lawsuits and the sizes of the awards remain high. Answer: D Terms: Major factors that have contributed to the continued high number of lawsuits against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking

4) The auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is "foreseen" by the auditor. Answer: TRUE Terms: Liability to clients under common law Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 5) Auditors have generally not been held liable for criminal acts in the courts. Answer: FALSE Terms: Liability to clients under statutory and common laws Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 6) Since the Sarbanes-Oxley Act of 2002, both the number of lawsuits and the sizes of awards to plaintiffs in the courts have been reduced against auditors. Answer: FALSE Terms: Liability to clients under statutory and common statutory laws Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 7) Many CPA firms have strategically decided to settle lawsuits brought against them out of court in order to avoid adverse publicity and costly legal fees. Answer: TRUE Terms: CPA firm's strategies in court to settle lawsuits brought against them Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 8) There has been, and continues to be, legislative efforts to control litigation costs against CPA firms by discouraging nonmeritorious lawsuits. Answer: TRUE Terms: Legislative efforts to control litigation costs against CPA firms Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking

9) Discuss at least three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs. Answer: Major factors include: • The growing awareness of the responsibilities of public accountants by users of financial statements • An increased consciousness on the part of the Securities and Exchange Commission regarding its responsibility for protecting investors' interests • The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations and financing transactions • The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with joint and several liability doctrine • The global recession and tough economic times result in business failures, which prompt stakeholders to seek restitution from others, including external auditors • Large civil court judgments against CPA firms awarded in a few cases • The willingness of CPA firms to settle legal problems out of court to avoid costly legal fees and adverse publicity, rather than pursuing resolution through the judicial process • The difficulty judges and jurors have understanding and interpreting technical accounting and auditing matters Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 5.2 Learning Objective 5-2 1) A(n) ________ failure occurs when an auditor issues an erroneous opinion because it failed to comply with requirements of auditing standards. A) business B) audit C) ethics D) process Answer: B Terms: Failure which occurs when an auditor issues an erroneous opinion Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking

2) The expectation gap A) exists between the auditor and the SEC. B) exists because auditors guarantee the accuracy of the financial statements. C) often results in unwarranted lawsuits against the auditor. D) is a legal concept supported by the federal courts. Answer: C Terms: Expectation gap Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 3) Which of the following is an accurate statement regarding audit risk, audit failure, and business failure? A) Audit risk is always avoidable if the audit is conducted in accordance with generally accepted auditing standards. B) Because auditors gather evidence on a test basis, and because well-concealed frauds are difficult to detect, audit risk is unavoidable. C) Legal precedent makes it easy to determine who has the right to recover losses in the event of an audit failure. D) A business failure will always result in an audit failure. Answer: B Terms: Distinguish among business failure, audit failure, and audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 4) Audit risk is the risk there will be an audit failure for a given audit engagement. Answer: FALSE Terms: Audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 5) The term "audit failure" refers to the situation when the auditor has followed auditing standards yet still fails to discover that the client's financial statements are materially misstated. Answer: FALSE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking

6) The term "audit failure" refers to the situation when the auditor issues an incorrect audit opinion that a qualified auditor, following auditing standards, would have not issued. Answer: TRUE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 7) The term "business failure" has basically the same meaning as "audit failure" as they pertain the auditing profession. Answer: FALSE Terms: Audit failure compared to business failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 8) Audit risk is avoidable, as long as the auditor performs the audit in accordance with auditing standards. Answer: FALSE Terms: Audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 9) When an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is not appropriate to question whether the auditor exercised due professional care in the performance of the audit. Answer: FALSE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 10) There is a public perception that auditors guarantee the accuracy of the financial statements they have audited and guarantee the financial viability of the business. Answer: TRUE Terms: Audit failure and business failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking

11) The term "expectation gap" refers to the difference in the results of an audit between what an auditor expects and what users of the financial statements audited by the auditor expect. Answer: TRUE Terms: Expectation gap Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 12) The legal issue with regards to the Big Four CPA firms being required to comply with the Fair Labor Standards Act with regards to overtime pay policies and procedures is settled. Answer: FALSE Terms: Fair Labor Standards Act Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking 13) Distinguish between what is meant by business failure and audit failure. Answer: Business failure occurs when a business is unable to repay its lenders or meet expectations of its investors because of economic or business conditions, such as recession, poor management decisions, or unexpected competition in the industry. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards. Terms: Business failure and audit failure Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking 5.3 Learning Objective 5-3 1) In the performance of an audit, a CPA A) is legally liable for detecting an immaterial client fraud. B) must strictly follow GAAP for privately held clients. C) must exercise constructive professional care in the performance of their audit responsibilities. D) must exercise due professional care in the performance of their audit responsibilities. Answer: D Terms: Prudent person concept; due professional care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

2) If an auditor fails to fulfill a certain requirement in the contract, they may be guilty of A) contract fraud. B) breach of contract. C) constructive fraud. D) criminal neglect. Answer: B Terms: Liability when auditors fail to exercise due care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 3) In the case of an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intent to deceive financial statement users. This is a description of the legal term A) ordinary negligence. B) gross negligence. C) constructive fraud. D) fraud. Answer: C Terms: Prudent person concept; due professional care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 4) The standard of due care to which the auditor is expected to adhere to in the performance of the audit is referred to as the A) prudent person concept. B) common law doctrine. C) constructive care concept. D) vigilant person concept. Answer: A Terms: Standard of due care Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

5) Auditors may be liable to their clients if they are found guilty of A) Ordinary negligence Gross negligence Yes Yes B) Ordinary negligence No

Gross negligence No

Ordinary negligence Yes

Gross negligence No

Ordinary negligence No

Gross negligence Yes

Answer: A Terms: Auditor liability to clients Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 6) Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include A) employees of the CPA firm. B) employees of the audit client. C) other CPA firms engaged to do part of the audit work. D) specialists employed by the CPA firm to provide technical advice on the audit. Answer: B Terms: Liability for the acts of others Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 7) "Absence of reasonable care that can be expected of a person in a set of circumstances" defines A) pecuniary negligence. B) gross negligence. C) extreme negligence. D) ordinary negligence. Answer: D Terms: Absence of reasonable care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 8 Copyright © 2020 Pearson Education, Inc.

8) An example of a breach of contract would likely include A) an auditor's refusal to return the client's general ledger book until the client paid last year's audit fees. B) a bank's claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan. C) a CPA firm's failure to complete an audit on the agreed-upon date because the firm had a backlog of other work which was more lucrative. D) an auditor's claim that the client staff is unqualified. Answer: C Terms: Breach of contract Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 9) Privity of contract exists between A) auditor and the federal government. B) auditor and third parties. C) auditor and client. D) auditor and client attorney. Answer: C Terms: Privity of contract Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 10) An individual who is not party to the contract between a CPA and the client, but who is known by both and is intended to receive certain benefits from the contract is known as A) a third party. B) a common law inheritor. C) a tort. D) a third-party beneficiary. Answer: D Terms: Individual who is not a party to the contract between a CPA and client Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 11) Laws that have been passed by the U.S. Congress and other governmental units are A) statutory laws. B) judicial laws. C) federal laws. D) common laws. Answer: A Terms: Laws passed through governmental units Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 9 Copyright © 2020 Pearson Education, Inc.

12) 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 is called A) separate and proportionate liability. B) shared liability. C) unitary liability. D) joint and several liability. Answer: D Terms: Assessment against a defendant of the full loss suffered by a plaintiff Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 13) The assessment against a defendant of that portion of the damage caused by the defendant's negligence is called A) separate and proportionate liability. B) joint and several liability. C) shared liability. D) unitary liability. Answer: A Terms: Assessment against a defendant of that portion of the damages Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 14) Fraud occurs when A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive. B) a misstatement is made and there is knowledge of its falsity but no intent to deceive. C) the auditor lacks even slight care in the performance in performing the audit. D) the auditor has an absence of reasonable care in the performance of the audit. Answer: A Terms: Fraud and errors Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 15) Which of the following most accurately describes constructive fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: D Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 10 Copyright © 2020 Pearson Education, Inc.

16) Which of the following most accurately describes fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: C Terms: Fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 17) A third-party beneficiary is one which A) has failed to establish legal standing before the court. B) does not have privity of contract and is unknown to the contracting parties. C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract. D) may establish legal standing before the court after a contract has been consummated. Answer: C Terms: Third-party beneficiary Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 18) If the CPA negligently failed to properly prepare and file a client's tax return, the CPA may be liable for A) the penalties the client owes the IRS. B) the penalties and interest the client owes. C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged. D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid. Answer: C Terms: Liability when a CPA negligently failed to properly prepare and file tax return Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 19) Constructive fraud A) is also known as recklessness. B) requires an intent to deceive. C) involves collusion with the client. D) is also known as breach of contract. Answer: A Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Analytic thinking

20) Which of the following statements is true? A) Gross negligence Fraud requires the All fraud should be may constitute intent to deceive detected during audit constructive fraud Yes Yes No B) Gross negligence may constitute constructive fraud No C) Gross negligence may constitute constructive fraud Yes D) Gross negligence may constitute constructive fraud No

Fraud requires the intent to deceive

All fraud should be detected during audit

Yes

Fraud requires the intent to deceive

All fraud should be detected during audit

Yes

Fraud requires the intent to deceive

All fraud should be detected during audit

Answer: A Terms: Gross negligence, fraud, and constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 21) The laws that have been developed through court decisions are called A) common laws. B) criminal laws. C) statutory laws. D) civil laws. Answer: A Terms: Common law Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

22) Which of the following is a true statement regarding CPAs' liability? A) The amounts assessed under joint and several liability will not differ significantly from the amounts assessed under separate and proportionate liability. B) When lawsuits are brought under the federal securities laws, the joint and several liability approach will always apply. C) If one owner was directly involved in the actions of the owner causing the liability, the personal assets of neither owner can be subject to the damages that arise. D) Under the federal statutes, the amount of damages under separate and proportionate liability can be increased if the main defendant is insolvent. Answer: D Terms: Assessment against a defendant of that portion of the damages Difficulty: Challenging Objective: LO 5-3 AACSB: Reflective thinking 23) The legal term for when an auditor issues an audit opinion, knowing that an adequate audit was not performed, is a A) breach of contract. B) tort action for negligence. C) constructive fraud. D) fraud. Answer: C Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 24) The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept. Answer: TRUE Terms: Standard of due care; Prudent person concept Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 25) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions does not extend to another partner's personal assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

26) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions extends to the firm's assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 27) Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units. Answer: FALSE Terms: Statutory laws Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 28) When an auditor has failed to conduct an adequate audit, liability may depend on the level of negligence. Answer: TRUE Terms: Liability and level of negligence Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 29) Several states have statutes that permit privileged communication between the client and auditor, allowing a CPA to refuse to testify in state and federal courts. Answer: FALSE Terms: CPA and privileged communication Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 30) Gross negligence is the existence of extreme or unusual negligence with the intent to deceive. Answer: FALSE Terms: Gross negligence Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 31) Under common law, CPAs have the right to withhold information from the courts on the grounds that such information is privileged. Answer: FALSE Terms: Lack of privileged communication Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 14 Copyright © 2020 Pearson Education, Inc.

32) Under Federal statutes, the amount of damages under separate and proportionate liability can be increased to 200 percent of the amount determined to be proportionate to the CPA's degree of fault when the main defendant is insolvent. Answer: FALSE Terms: Separate and proportionate liability Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 33) Define ordinary negligence, gross negligence, and constructive fraud. Answer: Ordinary negligence is the absence of reasonable care that can be expected of a person is a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation. Gross negligence is the lack of even slight care, tantamount to reckless behavior, that can be expected of a person in a set of circumstances. Some states do not distinguish between ordinary and gross negligence. Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or to do harm. It is also termed recklessness. In an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users. Terms: Ordinary negligence, gross negligence, and constructive fraud Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 34) An important concept in contract law for accountants to understand is the "third-party beneficiary doctrine." Explain and give an example. Answer: 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. Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement. Terms: Contract law; Third-party beneficiary doctrine Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 35) Distinguish between constructive fraud and fraud. Answer: Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive. Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 15 Copyright © 2020 Pearson Education, Inc.

36) Distinguish between "joint and several liability" and "separate and proportionate liability." Answer: Under joint and several liability, the defendant can be assessed the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. In contrast, under separate and proportionate liability, the defendant is assessed that portion of the damage caused by the defendant's negligence. Terms: Joint and several liability and separate and proportionate liability Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

37) Match seven of the legal terms (a-j) with the definitions provided below (1-7). a. b. c. d. e. f. g. h. i. j.

common law constructive fraud breach of contract joint and several liability ordinary negligence third-party beneficiary gross negligence statutory law fraud separate and proportionate liability

________ 1. laws that have been passed by the U.S. Congress and other governmental units ________ 2. absence of reasonable care that can be expected of a person in a set of circumstances ________ 3. lack of even slight care, tantamount to reckless behavior that can be expected of a person ________ 4. the assessment against a defendant of that portion of the damage caused by the defendant's negligence ________ 5. failure of one or both parties in a contract to fulfill the requirements of the contract ________ 6. 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 ________ 7. existence of extreme or unusual negligence even though there was no intent to deceive or do harm; also termed recklessness Answer: 1. h 2. e 3. g 4. j 5. c 6. d 7. b Terms: Constructive fraud; Breach of contract; Joint and several liability; Separate and proportionate liability; Gross negligence; Ordinary negligence; Statutory law Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

5.4 Learning Objective 5-4 1) The principal issue in cases involving alleged negligence is usually A) if an engagement letter was issued. B) the level of care required. C) if fraud was committed by upper-level management. D) whether the auditor is liable under civil or criminal laws. Answer: B Terms: Level of care; Negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 2) Which of the auditor's defenses against client suits contends no implied or expressed contract? A) lack of duty B) non-negligent performance C) contributory negligence D) absence of causal connections Answer: A Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 3) In connection with the audit of financial statements, an independent auditor could be responsible for failure to detect a material fraud if A) statistical sampling techniques were not used on the audit engagement. B) the auditor planned the audit in a negligent manner. C) accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier. D) the fraud was perpetrated by one employee who circumvented the existing internal controls. Answer: B Terms: Independent auditor could be responsible for failure to detect material fraud Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking

4) Which of the following is an illustration of liability to clients under common law? A) A client sues the auditor for not discovering a theft of assets by an employee. B) A bank sues the auditor for not discovering that the borrower's financial statements are misstated. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements. D) The federal government prosecutes the auditor for knowingly issuing an incorrect audit report. Answer: A Terms: Liability to clients under common law Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 5) Which of the following is an illustration of liability under the federal securities acts? A) A client sues the auditor for not discovering a theft of assets by an employee. B) A bank sues the auditor for not discovering that the borrower's financial statements are misstated. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements. D) The auditor sues a client for not cooperating during the engagement. Answer: C Terms: Liability under federal securities acts Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 6) A CPA firm normally uses one or a combination of four defenses when there are legal claims by clients. Which one of the following is generally not a defense? A) lack of duty B) nonnegligent performance C) contributory negligence D) foreseeable users Answer: D Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

7) Tort actions against CPAs are more common than breach of contract actions because A) there are more torts than contracts. B) the burden of proof is on the auditor rather than on the person suing. C) the person suing need prove only negligence. D) the amounts recoverable are normally larger. Answer: D Terms: Tort actions against CPAs Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 8) The principal issue to be resolved in cases involving alleged negligence is usually A) the amount of the damages suffered by plaintiff. B) whether to impose punitive damages on defendant. C) the level of care exercised by the CPA. D) whether defendant was involved in fraud. Answer: C Terms: Principal issue to be resolved in cases involving alleged negligence Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 9) In the auditing environment, failure to meet auditing standards is often A) an accepted practice. B) a suggestion of negligence. C) conclusive evidence of negligence. D) tantamount to criminal behavior. Answer: C Terms: Failure to meet auditing standards Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 10) A common way for a CPA firm to demonstrate a lack of duty to perform is by use of a(n) A) expert witness' testimony. B) engagement letter. C) management representation letter. D) confirmation letter. Answer: B Terms: Common way to demonstrate lack of duty to perform Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

11) To succeed in an action against the auditor, the client must be able to show that A) the auditor was fraudulent. B) the auditor was grossly negligent. C) there was a written contract. D) there is a close causal connection between the auditor's behavior and the damages suffered by the client. Answer: D Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 12) Which of the following is a true statement regarding auditors' liability? A) The level of care is easy to determine in a review or compilation. B) Engagement letters will relieve the auditor of all liability. C) An auditor will always be guilty of negligence if they fail to uncover fraud. D) The most common source of lawsuits against CPAs is from clients. Answer: D Terms: Auditors' liability to clients Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 13) One of the changes in auditing procedures which was brought about as a result of the 1136 Tenants case was that auditors were encouraged to begin using A) letters of representation. B) confirmation letters. C) engagement letters. D) billet doux letters. Answer: C Terms: Audit procedure brought about by 1136 Tenants case Difficulty: Challenging Objective: LO 5-4 AACSB: Reflective thinking

14) The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt's best defense? A) King is not in privity of contract. B) The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards. C) Lynch & Merritt were not guilty either of gross negligence or fraud. D) Lynch & Merritt were not aware of the King-Wilson surety relationship. Answer: B Terms: Defense in recovery against auditors with employee theft Difficulty: Challenging Objective: LO 5-4 AACSB: Analytic thinking 15) An auditor working for a CPA firm was found to be guilty of extreme or unusual negligence, though it was not proven that the auditor intended to deceive or do harm in the performance of an audit. Which of the terms related to negligence and fraud is this situation describing? A) fraud B) ordinary negligence C) constructive fraud D) gross negligence Answer: C Terms: Terms related to negligence and fraud Difficulty: Challenging Objective: LO 5-4 AACSB: Analytic thinking 16) An example of auditor legal liability to third parties under common law would be the federal government prosecuting an auditor for knowingly issuing an incorrect audit report. Answer: FALSE Terms: Four major sources of auditors' legal liability Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 17) The 1136 Tenants case was a criminal case concerning a CPA's failure to uncover fraud during a financial statement audit. Answer: FALSE Terms: 1136 Tenants case Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

18) Many litigation experts believe that a well written engagement letter significantly reduces the likelihood of adverse legal actions. Answer: TRUE Terms: Reasons for an audit and audit evidence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 19) Constructive fraud is also termed recklessness as it pertains to CPAs' potential liability. Answer: TRUE Terms: Constructive fraud Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 20) The Sarbanes-Oxley Act of 2002 is an example of a statutory law passed by the U.S. Congress which affects auditors. Answer: TRUE Terms: Statutory law Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 21) An example of a third-party beneficiary under contract law includes a bank having a large loan with a client which requires an audit as part of the loan agreement. In these cases, though the contract for the audit engagement is between the auditor and the client, both the auditor and the client are aware that the bank will be relying on the audited financial statements. Answer: TRUE Terms: Contract law and third-party beneficiaries Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 22) In audits, failure of the auditor to meet auditing standards are not, by themselves, conclusive evidence of negligence. Answer: FALSE Terms: Audits and evidence of negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking

23) The question of level of care is similar where the auditor is involved in a compilation or a review of financial statements. Answer: FALSE Terms: Level of care Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 24) A CPA firm is sued after performing a review of a client's financial statements for not uncovering a material misstatement. The CPA firm in this situation can claim lack of duty as a legal defense. Answer: TRUE Terms: Lack of duty Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 25) Even if the auditor conducts an audit properly, the auditor can be held legally responsible if subsequently there are undiscovered misstatements in the financial statements. Answer: FALSE Terms: Nonnegligent performance Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 26) A CPA firm notifies their audit client of a material weakness in internal controls in the warehouse storing inventories. Subsequently, the client discovers a large theft of inventory in the warehouse. In this case, the CPA firm would have the defense of contributor negligence. Answer: TRUE Terms: Contributory negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 27) Assume that an auditor failed to complete an audit for a client on an agreed-upon date. The client files a lawsuit against the auditor, claiming that this delay caused the client to delay a public offering of common stock. A potential defense for the auditor is that the public offering was delayed by the underwriters due to the weakening financial condition of the client. Answer: TRUE Terms: Absence of casual connection Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

28) There are four major sources of an auditor's legal liability. One source is liability to the audit client. List the other three sources. Answer: The other three sources of auditor's legal liability are: • liability to third parties under common law • civil liability under federal securities laws • criminal liability Terms: Sources of auditor's legal liability Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 29) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Answer: Lack of duty. The CPA firm claims that there was no implied or expressed contract. Non-negligent performance. The CPA firm claims that the audit was performed in accordance with auditing standards. Contributory negligence. The CPA firm claims that the client's own actions resulted in the loss that is the basis for the damages, or interfered with the conduct of the audit in such a way that prevented that auditor from discovering the cause of the loss. This defense is not available in third-party suits. Absence of causal connection. The CPA firm claims that the auditor's failure to follow auditing standards did not cause the damages suffered by the client. Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 5.5 Learning Objective 5-5 1) A financial institution sues the audit firm for failure to discover that a borrower's financial statements are materially misstated. This is an example of which of the following legal liability concepts? A) liability to clients B) liability to third parties under common law C) civil liability under federal securities law D) criminal liability Answer: B Terms: Liability to third parties under common law Difficulty: Easy Objective: LO 5-5 AACSB: Reflective thinking

2) Which of the following auditor's defenses usually means nonreliance on the financial statements by the user? A) lack of duty B) non-negligent performance C) absence of causal connections D) contributory negligence Answer: C Terms: Auditor defenses against third party suits Difficulty: Easy Objective: LO 5-5 AACSB: Analytic thinking 3) A group typically included as "third parties" in common law is A) Actual and potential stockholders Employees of client Yes Yes B) Actual and potential stockholders No

Employees of client No

C) Actual and potential stockholders Yes

Employees of client No

D) Actual and potential stockholders No

Employees of client Yes

Answer: A Terms: Third parties in common law Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 4) The major conclusion of the 1931 Ultramares case was that A) ordinary negligence is insufficient for liability to third parties. B) third parties must file criminal charges, not civil charges, against the auditor. C) fraud or gross negligence is sufficient for liability to third parties. D) auditors have no liabilities to third parties. Answer: A Terms: Major conclusion of 1931 Ultramares case Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking

5) Under common law, a foreseen user would be treated the same as A) A primary beneficiary A known third party Yes Yes B) A primary beneficiary No

A known third party No

A primary beneficiary Yes

A known third party No

A primary beneficiary No

A known third party Yes

Answer: A Terms: Foreseen user under common law treated the same as Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 6) A broad interpretation of the rights of third-party beneficiaries holds that users whom the auditor should have been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. This is known as the concept of A) foreseen users. B) foreseeable users. C) expected users. D) four-party contracts. Answer: B Terms: Rights of third-party beneficiaries; Privity of contract Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 7) 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) nonnegligent performance D) lack of duty Answer: B Terms: Auditor defenses against third party suits Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 27 Copyright © 2020 Pearson Education, Inc.

8) According to the principle established by the Restatement of Torts, foreseen users must be members of A) any potential user group. B) a legally protected class. C) a reasonably limited and identifiable user group. D) a reasonably limited and established user group. Answer: C Terms: Principle established by Restatement of Torts Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 9) Under the Ultramares doctrine, ordinary negligence is insufficient for liability to third parties unless the third party is A) a primary beneficiary. B) an injured party. C) a foreseen user. D) a bank. Answer: A Terms: Ultramares doctrine Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 10) Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor's report to make decisions about the client company has: A) no rights unless an auditor is grossly negligent. B) no rights unless an auditor is fraudulent. C) no rights against an auditor. D) the same rights against an auditor as a client. Answer: D Terms: Common law third-party rights Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking

11) The basic legal concept which was affirmed in the 1986 New York case, Credit Alliance, was that A) the auditor's defense of privity of contract is still valid. B) the auditor is liable for ordinary negligence to specifically foreseen third parties. C) the auditor is liable for ordinary negligence to reasonably foreseeable third parties. D) the auditor's defense of contributory negligence is no longer valid. Answer: A Terms: Basic legal concept affirmed in 1986 case, Credit Alliance Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 12) As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft? A) He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees. B) He would have no liability because privity of contract is lacking. C) He would be liable for losses attributable to his negligence. D) He would be liable only if it could be proven that he was grossly negligent. Answer: C Terms: Under common law, extent of liability where auditor failed to adhere to generally accepted auditing standards in examination of client and failed to detect employee embezzlement Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 13) If an auditor is unsuccessful in using the lack of duty defense to have a case dismissed in a third-party suit, the preferred defense is A) lack of duty to perform. B) nonnegligent performance. C) absence of causal connection. D) client fraud. Answer: B Terms: Preferred defense in third-party suits Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking

14) In the Rusch Factors v. Levin (1968) case, which of the following approaches did the court take to assign third-party liability under common law? A) primary beneficiary B) foreseeable user C) foreseen user D) identified user Answer: C Terms: Under common law, extent of third-party liability Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 15) Although there is confusion caused by the differing views of liability to third parties under common law, the movement is clearly away from the foreseeable user approach. Answer: TRUE Terms: Foreseeable user approach Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 16) The broadest interpretation of the right of third-party beneficiaries is the primary user concept. Answer: FALSE Terms: Third-party liability under common law Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking 17) The Credit Alliance approach to the concept of foreseen users states that to be liable to third parties, an auditor (1) must know and intend that the work product would be used by the thirdparty for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct. Answer: TRUE Terms: Credit Alliance approach Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking

18) Three approaches to the application of the foreseen users' concept are (1) the Credit Alliance approach, (2) the Restatement of Torts approach, and (3) the foreseeable user approach. Summarize each of these three approaches. Answer: The Credit Alliance approach upholds the concept of privity of contract established by the Ultramares Corporation v. Touche case. Under this approach, for an auditor to be liable to third parties, the auditor (1) must know and intend that the work product would be used by the third-party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct. Under the Restatement of Torts approach, foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA's work, such as creditors, even though those persons were not specifically known to the CPA at the time the work was done. Under the foreseeable user approach, any users that the auditor should have reasonably been able to foresee as likely users of the client's financial statements have the same rights as those with privity of contract. Terms: Three approaches to the application of foreseen users' concepts Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking 5.6 Learning Objective 5-6 1) An adequate system of internal control for SEC registrants was originally required by the A) Sarbanes-Oxley Act of 2002. B) Securities Act of 1933. C) Foreign Corrupt Practices Act of 1977. D) Securities Act of 1934. Answer: C Terms: Required an adequate system of internal control for SEC registrants Difficulty: Easy Objective: LO 5-6 AACSB: Reflective thinking

2) The increased litigation under the federal securities laws has resulted from A) The availability of class- The strict liability standards An excess of attorneys action litigation imposed on CPAs by the securities laws Yes Yes Yes B) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws Yes No C) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws Yes Yes D) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws No No

An excess of attorneys No An excess of attorneys No An excess of attorneys No

Answer: C Terms: Increased litigation under federal securities law Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 3) Under the Securities Act of 1933, the auditor's responsibility for making sure the financial statements were fairly stated extends to A) the date of the financial statements. B) the date the registration statement becomes effective. C) the date of the audit report. D) one year beyond the date of the financial statements. Answer: B Terms: Securities Act of 1933 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

4) Under the Securities Exchange Act of 1934, which type of organization is required to submit audited financial statements to the SEC? A) every company with securities traded on national and over-the-counter exchanges B) every corporation C) every company issuing new securities D) every corporation which is chartered by a state government Answer: A Terms: Securities Act of 1934; Organizations required to submit audited financial statements Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 5) The Securities and Exchange Commission can impose all but which of the following sanctions? A) suspend a CPA from auditing SEC clients B) prohibit a CPA from accepting new SEC clients for a period of time C) require a CPA to participate in continuing-education programs and make changes in their practice D) revoke a CPA license Answer: D Terms: Securities and Exchange Commission can impose sanctions Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 6) The Foreign Corrupt Practices Act (FCPA) of 1977 A) requires auditors to review and evaluate systems of internal control as a part of an audit. B) requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control. C) requires auditors to review client's internal control system in a manner which is thorough enough to judge whether client meets the requirements of the FCPA. D) requires auditors to file a report with the SEC if client's internal control system is inadequate. Answer: B Terms: Foreign Corrupt Practices Act of 1977 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

7) While the Foreign Corrupt Practices Act of 1977 remains in effect, its internal control provisions have been largely superseded by which of the following? A) Sarbanes-Oxley Act of 2002 B) Racketeer Influenced and Corrupt Organization Act C) Federal False Statements Statute D) Federal Mail Fraud Statute Answer: A Terms: Foreign Corrupt Practices Act of 1977; Internal control provisions Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 8) Which of the following is an accurate statement regarding recent actions brought against accountants by clients and third parties? A) Litigants will first seek state remedies because of the availability of class-action litigation. B) Gross negligence by the auditor must be proven under the Securities Acts of 1933 and 1934. C) The greatest growth in CPA liability litigation has been under the federal securities laws. D) The amount of damages that plaintiffs can receive is greater under common law than under the federal securities laws. Answer: C Terms: Factor in increase in number of lawsuits and sizes of awards Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 9) A major purpose of federal securities regulations is to A) provide sufficient reliable information to the investing public who purchase securities in the marketplace. B) establish the qualifications for accountants who are members of the profession. C) eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public. D) provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission. Answer: A Terms: Major purpose of federal securities regulations Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

10) The 2012 news of a massive alleged bribery scheme involving Wal-Mart has brought charges against the company under the A) Securities Act of 1933. B) Securities Act of 1934. C) Foreign Corrupt Practices Act of 1977. D) Sarbanes-Oxley Act of 2002. Answer: C Terms: Foreign Corrupt Practices Act of 1977 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 11) Which of the following statements about the Securities Act of 1933 is not true? A) A third party that purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in the audited financial statements. B) A third-party user does not have the burden of proof that he/she relied on the financial statements. C) A third-party user has the burden of proof that the auditor was either negligent or fraudulent in doing the audit. D) A third-party user does not have the burden of proof that the loss was caused by the misleading statements. Answer: C Terms: Securities Act of 1933 Difficulty: Challenging Objective: LO 5-6 AACSB: Analytic thinking 12) The most significant audit issue that came as a result of the court decision in the Escott et al. v. BarChris Construction Corporation case in 1968 was A) the court's reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent. B) the affirmation of an increase in the auditor's responsibility when performing a review of events subsequent to the balance sheet date (S-1 review) for registration statements. C) the increased auditor responsibility when associated with unaudited financial statements. D) the court's refusal to allow the percentage-of-completion method of accounting for revenues. Answer: B Terms: Significant audit issue from Escott et al v. BarChris Construction Corporation case Difficulty: Challenging Objective: LO 5-6 AACSB: Reflective thinking

13) One significant result of the Escott et al. v. BarChris Construction Corporation case was A) a greater emphasis on subsequent events procedures. B) new standards for unaudited statements. C) a broader definition of third-party beneficiaries. D) a requirement that more companies file annual reports with the SEC. Answer: A Terms: Significant result from Escott et al v. Bar Chris Construction Corporation case Difficulty: Challenging Objective: LO 5-6 AACSB: Reflective thinking 14) 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. Answer: B Terms: Securities Exchange Act of 1934 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 15) Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as A) the antifraud provisions. B) the new issues provisions. C) the full employment act for accountants. D) the RICO provisions. Answer: A Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 16) The U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, the auditor's ________ would be required to be shown to the court. A) ordinary negligence B) gross negligence C) knowledge and intent to deceive D) financial gain at the expense of the plaintiff Answer: C Terms: Securities Exchange Act of 1934 Rule 10b-5; U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 36 Copyright © 2020 Pearson Education, Inc.

17) Under the Securities Act of 1933, A) any party who relies on the company's audited financial statements can recover from the auditors. B) third-party users must prove that the auditor was negligent. C) the burden of proof is on the defendant. D) auditors face potential legal exposure for information contained in the Form 10-Q. Answer: C Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 18) Which of the following is an accurate statement regarding Rule 10b-5 of the Securities Exchange Act of 1934? A) The Supreme Court has ruled that liability under Rule 10b-5 does not extend to aiders or abettors who participated in financial statement misstatements that were not the primary defendants. B) Federal court decisions have clarified that Rule 10b-5 applies only to direct sellers. C) Hochfelder and subsequent court decisions have increased the liability of auditors under Rule 10b-5. D) According to most recent court decisions, poor judgment is proof of fraud. Answer: A Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Difficulty: Moderate Objective: LO 5-6 AACSB: Analytic thinking 19) One result from the Escott et al. v. BarChris case was a greater emphasis being placed on the audit staff's understanding of the client's business and industry. Answer: TRUE Terms: Escott et al. v. BarChris Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 20) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities. Answer: TRUE Terms: Securities Act of 1933 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking