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4-18 (Objective 4-6) The following questions concern independence and the Code of Professional Conduct or GAAS. Choose the best response.

  • What is the meaning of the generally accepted auditing standard that requires the auditor be independent?
    • (1) The auditor must be without bias with respect to the client under audit.
    • (2) The auditor must adopt a critical attitude during the audit.
    • (3) The auditor’s sole obligation is to third parties.
    • (4) The auditor may have a direct ownership interest in the client’s business if it is not material.
  • The independent audit is important to readers of financial statements because it
    • (1) determines the future stewardship of the management of the company whose financial statements are audited.
    • (2) measures and communicates financial and business data included in financial statements.
    • (3) involves the objective examination of and reporting on management-prepared statements.
    • (4) reports on the accuracy of all information in the financial statements.
  • An auditor strives to achieve independence in appearance to
    • (1) maintain public confidence in the profession.
    • (2) become independent in fact.
    • (3) comply with the generally accepted auditing standards of field work.
    • (4) maintain an unbiased mental attitude.

4-19( Objective4-7) The following questions concern possible violations of the AICPA Code of Professional Conduct. Choose the best response.

  • In which one of the following situations would a CPA be in violation of the AICPACode of Professional Conduct in determining the audit fee?
    • (1) A fee based on whether the CPA’s report on the client’s financial statements results in the approval of a bank loan.
    • (2) A fee based on the outcome of a bankruptcy proceeding.
    • (3) A fee based on the nature of the service rendered and the CPA’s expertise instead of the actual time spent on the engagement.
    • (4) A fee based on the fee charged by the prior auditor.
  • The AICPA Code of Professional Conduct states that a CPA shall not disclose any confidential information obtained in the course of a professional engagement except with the consent of the client. In which one of the following situations would disclosure by a CPA be in violation of the code?
    • (1) Disclosing confidential information in order to properly discharge the CPA’s responsibilities in accordance with the profession’s standards.
    • (2) Disclosing confidential information in compliance with a subpoena issued by a court.
    • (3) Disclosing confidential information to another accountant interested in purchasing the CPA’s practice.
    • (4) Disclosing confidential information during an AICPA authorized peer review.
  • A CPA’s retention of client records as a means of enforcing payment of an overdue audit fee is an action that is
    • (1) not addressed by the AICPA Code of Professional Conduct.
    • (2) acceptable if sanctioned by the state laws.
    • (3) prohibited under the AICPA rules of conduct.
    • (4) a violation of generally accepted auditing standards.


4-20 (Objectives 4-5, 4-6) The following situations involve the provision of nonaudit services. Indicate whether providing the service is a violation of AICPA rules or SEC rules including Sarbanes–Oxley requirements on independence. Explain your answer as necessary.

  • Providing bookkeeping services to a public company. The services were preapproved by the audit committee of the company.
  • Providing internal audit services to a public company that is not an audit client.
  • Implementing a financial information system designed by management for a private company.
  • Recommending a tax shelter to a client that is publicly held. The services were preapproved by the audit committee.
  • Providing internal audit services to a public company audit client with the preapproval of the audit committee.
  • Providing bookkeeping services to an audit client that is a private company.

4-21 (Objectives 4-6, 4-7) Each of the following situations involves a possible violation of the AICPA’sCode of Professional Conduct. For each situation, state the applicable section of the rules of conduct and whether it is a violation.

  • Emrich, CPA, provides tax services, management advisory services, and bookkeeping services and conducts audits for the same nonpublic client. Because the firm is small, the same person often provides all the services.
  • Franz Marteens is a CPA, but not a partner, with 3 years of professional experience with Roberts and Batchelor, CPAs. He owns 25 shares of stock in an audit client of the firm, but he does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth.
  • A nonaudit client requests assistance of M. Wilkenson, CPA, in the installation of a local area network. Wilkenson had no experience in this type of work and no knowledge of the client’s computer system, so he obtained assistance from a computer consultant. The consultant is not in the practice of public accounting, but Wilkenson is confident of his professional skills. Because of the highly technical nature of the work, Wilkenson is not able to review the consultant’s work.
  • In preparing the personal tax returns for a client, Sarah Milsaps, CPA, observed that the deductions for contributions and interest were unusually large. When she asked the client for backup information to support the deductions, she was told, “Ask me no questions, and I will tell you no lies.” Milsaps completed the return on the basis of the information acquired from the client.
  • Roberta Hernandez, CPA, serves as controller of a U.S. based company that has a significant portion of its operations in several South American countries. Certaingovernment provisions in selected countries require the company to file financial statements based on international standards. Roberta oversees the issuance of the company’s financial statements and asserts that the statements are based on international financial accounting standards; however the standards she uses are not those issued by the International Accounting Standards Board.
  • Steve Custer, CPA, set up a casualty and fire insurance agency to complement his auditing and tax services. He does not use his own name on anything pertaining to the insurance agency and has a highly competent manager, Jack Long, who runs it. Custer often requests Long to review the adequacy of a client’s insurance with management if it seems underinsured. He believes that he provides a valuable service to clients by informing them when they are underinsured.
  • Seven small Seattle CPA firms have become involved in an information project by taking part in an interfirm working paper review program. Under the program, each firm designates two partners to review the audit files, including the tax returns and the financial statements of another CPA firm taking part in the program. At the end of each review, the auditors who prepared the working papers and the reviewers have a conference to discuss the strengths and weaknesses of the audit. They do not obtain authorization from the audit client before the review takes place.
  • Archer Ressner, CPA, stayed longer than he should have at the annual Christmas party of Ressner and Associates, CPAs. On his way home he drove through a red light and was stopped by a police officer, who observed that he was intoxicated. In a jury trial, Ressner was found guilty of driving under the influence of alcohol. Because this was not his first offense, he was sentenced to 30 days in jail and his driver’s license was revoked for 1 year.

4-22 (Objectives 4-6, 4-7) Each of the following situations involves possible violations of the AICPA’sCode of Professional Conduct. For each situation, state whether it is a violation of the Code. In those cases in which it is a violation, explain the nature of the violation and the rationale for the existing rule.

  • The audit firm of Miller and Yancy, CPAs has joined an association of other CPA firms across the country to enhance the types of professional services the firm can provide. Miller and Yancy share resources with other firms in the association, including audit methodologies and audit manuals, and common IT systems for billing and time reporting. One of the partners in Miller and Yancy has a direct financial interest in the audit client of another firm in the association.
  • Bruce Sullivan, CPA, is the audit partner on the engagement of Xylium Corporation, which is a public company. In structuring the agreement with the audit committee for the audit of Xylium’s financial statements, Sullivan included a clause that limits the liability of Sullivan’s firm so that shareholders of Xylium are prohibited from suing Sullivan and the firm for performance issues related to the audit.
  • Jennifer Crowe’s audit client has a material investment in Polex, Inc. Jennifer’s nondependent parents also own shares in Polex and Polex is not an attest client of Jennifer’s firm. The amount of her parent’s ownership in Polex is not significant to Jennifer’s net worth.
  • Joe Stokely is a former partner in Bass and Sims, CPAs. Recently, Joe left the firm to become the chief operating officer of Lacy Foods, Inc., which is an audit client of Bass and Sims. In his new role, Joe has no responsibilities for financial reporting. Bass and Sims made significant changes to the audit plan for the upcoming audit.
  • Odonnel Incorporated has struggled financially and has been unable to pay the audit fee to its auditor, Seale and Seale, CPAs, for the 2009 and 2010 audits. Seale and Seale is currently planning the 2011 audit.
  • Connor Bradley is the partner in charge of the audit of Southern Pinnacle Bank. Bradley is in the process of purchasing a beach condo and has obtained mortgage financing from Southern Pinnacle.
  • Jessica Alma has been serving as the senior auditor on the audit of Carolina BioHealth, Inc. Because of her outstanding work, the head of internal audit at Carolina BioHealth extended her an offer of employment to join the internal audit department as an audit manager. When the discussions with Carolina BioHealth began, Jessica informed her office’s managing partner and was removed from the audit engagement.
  • Lorraine Wilcox is a CPA and professor of accounting at a major state university. One of her former students recently sat for the Audit section of the CPA exam. One day, the student dropped by Lorraine’s office and told her about many of the questions and simulation content on the exam. Lorraine was grateful for the information, which will be helpful as she prepares the course syllabus for the next semester.
  • Audrey Glover is a financial analyst in the financial reporting department of Technologies International, a privately held corporation. Audrey was asked to prepare several journal entries for Technologies International related to transactions that have not yet occurred. The entries are reflected in financial statements that the company recently provided to the bank in connection with a loan outstanding due to the bank.
  • Austin and Houston, CPAs, is performing consulting services to help management of McAlister Global Services streamline it production operations. Austin and Houston structured the fee for this engagement to be a fixed percentage of costs savings that result once the new processes are implemented. Austin and Houston perform no other services for McAlister Global.



5-17 (Objective 5-6) The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response.

  • Major, Major, & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if
    • (1) the misstatements were caused primarily by MacLain.
    • (2) it can be shown that at least some of the investors did notactually read the audited financial statements.
    • (3) it can prove due diligence in the audit of the financial statements of MacLain.
    • (4) MacLain had expressly assumed any liability in connection with the public offering.
  • Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security?
  Reliance on the Financial Statements Fraud by The CPA
(1) Yes Yes
(2) Yes No
(3) No Yes
(4) No No
  • Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc. to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds’ best defense?
    • (1) They did notintentionally certify false financial statements.
    • (2) Section 10b does notapply to them.
    • (3) They were notin privity of contract with the creditors.
    • (4) Their engagement letter specifically disclaimed any liability to any party that resulted from Markum’s fraudulent conduct.
  • Which of the following statements about the Securities Act of 1933 is not true?
    • (1) The third party user does not have the burden of proof that she/he relied on the financial statements.
    • (2) The third party has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.
    • (3) The third party user does not have the burden of proof that the loss was caused by the misleading financial statements.
    • (4) The auditor will not be liable if he or she can demonstrate due diligence in performing the audit.


5-19 (Objectives 5-4, 5-5) Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm’s in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work.

A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart’s inventory count procedures, Yost told the president she believed the method of counting inventory at different locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president would sign a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations.

Eighteen months later, Yost found out that the worst had happened. Management below the president’s level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations after it had been counted in a given location. The accounting records were inadequate to uncover these illegal transfers.

Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co.


Answer the following questions, setting forth reasons for any conclusions stated:

  • What defense should Lauren Yost & Co. use in the suit by Stuart?
  • What defense should Lauren Yost & Co. use in the suit by First City National Bank?
  • Is Yost likely to be successful in her defenses?
  • Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934?

5-21 (Objectives 5-3, 5-5) Doyle and Jensen, CPAs, audited the accounts of Regal Jewelry, Inc., a corporation that imports and deals in fine jewelry. Upon completion of the audit, the auditors supplied Regal Jewelry with 20 copies of the audited financial statements. The firm knew in a general way that Regal Jewelry wanted that number of copies of the auditor’s report to furnish to banks and other potential lenders.

The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Regal Jewelry had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting jewelry listed as inventory when in fact Regal Jewelry had only empty boxes. The audit failed to detect these fraudulent entries. Thompson, relying on the audited financial statements, loaned Regal Jewelry $200,000. She seeks to recover her loss from Doyle and Jensen.


State whether each of the following is true or false and give your reasons:

  • If Thompson alleges and proves negligence on the part of Doyle and Jensen, she will be able to recover her loss.
  • If Thompson alleges and proves constructive fraud (that is, gross negligence on the part of Doyle and Jensen), she will be able to recover her loss.
  • Thompson does not have a contract with Doyle and Jensen.
  • Unless actual fraud on the part of Doyle and Jensen can be shown, Thompson can not recover.
  • Thompson is a third-party beneficiary of the contract Doyle and Jensen made with Regal Jewelry.*
  • 5-26 (Objective 5-5)Sarah Robertson, CPA, had been the auditor of Majestic Co. for several years. As she and her staff prepared for the audit for the year ended December 31, 2010, Herb Majestic told her that he needed a large bank loan to “tide him over” until sales picked up as expected in late 2011.
  • In the course of the audit, Robertson discovered that the financial situation at Majestic was worse than Majestic had revealed and that the company was technically bankrupt. She discussed the situation with Majestic, who pointed out that the bank loan will “be his solution”—he was sure he will get it as long as the financial statements don’t look too bad.
  • Robertson stated that she believed the statements will have to include a going concern explanatory paragraph. Majestic said that this wasn’t needed because the bank loan was so certain and that inclusion of the going concern paragraph will certainly cause the management of the bank to change its mind about the loan.
  • Robertson finally acquiesced and the audited statements were issued without a going concern paragraph. The company received the loan, but things did not improve as Majestic thought they would and the company filed for bankruptcy in August 2011.
  • The bank sued Sarah Robertson for fraud.
  • Required
  • Indicate whether or not you think the bank will succeed. Support your answer.