HOMEWORK SOLUTIONS CHAPTER 1 THRU 4

1-1 The “crisis of credibility” largely arose from the number of companies that restated their previously issued financial statements as a result of accounting irregularities and fraud. Especially responsible were the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy and constituted the largest companies in American history to do so. The extent of the accounting irregularities and fraud being investigated and disclosed brought into question the effectiveness of financial statement audits. In addition, the criminal conviction of Arthur Andersen, LLP, one of the then Big 5 accounting firms, on charges of destroying documents related to the Enron case brought into question the ethical standards of the profession.

1-25 The Public Company Accounting Oversight Board was created because of the concerns about the credibility of the public accounting profession that occurred in the later part of 2001 and the early part of 2002. The large number of public company restatements due to accounting irregularities and fraud caused the investing public and Congress to question the effectiveness of audits. In addition, the conviction of Arthur Andersen LLP of destruction of evidence related to the Enron case caused Congress to question the profession’s ethical principles. The Public Company Accounting Oversight Board has the responsibility to oversee and discipline public accounting firms that audit public companies. Specifically, the PCAOB has the responsibility for:

(1) Establishing or adopting auditing, quality control, and ethic standards,(2) Registering public accounting firms,(3) Performing inspections of the practices of registered, (4) Conducting investigations and disciplinary proceedings of registered firms, and (5) Sanctioning registered firms.

1-28 (a) (3) All attest services are assurance services, but not all assurance services are attest services—this makes attest services a subset of assurance services. Answer (1) is incorrect because both attest and assurance services may both involve financial or nonfinancial data. Answer (2) is incorrect because objectivity (and independence) is required for all of these services. Answer (4) is incorrect because attest and assurance services are not different terms for referring to the same types of services—attest is a broader concept.

(b) (1) The client's management is primarily responsible for representations contained in the financial statements. The independent auditors are responsible for performing their audit in accordance with generally accepted auditing standards.

(c) (1) The most important benefit of having an annual audit by a public accounting firm is to provide assurance to investors and other outsiders that the financial statements are dependable. The expansion of the securities markets has tremendously increased the need for verification of financial statements performed by competent, independent persons. Answer (2) is incorrect because management cannot avoid responsibility for the financial statements by retaining independent auditors. Answer (3) gives no recognition to the fact that many nonpublic corporations and other business entities have no obligation to file audited financial statements with governmental agencies. It also disregards the fact that large corporations which secure capital from the general public would continue to provide audited statements even though there were no such requirements by governmental agencies. Answer (4) is unacceptable because it implies that an audit is designed to detect illegal acts without regard to type or size.

(d) (2) The PCAOB ordinarily does not review financial reports filed with the Securities and Exchange Commission—although, if they so desire, they may review such reports to accomplish their other responsibilities. The other three replies are all explicit responsibilities of the PCAOB.

(e) (4) The Public Company Accounting Oversight Board was given the authority by the Sarbanes-Oxley Act of 2002 to establish or adopt auditing standards for audits of public companies.

(f) (4) Governmental auditing often extends to audits of efficiency, effectiveness, and compliance (with laws, regulations, etc). The other responses, adequacy, evaluation, and accuracy, are terms not typically used to summarize the scope of governmental auditing.

(g) (3) Normally, the higher in an organization an internal auditor reports, the greater the degree of independence. Accordingly, reporting to the audit committee of the board of directors increases the likelihood that the internal auditor will be able to act independently of those being audited. Answers (1) and (2) may lead to a lesser degree of independence because when an internal auditor reports to the financial vice-president or the controller they cannot objectively review their work. Answer (4) is incorrect because it is generally not practical or effective for the internal auditor to report to stockholders on a timely basis.

(h) (4) Ethical scandals at the AICPA was not one of the causes of the passage of the Sarbanes-Oxley Act of 2002. All of the other responses contributed to passage of the Act.

(i) (3) The Federal Accounting Standards Advisory Board establishes accounting standards for United States governmental agencies. The Governmental Accounting Standards Board establishes accounting standards for state and local government entities.

(j) (4) Forensic audits are usually performed when fraud has been found or is suspected. Answer (1) is incorrect because it overstates the nature of most audits by suggesting that all audits are forensic in nature. Answer (2) is wrong in that CPA firms (or law firms) may perform forensic audits. Answer (3) is incorrect because while compliance audits may find fraud, they are not directed at fraud as are forensic audits.

(k) (1) Because the auditors’ purposes for considering internal control are to (a) plan the audit and (b) to determine the nature, timing, and extent of the tests to be performed, answer (1) is correct.

(l) (2) A compliance audit measures the compliance of an organization with established criteria such as laws and regulations. Answer (2) is correct because it addresses policies and procedures on environmental laws and regulations.

1-34 SOLUTION: Types of Services Provided by CPAs (Estimated time: 15 minutes)

The following are typical replies relating to this very general question. The purpose of this team exercise is to consider employment options within the profession of accounting. Students will typically have many concerns relating to this topic and an early discussion may provide them with helpful background information.

(a) Tax services performed by public accounting firms fall into the categories of compliance work and tax planning. Compliance work involves preparing the federal, state, and local tax returns of clients. Tax planning involves consulting with clients on how to structure their business affairs to minimize the amount and postpone the payment of taxes. Tax work while working for a corporation is similar in that it deals with compliance and with planning. It differs, however, in that the work will be performed for the one company, and not the broad range of clients typical of a public accounting firm. This obviously has advantages in terms of developing expertise related to the company.

Taxation work for the General Accounting Office will relate primarily to studies of general compliance with tax laws. Internal Revenue Service deals completely with compliance with various federal tax laws.

(b) Public accounting firms have historically emphasized the auditing of financial statements, although expansion of the attest function to a number of other areas is currently occurring. Auditing work with corporations generally involves working in the internal auditing department of that corporation. In addition to auditing financial information, internal auditing staff members devote a significant amount of time to operational and compliance audits.

The auditing work with the General Accounting Office includes both compliance and operational audits. Internal Revenue Service auditing work is, as indicated, related to compliance with various federal tax laws.

(c) Public accounting firms become involved with systems design both through audits and through consulting services. In audits, CPAs must analyze their clients' internal control, as well as make recommendations for improvements. However, public accounting firms that audit public companies may not perform systems consulting for those clients. Similarly, internal auditors for corporations, as well as information technology specialists Become involved in systems design. The General Accounting Office and the Internal Revenue do not typically become involved in systems design beyond that needed to perform compliance audits, and in the case of the GAO, operational audits.

2-2 Generally accepted accounting principles are accounting principles which have substantial authoritative support, such as approval by the Governmental Accounting Standards Board or the Financial Accounting Standards Board, or its predecessor, the Accounting Principles Board. These standards provide the criteria for financial reporting, including the nature and content of financial statements.

Generally accepted auditing standards (GAAS) refer to the 10 broad standards and the Statement on Auditing Standards (SASs) set forth by the Auditing Standards Board of the AICPA. Generally accepted auditing standards vary depending upon whether the audit is of a public or nonpublic company. Auditing standards for public companies are established by the Public Company Accounting Oversight Board.

Examples of generally accepted accounting principles are the matching principle, the realization principle, and the going concern assumption. There are a number of others, but no official list exists. Examples of generally accepted auditing standards (within the general standards subgroup) would include:

(1) The audit must be performed by a person or persons having adequate technical training and proficiency as an auditor.

(2) In all matters relating to the engagement, an independence in mental attitude is to be maintained by the auditor or auditors.

(3) Due professional care is to be exercised in the performance of the audit and the preparation of the report.

2-31 (a) (4) Because the license to practice as a CPA is granted by the state, the applicable state, through its state board of accountancy, has the right to revoke the right of an individual to practice as a CPA. Students are sometimes confused by the fact that while the CPA examination is administered nationally, it is the individual states that award CPA certificates.

(b) (2) The AICPA has authority to establish auditing standard for nonpublic companies. The Financial Accounting Standards board has authority for accounting standards of both public and nonpublic companies. The Public Company Accounting Oversight Board has authority to establish quality control standards and standards for interim reviews of public companies.

(c) (1) Statements on Auditing Standards are “Standards” not “interpretative publications.” Appendices to Statements on Auditing Standards, auditing guidance in AICPA Audit and Accounting Guides, and AICPA Auditing Statements of Position are all considered interpretative publications.

(d) (2) The three standards of field work relate specifically to criteria of audit planning and evidence-gathering. Answers (1) and (4) are not acceptable because they relate to the general standards group. Answer (3) relates to the standards of reporting.

(e) (2) The quality control standards were established to provide reasonable assurance that professional services confirm with professional standards. Answer (1) is incomplete since many standards in addition to reporting standards must be followed. Answer (3) is incorrect because a peer review monitors whether a firm's quality control standards are being met. Answer (4) is incorrect because continuing professional education is only one part of a system of quality control.

(f) (3) The internal control of the client is not explicitly mentioned in the unqualified standard report although it is implicit in the reference to generally accepted auditing standards. Answers (1), (2), and (4) are all explicitly set forth in the unqualified standard form of audit report.

(g) (1) An independent mental attitude on the part of the auditor is required by the second general standard of the generally accepted accounting principles. Answers (3) and (4) relate to the standards of field work. Answer (2) confuses generally accepted accounting principles with generally accepted auditing standards.

(h) (3) Such a quality control policy is designed to assure that personnel assigned to an engagement are independent to perform the work.

(i) (1) An audit provides reasonable assurance of detecting misstatements due to fraud, regardless of whether due to fraudulent financial reporting or misappropriation of assets.

(j) (1) An integrated audit report on the financial statements of a public company states that the audit was performed in accordance with Public Company Accounting Oversight Board standards, not AICPA standards.

(k) (3) The PCAOB staff performs inspections of audit firms that are registered with the PCAOB. In order to perform an audit of a public client an audit firm must be registered.

(l) (4) Neither the AICPA audit report nor the international audit report include an opinion on internal control. The other replies provide differences between the two reports in that the international audit report has an expanded discussion of management’s responsibility and the nature of the audit report, and may be signed by the audit partner, the firm or both.

2-35 SOLUTION: Casa Royale, Inc., (Estimated time: 20 minutes)

(a) The CPA issued a qualified audit report as shown by the first sentence of the opinion paragraph. This sentence contains the phrase "except for the effects of such adjustments, if any, as might have been determined to be necessary had I been able to examine evidence regarding plant assets," and this modification of the auditor's opinion on the fairness of the financial statements warrants classifying the report as qualified.

This type of report was not appropriate in the circumstances of the engagement. The client deliberately restricted the scope of the audit by specifying that the engagement was not to include the examination of the corporation's plant assets. The plant assets represented about 25% of the total assets and were therefore quite material. Because of this major restriction imposed by the client, the CPA did not gather sufficient evidence to justify the expression of any opinion on the fairness of the financial statements as a whole. The only acceptable type of audit report in these circumstances is a disclaimer of opinion.

(b) A contradiction exists between the scope paragraph of the audit report and the information in the note to the financial statements. The note indicates that the client dictated the extent of the auditor's work whereas the scope paragraph of the audit report states that the auditor made an audit in accordance with generally accepted audited stan-dards. Standard No. 3 of the Standards of Field Work states that "Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit."

To omit any examination of the plant assets, which represented 25% of total assets, clearly made this audit not in conformity with generally accepted auditing standards. The CPA violated the most fundamental of auditing concepts by implying that he had conducted an audit sufficient to warrant the expression of an opinion when in fact he had not done so.

The note to the financial statements is not a reasonable statement. The acquisition of plant assets over a 10-year period is in no way unusual and not an acceptable excuse for limiting the scope of the audit work. Perhaps the client was unwilling to pay for a complete audit and the CPA was willing to violate professional standards by indicating that he had performed all necessary work when he knew the contrary to be true.

(c) The omission of audit work on the plant assets prevented the auditor from knowing whether the cost of these assets was properly stated. Therefore, he could not verify the amount of depreciation expense which is an important part of the income statement. It is even possible that the client does not own any plant assets, but leases them, or that the plant assets are in fact fully depreciated.

3-26 (a) No. A partner in another office, with no ties to the audit, is not a covered member.

(b) Yes. An individual on the attest engagement team is a covered member.

(c) Yes. A partner in the engagement office is a covered member.

(d) Yes. Client employees are not covered members but the firms are.

(e) Yes. By serving as a consultant Sanders is able to influence the audit.

3-32 (a) (4) A partner in the national office of the firm that performs marketing services is not considered a covered member as it is unlikely that this partner will be in a position to influence the attest engagement. Individuals assigned to the attest engagement, all partners in the office, and a manager who provides tax services to the client are all included as covered members.

(b) (1) Advertising in newspapers is an acceptable practice. The other three replies are all prohibited by the Code of Professional Conduct.

(c) (1) A fee for audit clients which is dependent upon the results achieved by the CPA's efforts is a contingent fee and is prohibited for audit clients by Rule 302.

(d) (1) An auditor's independence would not be considered to be impaired with respect to a financial institution in which the auditor maintains a checking account which is fully insured.

(e) (1) The declaration requires the preparer to acknowledge that the return is "true, correct, and complete...based on all information of which the preparer has any knowledge."

(f) (3) CPAs in public practice are prohibited from disclosing confidential information without the consent of the client, except in certain specified circumstances. Answers (1), (2), and (4) are three of the circumstances in which disclosure of information is permitted.

(g) (2) Rule 505 requires that a firm practice under a firm name that is misleading. In this situation the name is misleading since it appears that Jones' firm is a partnership.

(h) (3) Rule 201-A prohibits a public accounting firm from accepting an engagement that the firm is not competent to perform. If technical competence problems develop during the engagement, the CPAs should advise the client and withdraw from the engagement.

(i) (4) Auditors may currently prepare the company’s tax return. The Sarbanes-Oxley Act as implemented by the PCAOB prohibits internal audit outsourcing, performing tax planning for the company’s officers, and performing bookkeeping services.

(j) (2) A CPA may help train client employees for an attest client. The Code of Professional Conduct prohibits maintaining custody of client assets, supervising client employees, and authorizing transactions.

(k) (4) The Statements on Responsibilities in Tax Practice are meant to provide guidance to CPAs, but are not directly enforceable under the Code of Professional Conduct. The other standards listed are all enforceable under Rule 202 of the Code.

(l) (3) The IIA Code of Ethics does not directly address the use of sampling methods.

3-43 SOLUTION: Gloria and Deloria, CPAs (Estimated time: 25 minutes)

(a)

Situation

Number Description

Independence impaired (yes, no, or indeter-minate)

Additional information needed for "indeterminate" replies

1 Customize and implement a prepackaged payroll system.

Indeterminate Whether client makes all management decisions relating to the system.

2 Manage a client's local area network system related to payroll.

Yes

3 Generate unsigned payroll checks on a continuing basis for the client; the client signs the checks.

No

4 Prepare the payroll tax return form and sign it on behalf of management.

Yes

5 Approve employee time cards. Yes

6 Accept responsibility to sign payroll checks, but only in emergency situations.

Yes

7 Monitor employee time cards and make changes when errors are detected.

Indeterminate Whether management approves the changes.

8 Post client approved entries to client's trial balance.

No

9. Provide all of the initial training and instruction to client employees on a newly implemented payroll information and control system.

No

10. Screen candidates and recommend the most highly qualified candidate to serve as treasurer for the client.

Indeterminate Whether criteria for evaluation of candidates are client approved; one might also wish to provide a list of qualified candidates rather than only one

top candidate, although this is not required.

11. Supervise client personnel in the daily operation of the payroll system.

Yes

12. Present payroll business risk considerations to the board of directors on behalf of management.

Yes

(b) If the client is not an attest client, any of the services may be performed.

4-27 (a) The unique aspect of this case is that the CPA firm of Arthur Andersen was found

guilty of the felony of criminal destruction of documents. The indictment named only

the firm and not any individual partner or professional staff. The conviction caused the

demise of this international accounting firm.

(b) This case illustrates how the actions of a few individual partners and employees

can lead to disastrous results for the firm. However, it should be noted that the

conviction was overturned by the U.S. Supreme Court based on the instructions given to

the jurors.

4-31 (a) (2) A CPA will be liable to third parties who were unknown and not foreseeable for gross negligence. It should be pointed out that if the third party had been "foreseeable," liability might be established for ordinary negligence under a court following the Rosenblum v. Adler decision.

(b) (2) The Rosenblum Approach provides more third parties the ability to recover damages from the CPA who has performed an engagement with ordinary negligence, and accordingly, is least desirable from the perspective of the CPA. The Ultramares Approach is most desirable, and the Restatement

Approach (also known as the Foreseen User Approach) is between the two extremes.

(c) (2) The plaintiffs need not prove that the CPA made a false statement, it is enough to prove losses and breach of a duty that the CPA had.

(d) (4) Negligent tax advice would ordinarily result in a suit brought under common law. Note that the client is not covered under the Securities Act of 1933 or the Securities Exchange Act of 1934.

(e) (1) The Credit Alliance Corp. v. Arthur Andersen & Co. case reaffirmed the principles in the Ultramares case by clarifying the conditions necessary for parties to be considered third-party beneficiaries.

(f) (1) Contributory negligence, negligence on the part of the plaintiff, may be used as a defense and the court may limit or bar recovery by a plaintiff whose own negligence contributed to the loss.

(g) (3) The Private Securities Litigation Reform Act of 1995 amended the Securities and Exchange Act of 1934 to place limits on the amount of the auditors’ liability through establishing proportionate liability.

(h) (4) A CPA may avoid liability under the 1933 Act by proving that their negligence was not the proximate cause of the plaintiff's loss. Accordingly, a finding that the false statement is immaterial would in all circumstances represent a viable defense.

(i) (3) A CPA may be found liable to a client when due care has not been exercised.

(j) (3) Under the Securities Act of 1933 purchasers of securities who sustain losses need only prove that the financial statements contained in the registration statement were misleading. Then the burden is shifted to the auditors to prove that they performed the audit with "due diligence."

` (k) (1) The Continental Vending case was a landmark in establishing auditors' potential criminal liability under the Securities Exchange Act of 1934. The case involved audited financial statements, was brought under statutory law, and did not involve registration statements (which are covered by the Securities Act of 1933).

(l) (2) The 1136 Tenants case was a landmark case concerning auditors' liability when they are associated with unaudited financial statements.

4-37 SOLUTION: Mark Williams, CPA (Estimated time: 20 minutes)

(a) CPAs as members of a profession are obligated to exercise due professional care. Thus, a CPA may be held liable to the client for the damages resulting from the CPA's ordinary negligence.

Since Jackson Financial was the client, Jackson can recover losses proximately caused by Williams' negligence. It would appear that Jackson Financial could also recover the audit fee as damages because of Williams' breach of contract.

(b) The first argument which Williams' attorney would make is that Apex had no rights under the contract between Jackson and Williams. In most jurisdictions, an "other" third party is able to recover losses attributable to the auditor's gross negligence, but not ordinary negligence.

A second argument is that Williams' negligence was not the proximate cause of Apex's loss. The loss apparently occurred prior to the audit by Williams and could not have been prevented even if Williams had discovered the defalcations. Finally, the attorney would argue contributory negligence on the part of Apex. Normally losses are allocated between the parties when both parties are negligent.

Whether the first argument that Jackson has no rights under the contract will prevail is an interesting question. There is little authority on the precise situation in the problem. Although Apex is not the client and is not mentioned as a beneficiary in the engagement letter, it is the company whose financial statements were audited. Whether this fact creates the duty of care owed by Williams to Jackson Financial is, at present, unclear.

(c) No. A CPA firm is not prevented from recovering against its insurer. This is precisely the purpose of this type of insurance; it serves to protect the insured firm from its own negligence. CPAs may be barred from recovering from their insurers, however, if they are found guilty of criminal fraud.