Midterm Exam Fall 2015 ACCT 612 – Auditing Instructions After you have downloaded this document from the Midterm Exam Assignment, please save a copy of this document and rename it using your own name as the file name so that I can keep them separate on my machine (i.e., "Jim Peters Mid.doc"). Type all your answers in this document. Once you have completed the exam, submit your completed Word files by attaching them to the Midterm assignment in LEO by midnight, November 1st. I will assess a 5% per day late penalty for late exams. If you need clarification on the wording of any question on the exam, you can e-mail me or call me at the phone numbers listed in my contact information. I will not accept direct quotes in your answers. If you use outside sources, you need to paraphrase the material in your own words. I will deduct points for not following these instructions. For example, I will deduct points if you do not type your answers in this document and submit some other type of file; if you do not attached your file to the assignment; or if you do not rename your file as instructed above. I have posted a spreadsheet file, which I refer to as a grading checklist, with this exam. That spreadsheet file shows you how I have allocated points to questions. When grading your exams, I will fill in a copy of this file for each student and return it with your graded exam. When I grade exams, I embed comments in the Word documents to explain why I am deducting points. Course Policy on Collaboration and Individual Work This exam is an individual assignment. You are not to discuss it with anyone other than myself. It is also open book and open note. However, it is not a research assignment and I want you to base your answers to the questions on the material I have included in the exam, the text for the course, and the materials I have handed out in class. Questions None of these questions has a style component, thus you don't have to write in complete sentences and well-formed paragraphs. You can use lists where appropriate if you want. You are a partner in a medium-sized, regional CPA firm and have been approached by XYZ, Inc., a relatively small, public company, to do their audit for next year. XYZ is registered with the SEC and has filed audited 10-Ks for the last 10 years since they went public. They haven't indicated why they are switching auditors. XYZ specializes in developing shale gas using fracking technology. Fracking technology involves drilling wells into shale formations and injecting high pressure water containing special chemicals into the well to fracture the shale formation and release the trapped natural gas. You and your firm currently are members of the AICPA. All the partners and managers are licensed CPAs in the state of New Mexico and also members of the AICPA. Your firm has limited experience with oil and gas extraction and has no other fracking clients. However, your firm has offices that ...

1. Midterm Exam Fall 2015
ACCT 612 – Auditing
Instructions
After you have downloaded this document from the Midterm
Exam Assignment, please save a copy of this document and
rename it using your own name as the file name so that I can
keep them separate on my machine (i.e., "Jim Peters Mid.doc").
Type all your answers in this document.
Once you have completed the exam, submit your completed
Word files by attaching them to the Midterm assignment in LEO
by midnight, November 1st. I will assess a 5% per day late
penalty for late exams.
If you need clarification on the wording of any question on the
exam, you can e-mail me or call me at the phone numbers listed
in my contact information.
I will not accept direct quotes in your answers. If you use
outside sources, you need to paraphrase the material in your
own words.
I will deduct points for not following these instructions. For
example, I will deduct points if you do not type your answers in
this document and submit some other type of file; if you do not
attached your file to the assignment; or if you do not rename
your file as instructed above.
I have posted a spreadsheet file, which I refer to as a grading
checklist, with this exam. That spreadsheet file shows you how
I have allocated points to questions. When grading your exams,
I will fill in a copy of this file for each student and return it
with your graded exam. When I grade exams, I embed
comments in the Word documents to explain why I am
deducting points.
Course Policy on Collaboration and Individual Work

2. This exam is an individual assignment. You are not to discuss
it with anyone other than myself. It is also open book and open
note. However, it is not a research assignment and I want you
to base your answers to the questions on the material I have
included in the exam, the text for the course, and the materials I
have handed out in class.
Questions
None of these questions has a style component, thus you don't
have to write in complete sentences and well-formed
paragraphs. You can use lists where appropriate if you want.
You are a partner in a medium-sized, regional CPA firm and
have been approached by XYZ, Inc., a relatively small, public
company, to do their audit for next year. XYZ is registered
with the SEC and has filed audited 10-Ks for the last 10 years
since they went public. They haven't indicated why they are
switching auditors.
XYZ specializes in developing shale gas using fracking
technology. Fracking technology involves drilling wells into
shale formations and injecting high pressure water containing
special chemicals into the well to fracture the shale formation
and release the trapped natural gas.
You and your firm currently are members of the AICPA. All
the partners and managers are licensed CPAs in the state of New
Mexico and also members of the AICPA. Your firm has limited
experience with oil and gas extraction and has no other fracking
clients. However, your firm has offices that can cover the
physical locations where the prospective client does business.
a) Develop a checklist of five areas or issues that you would
want to research before you accepted this firm as an audit
client. For each area or issue, explain why you would want to
research it and give an example of where you might go to get

3. some information about each issue.
i) Issue 1 -
ii) Issue 2 -
iii) Issue 3 -
iv) Issue 4 -
v) Issue 5 -
b) Describe two reasons why a firm like this firm would want an
audit even if they were not required to do so by the SEC. I am
looking for substantive reasons that show you understand the
importance of auditing in capital markets and why possible
stakeholders like lenders and investors would want a firm like
this to have an audit.
c) Describe three organizations, boards, or groups that have
legal authority to regulate aspects of your audit of this client
and discuss how that organization, board, or group would
regulate your work on this audit.
Describe how the following fit into an overall regulatory
framework that guides external audits: the Auditing Standards
Board's (ASB's) 10 Generally Accepted Auditing Standards,
SAS (The ASB's Statements of Auditing Standards), PCAOB
rules, and ISA (International Standards on Auditing). By "fit
into a regulatory environment" I mean that I want to you cover

4. the organizations that promulgates these standards, how those
organizations and the standards relate to each other, and what
types of audits they apply to.
For of the following situations, indicate whether it violates the
AICPA's Code of Professional Conduct. If it violates the Code,
indicate the rule is most directly violated and explain why.
That is, I want you to select the rule that is most clearly
violated by the specifics of the case. If you don't think it
violations a rule, explain why as well. Use the rule numbers
cited in the text and not paragraph numbers from the
codification. In all cases you are a CPA and member of the
AICPA.
1. You are a former partner for Sullivan and Peters, CPAs. You
left that firm two years ago and to become the CFO for one of
its financial services clients. While you worked for Sullivan
and Peters, you were the only expert in the financial services
industry. Therefore, Sullivan and Peters have maintained a
relationship with you and occasionally pays you consulting fees
to advise them on their financial service client audits.
e) You provide a variety of non-audit services to one of your
audit clients to include bookkeeping and tax preparation. You
also provide informal advice on tax planning issues for the
client's management and sometimes attend their Board of
Directors meetings. The client's CEO considers you one of the
firm's major business advisors. The client is not publicly
traded.
f) You have just completed your first audit of a new client.
During the audit, you identified an area of their tax return that
you believe could be handled differently that would result in a
refund for the client. You offer to advise them on preparing a

5. amended tax return and state that you will charge them 50% of
any refund that they obtain by following your advice. The
client accepts your offer.
g) You are working to build you client base of non-profit
organizations for the CPA firm of which you are a partner. You
take out an ad in a local newspaper where you claim that you
audit 40% of the largest non-profit organizations in the region.
You also state that your average fees when related to the size of
the non-profits you audit is the lowest in the region.
For each of the following situations, describe how the auditor
should modify the audit report for the firm's financial
statements and provide an explanation of why you made the
choice you did. Just cover the report on the financial
statements and ignore any reference to the report on internal
controls. By "modify the audit report," I mean what
modifications the auditor would make to any paragraph of the
report because of the information described. Make sure your
answer either states clearly that no modifications to any
paragraph are needed and explains why or describes what
modifications would be needed to which paragraphs of the
report and explains why.
h) The auditor wishes to emphasize that the auditee has engaged
in significant related party transactions. The information on the
related party transaction is fully disclosed in the footnotes to
the financial statements.
i) The auditor has substantial doubt about the auditee's ability to
continue as a going concern, but the circumstances are fully
disclosed in the financial statements. Cover both the case
where the auditor believes the situation is severe enough to
undermine the credibility of the financial statements taken as a

6. whole and where the auditor believes the situation is less severe
and the overall credibility of the financial statements are not
impaired.
j) The auditee experienced a computer failure during the year
being audited and the auditor was not able to verify the ending
inventory balance. Inventory is material to the auditee's
financial statements, but not pervasively material
k) You complete the audit of KLM, Inc. and, in your opinion,
the financial statements are fairly presented. On the last day of
the audit, you discover that one of your supervisors assigned to
the audit has a material investment in KLM.
Your annual audit of OPQ, Inc. had the following issues:
Even though OPQ had significant long-term debt, all of which
were bank loans secured by various fixed assets and some of
which included restrictive covenants, you decided not to
confirm the debt with the banks that issued the debt. You had
auditing the firm for years and their balance sheet listed the
same loans as last year, just reduced by the amount of the
principle they paid during the year. However, management
didn't tell you that the firm had incurred a major new loan to
compensate for a significant drop in its operating cash flows.
Thus, you ended providing a clean opinion on a set of financial
statements that materially understated long-term debt.
You were aware that all of the banks that had issued loans to
OPQ in the past required audited financial statements as part of
their loan approval process.
Shortly after you had issued your report, OPQ's cash flow
problems continued to deteriorate. The tried to compensate in
two ways. First, they took out another large bank loan from one
of the banks that held other bank notes from the firm, using

7. your audited financial statements as support for the loan.
Second, they sold additional stock to raise additional capital.
The used your audit financial statements in the prospectus they
issued to support the new stock sale. OPQ's stock is publicly
traded and subject to SEC regulation.
Approximately six months after OPQ executed both the new
loan and the stock sale, they declared bankruptcy because their
operating cash continued to deteriorate to the point they could
no longer make the debt payments. Because of the bankruptcy,
trading was suspended on OPQ's stock because its value had
dropped by 98% and the banks could only recover 20% of the
remaining balances on their loans.
Both the bank that had issued the new loan and several major
stockholders that had purchased stock from the new offering
sued you to recover their losses.
Answer the following questions and justify your answers with
specific references to the appropriate laws and legal principles.
Be thorough in covering all the issues concerning both if they
bank will prevail.
1. Will the bank be successful in their law suit against you for:
i) ordinary negligence?
ii) fraud?
m) Will the stockholders who purchased their stock in the stock
offering for which OPQ used your audit financial statements
succeed in against you under each of the following bodies of
law?
i) Common Law
ii) Federal securities law (be sure to indicate which statue)

8. The following is a list of independent situations that may affect
an auditor's report on a firm's internal controls under PCAOB
rules for such reports. For each situation, describe how the
auditor should modify the audit report for the firm's internal
controls and provide an explanation of why you made the choice
you did. By "modify the audit report," I mean what
modifications the auditor would make to any paragraph of the
report because of the information described. Make sure your
answer either states clearly that no modifications to any
paragraph are needed and explains why or describes what
modifications would be needed to which paragraphs of the
report and explains why. Note that the text isn't very clear on
how to handle scope limitation in the internal control report.
Modifications to the internal control report for scope limitations
are the same as those required for scope limitations on financial
statement audit reports.
n) The auditor identified several significant deficiencies in
internal control. Because of these significant deficiencies, the
auditor believes that there is a reasonable possibility that
internal controls will not prevent or detect a material
misstatement on a timely basis.
o) The auditee installed a new control procedure over inventory
near the end of the audit year. Inventory makes up 15% of the
auditee's total assets. The auditor believes that the control has
not been in place long enough to be adequately tested as of the
balance sheet date.
Questions 7 and 8 were taken from the CPA exam and reprinted
in the text. My normal warnings about attempting to access the
solutions apply. For each question, selected the best answer
and then explain why it is better than all the alternatives. Your
explanations should cover all the alternatives in the question

9. and explain why each one of is not as good as the answer you
select.
Because of the risk of material misstatement due to fraud (fraud
risk), an audit of financial statements in accordance with
generally accepted auditing standards should be performed with
an attitude of
p) impartial conservatism
q) independent integrity
r) professional skepticism
s) objective judgment
Answer:
Explanation:
Which of the following statements reflects an auditor's
responsibility for detecting fraud?
t) An auditor should design the audit to provide reasonable
assurance of detecting errors and fraud that are material to the
financial statements.
u) An auditor should plan the audit to detect fraud caused by
departures from GAAP.
v) An auditor is not responsible for detecting fraud unless the
application of the auditing standards would result in such
detection.
w) And auditor is responsible for detecting employee errors and
simple fraud, but not for discovering fraudulent acts involving
employee collusion and management override.
Answer:
Explanation:
1