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. 1) You have been approached by a local lumber producer who specializes in buying logs that have been thinned from the local forests around Las Vegas, NM and turning them into high quality lumber for things like flooring and molding in homes and businesses. The firm is a small, closely held corporation where the founder and his family members hold all the stock and, therefore, does not register with the SEC. You will be doing the first external audit that this firm has had done in its short lifetime. You currently are a member of the AICPA and you are a CPA with a license to practice in New Mexico. a) Develop a checklist of five areas or issues that you would want to research before you accepted this firm as an audit client and give an example of where you might go to get some information about each issue. Also, explain why you selected the area or issue, other than it is required by standards. That is, I want an explanation how the information might affect your client acceptance decision. Make your explanation and selections specific to this firm. b) 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. c) Describe two reasons why this firm might be seeking an audit. I am looking for substantive reasons that show that you understand the importance of auditing in capital markets. That is, I am not just looking for a possible transaction the firm might engage in that might be facilitated by an audit. I want an explanation of how an audit would facilitate that transaction. 2) Each of the following situations involves a possible violation by a member in industry of the AICPA's Code of Professional Conduct. For each situation, indicate whether it violates the Code. If it violates the Code, indicate which rule is violated and explain why. If you don't think it violations a rule, explain why as well. 2. Mitch Rider is the partner-in-charge of the audit of ABC, Inc. Over the years, he has become a golfing buddy of ABC's CEO, Shelly Rhoades. During the current year Rider and Rhoades jointly purchased an exclusive vacation home in North Carolina. The vacation home represents more than 10 percent of Rider's personal wealth. a) You are auditing a firm that you have audited for years. However, the auditee has yet to pay their full fee from last year's audit and you have turned the matter over to a collection agency. b) During the audit of a client, you found that the manager on the job had not reviewed a staff accountant's verification of the auditee's inventory balance at year-end. The client was a manufacturing firm and inventory represented 30% of their assets. c) During the a ...

1. 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.
1) You have been approached by a local lumber producer who
specializes in buying logs that have been thinned from the local
forests around Las Vegas, NM and turning them into high
quality lumber for things like flooring and molding in homes
and businesses. The firm is a small, closely held corporation
where the founder and his family members hold all the stock
and, therefore, does not register with the SEC. You will be
doing the first external audit that this firm has had done in its
short lifetime. You currently are a member of the AICPA and
you are a CPA with a license to practice in New Mexico.
a) Develop a checklist of five areas or issues that you would
want to research before you accepted this firm as an audit client
and give an example of where you might go to get some
information about each issue. Also, explain why you selected
the area or issue, other than it is required by standards. That is,
I want an explanation how the information might affect your
client acceptance decision. Make your explanation and
selections specific to this firm.
b) 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.
c) Describe two reasons why this firm might be seeking an
audit. I am looking for substantive reasons that show that you

2. understand the importance of auditing in capital markets. That
is, I am not just looking for a possible transaction the firm
might engage in that might be facilitated by an audit. I want an
explanation of how an audit would facilitate that transaction.
2) Each of the following situations involves a possible violation
by a member in industry of the AICPA's Code of Professional
Conduct. For each situation, indicate whether it violates the
Code. If it violates the Code, indicate which rule is violated
and explain why. If you don't think it violations a rule, explain
why as well.
2. Mitch Rider is the partner-in-charge of the audit of ABC, Inc.
Over the years, he has become a golfing buddy of ABC's CEO,
Shelly Rhoades. During the current year Rider and Rhoades
jointly purchased an exclusive vacation home in North Carolina.
The vacation home represents more than 10 percent of Rider's
personal wealth.
a) You are auditing a firm that you have audited for years.
However, the auditee has yet to pay their full fee from last
year's audit and you have turned the matter over to a collection
agency.
b) During the audit of a client, you found that the manager on
the job had not reviewed a staff accountant's verification of the
auditee's inventory balance at year-end. The client was a
manufacturing firm and inventory represented 30% of their
assets.
c) During the audit of client, you found out that the manager on
the job, who you had recently hired from a major competitor on
the auditee, had secretly shared details the auditee's pricing

3. strategies with his former employer.
3) For the following independent situations, assume that you are
the audit partner on the engagement. For each situation, explain
how you would modify your audit report and why. All
situations apply to non-SEC firms and so the internal control
report isn't required and not part of this question. Be sure to
cover all changes required to the report and be specific about
which paragraphs must be changed and why. If you don't
recommend any changes, explain why not.
3. During your audit of XYZ, Inc., you conclude that there is a
possibility that inventory is materially overstated. The Client
refuses to allow you to expand the scope of your audit
sufficiently to verify whether the balance is actually misstated.
Inventory represents 12% of XYZ's total assets.
a) You are auditing HIJ, Inc. and you have substantial doubt
about their ability to continue as a going concern, but the
circumstances are fully disclosed in the financial statements.
b) You complete the audit of Happy Time Department Store,
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 Happy Time.
c) During your audit of DEF company you found a material
misstatement of their Other Income account. DEF refused to
restate the account balance.
4) XYZ, Inc. is planning a major plant expansion recently

4. expanded its plant. It plans to finance the expansion through a
combination of a bank loan and stock offering. XYZ has
engaged your CPA firm to audit its 2013 financial statements.
They told you that they were going to give the financial
statements to ABC Bank and other, unnamed banks and, that
they would be included in the registration statement for the
stock offering.
When you performed the audit of the 2013 financial statements,
you did not discover a material overstatement of inventory
because you did not test XYZ's physical inventory at the end of
2013. XYZ is a manufacturing firm and so inventory tends to
make up a significant portion of their total assets. You were
also aware of a pending product liability lawsuit that XYZ had
not disclosed in its footnotes despite the fact that XYZ's
attorney informed you that XYZ's liability under the lawsuit
would result in material losses for XYZ. However, you issued
an unqualified opinion on their 2013 financial statements and
issued your report at the end of January, 2014.
In early February, 2014, ABC Bank relied on XYZ's financial
statements and your audit report and granted XYZ a $750,000
loan. In addition, XYZ raised $12,000,000 in June 2014 in a
public offering of common stock. They included their financial
statements and your audit report in their registration statement
for the stock offering.
By July, 2014, XYZ was in financial trouble, but was able to
stay in business because of the funds raised in the stock
offering. They had lost the product liability law suit and could
not pay the plaintiff the full amount of the loss. In addition,
they defaulted on their bank loan and petitioned for bankruptcy.
The bank lost most of the $750,000 loan and XYZ's stock price
fell sharply.
ABC bank has sued you for failure to exercise due professional
care and for common law fraud. The stockholders also are

5. alleging fraud under the Securities Act of 1933. All these
transactions took place in a jurisdiction that provides for
auditor liability for ordinary negligence to known and intended
users of the financial statements.
Answer the following questions and include your reasons for
them.
a) Will ABC bank be successful in their law suit against you
for:
i) ordinary negligence?
ii) fraud?
b) Will the stockholders who purchased their stock in the stock
offering for which XYZ used your audit financial statements
succeed in against you with their claim of fraud under the
Securities Act of 1933?
Questions 5, 6, and 7 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 address all the possible
alternatives presented in the question.
5) The following questions address fraud risk factors and the
assessment of fraud risk.
a) Which of the following characteristics is most likely to
heighten an auditor's concern about the risk of material
misstatements due to fraud in an entity's financial statements?
i) The entity's industry is experiencing declining customer
demand.

6. ii) Employees who handle cash receipts are not bonded.
iii) Internal auditors have direct access to the board of directors
and the entity's management.
iv) The board of directors is active in overseeing the entity's
financial reporting policies.
Answer:
Explanation:
b) Which of the following circumstances is most likely to cause
an auditor to increase the assessment of the risk of material
misstatement of the financial statements due to fraud?
i) Property and equipment are usually sold at a loss before being
fully depreciated.
ii) Unusual discrepancies exist between the entity's records and
confirmation replies
iii) Monthly bank reconciliations usually include several in-
transit items.
iv) Clerical errors are listed on a computer-generated exception
report.
Answer:
Explanation:
6) The following questions concern the auditor's responses to
the possibility of fraud.
a) If an independent audit leading to an opinion on financial
statements causes the auditor to believe that a material
misstatement due to fraud exists, the auditor should first
i) request that management investigate to determine whether
fraud has actually occurred.
ii) make the investigation necessary to determine whether fraud
has actually occurred.

7. iii) consider the implications for other aspects of the audit and
discuss the matter with the appropriate levels of management.
iv) consider whether fraud was the result of a failure by
employees to comply with existing controls.
Answer:
Explanation:
b) Which of the following is least likely to suggest to an auditor
that the client's management may have overridden internal
control?
i) There are numerous delays in preparing timely internal
financial reports.
ii) Management does not correct internal control weaknesses
that it knows about.
iii) Differences are always disclosed on a computer exception
report.
iv) There have been two new controllers this year.
Answer:
Explanation:
7) The following question addresses fraud risks in specific audit
areas and accounts.
a) Which of the following internal controls will best detect the
theft of valuable items from an inventory that consists of
hundreds of different items selling for $1 to $10 and a few
items selling for hundreds of dollars?
i) Maintain a perpetual inventory of only the more valuable
items, with frequent periodic verification of the validity of the
perpetual inventory records.
ii) Have an independent auditing firm examine and report on
management's assertion about the design and operating

8. effectiveness of the control activities relevant to inventory.
iii) Have separate warehouse space for the more valuable items,
with sequentially numbered tags.
iv) Require an authorized officer's signature on all requisitions
for the more valuable items.
Answer:
Explanation:
8) During audit planning, an auditor obtained the information
listed in the following table. For each item, indicate whether or
not you believe it is a fraud risk (yes or no), which element of
the fraud triangle is involved, and explain why you believe it is
a fraud risk. Note that we are not talking about evidence of
fraud, just factors that might increase the risk of fraud.
1
Item
Fraud Risk?
Fraud Condition
Explanation
1. There are recurring attempts by management to justify
marginal or inappropriate accounting on the basis of materiality.
2. The company's financial performance is threatened by a high
degree of competitor and market saturation.
3. Significant operations are located and conducted across

9. international borders or jurisdictions where differing business
environments and cultures exist.
4. The company's board of directors includes a majority of
directors who are independent of management.
5. New accounting pronouncements have resulted in explanatory
paragraphs for consistency for the company and other firms in
the industry.
6. The company has experienced low turnover in management
and its internal audit function.
7. The company's controller works very hard, including
evenings and weekends, and has not taken a vacation in two
years.
8. Assets and revenues are based on significant estimates that
involve subjective judgments and uncertainties that are hard to
corroborate.
9. The company is marginally able to meet exchange listing and
debt covenant requirements.

10. 7
Week 5 Homework Questions
Questions 1 and 2 were taken directly from the text and I am
aware that the answers are available through an internet search.
I want to remind you that searching the internet for the answers
and using those answers is a violation of UMUC academic
integrity policies. In addition, using any outside source without
citation is plagiarism. However, just gaining access to the
answers will not satisfy the homework assignment because I
have added the requirement that you explain your answers,
which cannot be found on the internet and needs to be reasoned
out from the material in the chapter. In grading, I will place
more emphasis you explanation than your selection of the
correct alternative.
The following are several multiple choice questions adapted
from the CPA exam that cover the concept and application of
materiality. For each question, selected the best answer and
then explain why it is better than all the alternatives. Your
explanations should address all the possible alternatives
presented in the question.
a) Which one of the following statements is correct concerning
the concept of materiality?
i) Materiality is determined by reference to guidelines
established by the AICPA.
ii) Materiality depends only on the dollar amount of an item
relative to other items in the financial statements.
iii) Materiality depends on the nature of an item rather than the
dollar amount.
iv) Materiality is a matter of professional judgment.

11. Answer:
Explanation:
b) In considering materiality for planning purposes, an auditor
believes that misstatements aggregating $10,000 will have a
material effect on an entity's income statement, but that
misstatements will have to aggregate $20,000 to materially
affect the balance sheet. Ordinarily, it is appropriate to design
audit procedures that are expected to detect misstatements that
aggregate to
i) $10,000
ii) $15,000
iii) $20,000
iv) $30,000
Answer:
Explanation:
c) A client decides not to record an auditor's proposed
adjustments that collectively are not material and wants the
auditor to issue the report based on the unadjusted numbers.
Which of the following statements is correct regarding the
financial statement presentation?
i) The financial statements are free from material misstatement,
and no disclosure is required in the notes to the financial
statements.
ii) The financial statements do not conform with generally
accepted accounting principles (GAAP).
iii) The financial statements contain unadjusted misstatements
that should result in a qualified opinion.
iv) The financial statements are free from material
misstatement, but disclosure of the proposed adjustment is
required in the notes to the financial statements.

12. Answer:
Explanation:
The following are several multiple choice questions adapted
from the CPA exam that cover audit risk. For each question,
selected the best answer and then explain why it is better than
all the alternatives. Your explanations should address all the
possible alternatives presented in the question.
d) Some account balances, such as those for pensions and
leases, are the result of complex calculations. The susceptibility
to material misstatements in these types of accounts is defined
as
i) audit risk.
ii) detection risk.
iii) inherent risk.
iv) sampling risk.
Answer:
Explanation:
e) As the acceptable level of detection risk decreases, the
auditor may do one or more of the following except change the
i) nature of audit procedures to more effective procedures.
ii) timing of audit procedures, by perhaps performing them at
year-end rather than an interim date.
iii) extent of audit procedures, by perhaps using larger sample
sizes.
iv) assurances provided by audit procedures to a lower level.
Answer:
Explanation:

13. f) Inherent risk and control risk differ from planned detection
risk in that they
i) arise from the misapplication of auditing procedures.
ii) may be assessed in either quantitative or qualitative terms.
iii) exist independently of the financial statement audit.
iv) can be changed at the auditor's discretion
Answer:
Explanation:
1
For each of the following independent scenarios, state the
effect, if any, on each component of the audit risk model and
explain why you made each selection. For your answer to the
effect portion of the question, select from I = increase, D =
decrease, or N = no effect. I have included a table for each
scenario to help you organize your answers and be complete.
This question was adapted from the text, but I have altered it to
require explanations. Also, I disagree with the text solutions
manual on some of them but since the solutions manual doesn't
provide an explanation of their answers, I cannot determine how
the authors arrived at their conclusions. I will be grading based
on my answers. As I reminder, attempting to access the
solutions manual to answer these questions is a violation of
academic integrity.
g) In discussions with management, you conclude that
management is planning to sell the business in the next few
months. Consequently several key accounting personnel have
recently quit. In addition, the firm's gross profit margin has
significantly increased since last year.

14. Risk Model Component
Effect
(I, D, N)
Explanation
AAR
IR
CR
PDR
h) The client began selling products online to customers through
its web page during the year under audit. The online ordering
process has not been integrated with the firm's accounting
system. The firm's sales staff print out online orders and
manually enter the information into the firms accounting
system.
Risk Model Component
Effect
(I, D, N)
Explanation
AAR
IR
CR

15. PDR
i) An account balance increased by a material amount from last
year without any explanation.
Risk Model Component
Effect
(I, D, N)
Explanation
AAR
IR
CR
PDR
j) The firm's management materially decreased long-term
contractual debt from what is was last year.
Risk Model Component
Effect
(I, D, N)
Explanation
AAR
IR
CR

16. PDR
k) This is the second year of the engagement and there were few
misstatements found in the prior year's audit. Consequently, the
auditor has decided to increase reliance on internal controls.
Risk Model Component
Effect
(I, D, N)
Explanation
AAR
IR
CR
PDR
Read the following description of the Preview Company.
Preview Company Case Description
Preview Company, a diversified manufacturer, has five
divisions that operate throughout the United States and Mexico.
Preview has historically allowed its divisions to operate
autonomously. Corporate intervention occurred only when
planned results were not obtained. Corporate management has
high integrity, but the board of directors and audit committee

17. are not very active. Preview has a policy of hiring competent
people. The company has a code of conduct, but there is little
monitoring of compliance by employees. Management is fairly
conservative in terms of accounting principles and practices, but
employee compensation packages depend highly on
performance. Preview Company does not have an internal audit
department, and it relies on its external auditor to review the
controls in each division.
Chip Harris is the general manager of the Fabricator Division.
The Fabricator Division produces a variety of standardized parts
for small appliances. Harris has been the general manager for
the last seven years, and each year he has been able to improve
the profitability of the division. He is compensated based
largely on the division's profitability. Much of the
improvement in profitability has come through aggressive cost
cutting, including a substantial reduction in control activities
over inventory.
During the last year, a new competitor has entered Fabricator's
markets and has offered substantial price reductions in order to
grab market share. Harris has responded to the competitor's
actions by matching the price cuts in the hope of maintaining
market share. Harris is very concerned because he cannot see
any other areas where costs can be reduced so that the division's
growth and profitability can be maintained. If profitability is
not maintained, his salary and bonus will be reduced.
Harris has decided that one way to make the division more
profitable is to manipulate inventory because it represents a
large amount of the division's balance sheet. He also knows
that controls over inventory are weak. He views this inventory
manipulation as a short-run solution to the profit decline due to
the competitor's price-cutting. Harris is certain that once the
competitor stops cutting prices or goes bankrupt, the
misstatements in inventory can be corrected with little impact

18. on the bottom line.
a) The following table includes two columns. Include a brief
phrase or sentence in the first column that merely describes the
strength or weakness. In in second column, explain why each
strength is a strength or why each weakness is weakness. In
addition, for each weakness you identify, suggest an
improvement that would reduce that weakness. Finally, include
issues that affect financial reporting and not operational
effectiveness. While the overall definition of internal controls
includes operational effectiveness, auditors primarily are
concerned about the accuracy of the financial statements. I
have included one example for each category to help illustrate
what I am looking for in your answers.
Entity Level Controls
Strength
Reason it is a strength
Entity Level Controls
Weakness
Reason it is a weakness and suggested improvement
b) What factors in Preview Company's control environment led

19. to and facilitated Harris' manipulation of inventory? Your
answer here may include items you listed above, but you should
relate the specifically to the inventory manipulation in the
question.
The following table contains a list of internal controls. For
each internal control, identify the type(s) of specific control
activity (or activities) to which it applies (such as proper
authorization and adequate documents and records); identify the
transaction-related audit objective(s) to which it applies; and
explain your selection of audit objective. This question was
adapted from the text, but I have altered it to require
explanations. As I reminder, attempting to access the solutions
manual to answer these questions is a violation of academic
integrity.
Control
Type(s)
Objective(s)
Explanation
Sales invoices are matched with shipping documents and
customer orders before recording in the sales journal.
Receiving reports are prenumbered and accounted for on a daily
basis.
Amounts on sales invoices are independently verified before
being sent to customers.

20. Payments by check are received in the mail by the receptionist,
who lists the checks and restrictively endorses them.
Overtime hours for payroll are approved by the employee's
supervisor.
Checks are signed by the company president, who compares the
checks with the underlying supporting documents.
Unmatched shipping documents are accounted for on a daily
basis.
All payroll payments must have a valid employee identification
number assigned by the human resources department at the time
of hiring.
The accounts receivable subsidiary ledger is reconciled to the
general ledger on a monthly basis.