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.


  • 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.




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 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.


  1. 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 some information about each issue.
  2. i) Issue 1 –



  1. ii) Issue 2 –



iii)           Issue 3 –



  1. iv) Issue 4 –



  1. v) Issue 5 –



  1. 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.



  1. 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.



2)             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 the organizations that promulgates these standards, how those organizations and the standards relate to each other, and what types of audits they apply to.



3)             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. a) 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.



  1. b) 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.



  1. c) 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 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.



  1. d) 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.



4)             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.

  1. a) 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.



  1. b) 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 whole and where the auditor believes the situation is less severe and the overall credibility of the financial statements are not impaired.



  1. c) 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



  1. d) 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.



5)             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 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. a) Will the bank be successful in their law suit against you for:
  2. i) ordinary negligence?



  1. ii) fraud?



  1. b) 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?
  2. i) Common Law



  1. ii) Federal securities law (be sure to indicate which statue)



6)             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.

  1. a) 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.



  1. b) 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 and explain why each one of is not as good as the answer you select.


7)             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

  1. a) impartial conservatism
  2. b) independent integrity
  3. c) professional skepticism