CASE 1
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
Financial statements are frequently relied on by outside parties such as
stockholders and banks when making decisions about an enterprise. Should
equity securities be bought or sold? Should a long-term loan be given?
(2)
A CPA firm could not be expected to maintain expertise in every potential
industry that it might audit. In reviewing a potential client, the firm should
evaluate its ability to gain the necessary industry expertise prior to the actual
(3)
A profit-sharing bonus plan gives employees an added incentive to seek
increases in company income; a larger profit figure will lead to a larger bonus at
the end of the year. Consequently, employees may be tempted to inflate income
(4)
Critics of the auditing profession have argued vehemently for a number of years
that advisory services such as those discussed in this question taint the
appearance (and possibly the reality) of independence. These services may
appear, to the public, to give the audit firm a financial interest in the success of
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(5)
In his article “The Initial Audit Engagement Conference” in the Journal of
Accountancy for September 1976, Bernard Valek lists a number of steps that can
be performed in a plant tour to avoid later “surprises” as well as to assist the firm
in establishing an appropriate audit fee. The first three are typical of a plant tour.
The others go beyond the typical tour. Students should not be expected to
anticipate each of these procedures but the question can be used to emphasize
the importance of the auditor’s complete understanding of the audit client. These
steps include:
* Inspect inventory for possible obsolescence and an indication of the major
product lines of the company.
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(6) A company may not want its CPAs to audit a client’s records because the
auditors gain a substantial amount of competitive information during an
SUGGESTED ANSWERS TO EXERCISES
(1)
(a) and (b) The independent auditor must be able to review massive quantities of
information and identify the fraud risk factors that may affect the amount of
evidence to be gathered or the opinion to be rendered. This question calls upon
the judgment abilities of the students. The format used by students for this
Fraud Risk Factors Auditor Follow Up
Internal Control – The president of the
company admits that the company’s
Since understanding the internal
control is one of the prerequisites for
Fraud Risk Factors Auditor Follow Up
states. may require the extensive gathering of
evidence, or even preclude an opinion.
Uncertainty Involved with the Sixth
Store – A qualified opinion was issued
Abernethy and Chapman must face the
question as to whether this issue can
Bonus System – This system has been
recently installed by Lakeside, so very
This factor alone can cause difficulty in
the auditor’s examination. In addition,
inflated income figures.
Related Party Transactions – The case
indicates that Lakeside has begun to
have financial dealings with the
president of the company.
Obviously, nothing is wrong with this
arrangement, but such related party
transactions are often difficult for the
auditor to verify. In addition, they
require clear disclosure.
Rental Agreements – Five of the stores
Abernethy and Chapman will have to
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Fraud Risk Factors Auditor Follow Up
can be returned within four months. As
of the end of the year, Lakeside will
have a large contingent liability
ability to estimate the amount must be
a concern.
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(2)
INDEPENDENT AUDITOR’S REPORT
To the Board of Directors:
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2011, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
During 2010, the Lakeside Company made a large investment in a retail
store located in the eastern sector of Richmond, Virginia. This store has failed to
reach a break-even sales point to date, and total recovery of the Company’s
investment is highly uncertain. In our opinion, the chances are reasonably
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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS
(1)
The issuance of stock is regulated by the Securities and Exchange Commission
and the accounting, auditing and reporting is regulated by the PCAOB since
2002. A summary of the regulations follows:
Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934.
Registration with the SEC is required, which includes financial reporting. The
(2)
CPA firms wishing to be associated with public companies must be registered
firms, accept the inspection process, and be subject to the discipline of the the
PCAOB. CPAs in public practice of three choices. It is not only public vs. private,