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2-1 The Sarbanes-Oxley Act of 2002 created the PCAOB and gave this body authority to develop auditing
standards for the audits of public companies. The AICPA has the authority, based on general
acceptance (and adoption by state boards of accountancy and other regulatory bodies), to develop
auditing standards for audits of nonpublic companies.
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. These standards provide the criteria (financial reporting
framework) for financial reporting, including the nature and content of financial statements. Generally
accepted auditing standards are those issued by the AICPA’s Auditing Standards Board (ASB).
GAAS are the standards for the auditor’s work in fulfilling the overall objectives of a financial
statement audit. GAAS address the general responsibilities of the auditor, as well as the auditor’s
further considerations relevant to the application of those responsibilities.
2-3 A financial reporting framework is a set of criteria used to determine measurement, recognition,
representation, and disclosure of all material items appearing in the financial statements; for example
United States GAAP or IFRS. It is important to an audit because it is through consideration of that
framework on which the auditor basis his or her opinion on the financial statements.
2-4 Generally accepted auditing standards are the Statements on Auditing Standards issued by the
Auditing Standards Board.
2-5 In the context of the audit of financial statements, professional skepticism includes maintaining a
questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or
error, and a critical assessment of audit evidence. Throughout the audit the auditors should be alert
for: (1) audit evidence that contradicts other audit evidence, (2) information that raises a question
about the reliability of documents and responses to inquiries, (3) conditions indicating possible fraud,
Solutions Manual, Chapter 2, Page 2 of 14
and (4) circumstances suggesting the need for additional audit procedures beyond those ordinarily
2-6 The auditors’ responsibilities concerning the detection of noncompliance with laws by clients depends
on the relationship of the law or regulation to the financial statements. Certain laws and regulations,
such as income tax laws, have a direct effect on the amounts and disclosures included in the financial
statements. The auditors have a responsibility to design their audit to obtain reasonable assurance of
detecting material violations of these laws and regulations.
Many other laws and regulations, such as occupational safety and health laws, do not have a
direct effect on the amounts included in the financial statements. An audit carried out in accordance
with generally accepted auditing standards is not designed to detect client noncompliance with these
Although an audit is not designed to provide reasonable assurance of detecting noncompliance
with other laws, the CPAs should be aware of the possibility that they have occurred and investigate
those identified. When they become aware of noncompliance with laws, the auditors should
communicate the situation to the audit committee of the board of directors to remedy the situation and
make appropriate modifications to the financial statements. If management fails to take appropriate
action, the auditors should consider withdrawing from the engagement.
2-7 The first sentence of the quotation is correct. The completion of an audit of financial statements by a
CPA following generally accepted auditing standards and satisfying the CPA provides the basis for
expression of an unmodified opinion on the fairness of financial statements.
The second sentence of the quotation is in error. Auditors never express an opinion (either
qualified or unmodified) on the fairness of financial statements without first performing an audit. The
audit provides the basis for the expression of an opinion. Such factors as audits made in prior years,
confidence in management, and a “quick review” of the current year’s financial statements are not an
acceptable substitute for appropriate audit procedures.
2-8 The management of Pike Company is primarily responsible for the fairness of the company’s financial
statements. The retention of certified public accountants to perform an audit and express an opinion
on the statements does not relieve management of its obligation to give an honest and complete
accounting of its conduct of corporate affairs.
Independent Auditor’s Report
To the Audit Committee of ABC Company
We have audited the accompanying consolidated balance sheets of ABC Company and its subsidiaries,
as of December 31, 20X1 and 20X0, and the related consolidated statements of income, retained
earnings, and cash flows for the years then ended.
Management’s Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these consolidated financial
statements in accordance with accounting principles generally accepted in the United States of
America; this includes the design, implementation, and maintenance of internal control relevant to the
preparation and fair presentation of consolidated financial statements that are free from material
misstatement, whether due to fraud or error.
Solutions Manual, Chapter 2, Page 3 of 14
Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements are free of material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures
in the consolidated financial statements. The procedures selected depend on the auditor’s judgment,
including the assessment of the risks of material misstatement of the consolidated financial statements,
whether due to fraud or error. In making those risk assessments, the auditor considers internal control
relevant to the entity’s preparation and fair presentation of the consolidated financial statements in
order to design audit procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes
evaluating the appropriateness of accounting policies used and the reasonableness of significant
accounting estimates made by management, as well as evaluating the overall presentation of the
consolidated financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for
our audit opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material
respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1 and
20X0, and the results of their operations and their cash flows for the years then ended in accordance
with accounting principles generally accepted in the United States of America.
Williams & Co. LLP
February 5, 20X2
2-10 Among the more common situations which prevent the issuance of an unmodified opinion upon
completion of an audit are the following:
(1) Certain necessary auditing procedures were omitted at the request of the client, or for reasons
beyond the control of the client or the auditors.
(2) The statements contained misstatements (or omissions) and the client refuses to change them.
2-11 In the opinion paragraph of the auditor’s standard report the auditors make representations as to the
(1) The fairness of the financial statements, in all material respects.
(2) Application of generally accepted accounting principles.
(3) By implication consistent application of generally accepted accounting principles.
(4) By implication adequate disclosure.
2-12 The issuance of a standard audit report tells us that the audit was performed in accordance with
generally accepted auditing standards and, accordingly, it was planned and performed to obtain
reasonable assurance about whether the financial statements are free of material misstatement due to
error or fraud. The audit included performing procedures to obtain audit evidence about the amounts
and disclosures in the financial statements. These procedures were determined based on the auditors’
judgment, including their assessment of the risks of material misstatements of the financial statements.
Solutions Manual, Chapter 2, Page 4 of 14
The auditors also evaluated the appropriateness of accounting policies used by the client, the
reasonableness of significant accounting estimates, and the overall presentation of the financial
2-13 The auditors’ report expresses an opinion on the client’s financial statements, not on the accounting
records. A major purpose of the audit is to give outsiders assurance that the financial statements are
reliable. The client’s accounting records are important to the public accounting firm only because they
constitute evidence supporting the financial statements. The CPAs also gather evidence from outside
the company and from internal sources other than the accounting records.
2-14 The public accounting firm must observe generally accepted auditing standards (or, if applicable,
PCAOB Standards) in order to merit confidence in its opinion. The result of following these
procedures is an audit report that includes a reasonable, but not absolute, assurance that the financial
statements do not contain material misstatements due to errors or fraud. Reasonable assurance implies
that there is a low level of risk remaining that the auditor expresses an opinion that the financial
statements are properly stated when they are not. Reasonable and not absolute assurance is necessary
due to (1) the nature of financial reporting (e.g., the necessary use of judgment), (2) the nature of audit
procedures (e.g., they often do not provide absolutely conclusive evidence) and (3) the need to conduct
an audit within a reasonable period of time at a reasonable cost. Accordingly, the auditor expresses an
opinion on the financial statements, not a statement of fact.
2-15 Regardless of how careful and professional an audit of financial statements the public accounting firm
has made, it cannot guarantee their correctness. The statements themselves include a variety of
estimates; for example, the estimate of the allowance for uncollectible accounts and the choice of
depreciation rates. Also, the auditors rely on a program of tests rather than on verifying every
transaction. Some errors, therefore, may go undetected. The audit gives the auditors a firm basis for
expressing an informed opinion on the financial statements, but no more than that.
2-16 A material amount is an amount that is sufficiently important to influence decisions made by
reasonable users of financial statements. The amount may differ by account based on specific account
characteristics. For example, a $100,000 shortage of cash may be extremely material to a small
company, and a shortage of that amount might lead to bankruptcy. But, a $100,000 valuation
overstatement of equipment may be of less significance if the company continues to produce its
products and operate as in the past. Materiality is discussed further in Chapter 6.
2-17 If the guidance for a transaction or event is not specified within the authoritative GAAP (the FASB
Codification), the auditor should first consider whether accounting principles for similar transactions or
events exist within GAAP; if that is the case, those principles are followed to the extent considered
appropriate. If not, nonauthoritative accounting guidance is consulted. Sources of nonauthoritative
accounting guidance and literature include
Practices that are widely recognized and prevalent either generally or in the industry.
FASB Concepts Statements.
AICPA Issues Papers
International Financial Reporting Standards.
Pronouncements of professional associations or regulatory agencies.
Technical Information Service Inquiries and Replies included in AICPA
Technical Practice Aids.
Accounting textbooks, handbooks, and articles.
The appropriateness of the above nonauthoritative accounting guidance and literature depends on its
Solutions Manual, Chapter 2, Page 5 of 14
relevance to particular circumstances, how specific it is, the general recognition of the issuer or author as
a authority, and the extent of its use in practice.
2-18 No. The attestation standards are meant to provide a general framework for the overall attestation
function and do not supersede the generally accepted auditing standard which were developed for
audits of annual historical financial statements. As a practical matter, the attestation standards are
most directly relevant to attest engagements that are not covered by specific authoritative standards,
such as attesting to attributes of computer software.
2-19 Quality control in a public accounting firm means policies and procedures which help assure that each
audit meets at least a minimum standard of quality. Such control is vital because even one substandard
audit could cause the firm to be defendant in a lawsuit that could threaten its continued existence.
Peer reviews refer to a study and appraisal by an independent evaluator (“peer reviewer”) of a
CPA firm’s work. In a system review, the evaluator considers the CPA firm’s system of quality control
to perform accounting and auditing work. In an engagement review, the evaluator studies and
evaluates a sample of a CPA firm’s actual accounting work, including accounting reports issued and
documentation prepared by the CPA firm as well as other procedures that the firm performed.
Engagement reviews are only available for CPA firms that do not perform audits or other similar
Inspections are similar to peer reviews but are performed by the staff of the Public Company
Accounting Oversight Board. However, in performing PCAOB inspections the staff focuses only on
selected quality control issues and may consider aspects of practice management, such as the
determination of partner compensation. In selecting audits and reviews for inspection, the PCAOB
staff uses a risk assessment approach, which focuses on audits that have a high risk of lack of
2-20 (a) Engagement performance. The objective of quality control procedures in this area is to
provide assurance that work performed is in accordance with professional standards and
regulatory and legal requirements, with policies and procedures addressing: (1) engagement
performance, (2) supervisions responsibilities and (3) review responsibilities.
(b) Human resources. The objective of quality control procedures in this area is to provide
assurance that the firm has personnel with the capabilities, competence and commitment to
ethical principles to: (1) perform its engagements in accordance with professional standards
and regulatory and legal requirements and (2) enable the firm to issue reports that are
appropriate in the circumstances.
(c) Monitoring. The objective of quality control procedures in this area is to determine that the
policies and procedures established for each of the elements are suitably designed and
2-21 The AICPA’s Statement on Quality Control Standards identify six “elements” (areas) in which the
Institute feels that quality control procedures are appropriate, but it does not require any specific
quality control procedures. The Statement recognizes that specific procedures will vary among firms,
depending upon the size of the firm, the number of offices, and the nature of the firm’s practice.
2-22 The duties of the Public Company Accounting Oversight Board include:
Register public accounting firms that prepare audit reports for financial statement issuers.
Solutions Manual, Chapter 2, Page 6 of 14
Establish or adopt auditing, quality control, ethics, independence and other standards relating to
audit reports for issuers.
Conduct inspections of registered public accounting firms.
Perform other duties or functions to promote high professional standards for audits, enforce
compliance with the enabling act establishing the Board (i.e., the Sarbanes-Oxley Act of 2002
discussed in Chapter 1), set the budget, and manage operations.
2-23 A system review involves peer reviewers’ study and appraisal of a CPA firm’s system of quality
control to perform accounting and auditing work. A systems review includes determining whether the
CPA firm’s system of quality control for its accounting and auditing practice (non-public clients) is
designed and complied with to provide the CPA firm with reasonable assurance of performing and
reporting in conformity with applicable standards, including the quality control standards. An
engagement review is a type of peer review in which the peer reviewer selects a sample of a CPA
firm’s actual accounting work, including accounting reports issued and documentation prepared by the
CPA firm. This form of peer review is only available for CPA firms that do not perform audits, but do
perform accounting work, including reviews and compilations. The objective of an engagement
review is to evaluate whether the CPA firm’s reports are issued and procedures performed
appropriately in accordance with applicable professional standards.
2-24 The international audit report differs from one based on PCAOB reporting standards in the following
(1) The international report has an expanded description of management’s responsibility for the
financial statements and internal controls.
(2) The report also includes an expanded explanation of the audit process, which includes a
description of the auditors’ responsibility for internal control.
(3) The international report allows the accountants the following reporting options:
(a) Instead of indicating that the financial statements “present fairly, in all material respects,”
the accountants may substitute the phrase “give a true and fair view.”
(b) The report may indicate that the financial statements comply with the country’s relevant
statutes or laws.
(c) The report may be signed using the personal name of the auditor, the firm, or both.
(4) The city in which the auditors maintain an office is required to be included in the international
Questions Requiring Analysis
2-25 The AICPA currently develops independence and ethical standards, quality control standards, and
auditing and attestation standards that apply to its members. However, AICPA standards are
applicable to the audits and auditors of nonpublic clients based on general acceptance by the courts,
and adoption by state boards of accountancy and other regulatory bodies. The AICPA also has a
voluntary peer review program, and enforces its standards on its members.
The PCAOB was given the legal authority to develop independence and ethical standards, quality
control standards, and auditing and attestation standards that apply to public company auditors and
integrated audits. The PCAOB also is charged with performing inspections of registered audit firms,
Solutions Manual, Chapter 2, Page 7 of 14
and may sanction the firms for noncompliance with its standards and the provisions of Sarbanes-Oxley
The state boards of accountancy regulate CPA firms and CPAs in the various states and jurisdictions.
They have the authority to establish their own standards, but have generally adopted the standards of
other bodies such as the AICPA and the PCAOB. A state board enforces its standards in its state or
jurisdiction and has the authority to revoke a CPA firm or individual CPA’s right to practice in the
2-26 A firm of certified public accountants might find it difficult to maintain an attitude of independence
during the audit of financial statements if the public accounting firm or a partner in the firm:
(1) Derived a major portion of the firm’s income from one client;
(2) Had a personal financial interest in the company being audited;
(3) Made the fee contingent upon the obtaining of a bank loan by the client;
(4) Was financially indebted to the client;
(5) Was a member of the board of directors of the client company or otherwise participated in the
management of the company.
2-27 If the certified public accountant is appointed controller of the corporation, he or she loses the
independent status which is the most essential qualification of the certified public accountant. The
interests of the officers of a corporation may at times be in conflict with the interests of creditors,
bankers, or stockholders. These outside groups are best protected when independent CPAs examine
the financial statements prepared by management of the corporation. The performance of an internal
audit function under the direction of the new controller may be a highly desirable step, but it does not
eliminate the need for an independent audit.
2-28 (a) To satisfy an auditor’s responsibilities to detect Smith’s errors and fraud, Reed should:
Assess the risk that Smith’s errors and fraud may cause its financial statements to contain a
Design the audit to provide reasonable assurance of detecting errors and fraud that are
material to the financial statements. In designing the audit, the auditors should respond to
risks by altering their overall approach to the audit or modifying the nature timing and
extent of audit procedures. They should also perform procedures to address the risk of
management override of internal control.
Exercise due care in planning, performing, and evaluating the results of audit procedures,
and exercise the proper degree of professional skepticism to achieve reasonable assurance
that material errors or fraud will be detected.
(b) Reed’s responsibilities to detect Smith’s noncompliance with laws that have a material and
direct effect on Smith’s financial statements are the same as that for errors and fraud.
Reed’s responsibilities to detect noncompliance with laws that have an indirect effect on
the financial statements are to be aware of the possibility that such noncompliance may have
occurred. If specific information comes to Reed’s attention that provides evidence concerning
the possible existence of such noncompliance, Reed should apply audit procedures specifically
directed to ascertaining whether noncompliance has occurred.
(c) Reed’s responsibilities when noncompliance with laws has been identified is to discuss the
situation with top management and to notify the audit committee of the board of directors so
Solutions Manual, Chapter 2, Page 8 of 14
that proper action can be taken, including making any necessary disclosures or adjustments to
the financial statements. If the client fails to take appropriate corrective action, Reed should
withdraw from the engagement. In addition, legal counsel or other appropriate specialist will
generally be contacted by the CPA.
2-29 (a) The two forms of peer review are a system review and an engagement review.
(b) The PCAOB inspections focus on the public-company audit practice of the firm. The
inspections are designed to determine the firm’s compliance with the Sarbanes-Oxley Act,
PCAOB and SEC requirements, and other professional standards.
(c) An inspection involves at least the following three components:
1. An inspection and review of selected public-company audit and review engagements.
2. An evaluation of the sufficiency of the quality control system of the firm, and the
manner of the documentation and communication of the system.
3. Performance of such other testing of the audit, supervisory, and quality control
procedures as are considered necessary.
PCAOB inspections differ from peer reviews in that the staff focuses only on selected quality
control issues and may consider aspects of practice management, such as the determination of
partner compensation. In selecting audits and reviews for inspection, the PCAOB staff uses a
risk assessment approach, which focuses on audits that have a high risk of lack of compliance.
(d) The PCAOB staff selects audit engagements for inspection on a risk basis. They select audits
with a higher risk of lack of noncompliance with professional standards. In addition, for the
selected audits, the staff focuses on the higher-risks aspects of the engagement.
2-30 Multiple Choice Questions
(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 standards for audits and reviews of public companies,
and quality controls for firms that audit public companies.
(c) (2) FASB Concepts Statements are considered nonauthoritative guidance. The other
replies all represent authoritative guidance.
(d) (2) Financial statement audits provide reasonable, not absolute assurance.
(e) (2) The quality control standards were established to provide reasonable assurance that
professional services confirm with professional standards. Answer (1) is incomplete
Solutions Manual, Chapter 2, Page 9 of 14
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 PCAOB. 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, an ethical requirement.
(i) (1) An audit provides reasonable assurance of detecting misstatements due to fraud,
regardless of whether due to fraudulent financial reporting or misappropriation of
(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
(l) (4) Neither the AICPA audit report nor the international audit report include an opinion
on internal control. The other replies provide actual differences between the two
2-31 Adapted AICPA Task-Based Simulation
Reviewer’s Comments Comment
(yes or no)
Explanation of incorrect
comments (not required)
a. The report should not be addressed to
Yes The report is ordinarily addressed to
the audit committee, the board of
directors, the shareholders or the
b. The report should indicate that we have
“audited,” rather than “examined” the
financial statements (first paragraph after
c. The report should not indicate anything
concerning management’s responsibility for
No The report is correct as presented.
d. The report should state that the auditor’s No While an audit does provide
Solutions Manual, Chapter 2, Page 10 of 14
responsibility is to express “reasonable
assurance,” not an opinion (first paragraph
under “auditor’s responsibility).
reasonable assurance, the report is
correct as presented.
e. The audit is designed to assess risks of
material misstatements due to errors or
fraud; the term “illegal acts” is incorrect
(second paragraph under auditor’s
Yes The word “errors” should replace
“illegal acts” in the report (and the
order of the terms should be
f. The report should not refer to an auditor as
“evaluating the appropriateness of
accounting policies,” since those are the
responsibility of management.
No An audit report does refer to the
appropriateness of accounting
g. The evidence should be sufficient and
appropriate rather than “adequate” (third
paragraph under auditor’s responsibility).
Yes Self explanatory.
h. The opinion should not include “in all
material respects” since the auditor is
providing an opinion on the accuracy of the
financial statements (opinion paragraph).
No Audits are performed to provide
reasonable assurance of detecting
material misstatements, and the
report so indicates.
i. The opinion should be on “accounting
principles generally accepted in the United
States of America,” not on auditing
standards (opinion paragraph).”
Yes The financial statements follow the
appropriate accounting principles,
while the audit follows generally
accepted auditing standards.
j. The signature on the report should be that of
the CPA firm, not that of the partner.
Yes While the international report allows
the partner to sign the report (in
addition to the CPA firm name), the
GAAS report does not.
Statement Agree (A) or
a. The report must begin with “CPA’s Report”
at the top.
D The top must have a title that
includes the term
b. The report is ordinarily addressed “to whom
it may concern.”
D It is ordinarily addressed to the
audit committee, the board of
directors, or the company
c. The report indicates that management is
responsible for the preparation of the
d. The report indicates that the auditor’s
responsibility is to obtain particular
assurance about whether the financial
statements are free of material misstatements.
D Reasonable assurance is
e. The report ordinarily concludes on whether
the financial statements are in conformity
with generally accepted auditing standards.
D It concludes on whether the
financial statements are in
conformity with generally
f. The report indicates that the audit procedures
selected depend on the auditor’s judgment.
Solutions Manual, Chapter 2, Page 11 of 14
g. The report indicates that the audit evidence
obtained is sufficient and appropriate to
provide a basis for the audit opinion.
h. The report indicates that the auditor
considers and provides an opinion on internal
D Internal control is considered,
but no opinion is provide on it.
Statement Type of
a. The auditors are unable to determine the overall fairness of the financial
b. This is the report most clients prefer. S
c. A limitation on the scope of the audit is significant, but not so as to
overshadow an overall opinion.
d. The financial statements are not fairly presented. A
e. A material departure from GAAP exists, but not so material as to overshadow
an overall opinion.
Principles Yes (Y)
a. The purpose of an audit is to provide financial statement users with an
opinion by the auditor on whether the financial statements are
presented fairly, in all material and immaterial respects, in accordance
with the applicable financial reporting framework.
b. The auditors are responsible for having appropriate competence and
capabilities to perform the audit.
c. The auditor is unable to obtain absolute assurance that the financial
statements are free from material misstatement.
d. The opinion states whether the financial statements are presented
fairly, in all material respects, in accordance with the applicable
financial reporting framework.
e. Inherent limitations of an audit include the need to conduct an audit to
achieve a balance between the benefit to management and the benefit
to the auditors.
N The balance
is a proper
a. 3 Agreed-upon procedures report.
b. 7 Audit report.
c. 6 An unintentional misstatement.
d. 8 Generally accepted accounting principles.
e. 12 Misappropriation of assets.
f. 4 A review of a CPA firm conducted by PCAOB.
g. 10 Human resources and monitoring.
Solutions Manual, Chapter 2, Page 12 of 14
h. 2 A CPA firm that may conduct audits of public or nonpublic companies.
2-36 SOLUTION: White Company (Estimated time: 20 minutes)
(a) No, Rezzo would not be justified in complying with White’s request. Although Rezzo is a
CPA, he has not audited the financial statements of White Company in accordance with
generally accepted auditing standards. Preparation of financial statements cannot be construed
as synonymous with auditing the statements. Furthermore, because of Rezzo’s deep
involvement with White Company, it is questionable whether he could maintain an
independence of mental attitude if he did audit the financial statements.
(b) If Rezzo were justified in issuing a standard audit report on the financial statements of White
Company, he should not do so until he has completed an audit of the financial statements. The
auditor does not express an opinion on financial statements without first performing an audit.
(c) No, it would not be reasonable for the public accounting firm employing Rezzo to assign him
to the audit of the White Company financial statements. Having himself prepared the financial
statements; Rezzo would be in the position of attempting to independently evaluate the
products of his own work. Independence of mental attitude in the appraisal of one’s own work
is extremely doubtful.
2-37 SOLUTION: Gray Manufacturing Corporation (Estimated time: 25 minutes)
The following memorandum summarizes the response of Bart James, CPA, to the request of a client
for extension of the attest function to the problem of pollution control.
As much as I support your strenuous efforts to minimize air and water pollution from the
manufacturing operations of your company, there are specific reasons which make it impossible for
me as a CPA to attest to the extent of your accomplishments in this area along the lines you have
suggested. When we perform the attest function with respect to your financial statements each year,
we are expressing our professional opinion that your financial statements are prepared in conformity
with certain standards, which we call “generally accepted accounting principles.” In order for us to
attest to the effectiveness of your pollution control program, recognized standards would have to be
established in this field. No such standards presently exist for a factory to the best of my knowledge.
Of course the federal government has set standards for exhaust emissions on automobile engines and
we could, by retaining independent consulting engineers, obtain a basis for attesting to the
compliance of a given automobile engine to those standards.
We are quite willing to extend the attest function in various directions if we can find a basis
for objective comparison of a given operation with a clearly defined standard. Perhaps your
engineering department can develop some specific quantitative data on the industrial waste from your
operations. We might then be able to perform the necessary examination of such data to enable us to
attest to the validity of your representations as to your operations. Of course, this would not be the
same thing as providing your relative position in the industry. After reviewing this possibility with
your engineering staff, if you would like to discuss the matter further with us, we will be glad to meet
Solutions Manual, Chapter 2, Page 13 of 14
In-Class Team Case
2-38 SOLUTION: Hide It (Estimated time: 25 minutes)
(a) No, this is not an error since errors are unintentional.
(b) This situation does appear to involve misstatements due to misappropriation of assets. It is a
misstatement due to fraudulent financial reporting because of the omission of the information
from the financial statements. If the $100,000 withdrawals have been abstracted for personal
use, the situation also involves a misstatement arising from misappropriation of assets.
(c) Certain laws have a direct effect on the financial statement amounts and are considered on
every audit. An example is income tax law that affects the amount of income tax expense in
the financial statements of most clients. This situation involves what appears to be noncompliance with a law that has a “direct effect” since, at a minimum; taxes have not been paid
on the income involved.
(d) The auditors will need to consider whether withdrawal is necessary, perhaps after consultation
with their attorney. The case suggests that the unrecorded deposits occurred prior to current
management involvement with the company. Note, however, that interest was earned during
the period this management has been with the company, and withdrawals have been made
during this same period. The auditors would wish to consider when current management
became aware of the account and the nature of the withdrawals when considering whether to
resign from the engagement.
Research and Discussion Case
2-39 SOLUTION: Enormo Corporation (Estimated time: 45 minutes)
(a) When the auditors discover illegal acts by a public client, they should consider three major
factors. First, the auditors should consider the effect of the acts on the client’s financial
statements, including the possibility of fines and loss of business. To comply with generally
accepted accounting principles, the financial statements must reflect the material effects of
Second, the illegal acts may affect the auditors’ assessment of the integrity of
management. In deciding whether to continue to serve the client, the auditors should consider
the nature of the illegal acts and management’s response to the acts after they are uncovered.
Third, the auditors should consider whether the occurrence of the illegal act indicates
that there is a material weakness in the company’s internal control over financial reporting.
(b) The following courses of action are available to the auditors:
(1) The auditors could issue an unqualified opinion and take no further steps regarding
the illegal activities. This course of action could be argued on the basis that the effect
of the acts on the financial statements is not material. If the auditors take this course
of action, they should also consider whether the illegal act and related actions by
management and the board indicate a material weakness exists that would affect their
report on internal control over financial reporting.
Solutions Manual, Chapter 2, Page 14 of 14
(2) The auditors could issue a qualified opinion because the financial statements depart
from generally accepted accounting principles, in that they fail to disclose the illegal
acts. This course of action could be argued on the basis that any illegal activities by
the client are material, especially when management fails to take any steps to prevent
the acts. If the auditors take this course of action, they should also consider whether
the illegal act and related actions by management and the board indicate a material
weakness exists that would affect their report on internal control over financial
(3) The auditors could withdraw from the engagement, because the client’s failure to take
actions to prevent such activities indicates that Enormo’s management lacks sufficient
(c) We believe that the auditors should consider withdrawing from the engagement. Enormo’s top
management seems far too complacent regarding these activities. Their refusal to take any
action to prevent the acts in the future provides a signal to lower level management that top
management approves of illegal acts. The auditors clearly should question the integrity of
management in this situation.