The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation:
1. Determine the applicable rule number from the Code,
2. Decide whether or not the Code has been violated, and
3. Briefly explain how the situation violates (or does not violate) the Code.
1. Kelley Brent, CPA, is a partner in the CPA firm that audits Dane, Inc., a closely held corporation. Kelley's sister is the chief financial officer in Dane, Inc.
2. Sarah Marin, CPA, is a senior auditor in the San Francisco office of Coopers & Snoopers, CPAs. Sarah's father is employed as the controller of Line Electronics, a large, publicly held company in Michigan. Line Electronics is one of Coopers & Snoopers' audit clients. Neither Sarah, nor the San Francisco office of Coopers & Snoopers, is involved in the audit of Line Electronics.
3. On August 20, 1999, Barbie Anderson, CPA and partner, was offered and accepted the engagement to audit the annual financial statements of Jungmann Corporation for the fiscal and calendar years ended December 31, 1999. The audit began on September 15, 1999, and ended on March 7, 2000. Jungmann Corporation is regulated by the SEC. Barbie served as controller of Jungmann Corporation from November 5, 1995, until January 10, 1999, at which time she terminated her employment with Jungmann. Barbie owned a material amount of Jungmann Corporation's common stock from November 5, 1995, until August 15, 1999, at which time she sold the stock.
AICPA Rule of Conduct Rule No: 101 Independence
The code has been violated. Kelley's sister is a "close family relationship" and in a "key position" so she is presumed to be biased with a family member in management.
AICPA Rule of Conduct Rule No: 101 ...
A sentence or two explains the rule.
Ethics, Legal Liability, and Fraud Auditing
1. Explain how the rules concerning stock ownership apply to partners and professional staff. Give an example of when stock ownership would be prohibited for each.
2. The following questions concern independence and the Code of Professional Conduct or GAAS. Choose the best response.
a. What is the meaning of the generally accepted auditing standard that requires the auditor be independent?
(1) The auditor must be without bias with respect to the client under audit.
(2) The auditor must adopt a critical attitude during the audit.
(3) The auditor's sole obligation is to third parties.
(4) The auditor may have a direct ownership interest in the client's business if it is not material.
b. The independent audit is important to readers of financial statements because it
(1) determines the future stewardship of the management of the company whose financial statements are audited.
(2) measures and communicates financial and business data included in financial statements.
(3) involves the objective examination of and reporting on management-prepared statements.
(4) reports on the accuracy of all information in the financial statements.
c. An auditor strives to achieve independence in appearance to
(1) maintain public confidence in the profession.
(2) become independent in fact.
(3) comply with the generally accepted auditing standards of field work.
(4) maintain an unbiased mental attitude.
3. The following questions concern possible violations of the AICPA Code of Professional Conduct. Choose the best response.
a. In which one of the following situations would a CPA be in violation of the AICPA Code of Professional Conduct in determining the audit fee?
(1) A fee based on whether the CPA's report on the client's financial statements results in the approval of a bank loan.
(2) A fee based on the outcome of a bankruptcy proceeding.
(3) A fee based on the nature of the service rendered and the CPA's expertise instead of the actual time spent on the engagement.
(4) A fee based on the fee charged by the prior auditor.
b. The AICPA Code of Professional Conduct states that a CPA shall not disclose any confidential information obtained in the course of a professional engagement except with the consent of the client. In which one of the following situations would disclosure by a CPA be in violation of the code?
(1) Disclosing confidential information in order to properly discharge the CPA's responsibilities in accordance with the profession's standards.
(2) Disclosing confidential information in compliance with a subpoena issued by a court.
(3) Disclosing confidential information to another accountant interested in purchasing the CPA's practice.
(4) Disclosing confidential information during an AICPA authorized peer review.
c. A CPA's retention of client records as a means of enforcing payment of an overdue audit fee is an action that is
(1) not addressed by the AICPA Code of Professional Conduct.
(2) acceptable if sanctioned by the state laws.
(3) prohibited under the AICPA rules of conduct.
(4) a violation of generally accepted auditing standards.
4. The following situations involve the provision of nonaudit services. Indicate whether providing the service is a violation of AICPA rules or SEC rules including Sarbanes-Oxley requirements on independence. Explain your answer as necessary.
a. Providing bookkeeping services to a public company. The services were preapproved by the audit committee of the company.
b. Providing internal audit services to a public company that is not an audit client.
c. Designing and implementing a financial information system for a private company.
d. Recommending a tax shelter to a client that is publicly held. The services were preapproved by the audit committee.
e. Providing internal audit services to a public company audit client with the preapproval of the audit committee.
f. Providing bookkeeping services to an audit client that is a private company.
5. Each of the following situations involves a possible violation of the AICPA's Code of Professional Conduct. For each situation, state the applicable section of the rules of conduct and whether it is a violation.
a. Jose Martinez is a CPA, but not a partner, with 3 years of professional experience with Lyle and Lyle, CPAs. He owns 25 shares of stock in an audit client of the firm, but he does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth.
b. A nonaudit client requests assistance of J. Bacon, CPA, in the installation of a local area network. Bacon had no experience in this type of work and no knowledge of the client's computer system, so he obtained assistance from a computer consultant. The consultant is not in the practice of public accounting, but Bacon is confident of his professional skills. Because of the highly technical nature of the work, Bacon is not able to review the consultant's work.
c. In preparing the personal tax returns for a client, Phyllis Allen, CPA, observed that the deductions for contributions and interest were unusually large. When she asked the client for backup information to support the deductions, she was told, "Ask me no questions, and I will tell you no lies." Allen completed the return on the basis of the information acquired from the client.
d. Sally Blanchard, CPA, serves as controller of a U.S. based company that has a significant portion of its operations in several South American countries. Certain government provisions in selected countries require the company to file financial statements based on international standards. Sally oversees the issuance of the company's financial statements and asserts that the statements are based on international financial accounting standards; however the standards she uses are not those issued by the International Accounting Standards Board.
e. Bill Wendal, CPA, set up a casualty and fire insurance agency to complement his auditing and tax services. He does not use his own name on anything pertaining to the insurance agency and has a highly competent manager, Frank Jones, who runs it. Wendal often requests Jones to review the adequacy of a client's insurance with management if it seems underinsured. He believes that he provides a valuable service to clients by informing them when they are underinsured.
f. Five small Chicago CPA firms have become involved in an information project by taking part in an interfirm working paper review program. Under the program, each firm designates two partners to review the audit files, including the tax returns and the financial statements of another CPA firm taking part in the program. At the end of each review, the auditors who prepared the working papers and the reviewers have a conference to discuss the strengths and weaknesses of the audit. They do not obtain authorization from the audit client before the review takes place.
g. James Thurgood, CPA, stayed longer than he should have at the annual Christmas party of Thurgood and Thurgood, CPAs. On his way home he drove through a red light and was stopped by a police officer, who observed that he was intoxicated. In a jury trial, Thurgood was found guilty of driving under the influence of alcohol. Because this was not his first offense, he was sentenced to 30 days in jail and his driver's license was revoked for 1 year.
h. Rankin, CPA, provides tax services, management advisory services, and bookkeeping services and conducts audits for the same nonpublic client. Because the firm is small, the same person often provides all the services.
6. The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response.
a. Major, Major, & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if
(1) the misstatements were caused primarily by MacLain.
(2) it can be shown that at least some of the investors did not actually read the audited financial statements.
(3) it can prove due diligence in the audit of the financial statements of MacLain.
(4) MacLain had expressly assumed any liability in connection with the public offering.
b. Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security?
Reliance on the Financial Statements | Fraud by the CPA
(1) Yes | Yes
(2) Yes | No
(3) No | Yes
(4) No | No
c. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc. to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds' best defense?
(1) They did not intentionally certify false financial statements.
(2) Section 10b does not apply to them.
(3) They were not in privity of contract with the creditors.
(4) Their engagement letter specifically disclaimed any liability to any party that resulted from Markum's fraudulent conduct.
7. Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm's in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work.
A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart's inventory count procedures, Yost told the president she believed the method of counting inventory at different locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president would sign a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations.
Eighteen months later, Yost found out that the worst had happened. Management below the president's level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations after it had been counted in a given location. The accounting records were inadequate to uncover these illegal transfers.
Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co.
Answer the following questions, setting forth reasons for any conclusions stated:
a. What defense should Lauren Yost & Co. use in the suit by Stuart?
b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?
c. Is Yost likely to be successful in her defenses?
d. Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934?
8. Watts and Williams, a firm of CPAs, audited the accounts of Sampson Skins, Inc., a corporation that imports and deals in fine furs. Upon completion of the audit, the auditors supplied Sampson Skins with 20 copies of the audited financial statements. The firm knew in a general way that Sampson Skins wanted that number of copies of the auditor's report to furnish to banks and other potential lenders.
The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Sampson Skins had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting skins listed as inventory when in fact Sampson Skins had only empty boxes. The audit failed to detect these fraudulent entries. Martinson, relying on the audited financial statements, loaned Sampson Skins $200,000. He seeks to recover his loss from Watts and Williams.
State whether each of the following is true or false and give your reasons:
a. If Martinson alleges and proves negligence on the part of Watts and Williams, he will be able to recover his loss.
b. If Martinson alleges and proves constructive fraud (that is, gross negligence on the part of Watts and Williams), he will be able to recover his loss.
c. Martinson does not have a contract with Watts and Williams.
d. Unless actual fraud on the part of Watts and Williams can be shown, Martinson cannot recover.
e. Martinson is a third-party beneficiary of the contract Watts and Williams made with Sampson Skins.
9. Sarah Robertson, CPA, had been the auditor of Majestic Co. for several years. As she and her staff prepared for the audit for the year ended December 31, 2008, Herb Majestic told her that he needed a large bank loan to "tide him over" until sales picked up as expected in late 2009.
In the course of the audit, Robertson discovered that the financial situation at Majestic was worse than Majestic had revealed and that the company was technically bankrupt. She discussed the situation with Majestic, who pointed out that the bank loan will "be his solution"?he was sure he will get it as long as the financial statements don't look too bad.
Robertson stated that she believed the statements will have to include a going concern explanatory paragraph. Majestic said that this wasn't needed because the bank loan was so certain and that inclusion of the going concern paragraph will certainly cause the management of the bank to change its mind about the loan.
Robertson finally acquiesced and the audited statements were issued without a going concern paragraph. The company received the loan, but things did not improve as Majestic thought they would and the company filed for bankruptcy in August 2009.
The bank sued Sarah Robertson for fraud. Indicate whether or not you think the bank will succeed.
10. You have identified a suspected fraud involving the company's controller. What must you do in response to this discovery? How might this discovery affect your report on internal control when auditing a public company?
11. The following questions address fraud risk factors and the assessment of fraud risk.
a. Because of the risk of material misstatements 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) objective judgment.
(2) independent integrity.
(3) professional skepticism.
(4) impartial conservatism.
b. Which of the following circumstances is most likely to cause an auditor to consider whether material misstatements due to fraud exist in an entity's financial statements?
(1) Management places little emphasis on meeting earnings projections of external parties.
(2) The board of directors oversees the financial reporting process and internal control.
(3) Significant deficiencies in internal control previously communicated to management have been corrected.
(4) Transactions selected for testing are not supported by proper documentation.
c. 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?
(1) The entity's industry is experiencing declining customer demand.
(2) Employees who handle cash receipts are not bonded.
(3) Internal auditors have direct access to the board of directors and the entity's management.
(4) The board of directors is active in overseeing the entity's financial reporting policies.
d. 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?
(1) Property and equipment are usually sold at a loss before being fully depreciated.
(2) Unusual discrepancies exist between the entity's records and confirmation replies.
(3) Monthly bank reconciliations usually include several in-transit items.
(4) Clerical errors are listed on a computer-generated exception report