ACCT 611.

Seminar in Auditing and Assurance Services

Sample Exam #1, Version 1

Name: _________________ Student ID: ________________

INSTRUCTIONS

1. Time for exam: 110 minutes.

2. *It is your responsibility to ensure that you have a functional
PC/pad (with word app) and internet access on the date of the
exam.
3. It is a close-book and close-note exam.
4. *This final exam has two versions. You are required to pick the
right version of the exam based on the last digit of your student
ID. You will receive an email 10 minutes before the exam on how
different versions are assigned. Two versions of the exam will be
posted 5 minutes before the exam.
5. *Students who pick the wrong person will lose 5 points out of 100.
6. *Please turn on the Zoom app and your PC’s webcam DURING the
exam. Please turn off the “virtual background” and student
“audio” in your Zoom app. The Zoom app is used here to monitor
the whole exam process.
7. Zoom’s chat function is reserved for the professor ONLY.
8. *Student are prohibited to make or receive phone calls, play with
smartphones, or read notes (hard copies or digital ones) during
the exam period.
9. *Save all your answers in the answer file (a word-format file).
Submit this ANSWER File only by email to the professor.
Students who do not follow this requirement will lose 20 points
out of 100.
10. Submission of hand-written answers is strongly discouraged.
11. 2 points will be deducted for every 5 minutes after the email
submission deadline).

Questions Max Points Scores

I. Multiple Choices 55
II. Short Essay Questions 25
III. Case Question: Risk 20
Assessment
Total 100

1
Note: Required Chapters for the 1st exam (Ch1, 2, 6, 7, 8, 9, 10, 11, 12). There will
be one MCQ question or one short-essay question from Chapter 25.

Chapter 26, 15, and 17 are NOT required for the 1st exam.

About 5-6 MCQ exam questions in Exam #1 will be collected from the Gleim’s
testbank.

2
I. Multiple Choices (55 points; 2.5 points each with 22 questions in total)

1. Which of the following best describes why an independent auditor is asked to

express an opinion on the fair presentation of financial statements?
A) It is difficult to prepare financial statements that fairly present a firm’s position
and performance without the expertise of an independent auditor.
B) It is management’s responsibility to seek available independent aid in the
appraisal of financial information in the financial statements.
C) The opinion of an independent party is needed because a company may
not be objective with respect to its own financial statements.
D) It is a customary practice that all stockholders of a firm receive an
independent report on whether the management team has worked hard to
maximize the total firm value.

2. Which of the following is considered an assurance engagement?

A) Bookkeeping
B) Preparation
C) Compilation
D) Audit

3. In a financial statement audit, the auditor obtains a reasonable level of assurance

about whether the financial statements are free from material misstatements in
order to express his final opinion. In order to obtain reasonable assurance, the
auditor must
A) have prior experience in the industry in which the audit client operates.
B) examine all documents available at client’s office.
C) obtain sufficient audit evidence.
D) test all controls around significant transaction cycles.

4. An auditor concludes that a client’s illegal act, which has a material effect on the
financial statements, has not been properly accounted for or disclosed.
Depending on the pervasiveness of the effect on the financial statements, the
auditor should express either a(an):
A) Adverse opinion or a disclaimer of opinion.
B) Qualified opinion or an adverse opinion.
C) Disclaimer of opinion or an unmodified (also called unqualified) opinion with
an emphasis-of-matter paragraph.
D) Unmodified (also called unqualified) opinion with an other-matter paragraph
or a qualified opinion.

5. Accounts receivable are recorded at the lower of cost or market value on the
balance sheet. To perform annual A/R audit, an auditor reviews aged accounts
receivable to assess likelihood of collection to support which assertion about A/R
account?
A) existence
B) rights
C) cutoff
D) valuation

3
 6. Which of these organizations has the responsibility to penalize auditors if they
violate ethics rules when they audit private companies?
A) American Institute of Certified Public Accountants.
B) Securities and Exchange Commission.
C) Financial Accounting Standards Board.
D) Public Company Accounting Oversight Board.

7. According to PCAOB audit standards, audit documentation must be retained for

A) three years.
B) five years.
C) seven years.
D) as long as possible until PCAOB allows a CPA firm to get rid of those files.

8. The AICPA over time has played an important role in standards setting. Which of
the following standards are currently established by the AICPA?
A) Accounting standards applicable to nonpublic companies.
B) Auditing standards applicable to audits of nonpublic companies.
C) Quality control standards applicable to audits of public companies.
D) Standards for reviews of the interim financial information issued by public
companies.

9. Which of the following types of audit evidence is generally the most reliable one?
A) A bank statement provided by client’s accounting department
B) A bank confirmation mailed directly to the CPA office
C) Analytical procedures
D) Inquiries of the client’s CFO

10. The 11 AICPA Auditing Principles requires that:

A) The auditors shall have appropriate competence and capabilities.
B) The audit be conducted in conformity with generally accepted accounting
principles.
C) Assistants shall all graduate from AICPA-approved accounting programs.
D) The auditors shall express an opinion at the end of audit and correct client’s
accounting misstatements.

11. An auditor most likely would apply analytical procedures in the planning stage to
A) Identify probable internal control weaknesses over certain transaction cycles.
B) Obtain audit evidence on one specific account.
C) Identify unusual account balances/patterns and high risk-areas.
D) Identify related party transactions.

12. An audit should be designed to achieve reasonable assurance of detecting

material misstatements due to:
A) Errors.
B) Errors and fraud.
C) Errors, fraud, and those illegal acts with a direct effect on financial
statement amounts.
D) Errors, fraud and illegal acts.

4
13. Which of the following is NOT a primary purpose of audit documentation?
A) To coordinate the audit to ensure compliance with audit standards.
B) To support the final audit conclusion
C) To support management’s financial statements
D) To provide evidence of the audit work performed.

14. In determining whether transactions have been recorded (or the completeness
assertion), the direction of the audit testing should be from the:
A) General ledger balances.
B) Adjusted trial balance.
C) Original source documents.
D) General journal entries.

15. Which of the following should NOT normally be included in the engagement letter
for an audit?
A) A description of responsibilities of client personnel to provide assistance.
B) Auditor’s scope of service and responsibilities.
C) A description of the limitations of an audit.
D) A listing of the client’s warehouses selected for inventory testing.

16. 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:
A) audit risk.
B) detection risk.
C) inherent risk.
D) sampling risk.

17. The risk that the auditors will conclude, based on substantive procedures, that a
material misstatement does not exist in an account balance when, in fact, such a
misstatement does exist is referred to as
A) Business risk.
B) Engagement risk.
C) Control risk.
D) Detection risk

18. Three conditions generally are present when fraud occurs. Select the one below
that is NOT one of those conditions.
A) Incentive or pressure.
B) Opportunity.
C) Supervisory position.
D) Attitude

5
19. An entity’s internal control system can malfunction due to the following reasons.
One of the four options is NOT one of those reasons. It is
A) Management overrides.
B) Segregation of duties does not work at one high-end department store, since
employees from different departments collide to steal expensive handbags.
C) One employee in the warehouse department misunderstands the internal
control manuals.
D) There are many well-trained internal auditors at L’Oreal, who travel
around the world to review internal controls at its subsidiaries in more
than 100 countries.

20. A primary objective of procedures performed to obtain an understanding of

internal control is to provide the auditors with:
A) Knowledge necessary to determine the nature, timing, and extent of
further audit procedures.
B) Audit evidence to use in reducing detection risk.
C) A basis for modifying tests of controls.
D) An evaluation of the consistency of application of management policies.

21. When the auditors are performing a first-time internal control audit in accordance
with the Sarbanes-Oxley Act and PCAOB standards, they should:
A) Modify their report for any significant deficiencies identified.
B) Use a “bottom-up” approach to identify controls to test.
C) Test controls for all significant accounts.
D) Perform a separate assessment of controls over operation.

22. Which of the following is correct concerning requirements about auditor

communications about fraud?
A) Fraud that involves senior management should be reported directly to
the audit committee regardless of the amount involved.
B) All fraud with a material effect on the financial statements should be reported
directly by the auditor to the Securities and Exchange Commission.
C) Fraud with a material effect on the financial statements should ordinarily be
disclosed by the auditor through use of an "emphasis of a matter" paragraph
added to the audit report.
D) The auditor has no responsibility to disclose fraud outside the entity under
any circumstances.

6
II. Short Essay Questions (25 points)

I list ALL examinable topics/questions below. Short essay questions in the 1st midterm
exam will be picked out of this pool. All answers are in the case homework, PPT slides
or the required textbook. It is your responsibility to find out those answers and prepare
accordingly.

1. When one talks about “completeness” assertion, the same assertion has different
meaning for account balances, transactions and events, and presentation and
disclosure. Please explain the meaning of “completeness” as one assertion
under “presentation and disclosure”.
2. When was the SEC created? What’s the primary responsibility of the SEC as a
federal agency? When was the annual audit requirement introduced for all
publicly traded companies in the U.S.A?
3. Since 1950s, the wording of auditor’s opinion has been switched from “a true and
accurate view of financial position” to “present fairly in all material aspects”.
Please provide at least 2 reasons why “fairness” took over and became the new
focus of financial statement audit.
4. In late 2001 through 2002, the accounting profession faced a “crisis of credibility.”
You are now familiar with the Enron fraud, but not the Worldcom case. Please
consult “Professor Google” and briefly describe the Worldcom case to me (e.g.
what did the CFO do to inflate reported profit, key accounts involved in this fraud,
how large was the total misstatement, who was the external auditor before
Worldcom’s final collapse, and who whistle-blowed this accounting fraud to the
audit committee?). Tip: https://en.wikipedia.org/wiki/MCI_Inc.
5. The Sarbanes-Oxley Act of 2002 established a new regulator over the CPA firms
that audit the publicly traded companies in the U.S. Please name this new
regulatory agency and explain the major responsibilities of this board. (FYI, in the
2020-2021 federal budget, the Trump administration proposed to consolidate
PCAOB into the SEC by 2022. It is not going to happen in the near future, at
least for 2020 and 2021).
6. For how long does the Sarbanes-Oxley Act require auditors of public companies
to retain audit documentation?
7. What are the impacts of the SOX Act of 2002 on auditors and management? If
an executive tampers accounting records and manipulates reported numbers at a
publicly-traded firm, what’s the maximum prison term he can get under the
Sarbanes-Oxley Act of 2002?
8. Who are responsible for the Enron failure? Please list at least three persons (or
parties). Why the Enron CFO established many unconsolidated SPEs overseas?
9. After 2003, AICPA and PCAOB have different regulatory powers in the audit
market. Please describe the details to the professor.
10. The professor mentioned that a firm faces both business risk and information
risk. Please briefly discuss the definitions of these two risks? Which risk is
directly affected by the auditor?
11. Please list the four management assertions on account balances and five
management assertions on transactions. Please briefly explain those assertions
to your professor. Professor might give you examples and ask you to identify the
relevant account balance assertions or accounting transaction assertions.
12. Distinguish between fraudulent financial reporting and misappropriation of
assets. Discuss the likely difference between these two types of frauds on the fair
presentation of financial statements.

7
13. What’s the purpose of audit according to the 11 AICPA audit principles?
14. What is “professional skepticism”? Why professional skepticism is important to
today’s auditors.
15. Explain why auditors need an understanding of the client’s industry.
16. In today’s world, why auditor can only provide reasonable assurance as to the
fairness of financial statements?
17. Who is primarily responsible for the fairness of the financial statements at a
publicly traded firm? The management, board of directors, auditor, or the SEC?
18. In the banking industry, “non-performing loan ratio” is a useful risk indicator.
Please explain to the professor what is non-performing loan? BTW, some
countries also call it “non-accrual loan ratio”. Tip: Definition is available at
https://www.investopedia.com/terms/n/nonperformingloan.asp; U.S. historical
data/graph are available here: https://fred.stlouisfed.org/series/NPTLTL.
19. Apex LLP is the auditor of ZCoupon Inc., a private startup with 20 employees
based in Santa Ana, California. Its 2016 audit report contains one paragraph on
auditor’s responsibility. It is copied and pasted below. Please identify wording
errors and correct them. “Our responsibility is to express an opinion on these
consolidated financial statements based on our audits. We conducted our audits
in accordance with auditing standards established by PCAOB. Those standards
require that we plan and perform the audit to obtain great confidence as to
whether the consolidated financial statements are free of financial misstatement”.
20. Who sets up the accounting standards in the U.S.A? PCAOB, AICPA or the SEC
or others?
21. When are analytical procedures useful? Before the audit, during the audit, or at
the end of annual audit?
22. What are the primary and secondary functions of audit working papers
(documentation)?
23. Confirmation through an independent third-party has been widely used to obtain
reliable audit evidence to verify some asset or liability accounts on the balance
sheet. Please list at least 3 asset accounts which can be audited by confirmation.
24. Today, American auditors can easily verify client’s asset or liability accounts
through electronic confirmation. Please name the firm that provides this online e-
confirmation platform?
25. Please explain to the professor briefly the definition of “materiality” as defined by
the FASB?
26. Internal control has one fundamental principle: Segregation of duties. Please
briefly describe how a credit sale transaction could be separated into 4 different
stages and assigned to 4 different departments (or groups of employees).
27. Please list five components of internal controls.
28. The professor shows that monthly bank cash reconciliation helps to detect cash
fraud perpetrated by low-level employees. Please briefly explain how monthly
bank cash reconciliation, an internal control practice, could be useful in
identifying cash embezzlement.
29. Under “risk assessment”, students are required to know “factors Indicative of
Increased Financial Reporting Risk”.
30. What are “general controls” and what are “application controls”?
31. Publicly-traded firms in the U.S. regularly file two kinds of financial accounting
reports with the SEC: 10-K and 10-Q. Please explain the differences.
32. (Chapter 25) Compilation, review, and exam (audit) provide different levels of
assurance. Please briefly describe their differences here.
33. Apex Inc. purchases, transports, and distributes natural gas to industrial and

8
residential customers in the whole Texas. On the morning of September 30,
2013, its CFO Andy read into the computer system and saw the drafted
forecasted quarterly income statement for the 3rd quarter of 2013:

(in Millions)
Revenue $100
COGs (50)
Gross Profit 50
Less: SG&A expenses 35
Operating Profit 15
Add: Other interest income 1
Less: Interest expense (2)
Income before tax $14

According to the Wall Street consensus, the analyst community expected a

quarterly revenue of $101.5 million and an income before tax number at $14.5
million. Andy worries that the Wall Street will be disappointed one month later
when quarterly income statement is released: Apex will miss both the top line
and bottom line targets! Andy called his close friend Jack, a senior investment
banking manager at Morris Linden, and arranged a last-minute sale transaction
of a natural gas barge ship to Morris Linden: Morris Linden agreed to buy this
used barge ship at $3 million (Apex purchased that barge ship 10 years ago, total
book historical cost at $4 million, half-depreciated with a net book value of $2
million. Due to recent natural gas market boom and inflation, the market value of
a comparable second-hand natural gas barge ship is now $3 million). Morris
Linden will warehouse this barge ship for two months, then sell back to Apex at
$3 million, plus warehouse fees for 60 days, and a “management fee” calculated
by multiplying current USD 2-month LIBOR+4% (London Inter-bank Offer Rate)
with 60 days. The annualized 2-month LIBOR on September 30, 2013, was 2%,
thus the LIBOR+4% was actually 6%.

Andy rushed the paper work to ensure that this transaction was concluded by the
mid-night of September 30, 2013. Jack promised that cash would be wired into
Apex’s Bank of America account in two business days. Andy informed the
controller Amy of this new transaction, and $3 million was added to the total
revenue. The new drafted quarterly income statement looks like below,

(in Millions)
Revenue $103
COGs (52)
Gross Profit 51
Less: SG&A expenses 35
Operating Profit 16
Add: Other interest income 1
Less: Interest expense (2)
Income before tax $15

Required: Please critically assess this last-minute transaction and the new
drafted quarterly income statement. Please review carefully the transaction terms

9
 and apply the “faithful representation” (also called SOF, substance over legal
form) principle to point out the true nature of this transaction and propose the
right journal entries.

III.Risk Assessment (20 points)

(Modified from an ACCA case)

You are a senior audit manager in DeBull LLP, a CA firm. You are reviewing some
information regarding a potential new audit client, GemMedical Inc., a supplier of
medical instruments. Extracts from notes taken at a meeting that you recently held with
the CFO of GemMedical Inc., Mark Edison, are shown below:

Meeting notes – meeting held 1 June 2008 with Mark Edison

GemMedical Inc. is a provider of specialized surgical instruments used in medical
procedures in California. The company is owner managed, has a fiscal year ending
30 June 2008, and has invited our firm to be appointed as auditor for the
forthcoming year end. The audit is not going out to tender. Mark Edison has been
with the company since January 2008, following the departure of the previous CFO,
who is currently taking legal action against GemMedical Inc. for unfair dismissal.

Company background
GemMedical Inc. manufactures surgical instruments which are sold to hospitals and
clinics. Due to the increased use of laser surgery in the last four years, demand for
traditional metal surgical instruments, which provided 75% of revenue in the year
ended 30 June 2007, has declined rapidly. Compared with the same first 9 months
in the previous fiscal year, sales of metal surgical instruments in the current fiscal
year had declined by 35% and the trend seems irreversible. As a response,
GemMedical Inc. is expanding into the provision of laser surgery equipment, but
research and development is at an early stage. The board of directors feel confident
that the laser instruments currently being designed will eventually receive the
necessary licence for commercial production, and that the laser product will replace
surgical instruments as a new leading source of revenue. In the medical industry, all
surgical instruments must be approved by governmental agency before they can be
sold to the hospitals/clinics. There is currently one scientist working on the new
laser equipment, who is now 63 years old. The building in which the research is
being carried out has recently been significantly extended by the construction of a
large laboratory.

The company’s manufacturing facility is located in an Eastern European nation,

where operating costs are much lower than in the U.S.A. The facility is under the
control of a local manager who visits the head office of GemMedical Inc. annually
for a meeting with senior management. Products are imported via airplane. The
overseas plant and equipment is owned by the company and was constructed 12
years ago specifically for the manufacture of metal surgical instruments.

The company has a line of credit with Union Bank of California and it utilizes a big
chunk of the credit now. A significant bank loan, which will carry a variable interest
rate, is currently being negotiated. The terms of the loan will be finalized once the
audited financial statements have been viewed by the bank.

10
You have also found a recent press report regarding GemMedical Inc.:

Extract from local newspaper – business section, 2 June 2008

It appears that local company GemMedical Inc. has breached local planning
regulations by building an extension to its research and development building for
which no local authority approval has been given. The land on which the premises is
situated has protected status as a ‘greenfield’ site which means approval by the
local authority is necessary for any modification to commercial buildings.

A representative of the local planning office stated today: ‘We feel that this is a
serious breach of regulations and it is not the first time that GemMedical Inc. has
deliberately ignored planning rules. The company was successfully sued in 2003 for
constructing an access road without receiving planning permission, and we are
considering taking legal action in respect of this further breach of planning
regulations. We are taking steps to ensure that these premises should be shut down
within a month. A similar breach of regulations by a different company last year
resulted in the demolition of the building.’

Required: Using the information provided, identify probable business risks faced by
GemMedical and identify accounts that are more vulnerable to material misstatement
due to business risks in GemMedical’s operation.

RECOMMENDED SOLOUTIONS:

1. Overstatement of tangible fixed assets-- related to the research building and

research equipment

GemMedical Inc. has constructed a research laboratory which is likely to be impaired at

the year end. The local authority has the power to shut down the illegally constructed
facility, and it is clear from the press cutting that this is likely to happen before the year
end.

In addition, any other tangible assets such as laboratory equipment located at the
premises should be tested for impairment as if the company cannot use the premises
then the assets contained within it are likely to have a lower recoverable amount than
the historical costs on its accounting book.

2. Overstatement of tangible fixed assets-- related to the overseas production

facility

It is a good idea to run the production in a low-cost country. But “overseas plant and
equipment is owned by the company and was constructed 12 years ago specifically
for the manufacture of metal surgical instruments”. Given the big irreversible
demand collapse in market demand for its main product in the last 4 years (35% down
in the most recent fiscal year, very similar to the Nokia’s experience in the smartphone
industry), it is quite possible that the historical costs of those production PPE will not

11
be recovered from future cash inflow, thus must be subject an impairment charge.

Note: overseas production plant could also be subject to labor disruption, currency
fluctuation and overseas political and financial risk. But those factors are secondary
here.

3. Contingency – fines or penalties imposed by local authority (understatement of

contingent liability and relevant expense)
The press cutting indicates that GemMedical Inc. has been sued before, and that the
local authority may again take legal action against the company--probable obligation at
the year end which can be estimated and measured reliably. If payment is deemed only
possible at the year end, then disclosure of the contingent liability should be made in a
note to the financial statements.

4. Demolition costs accrual – Violation of local building code

The local authority may require GemMedical Inc. to demolish the premises. If this
demand is made before the year end, GemMedical Inc. should recognize a provision for
demolition costs as an unavoidable legal obligation would have been created. The
financial statement risk is that in this situation, GemMedical Inc. fails to recognize a
provision and associated expense within the profit and loss account.

5. Going concern problem

Metal surgical instruments account for 75% of the revenue of the company and the
market demand is declining fast. The firm sounds too optimistic and underestimates the
risk associated with the new laser product under R&D (early stage of research, only one
old researcher, probable research failure, government license problem, etc). It might
run out of cash fast when revenue from the current metal instrument dries up and new
product is still nowhere in the market. Union Bank of California could pull the plug when
GemMedical runs into financial distress. The auditor shall watch out this problem even at
the planning stage.

Note: Students should not focus their answer on the breach itself, which has already
occurred, but on the possible consequences of the breach on financial statements, i.e.
financial risk of fines having to be paid, the need to find new premises, and operational
risk of further decline in demand for products.

12