Chapter 3 Professional Ethics and Legal Liability: Auditing, 14e (Arens)

Auditing, 14e (Arens)
Chapter 3 Professional Ethics and Legal Liability
3.1 Explain the fundamental principles that guide public accountants' professional ethics
1) Ethical behavior is considered to be a cornerstone for trust in everyday life as well as in business
practices. Ethics are
A) beliefs that we have about our own behaviour.
B) a set of moral principles or values.
C) rules in society that help us to do the right thing.
D) laws that govern how businesses should behave.
Answer: B
Diff: 1 Type: MC Page Ref: 50
Learning Obj.: 3-1 Explain the fundamental principles that guide public accountants' professional ethics
2) Society has attached a special meaning to the term professional. A professional is

A) someone who has passed a qualifying exam to enter the job market.
B) any person who receives pay for the services performed.
C) a person who is expected to conduct himself or herself at a higher level than the requirements of
society's laws or regulations.
D) someone who has both an education in the trade and on-the-job experience received under an
experienced supervisor.
Answer: C
3) The underlying reason for a high level of professional conduct, such as exemplified in a code of
conduct, for any profession is
A) the need for public confidence in the quality of service of the profession.
B) that it provides a safeguard to keep unscrupulous people out.
C) that it is required by federal legislation.
D) that it allows licensing agencies to have a standard to measure deficient performance.
Answer: A
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4) According to the CPA Code of Professional Conduct, ethical principles are aimed at
A) the emphasis on serving the public interest and at achieving orderly and courteous conduct within the
profession.
B) the ability to enforce the ideals.
C) the enforceability of minimum behaviour and performance standards.
D) the tendency to define the rules as maximum rather than minimum standards.
Answer: A
5) A code of professional conduct typically includes principles, rules of conduct, and interpretations or
examples. What is the purpose of the principles?
A) to state what a practitioner must do for each audit engagement conducted
B) to provide discussions of the rules of conduct and how they relate to practical situations
C) to provide minimum standards of ethical conduct stated specifically
D) to provide ideal standards of ethical conduct aimed to serve the public interest
Answer: D
3.2 Recognize ethical dilemmas that public accountants typically encounter and recommend acceptable
courses of action
1) Ethical dilemmas occur when

A) you know what you want to do but the rules say otherwise.
B) businesses disregard the laws and engage in illegal behaviour.
C) a person chooses to act in his/her own interest.
D) a choice must be taken about appropriate behaviour.
Answer: D
Learning Obj.: 3-2 Recognize ethical dilemmas that public accountants typically encounter and
recommend acceptable courses of action
2) A public accountant would be facing an ethical dilemma when deciding whether or not to
A) overlook a material overstatement of revenues to maintain a good client relationship.
B) overlook a non-material error in the financial statements.
C) accept an invitation from the client to go golfing in order to maintain a good client relationship.
D) participate in a charitable activity organized by the client.
Answer: A
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3) Formal frameworks have been developed to help people resolve ethical dilemmas. After obtaining the
relevant facts and identifying the ethical issues from the facts, what is the next step in the five-step ethical
framework described in the chapter?
A) Decide on the appropriate action to be taken in resolving the ethical dilemma.
B) Identify the likely consequences of actions that will be taken.
C) Identify who is affected and how each is affected.
D) Identify the alternatives available to the person who must resolve the dilemma.
Answer: C
4) You are the senior in charge of the accounts receivable section of the audit of a large clothing
manufacturer downtown in the clothing district. The client sells to local clothing stores as well as to other
retailers in the province.
Accounts receivables seem to be deteriorating, with many more accounts in the over 90 days column than
in the past. You sent out twenty accounts receivable confirmations, but only six were returned. Of these
six, only three confirmed the balance as in agreement with the client, while the others indicated that they
kept their records on an open item basis (rather than a balance forward basis) and were unable to respond
to the confirmation request. When you looked at the prior year's file, it seemed that the same thing had
happened last year.
When you phoned the supervisor in charge of the audit engagement, she told you to not bother with
follow up, as the engagement was already over budget and costs need to be kept down. You were
concerned that you would be unable to state a conclusion with respect to the fairness of the accounts
receivable balance and she was really angry with you, saying that she would have to sign off for you then.
Required:
Discuss the ethical and quality issues raised by this audit engagement.
Answer: The engagement indicates a lack of planning, as you were only aware of the problems with the
accounts receivable confirmation process after you had received the replies. The likelihood of non-
response should have been considered before selecting and sending the confirmations.
The pressures by the supervisor to sign off on the audit engagement without completing the necessary
audit procedures indicate a poor human resources environment at your audit firm. It also means that this
audit (and other audits) may have inadequate evidence on file to support an opinion on the financial
statements. This violates the general principle of due care and the third examination standard of sufficient
appropriate audit evidence under GAAS.
Diff: 2 Type: ES Page Ref: 51-56
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5) List the components of the auditor's ethical decision making framework.
Answer: Following are the five components of auditor's ethical decision making framework:
1. obtain relevant facts and identify the issues.
2. identify the ethical issues.
3. identify who is affected and how each is affected.
4. consider and evaluate courses of action.
5. implement the course of action.
Diff: 3 Type: ES Page Ref: 52
6) Describe an ethical dilemma that an auditor or an accountant might face in his or her business career.
Then illustrate how the auditor or accountant might use the five-step approach presented in Chapter 3 to
resolve the dilemma. Be specific.
Answer: Although students' answers will vary depending on the dilemma, their answer should list the
following steps, along with a discussion of how each step relates to their particular dilemma.
1. Obtain the relevant facts and identify issue. Students should list the key facts from their dilemma.
2. Identify the ethical issues. Students should identify the key ethical issue(s) in their dilemma.
3. Identify who is affected and how each is affected. Students should identify who is involved and how
each party is affected by the dilemma.
4. Consider and evaluate courses of action. Students should list the alternatives available to the auditor or
accountant. Students should identify both the short- and long-term effects of each alternative.
5. Implement the course of action. Students should indicate how the best solution should be
implemented.
3.3 Explain the impact of ethical blind spots on auditors' ethical reasoning
1) What is an ethical blind spot?

Answer: An ethical blind spot is an unconscious judgmental tendency that can hinder the ethical decision
making process or cause the decision maker to fail to recognize the ethical dimension of a choice.
Diff: 2 Type: SA Page Ref: 56
Learning Obj.: 3-3 Explain the impact of ethical blind spots on auditors' ethical reasoning
3.4 Understand the rules of professional conduct and apply that knowledge to resolve ethical conflicts
1) Which portions of the code of professional conduct are enforceable?

A) principles and rules
B) the rules of conduct
C) interpretations
D) rules and interpretations
Answer: B
Learning Obj.: 3-4 Understand the rules of professional conduct and apply that knowledge to resolve
ethical conflicts
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2) Generally, all of the rules of professional conduct for CPAs apply to
A) students in public practice.
B) students and members in firms.
C) members in public practice.
D) all members and firms.
Answer: D
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3) As a member of a professional accounting association, when considering the applicability of the rules
of professional conduct, a PA would be responsible for compliance by
A) themselves only.
B) their partners in the practice and themselves.
C) their employees.
D) themselves, their employees, and partners.
Answer: D
Diff: 2 Type: MC Page Ref: 56-57
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4) "Independence" in auditing means

A) remaining aloof from the client.
B) not being financially dependent on the client.
C) impartiality in performing professional services.
D) being an advocate for the client.
Answer: C
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5) When public accountants are able to maintain an independent attitude in fulfilling their responsibility,
it is referred to as independence in
A) fact.
B) appearance.
C) conduct.
D) total.
Answer: A
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6) When the users of financial statements have confidence in the independence of the public accountant, it
is referred to as independence in
A) fact.
B) appearance.
C) conduct.
D) total.
Answer: B
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7) Financial statement users cannot be expected to evaluate audit performance because they will not have
the time or the competence to do so. In such a situation, public confidence in the quality of professional
services is enhanced when there are
A) only business majors hired to work as auditing students with public accounting firms.
B) adequate controls at the public accounting firm to limit the amount of overtime worked.
C) high standards of performance and conduct on the part of all practitioners.
D) strict rules about the type of work that employees should complete on a daily basis.
Answer: C
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8) In which of the following circumstances would a public accountant be bound by ethics to refrain from
disclosing any confidential information obtained during the course of a professional engagement?
A) The public accountant is issued a subpoena that orders the public accountant to present confidential
information.
B) A major shareholder of a client company seeks accounting information from the public accountant
after management declined to disclose the requested information.
C) Confidential client information is made available as part of a practice inspection of the public
accountant's practice.
D) An inquiry by a disciplinary body of a provincial institute requests confidential client information.
Answer: B
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9) The confidential relationship will be violated if, without the client's permission, the public accountant
provides working papers about a client to
A) a court of law that subpoenas them.
B) the relevant provincial institute as part of a practice inspection.
C) another public accounting firm that has just purchased the public accountant's entire practice.
D) an investigative or disciplinary body of the relevant provincial institute that is conducting a review of
the public accountant's practice.
Answer: C
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10) The provincial institutes' Rules of Professional Conduct state, in part, that a public accountant should
maintain integrity and due care. Integrity in the Rules refers to a public accountant's
A) ability to maintain an impartial attitude on all matters that come under the public accountant's review.
B) ability to distinguish independently between accounting practices that are acceptable and those that
are not.
C) ability to be unyielding in all matters dealing with auditing procedures.
D) reputation for honesty and fair dealing.
Answer: D
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11) What should a PA do if approached by a client where he and his firm lack or do not have access to the
technical knowledge required to complete the audit?
A) subcontract the audit to another firm
B) indicate that they can do a review engagement, not an audit
C) decline the new audit engagement
D) conduct the engagement, but prepare a qualified audit report
Answer: C
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12) How is use of an applicable accounting framework enforced via legislation?

A) The Canada Business Corporations Act and many provincial incorporating acts require that financial
statements be prepared in accordance with CAS as set out in the CPA Canada Handbook.
B) PAs who do not prepare financial statements in accordance with such frameworks are expelled from
their professional association.
C) tax authorities may sue corporations who do not prepare their financial statements in accordance with
such frameworks.
D) financial executives may be sued if the financial statements prepared by their company are not in
conformance with such frameworks.
Answer: A
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13) Which one of the following situations is a violation of the professional rules of conduct? PA
A) looked the other way when he noticed that one of his firm's accounting staff accepted money from
client management.
B) resigned so that he could accept a position on the Board of Directors at a major client.
C) prepared personal and corporate tax returns for a client and all of its executive officers.
D) placed an advertisement in the local paper indicating that she conducted audit engagements for five
major insurance companies.
Answer: A
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14) The rules of accounting bodies in Canada require their members to behave in the best interest of the
profession and the public. Identify the situation where the accountant is acting in the best interest of the
profession. An accountant
A) reports a fellow accountant after noticing that the accountant helped a client with tax evasion.
B) openly criticizes a fellow accountant's competencies after having lost a bid for a new client.
C) brags about his competence and professional title, and encourages clients to invest in a new venture he
is starting.
D) refuses to cooperate with the new auditor after having lost a client.
Answer: A
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15) Which one of the following forms of advertisement would violate solicitation rules? PA
A) placed an advertisement in a newspaper indicating the opening of a new office.
B) conducted a cold-calling campaign where companies were asked if they would like to change PA
firms.
C) placed a media advertisement listing the different types of expertise available at the firm's major office
locations.
D) conducted a survey asking companies about the types of services that are provided by their
accounting firms.
Answer: B
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16) For which of the following engagements is a contingent fee permitted?

A) an audit engagement of a large listed corporation
B) a tax consulting assignment assessing the excise tax payment processes
C) a review engagement of a small manufacturing corporation
D) an assurance engagement of leasehold payments for a rental agreement
Answer: B
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17) PA has been asked to accept the audit engagement of BarneyBlues Corporation. PA sent a letter to the
predecessor auditor asking whether there was any reason why he should not accept the engagement.
Assuming that the prior year audit went smoothly, what would be an appropriate response by the
predecessor auditor?
A) Provide a brief statement that there is no reason of which he or she is aware that would prevent
accepting the engagement.
B) Send a copy of the entire working paper file to PA.
C) Telephone PA and say that PA should not take the engagement because the fee charged was too large.
D) Send a copy of the tax returns and tax assessments to PA.
Answer: A
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18) The Rules of Professional Conduct require a successor auditor to communicate with the previous
auditor. The primary concern in this communication is
A) to acquire information that will help the successor auditor determine whether the client management
has integrity.
B) to learn about the client by examining the predecessor's working papers.
C) to enable the successor to perform a more efficient audit.
D) to save the successor auditor time and money in gathering data.
Answer: A
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19) What is the difference between auditors and lawyers with respect to privileged information?
Answer: Public accountants do not have the right under common law to withhold information from the
courts on the grounds that the information is privileged. A court can subpoena information in an
auditor's working papers.
Lawyers can withhold confidential information from the courts.
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20) Each of the following situations involves a possible violation of the provincial institutes' Rules of
Professional Conduct. For each situation, (1) decide whether or not the Rules have been violated, and (2)
briefly explain how the situation violates (or does not violate) the Rules.
A) Johnny Line has a successful dentistry practice in Calgary. Johnny has recommended one of his
patients to Leslie King, public accountant. To show gratitude for the referral, Leslie has agreed to pay
Johnny 5% of the fee for audit services rendered by Leslie to Johnny's patient. Leslie discloses the
payment agreement to her new client.
Violation? Yes No
Explanation:
B) The accounting firm of Bayer & Peng, public accountants, is negotiating a fee with a new audit client.
They agree the client will pay $75 000 if Bayer & Peng issues a clean, unqualified opinion, $50 000 if a
qualified opinion is issued, $40 000 if an adverse opinion is issued, and $10 000 if a denial of opinion is
issued.
Violation? Yes No
Explanation:
C) Don Smith, public accountant, takes part in the audit of Shaw Corporation. Don is not a partner or a
manager in the public accounting firm, and does not own any stock in Shaw Corporation. Don's five year-
old daughter, Betty Lou, received one share of Shaw Corporation's common stock for her fifth birthday.
The stock was a gift from Betty Lou's grandmother. Betty Lou treasures that share of stock and is
absolutely unwilling to part with it.
Violation? Yes No
Explanation:
D) On August 5, 2017, Page Dane, public accountant, issued the audit report on Borhut Corporation's June
30, 2017 financial statements. On August 30, 2017, Borhut paid Page's audit fee with stock rather than
cash. Page sold the stock on September 15, 2017, two months prior to the beginning of the planning phase
for the audit of the June 30, 2018, financial statements.
Violation? Yes No
Explanation:
Answer:
A) Violation. A public accountant may not pay a referral fee to a non-public accountant.
B) Violation. This is a contingent fee agreement, which is prohibited by the Rules of Professional Conduct.
C) Violation. Participants in an audit are prohibited from having a financial interest in the client. The rule
also applies to the participant's dependents.
D) Violation. Public accountants are prohibited from owning stock in a client.
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21) Kimora is a senior manager at a public accounting firm. Kimora was assigned to the audit of Toble
Corp. Upon arriving at the client, Kimora met with the controller, Brad, who was a classmate in college,
20 years ago. She had not been in contact with Brad since college, but they realized that they still had
many friends in common. Brad invited Kimora to go to the company box to watch a hockey game and
catch up.
Discuss the issue of independence between Kimora and Toble Corp.
Answer: Kimora might not be independent in appearance, given that she knows Brad who is overseeing
the financial reporting of the company. However, Kimora can likely remain independent in fact because:
• she has not been in contact with Brad for 20 years.
• she doesn't have any close relationship with Brad or any personal interest in the company.
• going to a hockey game with a client is not a breach of independence.
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22) You are having lunch with a former employee of your firm, a friend of yours. Gino had been laid off
last year when he had failed to pass his professional examinations for the third year in a row. Gino told
you that he managed to obtain a CPA designation in the past year, and has started his public practice.
He has been circulating flyers and electronic email announcements with fixed rates: $400 for a
compilation engagement, $1000 for a review, and $5000 for an audit where revenues are less than $1
million, $15 000 for an audit for a client with revenues up to $5 million. He already has clients to keep him
busy for the next three months. He even has some feelers for clients that he personally handled while he
was working for your firm - there were a lot of contacts developed during the five years that he was
working there! To help attract some of the larger clients, he is considering not charging any fee for the
first ten hours spent on tax-related services.
Gino ended the conversation by asking you if you would like to join him in his new firm, because at this
rate he'll need a second person really soon!
Required:
Identify the violations in the professional rules of conduct and explain why they are violations.
Answer: Gino is actively soliciting clients of other firms (including his former employer), which is a
violation. He should be placing general advertisements or providing only announcements.
Gino is providing fixed fee engagements, without conducting any planning or assessing the risk in the
engagements. This means that he may be likely to conduct inadequate field work, violating GAAS.
Not charging for the tax work is also a violation, since this creates the same type of pressure for Gino to
not conduct his remaining audit work in accordance with GAAS.
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23) Sandra is a new partner at a PA firm. Sandra recently signed a new contract with Gretchen Fabrics to
become its auditor. In the process of accepting the client and planning the first year's audit, Sandra did
the following:
- Sandra contacted the previous auditor to enquire if there were any reasons not to accept the audit of this
client. Unfortunately, the previous auditor was on vacation and did not respond to Sandra before she
accepted the client.
- Upon his return, the previous auditor did communicate with Sandra and indicated that the client had
aggressive expense deferral policies that they disagreed on. Sandra asked to review the working papers
of the previous auditor with regards to these expenses and found them to be right below the materiality
threshold.
- Gretchen Fabrics imports most of its fabrics and has two production facilities in Asia. The company
therefore has a complex tax structure and many import duties. Since this is not the area of expertise of
Sandra, she asked another auditing firm to provide the required audit procedures for the international
taxes and duties expense. When selecting the other audit firm, Sandra researched the firm online. She also
ensured that they had their professional designation and enquired with the CPA and provincial
association if the firm had any complaints or litigation outstanding for malpractice.
- Since the bidding process took time, Sandra had to start the audit almost right after learning she had the
winning bid. She did not prepare an engagement letter before starting the work. She does not see this as
being a problem since waiting until the audit has begun will provide her with a better idea of what work
has to be done and what the engagement letter should include.
Required:
Identify the good and bad steps that Sandra has undertaken in reducing her exposure to legal liability.
Answer: - Contacting the previous auditor is a good step, however, Sandra did not wait to have a
response before accepting. Sandra should have waited to hear from the previous auditor.
- Reviewing the working papers of the previous auditor is a good step, however, when she learned that
the client had aggressive expense deferral policies, Sandra should not have been so quick to dismiss this
based on materiality. The deferral of expenses might exceed materiality in the upcoming year, causing the
financial statements to be misstated, and this is also evidence of questionable management integrity.
Sandra should have considered ending the relationship with the client upon learning this information.
- It appears that Sandra did not assess management integrity prior to accepting the client. This creates a
higher audit risk.
- Sandra did a good job in verifying the credentials of the other audit firm upon which she is going to
rely. It is correct to accept a client even if you cannot perform the entire audit yourself. If you can find an
expert to assist you in the process and you can ensure that the work of the expert is properly done, you
will be following GAAS. The steps to verify the qualification of the other auditors appear to be sufficient.
Note that Sandra will also have to review their work, once it is done.
- Sandra should have done an engagement letter prior to starting the work.
- If the time frame is too short, Sandra should have indicated to the client that she will need additional
time to complete the work.
- Sandra should have conducted a thorough risk assessment of both management and the industry before
accepting the audit.
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3.5 Identify and evaluate threats to independence and recommend appropriate safeguards to eliminate
or reduce the threats to an acceptable level
1) How do quality control processes for the financial statement audit process incorporate consideration of
legislation that affects the client?
A) they require second partner review of all working papers that relate to legislative matters
B) they provide auditors with copies of legislation that affects their client
C) they require the training of all auditors in legislation details that could affect all clients
D) they include in audit checklists questions that address relevant new legislation
Answer: D
Learning Obj.: 3-5 Identify and evaluate threats to independence and recommend appropriate safeguards
to eliminate or reduce the threats to an acceptable level
2) Independence is assessed in the eyes of external users and regulators. Which of the following is a tool
that helps the auditor identify whether the auditor is independent for a particular audit engagement?
A) completion of independence forms at time of employment
B) an independence threat analysis
C) an audit risk model assessment for each engagement
D) professional skepticism when assessing control risks
Answer: B
3) When should a PA assess the five threats to independence with respect to an audit engagement?
A) when deciding to accept a client or whether to continue an existing engagement
B) after signing the engagement letter and before commencing field work
C) after the completion of this year's audit, before starting the next engagement
D) after a discussion with the Board of Directors
Answer: A
4) Which of the following situations would be an example of a self-interest threat that would prevent a
PA from auditing the client?
A) The PA's uncle owns the business that the PA is auditing.
B) For the last two years, the client could not pay their fees, so the PA created a loan agreement covering
the fees, with the client paying 10% interest on the fees.
C) The PA has a small bank loan at normal business interest rates with the bank that his firm is auditing.
D) The PA has purchased a used car from one of the employees of the client.
Answer: B
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5) Which of the following situations best describes an advocacy threat? PA has been hired to
A) consult with the corporate controller and the bank manager about the conditions for financing a loan.
B) manage the accounting department for three weeks while the corporate controller is on vacation.
C) complete the personal tax returns of all executive management.
D) prepare the year end journal entries for a subsidiary company.
Answer: A
6) Which of the following situations would be an example of a self-review threat? Prior to commencing
the audit engagement, PA has completed
A) personal and corporate tax returns.
B) the audit of a company where the client owns a minority interest.
C) a purchase price allocation calculation for a company that the client purchased during the year.
D) an audit of the not-for-profit organization of the client.
Answer: C
7) Why does a self-review threat pose a problem when conducting an audit engagement?
A) The audit can be conducted more efficiently.
B) You are auditing your own work, and may not detect inadequacies.
C) The audit is more expensive, as you have to provide clear documentation.
D) The auditor may not have the expertise to complete the special work.
Answer: B
8) According to the profession's ethical standards, an auditor would be considered independent in which
of the following instances? The
A) auditor's chequing account, which is fully insured by CDIC, is held at a client financial institution.
B) client comprises 75% of the auditor's fees.
C) auditor does not have enough employees to meet the client's reporting deadline.
D) client owes the auditor fees for two consecutive annual audits.
Answer: A
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9) Which of the following situations best describes a familiarity threat?
A) design and implementation of a new payroll system
B) preparation and entry of bookkeeping transactions
C) completion of corporate transactions for subsidiary companies
D) PA has been working with this client for ten years, first as a manager, now as a partner
Answer: D
10) A familiarity threat at an audit engagement occurs when

A) the member has a financial interest in the client.
B) it is difficult to behave with professional skepticism.
C) PA promotes the client's position to third parties.
D) the member discloses financial information about the client.
Answer: B
11) Which of the following is the best example of an intimidation threat? Management
A) has decided to sue you because the audit fee was twice as high as they expected.
B) has changed auditors of all of its subsidiary companies as they can get the audit done for a lower cost.
C) threatens to change auditors if you do not let them overstate accounts receivable by $100 000 (the bad
debt allowance is too low).
D) threatens to resign from the company if the board of directors does not give them a 15% raise.
Answer: C
12) An intimidation threat occurs when

A) it is difficult to believe the actions of management because there is a suspicion of irregular activity in
the recording of transaction activity.
B) the auditor suspects that fraud has occurred at the middle management level of the organization.
C) the auditor has been working on a client engagement for many years and has trouble believing that
management would deceive the auditors.
D) a client threatens the firm or its staff with respect to the content of the financial statements or with
respect to the conduct of the audit.
Answer: D
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13) Some independence rules apply to all assurance engagements, while others apply only to a listed
entity. For the purposes of assessing the independence rules, a listed entity is defined as
A) an organization with share capital exceeding $10 million that has public accountability.
B) an entity whose debt or shares are listed on a stock exchange, with market capitalization and total
assets greater than $10 million.
C) any organization that has shares or debt listed on a stock exchange.
D) an organization that has shares or debt listed on a stock exchange, and that has redeemed shares.
Answer: B
14) If a PA firm provided corporate finance services to a company during the year, which of the following
engagements could the PA firm accept to provide to the same company?
A) non-assurance services
B) audit of listed entity
C) audit of non-listed entity
D) an assurance engagement other than an audit
Answer: A
15) Where an independence threat occurs, it may be that only the person affected needs to be removed
from the engagement. In this case, other members of the firm can complete the engagement. An example
of a situation where only the student or member would be excluded from the engagement is where PA
A) has a significant financial interest in the client, such that influence could be exerted.
B) used to be a controller at the client, but now works for the PA firm.
C) owns ten percent of the shares of the client.
D) is a board member of the client with signing authority for cheques.
Answer: B
16) At a small practice where the bulk of the work is accounting, bookkeeping, and review engagements,
what is an important procedure that should be followed by the PA to help ensure independence?
A) Management should be trained in accounting principles so that they can adequately assess the PAs
work.
B) All transactions should be prepared and processed by client personnel.
C) Transactions and journal entries should be discussed with and approved by the client.
D) The accountant should avoid doing bookkeeping for review engagements, and restrict this to
compilation engagements only.
Answer: C
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17) To ensure that employees remain independent, an audit firm should
A) ask employees to sign a form confirming that they do not have an investment in a company that they
are auditing.
B) prohibit an employee from the Toronto office to have an investment in a company audited by the Hong
Kong branch of the PA firm.
C) include a section in the code of conduct indicating that the employees should not invite their client to
dinner.
D) refuse an audit where the cousin of a staff member works in the marketing department.
Answer: A
18) For listed clients, the audit committee should approve both the appointment of the auditor and
A) all services that the PA firm provides to the client.
B) an engagement that might affect the appearance of independence, such as design of control systems.
C) any services that are provided for senior management.
D) the material that is included in the management letter by the PA firm.
Answer: A
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19) Each of the following situations involves a possible violation of the independence requirements of the
provincial institutes' Rules of Professional Conduct. For each situation, (1) decide whether the Rules have
been violated, and (2) briefly explain how the situation violates (or does not violate) the Rules.
A) Mike Lednicky, public accountant, is a partner in the Oshawa office of Arthur & Thompson, public
accountants. Mike's brother is employed as an inventory warehouse supervisor (an audit-sensitive
position) by Sweeny Appliances, a publicly held company in Manitoba. Sweeny Appliances is one of
Arthur & Thompson's audit clients. Neither Mike nor the Oshawa office of Arthur & Thompson is
involved in the audit of Sweeny Appliances.
Violation? Yes No
Explanation:
B) The accounting firm of Finke & Hersley, public accountants, provides bookkeeping and tax services for
Hendershot Corporation. Finke & Hersley also performs the annual audit of Hendershot Corporation.
Violation? Yes No
Explanation:
C) Brent Shaw, public accountant, is the auditor of Cafe Eccel. A couple of weeks ago, Cafe Eccel's
management expressed an intention to commence litigation against Brent, alleging he was negligent in
last year's audit. Brent believes there is a strong possibility that management will proceed with the
litigation. However, Cafe Eccel has not fired Brent as its auditor, and he is now working on the current
year's audit of Cafe Eccel.
Violation? Yes No
Explanation:
D) Melissa Barry, public accountant, is the auditor of Audio Video Inc. Audio Video has not paid
Melissa's audit fee for the past two years. Melissa is working on the current year's audit of Audio Video.
Violation? Yes No
Explanation:
Answer:
A) No violation. Although partners in a public accounting firms are not allowed to have close relatives
employed in a position of significant influence by a client, it is acceptable to have a close relative
employed in an audit-sensitive position (with no significant influence), particularly as Mike is not
involved in the audit engagement.
B) No violation. The Rules of Professional Conduct do not prohibit public accounting firms from
providing bookkeeping, tax, and audit services to the same client, as long as the client is not a listed entity
and management approves the transactions and journal entries.
C) Violation. When there is a lawsuit or intent to start a lawsuit between a public accountant and an audit
client's management, independence is impaired.
D) No violation. While independence may be impaired if fees remain unpaid for services provided more
than one year prior to the date of the report in some cases, there is no requirement under the Rules of
Professional Conduct not to continue in the role as auditor. Melissa should document in her audit file
how she has dealt with this self-interest threat and the steps that the client is taking to pay fees.
18
20) Xiao, PA, is the auditor of Minkle Credit Union, a medium-sized credit union. Xiao has prepared a
management letter with several serious control weaknesses. Management agrees with the facts, but does
not want to present the letter with the weaknesses to the audit committee or the board of directors.
Management has implied that they will request a change of auditors if your firm presents the
management letter to the board.
Required: Discuss the actions that Xiao should take. Justify your response.
Answer: Xiao is being faced with an intimidation threat. Xiao needs to consult GAAS (the CPA Canada
Handbook), standards employees, and other resources to first determine what must be reported to the
audit committee. Xiao should also consider that if management does not want to disclose these matters,
that there could be other issues that management is hiding, making it difficult to complete the audit. If the
weaknesses could lead to potential material misstatements, Xiao is required to report them to the audit
committee.
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21) Each of the following situations involves a possible violation of the provincial institutes' Rules of
Professional Conduct. For each situation (1) decide whether or not the rules have been violated, and (2)
briefly explain how the situation violates (or does not violate) the rules.
A) Carla is the CFO of Xenon Company. Carla was very happy after her husband Dwayne, a partner at a
large PA firm, was assigned as the new auditor of the company. Carla is confident that this will be helpful
to Xenon since Dwayne already knows so much about the business.
Violation? Yes No
Explanation:
B) Jeremy accepted a summer internship at a PA firm. Jeremy's parents own 0.1% of Raven Inc, a large
public company in Austria. Raven Inc. is a client of the Austrian branch of the PA firm. Jeremy reported
this to the partner of his office.
Violation? Yes No
Explanation:
C) Ken Burns is a partner at Burns and Fields LLP, a PA firm. Ken was approached by a friend who asked
him to invest in Safran Group Inc., a growing high tech company. The proposal would be for Ken to
invest $650 000 to obtain 1% of the company. Ken decided to go ahead with the investment because
Safran is a client from their Seattle office and he has never provided any services to Safran Inc. Ken
indicates that he will ensure that he does not work on the audit of Safran.
Violation? Yes No
Explanation:
D) Sintron Inc. is a payroll processing company. Over the past 5 years, Clarkson Coppers LLP, a PA firm,
has outsourced its payroll processing and other human resources tasks to Sintron. Clarkson Coopers LLP
is happy to outsource more functions to Sintron as Sintron has asked Clarkson for additional consulting
services with regards to system implementation and application of new accounting policies.
Violation? Yes No
Explanation:
Answer:
A) Violation. Independence is violated as a direct family member holds a position overseeing the financial
reporting.
B) No violation. Since Jeremy is only a student, this will not be a violation as long as Jeremy is not staffed
to work on any mandate for Raven. Jeremy did the right thing by reporting his interest in Raven to the
Partner.
C) Violation. As a partner, Ken is not able to own more than 0.1% of any company audited by the PA firm,
even if it is not a direct client of Ken's office.
D) No violation. The type of services that Clarkson Coopers appears to be providing are non-assurance
services. Therefore, this would not create a conflict of interest.
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22) Raul, PA, received a call from his friend Cristobal Franco. He needed an audit urgently, because the
bank might call his loan for his computer store CF Ltd. Since Cristobal had been his high school friend
and they still played soccer together every two weeks, Raul agreed. Raul and Cristobal had a quick
meeting, where Raul fixed the audit fee at $10 000. Cristobal stressed the importance of an unqualified
opinion for the bank.
Raul sent two available junior staff to CF's offices. The junior staff were experienced in review
engagements, and had been working for Raul for about six months. The two staff had a quick look
around the store, noting the documents strewn everywhere. The accounting staff came in and chatted
briefly after their smoke break. They were about a month behind on recording transactions, because
Cristobal had laid off one salesperson. The accounting staff also helped out with providing sales quotes
and Cristobal did all of the technical work.
At the end of the day, the junior staff were each given a $250 gift certificate to be used in the computer
store. This was great, because CF also sold MP3 players and supplies such as CDs and DVDs.
At dinner that night, the junior staff told their family that it would probably be a great idea to hold off on
any computer supplies or equipment purchases that they needed, since CF would likely hold a sale in the
next month or two to improve cash flow.
Required:
Identify and discuss the violations in the rules of conduct with respect to CF.
Answer: Raul is too familiar (familiarity threat) with Cristobal (i.e. they are close friends socially, and
have known each other for many years). This violates independence.
Raul set a fixed price for the audit without even assessing the amount of work to be conducted. This is a
self-interest threat (the appropriate amount of work may not be completed as it will cost Raul money to
do so), and jeopardizes the ability of the work to be properly completed in accordance with GAAS.
Cristobal indicated that he needed a clean audit opinion, and Raul complied. This could be as a
consequence of the familiarity threat, but means that Raul could be associating himself with false and
misleading financial information.
The junior staff are not competent to conduct an audit, so technical competence (GAAS) has been
violated. They were also not properly supervised (a violation of GAAS).
Junior staff were bribed (the gift certificate) and should not have accepted the certificates.
The junior staff violated confidentiality when they discussed the likelihood of a sale at CF with their
families.
21
23) Discuss the ways the accounting profession and society encourage public accountants to conduct
themselves in a professional manner (i.e., the factors that influence the ethical conduct of audit
practitioners).
Answer: There are many factors that encourage public accountants to conduct themselves at a high level,
including:
• CAS and interpretations.
• rules of professional conduct.
• legal liability.
• public accounting firm quality control standards.
• practice inspection.
• Canadian Public Accountability Board.
• continuing professional education requirements.
• professional examinations such as the CPA Common Final Examination (CFE).
• provincial securities commissions.
• audit committees.
Topic: Applies to whole chapter
3.6 Describe the CPA (Chartered Professional Accountant) profession's enforcement mechanisms for
public accountants' conduct
1) Pierre, a CPA, was convicted of stealing money from his clients and deliberately preparing personal tax
returns that were false. In addition, Pierre will likely
A) need to take additional training courses to upgrade his tax skills.
B) need to defend himself to prove non-negligent performance.
C) have a suspension of designation or expulsion from the professional accounting body.
D) have lack of privity with the federal and provincial tax authorities.
Answer: C
Learning Obj.: 3-6 Describe the CPA (Chartered Professional Accountant) profession''s enforcement
mechanisms for public accountants'' conduct
2) If the public accountant negligently failed to properly prepare and file a client's tax return, the public
accountant can be held liable for
A) the penalties the client owes Canada Revenue Agency.
B) the penalties and interest the client owes.
C) the penalties and interest, plus the tax preparation fee that the public accountant charged.
D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid.
Answer: C
22
3) PAs are members of a professional association that can impose sanctions for violations of the
professional code of conduct. What is an example of a severe penalty that can be imposed by a
professional association?
A) publication of information about the offence in a newsletter
B) requirement of the completion of training courses
C) requirement to have another peer review conducted within one year
D) expulsion from the professional association
Answer: D
3.7 Explain the relationship between the expectations gap and lawsuits
1) One reason for lawsuits against public accountants is

A) lack of awareness of the responsibilities of public accountants by users of financial statements.
B) the increasing complexity of auditing and accounting functions.
C) reduced consciousness on the part of provincial securities commissions of their responsibility for
protecting investors' interests.
D) many public accounting firms are not willing to settle legal problems.
Answer: B
Learning Obj.: 3-7 Explain the relationship between the expectations gap and lawsuits
2) When an auditor issues an erroneous opinion as the result of an underlying failure to comply with the
requirements of generally accepted auditing standards, it results in
A) business failure.
B) audit failure.
C) audit risk.
D) business risk.
Answer: B
3) An example of an audit failure is when the

A) auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of
CAS.
B) audit opinion is qualified.
C) company files for bankruptcy less than 12 months after receiving an unqualified opinion.
D) auditor issues an erroneous audit opinion as the result of an undiscovered fraud that took place in the
period being audited.
Answer: A
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4) Amin is distraught. Six months ago, a big-box stereo store opened just down the street from his
independent stereo and music business and now he is unable to continue operating his business. Only
eight months ago, you issued an unqualified audit opinion on his financial statements that showed the
financial results of a well-run, profitable store. Amin's business is experiencing
A) customer expectation gap.
B) audit failure.
C) fiduciary duty.
D) business failure.
Answer: D
5) Conflict between financial statement users and auditors often arises because of the
A) high cost of performing an audit.
B) extremely technical vocabulary auditors use in their reports.
C) placement of the auditor's report in the back of the client's annual report, where it is hard to locate.
D) expectation gap.
Answer: D
6) According to the CPA Canada Handbook, the auditor's responsibility for failure to detect fraud arises
A) when such failure clearly results from failure to comply with generally accepted auditing standards.
B) whenever the amounts involved are material.
C) only when the examination was specifically designed to detect fraud.
D) only when such failure clearly results from negligence so gross as to sustain an inference of fraud on
the part of the auditor.
Answer: A
7) The King Surety Company wrote a general fidelity bond covering defalcations by the employees of
Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17 200 of company funds. When the
activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity
bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, public accountants. Which of
the following would be Lynch & Merritt's best defence?
A) King is not in privity of contract.
B) The shortages were the result of clever forgeries and collusive fraud which would not be detected by
an examination made in accordance with generally accepted auditing standards.
C) Lynch & Merritt were not guilty of either negligence or fraud.
D) Lynch & Merritt were not aware of the King-Wilson surety relationship.
Answer: B
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8) In connection with the examination of financial statements, an auditor could be responsible for failure
to detect a material fraud if
A) statistical sampling techniques were not used on the audit engagement.
B) the auditor planned the work in a hasty and ineffective manner.
C) accountants performing important parts of the work failed to discover a close relationship between the
treasurer and the cashier.
D) the fraud was perpetrated by one client employee who circumvented the existing internal controls.
Answer: B
9) It is not practical for users to evaluate the quality of the performance of most professional services
because of their
A) complexity.
B) legal standing.
C) veracity.
D) salaries and working conditions.
Answer: A
3.8 Understand and analyze auditor legal liability
1) While performing services for their clients, professionals have always had a duty to provide a level of
care that is
A) reasonable.
B) greater than average.
C) superior.
D) guaranteed to be free from error.
Answer: A
Learning Obj.: 3-8 Understand and analyze auditor legal liability
2) The failure to perform a duty with the requisite standard of care is known as
A) lack of objectivity.
B) lack of independence.
C) negligence.
D) lack of CPA education.
Answer: C
25
3) A legal duty that arises when there is a contractual agreement with the client is known as
A) objectivity.
B) standard of care.
C) privity.
D) independence.
Answer: C
4) An example of a breach of contract would be

A) a bank's claim that an auditor had a duty to uncover material errors in financial statements that had
been relied on in making a loan.
B) an auditor's refusal to return a client's records until the client paid last year's audit fees.
C) a public accounting firm's failure to deliver a tax return on the agreed-upon date because the firm had
a backlog of other work that was more lucrative.
D) an auditor's failure to complete the audit by the agreed-upon date because the client's financial records
had been destroyed.
Answer: C
5) In rare cases, auditors have been held liable for criminal acts. A criminal conviction against an auditor
can result only when it is demonstrated that the auditor
A) was negligent.
B) was grossly negligent.
C) knowingly issued an incorrect auditor's report.
D) caused a financial loss to an innocent third party.
Answer: C
6) Most of the major lawsuits against public accounting firms have dealt with
A) audited or unaudited financial statements.
B) disputes over income-tax preparation services.
C) disputes arising in the performance of management consulting services contracts.
D) unaudited financial statements.
Answer: A
7) The principal issue to be resolved in cases involving alleged negligence is usually

A) the amount of the damages suffered by the plaintiff.
B) whether to impose punitive damages on the defendant.
C) the level of care required.
D) whether the defendant was involved in fraud.
Answer: C
26
8) In the auditing environment, failure to meet generally accepted auditing standards is often
A) an accepted practice.
B) a suggestion of negligence.
C) strong evidence of negligence.
D) tantamount to criminal behaviour.
Answer: C
9) To succeed in an action against the auditor, the client must be able to show that
A) the auditor was grossly negligent.
B) the auditor was fraudulent.
C) there is a close causal connection between the auditor's breach of the standard of due care and the
damages suffered by the client.
D) there was a written contract.
Answer: C
10) PA was engaged by Microcomputer Distributor Limited (MDL) to conduct a review engagement. The
financial statements are used primarily by the shareholders, management, and by the bank. Recently, an
employee was fired for stealing computer parts, primarily chips and boards that could easily be placed in
a pocket. MDL is suing PA because they believed that audit procedures, such as counting inventory,
would have detected this fraud. What is PA's best defence?
A) absence of causal connection
B) lack of negligence
C) contributory negligence
D) duty of care not required
Answer: D
11) The leading precedent-setting case in third-party liability was a 1931 U.S. case, Ultramares v. Touche.
What is the key aspect of this case?
A) To succeed, claimants must be foreseeable users of the audited financial statements that are part of the
claim process.
B) Ordinary negligence is insufficient for liability to third parties because of lack of privity of contract.
C) The auditor must have actual knowledge of the users of the financial statements to establish privity.
D) There is no general auditor liability to shareholders, since the loss of equity was suffered by the
company.
Answer: B
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12) The Ultramares doctrine is that ordinary negligence is insufficient for liability of auditors to third
parties because of the lack of privity of contract between the third party and the auditor. What type of
behavior on the part of an auditor would result in liability to more general third parties according to this
doctrine?
A) conducting an audit engagement when a review engagement had been contracted.
B) completing work in accordance with a contract that was signed with the client.
C) deliberate misstatement of the financial statements by management remaining undetected.
D) fraud or constructive fraud with respect to the working papers.
Answer: D
13) Which of the following lawsuits resulted in a decision that shareholders could not sue the auditors for
the loss in the value of their shares?
A) Haig v. Bamford et al.(1976)
B) Hercules Management Ltd. v. Ernst & Young (1997)
C) Ultramers Corporation v. Touche (1931)
D) United States v. Anderson (2002)
Answer: B
14) An investor suing an auditor for not discovering that the financial statements of a company were
materially misstated is an example of
A) criminal liability.
B) fiduciary duty.
C) third party liability.
D) liability to client under common law.
Answer: C
15) A bank sues an auditor after having lost a significant amount of money from a loan granted to a client
based on the financial statements that contained a material error. The source of the legal liability is
A) known third party liability.
B) client liability.
C) liability under provincial securities law.
D) criminal liability.
Answer: A
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16) Joan talked to the owners of Fancy Clothing Limited before investing. She obtained a copy of their
financial statements and saw that profits were low, even considering the fact that the owners had not
taken any money for themselves in the current year. However, she decided to invest in the company
because she believed her superior knowledge of the clothing industry would turn the business around,
resulting in enough profits for all owners. Unfortunately, this did not occur and the company went
bankrupt. Joan is suing the auditors because she relied upon the financial statements during her
investment decision. What is the auditor's best defence?
A) absence of misstatement
B) contributory negligence
C) non-negligent performance
D) duty of care
Answer: A
17) Winston Chang, a PA, conducted the audit of Manra Manufacturing Ltd., a small company that
produces a variety of machined parts for the automotive and computer industries. The audit showed that
the company produced a small profit after paying the owners of the company a high salary. Manra was
purchased by a competitor, Cheblay. Cheblay had hoped to produce efficiencies by combining the two
companies but was unable to do so. Cheblay sued Chang because it relied upon the financial statements
when purchasing the company's shares, claiming that the machines, which were about fifteen years old,
had been overvalued. The machines were recorded at cost, which was below net realizable value. What is
the auditor's best defence?
A) contributory negligence
B) absence of negligence
C) duty of care
D) absence of liability
Answer: B
18) Fabio recently sold his restaurant for $650 000, the value of the net assets as reported on the balance
sheet. After the sale, Fabio realized that he could have sold the restaurant for as much as $950 000 as the
fair value of the assets was $300 000 higher than what was reported on the balance sheet. Fabio is suing
the auditors for his loss. The auditor's best defence is
A) absence of a misstatement
B) lack of duty
C) no damages
D) absence of causal connection
Answer: A
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19) Musical Productions Limited has had declining sales as more and more media are being presented
online rather than on CD or DVD. It diversified its business by moving into backup systems, but is still
having trouble boosting income.
The audit team was led by Theresa Sanford, who obtained her CPA last year. Theresa had two
assistants, Marv and Uhta, who did the work in the accounts receivable and inventory areas. Theresa felt
that they did not require supervision, as they had been with the firm for two years and were expected to
do well on their professional exams this year. Marv found that the accounts receivable had many old
accounts and customers were difficult to contact. Accordingly, he decided to accept management's
representations with respect to the balances. Similarly, Uhta noted that there were still many CDs in
inventory that had been there for over three years. Management insisted on recording these at cost. Uhta
accepted managements' valuation.
Two months after the audit report was issued, Musical Productions Limited went bankrupt. It was
found that many accounts receivable were for fictitious customers and the receiver was only able to
obtain five cents on the dollar for the inventory, which was sold as scrap.
The bank is suing the auditors to recover its bank loan, which had been renegotiated based upon the
results of the financial statements.
Required:
Will the bank be successful in its suit? Why or why not?
Answer: Yes, the bank will be successful. The bank is a foreseeable user, so the auditor could not argue
lack of privity. The financial statements were misstated, as both inventory and accounts receivable were
overstated. If the audit had been conducted in accordance with GAAS, then it is likely that the errors
would have been detected. The audit was not conducted in accordance with GAAS due to lack of
adequate supervision and lack of sufficient appropriate audit evidence. The bank suffered a loss, and
would likely be able to link the loss to the reliance on the financial statements and to the misstatements.
30
20) You are the auditor of Jehello Incorporated, a public company with a December year end. Your firm
has audited Jehello for the past three years. The following issues were documented in the working paper
files for the prior year audit:
• The company had incurred expenditures of $400 000 related to the development of a new sound
system. The large majority of the costs were related to development of software, hardware, and
presentation of the results to customers who participated in focus groups. Management had been
optimistic that the new sound system would work well, even though focus group results had been poor.
These costs had been fully capitalized.
• About 40% of the company's revenues were from one customer. That contract had been due for renewal
on May 15, ten days after the audit report had been issued. Documents on file indicated that the customer
seemed likely to renew the contract, although quality control disputes were escalating. On May 14,
Jehello was informed that the contract would not be renewed.
Jehello has defaulted on its bank loans and the bank is suing you, saying that the financial statements
presented last year were false and misleading.
Required:
A) Which defences should the auditor use?
B) Do you believe that the auditor will lose the suit? Why or why not?
Answer: A) The auditor could argue lack of privity (i.e. that there was no duty of care to the bank). This
is likely to fail, as the bank is a foreseeable user of the financial statements.
Absence of misstatement: From the facts presented, it seems that the development costs should have
been written off, rather than capitalized, so the financial statements were misstated. However, it was not
foreseeable that the large customer would not renew the contract. The nature of the contract and its
expiry date would have been disclosed in the financial statements.
Absence of negligence: The auditor appears to have conducted the audit in accordance with GAAS.
Absence of causal connection: If the bank did not renew the loan recently, or if it was a long term
loan, then there would not be a connection between the information presented in the financial statements
and the bank's loss (unless there were specific debt/equity ratios that needed to be preserved).
Contributory negligence: This defence would likely be unusable.
B) This question could be argued either way. The student could say that the suit would be lost because of
the deferred expenses (that they should have been expensed) or that the auditor may win the suit as they
conducted their audit in accordance with GAAS.
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21) A) List the four items a defendant must prove in an action for negligence against a public accountant.
B) Discuss what is meant by the term "expectation gap."
Answer: A) The four items a defendant must prove are as follows:
• the auditor owed a duty of care to the plaintiff.
• the auditor was negligent and breached the duty of care (i.e., did not act in accordance with the prudent
person concept).
• the plaintiff suffered a loss.
• the plaintiff's loss resulted, in part or wholly, from the auditor's breach of duty.
B) The expectation gap refers to the difference in the beliefs of auditors and users of financial statements
concerning the role of the auditor. Most auditors believe that the conduct of the audit in accordance with
GAAS is all that can be expected of them, whereas many users of financial statements believe that the
auditor guarantees the financial viability of the company.
22) There are four major sources of auditors' legal liability. Briefly summarize the four sources.
Answer: The four sources of auditors' legal liability are:
• liability to clients under contract law (or common law).
• liability to third parties under common law and statute law.
• liability under provincial securities acts.
• criminal liability.
23) What are the four sources of legal liability in assurance engagements? Give examples of potential
claims or charges for these liabilities.
Answer: The four sources of legal liability in assurance engagements are:
• Common law liability to client - Client sues auditor for not discovering a defalcation during the audit.
• Common law liability to third parties - Bank sues auditor for not discovering materially misstated
financial statements.
• Liability under provincial securities acts - Purchaser of shares issued by a company sues auditor for not
discovering materially misstated financial statements in a prospectus (this is called the "primary market").
Purchaser of shares on the secondary market sues auditor for not alerting the purchaser of material
misstatement.
• Criminal liability - Court prosecutes auditor under the Criminal Code of Canada for knowingly issuing
an incorrect auditor's report.
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3.9 Explain how the profession and individual public accountants can reduce the threat of litigation
1) An auditor would be found negligent if he/she

A) relied on a report from management without considering management integrity.
B) relied on a report that contained errors that had been concealed by management.
C) did not consider the expenses from a division due to management intentionally withholding that
information.
D) failed to discover a payroll fraud by testing a statistical sample of transactions in the salary expense
account.
Answer: A
Learning Obj.: 3-9 Explain how the profession and individual public accountants can reduce the threat of
litigation
2) Small Town Lumberyard Limited (STLL) needed an additional bank loan to finance its operations. To
make its financial statements look better, the company overstated its inventory and overstated its
accounts payable. The auditors did not detect this deliberate misstatement because they conducted
limited tests of inventory and did not confirm accounts payable. Other auditors agreed that the
procedures conducted during this audit were inadequate. The auditors of STLL would likely be
considered to be
A) guilty of fraud.
B) negligent.
C) contributorily negligent with STLL.
D) guilty of constructive fraud.
Answer: B
litigation
3) A common way for a public accounting firm to demonstrate its defence of a lack of duty to perform is
by use of a(n)
A) engagement letter.
B) letter of representation.
C) confirmation letter.
D) expert witness.
Answer: A
litigation
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4) There are a number of things that the CPA, representing the profession as a whole, can do to reduce the
practitioner's exposure to lawsuits. One of them is to
A) sanction members for improper conduct and performance.
B) deal only with clients possessing integrity.
C) hire qualified auditors and train and supervise them.
D) perform quality audits.
Answer: A
litigation
5) Most accounting and auditing professionals agree that when an audit has failed to uncover material
misstatements, and the wrong type of audit opinion is issued, the audit firm
A) has failed to follow generally accepted auditing standards (GAAS).
B) deserves to lose the lawsuit.
C) should be asked to defend the quality of the audit.
D) should not be held responsible for the financial loss suffered by others.
Answer: C
litigation
6) Enron and WorldCom are companies that suffered from large frauds by corporate management. One
important lesson with respect to such cases is that
A) when a company does really well financially, it is important to suspect that such results are always
inflated.
B) an investigation of the integrity of management is an important part of deciding upon the extent of
audit work.
C) securities and exchange commissions expect auditors to be perfect in their assessment of management.
D) partners and staff should cooperate in preparing working papers that prove the accuracy of the
financial statements.
Answer: B
litigation
7) Individuals who accept fees (or property) and know or are willfully blind to the fact that the property
was obtained illegally can be charged with money laundering, a criminal offence. Which of the following
techniques will help a PA prevent such charges?
A) Ensure that the financial statements are in accordance with an acceptable reporting framework.
B) Require that clients carefully document the sources of their funds.
C) Carefully assess management integrity.
D) Obtain a detailed letter of representation from management confirming the sources of their funds.
Answer: C
litigation
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8) Bigland and Betton, PAs, is being sued by a bank for potential negligence during an audit engagement
that was completed over five years ago. Which of the following actions during that audit engagement will
help ensure that the suit is fairly assessed?
A) good quality documentation
B) honest management at the client
C) low employee turnover
D) good employee memory of events
Answer: A
litigation
9) The requirement for an attitude of professional skepticism means that the auditor should
A) not be blind to evidence that suggests the documents, books, or records have been altered or are
incorrect.
B) plan and conduct the audit with an attitude of distrust in management.
C) perform additional tests of controls to increase the probability of discovering fraud or errors.
D) not consider management's explanation as evidence on any subject.
Answer: A
litigation
10) One of the lessons learned from accounting scandals such as Enron's is that generally accepted
accounting principles (now under an acceptable financial reporting framework) cannot be relied upon
exclusively in deciding whether financial statements are fairly presented. Why is this the case?
Answer: Student answers may vary.
- GAAP and accounting frameworks prescribe the accounting principles that should be followed, but do
not consider internal controls or management integrity. These are important factors that affect the
financial statements and should be considered in the preparation of financial statements.
- GAAP and accounting frameworks also contain a lot of "grey areas" and require the firms' accounting
personnel to use their knowledge and judgment in reporting a transaction. Also, GAAP and accounting
frameworks may not have a given set of criteria for a situation encountered by the company. In those
situations, the auditor must be vigilant and consider more than simply the prescribed standards in
assessing if the financial statements are free from material misstatements.
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35
11) A) Describe some of the steps the CPA and the accounting profession as a whole can and are taking to
reduce practitioners' exposure to lawsuits.
B) Describe some of the steps individual practising auditors can take to minimize their legal liability.
Answer: A) Steps the profession is taking to reduce practitioners' exposure to lawsuits include:
• research in auditing.
• standard and rule setting and revisions to meet the changing needs of the profession.
• setting requirements to protect auditors.
• establishing practice inspection requirements.
• defending unjustified lawsuits.
• educating investors and other users of financial statements as to the meaning of the auditor's report and
the nature of the auditor's work.
• sanctioning members for improper conduct.
• lobbying for changes in laws.
B) There are many steps individual practitioners can take to minimize legal liability, including:
• dealing only with clients possessing integrity.
• hiring qualified personnel and train and supervise them properly.
• following the standards of the profession.
• maintaining independence.
• understanding the client's business.
• performing quality audits.
• documenting work properly.
• obtaining an engagement letter and a representation letter.
• maintaining confidential relations.
• carrying adequate insurance.
• seeking legal counsel.
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12) PA has been recently appointed auditor of Foible Ltd., a company that exports high-cost knickknacks.
To facilitate the rapid preparation of the financial statements, management had the physical inventory
counted in October, rather than at the December year-end. During the inventory count, PA noticed that
several of the boxes were labelled with receiving documents from a competitor. PA was told that the new
warehouse supervisor worked part-time at the competitor and must have picked up the wrong boxes.
Several employees have sued Foible Ltd. for wrongful dismissal, claiming that they were promised a
job that would last at least one year and would be provided with low cost accommodations. They are
suing for the balance of the year's wages and are claiming that they were brought into the country under
false pretenses. These employees are all from an Eastern-European country. The law firm has responded
in a legal letter that this suit is without merit.
During the year, Foible obtained legal services from a firm in which Foible's Chairman of the Board is
a partner. Fees and disbursements for these services for the year were $125 000, a material amount.
During the audit, employees often spoke in a foreign language among themselves before responding
to PA. Then one employee would respond after some (often heated) discussion.
Subsequent to the year end, the warehouse supervisor was arrested on criminal charges of theft, and
Foible was charged with selling stolen goods. PA was charged as an accomplice to money laundering, as
all of the management for Foible were members of a criminal group found to be laundering money from
Eastern Europe.
Required:
Discuss the actions that PA could have taken during the engagement to prevent these charges.
Answer: Prior to accepting an engagement, an auditor should assess the integrity of management. This
would involve credit checks and background checks using a credit bureau. PA could also have consulted
with the previous auditor (if taking over the audit from another PA) and/or reviewed previous permanent
files for hints of wrong-doing.
During the audit, PA had many warning signs, such as the possibility of stolen goods being included
in inventory. Management conflict of interest and possible illegal actions with respect to employees were
also present. When these signs occurred, PA should have consulted legal advice and also required second
partner review or peer assistance from his provincial professional association.
PA should have ensured that the lawsuits were disclosed in the financial statements and that the
related party transactions (the legal fees) also were disclosed in the financial statements. PA could have
consulted independent legal advice with respect to the employee lawsuits.
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37

Chapter 3 Professional Ethics and Legal Liability: Auditing, 14e (Arens)

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Auditing, 14e (Arens)

Chapter 3 Professional Ethics and Legal Liability

2) Society has attached a special meaning to the term professional. A professional is

1) Ethical dilemmas occur when

1) What is an ethical blind spot?

1) Which portions of the code of professional conduct are enforceable?

4) "Independence" in auditing means

12) How is use of an applicable accounting framework enforced via legislation?

16) For which of the following engagements is a contingent fee permitted?

10) A familiarity threat at an audit engagement occurs when

12) An intimidation threat occurs when

1) One reason for lawsuits against public accountants is

3) An example of an audit failure is when the

3.8 Understand and analyze auditor legal liability

4) An example of a breach of contract would be

7) The principal issue to be resolved in cases involving alleged negligence is usually

1) An auditor would be found negligent if he/she

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