Cpa Review Questions

CPA REVIEW QUESTIONS
Which of the following procedures would an auditor most likely perform to obtain
evidence about the occurrence of subsequent events?
A)
Recomputing a sample of large-dollar transactions occurring after year end for

arithmetic accuracy.
B) Investigating changes in stockholders' equity occurring after year end.

C)
Inquiring of the entity's legal counsel concerning litigation, claims, and assessments
arising after year end.
D) Confirming bank accounts established after year end.

Correct Answer: C
Explanation: The auditor should inquire of the entity's legal counsel regarding any
events occurring after year end as part of the auditor's search for subsequent events,
which are events or transactions that occur subsequent to the balance sheet date but
prior to the issuance of the auditor's report that have a material effect on the
financial statements and therefore require adjustment or disclosure in the
statements.
Which one of the following factors might cause a firm to increase the debt in its
financial structure?
A)
B)
C)
D)
An increase in the corporate income tax rate.

Increased economic uncertainty.
An increase in the Federal funds rate.
An increase in the price/earnings ratio.
Correct Answer: A
Explanation: An increase in the corporate income tax rate might cause a firm to increase
the debt in its financial structure. Increased economic uncertainty would not cause a firm
to increase the debt in its financial structure. An increase in the Federal funds rate would
not cause a firm to increase the debt in its financial structure. An increase in the price /
earnings ratio would not cause a firm to increase the debt in its financial structure.
Which of the following is least likely to be considered a security under the Securities

Act of 1933?
A)
B)
C)
D)
Stock options
Warrants
General partnership interests
Limited partnership interests
Correct Answer: C
Explanation: Under the Securities Act of 1933 securities are broadly interpreted to
include almost any type of multi-state investment contract. They include stocks, bonds,
warrants, stock options, debentures, collateral-trust certificates, investment contracts and
limited partnership interests. They do not include general partnership interests or
certificates of deposit. Thus, general partnership interests are not considered to be
securities. Stock options, warrants and limited partnership interests are considered to be
securities.
Neal Corp. entered into a nine-year capital lease on a warehouse on December 31,
2009. Lease payments of $52,000, which includes real estate taxes of $2,000, are due
annually, beginning on December 31, 2010, and every December 31 thereafter. Neal
does not know the interest rate implicit in the lease; Neal's incremental borrowing
rate is 9%. The rounded present value of an ordinary annuity for nine years at 9% is
5.6. What amount should Neal report as capitalized lease liability at December 31,
2009?
A)
B)
C)
D)
$280,000
$291,200
$450,000
$468,000
Correct Answer: A
Explanation: The capitalized lease liability should be the annual lease payments less the
executory cost (real estate taxes) times the present value factor for an ordinary annuity of
1 for nine years at 9%. The calculation would be: ($52,000 - 2,000) x 5.6 = $280,000.
The real estate taxes are a period cost and should be charged to expense.
At December 31, 2010, Bren Co. had the following deferred income tax items:
A deferred income tax liability of $15,000 related to a noncurrent asset
A deferred income tax asset of $3,000 related to a noncurrent liability
A deferred income tax asset of $8,000 related to a current liability
Which of the following should Bren report in the noncurrent section of its December

31, 2010, balance sheet?
A)
B)
C)
D)
A noncurrent asset of $3,000 and a noncurrent liability of $15,000

A noncurrent liability of $12,000
A noncurrent asset of $11,000 and a noncurrent liability of $15,000
A noncurrent liability of $4,000
Correct Answer: B
Explanation: In determining the deferred tax account that should appear on the balance
sheet, the noncurrent deferred tax liability ($15,000) would be netted against the
noncurrent deferred tax asset ($3,000). As a result a noncurrent deferred tax liability of
$12,000 ($15,000 - 3,000) would be shown on the December 31, 2010 balance sheet.
Which of the following factors most likely would affect an auditor's judgment about
the quantity, type, and content of the auditor's working papers?
A)
B)
C)
D)
The assessed level of control risk

The likelihood of a review by a concurring (second) partner
The number of personnel assigned to the audit
The content of the management representation letter
Correct Answer: A
Explanation: Factors affecting the auditor's judgment about the quantity, type, and
content of the working papers for a particular engagement include; the nature of the
engagement, the nature of the auditor's report, the nature of the financial statements on
which the auditor is reporting, the nature and condition of the client's records, the
assessed level of control risk, and the needs in the particular circumstances for
supervision and review of the work. "The assessed level of control risk " is the best
choice because it is specifically included as a factor.
The length of time required to recover the initial cash outlay of a capital project is
determined by using the
A)
B)
C)
D)
Discounted cash flow method.

Payback period.
Weighted net present value method.
Net present value method.
Correct Answer: B
Explanation: The payback method divides the initial cash outlay by the annual cash

inflows (if equal every year) or else the method subtracts from the initial cash outlay the
yearly inflows until the amount is reduced to zero. In either case, the number of years
required to recover the initial cash outlay is determined. The discounted cash flow
method discounts future cash flows at a given interest rate to calculate their present value,
or determines the interest rate which will discount their present value to equal the initial
cash outlay. The net present value method discounts future cash inflows at the company's
hurdle rate to determine whether their sum exceeds the initial cash outlay. The weighted
net present value method is like the net present value method but management may
choose to assign weights to different amounts.
Daly tried to collect on a property insurance policy covering a house that was
damaged by fire. The insurer denied recovery, alleging that Daly had no insurable
interest in the house. In which of the following situations will the insurer prevail?
A)
B)
C)
D)
The house belongs to a corporation of which Daly is a 50% stockholder.

Daly is not the owner of the house but a long-term lessee.
The house is held in trust for Daly's mother and, on her death, will pass to Daly.
Daly gave an unsecured loan to the owner of the house to improve the house.
Correct Answer: D
Explanation: An insurable interest is some economic interest in the goods at time of
loss. An unsecured creditor does not have an insurable interest in the debtor's property.
Thus, Daly would not have an insurable interest in the house because Daly was an
unsecured creditor.
The remaining answer choices are incorrect for the following reasons:
A 50% stockholder would have an insurable interest in a house owned by the
corporation.
A lessee has an insurable in the house that they lease.
A remainderman in a trust has an insurable interest in the property of the trust.
An auditor's decision either to apply analytical procedures as substantive tests or to
perform tests of transactions and account balances usually is determined by the:
A)
B)
C)
D)
Availability of data aggregated at a high level

Relative effectiveness and efficiency of the tests
Timing of tests performed after the balance sheet date
Auditor's familiarity with industry trends
Correct Answer: B
Explanation: Substantive tests, which are comprised of analytical procedures and tests of

details (transactions and account balances), must be performed to substantiate the
financial statement assertions. The decision about which procedures to use to achieve a
particular audit objective is based on the auditor's judgment on the expected effectiveness
and efficiency of the available procedures.
The method that recognizes the time value of money by discounting the after-tax cash
flows over the life of a project, using the company's minimum desired rate of return
is the:
A) Accounting rate of return method.
B) Net present value method.
C) Internal rate of return method.
D) Payback method
Correct Answer: B
Explanation: The net present value method does indeed recognize the time value of
money by discounting the after-tax cash flows using the company's hurdle rate. The
accounting rate of return deals with net income, not cash flows, and does not use the
time value of money. The internal rate of return does not use the company's
minimum desired rate of return for discounting, but rather finds the rate of return
which produces a zero net present value. The payback method does not discount
cash flows and may not even utilize all of the cash flows over the life of a project,
only those flows until payback is achieved.
The earliest time a purchaser of existing goods will acquire an insurable interest in
those goods is when _________________
A)
B)
C)
D)
the purchaser obtains possession.

title passes to the purchaser.
performance of the contract has been completed or substantially completed.
the goods are identified to the contract.
Correct Answer: D
Explanation: The earliest time a buyer of existing goods will obtain an insurable interest
in the goods is when the goods are identified to the contract (marked or tagged as goods
for this specific buyer). The remaining answer choices are incorrect because a buyer may
obtain an insurable interest prior to obtaining possession, prior to obtaining title or prior

to substantially completing performance of the contract as long as the goods have been
identified.
West Corp. leased a building and received the $36,000 annual rental payment on
June 15, 2009. The beginning of the lease was July 1, 2009. Rental income is taxable
when received. West's tax rates are 30% for 2009 and 40% thereafter. West has
elected early adoption of FASB Statement No. 109, Accounting for Income Taxes.
West had no other permanent or temporary differences. West determined that no
valuation allowance was needed. What amount of deferred tax asset should West
report in its December 31, 2009, balance sheet?
A)
B)
C)
D)
$5,400
$7,200
$10,800
$14,400
Correct Answer: B
Explanation: The annual rent of $36,000 is taxable in 2009 but only $18,000 is
considered rental income for financial purposes. This creates a temporary difference of
$18,000 which will be taxed at the future enacted tax rate of 40%. Therefore, the deferred
tax asset at December 31, 2009 is $7,200 ($18,000 x 40%).
Stone Co. began operations in 2009 and reported $225,000 in income before income
taxes for the year. Stone's 2009 tax depreciation exceeded its book depreciation by
$25,000. Stone also had nondeductible book expenses of $10,000 related to permanent
differences. Stone's tax rate for 2009 was 40%, and the enacted rate for years after
1999 is 35%. Stone elected early adoption of FASB Statement No. 109, Accounting
for Income Taxes. In its December 31, 2009, balance sheet, what amount of deferred
income tax liability should Stone report?
A)
B)
C)
D)
$8,750
$10,000
$12,250
$14,000
Correct Answer: A
Explanation: The nondeductible book expenses are permanent differences and do not
affect taxes. The temporary depreciation difference ($25,000) times the enacted future tax
rate (35%) will be the deferred tax liability on the December 31, 2009 balance sheet
($25,000 x 35% = $8,750 deferred tax liability).
Which of the following procedures would an auditor most likely perform to verify

management's assertion of completeness?
A)
B)
C)
D)
Compare a sample of shipping documents to related sales invoices.

Observe the client's distribution of payroll checks.
Confirm a sample of recorded receivables by direct communication with the debtors.
Review standard bank confirmations for indications of kiting.
Correct Answer: A
Explanation: Assertions about completeness deal with whether all transactions and
accounts that should be presented in the financial statements are so included. To test
management's assertion that all sales are included on the income statement, the auditor
would compare shipping documents, which typically provide evidence that a sale has
occurred and should be recorded, to related sales invoices, which provide the basis for
recording the sales transactions. The concern of the auditor is with fictitious or overstated
amounts, not omitted or incomplete amounts.
When a principal debtor defaults and a surety pays the creditor the entire obligation,
which of the following remedies gives the surety the best method of collecting from
the debtor?
A)
B)
C)
D)
Exoneration
Contribution
Subrogation
Attachment
Correct Answer: C
Explanation: The right of subrogation allows the surety to gain the creditor's rights, once
the creditor has been paid in full. Subrogation would give a surety not only their own
right to collect from the debtor (reimbursement), but also additional rights that the
creditor might have had.
Exoneration would simply give a surety a court order demanding that the debtor pay.
Exoneration does not confer additional collection rights against the debtor.
Contribution is only available to one cosuretor against other cosuretors. It is not
available against the debtor.
Attachment is the right of all creditors to place a lien on a debtor's property so it will be
available to satisfy a judgment. Subrogation is the better answer because it is specific to
surety's collection rights against a debtor and gives the surety additional rights.
A disadvantage of the net present value method of capital expenditure evaluation is

that
A)
B)
C)
D)
It is calculated using sensitivity analysis.

It computes the true interest rate.
It does not provide the true rate of return on investment.
It is difficult to apply because it uses a trial and error approach.
Correct Answer: C
Explanation: The NPV method does not provide the true rate of return on an investment.
Rather, it uses a company's discount rate to evaluate whether or not the investment has a
positive NPV. To compute an investment's rate of return, a company should use the
internal rate of return method. The NPV is not calculated using sensitivity analysis. It is
calculated using amount assumed to be accurate. However, sensitivity analysis may
subsequently be used to measure the sensitivity of the NPV to changes in the assumed
amounts. NPV does not compute any interest rate. It uses a company's discount rate to
evaluate whether or not an investment has a positive NPV. NPV does not use a trial and
error approach. It uses cash flow amounts and a discount rate assumed to be accurate and
computes NPV one time.
If the net present value of a capital budgeting project is positive, what would it
indicate?
A) That the present value of cash outflows exceeds the present value of cash inflows.
B) That the payback period is less than one-half of the life of the project.
That the internal rate of return is equal to the discount percentage rate used in the net
C)
present value computation.
That the rate of return for this project is greater than the discount percentage rate used
D)
in the net present value computation.
Correct Answer: D
Explanation: A rate of return greater than the discount percentage produces a positive
net present value, just as a rate of return less than the discount percentage produces a
negative one. If the present value of the cash outflows exceeds the present value of the
cash inflows, the net present value would be negative. The payback period, which does
not use discounted cash flows, has no mathematical relation to the net present value. If
the internal rate of return is equal to the discount percentage used in the net present value
computation, the net present value would be zero.
Gray Co. was granted a patent on January 2, 2008, and appropriately capitalized

$45,000 of related costs. Gray was amortizing the patent over its estimated useful life
of fifteen years. During 2011, Gray paid $15,000 in legal costs in successfully
defending an attempted infringement of the patent. After the legal action was
completed, Gray sold the patent to the plaintiff for $75,000. Gray's policy is to take
no amortization in the year of disposal. In its 2011 income statement, what amount
should Gray report as gain from sale of patent?
A)
B)
C)
D)
$15,000
$24,000
$27,000
$39,000
Correct Answer: B
Explanation: The $45,000 capitalized cost of the patent was amortized at $3,000 per
year ($45,000/15 years) for 2008, 2009, and 2010, which reduced the carrying amount to
$36,000. The cost of the successful defense of the patent ($15,000) is added to the
carrying amount for a total of $51,000. Therefore, the gain on the sale is $24,000
($75,000 - $51,000).
An auditor most likely would inspect loan agreements under which an entity's
inventories are pledged to support management's financial statement assertion of:
A)
B)
C)
D)
Existence or occurrence
Completeness
Presentation and disclosure
Valuation or allocation
Correct Answer: C
Explanation: Assertions about presentation and disclosure deal with whether particular
components of the financial statements are properly classified, described, and disclosed.
An auditor would inspect loan agreements regarding pledged inventories to determine
that management has adequately disclosed the security arrangements.
Under the Commercial Paper Article of the UCC, for an instrument to be negotiable
it must _________________
A) be payable to order or bearer.
B) be signed by the payee.
C) contain references to all agreements between the parties.

D) contain necessary conditions of payment.
Correct Answer: A
Explanation: To be negotiable an instrument must be signed by maker or drawer, be
unconditional, be payable in a certain sum of money, be payable to bearer or order
and be payable on demand or at a definite time. Thus, for an instrument to be
negotiable it must be payable to order or to bearer. (Note: checks may omit the word
"order" and still be negotiable.)
It is the maker or drawer that must sign, not the payee.
There is no requirement that the instrument contain any reference to agreements
between the parties to be negotiable.
An instrument must be unconditional to be negotiable and may not contain
necessary conditions of payment.
On November 1, 2009, Davis Co. discounted with recourse at 10% a one-year,
noninterest bearing, $20,500 note receivable maturing on January 31, 2010. What
amount of contingent liability for this note must Davis disclose in its financial
statements for the year ended December 31, 2009?
A)
B)
C)
D)
$0
$20,000
$20,333
$20,500
Correct Answer: D
Explanation: A note discounted with recourse creates a contingent liability for the face
of the note plus any interest due on the note. Since this note is a noninterest bearing note,
the contingent liability disclosed in the financial statements would be $20,500.
Which of the following types of audit evidence is the least persuasive?
A)
B)
C)
D)
Prenumbered purchase order forms

Bank statements obtained from the client
Test counts of inventory performed by the auditor
Correspondence from the client's attorney about litigation
Correct Answer: A

Explanation: Internal evidence, consisting of documents such as purchase orders that are
produced within the client's system, is generally considered low in competence and
therefore the least persuasive.
"Bank statements obtained from the client" is an example of external-internal evidence,
is considered more competent.
"Test counts of inventory performed by the auditor" is evidence obtained directly from
an external source, is better than evidence that goes through the client before reaching the
auditor.
"Correspondence from the client's attorney about litigation." is an example of the most
persuasive evidence because it is obtained directly by the auditor through physical
observation.
What is the effect on prices of U.S. imports and exports when the dollar depreciates?
A)
B)
C)
D)
Import prices and export prices will decrease.

Import prices will decrease and export prices will increase.
Import prices will increase and export prices will decrease.
Import prices and export prices will increase.
Correct Answer: C
Explanation: When the dollar depreciates, the opposing currency appreciates (inverse
relationship). The depreciation of the dollar means that foreign goods become more
expensive and import prices will increase. Conversely, as the value of the dollar
decreases, our goods become cheaper to foreign customers and our export prices will
decrease.
A secured promissory note would be nonnegotiable if it provided that
_________________
additional collateral must be tendered if there is a decline in market value of the
original collateral.
B) upon default, the maker waives a trial by jury.
C) the maker is entitled to a 5% discount if the note is prepaid.
D) it is subject to the terms of the mortgage given by the maker to the payee.
A)
Correct Answer: D
Explanation: For an instrument to be negotiable, it must be an unconditional promise or
order. If it is subject to another agreement or transaction it is non-negotiable.

References to collateral will not prevent negotiability unless it is subject to the terms of
that collateral.
Waiver of trial by jury does not make the note conditional and thus does not affect
negotiability.
Prepayment will not prevent negotiability.
If the objective of a test of details is to detect overstatements of sales, the auditor
should trace transactions from the:
A)
B)
C)
D)
Cash receipts journal to the sales journal

Sales journal to the cash receipts journal
Source documents to the accounting records
Accounting records to the source documents
Correct Answer: D
Explanation: The objective is to test whether recorded sales are valid (not overstated).
The auditor is answering the question, "Is this recorded sale a valid transaction?" In order
to answer that question, the auditor would start with the recorded sales and look for
documentation corroborating its validity. Negative confirmation requests ask the
respondent to reply only if the stated receivable information is incorrect. The presumption
is that a non-reply to a confirmation request is evidence that the account balance is
correct. Thus, negative confirmation procedures would not be used when there is a
likelihood that accounts are in dispute. They would be used where a small number of
accounts are in dispute.
North Corp. has an employee benefit plan for compensated absences that gives
employees 10 paid vacation days and 10 paid sick days. Both vacation and sick days
can be carried over indefinitely. Employees can elect to receive payment in lieu of
vacation days; however, no payment is given for sick days not taken. At December 31,
2009, North's unadjusted balance of liability for compensated absences was $21,000.
North estimated that there were 150 vacation days and 75 sick days available at
December 31, 2009. North's employees earn an average of $100 per day. In its
December 31, 2009, balance sheet, what amount of liability for compensated absences
is North required to report?
A)
B)
C)
D)
$36,000
$22,500
$21,000
$15,000
Correct Answer: D

Explanation: The liability for compensated absences at December 31, 2009, is $15,000
for the 150 vacation days times $100 per day. The key word in dealing with sick pay is
the word "required". The problem asks what is the liability required at December 31,
2009. Since the accrual of sick pay is optional, North Corp. would not be required to
accrue a liability for sick pay.
If the U.S. balance in its current account is -$300 billion, and its balance in its capital
account is -$100 billion, which of the following will happen to the U.S. holding of
official reserve assets?
A)
B)
C)
D)
It will go down by $200 billion.

It will go down by $400 billion.
It will go up by $200 billion.
It will go up by $400 billion.
Correct Answer: B
Explanation: If the U.S. balance in its current account is -"$300 billion, and its balance
in its capital account is -"$100 billion, which of the following will happen to the U.S.
holding of official reserve assets? Add larger minus sign in front of 300 billion and 100
billion.
The scope of an audit is not restricted when an attorney's response to an auditor as a
result of a client's letter of audit inquiry limits the response to:
Matters to which the attorney has given substantive attention in the form of legal
representation
An evaluation of the likelihood of an unfavorable outcome of the matters disclosed
B)
by the entity
C) The attorney's opinion of the entity's historical experience in recent similar litigation
D) The probable outcome of asserted claims and pending or threatened litigation
A)
Correct Answer: A
Explanation: During the audit of financial statements, the auditor is required to send a
letter of audit inquiry to the client's legal counsel concerning claims, litigation and
assessments. It is reasonable to assume that an attorney would be responsible to respond
concerning only those items that he has given substantive attention. He would not be able
to respond to items he has not given substantive attention (the attorney has no
knowledge). Therefore, such a limited response on the part of an attorney would not be
considered a scope limitation.
Winslow Co., which is in the business of selling furniture, borrowed $60,000 from

Pine Bank. Winslow executed a promissory note for that amount and used all of its
accounts receivable as collateral for the loan. Winslow executed a security agreement
that described the collateral. Winslow did not file a financing statement. Which of the
following statements best describes this transaction?
Perfection of the security interest occurred even though Winslow did not file a
financing statement.
Perfection of the security interest occurred by Pine having an interest in accounts
B)
receivable.
Attachment of the security interest did not occur because Winslow failed to file a
C)
Attachment of the security interest occurred when the loan was made and Winslow
D)
executed the security agreement.
A)
Correct Answer: D
Explanation: Three elements are required for attachment: an agreement between the
debtor and the creditor, value must be given by the creditor and the debtor must have
rights in the collateral. Attachment occurred when the loan was made because an
executed agreement was present, Pine gave value by making the loan and the debtor
certainly had rights in the collateral since the collateral was all of the debtor's receivables.
Filing is the only way to perfect with accounts receivable and no filing occurred.
On August 15, 2010, Benet Co. sold goods for which it received a note bearing the
market rate of interest on that date. The four-month note was dated July 15, 2010.
Note principal, together with all interest, is due November 15, 2010. When the note
was recorded on August 15, which of the following accounts increased?
A)
B)
C)
D)
Unearned discount
Interest receivable
Prepaid interest
Interest revenue
Correct Answer: B
Explanation: Since the note is dated July 15 and received on August 15, the assumption
is that the selling price is equal to the principal of the note plus one month's interest.
Therefore, interest receivable is increased on the date of the transaction.
If the United States has full employment and the dollar dramatically depreciates in
value, we can expect (other things equal):
A) Both U.S. imports and U.S. exports to rise.
B) Both U.S. imports and U.S. exports to fall.

C) U.S. exports to fall and U.S. imports to increase.
D) Inflation to occur.
Correct Answer: D
Explanation: The depreciation of the dollar will tend to increase exports and when there
is full employment, there will be a tendency toward inflation. A change in the value of the
dollar is not likely to simultaneously increase both imports and exports. If the dollar
depreciates in value, U. S. exports will rise. U. S. imports will decline and U. S. exports
will increase.
Which of the following will generate a demand for country X's currency in the
foreign exchange market?
A)
B)
C)
D)
Travel by citizens of country X in other countries

The desire of foreigners to buy stocks and bonds of firms in country X
The imports of country X
Charitable contributions by country X's citizens to citizens of developing nations
Correct Answer: B
Explanation: As foreigners seek to buy stocks and bonds of firms in country X, those
foreigners will have to acquire the currency of country X. Such travel would cause the
demand for the currencies of other countries to increase. As country X imports from other
countries, it will increase the demand for the currencies of other countries. Such
contributions would be in the currencies of the developing nations.
An auditor's purpose in reviewing credit ratings of customers with delinquent

accounts receivable most likely is to obtain evidence concerning management's
assertions about:
A)
B)
C)
D)
Presentation and disclosure

Existence or occurrence
Rights and obligations
Valuation or allocation
Correct Answer: D
Explanation: The auditor's review of credit ratings of customers with delinquent
accounts is normally accomplished during an audit in order to test the adequacy of the

allowance for doubtful accounts. The auditor is trying to validate the proper dollar
balance in the account. The valuation assertion is concerned with proper dollar valuation.
On December 31, 2010, Bit Co. had capitalized costs for a new computer software
product with an economic life of five years. Sales for 2011 were 30 percent of
expected total sales of the software. At December 31, 2011, the software had a net
realizable value equal to 90 percent of the capitalized cost. What percentage of the
original capitalized cost should be reported as the net amount on Bit's December 31,
2011, balance sheet?
A)
B)
C)
D)
70%
72%
80%
90%
Correct Answer: A
Explanation: Using a service life method, the capitalized costs would be amortized on
the basis of percentage of total projected sales. Therefore, 30% of the costs would be
amortized in 2011.
Under the UCC Sales Article, an action for breach of the implied warranty of
merchantability by a party who sustains personal injuries may be successful against
the seller of the product only when _________________
A)
B)
C)
D)
the seller is a merchant of the product involved.

an action based on negligence can also be successfully maintained.
the injured party is in privity of contract with the seller.
an action based on strict liability in tort can also be successfully maintained.
Correct Answer: A
Explanation: The implied warranty of merchantability arises if the seller is a merchant.
Merchantability does not require a showing of negligence, privity or strict liability.
Under the Sales Article of the UCC, which of the following statements is correct

regarding the warranty of merchantability arising when there has been a sale of
goods by a merchant seller?
A) The warranty must be in writing.
The warranty arises when the buyer relies on the seller's skill in selecting the goods
B)
purchased.
C) The warranty cannot be disclaimed.
The warranty arises as a matter of law when the seller ordinarily sells the goods
D)
purchased.
Correct Answer: D
Explanation: The warranty of merchantability is implied by law if the seller is a
merchant. One who ordinarily sells the product purchased would be a merchant. Since
merchantability is an implied warranty, no written or oral words are needed for it to arise.
The implied warranty of fitness for a particular purpose arises when the buyer relies on
seller to select goods, not the warranty of merchantability. Merchantability, like all
implied warranties, can be disclaimed.
An auditor's program to examine long-term debt should include steps that require:
A)
B)
C)
D)
Examining bond trust indentures

Inspecting the accounts payable subsidiary ledger
Investigating credits to the bond interest income account
Verifying the existence of the bondholders
Correct Answer: A
Explanation: When auditing notes payable and long-term debt, the auditor should obtain
copies of agreements and determine if provisions are being adhered to. If the debt is in
the form of bonds, the agreement is the bond trust indenture.
"Inspecting the accounts payable subsidiary ledger." does not relate to long-term debt,
but short-term payables.
"Investigating credits to the bond interest income account." refers to interest income,
rather than interest expense.
"Verifying the existence of the bondholders." deals with existence of bondholders; the
auditor is concerned with existence of the debt.
Evidence of a chronic balance of payments deficit is:

A)
B)
C)
D)
A decline in amount of the nation's currency held by other nations.

An excess of exports over imports.
Diminishing reserves of foreign currencies.
An increase in the international value of the nation's currency.
Correct Answer: C
Explanation: If a country has diminished reserves of foreign currencies, it is an
indication of persistent balance of payments deficits. The balance of payments does not
refer to the amount of a nation's currency held by other nations. Exports and imports are
only one element of a country's balance of payments. A deficit would suggest that there is
a large quantity of the country's currency in the banks of other countries. That large
supply would put downward pressure on the country's currency.
During 2009, Jase Co. incurred research and development costs of $136,000 in its
laboratories relating to a patent that was granted on July 1, 2009. Costs of registering
the patent equaled $34,000. The patent's legal life is 17 years, and its estimated
economic life is 10 years. In its December 31, 2009, balance sheet, what amount
should Jase report as patent, net of accumulated amortization?
A)
B)
C)
D)
$ 32,300
$ 33,000
$161,500
$165,000
Correct Answer: A
Explanation: The research development costs should be expensed because of the
uncertainty associated with any R & D effort. However, the cost of registering the patent
should be capitalized because it benefits future periods and should be amortized over its
useful life of 10 years. In this case, the amortization for the last six months of 2009 would
be $1700 ($34,000 divided by 10 years x 6/12). The amount presented on the balance
sheet would be the cost of $34,000 less the $1700 amortization or $32,300.

Burn Manufacturing borrowed $500,000 from Howard Finance Co., secured by
Burn's present and future inventory, accounts receivable, and the proceeds thereof.
The parties signed a financing statement that described the collateral and it was filed
in the appropriate state office. Burn subsequently defaulted in the repayment of the
loan and Howard attempted to enforce its security interest. Burn contended that
Howard's security interest was unenforceable. In addition, Green, who subsequently
gave credit to Burn without knowledge of Howard's security interest, is also
attempting to defeat Howard's alleged security interest. The security interest in
question is valid with respect to _________________
A)
B)
C)
D)
both Burn and Green.

neither Burn nor Green.
burn but not Green.
green but not Burn.
Correct Answer: A
Explanation: A creditor with a security interest will have rights against a debtor when
attachment has occurred. Three elements are required for attachment: an agreement
between the debtor and the creditor, value must be given by the creditor and the debtor
must have rights in the collateral. Howard will have rights against Burn (debtor), because
there was a written security agreement, value was given by Howard ($500,000) and the
debtor had rights in the collateral (inventory and accounts receivable). When two
creditors are fighting over the same collateral, usually the first creditor to perfect wins.
Since Howard perfected by filing before Green gave credit, Howard's security interest has
priority over Green.
Other things equal, the financing of a U.S. import transaction:

A)
B)
C)
D)
Increases the supplies of foreign currency held by United States banks.

Increases U.S. interest rates.
Decreases the supplies of foreign currency held by U.S. banks.
Increases GDP in the United States.
Correct Answer: C
Explanation: An import transaction will cause a reduction in foreign currency held by U.
S. banks as dollars are given and foreign currency is received from the bank to effect the
import transaction. The domestic company that needs the foreign currency to effect the
importation of goods will take foreign currency out of the U. S. banks. There is no

relation between U. S. interest rates and the financing of a U. S. import transaction. An
import implies that there has been no increase in domestic production as a result of the
transaction.
Webstar Corp. orally agreed to sell Northco, Inc. a computer for $20,000. Northco
sent a signed purchase order to Webstar confirming the agreement. Webstar received
the purchase order and did not respond. Webstar refused to deliver the computer to
Northco, claiming that the purchase order did not satisfy the UCC Statute of Frauds
because it was not signed by Webstar. Northco sells computers to the general public
and Webstar is a computer wholesaler. Under the UCC Sales Article, Webstar's
position is _________________
A) incorrect because it failed to object to Northco's purchase order.
B) incorrect because only the buyer in a sale-of-goods transaction must sign the contract.
correct because it was the party against whom enforcement of the contract is being
C)
sought.
D) correct because the purchase price of the computer exceeded $500.
Correct Answer: A
Explanation: A writing is not required to enforce a contract of more than $500 if a
merchant fails to object within ten days to a confirming letter sent by another merchant.
Since Webstar and Northco are both merchants and Webstar failed to object to the
purchase order sent by Northco, a writing signed by Webstar was not required under the
Statute of Frauds. UCC Sales does not require that only the buyer sign. Usually only one
party need sign (whether buyer or seller), but it can only be enforced against the one who
signed. The failure of a merchant to object to a written confirmation is an exception to the
rule that it can only be enforced against the one who signed.
An auditor searching for related party transactions should obtain an understanding

of each subsidiary's relationship to the total entity because:
This may permit the audit of intercompany account balances to be performed as of
concurrent dates.
Intercompany transactions may have been consummated on terms equivalent to
B)
arm's-length transactions.
This may reveal whether particular transactions would have taken place if the parties
C)
had not been related.
A)

D)
The business structure may be deliberately designed to obscure related party

transactions.
Correct Answer: D
Explanation: In determining the scope of work to be performed with respect to possible
transactions with related parties, the auditor should obtain an understanding of
management responsibilities and the relationship of each component to the total entity.
Normally, the business structure is based on the abilities of management, tax and legal
considerations, product diversification, and geographical location. Experience has shown,
however, that business structure may be deliberately designed to obscure related party
transactions. Therefore, when searching for related party transactions the auditor should
obtain an understanding of each subsidiary's relationship to the total entity.
Stone Co. began operations in 2009 and reported $225,000 in income before income
taxes for the year. Stone's 2009 tax depreciation exceeded its book depreciation by
$25,000. Stone also had nondeductible book expenses of $10,000 related to permanent
differences. Stone's tax rate for 1999 was 40%, and the enacted rate for years after
2009 is 35%. Stone elected early adoption of FASB Statement No. 109, Accounting
for Income Taxes. In its December 31, 2009, balance sheet, what amount of deferred
income tax liability should Stone report?
A)
B)
C)
D)
$8,750
$10,000
$12,250
$14,000
Correct Answer: A
Explanation: The nondeductible book expenses are permanent differences and do not
affect taxes. The temporary depreciation difference ($25,000) times the enacted future tax
rate (35%) will be the deferred tax liability on the December 31, 2009 balance sheet
($25,000 x 35% = $8,750 deferred tax liability).
Which one of the following would not shift the aggregate demand curve?
A) A change in the price level
B) Depreciation of the international value of the dollar

C) A decline in the interest rate at each possible price level
D) An increase in personal income tax rates
Correct Answer: A
Explanation: A change in the price level would result in an increase in real GDP without
shifting the aggregate demand curve. Depreciation of the international value of the dollar
will impact demand for exports and that will cause a shift in the aggregate demand curve.
The aggregate demand curve shows the relationship between the price level and real
GDP. An increase in personal income tax rates will cause a shift in the aggregate demand
curve.
A written client representation letter most likely would be an auditor's best source of
corroborative information of a client's plans to:
A)
B)
C)
D)
Terminate an employee pension plan.

Make a public offering of its common stock.
Settle an outstanding lawsuit for an amount less than the accrued loss contingency.
Discontinue a line of business.
Correct Answer: D
Explanation: In some cases, the corroborating information that can be obtained by the
application of auditing procedures other than inquiry is limited. When a client plans to
discontinue a line of business, for example, the auditor may not be able to obtain
information through other auditing procedures to corroborate the plan or intent.
Accordingly, the auditor should obtain a written representation to provide confirmation of
management's intent. The client's plans included in the other answers, in comparison to
the plans to discontinue a line of business, could be more readily corroborated by other
evidence.
In October 2011 Allen Company exchanged a used packaging machine, having a

book value of $120,000, for a dissimilar new machine and paid a cash difference of
$15,000. The market value of the used packaging machine was determined to be
$140,000. Assume that the transaction has commercial substance.
In its income statement for the year ended December 31, 2011, how much gain should
Allen recognize on this exchange?

A)
B)
C)
D)
$0
$5,000
$15,000
$20,000
Correct Answer: D
Explanation: Since the transaction has commercial substance, the asset received should
be recorded at fair value and a gain on the trade recorded immediately.
The gain is measured by the difference between the market value and the book value of
the machine exchanged or $140,000 - $120,000 = $20,000. The new machine will be
recorded at $140,000 + $15,000 or $155,000.
To satisfy the UCC Statute of Frauds regarding the sale of goods, which of the
following must generally be in writing?
A)
B)
C)
D)
Designation of the parties as buyer and seller

Delivery terms
Quantity of the goods
Warranties to be made
Correct Answer: C
Explanation: The Statute of Frauds generally requires that the writing contain a quantity.
It does not require the designation of buyer and seller, the delivery terms or the
warranties to be made.
Auditors should request that an audit client send a letter of inquiry to those attorneys
who have been consulted concerning litigation, claims, or assessments. The primary
reason for this request is to provide:
A)
B)
C)
D)
Information concerning the progress of cases to date

Corroborative evidential matter
An estimate of the dollar amount of the probable loss
An expert opinion as to whether a loss is possible, probable, or remote

Correct Answer: B
Explanation: A letter of audit inquiry to the client's lawyer is the auditor's primary
means of obtaining corroboration of the information furnished by management
concerning litigation, claims, and assessments.
The matters included in the incorrect answer choices could be covered in a letter of audit
inquiry but the primary reason for the request is to provide corroborative evidential
matter.
Merry Co. purchased a machine costing $125,000 for its manufacturing operations
and paid shipping costs of $20,000. Merry spent an additional $10,000 testing and
preparing the machine for use. What amount should Merry record as the cost of the
machine?
A)
B)
C)
D)
$155,000
$145,000
$135,000
$125,000
Correct Answer: A
Explanation: The cost of the machine should include all the necessary cost to purchase
the machine and get it ready for use. In this case that would include the purchase price of
the machine plus the shipping and testing. $125,000 + 20,000 + $10,000 = $155,000.
Which of the following best defines NDP?

A)
B)
C)
D)
NI plus net foreign factor income earned in the U.S. plus indirect business taxes.
NI plus corporate income taxes.
GDP deflated for increases in the price level.
GDP minus indirect business taxes.
Correct Answer: A
Explanation: Net foreign factor income and indirect business taxes explain the
difference between NI and NDP. Corporate taxes are part of the difference between

national income (NI) and personal income (PI). GDP deflated for price level changes is
called "Real GDP." Indirect business taxes is only one of the elements that explains the
difference between NDP and NI.
Under the Sales Article of the UCC, which of the following events will release the
buyer from all its obligations under a sales contract?
A) Destruction of the goods after risk of loss passed to the buyer.
B) Impracticability of delivery under the terms of the contract.
Anticipatory repudiation by the buyer that is retracted before the seller cancels the
C)
contract.
Refusal of the seller to give written assurance of performance when reasonably
D)
demanded by the buyer.
Correct Answer: D
Explanation: A buyer is released from liability if the seller refuses to give written
assurance of performance when reasonably demanded.
If risk of loss is with the buyer, the buyer is liable for all damage and would not be
released.
The seller may substitute a different means of delivery if the specified means becomes
impractical.
An anticipatory breach can be retracted as long as the injured party has not canceled the
contract or materially changed position.
Gibbs Co. uses the allowance method for recognizing uncollectible accounts. Ignoring
deferred taxes, the entry to record the write-off of a specific uncollectible account:
A)
B)
C)
D)
Affects neither net income nor working capital

Affects neither net income nor accounts receivable
Decreases both net income and accounts receivable
Decreases both net income and working capital

Correct Answer: A
Explanation: The entry to write off an account is a debit to the allowance account and a
credit to the accounts receivable account. Since the allowance account is a contra account
to accounts receivable and since both are balance sheet accounts, only " Affects neither
net income nor working capital." is correct.
If the Federal Reserve System buys government securities from commercial banks
and the public, what will be the effect?
A)
B)
C)
D)
Commercial bank reserves will decline.

Commercial bank reserves will be unaffected.
It will be easier to obtain loans at commercial banks.
The money supply will contract.
Correct Answer: C
Explanation: The Fed's buying of government securities puts money in the hands of
people and the people will deposit the money in commercial banks causing the bank to
have more loanable reserves.
Cooper, CPA, is auditing the financial statements of a small rural municipality. The
receivable balances represent residents' delinquent real estate taxes. The internal
control structure at the municipality is weak. To determine the existence of the
accounts receivable balances at the balance sheet date, Cooper would most likely:
A) Send positive confirmation requests.
B) Send negative confirmation requests.
C) Examine evidence of subsequent cash receipts.
Inspect the internal records such as copies of the tax invoices that were mailed to the
D)
residents.
Correct Answer: A
Explanation: Confirmation of receivables is a generally accepted auditing procedure.
The use of positive confirmation requests is preferable when individual account balances

are relatively large or when there is reason to believe that there may be a substantial
number of accounts in dispute or with inaccuracies or irregularities. The negative form is
useful when internal control surrounding accounts receivable is considered to be
effective. In this case, although the individual accounts may not be relatively large, the
internal control structure is weak and the balances, since they are delinquent, may be in
dispute.
On March 7, 2010, Wax Corp. contracted with Noll Wholesalers to supply Noll with
specific electrical parts. Delivery was called for on June 3, 2010. On May 2, 2010,
Wax notified Noll that it would not perform and that Noll should look elsewhere.
Wax had received a larger and more lucrative contract on April 21, 2010, and its
capacity was such that it could not fulfill both orders. The facts _________________
A) will prevent Wax from retracting its repudiation of the Noll contract.
B) are not sufficient to clearly establish an anticipatory repudiation.
C) will permit Noll to sue only after June 3, 2010, the latest performance date.
will permit Noll to sue immediately after May 2, 2010, even though the performance
D)
called for under the contract was not due until June 3, 2010.
Correct Answer: D
Explanation: An anticipatory repudiation occurs when one side states they will not
perform before the time of performance. The injured party can sue immediately or wait
until the time of performance and then sue. Wax told Noll prior to the time of
performance that Wax would not perform. Thus, Noll can sue immediately and need not
wait until June 3. Wax may retract its repudiation as long as Noll hasn't canceled the
contract or materially changed position.
On January 1, 2010, Heath Corp. established an employee stock ownership plan

(ESOP). Selected transactions relating to the ESOP during 2010 were as follows:
On April 1, 2010, Heath contributed $45,000 cash and 3,000 shares of its $10 par
value common stock to the ESOP. On this date, the market price of the stock was $18
a share. On October 1, 2010, the ESOP borrowed $100,000 from Union National
Bank and acquired 6,000 shares of Heath's common stock in the open market at $17
a share. The note is for one year, bears interest at 10%, and is guaranteed by Heath.
On December 15, 2010, the ESOP distributed 8,000 shares of Heath's common stock
to employees of Heath in accordance with the plan formula. On this date, the market
price of the stock was $20 a share.

In its 2010 income statement, what amount should Heath report as compensation
expense relating to the ESOP?
A)
B)
C)
D)
$99,000
$155,000
$199,000
$259,000
Correct Answer: A
Explanation: A company records compensation expense based upon cash or stocks (at
fair market value) contributed to the plan during the year. Therefore, the $45,000 cash
and $54,000 value of the shares contributed to the plan are reported as compensation
expense. The second and third transactions noted in the question do not result in any
expense recognition.
Under the Sales Article of the UCC, which of the following statements is correct?
A)
B)
C)
D)
The obligations of the parties to the contract must be performed in good faith.
Merchants and nonmerchants are treated alike.
The contract must involve the sale of goods for a price of more than $500.
None of the provisions of the UCC may be disclaimed by agreement.
Correct Answer: A
Explanation: UCC Sales requires all parties to act in good faith.
Merchants are held to a higher standard in some cases.
Goods may be sold for less than $500.
Provisions of the UCC may be disclaimed. For example, implied warranties may be
disclaimed if the disclaimer is conspicuous.
Which of the following procedures is least likely to be performed before the balance
sheet date?

A)
B)
C)
D)
Testing of internal control over cash

Confirmation of receivables
Search for unrecorded liabilities
Observation of inventory
Correct Answer: C
Explanation: The auditor is concerned with unrecorded liabilities as of the balance sheet
date (completeness assertion), thus audit procedures performed to identify unrecorded
liabilities before the balance sheet date would be meaningless. Accounts receivable may
be confirmed prior to the balance sheet date if the auditor concludes internal controls
surrounding accounts receivable are effective. Inventory counts may be observed prior to
year if the client maintains perpetual inventory records and the controls surrounding those
records are effective.
The purchase of government securities from the public by the Fed will cause:
A)
B)
C)
D)
commercial bank reserves to decrease.

the money supply to increase.
demand deposits to decrease
the interest rate to increase.
Correct Answer: B
Explanation: The purchase of government securities by the government puts money in
the hands of consumers. The purchase of government securities by the government will
tend to cause commercial bank reserves to increase because it will put money in the
hands of the people. The purchase of government securities by the government will cause
demand deposits to increase as people put the money in their bank accounts. Such an
action will increase the money supply and the increase in the money supply will tend to
cause interest rates to decrease.
An expansionary fiscal policy is shown as a:

A) Rightward shift in the economy's aggregate demand curve.
B) Movement along an existing aggregate demand curve.
C) Leftward shift in the economy's aggregate supply curve.

D) Leftward shift in the economy's aggregate demand curve.
Correct Answer: A
Explanation: An expansionary fiscal policy will result in a rightward, or outward shift in
the aggregate demand curve. Fiscal policy involves government spending and taxation
and both are intended to shift the aggregate demand curve. Fiscal policy does not impact
the aggregate supply curve. The impact on the aggregate demand curve will be just the
opposite.
Which of the following presumptions does not relate to the competence of audit
evidence?
The more effective the internal control structure, the more assurance it provides about
the accounting data and financial statements.
An auditor's opinion, to be economically useful, is formed within reasonable time and
B)
based on evidence obtained at a reasonable cost.
Evidence obtained from independent sources outside the entity is more reliable than
C)
evidence secured solely within the entity.
The independent auditor's direct personal knowledge, obtained through observation
D)
and inspection, is more persuasive than information obtained indirectly.
A)
Correct Answer: B
Explanation: There should be a rational relationship between the cost of obtaining
evidence and the usefulness of the information obtained. However, when considering
competency of evidence, time and cost are not relevant.
The more effective the internal control structure, the more assurance it provides about
the reliability of accounting data and financial statements.
When evidential matter can be obtained from independent sources outside the entity, it
is more competent than evidential matter secured solely within the entity.
The independent auditor's direct personal knowledge, obtained through examination,
observation, computation, and inspection, is more persuasive than information obtained
indirectly.
On January 2, 2010, Morey Corp. granted Dean, its president, 20,000 stock
appreciation rights. On exercise, Dean is entitled to receive cash for the excess of the

stock's market price on the exercise date over the market price on the grant date.
The rights are exercisable beginning on January 2, 2012 and expiring on December
31, 2012. The market price of Morey's stock was $30 on January 2, 2006 and $45 on
December 31, 2010. Morey used the Black-Sholes-Merton pricing model and
estimated the values of each right at $16 each. As a result of the stock appreciation
rights, the company should recognize compensation expense for 2010 of:
A)
B)
C)
D)
$300,000
$320,000
$150,000
$160,000
Correct Answer: D
Explanation: The service period is the period from the grant date, January 2, 2010, to the
exercise date, January 2, 2012, or two years. Therefore, the total compensation of
$320,000 (20,000 SARS X the estimated fair value of $16 each) divided by two years
equals the compensation expense of $160,000 each year.
On September 27, Summers sent Fox a letter offering to sell Fox a vacation home for
$150,000. On October 2, Fox replied by mail agreeing to buy the home for $145,000.
Summers did not reply to Fox. Do Fox and Summers have a binding contract?
A)
B)
C)
D)
No, because Fox failed to sign and return Summers' letter.

No, because Fox's letter was a counteroffer.
Yes, because Summers' offer was validly accepted.
Yes, because Summers' silence is an implied acceptance of Fox's letter.
Correct Answer: B
Explanation: Since Fox changed the terms of the offer, the letter was a counteroffer and
not a valid acceptance. The remaining answer choices are incorrect because no contract
was formed and Fox doesn't have to sign and return an offer to accept.
What is an appropriate fiscal policy for severe demand-pull inflation?

A) An increase in government spending.
B) Depreciation of the dollar.

C) A reduction in interest rates.
D) A tax rate increase.
Correct Answer: D
Explanation: A tax rate increase is a fiscal policy and it is appropriate in that it will
reduce consumer spending and shift the aggregate demand curve inward. An increase in
government spending will move the aggregate demand curve outward. Depreciation of
the dollar will cause exports to increase. A reduction in interest rates will cause an
outward shift in the aggregate demand curve and that will tend to increase the price level
even more.
On June 1, 2009, Oak Corp. granted stock options to certain key employees as
additional compensation. The options were for 1,000 shares of Oak's $2 par value
common stock at an option price of $15 per share. Market price of this stock on June
1, 2009, was $20 per share. The options were exercisable beginning January 2, 2010,
and expire on December 31, 2010.
Oak Corp. used the binomial option pricing model and estimated the value of each
option at $7.
On April 1, 2010, when Oak's stock was trading at $21 per share, all the options were
exercised. What amount of pretax compensation should Oak report in 2009 in
connection with the options?
A)
B)
C)
D)
$6,000
$5,000
$2,500
$7,000
Correct Answer: D
Explanation: The key point is that the service period is from June 1, 2009, to December
31, 2009 because the options are exercisable on January 2, 2010. Therefore, the total
compensation from the pricing model ($7 x 1,000 options) $7,000 is charged to
compensation for 2009.
On February 12, Harris sent Fresno a written offer to purchase Fresno's land. The
offer included the following provision: "Acceptance of this offer must be by
registered or certified mail, received by Harris no later than February 18 by 5:00
p.m. CST." On February 18, Fresno sent Harris a letter accepting the offer by
private overnight delivery service. Harris received the letter on February 19. Which
of the following statements is correct?
A) A contract was formed on February 19.
B) Fresno's letter constituted a counteroffer.
C) Fresno's use of the overnight delivery service was an effective form of acceptance.
A contract was formed on February 18 regardless of when Harris actually received
D)
Fresno's letter.
Correct Answer: B
Explanation: Acceptances must be unconditional, complying with all of the offeror's
terms. This was a counteroffer because it was not sent by registered or certified mail and
it was not received by February 18. The remaining answer choices are incorrect because
no contract was formed and overnight delivery service was not registered or certified as
required.
The third standard of field work states that sufficient competent evidential matter is
to be obtained through inspection, observation, inquiries, and confirmations to
afford a reasonable basis for an opinion regarding the financial statements under
audit. The substantive evidential matter required by this standard may be obtained,
in part, through:
A)
B)
C)
D)
Flowcharting the internal control structure

Proper planning of the audit engagement
Analytical procedures
Auditor working papers
Correct Answer: C
Explanation: Substantive audit procedures include test of balances and analytical
procedures. The objectives of analytical procedures is to gather evidence concerning the
completeness of the items included in the financial statements, and to indicate unusual

fluctuations in account balances that may require more detailed substantive audit
procedures.
In order to efficiently establish the correctness of the accounts payable cutoff, an

auditor will be most likely to:
A)
B)
C)
D)
Coordinate cutoff tests with physical inventory observation

Compare cutoff reports with purchase orders
Compare vendors' invoices with vendors' statements
Coordinate mailing of confirmations with cutoff tests
Correct Answer: A
Explanation: Cutoff tests are used to determine whether items have been recorded in the
proper period. By coordinating cutoff tests with the physical inventory, auditors can
determine if the items are physically present.
The installment method of recognizing revenue:

Should be used only in cases where there is no reasonable basis for estimating the
collectibles of receivables
B) Is not a generally accepted accounting principle under any circumstances
C) Should be used for book purposes only if it is used for tax purposes
Is an acceptable alternative accounting principle for a firm which makes installment
D)
sales
A)
Correct Answer: A
Explanation: According to APB #10 (par. 12), the installment method of accounting is
not acceptable unless "collection of the sale price is not reasonably assured."
David believes that we are moving into a period of deflation. If David's expectations
concerning deflation are correct, which of the following correctly pairs an investment
vehicle with an appropriate logic?
A) Savings and loan common stocks: deflation will cause savings and loans to lend at

higher rates.
B) Precious metals: deflation will cause these assets to increase in value.
C) Long-term, high-quality bonds: deflation will cause interest rates to decrease.
D) Short-term bonds: deflation will cause short-term interest rates to increase.
Correct Answer: C
Explanation: Deflation is a period of tepid demand, declining prices of goods and
services, declining interest rates, and rising bankruptcies among the weaker firms. Longterm bonds rated AA or higher are good investments in deflationary times. Deflation will
cause interest rates to fall not rise. A lender will be unable to lend at higher interest rates.
Tangible assets such as precious metals will decline in price during a deflationary
economy. Short-term bonds is not correct because the economic logic is faulty. Shortterm interest rates will decline in a deflationary economy.
On September 10, Harris, Inc., a new car dealer, placed a newspaper advertisement
stating that Harris would sell 10 cars at its showroom for a special discount only on
September 12, 13, and 14. On September 12, King called Harris and expressed an
interest in buying one of the advertised cars. King was told that five of the cars had
been sold and to come to the showroom as soon as possible. On September 13, Harris
made a televised announcement that the sale would end at 10:00 p.m. that night.
King went to Harris' showroom on September 14 and demanded the right to buy a
car at the special discount. Harris had sold the 10 cars and refused King's demand.
King sued Harris for breach of contract. Harris's best defense to King's suit would be
that Harris' _________________
A)
B)
C)
D)
offer was unenforceable.

advertisement was not an offer.
television announcement revoked the offer.
offer had not been accepted.
Correct Answer: B
Explanation: Advertisements and price quotes are not usually offers, they are invitations
to deal. The remaining answer choices are incorrect because no offer was made.
The type of unemployment associated with a recession is called:

A)
B)
C)
D)
Frictional unemployment.
Structural unemployment.
Cyclical unemployment.
Seasonal unemployment.
Correct Answer: C
Explanation: Cyclical unemployment is caused by declining GDP and declining GDP is
associated with a recession. Frictional unemployment is a component of the natural rate
of unemployment and the natural rate of unemployment is not likely to change in
response to a recession. Structural unemployment is a component of the natural rate of
unemployment and the natural rate of unemployment is not likely to change in response
to a recession. Seasonal unemployment is unemployment caused by seasonal changes
rather than changes in GDP.
An auditor generally tests the segregation of duties related to inventory by:

A)
B)
C)
D)
Personal inquiry and observation

Test counts and cutoff procedures
Analytical procedures and invoice recomputation
Document inspection and reconciliation
Correct Answer: A
Explanation: Some internal control procedures, such as the segregation of duties, may
not generate an audit trail of documents that the auditor can inspect. The auditor can test
this type of control procedure by making inquiries of client personnel and observing who
performs what duties. "Test counts and cutoff procedures" and "Analytical procedures
and invoice recomputation" are procedures that relate more to substantive tests of
financial statement amounts, rather than to tests of controls. "Document inspection and
reconciliation" is incorrect because segregation of duties related to inventory is a control
that is not evidenced by documents that the auditor can inspect.
The calculation of the income recognized in the third year of a five-year construction
contract accounted for using the percentage-of-completion method includes the ratio
of:

A)
B)
C)
D)
Total costs incurred to date to total estimated costs

Total costs incurred to date to total billings to date
Costs incurred in year 3 to total estimated costs
Costs incurred in year 3 to total billings to date
Correct Answer: A
Explanation: Income recognized in the third year of a five-year construction contract
using percentage-of-completion method would be calculated by multiplying the ratio of
the total cost incurred to date divided by the estimated total cost times the estimated total
gross profit on the contract less the gross profit recognized in years one and two. Note
that billings on the contract do not affect the calculation of income recognized.
In order for an offer to confer the power to form a contract by acceptance, it must
have all of the following elements except?
Be communicated to the offeree and the communication must be made or authorized
by the offeror.
B) Be sufficiently definite and certain.
C) Be communicated by words to the offeree by the offeror.
D) Manifest an intent to enter into a contract.
A)
Correct Answer: C
Explanation: Communication by words is not required as the communication can also be
done by actions. Equally, the communication need not be directly made by the offeror to
the offeree, as it could be communicated through a third party. An offer must be seriously
intended, communicated, and definite in its terms.
The overall attitude and awareness of an entity's board of directors concerning the
importance of the internal control structure usually is reflected in its:
A)
B)
C)
D)
Computer-based controls
System of segregation of duties
Control environment
Safeguards over access to assets

Correct Answer: C
Explanation: An entity's internal control structure consists of three elements: the control
environment, the accounting system, and control procedures. The control environment
reflects the overall attitude, awareness, and actions of the board of directors,
management, owners, and others concerning the importance of control and its emphasis
in the entity.
The incorrect answer choices are examples of control procedures.
If the unemployment rate is 9 percent and the natural rate of unemployment is 5

percent, then the:
A) Frictional unemployment rate is 5 percent.
Cyclical unemployment rate and the frictional unemployment rate together are 5
B)
percent.
C) Cyclical unemployment rate is 4 percent.
D) Natural rate of unemployment will eventually increase.
Correct Answer: C
Explanation: The unemployment rate is the sum of the natural rate of unemployment
plus the cyclical unemployment rate. The natural rate of unemployment is the sum of the
frictional unemployment rate and the structural unemployment rate. The unemployment
rate is the sum of the cyclical unemployment rate and the natural rate of unemployment.
One cannot draw conclusions about the increase or decrease of the natural rate of
unemployment by knowing only the unemployment rate and the natural rate of
unemployment. Changes in the natural rate of unemployment are gradual and they are
related to changes in society.
Young Corp. hired Wilson as a sales representative for six months at a salary of
$5,000 per month plus 6% of sales. Which of the following statements is correct?
Young does not have the power to dismiss Wilson during the six-month period
without cause.
Wilson is obligated to act solely in Young's interest in matters concerning Young's
B)
business.
C) The agreement between Young and Wilson is not enforceable unless it is in writing
A)

and signed by Wilson.
The agreement between Young and Wilson formed an agency coupled with an
D)
interest.
Correct Answer: B
Explanation: Because an agent owes a fiduciary duty of loyalty to their principal, they
must act solely in the principal's best interests in matters concerning their business.
Most agencies are terminable at will and therefore Young does have the power to
dismiss Wilson without cause.
Only an agency to buy land or one impossible to perform in one year would require a
writing under the statute of frauds (GRIPE + marriage).
With an agency coupled with an interest the principal makes a party their agent solely to
pay off a debt that the principal owes the agent. There is no indication that Wilson was
hired by Young solely to pay off a debt that Wilson owed Young.
Management can estimate the amount of loss that will occur if a foreign government
expropriates some company assets. If expropriation is reasonably possible, a loss
contingency should be:
A)
B)
C)
D)
Disclosed but not accrued as a liability

Disclosed and accrued as a liability
Accrued as a liability but not disclosed
Neither accrued as a liability nor disclosed
Correct Answer: A
Explanation: The key words are "reasonably possible". FASB #5 states that if a loss
contingency is reasonably possible, it should be disclosed but not accrued. A loss
contingency is accrued only if the loss contingency is probable and the amount of the loss
can be reasonably estimated.
As the acceptable level of detection risk decreases, an auditor may:

A) Reduce substantive testing by relying on the assessments of inherent risk and control

risk
B) Postpone the planned timing of substantive tests from interim dates to the year end
C) Eliminate the assessed level of inherent risk from consideration as a planning factor
Lower the assessed level of control risk from the maximum level to below the
D)
maximum
Correct Answer: B
Explanation: Detection risk is the risk that the auditor will not detect a material
misstatement that exists in an assertion. As the acceptable level of detection risk
decreases, the assurance provided from substantive tests should increase. Since applying
substantive tests as of an interim date rather than as of the year-end potentially increases
the risk that misstatements that may exist will not be detected, if the auditor wants to
decrease detection risk, he may decide to perform substantive tests at year-end rather than
at an interim date.
Substantive tests should be increased when allowable detection risk decreases.
Inherent risk cannot be ignored.
Control risk cannot be lowered without additional testing of controls.
Cali, Inc., had a $4,000,000 note payable due on March 15, 2009. On January 28,
2009, before the issuance of its 2008 financial statements, Cali issued long-term bonds
in the amount of $4,500,000. Proceeds from the bonds were used to repay the note
when it came due. How should Cali classify the note in its December 31, 2008,
financial statements?
A)
B)
C)
D)
As a current liability, with separate disclosure of the note refinancing

As a current liability, with no separate disclosure required
As a concurrent liability, with separate disclosure of the note refinancing
As a concurrent liability, with no separate disclosure required
Correct Answer: C
Explanation: Normally this note would be classified as a current liability. However,
FASB # 6 states that if Cali Inc. intends to refinance the note and has the ability to
refinance the obligation within one year, the note should be classified as noncurrent. The
ability to refinance must be demonstrated by either accomplishing the refinancing or

entering into an agreement to do so before the financial statements are issued. In this
case, Cali Inc. refinanced the note (accomplished the refinancing) on January 28, 2009
before the financial statements were issued. Therefore, both the intent and ability criteria
were met and the note should be classified on the December 31, 2008 balance sheet as
noncurrent with a separate disclosure of the criteria used in making the classification
decision.
Noll gives Carr a written power of attorney. Which of the following statements is
correct regarding this power of attorney?
A)
B)
C)
D)
It must be signed by both Noll and Carr.

It must be for a definite period of time.
It may continue in existence after Noll's death.
It may limit Carr's authority to specific transactions.
Correct Answer: D
Explanation: A power of attorney usually limits an agent's authority to specific
transactions.
A power of attorney need only be signed by the principal, not the principal and the
agent.
A power of attorney may be for an indefinite period of time.
Death of the principal terminates most agencies, to specifically include a power of
attorney.
A market with many independent firms, low barriers to entry, and product
differentiation is BEST classified as which of the following?
A)
B)
C)
D)
a monopoly.
a natural monopoly.
monopolistic competition.
an oligopoly.
Correct Answer: C

Explanation: Monopolistic competition is characterized by many firms in a situation in
which there can be product differentiation for a short period of time. An example is the
fast food industry. One fast food chain will develop a new concept; and the others will
soon be copying that concept. A monopoly is not correct because a monopoly usually has
only one firm. A natural monopoly is not correct because a natural monopoly is a
monopoly which is created because the economies of scale restrict competitors. An
example would be power generation. An oligopoly is not correct because an oligopoly
usually has only a few firms.
The element of the audit planning process most likely to be agreed upon with the
client before implementation of the audit strategy is the determination of the:
A)
B)
C)
D)
Evidence to be gathered to provide a sufficient basis for the auditor's opinion

Procedures to be undertaken to discover litigation, claims, and assessments
Pending legal matters to be included in the inquiry of the client's attorney
Timing of inventory observation procedures to be performed
Correct Answer: D
Explanation: The client is responsible for counting inventory and the auditor is
responsible for observing the client's count. Since the timing of the observation depends
on the timing of the count, there must be agreement between the auditor and client
regarding the inventory observation procedures before the auditor finalizes an audit
strategy for inventory.
The incorrect answer choices are evidence-gathering issues that are decided by the
auditor without specific regard to timing and other client concerns. Independently of the
client, the auditor determines the extent of evidence needed in the audit, the nature of
procedures to follow in the audit, and the scope of issues to be addressed in a legal letter.
Work Corp. has decided to expand the scope of its business. In this connection, it
contemplates engaging several agents. Which of the following agency relationships is
within the statute of frauds and thus should be contained in a signed writing?
A sales agency where the agent normally will sell goods which have a value in excess
of $500
B) An irrevocable agency
A)

An agency which is of indefinite duration but which is terminable upon one month's
notice
An agency for the forthcoming calendar year which is entered into in mid-December
D)
of the prior year
C)
Correct Answer: D
Explanation: The statute of frauds only requires a writing for contracts for sale of goods
of $500 or more, real estate, contracts impossible to perform in one year, a promise to
answer the debt of another, an executor's promise to be personally liable for the debt of an
estate and contracts where marriage is the consideration (GRIPE + marriage). An agency
entered into in mid-December and to last for the entire next year would be impossible to
perform in one year and would require a writing.
Although the sales contracts of $500 or more would need a writing, the agency would
not need to be in writing.
An irrevocable agency does not require a writing under the statute of frauds.
An agency which is terminable upon one month's notice is not impossible to perform in
one year.
If a group of consumers decide to boycott a particular product, the expected result

would be
A)
B)
C)
D)
An increase in the product price to make up lost revenue.

A decrease in the demand for the product.
An increase in product supply because of increased availability.
That companies in the industry would experience higher economic profits.
Correct Answer: B
Explanation: A boycott would decrease the demand at all price levels and result in a
shift in the demand curve to the left. A lower quantity would be sold at the same price.
There would be no increase in availability. The supply curve would be dictated by the
cost of production, not by the demand curve. The quantity demanded would be lower at
every price level with no change in the cost of production. Thus, profits would decline.

Reporting inventory at the lower of cost or market is a departure from the
accounting principle of:
A)
B)
C)
D)
Historical cost
Consistency
Conservatism
Full disclosure
Correct Answer: A
Explanation: ARB 43 states that "a departure from the cost basis of pricing the inventory
is required when the utility of the goods is no longer as great as its costs...and the
difference should be recognized as a loss of the current period." This utility is considered
to be their market value, therefore the term Lower of Cost or Market. Consistency is the
application of the same accounting principle from one period to the next. Conservatism is
the practice of avoiding an overly optimistic presentation of assets, income and owner's
equity in the financial statements.
What are the Statements of Financial Accounting Concepts intended to establish?

Generally accepted accounting principles in financial reporting by business
enterprises
The meaning of "Present fairly in accordance with generally accepted accounting
B)
principles."
The objectives and concepts for use in developing standards of financial accounting
C)
and reporting
D) The hierarchy of sources of generally accepted accounting principles
A)
Correct Answer: C
Explanation: FASB C-1 intends to establish objectives and concepts for use in
developing the standards of financial accounting and reporting to be used as a guideline
that will lead to consistent standards. GAAP is a technical term that encompasses the
conventions, rules, and procedures not only in broad guidelines but also detailed
procedures developed on the basis of experience, reason, custom and practical need. ASB
(Auditing Standards Board) is responsible for developing choice "Present fairly in
accordance with generally accepted accounting principles.". The AICPA's Code of
Conduct establishes the hierarchy of sources.

In microeconomics, which of the following is the distinguishing characteristic of the
long run of the supply side?
A)
B)
C)
D)
That only supply factors determine price and output.

That only demand factors determine price and output.
That firms are not allowed to enter or exit the industry.
That all inputs are variable.
Correct Answer: D
Explanation: In the long run, the firm has the opportunity to change the factors of
production. The firm can expand or contract in response to changes in consumer demand.
Thus, in the long run all inputs are variable. In the long run the demand factors play a role
in determining price and output. Supply factors play a role in determining price and
output. In the long run firms are assumed to enter and exit the industry.
Which of the following procedures most likely would not be an internal control
procedure designed to reduce the risk of errors in the billing process?
Comparing control totals for shipping documents with corresponding totals for sales
invoices
Using computer programmed controls on the pricing and mathematical accuracy of
B)
sales invoices
C) Matching shipping documents with approved sales orders before invoice preparation
Reconciling the control totals for sales invoices with the accounts receivable
D)
subsidiary ledger
A)
Correct Answer: D
Explanation: The reconciliation provides evidence that sales which have been invoiced
are recorded in the accounts receivable subsidiary ledger but does not reduce the risk of
errors in billing.
"Comparing control totals for shipping documents with corresponding totals for sales
invoices" is incorrect because it reduces the risk of errors in the billing process by
providing evidence that all items shipped were included in the sales invoices.
"Using computer programmed controls on the pricing and mathematical accuracy of
sales invoices" is incorrect because it reduces the risk of errors in the billing process by
controlling the mathematical accuracy of the computations on the sales invoices.
"Matching shipping documents with approved sales orders before invoice preparation"

is incorrect because matching shipping documents with sales orders reduces the risk of
errors in the billing process by providing evidence that approved sales orders were
shipped before being invoiced.
According to the standards of the profession, which of the following circumstances

will prevent a CPA performing audit engagements from being independent?
A) Obtaining a collateralized automobile loan from a financial institution client.
Litigation with a client relating to billing for consulting services for which the
B)
amount is immaterial.
C) Employment of the CPA's spouse as a client's internal auditor.
D) Acting as an honorary trustee for a not-for-profit organization client.
Correct Answer: C
Explanation: Under Rule 101 of the Rules of Conduct as interpreted, employment of a
CPA's spouse as an audit client's internal auditor would impair independence.
An auditor may obtain a collateralized automobile loan from a financial institution
client without impairing independence.
Independence is not impaired by litigation with an audit client if the amount is
immaterial and not related to the audit work.
An auditor may act as an honorary trustee for a not for profit audit client.
Reporting inventory at the lower of cost or market is a departure from the

accounting principle of:
A)
B)
C)
D)
Historical cost
Consistency
Conservatism
Full disclosure
Correct Answer: A
Explanation: ARB 43 states that "a departure from the cost basis of pricing the inventory
is required when the utility of the goods is no longer as great as its costs...and the

difference should be recognized as a loss of the current period." This utility is considered
to be their market value, therefore the term Lower of Cost or Market. Consistency is the
application of the same accounting principle from one period to the next. Conservatism is
the practice of avoiding an overly optimistic presentation of assets, income and owner's
equity in the financial statements.
A violation of the profession's ethical standards most likely would have occurred
when a CPA _________________
issued an unqualified opinion on the 2009 financial statements when fees for the
2008 audit were unpaid.
recommended a controller's position description with candidate specifications to an
B)
audit client.
purchased a CPA firm's practice of monthly write-ups for a percentage of fees to be
C)
received over a three-year period.
made arrangements with a financial institution to collect notes issued by a client in
D)
payment of fees due for the current year's audit.
A)
Correct Answer: A
Explanation: Under Rule 101 of the Rules of Conduct as interpreted, independence is
impaired if there is a direct financial interest in an audit client regardless of materiality.
Specifically independence is impaired if audit fees remain unpaid for more than one year
prior to the date of the current year's report. It is considered a loan.
Independence is not impaired by merely recommending a job position including
candidate specifications. However, independence would be +impaired if the CPA actually
did the hiring of the controller because this would be management.
There is no prohibition against purchase of a CPA firm's monthly write-ups for a
percentage of fees.
A CPA may make arrangements with a bank to collect notes issued by a client in
payment for a fee that is due.
Which of these statements is true in the long run about equilibrium price in
competitive product markets?
A) It will be a fair price all consumers can afford.

B) It will be set equal to the total costs of production.
C) It will be set equal to the total fixed costs of production.
D) It will be set equal to the marginal costs of production.
Correct Answer: D
Explanation: In a competitive market, the forces of demand and supply will, in the long
run, cause price to equal marginal cost. If price is higher than marginal cost, additional
production will be forthcoming. If price is lower than marginal cost, producers will quit
producing. A competitive market cannot assure a fair price that all consumers can afford.
The disposable income of the consumers dictates whether or not they can afford the
product at the equilibrium price. Some will be able to afford it and some will not. A price
set equal to the total cost of production fails to recognize that the total cost should be
divided by the number of units produced. A price set equal to the total fixed cost of
production fails to recognize that the total fixed cost should be divided by the total
number of units produced. Even then, the variable costs per unit would be ignored.
Upon receipt of customers' checks in the mailroom, a responsible employee should

prepare a remittance listing that is forwarded to the cashier. A copy of the listing
should be sent to the:
A)
B)
C)
D)
Internal auditor to investigate the listing for unusual transactions

Treasurer to compare the listing with the monthly bank statement
Accounts receivable bookkeeper to update the subsidiary accounts receivable records
Entity's bank to compare the listing with the cashier's deposit slip
Correct Answer: C
Explanation: A copy of the remittance listing is sent to the accounts receivable clerk and
posted to the subsidiary records. Accounting for assets is a function that should be
separated from the custody of those assets. The accounts receivable bookkeeper
maintains records of the balance owed by each customer, while the cashier has custody of
the cash. The cashier does not have an opportunity to cover a shortage of cash by using
checks received on account because the AR ledger would indicate a different balance than
that owed. There is no need to send copies to the internal auditor, the treasurer, or the
bank, because the goal is to establish accountability for the asset.

Which of the following is a step in an auditor's decision to assess control risk at below
the maximum?
Apply analytical procedures to both financial data and nonfinancial information to
detect conditions that may indicate weak controls.
Perform tests of details of transactions and account balances to identify potential
B)
errors and irregularities.
Identify specific internal control policies and procedures that are likely to detect or
C)
prevent material misstatements.
Document that the additional audit effort to perform tests of controls exceeds the
D)
potential reduction in substantive testing.
A)
Correct Answer: C
Explanation: AU 319 states that the auditor may make a preliminary assessment of
control risk at less than a high level only when the auditor:
Is able to identify policies and procedures of the accounting and internal control
systems relevant to specific assertions which are likely to prevent or detect material
misstatements in the financial statement.
Plans to perform tests of control to support the assessment.
Analytical procedures or tests of reasonableness test amounts of financial data.
Tests of details are performed as a substantive test to determine material mistakes in the
financial statements.
If the audit effort of performing tests of controls exceeds the potential reduction in
substantive testing, tests of controls will not be performed because doing so would reduce
audit efficiency.
A CPA's duty of due care to a client most likely will be breached when a CPA
_________________
A)
B)
C)
D)
gives a client an oral instead of written report.

gives a client incorrect advice based on an honest error of judgment.
fails to give tax advice that saves the client money.
fails to follow generally accepted auditing standards.
Correct Answer: D

Explanation: Liability for negligence requires proof of four elements: duty of care,
breach (lack of due care), damages and causality. Lack of due care is failure to act like a
reasonably prudent accountant and most often means the accountant failed to follow
GAAS or GAAP. Thus the due care required of an accountant to a client would be most
likely breached by a failure to follow generally accepted auditing standards (GAAS).
Submission of an oral report instead of a written report does not constitute failure to use
due care.
An honest error of judgment and a failure to give tax advice may be made by a
reasonably prudent accountant. Lack of due care only occurs when an accountant fails to
do what a reasonably prudent accountant would do.
Which statement is correct where exists a perfectly inelastic supply curve in a

competitive market?
A)
B)
C)
D)
It means the equilibrium price must be zero.

It says the market supply curve is horizontal.
It exists when firms cannot vary input usage.
It can only exist in the long run.
Correct Answer: C
Explanation: A perfectly inelastic supply curve is a vertical line; and it implies that a
change in price will not impact the quantity offered in the market. That would be the case
where firms cannot vary input usage. An equilibrium price of zero would mean that it is a
free good. A horizontal supply curve is used to represent a perfectly elastic supply curve,
not an inelastic one. A perfectly inelastic supply curve is more likely to occur in the short
run, than in the long run. In the long run, producers may be able to adjust to lower or
higher demand for the product.
In analyzing a company's financial statements, which financial statement would a

potential investor primarily use to assess the company's liquidity and financial
flexibility?

A)
B)
C)
D)
Balance sheet
Income statement
Statement of retained earnings
Statement of cash flows
Correct Answer: A
Explanation: Concepts Statement #5 states that the balance sheet includes "information
that is often used in assessing an entity's liquidity and financial flexibility." The current
assets are listed in order of liquidity which should allow an assessment of their nearness
to cash. An overall analysis of the balance sheet should indicate the financial flexibility to
respond to unexpected events.
Which of the following circumstances most likely would cause an auditor to consider
whether material misstatements exist in an entity's financial statements?
A)
B)
C)
D)
Management places little emphasis on meeting earnings projections.

The board of directors makes all major financing decisions.
Reportable conditions previously communicated to management are not corrected.
Transactions selected for testing are not supported by proper documentation.
Correct Answer: D
Explanation: AU 316 states that if a condition or circumstance differs adversely from
the auditor's expectation, the auditor needs to consider the reason for such a difference.
For example:
Analytical procedures disclose significant differences from expectations.
Significant unreconciled differences between reconciliations of a control account and
subsidiary records.
Confirmation requests disclose significant differences or yield fewer responses than
expected.
transactions selected for testing are not supported by proper documentation.
Supporting records or files that should be readily available are not promptly produced
when requested.
audit tests detect errors that apparently were known to client personnel, but were not
voluntarily disclosed.
When such conditions exist, the planned scope of audit procedures should be
reconsidered. As the differences from expectations increase, the auditor should consider

whether the assessment of the risk of material misstatement of the financial statements
made in the planning stage of the engagement is still appropriate.
"Management places little emphasis on meeting earnings projections." and "The board of
directors makes all major financing decisions." are encouraging factors that management
is not willing to circumvent the rules just to meet earnings projections and that the board
of directors makes all financial decisions. Uncorrected conditions do not necessarily
mean that material misstatements exist.
To which of the following rights is a stockholder of a public corporation entitled?

A)
B)
C)
D)
The right to have annual dividends declared.

The right to vote for the election of officers.
The right to a reasonable inspection of corporate records.
The right to have the corporation issue a new class of stock.
Correct Answer: C
Explanation: A stockholder has the right to inspect books and records of the corporation
at reasonable times and upon written demand. There is no inherent right to dividends for
stockholders. Stockholders elect directors, not officers. Officers are appointed by the
directors. Stockholders do not generally have the right to participate in management.
They have only two management rights: electing directors and voting on fundamental
changes in the corporation. They do not have the right to have the corporation issue a new
class of stock as this is not a fundamental change in the corporation.
Sun Corp. approved a merger plan with Cord Corp. One of the determining factors
in approving the merger was the financial statements of Cord that were audited by
Frank & Co., CPAs. Sun had engaged Frank to audit Cord's financial statements.
While performing the audit, Frank failed to discover certain irregularities that later
caused Sun to suffer substantial losses. For Frank to be liable under common law
negligence, Sun at a minimum must prove that Frank _________________
A)
B)
C)
D)
knew of the irregularities.

failed to exercise due care.
was grossly negligent.
acted with scienter.

Correct Answer: B
Explanation: Liability for negligence requires proof of four elements: duty of care,
breach (lack of due care), damages and causality. Thus Sun must prove Frank failed to
exercise due care.
Knowledge is not an element of negligence.
Gross negligence is constructive fraud. Fraud requires an element of intent and
negligence does not.
Scienter is the intent element of fraud and negligence does not require proof of intent.
The basis for classifying assets as current or noncurrent is the period of time
normally elapsed from the time the accounting entity expends cash to the time it
converts:
A)
B)
C)
D)
Inventory back into cash, or 12 months, whichever is shorter

Receivables back into cash, or 12 months, whichever is longer
Tangible fixed assets back into cash, or 12 months, whichever is longer
Inventory back into cash, or 12 months, whichever is longer
Correct Answer: D
Explanation: Current assets are those assets which are expected to be used or realized in
cash during the next operating cycle, which can be defined as the time elapsed from the
time the company spends cash until it turns inventory back into cash, or 12 months,
whichever is longer.
Ritz Corp. wished to acquire the stock of Stale, Inc. In conjunction with its plan of
acquisition Ritz hired Fein, CPA, to audit the financial statements of Stale. Based on
the audited financial statements and Fein's unqualified opinion, Ritz acquired Stale.
Within six months, it was discovered that the inventory of Stale had been overstated
by $500,000. Ritz commenced an action against Fein. Ritz believes that Fein failed to
exercise the knowledge, skill, and judgment commonly possessed by CPAs in the
locality, but is not able to prove that Fein either intentionally deceived it or showed a
reckless disregard for the truth. Ritz also is unable to prove that Fein had any

knowledge that the inventory was overstated. Which of the following two causes of
action would provide Ritz with proper bases upon which Ritz would most likely
prevail?
A)
B)
C)
D)
Negligence and breach of contract

Negligence and gross negligence
Negligence and fraud
Gross negligence and breach of contract
Correct Answer: A
Explanation: Liability for actual fraud requires proof of scienter, an intent to deceive.
With constructive fraud or gross negligence the scienter element is met by a reckless
disregard for the truth. Since Ritz cannot prove that Fein intentionally deceived or
showed a reckless disregard for the truth, Ritz would not prevail in either an action for
fraud or gross negligence.
The remaining answer choices are incorrect because Ritz will not prevail in an action for
fraud or gross negligence. For negligence a plaintiff must prove a duty of care, breach
(lack of due care), damages and causality. Failure of Fein to exercise the skill and care
possessed of CPA's in the locality would constitute a failure to use due care and would
make Fein liable for negligence. It would also be a breach of the contract for services that
Fein had with Ritz.
Yesterday's question:
A parent corporation owned more than 90% of each class of the outstanding stock
issued by a subsidiary corporation and decided to merge that subsidiary into itself.
Under the Revised Model Business Corporation Act, which of the following actions
must be taken?
A) The subsidiary corporation's board of directors must pass a merger resolution.
The subsidiary corporation's dissenting stockholders must be given an appraisal
B)
remedy.
C) The parent corporation's stockholders must approve the merger.
D) The parent corporation's dissenting stockholders must be given an appraisal remedy.
Correct Answer: B

Explanation: When a corporation owns 90% or more of the shares of a subsidiary
corporation, the subsidiary may be merged into the parent corporation without the
approval of the stockholders of either the parent corporation or the subsidiary corporation
and without the approval of the subsidiary corporation's board of directors. This is called
a short-form merger. In a short-form merger stockholders of the subsidiary corporation
have dissenters' rights, but the stockholders of the parent corporation do not.
Grum Corp., a publicly-owned corporation, is subject to the requirements for

segment reporting. In its income statement for the year ended December 31, 2008,
Grum reported consolidated revenues of $50,000,000, operating expenses of
$47,000,000, and net income of $3,000,000. Operating expenses include payroll costs
of $15,000,000. Grum's combined identifiable assets of all industry segments at
December 31, 2008, were $40,000,000. In its 2008 financial statements, Grum should
disclose major customer data if sales to any single customer amount to at least:
A)
B)
C)
D)
$300,000
$1,500,000
$4,000,000
$5,000,000
Correct Answer: D
Explanation: FASB #131 requires disclosure of major customer data if sales to any
major customer is 10% or more of consolidated revenues. Since consolidated revenues
amount to $50,000,000, disclosure of major customer data would be required if sales to
any single customer amount to $5,000,000. In addition the amount of revenue from each
major customer must be disclosed plus the name of the segment making the sale.
Hill, CPA, has been retained to audit the financial statements of Monday Co.
Monday's predecessor auditor was Post, CPA, who has been notified by Monday that
Post's services have been terminated. Under these circumstances, which party should
initiate the communications between Hill and Post?
A)
B)
C)
D)
Hill, the successor auditor

Post, the predecessor auditor
Monday's controller or CFO
The chairman of Monday's board of directors

Correct Answer: A
Explanation: AU 315 states that the initiative in communicating rests with the successor
auditor. The communication may be either written or oral. Both the predecessor and
successor auditors should hold in confidence information obtained from each other. This
obligation applies whether or not the successor accepts the engagement. Before
contacting the predecessor, the successor auditor must have the permission from the
client to do so.
Under which circumstance is the corporate veil most likely to be pierced and the
shareholders held personally liable?
A) The corporation has elected S corporation status under the Internal Revenue Code.
The shareholders have commingled their personal funds with those of the
B)
corporation.
C) An ultra vires act has been committed.
D) A partnership incorporates its business solely to limit the liability of its partners.
Correct Answer: B
Explanation: A stockholder may be held personally liable for corporate debts (piercing
the corporate veil). Specifically this may be done by a showing of fraud,
undercapitalization of the corporation and commingling of corporate and personal funds
by the stockholder. Thus, the corporate veil may be pierced if the stockholder
commingled their personal funds with those of the corporation. Choosing S corporation
status, commission of an ultra vires act and incorporation to obtain limited personal
liability are all insufficient grounds to pierce the corporate veil.
Which of the following provisions is basic to all workers' compensation systems?

A) The injured employee must prove the employer's negligence.
B) The employer may invoke the traditional defense of contributory negligence.
The employer's liability may be ameliorated by a co-employee's negligence under the
C)
fellowservant rule.
D) The injured employee is allowed to recover on strict liability theory.
Correct Answer: D

Explanation: Employees will receive workers' compensation benefits if injured in the
scope of employment. The employer is strictly liable without regard to fault. The
remaining answer choices are incorrect because negligence will not bar recovery.
Negligence is irrelevant. Thus, the employee does not need to prove the employer
negligent, the defense of contributory negligence by the employee is not available and the
liability of the employer is not changed by the negligence of a co-employee.
The following information pertains to Aria Corp. and its divisions for the year ended
December 31, 2010:
Sales to unaffiliated customers $2,000,000
Intersegment sales of products similar to those sold to unaffiliated customers 600,000
Interest earned on loans to other industry segments 40,000
Aria and all of its divisions are engaged solely in manufacturing operations. Aria has
a reportable segment if that segment's revenue exceeds:
A)
B)
C)
D)
$264,000
$260,000
$204,000
$200,000
Correct Answer: B
Explanation: The test is 10% of all sales including intersegment sales. Therefore, any
segment with revenues of $260,000 or more qualifies as a reporting segment.
Which of the following internal control activities most likely would prevent direct
labor hours from being charged to manufacturing overhead?
A)
B)
C)
D)
Periodic independent counts of work in process for comparison to recorded amounts

Comparison of daily journal entries with approved production orders
Use of time tickets to record actual labor worked on production orders
Reconciliation of work-in-process inventory with periodic cost budgets
Correct Answer: C

Explanation: Time tickets should be designed to keep track of hours worked, by whom,
and on what production orders. After approval by a production supervisor, time tickets
provide the information on number of hours worked directly on specific production
orders. If time tickets are properly used to record actual hours worked on orders, approval
and/or review of these cards should prevent direct labor hours from being incorrectly
charged to manufacturing overhead.
Counts of work in process will not provide breakdowns between direct and indirect
costs and therefore would not prevent direct labor hours from being incorrectly charged
to overhead.
Errors may be made on the production orders. In order to prevent and/or detect errors
regarding direct labor hours, the production orders would have to be compared to time
tickets.
Work-in-process inventory is a total which combines direct labor and manufacturing
overhead. Even if this total is correct, direct labor could have been incorrectly charged to
manufacturing overhead.
Destiny Manufacturing, Inc., is incorporated under the laws of Nevada. Its principal
place of business is in California and it has permanent sales offices in several other
states. Under the circumstances, which of the following is correct?
California may validly demand that Destiny incorporate under the laws of the state of
California.
Destiny must obtain a certificate of authority to transact business in California and
B)
the other states in which it does business.
C) Destiny is a foreign corporation in California, but not in the other states.
California may prevent Destiny from operating as a corporation if the laws of
D) California differ regarding organization and conduct of the corporation's internal
affairs.
A)
Correct Answer: B
Explanation: A foreign corporation is one doing business in any state other than their
state of incorporation. A foreign corporation must obtain a certificate of authority from
each state in which they do business. Thus, Destiny is a foreign corporation in California
because they were incorporated in Nevada and they were doing business in California.
Destiny must obtain a certificate of authority from California and all other states in which
it does business. Incorporation is not required merely because a corporation is doing
business in a state. Destiny is a foreign corporation in any state in which it does business.

Destiny as a Nevada corporation is only required to comply with Nevada's requirements
for incorporation and not California's requirements.
In a properly designed internal control system, the same employee most likely would
match vendors' invoices with receiving reports and also:
A)
B)
C)
D)
Post the detailed accounts payable records

Recompute the calculations on vendors' invoices
Reconcile the accounts payable ledger
Cancel vendors' invoices after payment
Correct Answer: B
Explanation: The accounts payable, or vouchers payable, department has the
responsibility to prepare vouchers for payment. As part of that process, an employee in
that department should check vendors' invoices for mathematical accuracy by
recomputing calculations and extensions, and should match the vendors' invoices with
receiving report sand purchase orders for quantities, prices, and terms.
P Co. purchased term bonds at a premium on the open market. These bonds
represented 20 percent of the outstanding class of bonds issued at a discount by S
Co., P's wholly owned subsidiary. P intends to hold the bonds until maturity. In a
consolidated balance sheet, the difference between the bond carrying amounts in the
two companies would be:
A)
B)
C)
D)
Included as a decrease to retained earnings

Included as an increase to retained earnings
Reported as a deferred debit to be amortized over the remaining life of the bonds
Reported as a deferred credit to be amortized over the remaining life of the bonds
Correct Answer: A
Explanation: In consolidation, the acquisition of the bonds payable of one of the
consolidating companies by another of the consolidating companies is treated (basically)
as a retirement of debt. The investment in bonds is eliminated against the bonds payable
and its related accounts and any difference is treated as a gain or loss.

The carrying value of the bonds is less than the amount paid to acquire the bonds as they
were issued at a discount (below face value) and acquired at a premium (above face
value). Therefore, there would be a loss on the elimination of intercompany bonds in
consolidation, resulting in a decrease in consolidated retained earnings.
Generally, which of the following statements concerning workers' compensation laws

is correct?
A)
B)
C)
D)
The amount of damages recoverable is based on comparative negligence.

Employers are strictly liable without regard to whether or not they are at fault.
Workers' compensation benefits are not available if the employee is negligent.
Workers' compensation awards are payable for life.
Correct Answer: B
Explanation: Employees will receive workers' compensation benefits if injured in the
scope of employment. The employer is strictly liable without regard to fault.
Negligence by the employee will not bar recovery or change the amount of the award.
Workers' compensation awards may be in the form of a lump sum and, thus, not be
payable for life.
Which of the following most likely would not be considered an inherent limitation of
the potential effectiveness of an entity's internal control?
A)
B)
C)
D)
Incompatible duties
Management override
Mistakes in judgment
Collusion among employees
Correct Answer: A
Explanation: Segregating incompatible duties is a typical control procedure. Thus, the
existence of incompatible duties is a weakness in control procedures, not an inherent
limitation of the internal control structure. Even if control policies and procedures are

placed in operation, the potential effectiveness of an entity's internal control structure is
subject to inherent limitations. Mistakes in the application of policies and procedures may
arise from such causes as mistakes in judgment as well as personal carelessness, fatigue,
and distraction. Also, policies and procedures that require segregation of duties can be
circumvented by management override or collusion among internal or external parties.
Grant, Inc. acquired 30% of South Co.'s voting stock for $200,000 on January 2,
Year 2. Grant's 30% interest in South gave Grant the ability to exercise significant
influence over South's operating and financial policies. During Year 2, South earned
$80,000 and paid dividends of $50,000. South reported earnings of $100,000 for the
six months ended June 30, Year 3, and $200,000 for the year ended December 31,
Year 3. On July 1, Year 3, Grant sold half of its stock in South for $150,000 cash.
South paid dividends of $60,000 on October 1, Year 3.
Before income taxes, what amount should Grant include in its Year 2 income
statement as a result of the investment?
A)
B)
C)
D)
$15,000
$24,000
$50,000
$80,000
Correct Answer: B
Explanation: $24,000 Investment income. As Grant's investment gives it the ability to
exercise significant influence over South's operating and financial policies, the equity
method would be used to account for the investment. Grant's equity in South's income is
$24,000 (30% x $80,000 income).
Long, Pine, and Rice originally contributed $100,000, $60,000, and $20,000,
respectively, to form the LPR Partnership. Profits and losses of LPR are to be
distributed 1/2 to Long, 1/3 to Pine, and 1/6 to Rice. After operating for one year,
LPR's total assets on its books are $244,000, total liabilities to outside creditors are
$160,000 and total capital is $84,000. The partners made no withdrawals. LPR has
decided to liquidate. If all of the partners are solvent and the assets of LPR are sold
for $172,000
A) Rice will personally have to contribute an additional $8,000.
B) Pine will personally have to contribute an additional $4,000.

Long, Pine, and Rice will receive $6,000, $4,000, and $2,000, respectively, as a
return of capital.
Long and Pine will receive $28,000 and $4,000, respectively, and Rice will have to
D)
contribute an additional $20,000.
C)
Correct Answer: D
Explanation: Upon dissolution of a general partnership the following order of
distribution occurs: first creditors are paid, second partners are repaid for any loans or
advances made to the partnership, third capital contributions are paid and lastly profits
are split.
Creditors are owed $160,000, there are no loans made by partners and a total of $180,000
is due for capital contributions (Long - $100,000, Pine - $60,000 and Rice- $20,000).
Thus, $340,000 is needed to pay creditors and capital contributions ($180,000 +
$160,000). Of the $340,000 needed, only $172,000 is available from the sale of assets.
This leaves a shortfall of $168,000 ($340,000 minus $172,000 = $168,000). Long's share
of the shortfall is 1/2 of $168,000 or $84,000. Thus, Long will receive his capital
contribution ($100,000) minus his share of the shortfall ($84,000), or $16,000. Pine's
share of the shortfall is 1/3 of $168,000 or $56,000. Thus Pine will receive his capital
contribution ($60,000) minus his share of the shortfall ($56,000), or $4,000. Rice's share
of the shortfall is 1/6 of $168,000 or $28,000. Rice will receive his capital contribution
($20,000) minus his share of the shortfall ($28,000) leaving a negative balance of $8,000.
Thus, Rice will have to contribute an additional $8,000.
One of the elements necessary to recover damages if there has been a material
misstatement in a registration statement filed under the Securities Act of 1933 is that
the _________________
A)
B)
C)
D)
issuer and plaintiff were in privity of contract with each other.

issuer failed to exercise due care in connection with the sale of the securities.
plaintiff gave value for the security.
plaintiff suffered a loss.
Correct Answer: D
Explanation: To recover damages under Section 11 of the Securities Act of 1933, the
plaintiff must prove that: (s)he acquired securities subject to registration, suffered a loss
and there was a material misrepresentation or omission of fact in the registration

statement. Thus, the plaintiff must prove (s)he suffered a loss. The plaintiff does not need
to prove privity, lack of due care or that (s)he paid value for the security.
A plaintiff wishes to recover damages from the issuer for losses resulting from
material misstatements in a securities registration statement. In order to be
successful, one of the elements the plaintiff must prove is that the
_________________
plaintiff was in privity of contract with the issuer or that the issuer knew of the
plaintiff.
B) plaintiff acquired the securities.
C) issuer acted negligently.
D) issuer acted fraudulently.
A)
Correct Answer: B
Explanation: o recover damages under Section 11 of the Securities Act of 1933, the
plaintiff must prove that: (s)he acquired securities subject to registration, suffered a loss
and there was a material misrepresentation or omission of fact in the registration
statement. Thus, the plaintiff must prove (s)he acquired the securities. The remaining
answer choices are incorrect because the plaintiff does not need to prove privity,
negligence or fraud.
Sage, Inc., bought 40% of Adams Corp.'s outstanding common stock on January 2,
Year 2, for $400,000. The carrying amount of Adams' net assets at the purchase date
totaled $900,000. Fair values and carrying amounts were the same for all items
except for plant and inventory, for which fair values exceeded their carrying amounts
by $90,000 and $10,000, respectively. The plant has an 18-year life. All inventory was
sold during Year 2. During Year 2, Adams reported net income of $120,000 and paid
a $20,000 cash dividend. What amount should Sage report in its income statement
from its investment in Adams for the year ended December 31, Year 2?
A)
B)
C)
D)
$48,000
$42,000
$36,000
$32,000
Correct Answer: B

Explanation: $42,000 income from investment in Adams. Under the equity method the
investor recognizes in income its share of the investee's net income or loss subsequent to
the date of acquisition. Furthermore, the investor should reflect adjustments which would
be made in consolidation, based on the investor's percentage ownership, if such
adjustments (eliminations) can be recorded between investment income and the
investment account.
When the shipping department returns nonconforming goods to a vendor, the

purchasing department should send to the accounting department the:
A)
B)
C)
D)
Unpaid voucher
Debit memo
Vendor invoice
Credit memo
Correct Answer: B
Explanation: The accounting department is responsible for recording amounts due to
vendors. If goods are returned to a vendor, a debit memo should be prepared indicating
that the buyer is debiting the vendor's payable account. The purchasing department may
prepare the debit memo, but the accounting department needs the debit memo to record
the reduction in the account payable account.
Downs, Frey, and Vick formed the DFV general partnership to act as manufacturers'
representatives. The partners agreed Downs would receive 40% of any partnership
profits and Frey and Vick would each receive 30% of such profits. It was also agreed
that the partnership would not terminate for five years. After the fourth year, the
partners agreed to terminate the partnership. At that time, the partners' capital
accounts were as follows: Downs, $20,000; Frey, $15,000; and Vick, $10,000. There
also were undistributed losses of $30,000.
Which of the following statements about the form of the DFV partnership agreement
is correct?
A)
B)
C)
D)
It must be in writing because the partnership was to last for longer than one year.
It must be in writing because partnership profits would not be equally divided.
It could be oral because the partners had explicitly agreed to do business together.
It could be oral because the partnership did not deal in real estate.

Correct Answer: A
Explanation: A partnership impossible to complete in one year would require a writing
under the statute of frauds. The partners agreed the partnership was not to be terminated
for five years and thus, a writing was required. How profits are to be divided has no
bearing on whether a writing is required. A writing was required for this partnership and
thus, the partnership could not be oral.
Daly tried to collect on a property insurance policy covering a house that was
damaged by fire. The insurer denied recovery, alleging that Daly had no insurable
interest in the house. In which of the following situations will the insurer prevail?
A)
B)
C)
D)
The house belongs to a corporation of which Daly is a 50% stockholder.

Daly is not the owner of the house but a long-term lessee.
The house is held in trust for Daly's mother and, on her death, will pass to Daly.
Daly gave an unsecured loan to the owner of the house to improve the house.
Correct Answer: D
Explanation: An insurable interest is some economic interest in the goods at time of
loss. An unsecured creditor does not have an insurable interest in the debtor's property.
Thus, Daly would not have an insurable interest in the house because Daly was an
unsecured creditor.
A 50% stockholder would have an insurable interest in a house owned by the
corporation.
A lessee has an insurable in the house that they lease.
A remainderman in a trust has an insurable interest in the property of the trust.
Which of the following controls most likely would help ensure that all credit sales
transactions of an entity are recorded?
The billing department supervisor sends copies of approved sales orders to the credit
A) department for comparison to authorized credit limits and current customer account
balances.

The accounting department supervisor independently reconciles the accounts
receivable subsidiary ledger to the accounts receivable control account monthly.
The accounting department supervisor controls the mailing of monthly statements to
C)
customers and investigates any differences reported by customers.
The billing department supervisor matches prenumbered shipping documents with
D)
entries in the sales journal.
B)
Correct Answer: D
Explanation: A sale typically occurs and should be recorded when goods are shipped.
Matching prenumbered shipping documents with sales journal entries is a good control to
ensure that all sales are recorded. All the shipping documents should be accounted for as
either resulting in a journal entry or having been voided.
On July 1, Year 3, Denver Corp. purchased 3,000 shares of Eagle Co.'s 10,000
outstanding shares of common stock for $20 per share. On December 15, Year 3,
Eagle paid $40,000 in dividends to its common stockholders. Eagle's net income for
the year ended December 31, Year 3, was $120,000, earned evenly throughout the
year. In its Year 3 income statement, what amount of income from this investment
should Denver report?
A)
B)
C)
D)
$36,000
$18,000
$12,000
$6,000
Correct Answer: B
Explanation: Denver Corp. acquired 30% of Eagle Company's outstanding common
stock. With no evidence to the contrary, an investment of 20% or more is assumed to give
significant influence, and would be accounted for using the equity method. Under the
equity method the investor recognizes in income its share of the investee's net income or
loss subsequent to the date of acquisition. Investment income = $120,000 x 30% x 1/2
year = $18,000.

Dowd, Elgar, Frost, and Grant formed a general partnership. Their written
partnership agreement provided that the profits would be divided so that Dowd
would receive 40%; Elgar, 30%; Frost 20%; and Grant, 10%. There was no
provision for allocating losses. At the end of its first year, the partnership had losses
of $200,000. Before allocating losses, the partners' capital account balances were:
Dowd, $120,000; Elgar, $100,000; Frost, $75,000; and Grant, $11,000. Grant refuses
to make any further contributions to the partnership. Ignore the effects of federal
partnership tax law.
What would be Grant's share of the partnership losses?
A)
B)
C)
D)
$9,000
$20,000
$39,000
$50,000
Correct Answer: B
Explanation: If a division of profits is specified in a partnership agreement, but not a
division of losses, losses will be divided in the same manner as profits. This partnership
agreement specified that profits were to be split Dowd - 40%, Elgar - 30%, Frost - 20%
and Grant - 10%. Therefore losses must be split the same way. With losses of $200,000
and Grant's share being 10%, Grant's share of the losses would be $20,000.
Cass is a general partner in Omega Company general partnership. Which of the

following unauthorized acts by Cass will bind Omega?
A)
B)
C)
D)
Submitting a claim against Omega to arbitration.

Confessing a judgment against Omega.
Selling Omega's goodwill.
Leasing office space for Omega.
Correct Answer: D
Explanation: It takes unanimous consent of all partners to submit a claim to arbitration,
to confess a judgment (admit liability in a law suit) and to sell the partnership's goodwill.
Leasing office space for the partnership by a partner would be within the partner's
apparent authority. Since it would be reasonable to believe that a partner could lease
space, the partnership would be bound.
An auditor's primary consideration regarding an entity's internal control policies

and procedures is whether the policies and procedures:
A)
B)
C)
D)
Affect the financial statement assertions

Prevent management override
Relate to the control environment
Reflect management's philosophy and operating style
Correct Answer: A
Explanation: Internal control structure policies and procedures relevant to an audit are
those that pertain to an entity's ability to record, process, summarize, and report financial
data consistent with management's assertions. The auditor's primary concern is the affect
those policies and procedures have on the financial statement assertions.
"Prevent management override" is an inherent limitation of internal control structures.
"Relate to the control environment" is one element of the internal control structure.
"Reflect management's philosophy and operating style" is a factor comprising the
control environment element of the internal control structure.
The earliest time a purchaser of existing goods will acquire an insurable interest in
those goods is when _________________
A)
B)
C)
D)
the purchaser obtains possession.

title passes to the purchaser.
performance of the contract has been completed or substantially completed.
the goods are identified to the contract.
Correct Answer: D
Explanation: The earliest time a buyer of existing goods will obtain an insurable interest
in the goods is when the goods are identified to the contract (marked or tagged as goods
for this specific buyer). The remaining answer choices are incorrect because a buyer may
obtain an insurable interest prior to obtaining possession, prior to obtaining title or prior

to substantially completing performance of the contract as long as the goods have been
identified.
Bren Co.'s beginning inventory at January 1, 2011, was understated by $26,000, and
its ending inventory was overstated by $52,000. As a result, Bren's cost of goods sold
for 2011 was:
A)
B)
C)
D)
Understated by $26,000
Overstated by $26,000
Understated by $78,000
Overstated by $78,000
Correct Answer: C
Explanation: When beginning inventory is understated, cost of goods sold will be
understated by the same amount. When ending is overstated, cost of goods sold will be
understated in an equal amount. Therefore, the effect of both of these errors is to
understate cost of goods sold by $78,000 ($26,000 + $52,000).
Queen paid Pax & Co. to become the surety on a loan which Queen obtained from
Squire. The loan is due and Pax wishes to compel Queen to pay Squire. Pax has not
made any payments to Squire in its capacity as Queen's surety. Pax will be most
successful if it exercises its right to _________________
A)
B)
C)
D)
reimbursement (Indemnification).
contribution.
exoneration.
subrogation.
Correct Answer: C
Explanation: Exoneration is the right of a surety prior to payment to get a court order
demanding that the debtor pay. Exoneration is the only right the surety may use prior to
payment. Reimbursement (the right of a surety to recover from the debtor payments made
to the creditor) only occurs after payment by the surety. Subrogation (the right of the
surety to gain the creditor's rights once the surety makes full payment) only occurs after
payment by the surety. Contribution (the right of a cosuretor to receive a pro rata
contribution from other cosuretors for amounts paid the creditor) only occurs after

payment by the cosurety. Since Pax the surety has not made any payments to the creditor,
the only right Pax can successfully assert is the right of exoneration.
To exercise due professional care an auditor should:

A)
B)
C)
D)
Attain the proper balance of professional experience and formal education

Design the audit to detect all instances of illegal acts
Critically review the judgment exercised by those assisting in the audit
Examine all available corroborating evidence supporting management's assertions
Correct Answer: C
Explanation: The third general standard is: Due professional care is to be exercised in
the performance of the audit and the preparation of the report. Exercise of due care
requires critical review at every level of supervision of the work done and the judgment
exercised by those assisting in the audit. The correct answer choice relates to the first
general standard. The incorrect answer choices include the word "all." Auditors are not
expected to examine all the evidence and detect all illegal acts.
During periods of rising prices, when the FIFO inventory method is used, a perpetual
inventory system results in an ending inventory cost that is:
A) The same as in a periodic inventory system
B) Higher than in a periodic inventory system
C) Lower than in a periodic inventory system
Higher or lower than in a periodic inventory system, depending on whether physical
D)
quantities have increased or decreased
Correct Answer: A
Explanation: Under the FIFO method, the cost of the oldest purchases are charged to
cost of goods sold and the costs of the most current purchases are assigned to ending
inventory. Therefore, the costs assigned to ending inventory and cost of goods sold are
the same when a periodic or perpetual inventory system is used with the FIFO cost flow
assumption.

Generally, under the Revised Uniform Partnership Act, a partnership has which of
the following characteristics?
1. Unlimited duration
2. Obligation for payment of federal income tax
A)
B)
C)
D)
Unlimited duration
Obligation for payment of federal income tax
Unlimited duration & obligation for payment of federal income tax
Neither unlimited duration nor obligation for payment of federal income tax
Correct Answer: D
Explanation: A partnership is not usually considered to be a separate legal entity.
Specifically, a partnership does not pay federal income tax. A partnership does not have
perpetual existence like a corporation.
When using the periodic-inventory method, which of the following generally would
not be separately accounted for in the computation of cost of goods sold?
A)
B)
C)
D)
Trade discounts applicable to purchases during the period

Cash (purchase) discounts taken during the period
Purchase returns and allowances of merchandise during the period
Cost of transportation-in for merchandise purchased during the period
Correct Answer: A
Explanation: Cash discounts, purchase returns and allowances, and cost of
transportation-in all occur after the actual purchase and would be accounted for
separately in cost of goods sold. Trade discounts are deducted from a list price in arriving
at the price charged the buyer and recorded on the purchase invoice and would not be
recorded separately.
An auditor uses the knowledge provided by the understanding of internal control

and the final assessed level of control risk primarily to determine the nature, timing,
and extent of the:
A) Attribute tests

B) Compliance tests
C) Tests of controls
D) Substantive tests
Correct Answer: D
Explanation: Substantive tests are audit tests performed to substantiate the fairness of
presentation of each account on the financial statements. The nature, timing, and extent of
substantive tests are determined by the creditor's assessment of control risk. The
remaining answer choices are synonymous terms, and these tests are used to determine
whether internal control procedures are actually in place in the client's operation.
When a principal debtor defaults and a surety pays the creditor the entire obligation,
which of the following remedies gives the surety the best method of collecting from
the debtor?
A)
B)
C)
D)
Exoneration
Contribution
Subrogation
Attachment
Correct Answer: C
Explanation: The right of subrogation allows the surety to gain the creditor's rights, once
the creditor has been paid in full. Subrogation would give a surety not only their own
right to collect from the debtor (reimbursement), but also additional rights that the
creditor might have had.
Exoneration would simply give a surety a court order demanding that the debtor pay.
Exoneration does not confer additional collection rights against the debtor.
Contribution is only available to one cosuretor against other cosuretors. It is not
available against the debtor.
Attachment is the right of all creditors to place a lien on a debtor's property so it will be
available to satisfy a judgment. Subrogation is the better answer because it is specific to
surety's collection rights against a debtor and gives the surety additional rights.

Which of the following requirements must be met to have a valid partnership exist?
1. Co-ownership of all property used in a business.
2. Co-ownership of a business for profit.
A)
B)
C)
D)
(1) only
(2) only
(1) & (2)
Neither
Correct Answer: B
Explanation: A partnership is an association of two or more co-owners of a business for
profit. Thus, (2) is a requirement of a partnership. It is not necessary that each piece of
property used in the business be co-owned by all the partners. For example, the
partnership may lease equipment from a third party or may use property that is owned by
one partner and not others. Thus (1) is not a requirement of a partnership.
A secured promissory note would be nonnegotiable if it provided that

_________________
additional collateral must be tendered if there is a decline in market value of the
original collateral.
B) upon default, the maker waives a trial by jury.
C) the maker is entitled to a 5% discount if the note is prepaid.
D) it is subject to the terms of the mortgage given by the maker to the payee.
A)
Correct Answer: D
Explanation: For an instrument to be negotiable, it must be an unconditional promise or
order. If it is subject to another agreement or transaction it is non-negotiable.
References to collateral will not prevent negotiability unless it is subject to the terms of
that collateral.
Waiver of trial by jury does not make the note conditional and thus does not affect
negotiability.
Prepayment will not prevent negotiability.
The independent auditor should acquire an understanding of a client's internal audit

function to determine whether the work of internal auditors will be a factor in
determining the nature, timing, and extent of the independent auditor's procedures.
The work performed by internal auditors might be such a factor when the internal
auditor's work includes:
A) Verification of the mathematical accuracy of invoices
Review of administrative practices to improve efficiency and achieve management
B)
objectives
C) Study and evaluation of internal accounting control
D) Preparation of internal financial reports for management purposes
Correct Answer: C
Explanation: The work of internal auditors is a part of, but not a substitute for, the
independent auditor's evaluation of internal control. "Verification of the mathematical
accuracy of invoices " is work not necessarily performed by internal auditors. The
remaining answer choices do not directly affect internal accounting control.
A retained earnings appropriation can be used to:

A)
B)
C)
D)
Absorb a fire loss when a company is self-insured.

Provide for a contingent loss that is probable and reasonable.
Smooth periodic income.
Restrict earnings available for dividends.
Correct Answer: D
Explanation: An appropriation of retained earnings (a reserve) is used to inform
financial statement users of a restriction on the availability of retained earnings for
dividends. The entry to record an appropriation charges Retained Earnings and credits
Appropriated Retained Earnings. When the appropriation is no longer needed, the only
proper entry is to reverse the entry that established the appropriation.
Which of the following steps in the strategic planning process should be completed
first?

A)
B)
C)
D)
Translate objectives into goals

Determine actions to achieve goals
Develop performance measures
Create a mission statement
Correct Answer: D
Explanation: The creation of a mission statement is always the first step in the strategic
planning process. The mission statement outlines the essential reasons for its existence.
Translating of objectives into goals, determining actions to achieve goals, and developing
performance measures are steps that follow the mission statement.
Burn Manufacturing borrowed $500,000 from Howard Finance Co., secured by

Burn's present and future inventory, accounts receivable, and the proceeds thereof.
The parties signed a financing statement that described the collateral and it was filed
in the appropriate state office. Burn subsequently defaulted in the repayment of the
loan and Howard attempted to enforce its security interest. Burn contended that
Howard's security interest was unenforceable. In addition, Green, who subsequently
gave credit to Burn without knowledge of Howard's security interest, is also
attempting to defeat Howard's alleged security interest. The security interest in
question is valid with respect to _________________
A)
B)
C)
D)
both Burn and Green.

neither Burn nor Green.
burn but not Green.
green but not Burn.
Correct Answer: A
Explanation: A creditor with a security interest will have rights against a debtor when
attachment has occurred. Three elements are required for attachment: an agreement
between the debtor and the creditor, value must be given by the creditor and the debtor
must have rights in the collateral. Howard will have rights against Burn (debtor), because
there was a written security agreement, value was given by Howard ($500,000) and the
debtor had rights in the collateral (inventory and accounts receivable). When two
creditors are fighting over the same collateral, usually the first creditor to perfect wins.
Since Howard perfected by filing before Green gave credit, Howard's security interest has
priority over Green.
When a company declares a cash dividend, retained earnings is decreased by the

amount of the dividend on the date of:
A)
B)
C)
D)
Declaration
Record
Payment
Declaration or record, whichever is earlier
Correct Answer: A
Explanation: Dividends are recorded as a liability and reduction of retained earnings at
the date of declaration.
Tests of controls are performed in order to determine whether or not:

A)
B)
C)
D)
Controls are functioning as designed.

Necessary controls are absent.
Incompatible functions exist.
Material dollar errors exist.
Correct Answer: A
Explanation: Tests of controls are designed to determine whether the control procedures
prescribed by the client are actually functioning. An example of a test of controls would
be to examine purchase orders for proper authorization.
Under the balanced scorecard concept developed by Kaplan and Norton, employee
satisfaction and retention are measures used under which of the following
perspectives?
A)
B)
C)
D)
Customer
Internal business
Learning and growth
Financial
Correct Answer: C
Explanation: The balance scorecard approach is an outgrowth of the old goal
congruence concept. In both ideas, the effort was to look at the tradeoffs associated with
each decision. For example, a company may invest $100,000 in a machine that is more
efficient and increases profits versus investing in R&D. The decision may be the right
one but at some point the scorecard has to be balanced and the company has to invest in
R&D. A typical scorecard includes profitability; customer satisfaction; innovation;
learning and growth; and efficiency, quality and time. Employee satisfaction and
retention are a part of learning and growth.
Major Corp. is considering the purchase of a new machine for $5,000 that will have
an estimated useful life of five years and no salvage value. The machine will increase
Major's after-tax cash flow by $2,000 annually for five years. Major uses the
straight-line method of depreciation and has an incremental borrowing rate of 10%.
The present value factors for 10% are as follows:
Ordinary annuity with five payments 3.79
Annuity due for five payments 4.17
Using the payback method, how many years will it take to pay back Major's initial
investment in the machine?
A)
B)
C)
D)
2.50
5.00
7.58
8.34
Correct Answer: A
Explanation: The payback method is the original investment divided by cash flow after
taxes, or $5,000 divided by $2,000 for a payback of 2.5 years. Payback does not utilize
discounted cash flows, so the information regarding the time value of money is not
needed to solve the problem.

On December 1, 2009, Line Corp. received a donation of 2,000 shares of its $5 par
value common stock from a stockholder. On that date, the stock's market value was
$35 per share. The stock was originally issued for $25 per share. By what amount
would this donation cause total stockholders' equity to decrease?
A)
B)
C)
D)
$70,000
$50,000
$20,000
$0
Correct Answer: D
Explanation: A donation of stock to the corporation causes no reduction of assets and
therefore does not affect total stockholders' equity. Under the cost method, there would be
only a memorandum entry in the treasury stock account. When reissued, the proceeds
would be credited to APIC: Donated Capital. Under the par value method, Treasury Stock
would be debited and APIC: Donated Capital would be credited for the par value. When
reissued, proceeds in excess of par would be credited to APIC: Donated Capital.
Attachment and perfection will occur simultaneously when _________________

A)
B)
C)
D)
the security agreement so provides.

there is a purchase money security interest taken in inventory.
attachment is by possession.
the goods are sold on consignment.
Correct Answer: C
Explanation: There are only three different ways to perfect: by possession, by filing and
perfection by attachment. Possession will not only create the security agreement required
for attachment, but will also result in perfection. Thus when attachment is by possession,
attachment and possession occur simultaneously. Note that they would also occur
simultaneously when perfection by attachment occurs.
Perfection will not occur merely because the security agreement so provides. You must
perfect by one of the three methods.
No possession or filing occurred and perfection by attachment requires a PMSI creditor

in consumer goods, not a PMSI creditor in inventory. Thus, no perfection occurred.
No possession, filing or perfection by attachment occurred and therefore there is no
perfection.
To obtain evidence that user identification and password controls are functioning as
designed, an auditor would most likely:
A) Attempt to sign-on to the system using invalid user identifications and passwords.
Write a computer program that simulates the logic of the client's access control
B)
software.
Extract a random sample of processed transactions and ensure that the transactions
C)
were appropriately authorized.
Examine statements signed by employees stating that they have not divulged their
D)
user identifications and passwords to any other person.
Correct Answer: A
Explanation: The correct choice is to attempt to sign-on to the system using invalid user
identifications and passwords. This will provide the auditor with the most competent
evidence that the user identification and password controls are functioning as designed.
The other answers do not relate directly to actual system access; they refer to
programming, authorization and written statements.
Winslow Co., which is in the business of selling furniture, borrowed $60,000 from
Pine Bank. Winslow executed a promissory note for that amount and used all of its
accounts receivable as collateral for the loan. Winslow executed a security agreement
that described the collateral. Winslow did not file a financing statement. Which of the
following statements best describes this transaction?
Perfection of the security interest occurred even though Winslow did not file a
Perfection of the security interest occurred by Pine having an interest in accounts
B)
receivable.
Attachment of the security interest did not occur because Winslow failed to file a
C)
Attachment of the security interest occurred when the loan was made and Winslow
D)
executed the security agreement.
A)

Correct Answer: D
Explanation: Three elements are required for attachment: an agreement between the
debtor and the creditor, value must be given by the creditor and the debtor must have
rights in the collateral. Attachment occurred when the loan was made because an
executed agreement was present, Pine gave value by making the loan and the debtor
certainly had rights in the collateral since the collateral was all of the debtor's receivables.
Filing is the only way to perfect with accounts receivable and no filing occurred.
The existence of audit risk is recognized by the statement in the auditor's standard
report that the:
Auditor is responsible for expressing an opinion on the financial statements, which
are the responsibility of management
Financial statements are presented fairly, in all material respects, in conformity with
B)
GAAP
Audit includes examining, on a test basis, evidence supporting the amounts and
C)
disclosures in the financial statements
Auditor obtains reasonable assurance about whether the financial statements are free
D)
of material misstatement
A)
Correct Answer: D
Explanation: AU 312 states that the existence of audit risk is recognized by the
statement in the auditor's standard report that the audit or obtained reasonable assurance
about whether the financial statements are free of material misstatement. Audit risk is the
risk that the auditor may unknowingly fail to appropriately modify the opinion on
financial statements that are materially misstated.
The sentence in the opinion in the financial statement is a division of responsibilities
between management and auditor. That portion of the report is supporting the opinion
rendered. The statement explains that due to timing and cost constraints the auditor has to
audit less than all evidence available through the use of statistical sampling.
Eagle and Falk are partners with capital balances of $45,000 and $25,000,
respectively. They agree to admit Robb as a partner. After the assets of the

partnership are revalued, Robb will have a 25% interest in capital and profits, for an
investment of $30,000. What amount should be recorded as goodwill to the original
partners?
A)
B)
C)
D)
$0
$5,000
$7,500
$20,000
Correct Answer: D
Explanation: Robb's investment of $30,000 for a 25% partnership interest represents an
objective basis for the determination of the fair value of the partnership and for the
calculation of goodwill. If $30,000 is 25% of the fair value of the partnership, then the
total fair value is $120,000 ($30,000 / 25%). The difference between the fair value of the
partnership ($120,000) and the total book value of the three partner's capital of $100,000
($45,000 + $25,000 + $30,000) is goodwill of $20,000.
The discount rate (hurdle rate of return) must be determined in advance for the
A)
B)
C)
D)
Payback period method.

Time adjusted rate of return method.
Net present value method.
Internal rate of return method.
Correct Answer: C
Explanation: The Net Present Value method discounts future cash flow benefits using
the cost of capital as the discount rate.
The payback period method does not employ a discount rate. "Time adjusted rate of
return method" and "Internal rate of return method" are incorrect as they are the same
method and it solves for the discount rate which equates the investment cost and the
future cash benefits.

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CPA REVIEW QUESTIONS

Recomputing a sample of large-dollar transactions occurring after year end for

B) Investigating changes in stockholders' equity occurring after year end.

D) Confirming bank accounts established after year end.

An increase in the corporate income tax rate.