Katherine Lupo

2-25 LO 6 The following factors describe a potential audit client. For each factor,
indicate whether it is indicative of poor corporate governance. Explain the
reasoning for your assessment. Finally, identify the risks to reliable financial
reporting that are associated with each factor.

a. The company is in the financial services sector and has a large number of
consumer loans, including mortgages, that are outstanding.

Answer: It is not indicative of poor corporate governance; the company

provides the loans to clients therefore the only risk is if they do not pay the
loan back.

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b. The CEO’s and CFO’s compensation is based on three components: (a) base

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salary, (b) bonus based on growth in assets and profits, and (c) significant

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stock options.

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Answer: It is indicative of poor corporate governance, because the CEO’s
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and CFO’s have an incentive to boost the company’s stock.
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c. The audit committee meets semiannually. It is chaired by a retired CFO
who knows the company well because she had served as the CFO of a
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division of the firm. The other two members are local community members
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—one is the president of the Chamber of Commerce and the other is a

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retired executive from a successful local manufacturing firm.

Answer: This is indicative of poor corporate governance; the audit

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committee most likely does not devote a lot of time to the company
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because it only meets twice a year. Also two of the members may not have
much experience dealing with financials
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d. The company has an internal auditor who reports directly to the CFO and
makes an annual report to the audit committee.
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Answer: I don’t this is indicative of poor corporate governance; I think

there could be more people involved with the system to have more checks
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and balances, but it is not necessarily needed.

e. The CEO is a dominating personality—not unusual in this environment. He

has been on the job for six months and has decreed that he is streamlining
the organization to reduce costs and centralize authority (most of it in
him).

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 Answer: This can be indicative of poor corporate governance, because if
the CEO becomes intimidating to the other staff and he has all the power
he could be asking them to commit fraud knowing they won’t speak out
against him.

f. The company has a loan committee. It meets quarterly to approve, on an

ex-post basis, all loans over $300 million (top 5% for this institution).

Answer: This is indicative of poor corporate governance, because they only

meet four times a year which is not enough, and they only check large
loans and only after they have been made. More checks and balances need
to be in place someone could be taking out small loans and saying they
have been paid.

g. The previous auditor has resigned because of a dispute regarding the

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accounting treatment and fair value assessment of some of the loans.

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Answer: This is indicative of poor corporate governance, because the
previous auditor quit because of the way things were being done which

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means they probably weren’t being don’t correctly and nobody wanted to
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correct them.
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2-33 PCAOB (LO 5)

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The development of the PCAOB is a significant component of the Sarbanes-Oxley

Act of 2002. Go to the PCAOB’s website www.pcaobus.org to learn more about the
organization.
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a. Identify the responsibilities of the PCAOB as described in the web site. How
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does the inspection process performed by the PCAOB likely affect the
practice of external auditing?
Answer: The PCAOB oversees the audits of public companies, oversees the
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audits of brokers and dealer, improve audit quality, reduce auditing

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failures, and to encourage public trust. The inspection process helps to

ensure that auditors are providing quality work.
b. The PCAOB can have no more than two CPAs among its five members. Read
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the biographies of the current board members and note which have the
CPA designation. What might be the rationale for such a requirement?
What are the advantages and disadvantages of the limitation concerning
CPA members on the board?

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 Answer: James G. Kaiser and Duane M. DesParte are the two current CPAs
on the board. Having only two members be CPAs allows a mix of
professions to serve on the board, leaving the board to make company’s
affairs in finances more broad rather than focusing on other accounting
aspects.
c. Do the auditing standards set by the PCAOB apply to audits of nonpublic
companies? Explain.
Answer: nonpublic audits comply with the PCAOB because they adopted a
lot of the standards from the ASB.

2-34 SEC (LO 5, 6)

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The Sarbanes-Oxley Act mandates that the audit committee of the board of

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directors of public companies be directly responsible for the appointment,

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compensation, and oversight of the external auditors. In addition, the audit
committee must preapprove all nonaudit services that might be performed by the

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audit firm.
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a. Discuss the rationale for this mandate, as opposed to the alternative of
letting the shareholders, CFO, or CEO have these responsibilities.
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Answer: Shareholders most likely do not have much experience about

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external auditors, if the CFO or CEO has control over the external auditor
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then the auditor will most likely favor management. The best option is to
adopt an audit committee that can represent both the shareholders and the
CFO and CEO.
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b. What factors should the audit committee consider in evaluating the

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independence of the external auditor?

Answer: The committee wants to ensure the auditor is independent in fact
and appearance.
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