Master of Accountancy Comprehensive Examination

Fall 2003

  1. The fall of Enron and the resulting failure of Arthur Andersen changed the environment of auditing in far-reaching ways.
  2. Describe as carefully as you can at least four changes that have occurred or are still evolving as a direct or indirect result of these two failures.
  3. SAS 99, “Consideration of Fraud in a Financial Statement Audit,” states that, “the auditor should ordinarily presume that there is a risk of material misstatement due to fraud relating to revenue recognition,” and that there is the possibility of management override of controls. How will these assumptions affect the conduct of the audit? (This question prohibits using the passage of SAS 99 as an answer to part a).
  1. A retail company begins operations late in 2002 by purchasing $600,000 of merchandise. There are no sales in 2002. During 2003 additional merchandise of $3,000,000 is purchased. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000. The management compensation agreement provides for incentive bonuses totaling 1 percent of after-tax income (before the bonuses). Taxes are 25 percent, and accounting and taxable income will be the same.

The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2003 ending inventory would be $700,000 and $1,000,000 under LIFO and FIFO respectively.

Required:

  1. How are accounting numbers used to monitor this agency contract between owners and managers?
  2. Evaluate management incentives to choose FIFO.
  3. Evaluate management incentives to choose LIFO.
  4. Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth?
  5. Why is the management compensation agreement potentially counterproductive as an agency-monitoring mechanism?
  6. Devise an alternative bonus system to avoid the problem in the existing plan.

3a. Proposal for New System

Recently, a potential client (large publicly-traded manufacturing corporation) forwarded you a Request for Proposal (RFP) to design and implement a new financial information system that would assist them in meeting the standards imposed on corporate management by the Sarbanes-Oxley Act of 2002 (SOX).

You are aware of the requirements of Section 1350 of SOX (reproduced below) that requires management to attest to the “fair presentation”of the periodic financial reports filed with the Securities Exchange Commission. You are also aware of the penalties imposed on management if the reports are not presented in accordance with SOX.
Sec. 1350. Failure of corporate officers to certify financial reports

(a)CERTIFICATION OF PERIODIC FINANCIAL REPORTS- Each periodic report containing financial statements filed by an issuer with the Securities Exchange Commission pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)) shall be accompanied by a written statement by the chief executive officer and chief financial officer (or equivalent thereof) of the issuer.

(b)CONTENT- The statement required under subsection (a) shall certify that the periodic report containing the financial statements fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C 78m or 78o(d) and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

(c)CRIMINAL PENALTIES - Whoever

  1. certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in this section shall be fined not more than $1,000,000 or imprisoned not more than 10 years, or both; or
  2. willfully certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report accompanying the statement does not comport with all the requirements set forth in this section shall be fined not more than $5,000,000, or imprisoned not more than 20 years, or both."

You are also aware of the provision of Section 201 of SOX (presented below), which pertain to the services provided by Certified Public Accountants (CPAs). You are not involved in any auditing services for this prospective client, although your firm does have the ability to provide full audit services for publicly-traded corporations.

Section 201

Services Outside the Scope of Practice of Auditors

(a) PROHIBITED ACTIVITIES- Section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1) is amended by adding at the end the following:

(g) PROHIBITED ACTIVITIES- It shall be unlawful for a registered public accounting firm (and any associated person of that firm, to the extent determined appropriate by the Commission) that performs for any issuer any audit required by this title or the rules of the Commission under this title or, beginning 180 days after the date of commencement of the operations of the Public Company Accounting Oversight Board established under section 101 of the Public Company Accounting Reform and Investor Protection Act of 2002 (in this section referred to as the `Board'), the rules of the Board, to provide to that issuer, contemporaneously with the audit, any non-audit service, including--

(1) bookkeeping or other services related to the accounting records or financial statements of the audit client;

(2) financial information systems design and implementation;

(3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;

(4) actuarial services;

(5) internal audit outsourcing services;

(6) management functions or human resources;

(7) broker or dealer, investment adviser, or investment banking services;

(8) legal services and expert services unrelated to the audit; and

(9) any other service that the Board determines, by regulation, is impermissible.

(h) PREAPPROVAL REQUIRED FOR NON-AUDIT SERVICES- A registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any of paragraphs (1) through (9) of subsection (g) for an audit client, only if the activity is approved in advance by the audit committee of the issuer, in accordance with subsection (i).'.

(b) EXEMPTION AUTHORITY- The Board may, on a case by case basis, exempt any person, issuer, public accounting firm, or transaction from the prohibition on the provision of services under section 10A(g) of the Securities Exchange Act of 1934 (as added by this section), to the extent that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors, and subject to review by the Commission in the same manner as for rules of the Board under section 107.

Required:

Prepare a description of how you would proceed to develop a proposal to meet the design and implementation of the client’s system. Be sure to outline the steps you would take in meeting the client’s needs.

3b. System Modeling

A systems analyst wishes to create an entity-relationship diagram for the sales and cash receipts of a hardware distributor selling wholesale to other businesses. The hardware business sells approximately 200 different products to over 100 customers. Each customer has a designated salesperson who is responsible for all aspects of customer service (sales, returns, etc.) and receives a sales commission. All sales are on credit and must be paid one invoice at a time in full on the due date.

Required:

  1. Draw an entity-relationship (ER) diagram that shows any and all relationships between the following entities:

1)Customer

2)Salesperson

3)Sale

4)Cash Receipt

  1. For each identified entity relationship in the diagram, indicate which entities are anchors (required) and specify the relationship cardinalities between the entities.
  2. Some analysts prepare both an Entity-Relationship (ER) diagram and a Resources, Events and Agents (REA) model when developing a system. How do the two models differ?

4.FARS Research

Your client, FanMart Inc., operates retail stores that specialize in electric fans of all types. In addition, FanMart Inc. produces baseball cards and similar collectible trading cards which it sells to wholesalers and retailers. The trading cards are not sold in its appliance stores. The board of directors believes that the two business are quite different and it would be better to split-off the trading card division. They believe that this will allow those separate companies to pursue opportunities in their respective industries and maximize their individual value.

With shareholder approval, the board plans to transfer all the assets and liabilities related to the trading card business to a newly created subsidiary called CardsRUs Corp. The common stock of the new entity will then be distributed to the current stockholders of FanMart Inc. on a prorata basis. This will be a nonmonetary transaction since no cash will be paid or received. The book value of the net assets of the trading card division is less than the fair value of the identifiable assets and liabilities (i.e., no impairment of value exists).

Your client wants to know how the transaction should be accounted for on FanMart Inc.’s income statement and what disclosures should be made. The chairman of the board believes it will be treated as a discontinued operation. The CFO thinks it would be a dividend in-kind.

Summary information about the two business segments (before the spinoff) is provided below.

A satisfactory answer will contain references to and possibly key (brief) quotations from the professional literature. However, merely collecting a series of references from the FARS will NOT suffice. The client wants a synopsis as well as your interpretation of any confusing issues. No journal entries are required. Allot your time wisely – spend no more than one hour on this question!

(In 000s) / Assets / Revenues / Net Income / Fair Value
Appliance stores / $600 / $450 / $150 / $775
Trading card publishing / $800 / $575 / $281 / $970

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