Cpa Review Questions

COMPREHENSIVE CPA REVIEW
Gandy Company has 5,000 obsolete desk lamps that are carried in inventory at a
manufacturing cost of $50,000. If the lamps are reworked for $20,000, they could be sold
for $35,000. Alternatively, the lamps could be sold for $8,000 to a jobber located in a
distant city. In a decision model analyzing these alternatives, what would the sunk cost be?
A) $ 8,000
B) $15,000
C) $20,000
D) $50,000
Correct Answer: D
Explanation: Sunk costs are costs that will not change or be affected by the selection of
available alternatives. In this situation, the prior manufacturing costs of $50,000 will be
unaffected by subsequent processing or sale.
For a large population of cash disbursement transactions, Smith, CPA, is testing
compliance with internal control by using attribute sampling techniques. Anticipating an
occurrence rate of 3% Smith found from a table that the required sample size is 400 with a
desired upper precision limit of 5% and reliability of 95%. If Smith anticipated an
occurrence rate of only 2% but wanted to maintain the same desired upper precision limit
and reliability the sample size would be closest to:
A) 200
B) 400
C) 533
D) 800
Correct Answer: A
Explanation: In this problem, the occurrence rate of 3% and the other factors indicated call for a
sample of 400. If the occurrence rate is made smaller, then the sample would decrease and the
only possible answer would be 200.
In order for an offer to confer the power to form a contract by acceptance, it must have all
of the following elements except?
A) 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.
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.
A lessee had a ten-year capital lease requiring equal annual payments. The reduction of the
lease liability in year 2 should equal:
A) The current liability shown for the lease at the end of year 1
B) The current liability shown for the lease at the end of year 2
C) The reduction of the lease obligation in year 1
D) One-tenth of the original lease liability
Correct Answer: A
Explanation: The portion of the lease payment which will reduce the lease obligation in year 2
is shown as a current liability at the end of year 1. The payments reduce an increased amount of
the liability each year.
In an income statement prepared using the variable costing method, fixed factory overhead
would
A) Not be used.
B) Be used in the computation of the contribution margin.
C)
Be used in the computation of operating income but not in the computation of the
contribution margin.
D) Be treated the same as variable factory overhead.
Correct Answer: C
Explanation: Under the direct or variable costing method, variable costs are deducted from sales
revenue to determine contribution margin and all fixed costs (overhead, selling, general and
administrative) are then deducted to obtain net income or income from operations. The
contribution margin is calculated in two steps:
1. Sales revenue less (variable) cost of goods sold = Contribution margin: manufacturing
2. Contribution margin: manufacturing less other variable costs (S, G & A) = Contribution
margin: final
rainbow wants to use unrestricted random sampling without replacement in 2010.
Compared to 2009, the population size of the raw-materials inventory is approximately the
same, and the variability of the items in the inventory is approximately the same. Rainbow
specifies the same precision but desires to change the specified reliability from 90% to
95%. Under these assumptions, the required sample size for 2010 should be:
A) Larger than the 2009 sample size
B) Equal to the 2009 sample size
C) Smaller than the 2009 sample size
D) Of a size that is indeterminate based upon the information given
Correct Answer: A
Explanation: Sampling without replacement was in use for the two years compared and the
finite population correction factor will not have any effect. An increase in the reliability from 90
to 95% will cause an increase in the sample size.
In general, which of the following statements is correct with respect to a limited
partnership?
A)
A limited partner has the right to obtain from the general partner(s) financial information
and tax returns of the limited partnership.
B) A limited partnership can be formed with limited liability for all partners.
C) A limited partner may not also be a general partner at the same time.
D) A limited partner may hire employees on behalf of the partnership.
Correct Answer: A
Explanation: The law gives to all investors the right to inspect books and records at reasonable
times. Stockholders, general partners and limited partners all have this right. Thus, a limited
partner may obtain financial information to include tax returns. A limited partnership must have
at least one general partner and general partners are personally liable for all partnership debts. A
limited partner may also be a general partner in the same partnership at the same time. A limited
partner may not take part in the control of the partnership.
On January 1, 2010, Harrow Co. as lessee signed a five-year noncancellable equipment
lease with annual payments of $100,000 beginning December 31, 2010. Harrow treated this
transaction as a capital lease. The five lease payments have a present value of $379,000 at
January 1, 2010, based on interest of 10%. What amount should Harrow report as interest
expense for the year ended December 31, 2010?
A) $37,900
B) $27,900
C) $24,200
D) $0
Correct Answer: A
Explanation: The interest expense for 2010 is $37,900the effective interest rate (10%) times
the January 1, 2010, present value ($379,000).
The most likely strategy to reduce the breakeven point would be to
A) Increase both the fixed costs and the contribution margin.
B) Decrease both the fixed costs and the contribution margin.
C) Decrease the fixed costs and increase the contribution margin.
D) Increase the fixed costs and decrease the contribution margin.
Correct Answer: C
Explanation: Breakeven point represents your fixed costs divided by your contribution margin.
Mathematically, by decreasing your numerator (fixed costs) or increasing your denominator

(contribution margin), your breakeven point must decrease.
A CPA should not submit unaudited financial statements of a nonpublic company to a
client or others unless, as a minimum, the CPA complies with the provisions applicable to:
A) Compilation engagements
B) Review engagements
C) Statements on auditing standards
D) Attestation standards
Correct Answer: A
Explanation: Since the CPA is associated with the financial statements (he is submitting them),
he must indicate the degree of responsibility he is taking with respect to the statements. Since the
statements are unaudited and the company is nonpublic, the appropriate standards are
compilation standards.
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.
C)
The employer's liability may be ameliorated by a co-employee's negligence under the

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.
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) 70%
B) 72%
C) 80%
D) 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.
In a traditional job order cost system, the issue of indirect materials to a production
department increases which of the following?
A) Stores control.
B) Work in process control.
C) Factory overhead control.
D) Factory overhead applied.
Correct Answer: C
Explanation: When indirect materials were initially purchased, they would be charged to the
stores control. However, when they are issued to a production department, they would be
charged (increased) to the factory overhead control account.
When reporting on an entity's internal control structure under Government Auditing
Standards, an auditor should issue a written report that includes a:
A)
Statement of negative assurance that nothing came to the auditor's attention that caused the
auditor to believe reportable conditions were present.
B)
Statement of positive assurance that the results of tests indicate that the internal control
structure either can, or cannot, be relied on to reduce control risk to an acceptable level.
Description of the weaknesses considered to be reportable conditions and the strengths that
D)
Description of the scope of the auditor's work in obtaining an understanding of the internal
control structure and in assessing control risk.
Correct Answer: D
Explanation: Government Auditing Standards requires a written report on the internal control
structure in all audits. Those standards also require description of any reportable conditions
noted, identification of the categories of the internal control structure, description of the scope of
the auditor's work in obtaining an understanding of the internal control structure and in assessing
control risk, and description of deficiencies in the internal control structure not considered
significant enough to be reportable conditions.
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) $ 32,300
B) $ 33,000
C) $161,500
D) $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.
Book Co. uses the activity-based costing approach for cost allocation and product costing
purposes. Printing, cutting, and binding functions make up the manufacturing process.
Machinery and equipment are arranged in operating cells that produce a complete product
starting with raw materials. Which of the following are characteristics of Book's activitybased costing approach?
I. Cost drivers are used as a basis for cost allocation.

II. Costs are accumulated by department or function for purposes of product costing.
III. Activities that do not add value to the product are identified and reduced to the extent
possible.
A) I only.
B) I and II.
C) I and III.
D) II and III.
Correct Answer: A
Explanation: Activity based costing assigns costs to products based upon the product's use of
activities (cost drivers) which caused the costs to be incurred. Costs are accumulated
(homogeneous cost pools) by activities (cost drivers) rather than by department or function as in
more traditional costing systems. Nonvalue-added activities (cost drivers), such as movement of
product, storage, set up, and inspection are minimized or eliminated without adversely affecting
the product or service.
One of a CPA firm's basic objectives is to provide professional services that conform with
professional standards. Reasonable assurance of achieving this basic objective is provided
through:
A) A system of quality control
B) A system of peer review
C) Continuing professional education
D) Compliance with generally accepted reporting standards
Correct Answer: A
Explanation: A system of quality control for a CPA firm, which usually encompasses quality
control policies and procedures, assignment of responsibilities, communication, and monitoring,
can provide a CPA firm with reasonable assurance of conforming with professional standards.
The remaining answer choices are incorrect for the following reasons:
Peer review which, as an external study of a firm's quality controls, can help evaluate a firm's
professional practice but is not done on a regular, ongoing basis.
Continuing professional education is one example of an element of quality control.

Compliance with generally accepted reporting standards could be considered an example of a
professional standard with which a firm should conform.
The installment method of recognizing revenue:
A)
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
D) Is an acceptable alternative accounting principle for a firm which makes installment sales
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."
As a company becomes more conservative in its working capital policy, it would tend to
have a(n)
A) Decrease in its acid-test ratio.
B) Increase in the ratio of current liabilities to noncurrent liabilities.
C) Increase in the ratio of current assets to units of output.
D)
Increase in funds invested in common stock and a decrease in funds invested in marketable
securities.
Correct Answer: C
Explanation: A conservative working capital policy results in an increase in working capital.
Therefore, current assets increase. Working capital = current assets minus current liabilities. A
conservative working capital policy reduces the liquidity risk. A decrease in acid test ratio means
that quick assets such as cash, receivables and marketable securities are decreasing in proportion
to current liabilities and this results in lower working capital. Increases in the ratio of current
liabilities to noncurrent liabilities increases liquidity risk, and represents a less conservative
working capital policy. As a company becomes more conservative in its working capital policy, it
will not increase the funds invested in common stock (long term) and decrease funds invested in
marketable securities (short term).
An auditor concludes that there is a material inconsistency in the other information in an
annual report to shareholders containing audited financial statements. If the auditor
concludes that the financial statements do not require revision, but the client refuses to
revise or eliminate the material inconsistency, the auditor may:
A)
Issue an "except for" qualified opinion after discussing the matter with the client's board of
directors.
B)
Consider the matter closed since the other information is not in the audited financial
statements.
C)
Disclaim an opinion on the financial statements after explaining the material inconsistency
in a separate explanatory paragraph.
D)
Revise the auditor's report to include a separate explanatory paragraph describing the
material inconsistency.
Correct Answer: D
Explanation: The auditor's responsibility with respect to information in an annual report does
not extend beyond the financial information identified in his report. However, he should read the
other information and consider whether it is materially inconsistent with information appearing
in the financial statements. If he concludes that the other information is inconsistent and the
client refuses to correct the inconsistency, the auditor should either revise his report to include an
explanatory paragraph describing the material inconsistency, withhold the use of his report in the
annual report, or withdraw from the engagement.
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) both Burn and Green.
B) neither Burn nor Green.
C) burn but not Green.

D) 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.
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) Total costs incurred to date to total estimated costs
B) Total costs incurred to date to total billings to date
C) Costs incurred in year 3 to total estimated costs
D) 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.
Attachment and perfection will occur simultaneously when _________________
A) the security agreement so provides.
B) there is a purchase money security interest taken in inventory.
C) attachment is by possession.
D) 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.
A principal auditor decides not to refer to the audit of another CPA who audited a
subsidiary of the principal auditor's client. After making inquiries about the other CPA's
professional reputation and independence, the principal auditor most likely would:
A)
Add an explanatory paragraph to the auditor's report indicating that the subsidiary's
financial statements are not material to the consolidated financial statements.
B)
Document in the engagement letter that the principal auditor assumes no responsibility for
the other CPA's work and opinion.
C)
Obtain written permission from the other CPA to omit the reference in the principal
auditor's report.
D)
Contact the other CPA and review the audit programs and working papers pertaining to the
subsidiary.
Correct Answer: D
Explanation: If an auditor decides that he or she is the principal auditor and that he or she can
use the other auditor's report, because the other auditor is reputable and independent, the
principal auditor must decide whether or not to make reference to the other auditor. If the
principal auditor decides not to refer to the other auditor, he or she should visit the other auditor,
discuss the procedures followed, and review the audit program and working papers of the other
auditor.
If the principal auditor decides not to refer to the other auditor, no references of any kind would
be made in the report.
Assuming no responsibility for the other CPA's work and opinion would not fulfill the principal
auditor's reporting responsibilities.
Permission would only be necessary if the principal auditor decides to refer to and name the
other auditor.
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) Disclosed but not accrued as a liability
B) Disclosed and accrued as a liability
C) Accrued as a liability but not disclosed
D) 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.
If a firm's credit terms require payment with 45 days but allow a discount of 2 percent if
paid within 15 days (using a 360-day year), the approximate cost/benefit of the trade credit
terms is what?
A) 2 percent.
B) 16 percent.
C) 48 percent.
D) 24 percent.
Correct Answer: D
Explanation: If the credit terms are 2/15 net 45, then a company not taking the 2% discount
would have an extra 30 days (45 - 15) to use the money. Thirty days divided into a 360 day year
equals twelve 30 day periods in a year. Therefore, if it costs 2% to hold the money an additional
30 days, and there are twelve 30 day periods in a year, then the approximate cost/benefit of the
trade credit terms is 24% (2% x 12).
King, CPA, was engaged to audit the financial statements of Newton Company after its
fiscal year had ended. King neither observed the inventory count nor confirmed the
receivables by direct communication with debtors, but was satisfied concerning both after
applying alternative procedures. King's auditor's report most likely contained a(an):
A) Qualified opinion
B) Disclaimer of opinion
C) Unqualified opinion
D) Unqualified opinion with an explanatory paragraph
Correct Answer: C
Explanation: Observation of the inventory count and confirmation of receivables is normally
performed during an audit. However, if circumstances do not permit these procedures to be
performed, the auditor may apply alternative audit procedures that may include observation of an
inventory count at a later date and the verification of receivable balances by auditing subsequent
cash receipts. If the auditor is able to employ alternative procedures he considers appropriate in
the circumstances, no modification or qualification of the audit report is necessary.
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) No, because Fox failed to sign and return Summers' letter.
B) No, because Fox's letter was a counteroffer.
C) Yes, because Summers' offer was validly accepted.
D) 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.
A company acquired a building, paying a portion of the purchase price in cash and issuing
a mortgage note payable to the seller for the balance.
A) Cash payment
B) Acquisition price
C) Zero
D) Mortgage amount
Correct Answer: A
Explanation: For transactions that are part cash and part noncash, only the cash portion is
reported in the statement of cash flows. The related disclosures (of noncash investing and
financing activities) should clearly describe the cash and noncash aspects of such transactions.
A disadvantage of the net present value method of capital expenditure evaluation is that
A) It is calculated using sensitivity analysis.
B) It computes the true interest rate.
C) It does not provide the true rate of return on investment.
D) 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.
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) Availability of data aggregated at a high level
B) Relative effectiveness and efficiency of the tests
C) Timing of tests performed after the balance sheet date

D) 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.
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?
A)
Young does not have the power to dismiss Wilson during the six-month period without
cause.
B) Wilson is obligated to act solely in Young's interest in matters concerning Young's business.
C)
The agreement between Young and Wilson is not enforceable unless it is in writing and
signed by Wilson.
D) The agreement between Young and Wilson formed an agency coupled with an 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.
Generally, which of the following statements concerning workers' compensation laws is
correct?
A) The amount of damages recoverable is based on comparative negligence.

B) Employers are strictly liable without regard to whether or not they are at fault.
C) Workers' compensation benefits are not available if the employee is negligent.
D) Workers' compensation awards are payable for life.
Correct Answer: B
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.
A violation of the profession's ethical standards most likely would have occurred when a
CPA _________________
A)
issued an unqualified opinion on the 2009 financial statements when fees for the 2008 audit
were unpaid.
B)
recommended a controller's position description with candidate specifications to an audit

client.
C)
purchased a CPA firm's practice of monthly write-ups for a percentage of fees to be received
over a three-year period.
D)
made arrangements with a financial institution to collect notes issued by a client in payment
of fees due for the current year's audit.
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.
What are the Statements of Financial Accounting Concepts intended to establish?
A) Generally accepted accounting principles in financial reporting by business enterprises
B)
The meaning of "Present fairly in accordance with generally accepted accounting

principles."
C)
The objectives and concepts for use in developing standards of financial accounting and
reporting
D) The hierarchy of sources of generally accepted accounting principles

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.
An auditor searching for related party transactions should obtain an understanding of
each subsidiary's relationship to the total entity because:
A)
This may permit the audit of intercompany account balances to be performed as of

concurrent dates.
B)
Intercompany transactions may have been consummated on terms equivalent to arm'slength transactions.
C)
This may reveal whether particular transactions would have taken place if the parties had
not been related.
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.
Under FASB Statement of Financial Accounting Concepts No. 5, which of the following
items would cause earnings to differ from comprehensive income for an enterprise in an
industry not having specialized accounting principles?
A) Unrealized loss on investments in available-forsake marketable equity securities
B) Unrealized loss on investments in trading marketable equity securities
C) Loss on exchange of similar assets
D) Loss on exchange of dissimilar assets
Correct Answer: A
Explanation: The correct choice is "Unrealized loss on investments in available-forsale
marketable equity securities"
The remaining answer choices described losses which are recognized in earnings as well as in
comprehensive income. An unrealized loss on investments in available-for-sale marketable
equity securities is not recognized in current earnings but is a factor in measuring comprehensive
income.
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.]
The primary objective of analytical procedures used in the final review stage of an audit is
to:
A) Obtain evidence from details tested to corroborate particular assertions.
B) Identify areas that represent specific risks relevant to the audit.
C) Assist the auditor in assessing the validity of the conclusions reached.
D) Satisfy doubts when questions arise about a client's ability to continue in existence.
Correct Answer: C
Explanation: The objective of analytical procedures used in the overall review stage of the audit
is to assist the auditor in assessing the conclusions reached and in the evaluation of the overall
financial statement presentation.
"Obtain evidence from details tested to corroborate particular assertions." refers to substantive
tests of details, not analytical procedures.
"Identify areas that represent specific risks relevant to the audit." is an objective of analytical
procedures used in planning the audit.
"Satisfy doubts when questions arise about a client's ability to continue in existence." involves
the auditor obtaining information about management's plans and assessing the likelihood that
such plans can be implemented; these are not analytical procedures.
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) Negligence and breach of contract
B) Negligence and gross negligence
C) Negligence and fraud
D) 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.
The functional currency of Nash, Inc.'s subsidiary is the French franc. Nash borrowed
French francs as a partial hedge of its investment in the subsidiary. In preparing
consolidated financial statements, Nash's translation loss on its investment in the
subsidiary exceeded its exchange gain on the borrowing. How should the effects of the loss
and gain be reported in Nash's consolidated financial statements?
A)
The translation loss less the exchange gain is reported separately as other comprehensive
income.
B) The translation loss less the exchange gain is reported in the income statement.
C)
The translation loss is reported separately in the stockholders' equity section of the balance
sheet and the exchange gain is reported in the income statement.
D)
The translation loss is reported in the income statement and the exchange gain is reported
separately in the stockholders' equity section of the balance sheet.
Correct Answer: A
Explanation: Gains and losses on foreign currency transactions that are designated as economic
hedges of a net investment in a foreign entity should be reported in the same manner as a
translation adjustment. Current changes in translation adjustments are reported as other
comprehensive income.
Which of the following best defines NDP?
A) NI plus net foreign factor income earned in the U.S. plus indirect business taxes.
B) NI plus corporate income taxes.
C) GDP deflated for increases in the price level.
D) 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.
Which of the following procedures is least likely to be performed before the balance sheet
date?
A) Testing of internal control over cash
B) Confirmation of receivables
C) Search for unrecorded liabilities
D) 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.
In a period of rising general price levels, Pollard Corp. discloses income on a current cost
basis in accordance with FASB Statement No. 89, Financial Reporting and Changing
Prices.
Compared to historical cost income from continuing operations, which of the following
conditions increases Pollard's current cost income from continuing operations?
A) Current cost of equipment is greater than historical cost.
B) Current cost of land is greater than historical cost.
C) Current cost of cost of goods sold is less than historical cost.
D) Ending net monetary assets are less than beginning net monetary assets.
Correct Answer: C
Explanation: Holding gains for equipment and land are not part of income from continuing
operations. The reduction in cost of goods sold is reflected in income from continuing operations
and is not applicable for current cost measurement.
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) The house belongs to a corporation of which Daly is a 50% stockholder.
B) Daly is not the owner of the house but a long-term lessee.
C) The house is held in trust for Daly's mother and, on her death, will pass to Daly.
D) 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 one of the following would increase the working capital of a firm?
A) Refinancing a short-term note payable with a two year note payable.
B) Purchase of a new plant financed by a 20-year mortgage.
C) Cash collection of accounts receivable.
D) Payment of a 20-year mortgage payable with cash.
Correct Answer: A
Explanation: Refinancing a short-term note payable with a two-year note payable would
increase the working capital of a firm.
Current Assets - Current Liabilities = Working Capital
Assuming CA = $10 and CL = $6, WC = $4. ($10 - $6 = $4)
If a company refinances $2 worth of short-term notes payable with a two year note payable,
working capital would increase. ($10 - $4 = $6).
The purchase of a new plant financed by a 20-year mortgage would not increase the working
capital of a firm. WC would stay the same. A cash collection of accounts receivable would not
increase the working capital of a firm. WC would stay the same. A payment of a 20-year
mortgage payable with cash would not increase the working capital of a firm. WC would
decrease.
A retained earnings appropriation can be used to:
A) Absorb a fire loss when a company is self-insured.
B) Provide for a contingent loss that is probable and reasonable.
C) Smooth periodic income.
D) 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.
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) 2.50
B) 5.00
C) 7.58
D) 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.
Correct Answer: C

FAR
The Heinline Company has maintained a defined-benefit pension plan for its employees for a
number of years. At the end of the most recent year, the following information was available:
--Service cost
$285,000
--Expected return on plan assets
59,000
--Actual return on plan assets
52,000
--Plan assets
600,000
--Projected benefit obligation
700,000
--Funding
220,000
--Interest on projected benefit obligation
65,000
--Amortization of prior service cost (created
when a contractual provision was amended
which reduced the projected
benefit obligation)
25,000
What should be reported as the pension expense for the year?
a. Less than $270,000
b. Between $269,999 and $280,000
c. Between $279,999 and $290,000
d. Between $289,999 and $300,000
e. Between $299,999 and $310,000
f. More than $309,999
Answer is A
Not all of the available numbers are used here in determining pension expense. The candidate
must determine which numbers are included and whether they increase or decrease the pension
expense. The service cost ($285,000) and the interest on the projected benefit obligation
($65,000) increase the expense. The income on the plan assets is a decrease to the expense. To
prevent wild swings in the reported expense that might occur from changes in the value of those
plan assets, the expected income ($59,000) is used rather than actual income. Finally, the
amortization of the prior service cost can be either an expense addition or subtraction. Here, the
prior service cost was created by a change in the projected benefit obligation that reduced this
obligation. Because the debt level went down, the amortization of that drop is the equivalent of
a gain and reduces the expense. Pension expense: $285,000 + $65,000 - $59,000 - $25,000 or
$266,000.
BEC
The Hasawono Corporation had earnings per share last year of $4.00 whereas this year the
companys earnings per share is now $6.00. In order to create this increase, the company
borrowed a significant amount of money. The companys earnings before interest and taxes
(EBIT) was reported as $300,000 last year. However, because of the extra interest charge from
the new debt, earnings before interest and taxes in the current year is only $360,000. What is
the companys degree of financial leverage?
a. 0.5
b. 1.0
c. 2.5
d. 5.0
Answer is C
The degree of financial leverage reflects how well a company uses borrowed money to increase
the income applicable to the owners of common stock. It is calculated by taking the percentage
increase in earnings per share which is then divided by the percentage increase in earnings before
interest and taxes. Here, earnings per share starts as $4.00 and increases by $2.00, a 50 percent
increase. Earnings before interest and taxes starts as $300,000 and increases by $60,000, only a
20 percent increase. Therefore, the degree of financial leverage is 50 percent divided by 20
percent or 2.5.
Regulation
The Aberthan Corporation reported net income of $300,000 for the most reason year. That
amount included federal income tax expense of $80,000 and a $12,000 long-term loss on the sale
of shares of another domestic US corporation. It does not include a $7,000 loss on the sale of its
treasury stock. What taxable income should this corporation report on its federal income tax
return?
A. $312,000
B. $368,000
C. $380,000
D. $392,000
Answer is D
Federal income taxes are not deductible on a federal income tax return. Likewise, for
corporations, long-term capital losses such as on the sale of an investment in shares of another
company cannot be deducted. Although both amounts are proper reductions in the production of
an income statement, they cannot be taken in determining the companys taxable income for
federal tax purposes. Removing the $80,000 expense and the $12,000 loss, increases the
amount of taxable income from $300,000 to $392,000. Gains and losses on treasury stock are
not included in either net income or taxable income. Because that loss was not included in net
income, no change is needed.
Auditing
The Laskebo Corporation has its fiscal year ending December 31, Year One. However,
inventory was counted on October 15, Year One, and the process was properly observed by the
independent auditing firm of James and Wade. Which of the following statements is true?
a. An unqualified opinion cannot be rendered because the count was done so far from the end
of the fiscal year.
b. The independent auditors must insist that a representative sample of the inventory be counted
again on December 31, Year One.
c. If the company has strong internal control and properly documents the events between the
count and year-end, no further count is necessary.
d. A disclaimer is not necessary but a scope qualification must be automatically reported by the
auditing firm.
Answer is C
As long as the company has adequately strong internal control and all accounting records are
properly documented, a year-end inventory count is not necessary. Among the strong internal
controls, the company should be using a perpetual inventory system.
Correct Answer: C
Generally, which of the following statements concerning workers' compensation laws is

correct?
A) The amount of damages recoverable is based on comparative negligence.
B) Employers are strictly liable without regard to whether or not they are at fault.
C) Workers' compensation benefits are not available if the employee is negligent.
D) Workers' compensation awards are payable for life.
Correct Answer: B
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.
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) Total costs incurred to date to total estimated costs
B) Total costs incurred to date to total billings to date
C) Costs incurred in year 3 to total estimated costs
D) 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.
Correct Answer: C
A secured promissory note would be nonnegotiable if it provided that _________________

A)
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.
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.
In open market transactions, Oak Corp. simultaneously sold its long-term investment in
Maple Corp. bonds and purchased its own outstanding bonds. The broker remitted the net
cash from the two transactions. Oak's gain on the purchase of its own bonds exceeded its
loss on the sale of Maple's bonds. Oak should report the:
A) Net effect of the two transactions as an extraordinary gain
B) Net effect of the two transactions in income before extraordinary items
C)
Effect of its own bond transaction gain in income before extraordinary items, and report the
Maple bond transaction as an extraordinary loss
D)
Effect of its own bond transaction as an ordinary gain, and report the Maple bond
transaction loss in income before extraordinary items
Correct Answer: D
Explanation: Each transaction must be reported separately since the gain on early
extinguishment of the company's debt is reported as an ordinary item and the loss on the sale of
the investment is an ordinary loss.
Multiple regression differs from simple regression in that it

A) Provides an estimated constant term.
B) Has more dependent variables.
C) Allows the computation of the coefficient of determination.
D) Has more independent variables.
Correct Answer: D
Explanation: Regression analysis is a sampling technique which measures the relationship of a
dependent variable to one or more independent variables. If one independent variable is used, the
method is referred to as simple regression. If more than one independent variable is used, the
method is referred to as multiple regression.
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.
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?
A)
Perfection of the security interest occurred even though Winslow did not file a financing
statement.
B) Perfection of the security interest occurred by Pine having an interest in accounts
receivable.
C)
Attachment of the security interest did not occur because Winslow failed to file a financing
statement.
D)
Attachment of the security interest occurred when the loan was made and Winslow
executed the security agreement.
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.
A bond issued on June 1, 2010, has interest payment dates of April 1 and October 1. Bond
interest expense for the year ended December 31, 2010, is for a period of:
A) Three months
B) Four months
C) Six months
D) Seven months
Correct Answer: D
Explanation: Interest expense begins on June 1, 2010 when the bond is issued and continues for
the seven months ending December 31, 2010.
Your client, a retail store, is interested in the relationship between sales (independent
variable) and theft losses (dependent variable). Using the proper formula, you compute the
coefficient of correlation at .95. What can you definitely conclude about these factors (sales
and theft losses)?
A) An increase in sales causes an increase in theft losses.
B) Movement of these factors is in opposite directions.

C) Movement of these factors is entirely unrelated.
D) Movement of these factors is in the same direction.
Correct Answer: D
Explanation: .95 as a coefficient of correlation is very high (the maximum is at 1.0), thus
showing a definite cause-effect relationship. An increase in sales causes an increase in theft
losses is incorrect because it does not provide for the fact that a decrease in sales would be
associated with a decrease in theft. Movement of these factors is in the same direction is correct
because it covers both possibilities and is the most correct.
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) The assessed level of control risk
B) The likelihood of a review by a concurring (second) partner
C) The number of personnel assigned to the audit
D) 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.
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) the seller is a merchant of the product involved.
B) an action based on negligence can also be successfully maintained.

C) the injured party is in privity of contract with the seller.
D) 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.
North Bank is analyzing Belle Corp.'s financial statements for a possible extension of
credit. Belle's quick ratio is significantly better than the industry average. Which of the
following factors should North consider as a possible limitation of using this ratio when
evaluating Belle's creditworthiness?
A) Fluctuating market prices of short-term investments may adversely affect the ratio.
B) Increasing market prices for Belle's inventory may adversely affect the ratio.
C) Belle may need to sell its available-for-sale investments to meet its current obligations.
D) Belle may need to liquidate its inventory to meet its long-term obligations.
Correct Answer: A
Explanation: The quick ratio includes the current assets that can be "quickly" converted to cash
such as cash, marketable securities and receivables. Therefore, fluctuating market prices for
short-term investments (marketable securities) may adversely affect the ratio.
Inventory is not included in the Quick Ratio and "Available-For-Sale" securities may be either
current or non-current assets.
Which of the following may be used to estimate how inventory warehouse costs are affected
by both the number of shipments and the weight of materials handled?
A) Economic order quantity analysis.
B) Probability analysis.
C) Correlation analysis.
D) Multiple regression analysis.
Correct Answer: D
Explanation: Regression analysis is a mathematical technique used to predict the value of one
variable and its changes (the dependent variable) based upon the value of some other variable
(the independent variable). Simple regression analysis involves the use of only one independent
(explanatory) variable, while multiple regression analysis allows for more than one independent
variable.
An auditor's program to examine long-term debt should include steps that require:
A) Examining bond trust indentures
B) Inspecting the accounts payable subsidiary ledger
C) Investigating credits to the bond interest income account
D) 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.
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) offer was unenforceable.
B) advertisement was not an offer.
C) television announcement revoked the offer.
D) 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.
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) Balance sheet
B) Income statement
C) Statement of retained earnings
D) 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.
If a company follows a practice of isolating variances at the earliest point in time, what
would be the appropriate time to isolate and recognize a direct material price variance?
A) When material is issued.

B) When material is purchased.
C) When material is used in production.
D) When purchase order is originated.
Correct Answer: B
Explanation: Since the material price variance relates to the difference between standard price
and actual price and might be viewed as measuring the performance of the company's purchasing
department, the variance should be determined on the basis of the units purchased and should
therefore be computed when the purchase occurs.
An auditor searching for related party transactions should obtain an understanding of

each subsidiary's relationship to the total entity because:
A)
This may permit the audit of intercompany account balances to be performed as of

concurrent dates.
B)
Intercompany transactions may have been consummated on terms equivalent to arm'slength transactions.
C)
This may reveal whether particular transactions would have taken place if the parties had
not been related.
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.
In order for an offer to confer the power to form a contract by acceptance, it must have all
of the following elements except?
A)
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.
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 functional currency of Nash, Inc.'s subsidiary is the French franc. Nash borrowed
French francs as a partial hedge of its investment in the subsidiary. In preparing
consolidated financial statements, Nash's translation loss on its investment in the
subsidiary exceeded its exchange gain on the borrowing. How should the effects of the loss
and gain be reported in Nash's consolidated financial statements?
A)
The translation loss less the exchange gain is reported separately as other comprehensive
income.
B) The translation loss less the exchange gain is reported in the income statement.
C)
The translation loss is reported separately in the stockholders' equity section of the balance
sheet and the exchange gain is reported in the income statement.
D)
The translation loss is reported in the income statement and the exchange gain is reported
separately in the stockholders' equity section of the balance sheet.
Correct Answer: A
Explanation: Gains and losses on foreign currency transactions that are designated as economic
hedges of a net investment in a foreign entity should be reported in the same manner as a
translation adjustment. Current changes in translation adjustments are reported as other
comprehensive income.
Nile Co.'s cost allocation and product costing procedures follow activity-based costing
principles. Activities have been identified and classified as being either value-adding or
nonvalue-adding as to each product. Which of the following activities, used in Nile
production process, is nonvalue-adding?
A) Design engineering activity
B) Heat treatment activity
C) Drill press activity
D) Raw materials storage activity
Correct Answer: D
Explanation: In the production process, storing raw materials until they are needed represents a
non-value added step, whereas engineering, heat treatment or drilling represents improving the
product. In addition, storage requires handling costs, cost of holding inventory, possible breakage
or misappropriation, while inventory simply waits for use at a later time.
In order to efficiently establish the correctness of the accounts payable cutoff, an auditor
will be most likely to:
A) Coordinate cutoff tests with physical inventory observation
B) Compare cutoff reports with purchase orders
C) Compare vendors' invoices with vendors' statements
D) 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.
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) knew of the irregularities.
B) failed to exercise due care.
C) was grossly negligent.
D) 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.
Kerr Company purchased a machine for $115,000 on January 1, 1992, the company's first
day of operations. At the end of the year, the current cost of the machine was $125,000. The
machine has no salvage value, a five-year life, and is depreciated by the straight line
method. For the year ended December 31, 1992, the amount of the current cost
depreciation expense which would appear in supplementary current cost financial
statements is:
A) $14,000
B) $23,000
C) $24,000
D) $25,000
Correct Answer: C
Explanation: Assuming that average current cost was used, the average current cost of the
machine is $120,000 for 1992, which would generate depreciation expense of $24,000 (5 year
life).
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.
B) The subsidiary corporation's dissenting stockholders must be given an appraisal 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.
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
D) Lower the assessed level of control risk from the maximum level to below the 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.
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.
C)
The employer's liability may be ameliorated by a co-employee's negligence under the

fellowservant rule.
D) The injured employee is allowed to recover on strict liability theory.

Correct Answer: D
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.
In a period of rising general price levels, Pollard Corp. discloses income on a current cost
basis in accordance with FASB Statement No. 89, Financial Reporting and Changing
Prices.
Compared to historical cost income from continuing operations, which of the following
conditions increases Pollard's current cost income from continuing operations?
A) Current cost of equipment is greater than historical cost.
B) Current cost of land is greater than historical cost.

C) Current cost of cost of goods sold is less than historical cost.
D) Ending net monetary assets are less than beginning net monetary assets.
Correct Answer: C
Explanation: Holding gains for equipment and land are not part of income from continuing
operations. The reduction in cost of goods sold is reflected in income from continuing operations
and is not applicable for current cost measurement.
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.
B) The shareholders have commingled their personal funds with those of the 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.
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) Evidence to be gathered to provide a sufficient basis for the auditor's opinion
B) Procedures to be undertaken to discover litigation, claims, and assessments
C) Pending legal matters to be included in the inquiry of the client's attorney
D) 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.
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) Exoneration
B) Contribution
C) Subrogation
D) 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.
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) $48,000
B) $42,000
C) $36,000
D) $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.
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) (1) only
B) (2) only
C) (1) & (2)
D) 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.
Which of the following most likely would not be considered an inherent limitation of the
potential effectiveness of an entity's internal control?
A) Incompatible duties
B) Management override
C) Mistakes in judgment
D) 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.
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?
A)
Perfection of the security interest occurred even though Winslow did not file a financing
statement.
B)
Perfection of the security interest occurred by Pine having an interest in accounts
receivable.
C)
Attachment of the security interest did not occur because Winslow failed to file a financing
statement.
D)
Attachment of the security interest occurred when the loan was made and Winslow
executed the security agreement.
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.
For inventory management, ignoring safety stocks, which of the following is a valid
computation of the reorder point?
A) The economic order quantity
B) The economic order quantity multiplied by the anticipated demand during the lead time
C) The anticipated demand during the lead time
D) The square root of the anticipated demand during the lead time
Correct Answer: C
Explanation: Perfection, ignoring safety stocks, is to replenish supplies as they reach zero level.
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
D)
Higher or lower than in a periodic inventory system, depending on whether physical

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.
When the shipping department returns nonconforming goods to a vendor, the purchasing
department should send to the accounting department the:
A) Unpaid voucher
B) Debit memo
C) Vendor invoice
D) 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.
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)
the seller is a merchant of the product involved.
B)
an action based on negligence can also be successfully maintained.
C)
the injured party is in privity of contract with the seller.
D)
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.
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) Trade discounts applicable to purchases during the period
B) Cash (purchase) discounts taken during the period
C) Purchase returns and allowances of merchandise during the period
D) 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.
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) 2.50
B) 5.00
C) 7.58
D) 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.
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.
B)
The accounting department supervisor independently reconciles the accounts receivable

subsidiary ledger to the accounts receivable control account monthly.
C)
The accounting department supervisor controls the mailing of monthly statements to

customers and investigates any differences reported by customers.
D)
The billing department supervisor matches prenumbered shipping documents with entries in
the sales journal.
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.
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.
B)
The warranty arises when the buyer relies on the seller's skill in selecting the goods
purchased.
C)
The warranty cannot be disclaimed.
D)
The warranty arises as a matter of law when the seller ordinarily sells the goods
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.
FAR A company buys a restaurant for $1 million with no residual value and a 20-year expected
life. It is being depreciated on the straight-line method. At the beginning of the third year, the
neighborhood around the restaurant starts to become dangerous and its fair value drops to
$789,000. However, the restaurant still has many loyal customers and is able to generate
$53,000 in net cash flows each year for its remaining life. What should be the net book value
for the restaurant on the first day of the third year?
A.
B.
C.
D.
$789,000
$900,000
$924,000
$954,000
Answer is B
Depreciation is $50,000 per year ($1,000,000/20 years) so net book value at the end of Year Two
is $900,000 ($1,000,000 less $50,000 and less $50,000). Although the fair value is only
$789,000, the restaurant is not viewed as having its value impaired because the future cash flows
of $53,000 for 18 years gives a total ($924,000) that is greater than the net book value of
$900,000. As long as the expected cash flows are greater than net book value, the asset is not
held to be impaired and remains reported at net book value.
Regulation
What is the Statute of Frauds?
A. It sets out rules that indicate the time periods for rules and other laws to be in existence.
B. It sets out rules that require certain contracts to be in writing.
C. It sets out rules that indicate which actions are gross negligence and which are fraudulent.
D. It sets out rules that spell out the actions that an agent can take on behalf of a principal.
Answer is B.
Most contracts can either be established orally or in writing. However, the Statute of Frauds
indicates which contracts must exist in writing and cannot be created orally. For example,
according to the Statute of Frauds, a contract in which a surety agrees to answer for the debts of
another must be in writing.
Auditing
The Ramsey Corporation is being audited by Keillor and Associates CPAs. The auditors
discovered that Ramsey is reporting a note receivable from Lexington Corporation, a company
that recently filed for bankruptcy. The note is still reported at its $250,000 face value although a
reasonable estimation is that only $140,000 will be collected. If these amounts are considered
material, which of the following statements is true?
A.
B.
C.
D.
An unqualified opinion should be given but only with an added explanation of the problem.
An unqualified opinion cannot be rendered and the scope paragraph must be modified.
A disclaimer of opinion must be given.
An unqualified opinion cannot be rendered but the scope paragraph should not be modified.
Answer is D
The account balance is materially misstated so, therefore, an unqualified opinion is not
appropriate. A disclaimer is also not correct because the auditor does have an opinion. The
problem here does not relate to the work of the auditor (which would be described in the scope
paragraph). The work of the auditor seems to be complete and reasonable. Therefore, the
scope paragraph is not changed. Instead, an explanatory paragraph is added to describe the
problem and the opinion paragraph is changed.
BEC
The Drexel Donut Company produces 8,000 dozen donuts under normal circumstances but
believes that 5,000 to 10,000 dozen donuts is a relevant range for its current production levels.
Fixed costs within this relevant range are $24,000. At 8,000 dozen, the company calculates that
a dozen donuts has a total cost of $4.00. If the company manages to push production levels to
10,000 dozen donuts, what is the cost of a dozen?
A. $3.40
B. $3.50
C. $3.80
D. $4.00
Answer is A
At 8,000 dozen, the cost is $4.00 per dozen or $32,000 in total. Of that amount, $24,000 is fixed
cost so the remaining $8,000 must be the variable cost. That is a variable cost of $1.00 per
dozen ($8,000/8,000 dozen). Thus, within the relevant range, fixed costs will stay at $24,000
and variable costs will stay at $1.00 per dozen. For 10,000 dozen, the fixed cost will be $24,000
and the variable costs will be $1.00 per dozen or $10,000. The total is $34,000 for 10,000 dozen
donuts or $3.40 per dozen.

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COMPREHENSIVE CPA REVIEW

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D) Be treated the same as variable factory overhead.

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COMPREHENSIVE CPA REVIEW

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Mathematically, by decreasing your numerator (fixed costs) or increasing your denominator

The employer's liability may be ameliorated by a co-employee's negligence under the

D) The injured employee is allowed to recover on strict liability theory.

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I. Cost drivers are used as a basis for cost allocation.

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Continuing professional education is one example of an element of quality control.

B) Is not a generally accepted accounting principle under any circumstances

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C) burn but not Green.

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C) Timing of tests performed after the balance sheet date

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A) The amount of damages recoverable is based on comparative negligence.

recommended a controller's position description with candidate specifications to an audit

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Independence is not impaired by merely recommending a job position including candidate

The meaning of "Present fairly in accordance with generally accepted accounting

D) The hierarchy of sources of generally accepted accounting principles

This may permit the audit of intercompany account balances to be performed as of

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Explanation: Observation of the inventory count and confirmation of receivables is normally

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Generally, which of the following statements concerning workers' compensation laws is

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A secured promissory note would be nonnegotiable if it provided that _________________

B) upon default, the maker waives a trial by jury.

COMPREHENSIVE CPA REVIEW

Explanation: For an instrument to be negotiable, it must be an unconditional promise or order. If

Multiple regression differs from simple regression in that it

COMPREHENSIVE CPA REVIEW

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

D) Confirming bank accounts established after year end.

B) Perfection of the security interest occurred by Pine having an interest in accounts

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B) Movement of these factors is in opposite directions.

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B) an action based on negligence can also be successfully maintained.

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showroom as soon as possible. On September 13, Harris made a televised announcement