Certified Public Accountant Case Studies & Practical Application 5 — Questions and Answers
Question 1: A CPA discovers during a tax engagement that a client has been skimming cash receipts for three years. The client confesses privately and refuses to correct the returns or notify the IRS. What should the CPA do?
- File amended returns on the client's behalf without consent
- Notify the IRS immediately under the duty to report
- Withdraw from the engagement and, depending on jurisdiction, consider notifying appropriate authorities (Correct answer)
- Continue the engagement after documenting the client's refusal
Correct answer: Withdraw from the engagement and, depending on jurisdiction, consider notifying appropriate authorities
The CPA should withdraw when the client refuses to correct known fraud; AICPA rules prohibit continued association, and state law may require reporting.
Question 2: A retail client uses a perpetual inventory system. The physical count at year-end shows inventory 8% lower than the book balance. What is the most likely audit risk the CPA should investigate?
- Overstatement of cost of goods sold in prior periods
- Theft, recording errors, or unrecorded write-downs causing inventory overstatement (Correct answer)
- Understatement of purchase returns and allowances
- Cutoff errors in accounts payable causing understatement of liabilities
Correct answer: Theft, recording errors, or unrecorded write-downs causing inventory overstatement
A book-to-physical shortage suggests inventory is overstated, which could result from theft, spoilage not written off, or fictitious purchase entries.
Question 3: A partner in a general partnership has an outside basis of $0 and receives a $50,000 cash distribution from the partnership. The partnership has no liabilities. What is the tax consequence to the partner?
- No taxable event; the distribution is tax-free
- $50,000 recognized as ordinary income
- $50,000 recognized as capital gain to the extent the distribution exceeds outside basis (Correct answer)
- The distribution reduces the partner's share of partnership liabilities
Correct answer: $50,000 recognized as capital gain to the extent the distribution exceeds outside basis
Under IRC §731, cash distributions exceeding a partner's outside basis are taxable as capital gain in the year of distribution.
Question 4: A company acquires 100% of a subsidiary for $10 million. The fair value of net identifiable assets is $7.5 million. What amount is recorded as goodwill, and under what circumstances would it later be impaired?
- $2.5 million goodwill; impaired if book value of reporting unit exceeds its fair value (Correct answer)
- $2.5 million goodwill; impaired when amortized to zero
- $7.5 million goodwill based on purchase price allocation errors
- No goodwill; excess purchase price is expensed immediately
Correct answer: $2.5 million goodwill; impaired if book value of reporting unit exceeds its fair value
Goodwill equals the acquisition price minus the fair value of net identifiable assets ($10M − $7.5M = $2.5M); under ASC 350, impairment occurs when a reporting unit's carrying value exceeds its fair value.
Question 5: A CPA's client receives an IRS notice proposing a $40,000 adjustment due to a disallowed deduction. The CPA believes the position is defensible but was not disclosed on the return. What standard governs whether the original position was appropriate?
- The position must have been more likely than not to prevail
- The position must meet the substantial authority standard (approximately 40% or greater likelihood of prevailing) (Correct answer)
- The position requires only a reasonable basis if the client signed the return
- The position is automatically valid if the CPA recommended it in writing
Correct answer: The position must meet the substantial authority standard (approximately 40% or greater likelihood of prevailing)
For non-disclosed positions, IRC §6694 and AICPA standards require substantial authority (roughly a 40% or greater chance of being sustained) to avoid preparer penalties.
Question 6: A CPA is performing a financial statement audit and identifies a material weakness in internal controls over financial reporting. What is required in the audit report for a nonpublic company?
- The material weakness must be reported to the SEC within four business days
- The CPA must communicate the material weakness in writing to management and those charged with governance (Correct answer)
- The CPA must issue an adverse opinion on the financial statements
- The CPA is required to issue a separate internal control report
Correct answer: The CPA must communicate the material weakness in writing to management and those charged with governance
AU-C 265 requires auditors to communicate material weaknesses in writing to management and those charged with governance; a separate ICFR opinion is required only for public companies.
Question 7: A calendar-year S corporation has a built-in gain of $600,000 on appreciated assets held when it converted from C corporation status five years ago. The corporation sells those assets this year. What is the tax treatment?
- The gain passes through to shareholders with no entity-level tax
- The gain is subject to the built-in gains tax at the highest corporate rate (21%) at the entity level (Correct answer)
- The gain is split between entity-level tax and shareholder pass-through
- The built-in gains tax no longer applies after three years post-conversion
Correct answer: The gain is subject to the built-in gains tax at the highest corporate rate (21%) at the entity level
Under IRC §1374, built-in gains recognized within the 5-year recognition period are subject to the corporate tax rate (21%) at the S corporation level, in addition to shareholder-level tax on the pass-through.
Certified Public Accountant Case Studies & Practical Application 5
A CPA discovers during a tax engagement that a client has been skimming cash receipts for three years.
The client confesses privately and refuses to correct the returns or notify the IRS.
What should the CPA do?