AUDITING AND ASSURANCE SERVICES AN INTEGRATED APPROACH 16TH EDITION - TEST BANK

AUDITING AND ASSURANCE SERVICES AN INTEGRATED APPROACH 16TH EDITION – TEST BANK

 

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Auditing and Assurance Services, 16e (Arens/Elder/Beasley)

Chapter 5   Legal Liability

 

5.1   Learning Objective 5-1

 

1) Which of the following factors does not contribute to the number of lawsuits against auditors?

1. A) large civil court judgments against CPA firms awarded in a few cases
2. B) growing awareness of the responsibilities of public accountants by users of financial statements
3. C) the simplicity of auditing and accounting functions
4. D) an increased consciousness by the SEC for its responsibility for protecting investors’ interests

Answer:  C

Terms:  Major factors that have contributed to the recent increase in the number of lawsuits against auditors

Diff:  Easy

Objective:  LO 5-1

AACSB:  Reflective thinking

 

2) Discuss three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs.

Answer:  Major factors include:

• The growing awareness of the responsibilities of public accountants by users of financial statements
• An increased consciousness on the part of the Securities and Exchange Commission regarding its responsibility for protecting investors’ interests
• The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations and financing transactions
• The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with joint and several liability doctrine
• The global recession and tough economic times result in business failures, which prompt stakeholders to seek restitution from others, including external auditors
• Large civil court judgments against CPA firms awarded in a few cases
• The willingness of CPA firms to settle legal problems out of court to avoid costly legal fees and adverse publicity, rather than pursuing resolution through the judicial process
• The difficulty judges and jurors have understanding and interpreting technical accounting and auditing matters

 

Terms:  Major factors that have contributed to the recent increase in the number of lawsuits against auditors

Diff:  Moderate

Objective:  LO 5-1

AACSB:  Reflective thinking

 

3) The auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is “foreseen” by the auditor.

Answer:  TRUE

Terms:  Liability to clients under common law

Diff:  Moderate

Objective:  LO 5-1

AACSB:  Reflective thinking

 

5.2   Learning Objective 5-2

 

1) A(n) ________ failure occurs when an auditor issues an erroneous opinion because it failed to comply with requirements of auditing standards.

1. A) business
2. B) audit
3. C) ethics
4. D) process

Answer:  B

Terms:  Failure which occurs when an auditor issues an erroneous opinion

Diff:  Easy

Objective:  LO 5-2

AACSB:  Reflective thinking

 

2) The expectation gap

1. A) exists between the auditor and the SEC.
2. B) exists because auditors guarantee the accuracy of the financial statements.
3. C) often results in unwarranted lawsuits against the auditor.
4. D) is a legal concept supported by the federal courts.

Answer:  C

Terms:  Expectation gap

Diff:  Moderate

Objective:  LO 5-2

AACSB:  Reflective thinking

 

3) Which of the following is an accurate statement regarding audit risk, audit failure, and business failure?

1. A) Audit risk is always avoidable if the audit is conducted in accordance with generally accepted auditing standards.
2. B) Because auditors gather evidence on a test basis, and because well-concealed frauds are difficult to detect, audit risk is unavoidable.
3. C) Legal precedent makes it easy to determine who has the right to recover losses in the event of an audit failure.
4. D) A business failure will always result in an audit failure.

Answer:  B

Terms:  Distinguish among business failure, audit failure, and audit risk

Diff:  Moderate

Objective:  LO 5-2

AACSB:  Reflective thinking

 

4) Distinguish between what is meant by business failure and audit failure.

Answer:  Business failure occurs when a business is unable to repay its lenders or meet expectations of its investors because of economic or business conditions, such as recession, poor management decisions, or unexpected competition in the industry. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.

Terms:  Business failure and audit failure

Diff:  Easy

Objective:  LO 5-2

AACSB:  Reflective thinking

 

5) Audit risk is the risk there will be an audit failure for a given audit engagement.

Answer:  FALSE

Terms:  Audit risk

Diff:  Moderate

Objective:  LO 5-2

AACSB:  Reflective thinking

 

6) The term “audit failure” refers to the situation when the auditor has followed auditing standards yet still fails to discover that the client’s financial statements are materially misstated.

Answer:  FALSE

Terms:  Audit failure

Diff:  Moderate

Objective:  LO 5-2

AACSB:  Reflective thinking

 

5.3   Learning Objective 5-3

 

1) In the performance of an audit, a CPA

1. A) is legally liable for detecting an immaterial client fraud.
2. B) must strictly follow GAAP for privately held clients.
3. C) must exercise constructive professional care in the performance of their audit responsibilities.
4. D) must exercise due professional care in the performance of their audit responsibilities.

Answer:  D

Terms:  Prudent person concept; due professional care

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

 

2) If an auditor fails to fulfill a certain requirement in the contract, they may be guilty of

1. A) contract fraud.
2. B) breach of contract.
3. C) constructive fraud.
4. D) criminal neglect.

Answer:  B

Terms:  Liability when auditors fail to exercise due care

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

3) In the case of an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intent to deceive financial statement users. This description is the legal term for

1. A) ordinary negligence.
2. B) gross negligence.
3. C) constructive fraud.
4. D) fraud.

Answer:  C

Terms:  Prudent person concept; due professional care

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

4) The standard of due care to which the auditor is expected to adhere to in the performance of the audit is referred to as the

1. A) prudent person concept.
2. B) common law doctrine.
3. C) constructive care concept.
4. D) vigilant person concept.

Answer:  A

Terms:  Standard of due care

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

 

5) Auditors may be liable to their clients if they are found guilty of

1. A)

Ordinary negligence	Gross negligence
Yes	Yes

 

1. B)

Ordinary negligence	Gross negligence
No	No

 

1. C)

Ordinary negligence	Gross negligence
Yes	No

 

1. D)

Ordinary negligence	Gross negligence
No	Yes

 

Answer:  A

Terms:  Auditor liability to clients

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

6) Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include

1. A) employees of the CPA firm.
2. B) employees of the audit client.
3. C) other CPA firms engaged to do part of the audit work.
4. D) specialists employed by the CPA firm to provide technical advice on the audit.

Answer:  B

Terms:  Liability for the acts of others

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

7) “Absence of reasonable care that can be expected of a person in a set of circumstances” defines

1. A) pecuniary negligence.
2. B) gross negligence.
3. C) extreme negligence.
4. D) ordinary negligence.

Answer:  D

Terms:  Absence of reasonable care

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

8) An example of a breach of contract would likely include

1. A) an auditor’s refusal to return the client’s general ledger book until the client paid last year’s audit fees.
2. B) a bank’s claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan.
3. C) a CPA firm’s failure to complete an audit on the agreed-upon date because the firm had a backlog of other work which was more lucrative.
4. D) an auditor’s claim that the client staff is unqualified.

Answer:  C

Terms:  Breach of contract

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

9) Privity of contract exists between

1. A) auditor and the federal government.
2. B) auditor and third parties.
3. C) auditor and client.
4. D) auditor and client attorney.

Answer:  C

Terms:  Privity of contract

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

10) An individual who is not party to the contract between a CPA and the client, but who is known by both and is intended to receive certain benefits from the contract is known as

1. A) a third party.
2. B) a common law inheritor.
3. C) a tort.
4. D) a third-party beneficiary.

Answer:  D

Terms:  Individual who is not a party to the contract between a CPA and client

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

11) Laws that have been passed by the U.S. Congress and other governmental units are

1. A) statutory laws.
2. B) judicial laws.
3. C) federal laws.
4. D) common laws.

Answer:  A

Terms:  Laws passed through governmental units

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

12) The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing is called

1. A) separate and proportionate liability.
2. B) shared liability.
3. C) unitary liability.
4. D) joint and several liability.

Answer:  D

Terms:  Assessment against a defendant of the full loss suffered by a plaintiff

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

13) The assessment against a defendant of that portion of the damage caused by the defendant’s negligence is called

1. A) separate and proportionate liability.
2. B) joint and several liability.
3. C) shared liability.
4. D) unitary liability.

Answer:  A

Terms:  Assessment against a defendant of that portion of the damages

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

14) Fraud occurs when

1. A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive.
2. B) a misstatement is made and there is knowledge of its falsity but no intent to deceive.
3. C) the auditor lacks even slight care in the performance in performing the audit.
4. D) the auditor has an absence of reasonable care in the performance of the audit.

Answer:  A

Terms:  Fraud and errors

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

15) Which of the following most accurately describes constructive fraud?

1. A) absence of reasonable care
2. B) lack of slight care
3. C) knowledge and intent to deceive
4. D) extreme or unusual negligence without the intent to deceive

Answer:  D

Terms:  Constructive fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

16) Which of the following most accurately describes fraud?

1. A) absence of reasonable care
2. B) lack of slight care
3. C) knowledge and intent to deceive
4. D) extreme or unusual negligence without the intent to deceive

Answer:  C

Terms:  Fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

17) A third-party beneficiary is one which

1. A) has failed to establish legal standing before the court.
2. B) does not have privity of contract and is unknown to the contracting parties.
3. C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract.
4. D) may establish legal standing before the court after a contract has been consummated.

Answer:  C

Terms:  Third-party beneficiary

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

18) If the CPA negligently failed to properly prepare and file a client’s tax return, the CPA may be liable for

1. A) the penalties the client owes the IRS.
2. B) the penalties and interest the client owes.
3. C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged.
4. D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid.

Answer:  C

Terms:  Liability when a CPA negligently failed to properly prepare and file tax return

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

19) Constructive fraud

1. A) is also known as recklessness.
2. B) requires an intent to deceive.
3. C) involves collusion with the client.
4. D) is also known as breach of contract.

Answer:  A

Terms:  Constructive fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Analytic thinking

 

 

20) Which of the following statements is true?

1. A)

Gross negligence may constitute constructive fraud	Fraud requires the intent to deceive	All fraud should be detected during audit
Yes	Yes	No

 

1. B)

Gross negligence may constitute constructive fraud	Fraud requires the intent to deceive	All fraud should be detected during audit
No	Yes	No

 

1. C)

Gross negligence may constitute constructive fraud	Fraud requires the intent to deceive	All fraud should be detected during audit
Yes	No	Yes

 

1. D)

Gross negligence may constitute constructive fraud	Fraud requires the intent to deceive	All fraud should be detected during audit
No	No	No

 

Answer:  A

Terms:  Gross negligence, fraud, and constructive fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

21) The laws that have been developed through court decisions are called

1. A) common laws.
2. B) criminal laws.
3. C) statutory laws.
4. D) civil laws.

Answer:  A

Terms:  Common law

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

 

22) Which of the following is a true statement regarding CPAs’ liability?

1. A) The amounts assessed under joint and several liability will not differ significantly from the amounts assessed under separate and proportionate liability.
2. B) When lawsuits are brought under the federal securities laws, the joint and several liability approach will always apply.
3. C) If one owner was directly involved in the actions of the owner causing the liability, the personal assets of neither owner can be subject to the damages that arise.
4. D) Under the federal statutes, the amount of damages under separate and proportionate liability can be increased if the main defendant is insolvent.

Answer:  D

Terms:  Assessment against a defendant of that portion of the damages

Diff:  Challenging

Objective:  LO 5-3

AACSB:  Reflective thinking

 

23) The legal term for when an auditor issues an audit opinion, knowing that an adequate audit was not performed, is a

1. A) breach of contract.
2. B) tort action for negligence.
3. C) constructive fraud.
4. D) fraud.

Answer:  C

Terms:  Constructive fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

24) Define ordinary negligence, gross negligence, and constructive fraud.

Answer:  Ordinary negligence is the absence of reasonable care that can be expected of a person is a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation.

 

Gross negligence is the lack of even slight care, tantamount to reckless behavior, that can be expected of a person in a set of circumstances. Some states do not distinguish between ordinary and gross negligence.

 

Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or to do harm. It is also termed recklessness. In an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users.

Terms:  Ordinary negligence, gross negligence, and constructive fraud

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

 

25) An important concept in contract law for accountants to understand is the “third-party beneficiary doctrine.” Explain and give an example.

Answer:  A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement.

Terms:  Contract law; Third-party beneficiary doctrine

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

26) Distinguish between constructive fraud and fraud.

Answer:  Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive.

Terms:  Constructive fraud

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

27) Distinguish between “joint and several liability” and “separate and proportionate liability.”

Answer:  Under joint and several liability, the defendant can be assessed the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. In contrast, under separate and proportionate liability, the defendant is assessed that portion of the damage caused by the defendant’s negligence.

Terms:  Joint and several liability and separate and proportionate liability

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

28) Match seven of the legal terms (a-j) with the definitions provided below (1-7):

 

1. common law
2. constructive fraud
3. breach of contract
4. joint and several liability
5. ordinary negligence
6. third-party beneficiary
7. gross negligence
8. statutory law
9. fraud
10. separate and proportionate liability

 

________ 1. laws that have been passed by the U.S. Congress and other governmental units

 

________ 2. absence of reasonable care that can be expected of a person in a set of circumstances

 

________ 3. lack of even slight care, tantamount to reckless behavior that can be expected of a person

 

________ 4. the assessment against a defendant of that portion of the damage caused by the defendant’s negligence

 

________ 5. failure of one or both parties in a contract to fulfill the requirements of the contract

 

________ 6. the assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing

 

________ 7. existence of extreme or unusual negligence even though there was no intent to deceive or do harm; also termed recklessness

Answer:

1. h
2. e
3. g
4. j
5. c
6. d
7. b

Terms:  Constructive fraud; Breach of contract; Joint and several liability; Separate and proportionate liability; Gross negligence; Ordinary negligence; Statutory law

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

 

29) The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept.

Answer:  TRUE

Terms:  Standard of due care; Prudent person concept

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

30) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s actions does not extend to another partner’s personal assets.

Answer:  TRUE

Terms:  CPA firm operating as a limited liability partnership

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

31) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s actions extends to the firm’s assets.

Answer:  TRUE

Terms:  CPA firm operating as a limited liability partnership

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

32) Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units.

Answer:  FALSE

Terms:  Statutory laws

Diff:  Easy

Objective:  LO 5-3

AACSB:  Reflective thinking

 

33) When an auditor has failed to conduct an adequate audit, liability may depend on the level of negligence.

Answer:  TRUE

Terms:  Liability and level of negligence

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

34) Several states have statutes that permit privileged communication between the client and auditor, allowing a CPA to refuse to testify in state and federal courts.

Answer:  FALSE

Terms:  CPA and privileged communication

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

 

35) Gross negligence is the existence of extreme or unusual negligence with the intent to deceive.

Answer:  FALSE

Terms:  Gross negligence

Diff:  Moderate

Objective:  LO 5-3

AACSB:  Reflective thinking

5.4   Learning Objective 5-4

 

1) The principal issue in cases involving alleged negligence is usually

1. A) if an engagement letter was issued.
2. B) the level of care required.
3. C) if fraud was committed by upper-level management.
4. D) whether the auditor is liable under civil or criminal laws.

Answer:  B

Terms:  Level of care; Negligence

Diff:  Easy

Objective:  LO 5-4

AACSB:  Reflective thinking

 

2) Which of the auditor’s defenses against client suits contends no implied or expressed contract?

1. A) lack of duty
2. B) non-negligent performance
3. C) contributory negligence
4. D) absence of causal connections

Answer:  A

Terms:  Auditors’ defenses against lawsuits

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

3) In connection with the audit of financial statements, an independent auditor could be responsible for failure to detect a material fraud if

1. A) statistical sampling techniques were not used on the audit engagement.
2. B) the auditor planned the audit in a negligent manner.
3. C) accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier.
4. D) the fraud was perpetrated by one employee who circumvented the existing internal controls.

Answer:  B

Terms:  Independent auditor could be responsible for failure to detect material fraud

Diff:  Easy

Objective:  LO 5-4

AACSB:  Reflective thinking

 

 

4) Which of the following is an illustration of liability to clients under common law?

1. A) A client sues the auditor for not discovering a theft of assets by an employee.
2. B) A bank sues the auditor for not discovering that the borrower’s financial statements are misstated.
3. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements.
4. D) The federal government prosecutes the auditor for knowingly issuing an incorrect audit report.

Answer:  A

Terms:  Liability to clients under common law

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

5) Which of the following is an illustration of liability under the federal securities acts?

1. A) A client sues the auditor for not discovering a theft of assets by an employee.
2. B) A bank sues the auditor for not discovering that the borrower’s financial statements are misstated.
3. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements.
4. D) The auditor sues a client for not cooperating during the engagement.

Answer:  C

Terms:  Liability under federal securities acts

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

6) A CPA firm normally uses one or a combination of four defenses when there are legal claims by clients. Which one of the following is generally not a defense?

1. A) lack of duty
2. B) nonnegligent performance
3. C) contributory negligence
4. D) foreseeable users

Answer:  D

Terms:  Auditors’ defenses against lawsuits

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

 

7) Tort actions against CPAs are more common than breach of contract actions because

1. A) there are more torts than contracts.
2. B) the burden of proof is on the auditor rather than on the person suing.
3. C) the person suing need prove only negligence.
4. D) the amounts recoverable are normally larger.

Answer:  D

Terms:  Tort actions against CPAs

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

8) The principal issue to be resolved in cases involving alleged negligence is usually

1. A) the amount of the damages suffered by plaintiff.
2. B) whether to impose punitive damages on defendant.
3. C) the level of care exercised by the CPA.
4. D) whether defendant was involved in fraud.

Answer:  C

Terms:  Principal issue to be resolved in cases involving alleged negligence

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

9) In the auditing environment, failure to meet auditing standards is often

1. A) an accepted practice.
2. B) a suggestion of negligence.
3. C) conclusive evidence of negligence.
4. D) tantamount to criminal behavior.

Answer:  C

Terms:  Failure to meet auditing standards

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

10) A common way for a CPA firm to demonstrate a lack of duty to perform is by use of a(n)

1. A) expert witness’ testimony.
2. B) engagement letter.
3. C) management representation letter.
4. D) confirmation letter.

Answer:  B

Terms:  Common way to demonstrate lack of duty to perform

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

 

11) To succeed in an action against the auditor, the client must be able to show that

1. A) the auditor was fraudulent.
2. B) the auditor was grossly negligent.
3. C) there was a written contract.
4. D) there is a close causal connection between the auditor’s behavior and the damages suffered by the client.

Answer:  D

Terms:  Auditors’ defenses against lawsuits

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

12) Which of the following is a true statement regarding auditors’ liability?

1. A) The level of care is easy to determine in a review or compilation.
2. B) Engagement letters will relieve the auditor of all liability.
3. C) An auditor will always be guilty of negligence if they fail to uncover fraud.
4. D) The most common source of lawsuits against CPAs is from clients.

Answer:  D

Terms:  Auditors’ liability to clients

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

13) One of the changes in auditing procedures which was brought about as a result of the 1136 Tenants case was that auditors were encouraged to begin using

1. A) letters of representation.
2. B) confirmation letters.
3. C) engagement letters.
4. D) billet doux letters.

Answer:  C

Terms:  Audit procedure brought about by 1136 Tenants case

Diff:  Challenging

Objective:  LO 5-4

AACSB:  Reflective thinking

 

 

14) The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson’s auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt’s best defense?

1. A) King is not in privity of contract.
2. B) The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards.
3. C) Lynch & Merritt were not guilty either of gross negligence or fraud.
4. D) Lynch & Merritt were not aware of the King-Wilson surety relationship.

Answer:  B

Terms:  Defense in recovery against auditors with employee theft

Diff:  Challenging

Objective:  LO 5-4

AACSB:  Analytic thinking

 

15) There are four major sources of an auditor’s legal liability. One source is liability to the audit client. List the other three sources.

Answer:  The other three sources of auditor’s legal liability are:

• liability to third parties under common law
• civil liability under federal securities laws
• criminal liability

Terms:  Sources of auditor’s legal liability

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

16) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients.

Answer:

Lack of duty. The CPA firm claims that there was no implied or expressed contract.

 

Non-negligent performance. The CPA firm claims that the audit was performed in accordance with auditing standards.

 

Contributory negligence. The CPA firm claims that the client’s own actions resulted in the loss that is the basis for the damages, or interfered with the conduct of the audit in such a way that prevented that auditor from discovering the cause of the loss. This defense is not available in third-party suits.

 

Absence of causal connection. The CPA firm claims that the auditor’s failure to follow auditing standards did not cause the damages suffered by the client.

Terms:  Auditors’ defenses against lawsuits

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

17) An example of auditor legal liability to third parties under common law would be the federal government prosecuting an auditor for knowingly issuing an incorrect audit report.

Answer:  FALSE

Terms:  Four major sources of auditors’ legal liability

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

18) The 1136 Tenants case was a criminal case concerning a CPA’s failure to uncover fraud during a financial statement audit.

Answer:  FALSE

Terms:  1136 Tenants case

Diff:  Moderate

Objective:  LO 5-4

AACSB:  Reflective thinking

 

19) Many litigation experts believe that a well written engagement letter significantly reduces the likelihood of adverse legal actions.

Answer:  TRUE

Terms:  Reasons for an audit and audit evidence

Diff:  Easy

Objective:  LO 5-4

AACSB:  Reflective thinking

5.5   Learning Objective 5-5

 

1) A financial institution sues the audit firm for failure to discover that a borrower’s financial statements are materially misstated. This is an example of which of the following legal liability concepts?

1. A) liability to clients
2. B) liability to third parties under common law
3. C) civil liability under federal securities law
4. D) criminal liability

Answer:  B

Terms:  Liability to third parties under common law

Diff:  Easy

Objective:  LO 5-5

AACSB:  Reflective thinking

 

 

2) Which of the following auditor’s defenses usually means nonreliance on the financial statements by the user?

1. A) lack of duty
2. B) non negligent performance
3. C) absence of causal connections
4. D) contributory negligence

Answer:  C

Terms:  Auditor defenses against third party suits

Diff:  Easy

Objective:  LO 5-5

AACSB:  Analytic thinking

 

3) A group typically included as “third parties” in common law is

1. A)

Actual and potential stockholders	Employees of client
Yes	Yes

 

1. B)

Actual and potential stockholders	Employees of client
No	No

 

1. C)

Actual and potential stockholders	Employees of client
Yes	No

 

1. D)

Actual and potential stockholders	Employees of client
No	Yes

 

Answer:  A

Terms:  Third parties in common law

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

4) The major conclusion of the 1931 Ultramares case was that

1. A) ordinary negligence is insufficient for liability to third parties.
2. B) third parties must file criminal charges, not civil charges, against the auditor.
3. C) fraud or gross negligence is sufficient for liability to third parties.
4. D) auditors have no liabilities to third parties.

Answer:  A

Terms:  Major conclusion of 1931 Ultramares case

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

 

5) Under common law, a foreseen user would be treated the same as

1. A)

A primary beneficiary	A known third party
Yes	Yes

 

1. B)

A primary beneficiary	A known third party
No	No

 

1. C)

A primary beneficiary	A known third party
Yes	No

 

1. D)

A primary beneficiary	A known third party
No	Yes

 

Answer:  A

Terms:  Foreseen user under common law treated the same as

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

6) A broad interpretation of the rights of third-party beneficiaries holds that users the auditor should have been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. This is known as the concept of

1. A) foreseen users.
2. B) foreseeable users.
3. C) expected users.
4. D) four-party contracts.

Answer:  B

Terms:  Rights of third-party beneficiaries; Privity of contract

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

7) Which of the auditor’s defenses is ordinarily not available when lawsuits are filed by a third party?

1. A) absence of causal connections
2. B) contributory negligence
3. C) nonnegligent performance
4. D) lack of duty

Answer:  B

Terms:  Auditor defenses against third party suits

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

8) According to the principle established by the Restatement of Torts, foreseen users must be members of

1. A) any potential user group.
2. B) a legally protected class.
3. C) a reasonably limited and identifiable user group.
4. D) a reasonably limited and established user group.

Answer:  C

Terms:  Principle established by Restatement of Torts

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

9) Under the Ultramares doctrine, ordinary negligence is insufficient for liability to third parties unless the third party is

1. A) a primary beneficiary.
2. B) an injured party.
3. C) a foreseen user.
4. D) a bank.

Answer:  A

Terms:  Ultramares doctrine

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

10) Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor’s report to make decisions about the client company has:

1. A) no rights unless an auditor is grossly negligent.
2. B) no rights unless an auditor is fraudulent.
3. C) no rights against an auditor.
4. D) the same rights against an auditor as a client.

Answer:  D

Terms:  Common law third-party rights

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Analytic thinking

 

11) The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was that

1. A) the auditor’s defense of privity of contract is still valid against third parties.
2. B) the auditor is liable for ordinary negligence to specifically foreseen third parties.
3. C) the auditor is liable for ordinary negligence to reasonably foreseeable third parties.
4. D) the auditor’s defense of contributory negligence is no longer valid.

Answer:  A

Terms:  Basic legal concept affirmed in 1985 case, Credit Alliance

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Analytic thinking

 

12) As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company’s controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft?

1. A) He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees.
2. B) He would have no liability because privity of contract is lacking.
3. C) He would be liable for losses attributable to his negligence.
4. D) He would be liable only if it could be proven that he was grossly negligent.

Answer:  C

Terms:  Under common law, extent of liability where auditor failed to adhere to generally accepted auditing standards in examination of client and failed to detect employee embezzlement

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Analytic thinking

 

13) If an auditor is unsuccessful in using the lack of duty defense to have a case dismissed in a third-party suit, the preferred defense is

1. A) lack of duty to perform.
2. B) nonnegligent performance.
3. C) absence of causal connection.
4. D) client fraud.

Answer:  B

Terms:  Preferred defense in third-party suits

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

14) Three approaches to the application of the foreseen users’ concept are (1) the Credit Alliance approach, (2) the Restatement of Torts approach, and (3) the foreseeable user approach. Summarize each of these three approaches.

Answer:  The Credit Alliance approach upholds the concept of privity of contract established by the Ultramares Corporation v. Touche case. Under this approach, for an auditor to be liable to third parties, the auditor (1) must know and intend that the work product would be used by the third-party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor’s conduct.

 

Under the Restatement of Torts approach, foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA’s work, such as creditors, even though those persons were not specifically known to the CPA at the time the work was done.

 

Under the foreseeable user approach, any users that the auditor should have reasonably been able to foresee as likely users of the client’s financial statements have the same rights as those with privity of contract.

Terms:  Three approaches to the application of foreseen users’ concepts

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Reflective thinking

 

15) Although there is confusion caused by the differing views of liability to third parties under common law, the movement is clearly away from the foreseeable user approach.

Answer:  TRUE

Terms:  Foreseeable user approach

Diff:  Moderate

Objective:  LO 5-5

AACSB:  Reflective thinking

 

16) The broadest interpretation of the right of third-party beneficiaries is the primary user concept.

Answer:  FALSE

Terms:  Third-party liability under common law

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Reflective thinking

 

17) The Credit Alliance approach to the concept of foreseen users states that to be liable to third parties, an auditor (1) must know and intend that the work product would be used by the third-party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor’s conduct.

Answer:  TRUE

Terms:  Credit Alliance approach

Diff:  Challenging

Objective:  LO 5-5

AACSB:  Reflective thinking

 

5.6   Learning Objective 5-6

 

1) An adequate system of internal control for SEC registrants was originally required by the

2002. A) Sarbanes-Oxley Act of 2002.
2003. B) Securities Act of 1933.
2004. C) Foreign Corrupt Practices Act of 1977.
2005. D) Securities Act of 1934.

Answer:  C

Terms:  Required an adequate system of internal control for SEC registrants

Diff:  Easy

Objective:  LO 5-6

AACSB:  Reflective thinking

 

2) The increased litigation under the federal securities laws has resulted from

1. A)

The availability of class-action litigation	The strict liability standards imposed on CPAs by the securities laws	An excess of attorneys
Yes	Yes	Yes

 

1. B)

The availability of class-action litigation	The strict liability standards imposed on CPAs by the securities laws	An excess of attorneys
Yes	No	No

 

1. C)

The availability of class-action litigation	The strict liability standards imposed on CPAs by the securities laws	An excess of attorneys
Yes	Yes	No

 

1. D)

The availability of class-action litigation	The strict liability standards imposed on CPAs by the securities laws	An excess of attorneys
No	No	No

 

Answer:  C

Terms:  Increased litigation under federal securities law

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

 

3) Under the Securities Act of 1933, the auditor’s responsibility for making sure the financial statements were fairly stated extends to

1. A) the date of the financial statements.
2. B) the date the registration statement becomes effective.
3. C) the date of the audit report.
4. D) one year beyond the date of the financial statements.

Answer:  B

Terms:  Securities Act of 1933

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

4) Under the Securities Exchange Act of 1934, which type of organization is required to submit audited financial statements to the SEC?

1. A) every company with securities traded on national and over-the-counter exchanges
2. B) every corporation
3. C) every company issuing new securities
4. D) every corporation which is chartered by a state government

Answer:  A

Terms:  Securities Act of 1934; Organizations required to submit audited financial statements

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

5) The Securities and Exchange Commission can impose all but which of the following sanctions?

1. A) suspend a CPA from auditing SEC clients
2. B) prohibit a CPA from accepting new SEC clients for a period of time
3. C) require a CPA to participate in continuing-education programs and make changes in their practice
4. D) revoke a CPA license

Answer:  D

Terms:  Securities and Exchange Commission can impose sanctions

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

 

6) The Foreign Corrupt Practices Act (FCPA) of 1977

1. A) requires auditors to review and evaluate systems of internal control as a part of an audit.
2. B) requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control.
3. C) requires auditors to review client’s internal control system in a manner which is thorough enough to judge whether client meets the requirements of the FCPA.
4. D) requires auditors to file a report with the SEC if client’s internal control system is inadequate.

Answer:  B

Terms:  Foreign Corrupt Practices Act of 1977

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

7) While the Foreign Corrupt Practices Act of 1977 remains in effect, its internal control provisions have been largely superseded by which of the following?

1. A) Sarbanes-Oxley Act of 2002
2. B) Racketeer Influenced and Corrupt Organization Act
3. C) Federal False Statements Statute
4. D) Federal Mail Fraud Statute

Answer:  A

Terms:  Foreign Corrupt Practices Act of 1977; Internal control provisions

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

Topic:  SOX

8) Which of the following is an accurate statement regarding recent actions brought against accountants by clients and third parties?

1. A) Litigants will first seek state remedies because of the availability of class-action litigation.
2. B) Gross negligence by the auditor must be proven under the Securities Acts of 1933 and 1934.
3. C) The greatest growth in CPA liability litigation bas been under the federal securities laws.
4. D) The amount of damages that plaintiffs can receive is greater under common law than under the federal securities laws.

Answer:  C

Terms:  Factor in increase in number of lawsuits and sizes of awards

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

 

9) A major purpose of federal securities regulations is to

1. A) provide sufficient reliable information to the investing public who purchase securities in the marketplace.
2. B) establish the qualifications for accountants who are members of the profession.
3. C) eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public.
4. D) provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission.

Answer:  A

Terms:  Major purpose of federal securities regulations

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

10) The 2012 news of a massive alleged bribery scheme involving Wal-Mart has brought charges against the company under the

1933. A) Securities Act of 1933.
1934. B) Securities Act of 1934.
1935. C) Foreign Corrupt Practices Act of 1977.
1936. D) Sarbanes-Oxley Act of 2002

Answer:  C

Terms:  Foreign Corrupt Practices Act of 1977

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

11) Which of the following statements about the Securities Act of 1933 is not true?

1. A) A third party that purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in the audited financial statements.
2. B) A third party user does not have the burden of proof that he/she relied on the financial statements.
3. C) A third party user has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.
4. D) A third party user does not have the burden of proof that the loss was caused by the misleading statements.

Answer:  C

Terms:  Securities Act of 1933

Diff:  Challenging

Objective:  LO 5-6

AACSB:  Analytic thinking

 

 

12) The most significant audit issue that came as a result of the court decision in the Escott et al. v. BarChris Construction Corporation case in 1968 was

1. A) the court’s reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent.
2. B) the affirmation of an increase in the auditor’s responsibility when performing a review of events subsequent to the balance sheet date (S-1 review) for registration statements.
3. C) the increased auditor responsibility when associated with unaudited financial statements.
4. D) the court’s refusal to allow the percentage-of-completion method of accounting for revenues.

Answer:  B

Terms:  Significant audit issue from Escott et al v. BarChris Construction Corporation case

Diff:  Challenging

Objective:  LO 5-6

AACSB:  Reflective thinking

 

13) One significant result of the Escott et al. v. BarChris Construction Corporation case was

1. A) a greater emphasis on subsequent events procedures.
2. B) new standards for unaudited statements.
3. C) a broader definition of third party beneficiaries.
4. D) a requirement that more companies file annual reports with the SEC.

Answer:  A

Terms:  Significant result from Escott et al v. Bar Chris Construction Corporation case

Diff:  Challenging

Objective:  LO 5-6

AACSB:  Reflective thinking

 

14) Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor’s involvement with the

1. A) 8-K form.
2. B) 10-K form.
3. C) 10-Q form.
4. D) S-1 form.

Answer:  B

Terms:  Securities Exchange Act of 1934

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

15) Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as

1. A) the antifraud provisions.
2. B) the new issues provisions.
3. C) the full employment act for accountants.
4. D) the RICO provisions.

Answer:  A

Terms:  Securities Exchange Act of 1934 Section 10 and Rule 10b-5

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

16) The U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, the auditor’s ________ would be required to be shown to the court.

1. A) ordinary negligence
2. B) gross negligence
3. C) knowledge and intent to deceive
4. D) financial gain at the expense of the plaintiff

Answer:  C

Terms:  Securities Exchange Act of 1934 Rule 10b-5; U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

17) Under the Securities Act of 1933,

1. A) any party who relies on the company’s audited financial statements can recover from the auditors.
2. B) third-party users must prove that the auditor was negligent.
3. C) the burden of proof is on the defendant.
4. D) auditors face potential legal exposure for information contained in the Form 10-Q.

Answer:  C

Terms:  Securities and Exchange Commission

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

18) Which of the following is an accurate statement regarding Rule 10b-5 of the Securities Exchange Act of 1934?

1. A) The Supreme Court has ruled that liability under Rule 10b-5 does not extend to aiders or abettors who participated in financial statement misstatements that were not the primary defendants.
2. B) Federal court decisions have clarified that Rule 10b-5 applies only to direct sellers.
3. C) Hochfelder and subsequent court decisions have increased the liability of auditors under Rule 10b-5.
4. D) According to most recent court decisions, poor judgment is proof of fraud.

Answer:  A

Terms:  Securities Exchange Act of 1934 Section 10 and Rule 10b-5

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Analytic thinking

 

19) Discuss the sanctions the Securities and Exchange Commission can impose on auditors.

Answer:  The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. The SEC’s Rules of Practice permit them to temporarily or permanently deny a CPA or CPA firm from being associated with financial statements of public companies, either because of lack of appropriate qualifications or having engaged in unethical or improper professional conduct.

 

In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits of SEC clients. It has also prohibited a number of CPA firms from accepting any new SEC clients for a period. In some cases, the SEC has required an extensive review of a major CPA firm’s practices by another CPA firm, or made CPA firms make changes in their practices. Individual CPAs and their firms have also been required to participate in continuing education programs. Sanctions such as these are published by the SEC and are often reported in the business press, making them a significant embarrassment to those involved.

Terms:  Securities Exchange Act of 1934 Section 10 and Rule 10b-5

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

20) One result from the Escott et al. v. BarChris case was a greater emphasis being placed on the audit staff’s understanding of the client’s business and industry.

Answer:  TRUE

Terms:  Escott et al. v. BarChris

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

21) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities.

Answer:  TRUE

Terms:  Securities Act of 1933

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

22) Under the Securities Act of 1933, a third party plaintiff does not have the burden of proof that he or she relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Rather, the plaintiff need only prove that the audited financial statements contained a material misrepresentation or omission.

Answer:  TRUE

Terms:  Securities Act of 1933; Burden of proof

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

23) Companies with securities traded on national and over-the-counter exchanges are required to submit audited financial statements once every three years to the Securities and Exchange Commission.

Answer:  FALSE

Terms:  Securities Act Commission; Securities traded on national exchanges

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

24) The same three defenses available to auditors in common lawsuits by third parties—nonnegligent performance, lack of duty, and absence of causal connection—are also available for suits under the Securities Exchange Act of 1934.

Answer:  TRUE

Terms:  Securities Act of 1934; Defenses available to auditors in common law suits by third parties

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

25) The defense of contributory negligence by a third party is often used by auditors if charged with a violation of the 1934 Securities Act.

Answer:  FALSE

Terms:  Securities Exchange Act of 1934

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

26) The Sarbanes-Oxley Act requires the CEO and CFO of a public company to certify the annual and quarterly financial statements filed with the PCAOB.

Answer:  FALSE

Terms:  Sarbanes-Oxley Act

Diff:  Moderate

Objective:  LO 5-6

AACSB:  Reflective thinking

 

 

5.7   Learning Objective 5-7

 

1) In which case were auditors prosecuted for filing false financial statements for a client with the government?

1. A) United States v. Natelli
2. B) United States v. Simon
3. C) Escott et al. v. BarChris
4. D) ESM Government Securities v. Alexander Grant & Co.

Answer:  B

Terms:  Case where auditors were prosecuted for filing false financial statements

Diff:  Moderate

Objective:  LO 5-7

AACSB:  Reflective thinking

2) A CPA is subject to criminal liability if the CPA

1. A) refuses to turn over requested audit documentation to a client.
2. B) performs an audit in a negligent manner.
3. C) is knowingly involved with false financial statements.
4. D) willfully breaches a contract with a client.

Answer:  C

Terms:  CPA subject to criminal liability

Diff:  Moderate

Objective:  LO 5-7

AACSB:  Reflective thinking

 

3) Critical lessons learned after analyzing major criminal cases against auditors include the fact that

1. A) the partner, but not the audit staff, must be independent.
2. B) transactions with related parties are an indication of fraud.
3. C) an investigation of the integrity of management is an important part of deciding whether to accept a new client.
4. D) accounting principles can be relied on exclusively in deciding if the financial statements are fairly presented.

Answer:  C

Terms:  CPAs held liable for criminal activity and federal laws; Infamous cases

Diff:  Moderate

Objective:  LO 5-7

AACSB:  Reflective thinking

 

 

4) The Sarbanes-Oxley Act of 2002 makes it a felony to destroy or create documents to impede or obstruct a federal investigation. Those provisions were adopted following which of the following legal cases?

1. A) United States v. Natelli
2. B) United States v. Andersen
3. C) ESM Government Securities v. Alexander Grant & Co.
4. D) United States v. Simon

Answer:  B

Terms:  CPAs held liable for criminal activity and federal laws; Infamous cases

Diff:  Moderate

Objective:  LO 5-7

AACSB:  Analytic thinking

5) CPAs can be held liable for criminal activity under both state and federal laws. Infamous cases include United States vs. Natelli and ESM Government Securities v. Alexander Grant and Co. Discuss what occurred in each case.

Answer:  Natelli–two auditors were convicted of criminal liability under the 1934 act for certifying financial statements of National Student Marketing Corporation that contained inadequate disclosures.

 

ESM–management revealed to the partner in charge of the audit of ESM that the previous year’s financial statements contained a material misstatement. Rather than complying with the profession and firm standards, the partner agreed to say nothing in the hope that management would work its way out of the problem during the current year. The partner was convicted of criminal charges for his role in sustaining the fraud.

Terms:  CPAs held liable for criminal activity and federal laws; Infamous cases

Diff:  Moderate

Objective:  LO 5-7

AACSB:  Reflective thinking

 

6) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to 10 years in prison.

Answer:  FALSE

Terms:  Sarbanes-Oxley Act of 2002; Destruction of audit documentation punishable

Diff:  Challenging

Objective:  LO 5-7

AACSB:  Reflective thinking

Topic:  SOX

 

 

5.8   Learning Objective 5-8

 

1) Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation?

1. A) Private Securities Litigation Reform Act
2. B) Public Securities Damages and Settlements Act
3. C) Racketeer Influenced and Corrupt Organization Act
4. D) U.S. Securities Claims Reform Act

Answer:  A

Terms:  Federal law passed in 1995 significantly reduced potential damages

Diff:  Moderate

Objective:  LO 5-8

AACSB:  Reflective thinking

 

2) In order to protect themselves from legal liability, it is important that CPAs

1. A) are organized as sole-proprietors.
2. B) accept client representations.
3. C) understand the client’s business.
4. D) use engagement letters, not representation letters.

Answer:  C

Terms:  Protecting individual CPAs from legal liability

Diff:  Moderate

Objective:  LO 5-8

AACSB:  Reflective thinking

3) Discuss at least 3 steps the AICPA and the accounting profession as a whole can and are taking to reduce the practitioner’s exposure to lawsuits.

Answer:  Steps the profession is taking to reduce practitioners’ exposure to lawsuits include:

• Set standards and revise them to meet the changing needs of auditing.
• Oppose lawsuits.
• Educate investors and other users of financial statements as to the meaning of an auditor’s opinion and the extent and nature of the auditor’s work.
• Sanction members for improper conduct and performance.
• Lobby for changes in laws.

Terms:  Steps the AICPA and accounting profession taking to reduce practitioner’s exposure to lawsuits

Diff:  Moderate

Objective:  LO 5-8

AACSB:  Reflective thinking

 

4) Match eight of the following terms (a-n) with the definitions provided below (1-8):

 

1. Foreign Corrupt Practices Act
2. Securities Exchange Act of 1934
3. Securities Litigation Uniform Standards Act of 1998
4. Securities Act of 1933
5. Ultramares doctrine
6. audit risk
7. audit failure
8. standards failure
9. business failure
10. absence of causal connection
11. contributory negligence
12. lack of duty to perform
13. nonnegligent performance

 

________ 1. a situation in which an incorrect audit opinion is issued because it failed to comply with the requirements of auditing standards

 

________ 2. a federal statute dealing with companies that trade securities on national and over-the-counter exchanges. Auditors are involved because the annual reporting requirements include audited financial statements.

 

________ 3. an auditor’s legal defense under which the auditor claims that the client’s own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss

 

________ 4. a federal statute that makes it illegal to offer a bribe to an official of a foreign country

 

________ 5. a common-law approach to third-party liability in which ordinary negligence is insufficient for liability to third parties, because of the lack of privity of contract between the third-party and the auditor unless the third-party is a primary beneficiary

 

________ 6. a federal statute designed to significantly reduce the potential damages in federal securities-related litigation by providing for proportionate liability in most cases

 

________ 7. an auditor’s legal defense under which the auditor claims that the audit was performed in accordance with generally accepted auditing standards

 

________ 8. an auditor’s legal defense under which the auditor claims that the failure to follow auditing standards did not cause the damages suffered by the client

Answer:  1. g, 2. b, 3. k, 4. a, 5. e, 6. c, 7. m, 8. j

Terms:  Audit failure; Securities Exchange Act of 1934; Contributory negligence; Foreign Corrupt Practices Act; Securities Litigation Uniform Standards Act of 1998; Ultramares doctrine; Nonnegligent performance; Absence of causal connection

Diff:  Moderate

Objective:  LO 5-8

AACSB:  Reflective thinking

 

5) Discuss some of the steps practicing auditors can take to minimize their legal liability.

Answer:  There are many steps individual practitioners can take to minimize legal liability including:

• Deal only with clients possessing integrity
• Maintain independence
• Understand the client’s business
• Perform quality audits
• Document the work properly
• Obtain an engagement letter and a representation letter
• Exercise professional skepticism
• Carry adequate insurance
• Choose a form of organization that provides some form of legal liability protection to owners
• Consult with experienced legal counsel in the event of actual or threatened litigation

Terms:  Steps auditors can take to minimize legal liability

Diff:  Easy

Objective:  LO 5-8

AACSB:  Reflective thinking

 

6) The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to the amount of the audit fees charged.

Answer:  FALSE

Terms:  Private Securities Litigation Reform Act of 1995

Diff:  Easy

Objective:  LO 5-8

AACSB:  Reflective thinking