To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com Auditing and Assurance Services, 14e (Arens) Chapter Legal Liability Learning Objective 5-1 1) 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 • Large civil court judgments against CPA firms • 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 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 Te rms: Major factors that have contribute d to the rece nt increase in the numbe r of lawsuits against auditors Diff: Mode rate Objective : LO 5-1 AACSB: Re flective thinking skills 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 A) business B) audit C) ethics D) process Answer: B Te rms: Failure which occurs whe n an auditor issues an erroneous opinion Diff: Easy Objective : LO 5-2 AACSB: Re flective thinking skills 2) 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 Te rms: Busine ss failure and audit failure Diff: Easy Objective : LO 5-2 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 3) Audit risk is the risk there will be an audit failure for a given audit engagement A) True B) False Answer: B Te rms: Audit risk Diff: Mode rate Objective : LO 5-2 AACSB: Re flective thinking skills 4) 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 A) True B) False Answer: B Te rms: Audit failure ; Followe d audit standards and fail to discove r mate rial misstateme nt Diff: Mode rate Objective : LO 5-2 AACSB: Re flective thinking skills Learning Objective 5-3 1) In the performance of an audit, a CPA: A) is legally liable for not detecting client fraud B) must strictly follow GAAS for privately held clients C) must strictly follow PCAOB auditing standards for publicly held clients D) must exercise due professional care in the performance of their audit responsibilities Answer: D Te rms: Performance of an audit Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 2) Auditors who fail to exercise due care in their performance of professional services may be liable for: A) punitive liability B) breach of contract C) excess liability D) criminal charges Answer: B Te rms: Liability whe n auditors fail to e xe rcise due care Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 3) Recklessness in the case of an audit 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: A) ordinary negligence B) gross negligence C) constructive fraud D) fraud Answer: C Te rms: Legal te rm for reckless in an audit with not inte nt to dece ive Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 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: A) prudent person concept B) common law doctrine C) due care concept D) vigilant person concept Answer: A Te rms: Standard of due care Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 5) Auditors may be liable to their clients for: A) Punitive damages Compensatory damages Yes Yes B) Punitive damages No Compensatory damages No Punitive damages Yes Compensatory damages No Punitive damages No Compensatory damages Yes C) D) Answer: A Te rms: Auditor liability to clie nts Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 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: A) employees of the CPA firm B) employees of the audit client C) other CPA firms engaged to part of the audit work D) specialists employed by the CPA firm to provide technical advice on the audit Answer: B Te rms: Laws of age ncy Partners of CPA firm liable for work of othe rs on whom the y re ly Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 7) "Absence of reasonable care that can be expected of a person in a set of circumstances" defines: A) pecuniary negligence B) gross negligence C) extreme negligence D) ordinary negligence Answer: D Te rms: Absence of reasonable care Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 8) An example of a breach of contract would likely include: A) an auditor's refusal to return the client's general ledger book until the client paid last year's audit fees 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 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 D) an auditor's claim that the client staff is unqualified Answer: C Te rms: Breach of contract Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 9) Privity of contract exists between: A) auditor and the federal government B) auditor and third parties C) auditor and client D) auditor and client attorney Answer: C Te rms: Privity of contract Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 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: A) a third party B) a common law inheritor C) a tort D) a third-party beneficiary Answer: D Te rms: Individual who is not a party to the contract be twee n a CPA and clie nt, but who is known Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 11) Laws that have been passed by the U.S Con gress and other governmental units are: A) statutory laws B) judicial laws C) federal laws D) common laws Answer: A Te rms: Laws passe d through state le gislatures Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 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: A) separate and proportionate liability B) shared liability C) unitary liability D) joint and several liability Answer: D Te rms: Assessment against a de fe ndant of the full loss suffe re d by a plaintiff Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 13) The assessment against a defendant of that portion of the damage caused by the defendant's negligence is called: A) separate and proportionate liability B) joint and several liability C) shared liability D) unitary liability Answer: A Te rms: Assessment against a de fe ndant of that portion of the damages Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 14) Audit fraud occurs when: A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive B) a misstatement is made and there is knowledge of its falsity but no intent to deceive C) the auditor lacks even slight care in the performance in performing the audit D) the auditor has an absence of reasonable care in the performance of the audit Answer: A Te rms: Audit fraud Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 15) Which of the following most accurately describes constructive fraud? A) Absence of reasonable care B) Lack of slight care C) Knowledge and intent to deceive D) Extreme or unusual negligence without the intent to deceive Answer: D Te rms: Describes constructive fraud Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills 16) Which of the following most accurately describes fraud? A) Absence of reasonable care B) Lack of slight care C) Knowledge and intent to deceive D) Extreme or unusual negligence without the intent to deceive Answer: C Te rms: Describes fraud Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills 17) A third-party beneficiary is one which: A) has failed to establish legal standing before the court B) does not have privity of contract and is unknown to the contracting parties C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract D) may establish legal standing before the court after a contract has been consummated Answer: C Te rms: Third-party bene ficiary Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 18) If the CPA n egligently failed to properly prepare and file a client's tax return, the CPA may be liable for: A) the penalties the client owes the IRS B) the penalties and interest the client owes C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid Answer: C Te rms: Liability whe n a CPA neglige ntly faile d to prope rly pre pare and file tax re turn Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills 19) Which of the following, if present, would most likely support a finding of constructive fraud on the part of a CPA? A) Gross negligence in applying GAAS B) Ordinary negligence in applying GAAS C) Lack of duty to perform D) Contributory negligence Answer: A Te rms: Support a finding of constructive fraud Diff: Mode rate Objective : LO 5-3 AACSB: Analytic skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 20) Which of the following statements is true? A) Gross negligence may constitute constructive Fraud requires the fraud intent to deceive Yes Yes All fraud should be detected during audit No B) Gross negligence may constitute constructive fraud No Fraud requires the intent to deceive Yes All fraud should be detected during audit No C) Gross negligence may constitute constructive fraud Yes Fraud requires the intent to deceive No All fraud should be detected during audit Yes D) Gross negligence may constitute constructive fraud No Fraud requires the intent to deceive No All fraud should be detected during audit No Answer: A Te rms: Gross ne glige nce , fraud, and constructive fraud Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills 21) When performing an audit the CPA is required to: A) exercise the level of care of a reasonably prudent CPA B) strictly adhere of GAAS C) strictly be liable for detection of material misstatements in the financial statements D) avoid gross negligence in the performance of their duties Answer: A Te rms: Performing an audit CPA re quire d to Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 22) Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant Elise was negligent while auditing several of the firm's clients Under these circumstances, which of the following statements is true? A) Elise would have no personal liability for negligence B) Gregory & Hedrick is not liable for Elise's negligence because CPAs are gen erally considered to be independent contractors C) Gregory & Hedrick would not be liable for Elise's negligence if Winters disobeyed specific instructions in the performance of the audits D) Gregory & Hedrick can recover against its insurer on its malpractice policy even if one of the partners was also negligent in reviewing Elise's work Answer: D Te rms: Auditor ne glige nt while auditing Diff: Challe nging Objective : LO 5-3 AACSB: Re flective thinking skills 23) Define ordinary negligence, gross negligence, and constructive fraud Answer: Ordinary negligence is the absence of reasonable care, whereas 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 Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or to harm It is also termed reckless, in the case of an audit 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 Te rms: Ordinary neglige nce , gross neglige nce , and constructive fraud Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 24) 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 Te rms: Contract law; Third-party be ne ficiary doctrine Diff: Easy Objective : LO 5-3 AACSB: Re flective thinking skills 25) 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 harm In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive Te rms: Constructive fraud and fraud Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 26) 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 Te rms: Joint and seve ral liability and se parate and proportionate liability Diff: Mode rate Objective : LO 5-3 AACSB: Re flective thinking skills 10 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 11) The basic legal concept which was affirmed in the 1985 New York case, Credit All iance, was that: A) the auditor's defense of privity of contract is still valid against third parties B) the auditor is liable for ordinary negligence to specifically foreseen third parties C) the auditor is liable for ordinary negligence to reasonably foreseeable third parties D) the auditor's defense of contributory negligence is no lon ger valid Answer: A Te rms: Basic le gal conce pt affirme d in 1985 case , Cre dit Alliance Diff: Challe nging Objective : LO 5-5 AACSB: Analytic skills 12) The partnership of Booth & Haynes, CPAs, has been engaged to examine the financial statements of Paul, Inc., in connection with the registration of Paul's securities with the Securities and Exchange Commission Under these circumstances, which of the following statements is true? A) Booth & Haynes is assuming much greater third-party liability than it assumes on engagements under common law B) If its examination is not fraudulent, Booth & Haynes may issue an appropriate disclaimer to the financial statements and thereby avoid liability C) Booth & Haynes must incorporate if they wish to practice before the SEC D) Booth & Haynes must be a large interstate firm if they wish to practice before the SEC Answer: A Te rms: CPAs engage d to e xamine financial stateme nts in connection with re gistration of securitie s with the Securities and Exchange Commission Diff: Challe nging Objective : LO 5-5 AACSB: Analytic skills 13) 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? A) He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees B) He would have no liability because privity of contract is lacking C) He would be liable for losses attributable to his negligence D) He would be liable only if it could be proven that he was grossly negligent Answer: C Te rms: Unde r common law, e xtent of liability whe re auditor faile d to adhe re to ge ne rally acce pte d auditing standards in e xamination of clie nt and faile d to de tect e mployee e mbe zzle ment Diff: Challe nging Objective : LO 5-5 AACSB: Analytic skills 22 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 14) Three approaches to the application of the foreseen users' concept are (1) the C redit 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 Te rms: Three approaches to the application of foreseen use rs' conce pts; Cre dit Alliance approach; Restateme nt of torts approach; foreseeable use r approach Diff: Challe nging Objective : LO 5-5 AACSB: Re flective thinking skills 15) Of the three approaches to applying the concept of foreseen users (C redit Alliance approach, restatement of torts approach, and foreseeable user approach), the approach followed by the most states is the Credit Alliance approach A) True B) False Answer: B Te rms: Cre dit Alliance approach; Restateme nt of torts approach; Foreseeable use r approach Diff: Mode rate Objective : LO 5-5 AACSB: Re flective thinking skills 16) The restatement of torts approach to the concept of foreseen users states that any users that the auditor should have reasonably been able to foresee as being likely users of financial statements have the same rights as those with privity of contract A) True B) False Answer: B Te rms: Restate ment of torts approach; Foreseen users; Privity of contract Diff: Challe nging Objective : LO 5-5 AACSB: Re flective thinking skills 23 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 17) The C redit 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 A) True B) False Answer: A Te rms: Cre dit Alliance approach; Foresee n users; Liability to third parties Diff: Challe nging Objective : LO 5-5 AACSB: Re flective thinking skills Learning Objective 5-6 1) Which of the following required an adequate system of internal control for SEC registrants? A) Sarbanes-Oxley Act of 2002 B) Securities Act of 1933 C) Foreign Corrupt Practices Act of 1977 D) Securities Act of 1934 Answer: C Te rms: Require d an adequate system of inte rnal control for SEC re gistrants Diff: Easy Objective : LO 5-6 AACSB: Re flective thinking skills 24 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 2) The increased litigation under the federal securities laws has resulted from: A) The strict liability standards The availability of class-action imposed on CPAs by the litigation securities laws An excess of attorneys Yes Yes Yes B) The strict liability standards imposed on CPAs by the securities laws No An excess of attorneys No The strict liability standards The availability of class-action imposed on CPAs by the litigation securities laws Yes Yes An excess of attorneys No The availability of class-action litigation Yes C) D) The availability of class-action litigation No The strict liability standards imposed on CPAs by the securities laws No An excess of attorneys No Answer: C Te rms: Increase d litigation unde r fe deral securities law resulte d from Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 3) Under the Securities Act of 1933, the auditor's responsibility for making sure the financial statements were fairly stated extends to: A) the date of the financial statements B) the date the registration statement becomes effective C) the date of the audit report D) on e year beyond the date of the financial statements Answer: B Te rms: Securities Act of 1933; Auditor responsibility for making sure financial state ments we re fairly state d e xte nds Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 25 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 4) Under the Securities Exchange Act of 1934, which type of organization is required to submit audited financial statements to the SEC? A) Every company with securities traded on national and over -the-counter exchanges B) Every corporation C) Every company issuing new securities D) Every corporation which is chartered by a state government Answer: A Te rms: Securities Act of 1934; Organizations require d to submit audite d financial state ments Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 5) The Securities and Exchange Commission can impose all but which of the following sanctions? A) Suspend a CPA from auditing SEC clients B) Prohibit a CPA from accepting new SEC clients for a period of time C) Require a CPA to participate in continuing-education programs and make changes in their practice D) Revoke a CPA license Answer: D Te rms: Securities and Exchange Commission can impose sanctions Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 6) The Foreign Corrupt Practices Act (FCPA) of 1977: A) requires auditors to review and evaluate systems of internal control as a part of an audit B) requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control 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 D) requires auditors to file a report with the SEC if client's internal control system is inadequate Answer: B Te rms: Fore ign Corrupt Practices Act of 1977 Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 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? A) The Sarbanes-Oxley Act of 2002 B) The Racketeer Influenced and Corrupt Organization Act C) Th e Federal False Statements Statute D) The Federal Mail Fraud Statute Answer: A Te rms: Fore ign Corrupt Practices Act of 1977; Inte rnal control provisions Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills Topic: SOX 26 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 8) Which of the following is not likely a factor in the increase in the number of lawsuits and sizes of awards to plaintiffs related to auditor behavior? A) Increased awareness of auditor responsibilities by users of financial statements B) CPA firms are more willing to settle lawsuits C) Difficulty judges and jurors have in understanding legal matters D) Increased consciousness on the part of the SEC for its responsibility to protect investors Answer: C Te rms: Factor in increase in numbe r of lawsuits and sizes of awards Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 9) A major purpose of federal securities regulations is to: A) provide sufficient reliable information to the investing public who purchase securities in the marketplace B) establish the qualifications for accountants who are members of the profession C) eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public D) provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission Answer: A Te rms: Major purpose of fe de ral securities re gulations Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 10) The leading precedent-setting auditing case in third-party liability is: A) Escott et al v Bar Ch ris Construction Corp B) Hochfelder v Ernst & Ernst C) Ultramares Corporation v Touche D) United States v Simon Answer: C Te rms: Leading prece de nt-se tting auditing case in third-party liability Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 11) Which of the following statements about the Securities Act of 1933 is not true? 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 B) A third-party user does not have the burden of proof that he/she relied on the financial statements C) A third-party user has the burden of proof that the auditor was either negligent or fraudulent in doing the audit D) A third-party user does not have the burden of proof that the loss was caused by the misleading statements Answer: C Te rms: Securities Act of 1933 Diff: Challe nging Objective : LO 5-6 AACSB: Analytic skills 27 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 12) The most significant audit issue that came as a result of the court decision in the Escott et al v Bar Chris Construction Corporation case in 1968 was: A) the court's reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent B) the affirmation of the increased auditor's responsibility when performing an S-1 review, a review of events subsequent to the balance sheet, for registration statements C) the increased auditor responsibility when associated with unaudited financial statements D) the court's refusal to allow the percentage-of-completion method of accounting for revenues Answer: B Te rms: Significant audit issue from Escott e t al v Bar Chris Construction Corporation case in 1968 Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 13) Under the federal securities acts, one significant result occurring directly due to the Escott et al v Bar Chris Construction Corporation case was that SAS was changed to require: A) greater emphasis on subsequent events procedures B) new standards for unaudited statements C) a broader definition of third-party beneficiaries D) more companies to file annual reports with the SEC Answer: A Te rms: Significant result from Escott e t al v Bar Chris Construction Corporation case Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 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: A) 8-K form B) 10-K form C) 10-Q form D) S-1 form Answer: B Te rms: Securities Exchange Act of 1934 Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 15) Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as: A) the antifraud provisions B) the new issues provisions C) the full-employment act for accountants D) the RICO provisions Answer: A Te rms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 28 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 16) In a leading securities law and CPA liabilities case, the U.S Supreme Court r uled 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, what would be required to be shown to the court was the auditor's: A) ordinary negligence B) gross negligence C) knowledge and intent to deceive D) financial gain at the expense of the plaintiff Answer: C Te rms: Securities Exchange Act of 1934 Rule 10b-5; U.S Supre me Court rule d in 1976 in Hochfe lde r v Ernst & Ernst Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 17) The Sarbanes-Oxley Act of 2002 makes it felony to destroy or create documents to impede or obstruct a federal investigation Those provisions were adopted following which of the following legal cases? A) United States v Natelli B) United States v Andersen C) ESM Government Securities v Alexander Grant & Co D) United States v Simon Answer: B Te rms: Similarity be twee n Unite d States v Nate lli case (i.e , the National Stude nt Marke ting case of 1975), and the ESM Gove rnment Securities v Ale xande r Grant & Co case of 1986 Diff: Challe nging Objective : LO 5-6 AACSB: Analytic skills 18) The Securities and Exchange Commission has authority to: A) prescribe specific auditing procedures to detect fraud concerning inventories and accounts receivable of companies engaged in interstate commerce B) deny lack of privity as a defense in third-party actions for gross negligence against the auditors of public companies C) determine accounting principles for the purpose of financial reporting by companies offering securities to the public D) require a change of auditors of governmental entities after a given period of years as a means of ensuring auditor independence Answer: C Te rms: Securities and Exchange Commission authority Diff: Challe nging Objective : LO 5-6 AACSB: Re flective thinking skills 29 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 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 un ethical or improper professional conduct Te rms: Sanctions the Securities and Exchange Commission can impose on auditors Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 20) One result from the Escott et al v Bar Ch ris case was a greater emphasis being placed on audit staff understanding the client's business and industry A) True B) False Answer: A Te rms: Result from Escott e t al v Bar Chris Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 21) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities A) True B) False Answer: A Te rms: Securities Act of 1933 Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 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 A) True B) False Answer: A Te rms: Securities Act of 1933; Burde n of proof Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 30 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 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 A) True B) False Answer: B Te rms: Securities Act Commission; Securities trade d on national e xchanges Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 24) The same three defenses available to auditors in common lawsuits by third parties -non-negligent performance, lack of duty, and absence of causal connection–are also available for suits under the Securities Exchange Act of 1934 A) True B) False Answer: A Te rms: Securities Act of 1934; De fe nses available to auditors in common law suits by third parties Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 25) The United States Supreme Court has ruled that outside professionals such as accountants who don't help run corrupt businesses cannot be sued under the provisions of the Foreign Corrupt Practices Act A) True B) False Answer: B Te rms: Unite d States Supreme Court; Fore ign Corrupt Practices Act Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 26) The Foreign Corrupt Practices Act of 1977 allows an injured party to seek treble (triple) damages and recovery of legal fees in cases where it can be demonstrated that the defendant was engaged in a pattern of fraudulent activity A) True B) False Answer: B Te rms: Fore ign Corrupt Practices Act of 1977 Diff: Mode rate Objective : LO 5-6 AACSB: Re flective thinking skills 31 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com Learning Objective 5-7 1) In which case were auditors prosecuted for filing false financial statements for a client with the government? A) 1136 Tenants case B) United States v Simon case C) Escott et al v Bar Chris case, aka Bar Chris D) Ultramares Corporation v Touche case Answer: B Te rms: Case where auditors we re prosecute d for filing false financial state ments Diff: Mode rate Objective : LO 5-7 AACSB: Re flective thinking skills 2) A CPA is subject to criminal liability if the CPA: A) refuses to turn over requested audit documentation to a client B) performs an audit in a negligent manner C) willfully omits a material fact from a set of financial statements D) willfully breaches a contract with a client Answer: C Te rms: CPA subje ct to criminal liability Diff: Mode rate Objective : LO 5-7 AACSB: Re flective thinking skills 3) Which of the following best describes a trend in litigation involving CPAs? A) A CPA cannot render an opinion unless the CPA has audited all affiliates of a company B) A CPA may not successfully assert that the CPA had no motive to be part of a fraud C) A CPA may be exposed to criminal as well as civil liability D) A CPA is primarily responsible for a client's footnotes filed with the SEC Answer: C Te rms: Trend in litigation involving CPAs Diff: Mode rate Objective : LO 5-7 AACSB: Re flective thinking skills 32 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 4) CPAs can be held liable for criminal activity under both state and federal laws Infamous cases have involved United States vs Natelli and ESM Government Securities v Alexander Grant and Co Discuss what occurred and prepare a summary of the court findings 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 Te rms: CPAs he ld liable for criminal activity and fe de ral laws; Infamous cases Diff: Mode rate Objective : LO 5-7 AACSB: Re flective thinking skills 5) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to 10 years in prison A) True B) False Answer: B Te rms: Sarbanes-Oxle y Act of 2002; Destruction of audit documentation punishable Diff: Challe nging Objective : LO 5-7 AACSB: Re flective thinking skills Topic: SOX 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? A) Private Securities Litigation Reform Act B) Public Securities Damages and Settlements Act C) Racketeer Influenced and Corrupt Organization Act D) U.S Securities Claims Reform Act Answer: A Te rms: Fe de ral law passé in 1995 significantly re duce d pote ntial damages Diff: Challe nging Objective : LO 5-8 AACSB: Re flective thinking skills 33 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 2) The Private Securities Litigation Reform Act of 1995 reduced potential damages in securities -related litigation, but because the act applied only to federal courts, attorneys began taking cases to state courts Which of the following eliminated this loophole? A) Private Securities Litigation Reform Amendment B) Securities Litigation Uniform Standards Act of 1998 C) Racketeer Influenced and Corrupt Organization Act D) U.S Securities Claims Reform Act Answer: B Te rms: Private Securities Litigation Re form Act of 1995; Eliminate d loophole Diff: Challe nging Objective : LO 5-8 AACSB: Re flective thinking skills 3) Discuss at least 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: • Improve auditing to better meet users' needs • Standard and rule setting and revisions to meet the changing needs of auditing • Oppose lawsuits • Educate investors and other users of financial statements as to the meaning of the opinion of the auditors and the nature of the auditor's work • Sanction members for improper conduct and performance • Lobby for changes in laws • Educate users about the limits of auditing Te rms: Ste ps the AICPA and accounting profession taking to re duce practitione r's e xposure to lawsuits Diff: Mode rate Objective : LO 5-8 AACSB: Re flective thinking skills 34 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com 4) Match eight of the following terms (a-n) with the definitions provided below (1-8): a b c d e f g h i j k l m n Foreign Corrupt Practices Act Securities Exchange Act of 1934 Securities Litigation Uniform Standards Act of 1998 Securities Act of 1933 Ultramares doctrine Audit risk Audit failure Standards failure Business failure Absence of causal connection Contributory negligence Lack of duty to perform Private Securities Litigation Reform Act Nonnegligent performance A situation in which an incorrect audit opinion is issued because it failed to comply with the requirements of auditing standards A federal statute dealing with companies that trade securities on national and over -thecounter exchanges Auditors are involved because the annual reporting requirements include audited financial statements 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 A federal statute that makes it illegal to offer a bribe to an official of a foreign country 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 A federal statute designed to significantly reduce the potential damages in federal securities related litigation by providing for proportionate liability in most cases An auditor's legal defense under which the auditor claims that the audit was performed in accordance with generally accepted auditing standards An auditor's legal defense under which the auditor claims that the failure to follow audi ting standards did not cause the damages suffered by the client 35 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall To Todownload downloadmore moreebooks, ebooks,slides, slides,SM SMand andTB TBvisit: visit:http://downloadslide.blogspot.com http://downloadslide.blogspot.com Answer: g b k a e c n j Te rms: Audit failure ; Securities Exchange Act of 1934; Contributory ne glige nce ; Fore ign Corrupt Practices Act; Securities Litigation Uniform Standards Act of 1998; Ultramares doctrine ; Nonneglige nt performance; Abse nce of causal connection Diff: Mode rate Objective : LO 5-2, LO 5-5, LO 5-5, LO 5-6 and LO 5-8 AACSB: Re flective thinking skills 5) Discuss some of the steps individual 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 • Hire qualified personnel and train and supervise t hem properly • Follow the standards of the profession • Maintain independence • Understand the client's business • Perform quality audits • Document the work properly • Obtain an engagement letter and a representation letter • Maintain confidential relations • Carry adequate insurance • Consult with experienced legal counsel • Choose a form of organization that provides some form of legal liability protection to owners • Exercise professional skepticism Te rms: Ste ps auditors can take to minimize le gal liability Diff: Easy Objective : LO 5-3 and LO 5-8 AACSB: Re flective thinking skills 6) The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to the amount of the audit fees charged A) True B) False Answer: B Te rms: Private Securities Litigation Re form Act of 1995 Diff: Easy Objective : LO 5-8 AACSB: Re flective thinking skills 36 Copyright © 2012 Pearson Education, Inc publishing as Prentice Hall ... client paid last year's audit fees 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 C) a CPA firm's failure... Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement Te rms: Contract law; Third-party be ne ficiary doctrine Diff: Easy Objective... caused by the defendant's negligence is called: A) separate and proportionate liability B) joint and several liability C) shared liability D) unitary liability Answer: A Te rms: Assessment against